inflation and the rpi-cpi wedge

INFLATION AND THE RPI-CPI WEDGE November 2015

1 OVERVIEW

The Retail Price Index (“RPI”) and Consumer Price Index (“CPI”) are the two main inflation measures in the UK, based on the cost of a predetermined, weighted basket of goods and services. RPI has historically been the reference index for all major components of the UK inflation market. CPI came to significance when it was adopted by the Bank of England (“BoE”) as the inflation target in 2003. The CPI target for the BoE Monetary Policy Committee is currently set at 2.0%.

The two inflation measures are intrinsically linked to government policy measures, domestic and global factors, and the exchange rate. The CPI is used for the indexation of state and civil service pensions and benefits, since the government announced a switch from the RPI measure in April 2011. As set out in the 2012 Autumn Statement, several benefits are currently increased annually by a fixed percentage, having previously been increased in line with CPI. Only a few benefits, including Disability Living and Carers Allowance are still updated in line with CPI. From April 2016 onwards, social housing rents shall be delinked from inflation on a temporary basis, switching from a CPI + 1% annual increase to a nominal -1% decrease over four years, whilst vehicle excise duty rates will increase from 2017.

Although the RPI has lost its status as an official national statistic, it continues to be used in the determination of many instruments. For one, the government currently uses RPI to price inflation-linked gilts; seemingly to attract investors with the typically higher rate. Due to the make-up of RPI, it is used in the determination of several tax allowances/thresholds, including corporation tax on chargeable gains, rates levied on business properties and a variety of indirect taxes including excise duties. Furthermore, despite the annual rate of increase associated with private pension schemes switching from an RPI-basis to CPI, certain pension schemes continue their RPI usage today.

The chart below plots the movement of year-on-year RPI and CPI since 1996:

-2%

-1%

0%

1%

2%

3%

4%

5%

6%

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

RPI v CPI (1996 - 2015)RPI CPI

Around 180,000 monthly price quotations are used in compiling the indices, covering around 700 representative consumer goods and services.

Both measures are calculated using Divisia money; a weighted average of growth rates of a number of different prices within the basket of goods and services. The components are weighted as two-period moving averages according to their usefulness, which is represented by the user-cost of holding these components. The user cost is measured by the difference between the interest rate paid on component balances and a benchmark rate. Pre-2005, this benchmark-rate was based on the rate of government bonds. However, since the Office of National Statistics (“ONS”) revised their methodology in early 2005 to adopt an envelope approach, the new benchmark rate is calculated as the highest rate amongst all components within each goods/services category, and therefore the least useful for transactions by assumption.

The difference between these two indices (the wedge) is of notable importance. For one, the aforementioned 2% CPI target means that a permanent wedge increase affects the corresponding RPI inflation rate. When assessing the wedge, it is important to distinguish between short-term factors affecting the wedge and longer-term factors. Short run differences in the wedge are variable and can be extreme as witnessed in the 2009 housing market downturn whilst long-term differences may emerge relatively stable.

This paper sets out a review of long-run inflation by first looking at the RPI and CPI measures, before decomposing key factors contributing to the differences between the two indices. Through this, we assess the long-term projection for the RPI-CPI wedge.

2 CPI BREAKDOWN

Consumer price inflation is the rate at which the prices of goods and services bought by households rise or fall using a sample basket of goods and services, updated annually to reflect the changing demands of the population. Launched in 1996, it is an internationally comparable measure of inflation that employs methodologies and structures that follow international legislation and guidelines.

A breakdown of the main components of the CPI basket of goods and services is highlighted in the table below:

September 2015 CPI Weighting (%) Avg. annual variation (%) No. item categories

Food & non-alcoholic beverages 11.0 -2.3 23Alcohol & tobacco 4.3 3.1 4Clothing & footwear 7.0 0.2 11Housing & household services 12.8 1.0 4Furniture & household goods 5.9 0.0 10Health 2.5 2.0 3Transport 14.9 -1.8 6Communication 3.1 0.9 2Recreation & Culture 14.7 -0.4 17Education 2.6 9.9 1Restaurants & Hotels 12.1 2.1 8Miscellaneous Goods & Services 9.1 -0.1 11Total 100.0 0.3 100

2

Some notable exceptions from the CPI basket that affects households include mortgages, savings and investments, charges for credit, betting and cash gifts. Since March 2013 the ONS has published a new measure of consumer price inflation called CPIH, which includes these costs.

The CPI weights are based on the monetary expenditure of all private households in the UK, foreign visitors to the UK and residents of communal establishments such as nursing homes, retirement homes and university halls of residence. The weights are mainly derived from the Household Final Monetary Consumption Expenditure component of the National Accounts.

Since the methodology was revised in 2005, CPI has fluctuated between highs of 5.3% and the current low levels of -0.1%, having slipped into deflation in March 2015 for the first time. Combining weighting with the average annual variation over the past year to September shows that some components are inflating significantly whilst others are deflating, netting out to give the around 0% CPI headline figure over the majority of 2015. The most notable deflationary components are food and non-alcoholic beverages owing to the continued supermarket pricing war, and transport which is largely related to the global fall in oil prices, down over 45% compared with a year ago, filtering through to fuel prices. Contrarily, education continues to inflate at a strong pace, up almost 10% from a year ago, with alcohol and restaurants/hotels following in second place, the latter of which has a total weight of 12.1% on the index.

Around two thirds of the CPI index is calculated through use of the geometric mean, while the remainder is calculated through the arithmetic mean. Arguments for the use of this combined calculation approach have been the subject of widespread debate since its adoption.

3 RPI BREAKDOWN

The RPI was first calculated for June 1947 and was developed as an aid to protect ordinary workers from price increases associated with the Second World War. It was only much later, after a number of significant developments that it came to be used as the main domestic measure of inflation. It has since been superseded in that regard by the CPI but it is still used by the government and markets for a range of purposes including wage determination and index-linked gilt markets.

Although the RPI is calculated by making use of a similar basket of c. 180,000 goods and services, the actual components selected vary quite significantly. Notable items that only the RPI measure accounts for include housing-related items, local authority taxes, indirect taxes and car prices. The housing-related items consist primarily of mortgage interest payments, housing depreciation, housing transaction costs, electricity, fuel water and maintenance costs and rents.

Weights for the RPI are derived from a number of sources but mainly from the ONS Living Costs and Food Survey. Each year a sample of several thousand households from across the UK keep records of their spending over the course of a fortnight. They also record details of major purchases over a longer period. In calculating the weights for the RPI, the expenditure of certain private households is excluded. Households whose income is within the top 4 per cent of all households and pensioner households which derive at least three quarters of their total income from state pensions and benefits are excluded on the grounds that the spending of these groups are significantly different from the majority. In addition, the RPI also excludes residents of communal establishments and foreign visitors to the UK. These restrictions are designed to make the RPI more representative of the ‘typical household’.

3

The RPI is calculated solely through arithmetic means and, when assessed against the Code of Practice for Official Statistics in 2013, was found not to meet the required standard for designation as National Statistics.

4 THE RPI-CPI WEDGE

For a number of years, a widely held view was that the long-run difference between RPI and CPI inflation was around 0.75%. Supporting this statement, RPI tended to be around 0.7% higher than CPI, on average between 1989 and 2011.

However, recent developments since the global economic crisis appear to suggest this statement no longer holds true, and will vary in the long term. Indeed, the Office of Budget Responsibility (OBR) projected a long-term wedge of 1.4% in 2011. As of March 2015, the OBR revised this forecast of the long-term wedge of 1.0% based on latest evidence of fiscal changes.

The differences between the RPI and CPI measures can be grouped into three main categories:

1. The Formula Effect – This happens as a result of the methodologies utilised in the calculation of the two indices. RPI makes use of arithmetic mean alone whilst the CPI, in accounting for cross-price elasticity of different goods and services, uses a combination of geometric and arithmetic means.

2. Housing Components – The RPI index includes goods and services related to housing such as depreciation of properties, mortgage interest payments and council tax, all of which are currently excluded from the CPI measure. This represents a significant proportion of household expenditure and, as such, it could potentially change RPI to a large extent compared to CPI.

3. Coverage and Weighting Differences – Aside from housing, the CPI Index includes a number of components not included in the RPI such as student accommodation fees, overseas tuition fees and brokerage fees. Similarly, the RPI exclusively contains certain items such as TV licence fees, vehicle excise duty and trade union subscriptions. Additionally, differing data sources and population sources are used to calculate appropriate weighting for the CPI and RPI indices, which can lead to discrepancies in figures.

5 FACTORS AFFECTING THE WEDGE

In this section we take a more detailed look at the three main factors driving the wedge.

5.1 The Formula Effect

This happens as a result of the methodologies utilised in the calculation of the two indices. RPI makes use of arithmetic mean alone whilst the CPI, in accounting for cross-price elasticity of

different goods and services, uses a combination of geometric and arithmetic means.

The geometric mean has an inbuilt tendency to understate the value of price rises. Advocates of this approach argue that this under-estimation is justified on the basis that it allows for price substitution; the notion that households respond to rising prices by switching purchases to lower cost alternatives. Those against its use point out that although examining household expenditure patterns is important when attempting to measure inflation accurately, cross-price elasticity of demand does not reflect

4

inflation directly; inflation is merely a measure of how much a typical basket of goods and services changes in value over a certain time period.

The graph below illustrates the percentage difference between RPI and CPI inherently caused as a by-product of the formula effect.

0.0%

0.2%

0.4%

0.6%

0.8%

1.0%

1.2%

2008 2009 2010 2011 2012 2013 2014 2015

PERCENTAGE DIFFERENCE BETWEEN RPI AND CPI CAUSED BY THE FORMULA EFFECT

Before 2010, the formula effect generally accounted for an average of 0.5% of the long-run difference between RPI and CPI inflation. Since 2010, this has risen rapidly to account for an average 1% difference over 2014 and 2014, although the OBR expects the effect to settle around 0.9% level in the long-term.

5.2 Housing Components

The RPI index includes goods and services related to housing such as depreciation of properties, mortgage interest payments and council tax, all of which are currently excluded

from the CPI measure. This represents a significant proportion of household expenditure and, as such, it could potentially change RPI to a large extent compared to CPI.

The RPI includes housing components comprised of owner-occupiers’ housing depreciation, council tax and rates, rent, water and other charges, repairs and maintenance charges, do-it-yourself materials, dwelling insurance, ground rent, house transaction costs (e.g. estate agent fees and surveying costs) and mortgage interest payments. By contrast, the CPI index only includes services associated with rents e.g. minor repairs and maintenance costs, water and other charges.

5

-3.0%

-2.0%

-1.0%

0.0%

1.0%

2.0%

2008 2009 2010 2011 2012 2013 2014 2015

PERCENTAGE DIFFERENCE BETWEEN RPI AND CPI CAUSED BY HOUSING COMPONENTS

Other housing components Mortgage interest payments

The effect of mortgage interest payments (MIPs) on the wedge is greatest and, although its contribution averaged 0% over 2014 and 2015 to-date, it has accounted for over 2.5% of the difference in the past. The fluctuation in its contribution towards the wedge alone reveals the significance of this component.

MIPs attempt to measure the amount each month the average consumer pays to service their mortgage. Prior to 2010, the Standard Variable Rate (SVR) was used to calculate MIPs. However, from March 2010 following the extreme variation witnessed in the RPI measure, the ONS adopted Annual Effective Rate (AER) instead. AER is effectively a basket of over 250 mortgage rates (such as base trackers and fixed rates) weighted according to their market importance, meaning its volatility is considerably less than the SVR basis as can be seen in the chart above. It should be noted that an upward drift in the MIPs index is expected even with no changes in mortgage rates as average debt levels continue to rise.

Amongst the other housing components assessed it is housing depreciation and council tax that contribute the most towards RPI and CPI differences. Total contribution from housing depends heavily upon developments in the housing market, which has exhibited considerable volatility in the past, such as in 2009 during the housing market collapse.

Over the long-term, we might expect mortgage interest payments and housing depreciation to grow in line with the average earnings growth assumption whilst assuming interest rates are unchanged. In March 2015, the OBR reduced the long-run average earning projection from 4.7% to 4.4%.

Additionally, we might make the plausible assumption of council tax growing in line with forecast long-term CPI inflation, which is currently 2% compared to a 3% assumption in 2011 previously based on historical average growth rate. Factoring in the weighting of housing components in the RPI compared to the CPI, this leads to a current long-term prediction of a 0.5% wedge between RPI and CPI solely caused by housing components.

5.3 Coverage and Weighting Differences

Aside from housing, the CPI Index includes a number of components not included in the RPI such as student accommodation fees, overseas tuition fees and brokerage fees. Similarly, the

6

RPI exclusively contains certain items including TV licence fees and vehicle excise. Additionally, differing data sources and population sources are used to calculate appropriate

weighting for the CPI and RPI indices, which can lead to discrepancies in figures.

The contribution from disparities in weighting is particularly substantial and stems from the RPI and CPI utilising two different data sources. The CPI weights are largely calculated based on data from Household Final Monetary Consumption within the National Accounts whilst RPI weights rely upon the Living Costs and Food survey. As mentioned in Section 3, the latter excludes expenditure of private households whose income is within the top 4 per cent of all households and pensioner households which derive at least three quarters of their total income from state pensions and benefits, alongside some other selective criteria. These restrictions are designed to make the RPI more representative of the ‘typical household’.

-1.0%

-0.8%

-0.6%

-0.4%

-0.2%

0.0%

0.2%

0.4%

2008 2009 2010 2011 2012 2013 2014 2015

PERCENTAGE DIFFERENCE BETWEEN RPI AND CPI CAUSED BY COVERAGE AND WEIGHTING DIFFERENCES

Coverage Differences Weighting Differences

Since the 2010 change in the collection of clothing prices, these other differences in coverage and weighting have contributed on average around -0.4 percentage points to the wedge.

This is despite a bottom-up estimate of the difference in weights at the item level, suggesting an effect of zero. The OBR has stated that part of this difference is derived from the interactions between categories, in particular between the formula and weights effects. This is demonstrated by the gap between RPI and RPIJ (the RPI calculated using the CPI methodology of geometric mean), which has averaged 0.65% since 2010, whereas the published ONS formula effect (the formula effect calculated using CPI weights) remains around 0.9%.

In effect, these differences have impacted the wedge negatively since late 2010, counterbalancing the widening effect of other factors. Other coverage differences have had the least impact to the long-term RPI-CPI wedge over time, although it’s significance has gradually increased over time.

With the differences dependent upon global economic factors affecting the different components, and their weighting proportionately skewing the impact on both inflation measures, assuming the average contribution from this category since 2010 will persist in the long-run is considered reasonable.

7

6 SUMMARY

The chart below illustrates the effect of each component on the RPI-CPI wedge, alongside the actual wedge from 2008 until present.

2008 2009 2010 2011 2012 2013 2014 2015-4.0%

-3.0%

-2.0%

-1.0%

0.0%

1.0%

2.0%

CONTRIBUTIONS TO THE RPI-CPI WEDGE

Formula Effect MIPs Other Housing Components Coverage & Weighting Difference RPI-CPI Wedge

Evidently, the formula effect has had a steady presence on the wedge whilst the mortgage interest payments aspect affects the wedge to varied extents over time, heavily dependent upon the UK economy. Coverage and weighting differences have impacted the wedge in both directions.

In the long-run the formula effect is expected to contribute to a 0.9% wedge, MIPs and housing components 0.5% and differences arising from other component and weighting differences, -0.4%. This leads to a projected long-term RPI-CPI wedge of 1.0%, based on the methodology of both measures remaining constant. This projection is consistent with both TradeRisks’ and the Office of Budget Responsibility’s latest analyses.

Interestingly, the Bank of England’s last published estimate for the long-run wedge was in the February 2014 inflation report, at 1.3%. The difference from the 1.0% OBR forecast constitutes of a +0.1% difference in MIPs and housing components and +0.2% in other component and weighting differences.The Bank of England’s contribution of housing is underpinned by the simplifying assumption that house prices in the long-run increase in line with earnings, which had risen by around 4.5% a year on average. Assuming no change in the weight of housing in the RPI basket, that implies a 0.6 percentage point contribution from housing to RPI, and hence to the wedge.

The Bank did, however, mention that discussions with market participants suggests the long-run wedge priced into inflation breakevens is a little lower than the Bank’s estimate, at around 0.9% to 1.0% on average. In Q2 2015, this band was widened to between 0.8% - 1.0%.

Clearly the wedge will deviate from the long-term forecast over the short-term. The forecast wedge over the next few years according to the OBR is as follows:

8

-

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1.6

1.8

2010 2011 2012 2013 2015 2016 2017 2018 2020

RPI - CPI Wedge ForecastOffice of Budget Responsibility, July 2015

Historic Forecast

The projected wedge of above 1.0% in the short term appears to be consensus between market experts, with an average wedge of 1.1% projected in 2016 and those forecasting 2017 figures showing an even larger wedge. This is largely down to the formula effect combined with forecast higher annual house price inflation owing to a lack of supply and swelling demand. With a wedge expected to be driven between house price inflation and earnings growth, this will contribute to the wedge between RPI and CPI, where RPI includes housing components whilst CPI is the most representative measure of household demand and thereby intrinsically linked to earnings growth.

0.0% 0.2% 0.4% 0.6% 0.8% 1.0% 1.2% 1.4% 1.6% 1.8%

Economic PerspectivesCommerzbank

HSBCGoldman Sachs

ScotiabankMorgan Stanley

CitigroupCEBR

HIS Global InsightCBI

Experian EconomicsCapital Economics

Societe GeneraleITEM Club

Fathom ConsultingBritish Chambers of Commerce

BAMLRBS

IENSRCredit Suisse

NomuraOxford Economics

Schroders

Forecast RPI-CPI Wedge in 2016

9

7 RPI INFLATION MARKET

The graph below depicts the 30-year RPI swap rate against the 30-year real swap rate, where the real swap rate is the 30-year interest swap rate minus the 30-year RPI swap rate. Long-term RPI swap rates have decreased slightly in recent years whilst long-term interest swap rates have fallen dramatically since mid-2014. This has led to current market conditions where real rates are extremely low.

-2.0%

-1.0%

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

30Y RPI SWAP RATE V REAL SWAP RATE

RPI 30Y Real RPI 30Y

The following chart illustrates the RPI zero coupon swap rates for maturities up to 30 years as at end of day 12th November 2015, and the implied RPI forward rates (“September RPI Annual”). The zero-coupon curve incorporates average expected inflation rates over specified maturities whilst the implied forward rate embodies the expected inflation rate at a specified point in future, accounting for risk.

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

1 2 3 4 5 6 7 8 9 10 15 20 25 30Maturity (years)

RPI ZERO COUPON SWAP v IMPLIED FORWARD RPI RATES

Zero Coupon RPI Swap September RPI Annual

10