The consumer price index (CPI) rose 8.5 percent over the last 12 months — the highest inflation the US market has seen in more than 40 years. This, combined with a strong job market, has heightened employee expectations for increased compensation this year; and employers are responding.

Wages are on the rise. According to Mercer’s US Compensation Planning Survey, the average 2022 merit increase budget is 3.4 percent, with total increases (including other types of base pay increases, such as promotional awards) reaching 3.8 percent. These are the highest budgets we’ve seen since the 2008 financial crisis. However, they don’t paint the full picture of wage increases. The hot job market has led many employers to resort to off-cycle increases (outside the annual merit cycles) and adjustments to starting wages. When comparing the average base pay per employee from 2021 to 2022, wages increased an average of 4.9 percent. This was most pronounced in industries such as retail, where wages increased an average of 7.7 percent per employee, largely due to companies increasing their internal minimum wage in response to a fast-moving job market. Regardless of the compensation increase figure you look at, none are rising near the level of inflation — creating much angst for employees.

The Inflation-Compensation Connection

Sky-rocketing prices have begun to raise many questions from US employers on how to manage compensation budgets in times of high inflation. To address this question, it’s helpful to examine how compensation budgets have been impacted by rising inflation in years past. The short answer is: they haven’t.

Looking back over the last two decades, the inflation rate has been low — most commonly between 0 and 2 percent, while merit budgets have remained relatively stable at around 3 percent.

In the 1980s, most employers moved away from cost of living wage increases and instead focused on cost of labor — the market rate for the job being performed. Cost of labor is a function of supply and demand, and is typically measured through compensation surveys that contain the “going rate” for jobs. For most employers, cost of living increases are a thing of the past. The last remaining legacy of this historical practice is reflected in some labor contracts and collective bargaining agreements where wage increases remain indexed to CPI.

While in today’s period of high inflation this may seem disadvantageous to workers, the reality is that over the last two decades, this approach has delivered larger compensation increases to workers than it would have if budgets were indexed to CPI.

While inflation has had limited impact on compensation planning in recent history, it can play a larger role outside the US, where countries are more likely to experience hyperinflation or persistent and sustained high inflation as part of their economy (e.g., Turkey and Argentina in recent years). In these instances, companies may take action to offset the rising cost of inflation, such as lump sum awards for employees or more frequent salary reviews. For example, twice per year compensation increases have become the norm in Argentina.

In the US, however, it’s more likely the high inflation we are seeing today will be temporary, driven by supply shocks from COVID lockdowns and the Russia/Ukraine crisis, and that we’ll see a return to more “normal” levels of inflation. The Federal Reserve has already begun taking aggressive action for this to happen. As a result, while painful, at this point the US inflation levels have not risen to the level we typically see for wide-scale intervention in compensation programs.

What Can Employers Do?

We recommend employers consider three actions:

Close any gaps in competitiveness

In the US, however, it’s more likely the high inflation we are seeing today will be temporary, driven by supply shocks from COVID lockdowns and the Russia/Ukraine crisis, and that we’ll see a return to more “normal” levels of inflation.

While employers may not need to take broad-scale action on compensation due to inflation, action is warranted based on the conditions of the labor market. We are in the midst of a labor shortage in the US, and wages are moving up — especially for hourly pay. Now is the time for employers to close any gaps in competitiveness and keep a close pulse for fast-moving market segments. Most organizations address gaps in competitiveness over time through merit budgets, but the current labor market warrants a more aggressive approach to market adjustments to ensure that pay is competitive for all employees —not just in aggregate. The pace of change in the market may also warrant employers to make adjustments outside of the traditional annual pay cycles

Evaluate the impact of inflation on low wage workers

In our Inside Employees’ Minds research, “covering monthly expenses” was the number one concern of low wage workers, and it has become an even greater challenge amidst inflation as workers face escalating gas prices and more expensive grocery bills. Mercer’s 2022 Global Talent Trends found that organizations are increasingly placing emphasis on the sustainability of human capital, with one in three executives believing that delivering on good work standards such as fair pay or worker protection – will deliver the greatest ROI, and nearly nine in 10 HR leaders say that delivering on good work standards is a priority for HR.

We have seen this manifest through an emerging shift in approach to compensation setting for low wage workers. One in three organizations say they have, or plan to take, a living wage approach for hourly wages, according to Mercer’s Compensation Planning Survey. Consider whether starting wages require a boost — either overall or in select high-cost markets. With the potential for price hikes to be temporary, employers may alternatively consider lump sum awards to offset rising prices. For example, some companies have been considering stipends or allowances to help workers combat the rising gas prices.

Become more transparent around pay

Employees today see compensation as a “black box” and don’t understand how their pay is set. Rising wages due to the labor shortage, coinciding with periods of high inflation, have created confusion for employees. Employers have an opportunity to share with employees not only how pay levels are set, but also information on the market range for their role. Not only will this help better manage employee expectations around their pay in today’s difficult market, it will also help prepare and respond to heightened pay transparency requirements amidst ever-changing state laws.

Where do we go from here?

In summary, wages are going up, but inflation is not the trigger. As long as the economy and the job market remains strong, we’re likely to see continued upward pressure on higher wages, particularly with hourly workers and in certain industry sectors. With 11.3 million job openings, employees have options. And with the quit rate hovering near 20-year highs of 2.9 percent per month, employees are taking advantage. Don’t let pay be the reason your employees start to explore other opportunities. Take this opportunity to seal any cracks in your competitive position, increase pay transparency, and reassure employees that their pay is aligned with the external market — even if they don’t see their pay moving at the rate of inflation.

Looking for more information on making sure your pay strategy is competitive? Give us a call at 1-855-286-5302. Prefer to email? You can reach us at surveys@mercer.com.