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.
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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.
This article is taken from the free investment email Money Morning. Sign up to Money Morning here .
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