There was surprise last week when Jil Matheson, the UK’s national statistician, rejected a proposal to make radical changes the way the retail prices index (RPI) is calculated, despite conceding that the current method systematically overestimates inflation.
A two-year consultation launched by the UK Statistics Authority examined the ‘formula effect’ which is responsible for the different trajectories in RPI and the consumer prices index (CPI). One suggested solution was to bring the formula for RPI into line with that used for CPI, which was widely expected to be the national statistician’s recommendation.
However, 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.”
This came despite the national statistician’s acceptance that the formula used to produce the RPI “does not meet international standards”. But a new RPI-based index using the Jevons geometric formulation, known as RPIJ, will be published from March 2013.
The RPI winners and losers
Asset managers were among the biggest beneficiaries of the decision, after much lobbying for the current system to be preserved. Aligning RPI’s calculation with the formula used for CPI could have shaved up to 0.9% from the measure and led to lower returns on index-linked bonds.
Jonathan Gibbs, head of real returns at Standard Life Investments, said: “The decision not to change RPI has seen practicality and consistency win out over mathematical accuracy.
“The debate was always a clash between these two arguments and the national statistician has clearly taken account of the huge number of assets priced off RPI. To that extent this represents a pragmatic decision by [Office for National Statistics] which balances practicalities with principles.”
Pensioners will also win, as their index-linked annuities will remain the same. However, some groups have will lose out because of the decision – including pension funds that would have benefited from lower future liabilities, firms that would have seen lower RPI-linked business rates and those buying rail fares and other index-linked goods and services.
Vicky Redwood, chief UK economist at Capital Economics, said: “The government is certainly the biggest loser from the decision – we had estimated that the proposed changes could have saved the chancellor around £7bn per annum by 2016/17 [through lower interest on index-linked gilts].”
Is RPI heading to the scrap heap?
So, has the RPI debate been settled? Will the UK continue to use a flawed method that fails to meet international standards and pay higher interest on some of its government debt because of it?
Asset managers may be celebrating today but I doubt their victory will last forever. When a shop has put the wrong price on a product, I don’t expect to keep paying the lower price every time I go back. The analogy might be simplistic but I can’t see why inflation-linked securities will continue to be priced off an index everyone accepts is flawed.
In all likelihood, the errors created by RPI’s calculation are likely to return to the spotlight and pressure to price index-linked bonds off a lower measure will grow. The new RPIJ index could play an important role in this.
Azad Zangana, European economist at Schroders, said: “The introduction of the new RPIJ index is designed to highlight the problem with the RPI index over time and will probably eventually replace the RPI index as the key benchmark for compensating inflation-linked bond investors.”
Standard Life Investments’ Gibbs, on the other hand, argued that the consultation means there is a higher chance of inflation-linked bonds being priced off CPI – although he doesn’t expected to see any changes in the next couple of years.
In either case, the coupons on index-linked bonds will probably be lower than if they stuck with RPI.
It could be that RPI’s days are numbered. The UK Statistics Authority wants RPI to be re-assessed immediately to see if it should be stripped of its ‘national statistic’ status. Although the asset management industry won under the recent consultation, it should still prepare for the lower RPI world it is trying hard to avoid.
