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Inflation should drive changes to minimum wage, not your employee’s salaries.

February 13, 2024

Speak to 100 people and 99 will say the same thing: when inflation goes up, my salary should, too.

If that sentiment was owned by someone on the minimum wage, they’d be right. The minimum wage ensures a basic standard of living and should track inflation, which measures changes to that standard. However, salaries are determined by the free market for talent, not inflation.

While sentiment influences salary supply and demand, inflation and salaries are distinct markets.

Companies using inflation for salary adjustments may pay their people out of line with the job market, causing attrition or unnecessary expense.

Companies must look to the job market to determine reasonable salary adjustments, ensuring parity with their chosen pay position – ignoring inflation.

Markets and Inflation 101

First, let’s unpack what a market is. According to Google, a market is any place where two or more parties can meet to engage in an economic transaction.

Transactions in a market used to occur via bartering, where goods or services were traded without using modern currency.

Even when cows were traded for magical beans, supply and demand dictated relative value. In its simplest form, it explains that when one outmatches the other, it influences value. With bartering, one cow was worth three beans. Today, currency represents that value, and a cow requires a specific amount of money to be bought, instead of an exchange of comparable goods or services.

What does supply and demand look like in action? If you’re an ACME products maker, and there are more products than buyers, supply is high and demand is low. This often leads to reducing the price until demand matches supply. When this dynamic flips, so that supply is low and demand is high, you can raise the price to the extent that someone is willing to pay.

This supply/demand force influences the price of goods and services, and it’s common for things to increase in price over time, so we refer to the aggregate change in goods and services over time as ‘inflation’. The technical term for tracking this change is the Consumer Price Index or CPI.

The CPI is determined by tracking the price of a ‘market basket’ of commonly traded items over time. The cumulative price change of this basket determines if the CPI goes up or down. For example, if our basket is $5 this year and $5.50 the next, the cost of living has increased by 10% (0.5 / 5 = 0.1 or 10%).

When it comes to CPI, inflation is a result of excess money (demand) and limited supply, prompting suppliers to raise prices to capitalise on demand or due to increased costs. Inflation is corrected by reducing the purchasing power of buyers. When fewer people can afford something, suppliers stop raising or even lower the price, stabilising or reducing the cost of living or CPI.

Many factors influence supply and demand in the market and can change CPI. Fortunately, we don't need an economics degree to understand all of it. Having this high-level overview will help us understand how the concept relates to what people are paid.

Inflation and the minimum wage

In a philosophical sense, the minimum wage forms the currency-based embodiment of the base standard of living we believe someone in our society should maintain.

If society agrees that a roof over your head, access to healthcare, and food on the table should be guaranteed regardless of your job, then the minimum wage should reflect that standard.

The CPI reflects a change in the cost of living and directly impacts the ability of someone on minimum wage to achieve the standard of living we set out. So, any change to CPI should translate to a change in the minimum wage. When CPI rises, the minimum wage increases; when CPI falls, it decreases. Although the minimum wage determination is much more complex than this in reality, this should be the fundamental principle.

Is the minimum wage all things to all people? No, but nor should it be, as it can interfere with the environment that a free market seeks to create.

Let’s look at an example of the minimum wage in a metropolitan vs regional setting. Is the minimum wage going to achieve the same standard of living in the city as compared to somewhere more regional? No. But that, too, can be adjusted by the forces of supply and demand. If there are minimum wage jobs in the city but someone cannot afford to live there due to the increased cost of living, they are motivated to either get a higher paying job in the city or to secure a minimum wage job in a more regional location, where their dollar can stretch further and that lifestyle be achieved. If the employers requiring such labour find there is a shortage, they must pay more to attract and keep that talent. Supply and demand at work.

While a base standard of living might be the philosophical goal of the minimum wage, it doesn’t necessarily mean that it’s a comfortable life. In fact, in almost all cases the opposite is true. Therefore, only the most basic of needs are met, which acts as an incentive to increase one’s earning capacity through the attainment of further skills and experiences, and to secure a role that pays a higher rate and affords a higher quality of life.

To do so, someone is likely to garner skills and experiences that are in demand from employers. And here is where we are introduced to a second market that drives the price of labour — the jobs market.

The jobs market

When someone has a very particular set of skills, skills that are sought after by employers, they possess something that has a more limited supply than unskilled labour and is therefore in higher demand from employers. This means they get to shift the price (salary) for their skills up towards the limits of what employers are willing to pay.

Many employers subscribe to salary surveys that report on those with the same skillset to learn what salary a person would expect. These salary surveys therefore seek to capture and report on the going rate for skills in what is fundamentally the jobs marketplace.

If companies are desperately seeking a set of skills for their business, they will pay a higher salary to secure those skills and deliver on those business needs. On the contrary, when a set of skills becomes obsolete or talent is in higher supply than the companies demanding it, they can pay less because those people might otherwise be unable to secure employment. This is what largely drives the fluctuations of salaries around the world.

By adjusting someone’s salary in direct response to the rate of inflation, a company is applying the change in the price of goods and services for a consumer, to a separate market for the price of labour. Two key things are wrong with this approach:

  1. We already know inflation is a way of markets correcting for there being too much money in a marketplace. By continuing to perpetuate a higher purchasing power (more people with more money), companies create a cat-and-mouse effect of salaries chasing the rate of inflation, with each driving the other higher.
  2. By changing someone’s salary independent of the supply and demand for those skills, companies risk over or underpaying their people relative to the actual market for their skills.

Let’s see what number 2 looks like in practice.

What happens when salaries change with CPI?

Let’s say you’ve hired Liam Neeson for $100,000 to do what he did in Taken but for all your clients who have kidnapped family members.

Liam Neeson has a very particular set of skills

If we’re increasing salaries with CPI in this scenario, let’s go ahead and do that by assuming a very reasonable year-on-year rate of 3% inflation. If you’re increasing salaries in line with inflation, after 5 years of the same CPI, you’re paying a salary of about $116k or a cumulative increase of $47k over those 5 years. Seems reasonable.

What if the going rate other companies were paying for that ‘particular set of skills’ was higher or lower? Let’s explore both.

If the set of skills were so particular and niche that more companies were demanding it — let’s assume a year-on-year increase of 6% — in year 5, that rate at other companies is now $134k to your $116k. Liam Neeson is now incentivised to go to your competitor and retrieve all of their kidnapped family members, leaving yours un-rescued — that’s not good for your clients.

If the rate of kidnappings is decreasing and there are many people with the skills but nowhere to go, then the skill has stagnated. If this is the case, and everyone else is still paying $100k, you’re now paying a premium — this might push your costs higher than your clients are willing to pay when they could get the same service elsewhere for cheaper. If you were to hire his role again today, you would pay much less. To a degree, this is something most companies are (and should be) willing to stomach because of course Liam Neeson has the depth of experience in the company now that a new person doesn’t. The question though, is how much is that worth if you continue to increase the gap between his salary and the cost to hire a new person with that same set of skills?

A table showing the different salary when increases happen in line with CPI or the jobs market

Therein lies the main problem with salaries following CPI as a mechanism for awarding compensation increases, they detach people from the market for their skills.

What does this mean for employers?

Companies should instead ensure that they align their people’s salaries to the market for jobs and not the market for goods and services.

To do this, establish strong practices for assessing the jobs market and aligning your people’s salaries. Strong means:

  • Developing a compensation philosophy to choose where you pay in the market — define whether you lead (pay more), meet (pay median) or lag (pay less) the market and why.
  • Implementing job levelling to ensure that you’re clear on what makes up a role in your organisation, and to ensure you’re comparing them to similar roles in the market. And lastly,
  • Accessing reliable salary data from which to benchmark, and to ensure you stay informed about where you pay in comparison to others and in alignment with your philosophy.

From here, continue to align your people’s salaries with their benchmark at whatever cadence your business chooses and is set out in your comp philosophy.

“But my employees keep talking about inflation being high, what do I do?” First, educate them on the differences between these two markets, and how your organisation sets its pay practices. Educating people on the mechanisms behind company pay determinations is the best way to prevent them from raising it as an issue because it creates a channel through which they can take direct action. Help them understand how they can influence their earning capacity through skills and career growth.

If it’s within a company’s interest to provide cash-based cost of living relief, then one-off payments are the best method, not permanently increasing salaries and creating the issue raised above.

What does this mean for employees?

This might all be surprising to you if you’re an employee. Many organisations fail to illustrate the connection between salaries and markets that you’ve just spent time reading about. There is a common argument from those who see rising inflation and stagnant salaries that “my salary is going backwards”.

And while yes, your ability to buy the things that are reportedly increasing in price has diminished, in reality, inflation is a deeply personal thing. What comprises a market basket may not be what you as an individual purchase yourself, and it’s important to confirm it for yourself vs just taking the word of what is being reported.

If your purchasing power is decreasing, or you just want to increase your lifestyle, then the antidote is the same as it was for those on minimum wage — attain skills and experiences that place you in higher demand.

It’s always good to explore how you can do this with your current employer first. Start to learn about what dictates pay at your company and use it as a path to increasing your income. If you aren’t familiar with it already ask for information on your company’s compensation philosophy. Familiarise yourself with the job levelling framework and your place on it. What does it take to get to a higher level? What criteria does your company look at for increasing pay? Use this as your roadmap for increasing your salary and keeping ahead of the inevitable trend of inflation.

Conversely, if your company lacks these essential elements and you are unable to extract them from a conversation with your leader or the People team, it is time to explore opportunities outside your current company to enhance your earning potential. It is crucial to always be aware of your value. Assessing the value of your skills in the marketplace has never been easier with the multitude of online salary databases available. If you can find a similar salary elsewhere but with improved conditions, discuss this with your employer to determine if they are willing to offer a market premium to retain you. However, ultimately, updating your CV and engaging with other companies will provide the best opportunity to discover what they are willing to offer. If their offer is no different from your current situation, then it is time to invest in yourself so that they will recognise your worth and invest in you.

Wrapping it up

Commercial People professionals must be across the spectrum of things that influence workforce salaries. Aligning your people’s salaries with the job market ensures fair compensation, it avoids the risks of adding increased cost to your business and it ensures your people are paid in alignment with the market — reducing attrition.

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