Sunday, November 18, 2012
Inflation: Is the ONS right to want to shake up the RPI?
Posted by David Smith at 08:59 AM
Category: David Smith's other articles

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The ONS wants to change the way the retail prices index (RPI) is calculated, and is consulting on it. If it has its way, the longest-running and probably most trusted measure of inflation in Britain will look very different next year.

Any individual, business or investor which has its fortunes, revenues or outgoings linked to the RPI will see a change. Retirement funds paying RPI-linked pensions could see payments drop by 10% to 15% over the long-term, with a corresponding loss to pensioners.

Investors in index-linked gilts would see returns lowered and, subject to a judgement by the Bank of England, might have to be compensated. This could take Britain down a very rocky road, with international investors in particular suspecting trickery.

On the other hand, lower retail price inflation would mean smaller increases in rail fares and some utility bills (though these days they have a life of their own).

So why might it happen, and what would be the consequences? Inflation is always controversial. When, in 2003, Gordon Brown shifted the Bank’s inflation target from RPI (excluding mortgage interest payments) to CPI (the consumer prices index), Mervyn King, newly appointed as Bank governor but yet to be knighted, said: “When defending a free kick from David Beckham, you don’t expect somebody to move the goalposts.”

The change was blamed, wrongly in my view, for the Bank’s pre-crisis policy errors. It sparked suspicion the government was trying to foist a dodgy measure of inflation on an unsuspecting public. The ONS, in response, put a personal inflation calculator on its website, for people to work out their own rate. Apparently they still are.

What is the rate of inflation? Figures on Tuesday showed it is 2.7% for consumer price inflation, 3.2% measured by the RPI and 3.1% for RPIX, the old target.

One thing we know is that everybody has a different inflation experience. The average pensioner, living alone, had an inflation rate of 3.2% in the third quarter, but at the end of last year was being squeezed by a 7.3% rate.
Pensioners tend to suffer most when necessities are going up in price, so the latest round of energy and food price hikes will hurt.

People in general tend to notice prices when they are rising but not when they are stable or falling. We have an in-built upward inflation bias, even if when we shop, we try to avoid things rising too rapidly in price, switching to cheaper lines.

What is the ONS proposing? To answer we need to go back to three greats: Gian Rinaldo Carli (1720-95), Nicolas Dutot (1684-1741) and William Stanley Jevons (1835-1882). All three contributed ways of measuring inflation which are used today.

Dutot derived his index approach in 1738, as part of an exercise to compare the real wealth of Louis XII and Louis XV of France. Carli’s in 1764, was as a result of a study into what had happened to prices since the discovery of the Americas. The main contribution in this field by Jevons, in 1863, was the use of the geometric rather than arithmetic mean for calculating price changes.

The RPI is mainly a Carli and Dutot index, with nothing from Liverpool-born Jevons. The CPI is a Jevons index, with a little Dutot and no Carli.

None of the three measures is perfect but the Carli has the oddest characteristic of all, which is that if the price of a product rises but then falls back to its original level, a Carli index will still record it as a rise.

For some items where it is used in the RPI, this leads to huge differences. Clothing and footwear prices last month were down 0.1% on a year earlier in the CPI but up 6.4% in the RPI. At times the difference in clothing inflation between the two has been as 10 percentage points.

Most countries do not use Carli. The International Monetary Fund advises against it and the Consumers Prices Advisory Committee says it should be dropped.

The ONS is consulting, and the consultation period closes in 12 days’ time. By March, the national statistician will have recommended one of four options: no change, dropping the Carli in measuring clothing inflation, dropping it for all items in which it is used and aligning RPI formulae with those used in the CPI.

None of these changes would mean RPI inflation would exactly match CPI inflation. RPI excludes households on very low and high incomes, while the CPI does not.

However, the RPI has owner occupiers’ housing costs, including mortgage payments and a house price measure. The CPI does not, though a new series (CPIH), will next year include private rental costs.

For users of these inflation measures, however, what matters is the change. We have got used to CPI inflation being lower than RPI inflation, often significantly. ONS figures show, however, that if the so-called formula effect were eliminated RPI inflation would have been lower than CPI inflation since April last year. In October, RPI inflation would have been 2.3%, not 3.2%, so lower than the 2.7% CPI inflation rate.

These are surprisingly deep waters. Though any change would not be retrospective, if we have been overestimating inflation in the past it implies real incomes (and growth) were healthier than we thought.

But dropping Carli would mean the Bank would surely have to decide this was a “fundamental and detrimental” change affecting holders of index-linked gilts and National Savings. The ONS might produce a parallel RPI, using the existing method, for investors, though that cannot be a permanent solution. The longest index-linked gilts stretch half a century into the future.

What should happen? It is daft for the ONS to carry on using an RPI formula that comes up with obviously suspect results. From a statistical and economic perspective, the case for change is overwhelming.

The politics, however, are trickier. Unemployment figures have never regained the public confidence there was before the Tories introduced repeated changes to them in the 1980s. The Osborne £35 billion QE "grab" has had less public impact but has a whiff of something dodgy about it.

Anything like that has to be avoided for the RPI. If the public and the markets sense trickery, trust in the inflation numbers will disappear. Like the boy who cried wolf, once you get a reputation, it can be hard for people to believe you.