Managing the Impact of Inflation on Salaries

The dangers of buying into the wage-price spiral

As Ian Harper, Professor of Economics at Melbourne Business School, confirms, organisations are facing pressure to accept the rising cost of labour on the assumption they can be compensated for this by raising prices.

“We see unemployment at a 50-year low and labour force participation has never been higher,” he says. “There is one vacancy for every unemployed person, and we are already seeing substantial wage hikes in certain quarters, such as professional and financial services, and mining. We would certainly expect to see rates of inflation built into wage demands and enterprise bargaining agreements, and we’re seeing both the media and businesses saying they’re making money and are short of labour, so the solution is to put salaries up.

“However, this thinking and behaviour can lead to a wage-price spiral,” he adds. “Once it gets a grip and becomes part of people’s psychology, it’s hard to shake. Businesses have found it hard to raise prices for so long because inflation has been low for around three decades. It can be tempting to jump on the bandwagon, raise prices and blame rising labour, energy or transport costs. The question is: will the market sustain that? The answer is yes if everyone is doing the same thing. But this ends up reducing real incomes for Australians, so they demand more pay rises and we get into a situation where inflation becomes self-fulfilling and entrenched, as we saw in the 1970s and 80s.”

However, Professor Harper warns organisations of the danger in getting caught up in this assumption that rising wage costs will be absorbed by customers rather than eroding profit margins. “You can build these costs in and then discover you’re out on a limb,” he says. “You tick and flick, paying higher costs imposed by your talent and your suppliers only to discover you can’t pass them on. You need to be vigilant about this and do your homework on costs and prices your market can bear before you agree to anything.”

Rising inflation means a conversation around salaries is now urgent

In late 2019, Australia was experiencing the lowest official wages growth on record. When the pandemic hit, this led to economic uncertainty resulting in another sharp fall in wages growth to below 1.5 per cent, before rebounding back to pre-pandemic levels in late 2021.[2]

With this persistently low level of wage increases, it is no surprise that employees are now pressing for higher salaries, either with their existing employers or by looking for a better offer elsewhere. In the context of a more competitive job market and the rising cost of living, they have a strong case for their demands.

For employers, this can have a ‘ripple effect’. When employees exit an organisation, their positions need to be backfilled, forcing their employer to pay the ‘new hire premium’ to attract fresh talent to replace them. While organisations would be wise to ensure their overall salary spend stays within a budget that can be supported by their earnings, they are under increasing pressure to meet the market on pay expectations.

Salary budgets across most sectors have risen in the short term

When looking at data aggregated from Aon’s 2022 remuneration reports, we see a clear trend for forecast salary increases from 2022 to 2023. All sectors – except IT and consulting engineering – are expecting a larger percentage increase in their salary budget for the coming year. With candidates being hired at higher salaries, this raises the bar for compensation levels for existing employees.

Source: Aon’s Australian Remuneration Reports 2022

Employee pay should be set by market supply and demand for labour – not the cost-of-living

Many organisations consider the rate of inflation when determining annual budgets. Afterall, no-one wants to be accused of sending real wages backwards without good reason.

Tying salary increases to the inflation rate can create systemic problems, such as overpaying or underpaying employees in certain roles or industries, pay disparity within the organisation, and the need for review and implementation mechanisms to moderate salary increases when economies stabilise. Aon’s recent analysis of over 1300 organisations[1] found the majority of organisations, while having to lift salary budgets compared with recent years, are keeping increases below inflation. Only a handful of organisations included in the 2022 Aon Australian General Industry Remuneration Report are setting their salary budgets at or above inflation.

Organisations that grant pay adjustments to account for inflation should exercise prudence in designing programs and practices that are variable in nature and can be unwound where permitted by local statutes. This ensures they are not bound to unusually high levels of compensation, while still accommodating employees seeing varying levels of real wage deflation.

While in the past, a 3 percent per year increase was considered the norm, this is no longer the case. Each industry and company will have its own unique pattern, making it imperative for employers to consistently analyse the market, study available data and determine their own best path forward.

Now is the time to put a remuneration strategy in place

Companies may want to exercise caution when raising salary budgets or using other compensation tools like sign-on bonuses, spot bonuses and counter offers in response to inflation and high turnover.

Unless there is a review of existing employees’ pay, organisations that hire at rates above the market median could create inequity and disengagement with existing employees as a result.

In the current market, however, it may be unrealistic to ignore short term pressure to raise salaries. One approach is to allocate one budget for remuneration reviews and another for dealing with challenges, such as securing in-demand talent or counter offers to avoid unexpected resignations.

This is an approach that can become expensive, so it is essential to develop a strategy that is informed by robust internal and external data, which can help you prioritise and build a business case for additional funding.

Are you paying the same or less than competitors?

Understanding your market for talent and what’s happening in that market are critical first steps in developing a sustainable remuneration strategy. Your pool of talent may no longer be sector-specific. Organisational proficiency in new areas like cognitive flexibility, critical thinking, and complex problem-solving are increasingly in demand for every type of organisation.

The data on turnover demonstrates that every sector is now competing for talent, which means you may need to expand your market for talent when considering how competitive you are on pay. Particularly in a hyper-competitive job market, sourcing new ‘pools’ of talent may become a necessity.

Source: Aon’s Australian Remuneration Reports 2022

A considered and transparent process can support talent retention strategies

Achieving fair and reasonable pay for key contributors supersedes the impossible goal of universal satisfaction with pay increases during challenging times. After all, remuneration budgets are not limitless. An organisation that communicates to employees how pay increases connect to the company’s compensation philosophy and process can better manage employee expectations and meet demands for fairness.

Making remuneration decisions without detailed information could mean your organisation spends too much on talent or fails to attract in-demand skills, putting you behind the competition. Remuneration reports help organisations interpret and respond to employment market data, so they can make informed decisions that help improve business and talent management outcomes.

Learn about Aon’s remuneration reports and research, and how we can help here.

[1] Aon Australian General Industry Remuneration Report, November 2022

[1] https://aoninsights.com.au/the-great-resignation-or-the-great-re-alignment/

[2] https://aoninsights.com.au/what-is-really-happening-with-wages-growth-in-australia/#continue