How Inflation is Influencing Reward Decision-Making in 2026

The Bank of England’s Monetary Policy Committee’s latest decision to hold interest rates at 3.75 per cent gives employers a clearer understanding of the economic landscape ahead, but not necessarily greater comfort.

Inflation has proven more persistent than hoped in recent months, rising to 3.4 per cent in December, however the forward outlook is more positive. Inflation is now forecast to fall back to the Bank’s two per cent target sooner than forecast, which Governor Andrew Bailey described as “good news.” However, this is offset by downgraded growth expectations and warnings that unemployment will rise more than previously anticipated.

For employers, the result is a familiar but increasingly complex operating environment, as affordability pressures remain entrenched. Borrowing costs are still high by historical standards, margins remain tight and workforce expenditure continues to be scrutinised, as the largest controllable cost in most organisations.

Against this backdrop, organisations are refocusing reward spend by sharpening how they interpret labour market data, structure pay frameworks and manage pay decisions.

Interest rates offer stability without relief

The Monetary Policy Committee’s knife-edge 5 - 4 vote to hold rates underlines the uncertainty still facing the UK economy. Keeping the base interest rate at 3.75 per cent, its lowest level since February 2023, stabilises financing costs but does little to ease them. Many businesses are therefore maintaining a cautious stance on hiring, reward investment and bonus funding while they await clearer signals on growth.

While analysts expect a possible rate cut as early as March, many employers have already finalised their 2026 pay plans, or are at least well underway in the process. Employers are therefore proceeding on the basis that affordability pressures, linked to inflation in wages and supplier costs, will persist throughout much of 2026.

Labour Market Movement: Rising redundancies

Labour market data reinforces the Bank’s warning that unemployment will edge higher as employers seek to reset cost bases. Analysis of ONS data indicates that redundancies have risen year-on-year, reflecting restructuring, cost management and weaker growth expectations, but remain below recessionary levels, signalling cautious workforce recalibration rather than large-scale cuts.

Employment has held broadly steady at 75.1 per cent, while unemployment has edged up to 5.1 per cent. Vacancies remain below previous peaks and payrolled employee numbers have declined modestly over the year.

These shifts reflect a labour market that is cooling after several years of intense hiring activity and wage volatility driven by inflation-led pay competition and cost-of-living pressures. For employers, this easing of demand does provide some leverage on pay negotiations, but it also introduces engagement and retention risks, particularly in critical skills areas that remain supply-constrained. This is an important opportunity for recalibration.

Restructuring for resilience

Many employers spent 2025 taking stock after successive economic shocks. Rather than expanding workforces, organisations focused on optimisation through restructuring, digitisation and productivity. Operating models were redesigned, management layers streamlined and investment channelled into automation and AI, aligning workforce cost and capability to future strategy.

Ensuring the right roles, skills and cost structures were in place, became the dominant theme. This restructuring has shaped how employers are now approaching reward. During peak inflation, pay strategy was reactive. Off-cycle reviews, retention payments and cost-of-living bonuses were deployed to stabilise workforces and offset real-income erosion.

Targeted pay investment

As inflation eases, that reactive approach is giving way to one that is more deliberate and sustainable – shifting to an inflation-managing reward design. Employers are refocusing pay investment where it has the greatest strategic value.

Pay budgets are being directed toward:

Critical technical skills
Digital and AI roles
Revenue-generating functions
Leadership succession pipelines

Meanwhile, broad, inflation-matching increases are becoming less common as organisations seek to avoid locking in permanently higher fixed costs. Variable pay options, such as bonus and incentives are playing a larger role, allowing organisations to reward performance without permanently increasing fixed cost bases.

Interpreting Market Data: Getting the most out of benchmarking

Making effective reward decisions requires more sophisticated use of labour market intelligence. In an affordability-constrained environment, how employers interpret market data is as important as the data itself. Benchmarking risks being treated as a blunt instrument, whereas market median needs to be analysed alongside market forces to set competitive pay targets.

In reality, market data must be interpreted through the lens of business strategy, affordability and talent risk. This helps to distinguish inflation-driven pay movement from structural market shifts; segmentation is critical.

The market for AI engineers or cyber specialists operates very differently from that for corporate services roles. Sector, geography and organisation size also shape pay positioning. Employers that translate headline figures into market nuances, analysing trends over time and total reward rather than base pay alone, are better equipped to deploy scarce pay budget effectively.

Hiring Outlook: Cautious optimism returns

Forward-looking hiring data suggests some stabilisation in employer confidence. The latest ManpowerGroup Employment Outlook Survey shows an uptick in hiring intentions – the first improvement since mid-2025. Growth, however, is uneven and sector-led:

Construction and Real Estate (+24 per cent)
Information (+26 per cent)
Manufacturing (+15 per cent)
Hospitality (-9 per cent)

Construction, manufacturing and digital sectors are driving demand, while hospitality and other consumer-exposed industries remain under pressure from wage costs and subdued spending. This uneven recovery reinforces the need for targeted, data-led reward decisions rather than uniform pay strategies.

Managing employee pay expectations

Even as inflation slows, its legacy continues to shape employee expectations. Workers remain acutely aware of the cumulative erosion of purchasing power over recent years. This sustains pressure on employers to deliver meaningful pay progression, even where current inflation is falling. Within this environment, pay compression is emerging as a growing structural risk. In some sectors, minimum wage increases have compounded the effect. Left unmanaged, compression can undermine perceptions of fairness, damage engagement and create retention risks among tenured or high-performing employees. It can even create equal pay risks.

Upholding fair pay and reward

Achieving pay parity requires structural solutions rather than one-off pay adjustments. This is where job evaluation and formal pay frameworks become essential. By objectively assessing role size and aligning jobs to grade structures, organisations can maintain robust pay relationships even in constrained pay environments. This ensures that inflation responses do not distort internal relativities. Pay scales and salary ranges provide governance, ensuring increases are allocated consistently and transparently.

In affordability-pressured conditions, such frameworks do more than manage cost; they protect trust. Employees are more likely to accept moderated pay outcomes when they understand the rationale and see fairness applied.

Effective employee communication

Employers are responding by tightening performance conditions, increasing bonus deferrals and placing greater emphasis on transformation, productivity and ESG outcomes within incentive design. Variable pay remains a crucial lever, offering flexibility that base salary increases cannot. But payouts are becoming less predictable and more closely aligned to business performance realities.

With fixed pay constrained, many organisations are placing greater emphasis on communicating the full value of employment. This broader framing of reward is increasingly important in offsetting the perceived impact of inflation on take-home pay.

A holistic approach to delivering employee value

In many organisations, indirect reward represents a significant proportion of employment value, yet it is often under-recognised by employees. Making it visible can strengthen retention without increasing salary spend – a critical advantage in inflation-sensitive cost environments. Career development is also emerging as a central retention currency.

Investment in skills, progression pathways and internal mobility offers a more sustainable response to pay pressure than competing solely on cash. As AI and digital transformation reshape job design, upskilling is becoming both a workforce necessity and an engagement driver.

Get in touch

The Bank of England’s decision points to an economy stabilising, but not accelerating. Interest rates holding at 3.75 per cent maintain cost pressure even as inflation improves. Growth downgrades constrain reward funding, while rising unemployment mitigates, but does not eliminate, talent competition – particularly where inflation has reshaped skills pricing.

For employers, the response is increasingly strategic rather than reactive. Pay decisions are being informed by deeper market analysis. Reward investment is being targeted rather than spread. Structural pay governance is being strengthened to manage compression and equity risks, ensuring inflation responses are measured and sustainable.

Organisations that balance affordability with competitiveness, and financial reward with career value will navigate continued constrained pay and reward decisions effectively. Get in touch to discuss how we can help you optimise your HR budget by interpreting market data intelligently, managing pay structures proactively and communicating the full spectrum of reward effectively.

How Inflation is Influencing Reward Decision-Making in 2026

The Bank of England’s Monetary Policy Committee’s latest decision to hold interest rates at 3.75 per cent gives employers a clearer understanding of the economic landscape ahead, but not necessarily greater comfort.

Interest rates offer stability without relief

Labour Market Movement: Rising redundancies

Restructuring for resilience

Targeted pay investment

Interpreting Market Data: Getting the most out of benchmarking

Hiring Outlook: Cautious optimism returns

Managing employee pay expectations

Upholding fair pay and reward

Effective employee communication

A holistic approach to delivering employee value

Get in touch

Tim Kellett

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