Alec Levenson
Economist / Senior Research Scientist at Center for Effective Organizations, University of Southern California
This blog was originally published in HRZone and is the second in a series. The first one is on how long until the new normal.
When Covid-19 gripped the global economy in the first half of 2020, there was an immediate shock to the economic system because the “price” of doing work in person was suddenly, and quite dramatically shifted. If the virus mitigation measures and vaccines rollouts over the past 19 months had put the world on a path to sustainable economic recovery heading into 2022, the negative economic impacts would be going away quickly right now. Yet they are not because we are faced with a prolonged period of the virus disrupting economic fundamentals. And the longer-term impacts on consumer and labor markets are only now starting to emerge.
From short-term reaction to longer-term adjustment. Consumers, workers, employers and commercial relationships among companies, all have lagged behavioral responses when a disruption like Covid-19 hits. Just like the oil supply and price shocks of the 1970s, we are now looking at disruptions to economic transactions throughout the global economy that will persist for at least 3 years, and likely longer. Robust business models can sustain short-term disruptions like the shutdowns that occurred in 2020. But when those disruptions stretch out to last at least three years, they can no longer be viewed as transitory and have to be dealt with as the current state reality.
Short-term vs. longer-term price adjustments. Much has been made of sharply increasing prices for many products and services that are taking place throughout the economy. Prominent examples including global container shipping, truck transportation, food, and single-family housing. Yet for every item that has seen large price increases, there are many more that have remained constrained.
Many price increases are hidden from the view of consumers because they reflect withdrawal of discounts and promotions that make the net price paid lower than the list price on the product (https://hbr.org/2021/06/if-youre-going-to-raise-prices-tell-customers-why). In addition, the fear of losing market share contributes to overall reluctance to raise list prices, which has been embedded in most economies by a very low-inflation macroeconomic environment going back as long ago as the 1980s. Now that the pandemic has persisted and show no signs of disappearing soon, companies are moving towards making price adjustments that were held back during the initial period of economic shutdowns and vaccine rollouts.
Existing contracts often lock prices in for extended periods of time, in some cases as long as a year. Strong competition means most suppliers are reluctant to raise their prices until and unless they are certain that (a) their cost increases will persist, and (b) their competitors are in the same position and cannot sustain profitability at the current price levels. This creates a game of “chicken” where vendors compete to not raise prices but eventually succumb. Some of those increases are already happening in 2021. As companies do their annual planning for 2022, more such price adjustments are happening. Even then, the price increases won’t fully reflect the rising costs in most cases, leaving additional further pressures to increase prices in the second half of 2022 and into 2023.
The reluctance to raise prices is the flip side of the supply shortages that are everywhere in the global economy. If companies let prices fully rise to meet the immediate levels of demand, the increases would be so sharp that many consumers would pull back on their spending. Companies are reluctant to do that for fear of alienating large parts of their customer base who might never come back again. Instead, they are muddling through with more limited price increases coupled with supply shortages, and that’s going to continue for quite some time.
Rising labor costs are just starting to be addressed. If you think price adjustments for products and services are “sticky” and take longer to adjust than one would expect, the situation is magnified even more when it comes to labor cost.
From a psychological perspective, compensation can only be raised, not lowered, so companies do everything they can to keep compensation costs from rising in response to short-run changes in labor demand and supply. That’s the reason why we’re seeing so many examples of companies offering signing bonuses and other ways to entice people to join without raising base pay. But after over a year of holding off on raising base pay in the hopes that labor supply would revert back to what it was before, companies this year are starting to increase base pay. Yet given their overall reluctance to quickly increase compensation and the continued uncertainty about what a post-Covid economic world looks like, the current compensation increases in many organizations are going to lag behind the market, while other organizations hold out even longer on increasing compensation. The net impact is that the compensation adjustments are going to ripple through national and global economies well into 2022.
The other ways companies deal with higher labor costs is adjusting staffing levels. When hourly labor costs rise, companies seek to reduce total labor hours needed to produce their products and services. Yet the higher absenteeism under Covid-19 means that they have to keep more people on hand than before the pandemic to ensure roles are filled. The strategy of substituting capital for labor through increased automation is being considered. Yet making such changes typically requires large-scale redesign of business processes, an adjustment cost that can be greater than short-run increases in labor cost. So companies in many cases are being similarly slow in rushing to bring in more automation, until they have greater certainty that labor costs are now permanently higher.
The other option companies have reached for during the pandemic is shifting work responsibilities around, including having managers step in to do frontline worker tasks where needed to deal with turnover and absenteeism among their frontline employees. In the short run that can reduce total labor hours among frontline employees. Yet that is not a sustainable long-run solution: the managers run the risk of burnout. So eventually the company has to hire more managers or more frontline employees.
The current period of “one-time” price adjustments for goods and services, including compensation costs, does not necessarily translate into constantly rising prices and sustained inflation that will stretch deep into the 2020s. However, it is going to last easily for the next 1-2 years, prolonging the negative economic impacts of Covid-19.