Measuring Inflation Contents

Summary

Consumer price inflation is the rate at which the prices of goods and services purchased by households rise or fall. The UK has three main estimates: Consumer Prices Index (CPI), Consumer Prices Index including owner-occupiers’ housing costs (CPIH) and Retail Prices Index (RPI). These indices differ in the goods and services which they take account of (for example, the RPI includes a measure of owner-occupier housing costs and the CPI does not) and the way in which price changes are combined to calculate averages.

The UK Statistics Authority has admitted that there is a problem with the RPI. The problem is an unintended consequence of a routine methodological improvement to the collection of price quotes for clothing. It has caused the ‘formula effect’—the difference in the annual rate of change in the RPI compared to the CPI due to the way in which price averages are calculated—to widen: the gap was around 0.5 percentage points before 2010, the year the change was made, and it has been around 0.8 percentage points since.

The Authority has a statutory duty to promote and safeguard the quality of official statistics. This includes ensuring the accuracy of official statistics. But despite these responsibilities, the Authority has refused repeatedly to correct the problem.

This is far from just being a technical debate about the correct way to measure inflation. The Authority’s error created winners and losers.

Who benefited? Holders of RPI-linked Government bonds. We heard that the value of the interest payments they received has increased by around £1 billion each year.

Who lost out? Amongst others, commuters and students. Annual rail fare increases and the interest on student loans are linked to RPI.

The increased divergence between changes in the RPI and CPI has also encouraged governments to ‘index shop’: benefits, tax thresholds and public sector and state pensions were all switched from being uprated by the higher RPI to the lower CPI in 2011.

This is clearly unsatisfactory. But why is the UK Statistics Authority unwilling to fix a statistic that it has admitted openly is flawed?

Position of index-linked gilt holders

A correction of the error would cause the RPI to rise more slowly which would mean that the price of index-linked gilts—those purchased before and after the 2010 change—would fall and index-linked gilt holders would lose out.

The Statistics and Registration Service Act 2007 provides that for some gilt issues, a proposed change to the RPI that will cause a “material detriment” to index-linked gilt holders requires the approval of the Chancellor of the Exchequer. The Chair of the UK Statistics Authority told us that there was no point requesting to correct the clothing change, because the Chancellor would say no. The Authority told us that the RPI “is not a good measure of inflation, does not have the potential to become one, and we strongly discourage its use.”

Retail Prices Index as a legacy measure

The Authority consulted on the future of the RPI in 2012. It decided to make no further improvements to the RPI. Its status of a ‘National Statistic’ was revoked in 2013 and the statistical authorities began to advocate actively against its use.

This position was confirmed by a 2015 review of consumer price indices by Paul Johnson, which concluded that the RPI should be maintained only as a ‘legacy measure’ and that the Government and statistical authorities should work towards ending its use as soon as possible.

Four years on from the Johnson Review however, the RPI remains in widespread use. As well as the uses above, the RPI is used to uprate private sector pensions and in corporate bonds. It is also embedded in some contracts for many years: the last RPI index-linked gilt matures in 2068.

Fixing RPI

The present position of the Authority is untenable. Rather than pre-empting the decision of the Chancellor, it should fulfil its statutory duty to promote and safeguard the quality of official statistics and to do that, it should request a fix to the clothing problem. The Chancellor should approve this change regardless of the effects on index-linked gilt holders, holders of which before 2010 received an unwarranted windfall.

Given RPI remains in widespread use, the Authority should stop treating RPI as a legacy measure and resume a programme of periodic methodological improvements.

Using inflation indices fairly

We believe it is confusing for the public to have multiple official measures of consumer price inflation in use. The Authority and the Government should agree on a single general measure of inflation for official use within the next five years. This will prevent a government from engaging in index or inflation shopping.

To have credibility, the single general measure must have a satisfactory measure of owner-occupier housing costs. There are critics of how these costs are measured presently in CPIH and RPI (CPI does not include a measure). The Authority, together with its stakeholder and technical advisory panels, and in consultation with a wider range of interested parties, should agree on a best method for capturing owner-occupier housing costs in the single general measure of inflation.

To prevent index shopping in the interim, the Government should switch to CPI from RPI in all areas of present use that are not governed by private contracts. This includes issuing new gilts that are linked to CPI rather than RPI.

Once the single general measure has been agreed, the Government should begin to issue gilts linked to that index. The UK Statistics Authority and the Government should then decide whether to continue to publish the RPI as a separate index for legacy measures, or whether it should set out a programme of adjustments so that RPI converges on the single general measure in the long-term.

Summary of conclusions and recommendations

Shortcomings of the RPI

1.We heard evidence that the Carli formula, as used in the RPI, produces an upward bias. But expert opinion on the shortcomings of the RPI differs. (Paragraph 99)

2.There is however broad agreement that the widening of the range of clothing for which prices were collected has produced price data which, when combined with the Carli formula, have led to a substantial increase in the annual rate of growth of RPI. (Paragraph 100)

3.We are not in a position to reach a conclusion on the question of whether the Carli formula is problematic in areas other than clothing. Given the properties of the Carli formula that may lead to upward bias have long been evident, yet expert opinion still differs, it may be a perpetual debate. (Paragraph 101)

Fixing RPI and the statutory duties of the UK Statistics Authority

4.Given its widespread use, it is surprising that the UK Statistics Authority is treating RPI as a ‘legacy measure’. The programme of periodic methodological improvements should be resumed. (Paragraph 116)

5.We are unconvinced by the National Statistician’s suggestion that in publishing statistics that serve the public good, the interests of those who may be affected negatively by any change should be taken into account. It is not clear from section 7 of the Statistics and Registration Service Act 2007 that this is a relevant consideration for the statistical authorities to be taking into account when they are producing and publishing statistics. (Paragraph 117)

6.What is clear from section 7 is that the UK Statistics Authority has to promote and safeguard the quality of official statistics, which includes their impartiality, accuracy and relevance, and coherence with other statistics. In publishing an index which it admits is flawed but refuses to fix, the Authority could be accused of failing in its statutory duties. (Paragraph 118)

7.We believe section 7 requires the Authority to attempt to fix the issue with clothing prices. Section 21 may require the Authority to consult the Bank of England over the change and obtain the consent of the Chancellor of the Exchequer, however this provision cannot be cited as a reason for not requesting the change in the first place. (Paragraph 119)

8.If the Authority requests the change, the Chancellor of the Exchequer should consent to it. It is untenable for an official statistic, that is used widely, to continue to be published with flaws that are admitted openly. (Paragraph 120)

Towards a single general measure of inflation

9.While we accept the arguments that consumer price indices have different purposes, we do not believe this warrants the production of multiple indices for government use. Two different measures of inflation allow a government to engage in ‘inflation shopping’. (Paragraph 134)

10.The Government should address the imbalance in its use of consumer price indices. It risks undermining public confidence in economic statistics. It is encouraging to see that the present Government is taking some steps to address the imbalance, for example with the change to uprating business rates by CPI and recent discussions around rail fares. (Paragraph 135)

11.In future there should be one measure of general inflation that is used by the Government for all purposes. This would be simpler and easier for the public to understand. But the UK Statistics Authority should also continue to develop the Household Cost Indices, discussed below. (Paragraph 136)

Candidates for the single general measure

12.We disagree with the UK Statistics Authority that RPI does not have the potential to become a good measure of inflation. With the improvements to RPI that we set out in the previous chapter, and a better method of capturing owner-occupier housing costs as discussed below, we believe RPI would be a viable candidate for the single general measure of inflation. (Paragraph 139)

13.We are not convinced by the use of rental equivalence in CPIH to impute owner-occupier housing costs. The UK Statistics Authority, together with its stakeholder and technical advisory panels and a consultation of a wide range of interested parties, should agree on the best method for capturing owner-occupier housing costs in a consumer price index. (Paragraph 153)

14.Once a method of capturing owner-occupier housing costs has been agreed, the UK Statistics Authority, after consulting the stakeholder and technical panels, should decide which index to recommend as the Government’s single general measure of inflation. The Government should have adopted the preferred candidate as its single general measure of inflation within five years. (Paragraph 154)

Preventing index shopping

15.Our recommendations will not however solve the issue of index or inflation shopping immediately. The Government will need to take action in the interim to address this. (Paragraph 155)

16.While the single general measure is being determined, the Government should switch to CPI for uprating purposes in all areas where it is not bound by contract to use RPI (except for the interest rate on student loans which, as we recommended in our Treating Students Fairly report, should be set at the ten year gilt rate thus reflecting the Government’s cost of borrowing). (Paragraph 156)

Gilts

17.The Government should begin to issue CPI-linked gilts and stop issuing RPI-linked gilts. We heard evidence to suggest there was sufficient demand to make a viable market. (Paragraph 170)

18.Once the long-term single official measure of inflation has been agreed, gilts should begin to be issued that are linked to that index. The prospectuses for new issuances of index-linked gilts should be clear that the inflation index will change to the Government’s single general measure of inflation once it has been agreed. (Paragraph 171)

Long-term future of the RPI

19.Once the single general measure of inflation has been introduced, the UK Statistics Authority and the Government should decide whether RPI should continue to be published in its existing form for the purposes of existing RPI-linked contracts, or whether a programme of adjustments should be made to the RPI so that it converges on the single general measure. (Paragraph 194)

20.To avoid disruption, we envisage any programme of convergence would take place gradually, over a sufficiently long time, and that the plan for that should be published at the outset. (Paragraph 195)

21.We note that the consent of the Chancellor of the Exchequer to changes to RPI that cause material detriment to index-linked gilts holders is no longer required after the last issuance to which that clause relates to expires in 2030. (Paragraph 196)





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