Budget alert:The dangers of using the Consumer Price Index rather than the Retail Price Index

Today in his Budget the Chancellor George Osbourne has announced some far-reaching changes to the treatment of some benefits and pensions. However in a move which I consider to be rather sneaky he has made them via the back-door. He is hoping that most people will not understand the nature of the changes that he has made and I feel that the changes for that reason are somewhat shameful. They also continue an official trend in the UK of downplaying and downgrading inflation statistics and inflation measures such that if they are not careful they will lose all trust and credibility. 

To help explain my point let me quote from the Chancellor’s speech directly. 

First, we need to put the whole welfare system on a more sustainable and affordable footing.So from next year, with the exception of the state pension and pension credit, we will switch to a system where we up-rate benefits, tax credits and public service pensions in line with consumer prices rather than retail prices. The consumer price index not only reflects everyday prices better, it is of course now the inflation measure targeted by the Bank of England. This will save over £6 billion a year by the end of the Parliament. I believe this is a fairer approach than a benefits freeze. In time for the next Budget we will also publish proposals to move the indexation in the tax system from RPI to CPI in a way that protects revenues. 

What does this mean? 

What the Chancellor is saying is that benefits from next year will go up by the (usually lower) CPI rather than the (usually higher) RPI. I hope that you are beginning to get my point in that this is a downgrade which will lead to benefits, tax credits and public sector pensions going up more slowly in the future. Whilst there are issues over public sector pensions and their cost this almost subliminal downgrade is not the way to do it and of course it pre-empts the Hutton Review. For benefits and tax credits this is an outright cut in future payments in real terms. He is hoping that this will be considered something complicated and arcane and that the full implications will not be focused on. 

Let me spell out the implications of it on this years evidence. Currently CPI inflation is at 3.4% and RPI is at 5.1%. However this is not a one month fluke. Let me explain by showing the annual rates of change for the two indices from 2002 to illustrate my point. 

CPI: 1.3%;1.4%;1.3%;2.1%;2.3%;2.3%;3.6%;2.2% 

RPI:1.7%;2.9%;3.0%;2.8%;3.2%;4.3%4.0%;-0.5% 

As you can see in every year RPI inflation exceeded CPI inflation up until 2008. 

NB: 2009’s implications are not what you might think 

Of the two CPI inflation was only higher in 2009 and I am afraid that even 2009 is worse not better as it may at first appear! You see RPI was driven down in that year to -0.5% by the cuts in interest rates made by the Bank of England which affects mortgage rates which are not in the CPI. As base rates are now 0.5% there is now virtually no room for anymore cuts so the next likely move is upwards. What will this do? It will raise the RPI by more than the CPI. So not only is this a bad move overall but the timing is particularly sneaky and to my mind too clever and sneaky by half. Of course many will miss the subtleties of this. 

Comment and Conclusion 

As tax credits and benefits payments will be affected by this (the state pension is being treated much more favourably). Then this move is travelling in exactly the opposite direction to the principle of what I have advocated. It will reduce the real value of benefits to many of our poorest citizens. I think it is an underhand and low quality move. 

Furthermore there is another corollary to this. These moves tend to spread so that anybody who has a private sector pension that depends on a promised benefit level rather than a fund value is likely to be affected as time goes by from a type of inflation index creep. Let nobody be in any doubt that this is a downgrade and that over the length of time that a pension may well be in payment will lead to a quite considerable fall in the real value of the pension payment in my view. These days if you retire at 60 you are expected to live for 20/25 or 30 years so please go back to the inflation numbers I have put above and extrapolate the effect of them over such a period if you are likely to be a pension beneficiary. If you doubt my view that these things tend to spread then please look at “In time for the next Budget we will also publish proposals to move the indexation in the tax system from RPI to CPI” from the Chancellors statement. 

The timing of the move is to my mind also influenced by the fact that RPI based inflation has fallen as interest rates have fallen but to avoid it rising as and when interest rates finally rise again. 

I think that the following sentence begins with a shameful and untrue statement and goes on to describe something of which I have been very critical. 

The consumer price index not only reflects everyday prices better, it is of course now the inflation measure targeted by the Bank of England 

To the first part of the sentence my reply is no it does not and my views on the use of CPI as an inflation target have been the subject of several articles by me but here are my views from the 20th April. 

 

Technical Point 

 

I felt that when the inflation targeting system was changed in the UK it was a policy error and I feel that this years figures are confirming this. When it was changed I argued that there were two main flaws. 

1. The gap between the new and old target should have been more like 0.75% rather than 0.5% 

2. There is a difference in the standard deviation of the two measures with RPIX being likely to have a higher measure on this than CPI. In other words for the same rise (fall) in inflation we are likely to see a bigger move in RPI than CPI. 

Unfortunately I was only one voice but this years numbers are reinforcing my original criticisms of the change. Our current inflation measure is 1.4% over target and our previous measure is 2.3% over target. Seeing as they are supposed to be measuring the same concept this is quite a difference! 

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14 thoughts on “Budget alert:The dangers of using the Consumer Price Index rather than the Retail Price Index

  1. Thank you very much for this. You’re so right that it is a cunning and clever move which will avoid political flak but diminish pensions and benefits significantly. I don’t fully understand the mention of forthcoming proposals by the time of the next budget “to move the indexation in the tax system from RPI to CPI in a way that protects revenues”. If reliefs are to be given in line with the lower CPI surely that automatically protects revenues? In what way could revenues potentially be damaged? I must be missing something here, clearly.

  2. Thanks Shaun, I also noticed the rather disingenuous inflation index trick. Arguably it was politically quite clever, because it was Brown who ushered in the double index arrangement, but I think you are right, it is underhand and will likely be the cause of problems in the future. Clearly the government wants some benefits to wither gradually on the vine, but does not have the courage to make the cuts explicit or immediate.
    Anyhow, I look forward with great interest to your comments on other aspects of the Budget!

    • Hi Ian
      You should be ok as they are relatively short-term the longest of them I can remember goes for 5 years and you can get a prospectus with them which should pin it down. Those with index linked gilts either outright or in a fund may be a little more nervous as in the longest case there is plenty of time between now and 2055! There is a clause saying that you cannot be “materially disadvantaged” in index linked gilts but I will talk more on that as part of tomorrows article.

  3. It is surely interesting that soon after the election Osbourne was stating that he was not happy with CPI as the flagship metric, since he believed that the failure to include housing costs and interest costs was unrealistic and those should be included in the metric, as with RPI.

    Now with the pressure of fiscal problems he evidently has taken the cowards’ way out? Does one hear a cry of “Politicians – they are all the same”? !

  4. Not sure of the issue here. Aren’t benefits supposed to be a safety net? In this case it would seem logical to use the CPI as one can’t buy a house with state benefits. Same with a pension.

    They want to make savings and this would seem a logical move to me. I’m not saying it’s ‘fair’, but to me it does seem to realign benefit provision with their intent. If the poorest (and not so poor these days) can’t afford a roof because of it then that would best be provided for in a specific way that fully facilitates house costs.

  5. I am in receipt of a (small) pension fromthe TPA and am very disgruntled about the switch from the RPI to the CPI. Naiveley I had rather imagined that once the pension was in payment they would not be able to change the basis on which it is paid. I am surprised that I have not heard any comment on the legality of this switch from the public sector unions. After all the government of the time considered it was impossible to cut back on Sir Fred Goodwin’s pension because of his contractual rights, but then he was a banker and as such a much more worthy and useful citizen than a mere teacher….

  6. I agree with Ken that CPI does not seem a wholly inappropriate choice for incrementing benefits most benefits, since they are not supposed to pay for accommodation costs (although even then CPI includes rental costs unless I am mistaken). For the years you have shown, RPI inflation is indeed a lot higher than CPI inflation, but during these years an unprecedented house price bubble developed. With this deflationary budget, hopefully we will see the end of silly house prices and mortgage multiples (I am of the generation that would like to own a house, but am reluctant to take on two houses worth of debt to do so). Also, as someone who receives child tax credits and child benefit, I must admit this budget wasn’t as painful as I’d feared. The real pain will come from the 25% real reduction in departmental budgets – although my guess is that Osborne was being over-ambitious to make up for the fact that any target for real cuts is unlikely to be met. Overall, I thought the budget was quite fair and reasonable for business (yes, I know VAT went up, but it was anomalously low in the first place).

  7. The local government pension scheme web site contains an explicit statement that pensions are guaranteed to rise in line with RPI. Furthermore on the basis of that representation some will have entered into contracts to purchase additional pension. I too am curious to learn how this differs from what we were led to believe in respect of RBS.

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