RPI vs. CPI inflation: who pays the price?

The government will keep using flawed inflation statistics to calculate price rises for things such as rail fares, student loan interest rates and cigarette duties, the chancellor has confirmed.

With attention focused on Brexit, Sajid Javid quietly confirmed this month that the Treasury will continue to use the widely discredited Retail Price Index (RPI).

Used to calculate annual changes in regulated rail fares, road tax, duties charged on tobacco, alcohol and flights, student loan interest rates, and many other items, “the move is likely to leave commuters, graduates, and smokers worse off, with above inflation price rises now likely for at least the next five years”, says Yahoo UK Finance.

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Debates about the use of RPI have been raging for years but what is it, how is it different from the official Consumer Prices Index (CPI) inflation measure and why do we have conflicting indices for inflation anyway?

What is RPI?

It's the original gauge by which the government tried to get a handle on how prices were increasing for ordinary citizens every year, to help them argue for fair cost of living pay rises.

The history of the measure dates back to the First World War, says InflationMatters.com, when the first index of food prices was published in 1914. This was expanded to include clothing fuel and other items in 1916.

It was used in this form until 1947 when it was overhauled to include an annual comparison of a much broader basket of goods – and was updated again in 1956 to establish the current index.

How is this index different to CPI?

The CPI measure of inflation was created in 1996 in accordance with EU principles to create an internationally comparable measure of price rises, says the Daily Telegraph.

There are some differences in what's covered. CPI doesn't include homeowner costs like insurance or council tax, and uses rent as a simple proxy for housing costs instead. But the main difference is in the calculation formulae used.

RPI uses a formula known as "Carli" that doesn't account for changes in shopping behaviour if prices rise. It tracks inflation as having risen if a price drops and returns to its previous level, says the Financial Times.

No other advanced economy uses a Carli-based measure of inflation. RPI is believed to overstate inflation by an average of 0.8%. It lost its National Statistics kitemark six years ago.

CPI uses the more robust “Jevons” formula that is used in most developed economies. It has been used as the main benchmark for UK inflation since 2003.

What are the costs?

RPI generally runs at about 1% higher than CPI and is currently 2.8%, compared to a CPI of 1.9%.

With annual rail fare increases calculated using RPI it is unsurprising passenger groups have called for fares to be linked to CPI instead.

Yet there are broader consequences related to the fact that RPI is still used to uprate most private sector pensions and inflation-linked government bonds.

A scathing report from the House of Lords concluded that RPI created “winners and losers”. Peers accused the government of “inflation shopping,” using the lower CPI measure to calculate many payouts to the public such as benefits, but using the higher RPI measure to calculate what the public have to pay.

For example, government bondholders still receive a bonus of an estimated £1bn a year because their payments are linked to RPI, while rail passengers and graduates pay 0.3% more every year.

What do the experts say?

Official statisticians have long been at pains to stress they do not endorse RPI as a measure of inflation used to uprate rail fares by law – in part because it overstates price rises.

Sir David Norgrove, chairman of the UK Statistics Authority, noted RPI “isn’t a good measure, at times significantly overestimating inflation and at other times underestimating it”.

He echoes similar sentiments made by the Office for National Statistics (ONS), which has in the past admitted RPI is “not a good measure”, while a 2015 review by the Institute for Fiscal Studies' Paul Johnson labelled it deeply “flawed”.

So why doesn't the government kill RPI?

That’s a good question that can best be answered by a combination of political and legal considerations.

Ending RPI would be unpopular with bondholders and pensioners, and could require a change in the law to allow pension schemes to revise their calculations. According to calculations from Unison, scrapping RPI could leave pensioners of defined benefit schemes £12,000 worse off.

As for rail fares, the government says the industry still uses RPI as a basis for its own costs so it only makes sense to link it to rail fares.

And then there is Brexit. Javid said he would not overhaul the system because of “the government’s focus on Brexit” and the likely disruption any reform would cause.

He has announced a consultation to launch next year on whether to merge it with another measure of inflation (CPI-H). However, the changes will not come into effect until 2025 - with experts claiming that the UK's Statistics Authority would not be able to make changes without permission from the chancellor until at least 2030, reports This is Money.

But make no mistake, Javid’s decision to delay scrapping RPI is “very serious”, says the New Statesman.

“In ignoring the UKSA’s recommendations, Javid has allowed one of the fundamental problems of the UK’s economy to persist. In doing so, he quietly hands an unearned bonus to wealthy retirees while reducing the pay of younger workers and reinforcing inequalities between rich and poor, young and old, in the decades to come,” the magazine adds.