Inflation measurement is vital to the UK economy, so we have to get it right

Written by John Astin & Jill Leyland on . Posted in Features

To an outsider, the debate surrounding the UK’s price indices may seem unfathomably complex. But beneath this complexity lies an issue of vital national importance in how we are to measure consumer price inflation in the future. The fact is, users of price indices can have vastly different needs, and these can both clash and complement each other in complicated ways.

The UK Statistics Authority (UKSA) has just conducted a consultation on the future of price indices. The ultimate decision will have a powerful effect on the evidence available for economic decisions for decades to come.

In the case of consumer prices, the challenge facing official statistics is immense. Satisfying so many user needs - while compiling an index that communicates the general rate of inflation to the public - is fraught with difficulty.

When John Pullinger launched the UKSA consultation in June, he outlined the three broad areas that rely on official price indices. The first is macroeconomics, the second is households and the third is the many contracts and gilts that are indexed to inflation. This third need demonstrates the complicated effects of changing (or discarding) any price index.

The Retail Prices Index (RPI)

The longest running measure of inflation we have is the retail prices index (RPI), which has been calculated consistently since the 1950s. While official statisticians believe that the RPI has some basic statistical shortcomings, this view is not universally supported.  

The UKSA has stripped the RPI of its ‘national statistic’ status. However, it cannot be simply condemned to the statistical scrapheap. Beyond its enshrinement in legislation, it is also the legally indexed measure for many contracts and gilts that were signed years ago - the longest-dated gilt will not expire until 2068.

It is also the most used index for uprating private sector pensions and is widely used in business contracts. Furthermore, many users believe it is a better indicator of inflation than the main alternative, the consumer price index, and challenge whether its shortcomings are as serious as official statisticians believe.

For these reasons, we don’t believe that the RPI’s methodology should be frozen in time. It remains an important price index and as such, needs to be improved and updated as any other key statistical series would be.

The Consumer Prices Index (CPI)

The consumer prices index is in reality the European Harmonised Index of Consumer Prices (HICP), and, as such, beyond the control of ONS. It is however designated as a UK 'national statistic'. It is the Bank of England’s target index for setting the interest base rate. Since 2010 the government has used it instead of the RPI for a number of purposes including the uprating of public sector pensions and as part of the triple lock for the state pension. 

It was constructed explicitly as a 'macroeconomic' index, and not designed for indexation or uprating. Indeed, its focus is far from being that of the typical household. The implicit expenditure profile of the CPI is that of households approximately two thirds up the expenditure scale. Moreover, it does not include owner-occupier housing costs (except repairs and maintenance) and it does not cover the major part of insurance premiums.

These very real forces on the cost of living, as experienced by consumers, have to be met with a measure that reflects the way households contend with inflation. For this very reason, most other European nations have a national price index separate from their EU mandated index.

The Consumer Prices Index with Housing costs (CPIH)

Paul Johnson’s recent review of inflation statistics recommended that CPIH be made the main measure of the UK’s inflation. CPIH is the same as the CPI except that it includes an allowance for owner occupier housing costs. But this is based on ‘rental equivalence’ which implicitly assumes that the costs of owner-occupation move in line with rental markets for similar properties.

RSS president, Peter Diggle, wrote a letter to John Pullinger following Johnson’s review to express the Society’s view that CPIH is not sufficient to satisfy the needs of households. In this regard, Peter wrote: 'We believe the review should have started from first principles by examining the different needs that consumer price indices aim to meet, then deciding what sort of index is required for each need and the extent to which they can, or cannot, be combined.'

He continued, 'we therefore urge that the approach of a full "household inflation index" based on actual expenditures incurred be examined in detail and a practical route for its development set out. I hope you will ask ONS staff to work on this so that it can be one of the options in the consultation.'

Towards a Household Inflation Index (HII)

Subsequently the RSS asked the two of us to work on a proposal for a Household Inflation Index, or HII, that might ultimately be used to replace the RPI and would reflect its original purpose.

The first principle behind a household inflation index would seek to measure ‘inflation as perceived and experienced by households in their role as consumers’. This is a definition taken from the Preface to the International Manual on Consumer Price Indexes (ILO, 2004).

The goods and services covered by a household index should therefore cover the expenditures actually made by households, and weighted according to typical household expenditure patterns. Thus it would need to cover interest payments – especially mortgage interest (as in the RPI) - and, of course, Council Tax. More fundamentally, it must be an index which can be accepted by most citizens as an index which genuinely reflects their average rate of inflation.

Our proposal for such a household inflation index (which is set out fully here) are not set in stone but they set out, we believe, a basis from which the needed new index can be developed.

The rate at which prices are rising or falling is one of the most vital indicators we have for managing the economy. The task facing the UKSA in satisfying the intricate needs of these various interested parties and legislative requirements is a difficult balancing act. Few would dispute the need for producing different price indices for different purposes – it is unlikely that any single index could suit all purposes.

However, the current array (totalling twelve different measures) has developed in a haphazard way, each responding to different needs at different times. The original aim of the RPI – and indeed its predecessors stretching back over a century – has become largely neglected.

It is vitally important that we remember the need for a household inflation index when deciding on the future of these outputs. The general public needs an index that can be easily understood and relied upon to give an accurate picture of how the cost of living is changing for them.

 

The views expressed in the Opinion section of StatsLife are solely those of the original authors and other contributors. These views and opinions do not necessarily represent those of The Royal Statistical Society.

John Pullinger UK Statistics Authority Inflation

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