Sunday, October 05, 2003
Moving the inflation goalposts
Posted by David Smith at 09:35 PM
Category: David Smith' s magazine articles

In November, if he sticks to his planned timetable, Gordon Brown will introduce the biggest change in monetary policy since the Bank of England was given independence – control over interest rates – in May 1997.

Since that time, indeed for five years before that, monetary policy in Britain has been geared towards a simple aim, that of keeping a well-known measure of inflation, the retail prices index excluding mortgage interest payments, within strict bounds.

Prior to independence, the policy was to keep RPIX, as it is called, within a 1% to 4% range, although the then Conservative government also pledged to have inflation running at 2.5% or below by the time of the 1997 election.

After independence, the target became simpler, an uncomplicated 2.5%, to be achieved at all times. There was, however, an implicit range in the target set for the newly independent Bank. If inflation dropped below 1.5% or rose above 3.5% the governor would be required to write a public letter of explanation to the chancellor.

The intention was not only to keep the Bank on its toes, and prevent inflation drifting too far away from target, it was also to underline that the approach to policy was strictly symmetrical. It would be just as bad, in other words, to undershoot the target too much as it would be to overshoot. The purpose of this, in turn, was to reassure those worried that an independent central bank, left to its own devices, would overachieve in terms of getting inflation down, perhaps thus threatening economic growth.

Symmetry will continue to be the watchword when Brown makes his change in his November pre-budget report. It will, however, be based on a different target. Out will go RPIX, which in one form or another has provided the basis for measuring inflation in Britain for most of the past century. In will come the “harmonised” index of consumer prices (HICP), which is very much the new kid on the block.

The HICP, as the “harmonised” part of its name implies, is intended to provide a measure of inflation that is comparable across countries, in this case the countries of the European Union. Whereas RPIX is designed and produced by Britain’s official statistics body, the Office for National Statistics, what goes into the HICP, and how it is calculated, is the responsibility of Eurostat, the EU’s statistical agency.

The express purpose of the chancellor’s change, indeed, is to bring Britain more into line with Europe. He announced he would change the target on June 9, when presenting the Treasury’s verdict that Britain was not yet ready for euro membership but would be working to make itself ready. The likely inflation target on the new measure, 2%, will be identical to that used by the European Central Bank in Frankfurt. The only difference, to return to the symmetry point, is that there will be a “letter-writing” range for the Bank governor based on the new target, probably 1% to 3%.

Changing from one measure to another may sound like a matter of statistical detail, and one strictly for the aficionados. It is, however, quite important and poses challenges that have made the Bank’s new governor, Mervyn King, more than a little uneasy.

First, when the change comes the inflation picture will change abruptly. At present RPIX, rising by nearly 3%, is above target. But HICP, which shows an inflation rate of just over 1%, is well below its likely target. The difference in inflation shown by the two measures, in fact, is at a near-record level, hardly the best time to make the change. The Bank fears people will think the inflation goalposts have been moved, so achieving the target suddenly becomes very easy. While the old target implies that the Bank should be thinking of raising rates, the new one appears to suggest cuts should be on the agenda.

Second, HICP is notable for what it leaves out of the inflation measurement. There is a big debate in statistical circles about whether house prices should be included in an inflation measure. Some argue that rising house prices are more important for their impact on household wealth than living costs. We do not include share prices in RPIX, so why house prices?

The fact is, however, that house prices have been part of RPIX, though what is called the housing depreciation component, and given their importance in the UK economy, it has been a good thing that they are. Without the housing element, inflation and by implication interest rates would have been lower. The dangers of housing boom and bust would have been greater.

HICP, for good or bad, does not include house prices. Eurostat is examining whether it should do so. Most EU countries, however, have very poorly developed measures of housing inflation, making a change any time soon highly unlikely. The result, the Bank fears, is that it will be flying blind as far as the housing market is concerned. HICP inflation could be very low, requiring the Bank to cut interest rates, even when house prices were rising at, say, 20% or 30%.

Finally, the shift to HICP will move the Bank away from the inflation measure used widely across the economy. RPIX (or just plain RPI) is used to uprate pensions and welfare benefits, and across a wide-range of index-linked financial products. It is the starting point for wage negotiations, understood and trusted by employers and trade unions alike. It has retained the trust of people even when other statistical measures produced by the government, for example the unemployment figures, have lost it.

The HICP is unknown and will be regarded with suspicion. The unions will see it as an attempt to artificially foist a lower inflation rate on the country, squeezing the pay increases of their members. For the Bank, which has been trying to educate the public on RPIX and the importance of low inflation, it will be back to square one.

Moving the goalposts is never a good idea. The chancellor is likely to find that the crowd does not like it one bit.

From Professional Investor, October 2003