Sunday, December 14, 2003
Inflation cutting made easy
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

Watching Gordon Brown last Wednesday brought to mind David Blaine. When Blaine was suspended in that plastic box, we wondered what the trick was, what clever illusion we were being fooled by. In the end, though, it was just a man in a box.

The chancellor’s speech was full of content. So busy was he with other things that he had to rush through the numbers on the public finances. Brown gave us an agenda so full that news editors were spoilt for choice. We wondered what it was all about. In the end, though, it was just a man announcing a lot more government borrowing.

A year ago, Brown raised his borrowing projections and appeared embarrassed about it. This year he did it with bravado. But the change of presentational style cannot disguise the underlying truth: 37 billion of borrowing this year and an admitted 199 billion over the period 2002-9 is a lot of red ink. The default position now appears to be for the government to borrow 30 billion a year.

The chancellor’s advisers, using slightly dodgy figures, say the public finances are so on track he could cut a couple of pence off income tax before the election and still meet both his fiscal rules. The grumpy old man in me says: I don’t believe it. Nor will spending departments, facing a Treasury clampdown in the coming months. Post-election tax rises look inevitable. The chancellor may claim he is racing to head them off but, as things stand, the tax hikes are hot favourites to win.

Anyway, so much of the pre-budget report was about the future, it is worth concentrating here on something that takes effect immediately: the new inflation target.

Since earlier in the year, when Brown said he was minded to change the Bank of England’s inflation target, we have been looking forward to the arrival of the Hiccup, otherwise known as the harmonised index of consumer prices. Some in the City thought the chancellor would phase in the change over a long period.

But the Hiccup has arrived, and on Wednesday became the Bank’s official target. Except that the statisticians have renamed it the consumer price index (CPI), depriving headline writers of a lot of innocent fun in the months and years ahead.

It replaces the RPIX (retail prices index excluding mortgage interest payments) and, because the new CPI tends to show lower inflation, for reasons I will come to, the target for inflation is now 2%, rather than the 2.5% under the old measure.

Why should this matter? Partly nostalgia. The history of the RPI, probably the most trusted economic indicator in Britain, is quite interesting. Although inflation in Britain has been estimated as far back as 1250, it was only officially measured from 1914 onwards, as a means of ensuring workers were adequately compensated for price rises during the first world war.

It was not as comprehensive as it might have been — beer was excluded because it was not considered to be the right thing for working men to be spending their money on.

But it continued to be produced through the inter-war years of deflation (falling prices). In the 1950s, with a new official emphasis on producing good-quality economic statistics, the RPI began to be based on detailed annual surveys of household spending. An advisory committee, which still meets, was set up to oversee changes in the index. It has been kept up to date by including such things as foreign holidays, unknown to working men in 1914.

The harmonised measure, the CPI, is by contrast a much newer animal, a direct result of Europe’s single currency. A single method of measurement was needed to assess the degree of inflation convergence for prospective euro members.

The Office for National Statistics (ONS) first produced it for Britain in 1997. Since that time it has been above the new 2% target for only a single month, although a run of back data by the ONS shows higher rates in the late 1980s and early 1990s.

The two indexes differ. This is not one for a Sunday morning but the CPI uses geometric means, while the RPI uses arithmetic means. All this means is that the CPI can be re-weighted more quickly for relative price changes, for example if Pepsi falls in price relative to Coca-Cola, more people will buy it. But the ONS also claims that both measures overstate inflation. Neither fully picks up the fact that we shop around for the lowest prices.

There are also differences in coverage. The CPI, for example, includes stockbrokers’ dealing charges, university accommodation fees and foreign students’ university tuition fees. The RPI and RPIX have council tax, owner-occupiers’ housing costs, estate agents’ fees and trade- union subscriptions. The big difference, of course, is the different treatment of housing. As the official statisticians put it: “The CPI’s exclusion of most elements of owner-occupier housing costs ... lessens its relevance for some users.”

There’s the nub. Should the Bank be switching to a target that ignores housing which, on the chancellor’s admission, has been responsible for much of the boom and bust in Britain’s economy? Not only that, should it be switched to an inflation measure that is still being developed? Our official statisticians are working with their European counterparts on including housing costs in the index. That could bump up measured inflation by 0.5%, requiring another early change in target.

There are other problems. The chancellor says pensions and other benefits will continue to be uprated in line with the RPI but wage negotiators should focus on the CPI. That doesn’t look sustainable. If it continued, benefits would gradually close the gap on wages, with damaging consequences for incentives. The RPI, for the time being, will also be the index used for other upratings, and for index-linked gilts.

The big problem is one of credibility. The RPI, as I say, is one of our most trusted indicators. The CPI is new and currently shows what to most people is an implausibly low inflation rate of 1.4%. Wage negotiators will smell a rat.

The Bank’s credibility is also at stake. It has embarked on what looks to be a programme of rate hikes at a time when inflation on the new measure is well below target. Since 1997 inflation on the new measure has averaged 1.1 percentage points below the existing one, lessening the pressure on the Bank to act. But the likelihood is that it will continue raising rates, with the next coming in February.

The Bank will by then have no doubt come up with forecasts showing CPI inflation rising to 2% or more. Whether we believe it is another matter. This is an entirely unnecessary change.

PS: Professor David Miles of Imperial College came in for some flak for his report on the mortgage market last week. Unkind souls have said that his diagnosis — that people will always choose discounted short-term mortgages in preference to dearer undiscounted long-term ones — was a statement of the obvious and did not need a learned academic and a team of officials to come up with it.

That’s a bit unfair. Some of the best analyses are the simplest. It may have been staring us in the face that the mortgage market benefited the “rate tarts” — those who move around frequently — at the expense of inert, loyal customers, but nobody had pointed it out in quite that way.

That said, it is not obvious where Miles’s review goes from here. Preventing lenders from offering attractive deals to new customers would reduce competition in the market, while the Treasury is not attracted to new tax subsidies for long-term mortgages or to establishing a mortgage-guarantee corporation. Even Brown may have to accept that there are some markets he can’t change.

From The Sunday Times, December 14 2003