Why is it so hard to measure changes in the cost of living?
A battle is raging over inflation. Not the public one over how to defuse the looming cost of living crisis. But a much deeper one about how inflation is measured and if that can be changed retrospectively.
The evidence for the battle is published every month by the guardians of truth in official numbers – the Office for National Statistics. Its consumer prices bulletin publishes not one but three different rates of inflation. The latest batch revealed in January were 4.8%, 5.4%, and 7.5%.
The range is massive. The highest is 2.7 percentage points above the lowest. If your pension was linked to that the rise would be 56% more than if it was linked to the lowest. Yet the government’s latest plan is to do just that.
The lowest rate is also the ONS’s preferred measure called CPIH which stands for Consumer Prices Index (including Housing). It has been criticised for using changes in rent as a proxy for housing cost changes for owner occupiers. It is the index which now tops ONS press releases and briefings and to find any other measure requires research or even downloading a spreadsheet. Despite that the media doesn’t generally report CPIH and it is not used in the real world for any practical purpose except by Ofwat for setting controlled water prices.
Until 2011 there just one main measure of inflation – the Retail Prices Index or RPI. It is the highest of the three and was used since its introduction in 1947 for any official calculations relating to the cost of living including wage bargaining. It is so prevalent that it has been back calculated by ONS boffins to the year 1270 when Edward I was on the throne, and it is still used for historical calculations to tell us what £100 in Victorian or Elizabethan times is ‘worth’ now.
But statisticians said the RPI was flawed and wanted to replace it with the more internationally favoured measure called the Consumer Prices Index or CPI (no H yet). The Government gladly accepted their advice largely, cynics say, because CPI was lower than RPI. That is due principally to what is called the formula effect. The RPI aggregates multiple prices using a simple arithmetic mean or average – add them up and divide by how many there are. But CPI uses the geometric mean – multiply the prices together and take the nth root where n is the number of items. For positive numbers that always gives a lower number. Since January 2015 the average reduction in inflation due to the formula effect is 0.81 percentage points.
CPI was published from 1997 and from 2003 it was used for the Bank of England inflation target. But it was only in 2011 it became the official government measure of inflation and was used to raise benefits which saved a cumulative £2 billion a year. It has since come to replace RPI for other things such as tax allowances – when they are not frozen to save even more money.
Two years later RPI was dealt another blow when the National Statistics Authority declared it was no longer what it calls a National Statistic. The Authority and ONS both advise against using RPI.
Nevertheless ONS publishes RPI each month because it is used in many calculations not least where it saves the Government money such as raising controlled rail fares and the interest charged on student loans. It is also used to increase various duties. Car tax – VED – will rise by RPI in April as will Gaming Duty and Landfill Tax.
It is also used in the contracts of many company pensions which specify RPI for the annual cost of living increase. Most pension schemes where the contract does not specify RPI have made the change to CPI – a welcome relief for the fund if not the pensioners. But where RPI is specified the Supreme Court ruled in November 2018 that it cannot be changed.
The biggest problem for the Government is the £819 billion pounds-worth of index-linked gilts. These inflation proof government bonds account for nearly a quarter of all gilts and are linked to the RPI – a phenomenal return now that RPI is 7.5% compared with a 25-year standard gilt issued in January 2021 which paid just 0.875 per cent.
The Government now plans to keep RPI but change the arithmetic so in effect it becomes CPIH. That will happen with the RPI issued in February 2030. Holders of index-linked gilts and others will not be compensated – a saving, says Insight Investment, of £100bn to the Government over the life of the bonds and a cut in the value of pensions by 10 to 15 per cent.
When it does that it is hard to see the CPI surviving as the measure used to uprate benefits and tax allowances. CPIH – the lowest of the three measures – will have triumphed, albeit under the name RPI.
In December the High Court gave three major pension funds, which have 450,000 members between them, the right to challenge these plans. Their judicial review hearing is expected in the summer. The Government’s defence could be published as soon as this February.
The battle for RPI continues.
This blogpost is adapted from a piece first published in FT Money 15 January 2022.
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28 January 2022
