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Inflation – more complicated than you might think

On 10 January 2013, the Office for National Statistics (ONS) announced that in the future, the Retail Prices Index (RPI) will continue to be calculated in the way in which it has been calculated in On 10 January 2013, the Office for National Statistics (ONS) announced that in the future, the Retail Prices Index (RPI) will continue to be calculated in the way in which it has been calculated in the recent past.  During 2011, the ONS had run a consultation exercise on possible changes to calculating RPI inflation.  The ONS is the Executive Office of the UK Statistics Authority which is independent of ministers but does report to Parliament.

RPI is not the only measure of inflation which exists in Britain.  Inflation, of course, tries to be a measure of whether what we spend our money on costs more than it did a year ago and if so by how much.  But measuring it is not as simple as measuring the same prices each year – if bread goes up by 10p and cereal goes up by 10p you will probably still choose your favourite for breakfast.  But if bread suddenly cost £10 a loaf would you have toast for breakfast as you did last year or would you now buy cereal?  Housing costs are a major expenditure for many people but should they count given that some people have paid off their mortgages, others live rent-free with mum and dad and others have housing benefit?  Should the expenditure of the very rich count at all – if Lamborghinis* are on sale does that really affect what most of us spend? 

There is another inflation measure - CPI (the Consumer Prices Index) which is more consistent with the measure of inflation used across the European Union.  In recent years, CPI has replaced RPI as the index used for increasing public sector pensions and for the pensions of those schemes which automatically adopt public sector pension increases for their own pensions.  But RPI is still used for a lot of purposes, including the annual uprating of compensation limits in Employment Tribunals, a large number of private sector pension schemes which specifically refer to RPI and contractual terms which refer to RPI, for instance a company and a trade union could use it in a three year or five year pay deal.  Compared to RPI, CPI excludes housing costs, excludes the expenditure of the highest earners and assumes we eat cereal when bread prices rise.

For a number of businesses, a measure of inflation may also be important for their income stream – rail fares, utility bills, outsourcing contracts, etc may all use a measure of inflation, usually RPI, as a base.  (This, of course, can be circular as some of these bills are paid by consumers and so push up inflation.)

Changing how they calculate RPI was considered by ONS and if they had a blank piece of paper they would not have come up with RPI now but, as the National Statistician Jil Matheson said, "There is significant value to users in maintaining the continuity of the existing RPI's long time series without major change, so that it may continue to be used for long-term indexation and for index-linked gilts and bonds".  A new measure of inflation – RPIJ – has been introduced and is considered by the National Statistician to be a much better measure of inflation, to be consistent with international standards and it will be promoted as such each month.  The old RPI measure will continue to be calculated for continuity purposes for those items which use it, but it will be given much less publicity.  RPIJ will be measured in the way which was proposed for RPI and so it will be slower in rising than RPI where some but not all items used for the index increase prices.  This is due to arithmetical processes applied in calculating it - greater detail on these is in the ONS papers.  In simple terms it assumes you'll have cereal for breakfast if bread gets expensive.

A significant body of opposition to the proposed changes to RPI came from the pensions industry, as the effect of the change would have been to reduce people's pensions over time.  It is not clear what RPIJ will be used for – it might in years to come be used for utility bills, rail fares, etc but what we do know is thatBritainwill now be publishing several different measures of inflation.  Indeed, the BBC report that a fourth measure (CPIH – a consumer price index which includes an element which represents housing costs) may also be published.  Anyone who creates legally-binding relationships which refer to "inflation" will need to make sure they define which of the four measures will be used.  Failure to do so is likely to produce confusion and argument in years to come.

* If Lamborghini consider this advert deserves a reward I'd be happy to have one, any colour, delivered to 35 Vine St.

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