The fight over measuring UK inflation

A hidden battle is raging over inflation. Alongside the public fight over how to defuse the looming cost of living crisis, there is a guerrilla war going on about how UK inflation is measured and if that calculation can be changed retrospectively.

The evidence for the battle is published every month by the guardians of truth in official numbers — the Office for National Statistics. Its consumer prices bulletin publishes not one but three different rates of inflation. When the next batch is revealed, two bets are pretty safe: all three will be different and they will be higher than the 4.6 per cent, 5.1 per cent, or 7.1 per cent it published in December.

The range is massive. The highest is 2.5 percentage points above the lowest. If your pension was linked to that, the rise would be 54 per cent more than if it was linked to the lowest. Yet the government’s latest plan is to do just that.

The lowest rate happens to be the ONS’s preferred measure called CPIH which stands for consumer prices index (including housing). It is the one which has topped ONS press releases and briefings since its launch in March 2017. To find any other measure you need to burrow down or even download a spreadsheet to find all the others.

Despite that, the media doesn’t report CPIH and it is not used in the real world for any practical purpose except by Ofwat for setting controlled water prices. It has been criticised for using changes in rent as a proxy for housing cost changes for the 65 per cent of householders who are owner occupiers.

Until 2011 just one measure of inflation was used — the retail prices index or RPI. It is currently the highest of the three and has been used since its introduction in 1947 for any official calculations relating to the cost of living, including wage bargaining. It is so prevalent that it has been back-calculated by ONS boffins to the reign of Edward I in 1270 and is still used for historical calculations to tell us what £100 in Victorian or Elizabethan times is “worth” now.

But statisticians said the RPI was flawed and wanted to replace it with the more internationally favoured measure called consumer prices index or CPI (no H yet). The government gladly accepted their advice largely, cynics say, because CPI was lower than RPI.

That is due almost entirely to what is called the formula effect. The RPI aggregates multiple prices using a simple arithmetic mean or average — add them up and divide by how many there are. The CPI uses the geometric mean — multiply the prices together and take the nth root where n is the number of items. For positive numbers that always gives a lower number. Since January 2015 the average reduction in inflation due to this formula effect is 0.81 percentage points. Last month it was 1.16 out of the 2 percentage points difference between the two.

CPI was published from 1997 but it was only in 2011 it became the official government measure of inflation and was used to raise benefits — saving £2bn a year, cumulatively — and has come to replace RPI for other things such as lifting tax allowances — that is, when they are not frozen to save even more money.

Two years later RPI was dealt another blow when it was declared by the National Statistics Authority to be no longer an official statistic. The Authority and ONS advise against using RPI.

Despite that, the ONS publishes RPI each month because it is used in many calculations, not least where it ultimately saves the government money such as in raising controlled rail fares — which reduces the Treasury subsidy — and the interest charged on student loans — which means more money is paid.

The government now plans to keep RPI but redefine its arithmetic so in effect it becomes CPIH

It is also baked into the contracts of many company pensions which specify RPI for the annual cost of living increase. Most pension schemes where the contract does not specify RPI have made the change to CPI — a welcome relief for the fund if not the pensioners. But where RPI is specified the Supreme Court ruled in November 2018 that it cannot be changed.

The biggest problem for the government is the £819bn of index-linked gilts. They account for nearly a quarter of all gilts and are linked to the RPI — a phenomenal return now RPI is 7.1 per cent compared with a 25-year gilt issued in January 2021 which paid just 0.825 per cent. The government now plans to keep RPI but redefine its arithmetic so in effect it becomes CPIH. That will happen with the RPI issued in February 2030. Holders of index-linked gilts and others will not be compensated — a saving says Insight Investment of £100bn to the government over the life of the bonds and a cut in the value of pensions by 10 to 15 per cent.

In December, the High Court gave three major pension funds with 450,000 members the right to challenge the plans. The judicial review hearing is expected in the summer. The government’s defence could be published as soon as February.

 The battle for RPI continues.

Paul Lewis presents ‘Money Box’ on BBC Radio 4, on air just after 12 noon on Saturdays, and has been a freelance financial journalist since 1987. Twitter: @paullewismoney