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Action, reaction … or no action? How inflation influences pay practices

By Darryl Davis | February 8, 2022

Ask the right questions about CPI to balance the cost of your compensation programs with your market competitiveness.
Compensation Strategy & Design|Ukupne nagrade |Executive Compensation
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Successive waves of challenges that have little or no modern equivalent have battered people, companies and governments, and for two years much of the world has seemingly been at the mercy of the proverb, “May you live in interesting times.”

On top of that, starting in the second half of 2021, one challenge in particular gained attention across several markets: unexpected, sharp increases in consumer price inflation (CPI), with year-on-year (YOY) movements in some markets ending 2021 well above rates that were forecasted just three to six months prior. In other markets, current CPI trends represent as an all-too-familiar spectre where sharp price inflation is a regular occurrence. Regardless, as most employers face a mountain of numbers and pressures they are still wondering, “What do we do?”

To be clear, there is no single (or easy) answer. Exceptional challenges don’t change the fact that – at their best – reward programs and value propositions link organizations’ goals to the talent needed to achieve them while at the same time embodying organizational values and brand.

But by asking the right questions about CPI, employers can assess the markets in which they operate through the lens of their programs, practices and positioning. In turn, they can parse among various situations and needs and (hopefully) arrive at answers that are right for them. The following are key questions to consider.

How should we interpret CPI?

Broadly speaking, how employers around the world address CPI pressures depends on various factors:

  • The severity of the pressure, particularly the degree to which current CPI differs from the norm
  • The frequency of the issue (i.e., is this likely a one-off or a recurring problem?)
  • The expected duration of CPI pressures
  • Considerations of contagion and precedent (i.e., can the issue be isolated or will pressure to act spread and/or create an unwelcome precedent if the issue recurs?)

To an extent, some of the above factors boil down to historical context and markets’ prior experiences with inflation. In Figure 1, YOY movements in monthly CPI at the end of 2021 among G20 economies are presented against the background of the range of annual CPI movement during the 40 prior years. (Note: Country graphs are grouped based on the nature of their historical context, with ranges that include values less than 0% or more than 16% [shown in their own graphs for ease of analysis].)

Graph showing the range of annual average inflation (1980-2020) vs year-on-year monthly inflation (December 2021)
Figure 1. Average annual CPI 1980-2021 (P10-P90) vs 2021

1980-2020: statistical range (10th to 90th percentile) of average annual changes in CPI (source: Economist Intelligence Unit); 2021: YOY changes in CPI as of December 2021 (source: various national banks and government statistical offices)

The range of YOY increases at the end of 2021 is enormous, spanning 0.1% in Japan to 50.1% in Turkey, but where those rates fall within each country’s inflation experience over the past 40 years can be revealing. In some cases, CPI has rarely reached end-2021 YOY levels in that timeframe (Canada, United Kingdom). In other cases, the rate is just entirely out of range (Germany, United States).

Meanwhile, in markets with historical CPI issues, the 2021 rate may be well within their experience (Brazil, where the 90th percentile for the period 1980 to 2020 tops out at 994%). In other cases, end-2021 YOY levels were comparatively low (China, Japan) or even below the 10th percentile of experience (Indonesia).

In addition, certain regional similarities may be observed (Figure 2). For example, end-2021 CPI rates among countries in the Asia-Pacific region were all below their historical medians (and in some cases, well below). Meanwhile, Western Europe, Latin America and North America were universally above their historical medians, exceeding the 75th percentile in most cases and, in some cases, to extents not witnessed for 40 years.

Figure 2. 2021 CPI vs 1980-2020 (most recent year CPI reached or exceeded end 2021 levels)
Below 10th Percentile (P) Indonesia (2020)
P10-P25 China (2020)
P25-Median India (2020), South Africa (2020), Japan (2019), South Korea (2016), Russia (2015), Australia (2011)
Median-P75 Saudi Arabia (2020), Mexico (2011), Turkey (2002), Brazil (1996), Italy (1995)
P75-P90 Argentina (2019), Canada (1991), France (1991), United Kingdom (1991), Spain (1990)
Above P90 Germany (1981), United States (1981)

Excluding other possible influences, broadly speaking, markets with 2021 CPIs that are far beyond their norms are attracting a lot of attention. Any action, if taken, will be influenced by judgments around the persistence of elevated CPI levels and the competitiveness of pay offered. And, depending on the conclusions reached, that may lead employers to implement short- or long-term responses.

For example, end-2021 YOY rates for both Canada (4.7%) and Argentina (50.1%) fall in the same group (P75-P90). However, Canada’s CPI was the highest it has been in 30 years while Argentina last exceeded 50% CPI in 2019 (2007 was the last year Argentina recorded single-digit inflation).

Can we make projections?

One measure that reward professionals commonly use when setting pay increase budgets and making other decisions are CPI estimates and projections for the current year and the year to come. In many of the most developed markets, inflation largely has been a non-issue for some time, with modest differences between estimated and actual CPI.

For the time being, however, this isn't necessarily the case. Figure 3 depicts how monthly YOY CPI movements evolved in select markets between April and December 2021. In the United Kingdom, YOY increases roughly tripled over the period. Meanwhile, in Turkey, they nearly doubled in a single month (November to December 2021). Under current economic, business and social conditions, it may be necessary to monitor markets more closely, and/or adjust business models to account for higher price volatility.

Graph showing the evolution of 2021 year-on-year CPI projections (%; April-December 2021)
Figure 3. Evolution of 2021 YOY CPI projections

What else should we consider?

While doing nothing in response to a sudden problem in the hope that the problem goes away is an option, the particular circumstances of individual companies may necessitate a different response. Any such determination by employers of if, when and how to respond may include looking at:

  • Current market competitiveness, be it in terms of employees’ guaranteed packages or total packages (depending on reward philosophies)
  • Differentiation by staff categories, functions or pay levels
  • Availability of short-term options, especially tax-favored ones
  • Any known or potential mandatory actions that may apply, such as collectively bargained pay increases or the far rarer practice of mandatory indexation, where it exists
  • The potential impact of action beyond the market concerned

Through the combination of current market information, relevant analysis and a clear understanding of one’s own organization, employers can strike a balance between cost management and competitiveness while meeting their objectives.

Author

Director, Global Research Unit, WTW Research and Innovation Center
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