FT Alphaville " RIP (old) RPI and hello a happier Chancellor The Office for National Statistics is out to get the Retail Price Index... or at least the part of responsible for the "formula effect gap." But before we get to the sexy stuff - involving gilts and clauses and all - a quick statistical primer is called for. The RPI began life as a compensation index, developed as an aid to protect ordinary British workers from price increases associated with WWI. It didn't become the main domestic measure of inflation until much later. While the Consumer Price Index, which was introduced due to EU requirements in 1996, is internationally comparable and the basis for the government's inflation target. So, they are two different but similar things, mainly separated by their differing population coverage and the formulae used in their constructions. More detail here-so boxed (click to enlarge) and here-so linked: It's clearly the "formula effect" gap that needs to be concentrated on. At present, the RPI is largely constructed using two different types of arithmetic means (the "Carli" and "Dutot" formulae), while the CPI (which is bound by European regulations) largely uses geometric means (the "Jevons" formula). The resulting "formula effect" is worth 0.88% YoY at present, and over time this accounts for most of the RPI-CPI wedge. Most of that 0.9 per cent or so problem lies within the Carli index, which has been ditched by every other large advanced economy due, primarily, to its large upward bias but which still persists within the RPI. The ONS consultation on the CPI-RPI gap looks at a range of options from "no change" to "get rid of Carli for clothing" to "change the RPI formulae completely to mirror the CPI formula." The Consumer Prices Advisory Committee is pretty clearly gunning for option three or four, and the consultation process itself will end on November 30 with recommendations published in January. Now, if this all seems a bit esoteric and silly to you, it shouldn't. Thing is, Carli, for a forumla with such a pretty name, seems able to wreak a lot of damage. For the record, this is the sexy stuff. From Chris Giles in the FT last month (with our emphasis): The consequence is that the RPI has been overstating inflation by roughly 0.5 percentage points for decades and by more since 2010. Real living standards have grown by more than we thought. Since annual benefits uprating was moved to follow the CPI in 2011, we now know that social security payments have been rising in real terms year-by-year. To the extent that wages are influenced by RPI inflation, there is a danger that workers were pricing themselves out of jobs and making Britain less competitive. The exchequer effects are frightening. With an annual social security bill over £200bn, in today's prices a half percentage point upward bias costs taxpayers an extra £1bn in the first year, £2bn the following year and so on. Even with most of the tax and benefit system now linked to the CPI, every year the Carli index remains part of the RPI calculation, it imposes a tax of a little under £1bn on society to give windfall benefits to the holders of index-linked government debt. About those holders of index-linked government debt... they will be watching this consultation like hawks. In fact the ONS will have to consult with the Bank of England before pushing ahead with any reform in case it is "materially detrimental to the interests of the holders of relevant index-linked gilt-edged securities." Section 21 of the Statistics and Registration Service Act 2007 states that: (3) If the Bank of England considers that the change constitutes a fundamental change in the index which would be materially detrimental to the interests of the holders of relevant index-linked gilt-edged securities, the Board may not make the change without the consent of the Chancellor of the Exchequer. From the Explanatory Notes (with our emphasis): If any change should be made to the coverage or the basic calculation of the [Retail Prices] Index which, in the opinion of the Bank of England, constitutes a fundamental change in the Index which would be materially detrimental to the interests of the stock-holders, Her Majesty's Treasury will publish a notice in the London Gazette immediately following the announcement to the relevant Government Department of the change, informing stockholders and offering them the right to require Her Majesty‟s Treasury to redeem their Stock in advance of the revised index becoming effective .... The rationale of the redemption clause was to protect holders against arbitrary changes in the nature of the RPI. However, depending on the nature of the change to the RPI and on market circumstances at the time, the triggering of the section could have a significant impact on financial markets and potentially on the public finances. There are now five gilts in issue containing the clause, with maturities ranging from 2013 to 2030: That's a fair whack of redeemable value right there. But there are still a whole load of other gilts linked to the RPI which don't contain the "detrimental" clause. (There's also a two per cent Index-linked 2035 Treasury Stock with a market value of £19bn or so but, to be honest, it just wasn't worth cutting and pasting it over. Sorry.) And, as Citi note, the OBR previously reported that a one per cent drop in RPI inflation would cut debt service payments by about £3bn for 2013 -14, rising to about £6bn for 2016 -17... which suggests this ONS consultation might just make the Chancellor pretty happy anyway. Related links: The long-run difference between RPI and CPI inflation - OBR Britain must fix its broken method of measuring inflation - FT Why Elementary Price Index Number Formulas Differ: Price Dispersion and Product Heterogeneity - IMF Treasury could save £3bn with inflation changes - Telegraph This entry was posted by David Keohane on Tuesday, September 18th, 2012 at 16:53 and is filed under Uncategorised. Tagged with cpi, gilts, inflation, ONS, Rpi.