The government takes another step closer to fiddling the inflation figures

Pensioners got a bit of good news for once yesterday.

The government has decided against making yet another change to the way that inflation is calculated.

Oddly enough, when governments recalculate inflation, it almost always means that inflation ends up being lower than it was before.

There’s a good reason for that. A lot of payments the government has to make are linked to inflation. So the lower inflation looks, the better.

Also, the government is heavily in debt. Inflation helps to erode away debt. So the government has an interest in understating it.

So yesterday’s reprieve was good news. But a look at the small print makes us think that it won’t last…

A brief history of inflation measures

The Retail Price Index (RPI) is the price index that most British people still refer to when they’re asked what the rate of inflation is. It’s also the index used to calculate the value of index-linked government bonds. In all, as the FT points out, “the RPI underpins £249bn in index-linked government bonds”.

RPI has been around since the late 1940s. That’s pretty old as these things go. And it was the UK’s core inflation measure – the Bank of England’s inflation target was derived from the index until 2003.

Then, under the New Labour government, the Consumer Price Index (CPI) became the Bank’s target measure. CPI is calculated differently to RPI. I won’t go into the details, but CPI always came in a little bit lower than RPI – about half a percentage point. So when the Bank switched to the CPI target from an RPI-based one, the target rate fell to 2% from 2.5%.

Why make the change? To be fair to Gordon Brown (regular readers will know that’s not something I’m often inclined to be), this move was probably as much to do with arguments over whether to join the euro or not, as with fiddling the inflation figures.

In any case, we were all assured by the New Labour government of the time that RPI would continue to be used for wage settlements, benefit changes, and pension changes. After all, no one wanted to see their incomes pegged to a measure of inflation that was consistently lower.

Of course, New Labour isn’t in power any more. We have a cash-strapped coalition running things. And one way to save money is to switch inflation measures from RPI to CPI where possible, so that you raise benefits, and tax thresholds, by just a little bit less each year. Over time, that saves a lot.

Already, the coalition has switched from using the RPI to CPI for calculating rises in both the state pension and public sector pensions.

But switching from RPI to CPI is quite a noisy move politically. It’s pretty obvious that you’re doing it. What you want is to find a sneaky way to drag down the cost of the more politically sensitive areas that are linked to inflation.

Expect to see more pressure to change the inflation measure

So when the Office for National Statistics announced last year that it was reviewing how RPI was calculated, it seemed almost certain that RPI would be changed to be more like CPI. In other words, it would have ended up being significantly lower.

A lower RPI would have meant lower payments on index-linked bonds. The FT estimates it could have saved the government about £3bn a year in interest payments. So you can see the attraction for a skint government.

Better yet, there’s an intellectual fig-leaf available to justify the change. Lots of economists have harrumphed that the way the RPI is calculated is ‘out of date’ and ‘out of step’ with the rest of the world.

They may well be right. Although I do find it intriguing that no government ever recalculates an inflation index so that it shows prices rising more rapidly than anyone had realised.

It seems that the more efficient the price index, the less inflation it reveals. Funny that.

Anyway, in the end, our statistics body decided not to make the change. The chief statistician – Jil Matheson – agrees that there are flaws with the way RPI is calculated. But overall, the government “had a responsibility to continuing users… which said that you just can’t suddenly change a series that has gone back to 1947”. Many annuities are linked to RPI too. So a change would have been bad news for pensioners.

In other words, Matheson has enough grasp of the real world to realise that it’s very risky to change the terms of a government debt contract overnight. Particularly when you are so dependent on the goodwill of bond investors.

So can those with RPI-linked annuities and holders of index-linked gilts relax? Well, I wouldn’t get too comfortable. From March, a new inflation index – RPIJ (the ‘J’ stands for ‘Jevons’) – will be published alongside RPI and CPI.

This index will be the new and improved version of RPI. It won’t be used yet to calculate anything. But as we learned with CPI, it’ll only be a matter of time before the government finds a convenient excuse to make the change.

These constant attempts to understate and massage inflation are just another example of ‘financial repression’. This is where the state attempts to inflate its way out of debt without scaring the horses too much. In essence, it means it’ll become ever harder for you to earn an income and a return on your investments that keeps up with the cost of living.

We’ll be writing a lot more about this in the near future. In the meantime, you can see why we’re so concerned about the current state of the UK in our most recent report – if you haven’t seen it yet, click here.

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  • Boris MacDonut

    Isn’t the £375billion of QE the biggest attempt to “massage” the inflation figures? Without it we’d have zero inflation or even deflation. It is politically much worse having to offer pay cuts than pay freezes and modest rises. People are fickle and up is up even when it doesn’t mean keeping up.

  • GFL

    What about the way both the RPI and CPI are measured? With basket substitutions and what not.

    My core costs ALWAYS go up above the rate of inflation; petrol, energy, train fares, gym membership, school fees, food, entertainment, etc. In fact pretty much everything apart from consumer electronics.

    I really feel for the ‘squeezed middle’ or those fairly new to the labour market, wages will not keep up with the real rate of inflation (in my opinion around 6%) for some time to come, especially with the BoE doing all it can to make sterling weaker.

  • Lupulco

    Anyway, in the end, our statistics body decided not to make the change. The chief statistician – Jil Matheson – agrees that there are flaws with the way RPI is calculated. But overall, the government “had a responsibility to continuing users… which said that you just can’t suddenly change a series that has gone back to 1947”. Many annuities are linked to RPI too. So a change would have been bad news for pensioners.

    In other words, Matheson has enough grasp of the real world to realise that it’s very risky to change the terms of a government debt contract overnight. Particularly when you are so dependent on the goodwill of bond investors.

    An honest and brave Civil Servant, bang goes the OBE.

  • RT

    Maybe there is now an argument for us (the taxpayer and consumer) to create a new RPI reflecting consumption patterns of middle to lower end wage earners and retirees(which is after all the bulk of the population) and not an RPI/CPI created by the government on behalf of the government to further its own ends. Over the last 30 years the RPI has developed into a complicated and generally unintelligible statistic which bears little resemblance to the spending patterns of most of us. I think we are in general agreement that the categories of consumers above are experiencing more like a 5%-6% inflation rate. Moneyweek please produce a simplified RPI!!

  • Clive

    I believe this example of why RPI is wrong was published in The Times some months ago.

    Take two items: A costs £1, B costs £1
    prices change: A now £1.25 (+25%), B now 80p (-20%)
    RPI says average is (+25%-20%)/2, hence 2.5% increase
    Correct. Basket of goods went from £2 to £2.05, up 2.5%

    Now A drops to £1 (-20%), B moves up to £1 (+25%)
    RPI again says average is 2.5% increase

    So, in the two moves, RPI says inflation was 2.5% each time
    BUT, basket of goods went £2, to £2.05, back to £2. ZERO change, now 2 x 2.5%

    Moral: RPI does not accurately show inflation of basket of goods over time if prices both increase and decrease (as they can & do)

  • Clive

    sorry, typo in my previous entry (5)

    “BUT, basket of goods went £2, to £2.05, back to £2. ZERO change, now 2 x 2.5%”

    Should read

    “BUT, basket of goods went £2, to £2.05, back to £2. ZERO change, NOT 2 x 2.5%”

  • Banker

    Clive – you are wrong with your calc – you did not take into account basket rebalancing.

  • jrj90620j

    Exactly the same as in the U.S.Govt has changed it’s method of calculating inflation twice,since the high inflation of the late 1970’s and is proposing changing again,to make inflation look even lower.I guess the majority of citizens are fine with it,since they have been dumping stocks and moving into bonds,for several years.I have figured out that to find the real inflation number,just multiply govt figures by 2.5-3.0X.

  • Clive

    Banker @ 7

    “you did not take into account basket rebalancing”. Not sure if that was a joke/not. Doesn’t matter to me, wasn’t my calculation, came from The Times.

    Little bit of research on my part suggests
    -RPI uses the so-called Carli formula
    -said to have an upward bias on rate of inflation
    -we see to be only country that uses it
    -mentions averaging, presumably of rates of inflation per item, which is what The Times were hinting at
    -imo, that’s not mathematically valid.
    -to me, answer should be 100% x (cost of all goods “after”)/(cost of all goods “before”)

    Bottom line would seem to be: doesn’t invest in inflation linked products if you don’t trust the calculation

  • dr ray

    Lupulco@#3

    “An honest and brave Civil Servant”

    Maybe. The other explanation which springs to mind is that she is in an index linked final salary pension scheme.

  • dr ray

    There is a recent article by Peter Schiff on inflation in the US which is a good read.
    http://www.marketoracle.co.uk/Article38445.html

    It doesn’t cover some of the more blatant manipulation of the statistics such as removing things which have become more expensive from the ” basket” because people can no longer afford to buy them!

  • Soapy

    Surely pensions and payments towards them are the subject to a legally binding contract between provider and the recipient? It follows that if the RPI is the declared measure used to calculate pension increases then this has to be the RPI as it was defined when the pension contract was agreed. Retrospective application of a changed definition cannot be legitimate. Or are the ‘contracts’ so weaslly-worded that this nicety can be circumvented in both government and company pension payments ?

  • JimW

    Why did it take from 1947 to now, 66 years in total, to catch on that RPI is being calculated wrong?

    Am I missing something or am I being thick?!

  • Mark

    @JimW Because stuff like this can be used by politicians for their own gain. It’s so complicated that the general public don’t see it.

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