Peter Levell of the IFS analyses changes in the way the Retail Prices Index (RPI) is calculated and discusses what they entail. Most benefit payments and tax rates have already switched to being linked to the CPI and so any change to the RPI would not affect them, but government bondholders may be adversely impacted

Levell, Peter

English

LSE Research Online

blo gs.lse.ac.uk http://blogs.lse.ac.uk/po liticsandpolicy/archives/29025Possible changes to the Retail Prices Index: what they areand why they matterPeter Levell of the IFS analyses changes in the way the Retail Prices Index (RPI) iscalculated and discusses what they entail. Most benefit payments and tax rates havealready switched to being linked to the CPI and so any change to the RPI would not affectthem, but government bondholders may be adversely impacted.In October the Of f ice f or National Statistics announced a consultation on possibleref orms to the Retail Prices Index (RPI). These ref orms could have f ar-reachingconsequences. Recently, we published a working paper with our thoughts on technical aspects of  theproposed changes.The UK has two main measures of  consumer price inf lation, the Retail Prices Index (RPI) and theConsumer Prices Index (CPI), which can give quite dif f erent impressions of  how prices are changing f romyear to year. Some of  the dif f erences between these two measures are quite easy to explain. Forinstance, the CPI does not include mortgage interest costs while the RPI does. But there is onedif f erence that has been a source of  conf usion f or those using the two indices: the RPI and CPI usedif f erent mathematical f ormulae to work out how prices are changing, meaning that even if  they were f edthe same raw price data, the two would report dif f erent inf lation rates.This impact of  this specif ic dif f erence between the RPI and CPI is known as the ‘f ormula ef f ect’.Historically, it has consistently pushed up RPI inf lation relative to CPI inf lation (see Chart 1). Users ofthese indices have long been entit led to ask what reason is there f or this dif f erence – why is a givenmethod pref erable in one index but not the other? These questions only became more pertinent whenthe size of  the f ormula ef f ect nearly doubled in size f ollowing a seemingly minor change to the wayclothing prices were sampled in 2010. That’s why in October the ONS started seeking views on whetherto change the f ormulae used in the RPI to bring them in line with those used in the CPI (other options inthe consultation would serve to reduce the f ormula ef f ect without eliminating it entirely).Chart 1: RPI and CPI inflation rates and the formula effect, 2005-2012Source: Office for National StatisticsSo what are these dif f erent f ormulae and why should the ONS want to change them in the RPI? Indiceslike the RPI and CPI have to combine many dif f erent prices into a single inf lation f igure. They both startby working out the price changes of  individual ‘items’ (such as ‘white unsliced bread’) f rom a detailed setof  price quotes (such as prices of  dif f erent brands of  white unsliced bread). In the RPI, in some cases, asimple average is taken of  the price changes of  the individual brands. This is the RPI’s ‘f ormula’, whichthe ONS is considering replacing. In the CPI, on the other hand, a geometric average is usually taken.This method was f irst proposed in an essay on gold prices written in 1863 by the Brit ish economistWilliam Stanley Jevons, and is now called the ‘Jevons index’. This dif f erence may sound extremelyarcane, but it has a big ef f ect. According to estimates of  the size of  the f ormula ef f ect shown in Chart 1,using the same averaging methods in the RPI as in the CPI would reduce RPI inf lation by just under onepercentage point on average each year.The case against the current RPI f ormula essentially boils down to the f act that it can give quite oddresults. For example, if  prices f or some item go up one year and then f all back to their original level thenext, the RPI will show that item as being more expensive at the end of  the period. This does not seemlike a very desirable property f or a price index to have, and f ew other countries still use the RPI methodpartly f or this reason. The CPI’s geometric average does not lead to the same problem. However, as wepoint out in our working paper, moving to the CPI method would not prevent the RPI as a whole (ratherthan the RPI f or particular items) giving these sorts of  results, because of  the way inf lation rates f or theindividual items are later combined together into an overall f igure. Indeed, the same problem occurs withthe overall CPI as well. So this issue needn’t be f atal f or the RPI’s f ormula, though taken together withother problems it does add to a cumulative case f or change. The working paper goes into more detailabout this and other issues.In any case, even if  we could all agree that the current RPI method is inappropriate, ref orming it willinevitably create losers. Plenty of  contracts are signed guaranteeing one party or the other a returnbased on RPI inf lation. For instance, owners of  inf lation- indexed bonds get a return equal to RPIinf lation plus some yield each year (protecting the value of  investments f rom being eroded byunexpected increases in prices). If  RPI inf lation were to be reduced, then they would see theirinvestments f all in value, with holders of  long term bonds suf f ering the greatest losses. Importantly,most benef it payments and tax rates have already switched to being linked to the CPI and so any changeto the RPI would not af f ect them. One exception might be increases in excise duties such as f uel, alcoholand tobacco taxes, which are still linked to RPI, though one would expect the government to adjust theway these are uprated if  the RPI were changed.The ONS consultation will close by the end of  November, and the intention is that any change would beimplemented f rom March 2013. The eventual decision would have to be considered by the Bank ofEngland, who would assess whether or not the change would be “materially detrimental” to bondholders.If  so, responsibility f or approval would then pass to the Chancellor. Of  course, f rom his perspective, areduction in the amount of  interest he needs to pay to the holders of  government debt would be awelcome windf all – helping him cut the def icit at a stroke. Jevons himself  used his own index to assessthe consequences of  new gold discoveries on prices and noted that “The most remarkable ef f ect of  thedepreciation of  gold is a considerable reduction in the National Debt”. Using his index in the RPI mighthave rather similar consequences today.This art icle f irst appeared on the IFS website.Note: This article gives the views of the author, and not the position of the British Politics and Policy blog, norof the London School of Economics. Please read our comments policy before posting.About the authorPeter Levell is a research economist in the consumption research sector. He joined the IFS in September2009. His current work covers issues to do with inflation, environmental taxes, and consumption and savingsdecisions over the life-cycle.You may also be interested in the following posts (automatically generated):1. History tells us that we can get out of  the current economic slump if  government guarantees lowinterest rates, rising prices, and provides a more sensible planning system. (20.8)2. The Bank of  England has f ailed to achieve the 2% inf lation rate and its f orecasting has been ill-judged. However, its stance on interest rates is entirely justif ied given the parlous state of  theUK’s domestic economy (8.1)3. There is a growing need f or a policy response to the ‘new inf lation’ (6.5)4. With an easing of  f iscal policy of f  the cards, George Osborne’s only hope f or growth may lie withanother round of  quantitative easing (6)

Possible changes to the Retail Prices Index: what they are and why they matter

Abstract

Similar works

Full text

Available Versions

LSE Research Online