Mooted changes to ‘flawed’ inflation measure could hurt investors
The Chancellor has refused to review a decision on whether to scrap the controversial Retail Prices Index (RPI) measure of inflation in the short-term, despite reputable statisticians saying it is a flawed measure of price increases.
However, an indication that it will be reviewed from 2025 has sent shockwaves through the RPI inflation-linked UK Government debt market, causing the price of some longer-duration bonds to fall by 10%.
Investors were caught off-guard and many were unaware of how changes to inflation measures would impact certain investment products.
Switching away from RPI could see inflation-linked government bonds, also known as ‘linkers’, produce lower returns.
WHAT IS THE DIFFERENCE BETWEEN RPI AND CPI?
The RPI measure of inflation was introduced in 1947, but was usurped by the Consumer Prices Index (CPI) measure of inflation, introduced in 2003 and thought to be more reliable.
The two differ in how they calculate inflation, with RPI typically running around one percentage point higher than CPI. More recently the CPIH measure was introduced, which charts inflation including housing costs.
However, a number of parts of our everyday life are still linked to RPI, from student loans to pensions and train fares.
The Bank of England, which produces the figure each month, has already said the RPI measure is not fit for purpose, with Governor Mark Carney saying it is ‘of no merit’ and should be scrapped. He’s not alone – the Office for National Statistics has branded the RPI measure of inflation as ‘flawed’ with ‘serious shortcomings’ and does not recommend it being used.
More recently the UK Statistics Authority said that RPI should be scrapped and merged with the CPIH measure of inflation. However, Chancellor Sajid Javid has delayed making any decision, saying any change will be consulted on between 2025 and 2030 – effectively kicking the can down the road.
David Norgrove, chair of the UK Statistics Authority, says: ‘We continue to urge the Government and others to cease to use the RPI. It would be wrong for the Government to continue to use a measure of inflation which it itself accepts is flawed, where it has the opportunity to change.’
WHY DOES IT MATTER?
Despite being discredited, some big price rises in our lives are determined by RPI, rather than CPI, meaning it likely affects most people in one way or another.
The Government has been accused of cherry-picking which measure of inflation is used. CPI is often used for hikes that benefit the public, such as state pension increases, tax credits or public sector final salary schemes, while RPI is used for things that cost them, such as price hikes on rail fares and setting interest rates for student loans.
Tom Selby, senior analyst at AJ Bell, says: ‘The Government’s reticence to abandon RPI is likely in part driven by the fact it has been used as a money-making machine in recent years. For example, back in 2011 the Government chose to switch the inflation measure used for public sector pension increases from RPI to CPI, saving the Treasury tens of billions of pounds in the process.’
WHO IS HIT IF RPI’S USE IS EXTENDED?
One of the biggest hits is for graduates as student loan interest rates are linked to RPI rather than CPI. This means they pay more interest on their loan than if it was linked to CPI.
The rate is based on the inflation figure from March the previous year. This year RPI inflation in March was 2.4% compared to 1.9% for CPI.
For someone with the average student loan debt of £50,000, this equates to an extra £300 in interest a year. It’s also worth noting that the difference between CPI and RPI is usually larger, so the difference would usually be greater.
Commuters are also hit with an RPI increase to their train fares and season tickets each year. People have long called for this to be changed, but the train companies argue that its workers’ wages are linked to RPI increases each year. July’s figure for RPI is used for rail fare increases in the following year – this July the figure for RPI was 2.8%, while CPI was 2.1%.
WHO BENEFITS IF RPI ISN’T SCRAPPED IMMEDIATELY?
Pensioners and investors will likely benefit from RPI still being in place until at least 2025. Some private sector defined benefit pension schemes have RPI-linked increases baked into their scheme rules, which means that each year the rise is higher than if it was linked to CPI.
Some pension schemes have already tried to switch to the lower CPI measure, but have been defeated in their attempts – as it would effectively equate to a pay cut for pensioners.
Another area where many pensioners benefit is the millions of people who have bought annuities that rise in line with RPI. Investors also enjoy RPI-linking, as those who have purchased index-linked Government gilts from the Bank of England see the value of their coupon or yield increase in line with RPI.
If RPI is eventually scrapped, the Government will have to figure out what to do about the existing stock of products and benefits where the inflation measure is used. It might be that the measure is continued for existing contracts, but all new contracts are switched to CPI. What seems certain is that many investors will lose out should RPI go.