RPI: a Bedtime Story

The Office for National Statistics has just decided against modernising the way it calculates the Retail Price Index. It’s a not uncomplicated issue, so perhaps best to listen in on a father-son bedtime explanation.

Q: Daddy, what’s inflation?

A: Well Johnny, it’s very simple. It’s a way of measuring how much the prices of stuff we pay for has increased over the past year. Now, it’s very important because it’s one of the things that shows you how the economy’s doing, and the Bank of England’s main job is to try to keep CPI inflation as close to 2% as possible.

Q: What’s CPI?

A: Good question: CPI is the consumer price index. It’s one of the ways of measuring inflation. But Johnny, don’t whatever you do confuse it with RPI, the retail price index.

Q: So… why are there two types of inflation?

A: Well it would be nice to pretend that there was a good reason for it but it’s mainly a quirk of history. RPI was originally set up following World War Two as a compensation index to ensure British workers weren’t being done out of their pay – as they did in the interwar period. But then, as people realised they needed a broad measure of prices in the economy, they started to use RPI. Companies linked pay contracts to it; pension firms used it to calculate how much their pensioners would get in benefits; privatised industries like rail and utilities used it to calculate annual ticket price increases; the Government based benefits increases on it, and when it sold index-linked (inflation-proof) bonds, it agreed to tie them to RPI.

In other words, it gradually transmogrified into Britain’s main inflation index. But then, a couple of years ago, the Office for National Statistics introduced CPI and that’s become more and more important. And they all lived happily ever after. Time for bed.

Q: But Daddy you didn’t answer my question: why are there two types of inflation?

A: OK. Deep breath. Short answer: they give you different numbers. RPI tends to be, on average, about 0.9% points higher than CPI – even when the raw data, the prices that make it up the measures, are precisely the same.

Now, one explanation is that the two measures include slightly different things – for instance RPI includes mortgage payments and council tax; CPI includes university accommodation and stockbroker fees. But really the big reason is they’re calculated slightly differently. You remember from your maths classes the difference between multiplication and addition? Well, the RPI formula uses addition to average out the prices while the CPI formula uses multiplication.

Q: My head hurts.

A: Hang on, I’m not quite there yet. The particular addition method formula used in the RPI process is, well, a bit unusual. It’s called the Carli formula, based on a recipe from an 18^th century mathematician called Giovanni Rinaldo, Count of Carli-Rubbi. And the upshot is that if prices rose during the year and then fell back to zero, the Carli formula used in RPI could show an increase in inflation, while most other average methods would show prices remained unchanged.

Q: That’s silly. So when they realised they got rid of it?

A: Ah. No. The Office for National Statistics has now decided to leave RPI as it is, despite the fact that the vast majority of economists and statisticians say it’s faulty. It means that gap between RPI and CPI will remain in place.

Q: Oh but Daddy why?

A: Come on: I think it really is time for bed now.

Q: Daddy, please!

A: Alright. Well basically it wasn’t changed because there were lots of people who made a fuss about it.

Q: But didn’t the experts want to get rid of it?

A: Yes, but they were out-argued by the people who were going to lose out from the switch.

Q: The rich people?

A: Don’t be crude, Johnny. Wealthy pensioners, big investors, landlords, rail companies and the student loans company – people like that. They would have all lost out on that extra 0.9% of interest/inflation if the RPI had changed since. So they persuaded the ONS to leave the index unchanged, arguing that it would be unfair to switch it arbitrarily like this.

Q: So everyone stays on RPI, right?

A: Erm, no. If you’re on benefits or on the state pension, your payments no longer increase in line with RPI. You’re likely to be worse off. Or if you pay a student loan, or railfares, or utility bills, all of which will be higher as a result. And given taxpayers end up having to pay about £1bn extra a year in interest on index-linked bonds, essentially every UK taxpayer ends up paying more.

Q: So. What you’re saying is that rich pensioners and investors have won out and everyone else has lost out.

A: Well that’s one way of looking at it, but it’s really a lot more complicated than that.

Q: Daddy, don’t you have a lot of index-linked bonds?

A:  Shh Johnny! Clearly it’s all a bit too complicated for you to understand. The thing to remember is that the right decision was taken. Anyway, don’t worry because on the bright side the ONS has come up with an alternative measure of inflation, the RPIJ, which will show you what RPI really ought to look like. Unfortunately it won’t actually be used for anything for the foreseeable future. And…

Q: Wah. I thought you said there were only two measures of inflation.

A: No dear, I was simplifying a bit. In fact, there’s now eight monthly indicators: CPI, CPIY, CPI-CT, RPI, RPIX, RPIY, TPI and now RPIJ.

Q: I feel sleepy.

A: Goodnight, Johnny.