Thursday, June 23 2022

It is clear that inflation is a problem that is not going to subside anytime soon. Producer prices and Inflation of goods according to the consumer price index both were up 10% in February from a year ago. The ongoing geopolitical mess in Ukraine and Russia has made matters worse as commodity prices are impacted by trade sanctions and supply disruptions. Economists hope the Federal Reserve can now successfully rein in the money supply it has increased to unprecedented levels to meet congressional pandemic relief spending. And everyone hopes that the supply chain aspect of inflation will subside this year.

How long and to what extent these will have an impact is anybody’s guess. But right now, workers around the world are expecting or even demanding higher wages to offset rising prices and housing costs, and labor markets are tight enough that employers have no other choice but to accommodate them one way or another. Union negotiators and public sector budget officers have to face the reality that union representatives cannot come to the bargaining table asking for less than a catch-up on the inflation that has already hit their members. In many cases, their workers are now pay more for goods and services that their salary increased last year. The graph below clearly highlights the problem of the recent decline in real wages – wages whose purchasing power is adjusted for inflation:

Source: Barrons

So there’s no realistic reason to expect the employees represented to settle for a compensation package that has already been eroded by inflation and will get even worse this year. Management teams need to impress on their boards that we don’t live in the high inflation world of the 1970s, when there was no shortage of skilled workers for government jobs, or in the Great Recession, when incomes exploded. But at the same time, they should avoid giving anticipated future increases that could lead to overcompensation if inflation starts to stabilize in 2023.In this context, public sector leaders, human resource departments, budget managers and union negotiators face several unique challenges. State and local government revenues are increasing in most places, although at different rates, as the economy recovers from the pandemic. Inflation itself generally generates more revenue from sales, income and property taxes. With few exceptions, the issue at the moment is rarely a lack of funds to pay higher wages, but rather how to calibrate pay increases fairly and without putting public employers in a budget squeeze in the future. As stock market pundits now blather on the “inverted yield curve recessionAccording to this thesis, the worst of all worlds would be to pay wage increases according to the CPI formula because of falling incomes amid layoffs in a year or two.

For employers looking to negotiate a multi-year labor agreement that will extend beyond 2022, the big issue now is how to structure future CPI and cost-of-living adjustments. Inflation will not drop to zero next year, or even recede to the 2% annual rate that the Federal Reserve is aiming for as it tries to put the inflation genie back in the bottle. But it is likely to slow by mid-2023, hopefully on a two-year descent trajectory to low single digits. Nonetheless, employer representatives negotiating future pay raise formulas need to recognize that, as in 2021 most public employees’ pay has not kept up with inflation, they are now playing catch-up baseball.

But extrapolating current inflation rates of 7-10% to 2023-24 wage increases is likely a reckless overshoot, if not structured and calibrated properly. No one drives a car looking only in the rear view mirror and never braking. The current acceleration in labor costs is expected to slow next year, even as the economy continues to expand.

The fallacy of the “Bonus COLA”

A tactic used by some employers in the past, dating back to the 1970s, was to separately formulate inflation compensation as a bonus or special pay item, on the theory that it will not be integrated into base salary and salaries that cannot be reversed. My professional experience from that time, however, was that most of these one-time payments eventually made their way into base pay, and cosmetic efforts to isolate them proved futile.

Economists say inflation and wages are both “sticky” – resistant to changing as quickly as market conditions – and are always rising, never to go back below the starting point. Next year we are likely to see ‘disinflation’ – successively lower rates of inflation – but we will rarely encounter true ‘deflation’, a reduction in overall price and wage levels. Thus, those who launch the political strategy of the “BONUS COLA” must understand that they are only doing it themselves. While that word makes it easier to convince frugal foot-draggers who think they can avoid the inevitable, it’s really just that – either a pretense, political posturing or wishful thinking.

An exception could be employers with revenue caps, such as California municipalities that are subject to Proposition 13 tax limitations and heavily dependent on property taxes. There, a formula could provide that salary increases be limited to the total increase in employers’ revenues if they continue to operate at a lower rate than the CPI itself. In such a case, an additional “unfunded COLA allowance” for inflation payments above the employer’s revenue growth rate could be provided and subject to a future employee vote to discontinue them in lieu of predictable layoffs if the jurisdiction’s wage-income gap is widening or a recession is deepening.

Avoid handpicked data

A suggestion for parties engaged in disputes over CPI math is that they should agree on a common piece of the CPI index showing each month’s annualized rate of increase and the retrospective change prices over 12 months. Graphing contract periods and last salary increase dates with these benchmarks will reduce the tendency for litigants to pick data based on their argument. Fortunately, the Government Finance Officers Association is setting up a useful new web page with these data and tools, which should be available very soon for the public finance community.

In some cases, it will be impossible to agree on multi-year contracts if the conflicting expectations for the next two years are irreconcilable. In this case, a short-term deal may be unavoidable, with the understanding that next year will be a new ballgame. Employers seeking social peace, or at least predictability, will likely have to pay an inflation premium. To appease tight policymakers who are constantly pinching pennies from the payroll, a rollback clause may be the only way to appease them, even if only cosmetically.

Of course, no one today can predict what will happen to consumer prices in 2023, especially if Ukrainian hostilities and Russian sanctions get worse instead of better. Even if global normality returns by the end of the year and the Fed continues to raise interest rates to the desired modest levels that markets are still expecting, a CPI rate of 4-5% for the calendar year 2023 seems plausible, with more risk above this range than below. The latest projection based on the financial market is 5.6%.

Inflation will therefore be the major labor relations issue in the public sector this year, and now is the time for management, finance staff and policy makers to realize the limits of their ability to control pay rates until that we achieve national and international stability. Explaining it to voters will probably be the biggest challenge.

GoverningThe opinion columns of reflect the opinions of their authors and not necessarily those of Governingthe publishers or the management of.

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