RPI vs CPI: seconds out, round two
The Chancellor of the Exchequer is not getting away unchallenged with his decision to link benefits and pensions to a different inflation measure, mentioned earlier on these pages.
George Osborne has announced that in future the index used will be the Consumer Price Index (CPI), not the Retail Price Index (RPI). He’s given private pension schemes the right to opt for the change, too, so long as the rules of the scheme do not specifically refer to RPI.
The advantage to those responsible for paying pensions and benefits is that CPI rises more slowly than RPI – so they’ll save money. That’s probably enough of an argument to satisfy Mr Osborne. But those in receipt of benefits and pensions will lose: and over a lifetime, they’ll lose a lot.
Is it satisfactory for this change to be made without consultation or argument? And why, if the indices differ, should one be chosen over another? Professor David Hand, President of the Royal Statistical Society, has just written a letter to Sir Michael Scholar, chair of the UK Statistics Authority, raising a series of questions along these lines.
First, he asks why the CPI is now the headline index even though it is not nesessarily the best for all purposes. It excludes housing costs for owner-occupiers (such as insurance), council tax, vehicle excise duty, and TV licences, all costs that consumers have to bear. Its use as the principal index means that, for example, trade unions arguing for pay rises have to justify it against an index that does not reflect all the extra costs their members may be paying.
But it includes foreign students university tuition fees and foreign exchange commission for tourists changing their own currency into sterling, which for most UK citizens are irrelevant.
“We do not think that CPI should have sole star billing” Professor Hand argues. Other EU countries, including France, Germany, Italy, Spain and the Netherlands, he says, all publish their own national inflation indices alongside CPI, which was originally developed by the EU as the Harmonised Index for Consumer Prices to make international comparisons possible. “Giving prominence to CPI ahead of other indices means that users are implictly being encouraged to use it for purposes, such as wage negotiations, for which it is not ideal.”
Why do RPI and CPI differ? Partly because they count slightly different things, but also because they use a different method of calculation – the so-called Formula Effect. Even if they counted identical things, they would still differ by a substantial amount. Over the past five years, the difference in annual inflation rates due to the Formula Effect has never been less than 0.43 per cent, and has been as high recently as 0.86 per cent.
RPI uses the arithmetic mean of prices rises for goods and services, weighted to reflect the consumption pattern of UK households. CPI uses the geometric mean which, ONS argues, allows for the substitution of cheaper goods for more expensive ones when relative prices change. (For an explanation of the difference, try this link to a paper prepared by the special adviser to a Lord selct committee investigating the Monetary Policy Committee of the Bank of England.)
There is a further subtlety. In RPI, the arithmetic mean can be calculated either by the “ratio of averages” or the “average of relatives” method. Let us assume an index based on prices of 30 different goods. The relatives are the changes in prices for each good over one year. How do you work out the index?
You can tot up the prices for all 30 goods in year one, and divide by 30 to get an average price. Do the same for the second year, then take the ratio betwen the two averages: the ratio of averages. Or you can calculate relatives (price changes) for each of the 30 goods between year 1 and year 2 and average the relatives. The first result is a ratio of two averages: the second an average of 30 relatives.
Just to keep it simple, RPI uses both: ratio of averages for homogenous items, and average of relatives for items with a wide distribution of price levels. According to Professor Hand. the UK uses average of relatives to a greater extent than other countries, and this may help explain why there is such a big difference between CPI and RPI. But nobody seems to know.
“We consider it highly unsatisfactory that a difference in statistical treatment should generate such a substantial difference in the two indices” he says. “We are not aware of any other country where the difference is as great.”
The result may be that RPI overstates inflation. If it does, it means that holders of index-linked gilts are being overcompensated for inflation at the cost of the taxpayer. Even if not, it would be nice to have a proper explanation of how these differences arise, and why one index should be preferred to another, beyond the convenience of saving the Treasury money.
Finally Professor Hand calls for greater openeness in the work of the Consumer Prices Advisory Committee, recently established – including the publication of summary minutes, and some idea of its work programme.
“The Chancellor’s decision makes matters more urgent and increases the need for a more comprehensive review” he concludes. “The political and legal factors involved make this all the more necessary.”
Nick Leaton (not verified) wrote,
Wed, 01/09/2010 - 12:42
The result may be that RPI overstates inflation. If it does, it means that holders of index-linked gilts are being overcompensated for inflation at the cost of the taxpayer.
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No it doesn't.
The ILG market is a market. People buy for the return.
If you start issuing as a spread over CPI, all that will happen is the spread will become larger.
leo (not verified) wrote,
Wed, 27/10/2010 - 12:25
its typical Tory tactics , the people who earn the least get the boot stuck into them. its always easy at the stroke of a pen to take money away from people who in the years to come do really need it, and that will eventually come home to haunt the Tories and their side-kicks.
Tim Bates (not verified) wrote,
Mon, 29/11/2010 - 12:04
Debates about whether RPI or CPI is "bigger" seem to miss the point: The question is whether CPI or RPI is more valid as a representation of the change in costs over a period.
Price changes are changes in proportions over a period of time: 10% growth, 2% growth etc. A good estimator of average changes over a period of time will allow a user to most accurately recover a given year's cost based on a base year and average inflation over the intervening period. RPI is bad at this: It typically OVER estimates the change in cost.
The CPI, with its use of geometric mean, is more valid for the task of estimating averages of proportional price changes.
The question of which goods are included is separate, and important also. It might be that an index designed for a reserve bank to control money supply would not include fixed supply assets like land. A cost-of-living allowance might focus on costs of living.
Either way, a geometric version would be an improvement.
Finally there is the real question at issue: Savings. People can have any index they like including 10-times-CPI/yr, but if they haven't saved and invested, the fund can't pay. Reality bites.
whomightyoube (not verified) wrote,
Fri, 10/12/2010 - 14:01
It is somewhat fraudulent of the government to exclude house prices form an inflation index. Interest payments on a mortgage should not be considered but the cost of houses should. The cost of borrowing money is irrelevant, other wise why include price increases for anything. I think that inflation is under reported by the RPI. I have a pension frozen in 1989 that has hardly changed in stated benefits; yet over the same period the largest item anyone is likely to buy, that is their house, has quadrupled in price.
Michael (not verified) wrote,
Tue, 25/01/2011 - 19:10
I am hoping to produce a presentation for working class areas in Belfast to prove that life on benefits will become harder, is there available a graph or figures for say the past 10 years showing the different increase in percentage rates of RPI versus CPI? The aim of the presentation (should anyone be interested) will be to encourage parents and people that ensuring their children do well out of free state education is more important than ever.
Michael
John B (not verified) wrote,
Wed, 09/02/2011 - 15:54
It seems particularly unfair to those already retired and in receipt of a pension that the terms of that pension have significantly worsened for them. Having spent their working life carefully investing for that retirement it is now too late to make compensating arrangements.
Some public sector pension schemes are well structured and can continue to pay RPI indexation without help from the taxpayer. Why should they have to change?
Tod (not verified) wrote,
Thu, 03/03/2011 - 09:58
Could the CPI rate ever exceed the RPI . I seem to remember Thatcher meddling with these indices because of high interest rates in the 80s. Also, could switching from RPI to CPI effect the calculation of the value of a commuted portion of a pension because the projected whole pension cost would be lower.
rob (not verified) wrote,
Wed, 23/03/2011 - 16:57
I would like to know if those who are in receipt of a pension have the legal right to insist, that the terms of the contract that they had entered into - be honored. i.e. "The rules and conditions of the pension fund RPI calculation of inflation" as was agreed when they first joined. This could also be applied to those not receiving a pension as yet but who have been contributing to the fund for over an agreed number of years.
unhappypensioner (not verified) wrote,
Wed, 27/04/2011 - 22:49
I fully expect that when new employees realise that the State can change the contract on pensions whenever they please, and expect employees to pay in for over forty years to a notional fund (i.e there is no pension fund) that public sector pension schemes will become unpopular. This should be a real opportunity for Labour to promise to reverse the change back to the original contract but they are too timid or stupid to realise this opportunity to gain the votes of most of the retired and near to retired nurses, teachers, policemen, local authority employees etc. etc.
Jeremy (not verified) wrote,
Tue, 17/05/2011 - 14:21
It is particularly disingenous of the government as the proposal for repayment of 9K tuition fees is that interest accrues at RPI + 0-3%. If the government thinks CPI is the better index it should be consistent across the whole range of government policy
Stuart (not verified) wrote,
Fri, 08/07/2011 - 09:39
It seems that it's not "Which Index is better?", but more "How can we make RPI better?".
CPI fails at constituent level to cover real living costs in the UK, but RPI overstates the change due to its Arithmetic Mean calculation.
Surely RPI calculated geometrically is a compromise? It's a fairer way of calculating change with a broader range of relevant constituents.