Breaking up is hard to do

Breaking up is hard to do

Richard Conway Weekly bulletin January 2019
The House of Lords last week published their review into the use of RPI, highlighting issues around the measurement of inflation in the UK, and suggesting a roadmap for long-overdue reform. Few column inches were devoted to the subject, but the impact of any changes could be far-reaching.
Measuring inflation in the UK

As the review makes clear, the history of this topic has been far from straightforward.

Over the years we’ve seen a number of techniques for measuring changing prices – including RPI, RPIX, RPIJ, CPI (known as HICP on the continent), CPIH, and core CPI. Differences broadly concern the population covered, the method of calculation, and the basket of goods used.

Some of these have been discontinued (RPIJ), some have been dropped and have come back following reforms (CPIH), and some live on as zombie statistics (RPI). The latter are still published but no longer ‘recognised’ as an official statistic and their use discouraged by statistics authorities – statistical limbo, for want of a better term.

Battle of the benchmarks

Despite the large number of competing measures, most would agree that it’s really a two-horse race between RPI and CPI (or CPIH).

RPI is generally thought of as a legacy measure, although a large number of contracts still reference the index, as does the majority of inflation linked debt.

CPI, on the other hand, is now accepted as a better measure of the cost of living based on more robust methodology. It has therefore replaced RPI in many respects, perhaps most importantly in its use as part of the Bank of England’s inflation target.

The need for reform

While the trend is one of a move from RPI to CPI, progress has been slow. More worryingly, the use of two inflation indices concurrently has created winners and losers – which has stirred up the House of Lords.

As the UK Statistical Authority has admitted, there are problems with RPI. Methodological issues have skewed this measure of inflation permanently higher than CPI since 2010.

The divergence has afforded windfall gains to holders of inflation linked gilts and other securities, while increasing costs for commuters, students, and others who face RPI linked costs while their salaries increase by the lower CPI measure. Index shopping, whereby incomes are linked to RPI but costs to CPI, is another issue.

As the Governor of the BoE has put it, “At the moment, we have RPI, which most would acknowledge has known errors. We have CPI, which is what virtually everyone recognises and is in our remit. Then there is the ONS’s favourite, if you will, the CPIH, which includes housing costs. At some point, it would be good to consolidate the focus on to one.” [1]

Influence of the markets

Holders of index linked gilts are cited by many as the main issue here. Reasoning goes that any change to the indexation of these instruments would necessitate involvement of the Chancellor, who many think would throw out the proposals.

However it’s far from clear whether that would be the case, and in any event he’s yet to be formally consulted by the statisticians on the other side of the table.  We are therefore, at a stalemate.

Lords’ conclusions

Advice from the report is that a process of reform be initiated as soon as possible.

In the first instance, this would involve the indexation of new gilts and contracts to CPI rather than RPI. This would be followed by a renewed programme of improvements to RPI to bring it back in line with CPI, as well as work on a single unified measure. Five years down the line, the Lords would like to see a new benchmark.

While we are a little uncertain of whether this three-stage approach is practicable, the increased focus on this long-standing concern is welcome. Time will tell whether their suggestions are taken up with gusto by policymakers and the markets.

Lessons for LIBOR

The process holds some useful lessons for LIBOR.

In announcing a fixed end date for the interest rate benchmark, the BoE has forced market participants to come to the table and discuss reform. In comparison, inflation reform is at early days and does not have a timetable to drive progress.

The Lords review also highlights the crucial importance of contracts. There are 30 index linked gilts in issuance, accounting for some 25% of the government’s £1.6tn portfolio.

If changing the benchmark for these is a potential issue, with the Treasury and BoE’s powers of persuasion, one can only imagine the work involved in updating the far larger number of private sector contracts referencing LIBOR.

As our recent survey has pointed out, all the more reason to start the process sooner rather than later.

[1] Governor of the Bank of England, January 2018. Oral evidence taken on 30 January 2018 (Session 2017–19), Q 11 (Dr Mark Carney)

For more information, please contact Richard Conway, Associate Director at JCRA, at richard.conway@jcrauk.com.

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