How to cut the debt – and inflation – at a stroke

We’ve written here in the past about the various ways the government might use to try and cut the Retail Price Index. There are all sorts of reasons why this would work for them.

First and most obviously, low inflation is better than high inflation; so the lower you can make the RPI look, the better. Second, it would make the liabilities of private sector occupational pension schemes look less bad – many of their payouts are linked to RPI, so the lower RPI is expected to be, the better they look.

However, possibly the most important reason to keep RPI down from the government’s point of view is to keep the returns the Treasury has to pay out on index-linked gilts (which are linked to RPI) down.

There was a suggestion that the Treasury might deal with the high cost of index-linked bonds by starting to issue CPI-linked bonds rather than RPI-linked bonds (CPI has been about 0.7% lower than RPI over the last two decades). See last year’s consultation paper on this.

But the release of minutes from a meeting of the Consumer Prices Advisory Committee (CPAC) suggests that there is now the beginning of a new plan underway – to adjust the RPI formula to bring it in line with the CPI.

Peter Warburton, writing in the Halkin newsletter, notes that the committee discussed the “identification, understanding and elimination of unjustified causes” of the difference between the two measures, something which is known as the ‘formula effect’. Were this to happen – ie the formula effect to be eliminated – and the RPI to fall near to CPI, this could, says Warburton “slice off perhaps 25% of the inflation-linked element of the return to redemption on a bond.”

Ben Lord of M&G thinks it could be even more significant than that. Commenting in the FT’s FTfm section earlier this week, he claims that were the RPI to be calculated on a geometric mean as the CPI is (rather then the current arithmetic mean) and that calculation was applied to all goods and services, the RPI would fall in the region of 0.9%. That, he says, would wipe off around 40% of the value of the typical linker.

The move would, Lord says, not be particularly different to the way in which the government cut the coupon on War Loans from 5% to 3.5% in 1932 (I’ve written about this here). It might not be an official default, but it would still be one. Is it likely? Hard to say.

The Bank of England has 80% of its pension fund in index-linked bonds, and also has the right to object to any changes it considers to be “materially detrimental” to holders of them. On the other hand, if the UK government is hoping to reduce its debt burden via inflation, having a huge proportion of its debt in instruments linked to the RPI – the highest level of inflation it calculates – really isn’t very helpful at all.