A sign on the cash register in the Dashing Diner in Johnstown, Ohio in June. (AP Photo/Gene J. Puskar)

Government employees have recently come to a close when it comes to adjusting their salaries for inflation. The gap in salary increases could be closed in the coming year if cost-of-living adjustments (COLAs) are given on a formula basis to public employees, but that’s a big deal if. And don’t be surprised if there are debates about which inflation index to use and how.
The latest inflation report which is closely watched by the Federal Reserve showed “personal consumption expenditure” (PCE) inflation at 6.3% for May, lately well below the consumer price index. (CPI) of year-on-year inflation which is commonly used for collective bargaining and pension adjustments. The comparable CPI rate for the same period was 9% and stood at 8.5% in July.

This disparity illustrates the complexity of calibrating inflation at the state and local level. It is not surprising that parties with competing viewpoints select their data, as well as the most relevant past or future time windows to make compensation adjustments.

Cost-of-living adjustments have been around for decades and became commonplace in the “stagflationary” 1970s. Social Security began paying COLAs in 1975 (the three-month average of urban wage earner CPI increases it uses is expected to invoke a more than 9% increase in COLA for beneficiaries in 2023). COLA indexing became popular in public sector collective agreements around this time. Many public pension funds initially attempted to make one-off, unsystematic adjustments to inflation, but this became a political and actuarial nightmare because these one-off, emotionally driven adjustments were unfunded, which spoiled the financial structures of the pensions. As a result, the Department of Labor’s CPI became the common standard used in the public sector for COLA adjustments.

The CPI weighs more heavily on housing costs (at about a third of the index) than the Commerce Department’s PCE, while giving a lower weight to medical expenses that are often covered by subsidized public health insurance. by the employer. These housing and medical cost factors alone would seem to make the CPI more relevant for civil servant pay rates, although some might argue that younger and older workers face varying housing inflation pressures in based on tenant versus landlord status, when the latter’s mortgage rates were set, and who has what type of property tax protection.

In setting monetary policy, it is likely that the Federal Reserve board will continue to pay more attention to the PCE to guide it in raising interest rates. However, government decisions on wage and pension policy and collective agreements will be dictated by the CPI. Given that house prices have soared to double-digit rates over the past couple of years, it’s possible that the CPI measure will continue to run hotter than the PCE for months to come. Explaining these nuances to policy makers, workers and pensioners will be an ongoing challenge for public sector managers, pension officers, worker representatives and budget workers.

Mirror or fogged windshield?

Putting aside the CPI-PCE measurement discrepancies for now, and hoping that the CPI will continue to be the index of choice among states and local governments, the challenge for policy makers, labor negotiators and pension officials will be figuring out how best to make COLA adjustments when the underlying inflation rate has spiked. Although the escalation in the CPI should subside in 2023, it is unlikely to fade to the idyllic level of 2% that most central bankers consider optimal. So what is the fair solution to adjusting the rates of pay and pension benefits? Should we focus on past, present or likely future inflation rates?

For those who believe the economy is on the verge of a full-blown recession with widespread layoffs and a sharp contraction in economic activity and tax revenues, and other nasty consequences that hamper ability to pay public employers, the problem is whether we should focus on the clear but cluttered rearview mirror or try to look through a foggy windshield. But for those who worry about workers’ purchasing power, the permanent damage to the wallet has already been done and needs to be permanently compensated. Arguably, even those who have locked in their housing costs with a fixed rate mortgage and local property tax limitations are unlikely to stay indefinitely, so their purchasing power will eventually erode. This supports using the CPI index and making COLA adjustments based on price increases in the past year.

Where it gets complicated is in the ability of public employers to finance the inflationary costs of wages and pensions. As long as incomes continue to rise with inflation and the economy grows, there is no tax dilemma. But if a recession hits and we see reductions in state and local tax revenue, the end result of high COLA payments is that budgets can’t afford it and layoffs and job cuts services will be unavoidable unless sufficient money for rainy days is set aside to weather this storm.

For employers and collective bargaining, the recession risk scenario requires thinking about strategies to ensure sufficient sustainable funding to continue paying COLA-inflated wages. An obvious solution is to focus collective bargaining and worker attention on the need to properly fund a contingency fund for this eventuality before making a generous COLA adjustment that may not be affordable over the next two years. This could mean that any permanent COLA wage adjustment would have to be lower than the CPI, with provision for “catch-up” payments if the feared recession does not materialize. Or alternatively, the COLA adjustment could be bifurcated, with half added to wages now and the other half paid as a one-time COLA bonus payment that would be rolled into future wages at a time when earnings adequacy is clear. established – when the storm of an income recession has passed, or if it never really comes.

View STARs

For pension funds, especially those where public employers have volatile income tax revenues or operate under property tax limits like California’s Proposition 13 that constrain the revenue base well below rate inflation, one approach is the one that some Californian pension systems have adopted: the additional targeted adjustment for retirees, acronym “STAR COLA”. Pension adjustments are capped at a fixed annual level and future ‘compensation’ payments – STAR COLA – are paid if inflation declines. In 2023, this means that these pensioners will not receive a raise of more than 2 or 3%, depending on the labor agreements, with the remainder of any CPI adjustment being payable in future years if and when the rate of inflation is lower than the predetermined STAR COLA rate. obstacle rate.

In addition to employer income constraints, part of the rationale for STAR COLAs is that retirees face lower inflation than active employees, presumably having stabilized their housing costs, so they are better able to pay. accept a delay in COLA payments as long as they can possibly catch up. This arrangement also helps pension actuaries make realistic forecasts of future pension cost inflation (now around 2.6% nationally) because the cap is there, and they can model the accrual of payments of “STAR reserve” which will eventually trickle down to the retiree. liability calculation.

While this wording may sound odd to policymakers in other states, it’s actually a pretty sensible solution to a complex problem that should be considered for pensions elsewhere – and perhaps also for salary adjustments when the employer’s income is limited or volatile.

Outlook: My crystal ball still sees inflation rates in 2023 registering above 4 or even 5% at the start of the year and above 3% for most others, but nothing like this than the 8-9% year-over-year CPI increases we’ve seen lately. The most likely path to “persistent disinflation” will be a gradual downward staircase pattern of successively lower CPI reports as the Fed tries to thread the needle to bring the economy to a soft landing without causing a hard recession. Having a game plan for both possible outcomes is a really smart strategy.

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