Changes to the UK Retail Prices Index – implications for index-linked gilts

The UK’s Office for National Statistics (“ONS”) has announced a consultation on a proposal to change the way it calculates the Retail Prices Index (“RPI”). For the last few decades, in the minds of the British public this is believed to be the best measure of inflation in the economy. This has been reinforced by the introduction in the 1980s of index-linked bonds, which are government bonds offering inflation protection by indexing both capital and income payments by the change in the RPI. In addition, many private sector pension schemes have pensions which rise in line with the RPI, and many regulated industries have their pricing models set by regulators which are linked to the RPI. The RPI is a key part of the fabric of British life.

Sadly, the ONS believe that it is, statistically, a rather poor measure of inflation (as described later). In 1996, all EU members were required to calculate their inflation measures on a consistent basis – this index is the Consumer Prices Index (“CPI”), and being of a much more modern construction, this is the measure now preferred by the government for setting its inflation objective to the Bank of England (“BoE”), and state pensions and benefits are now linked to the CPI.

The RPI and CPI use the same price inputs each month, but a different statistical formula – this formula effect meant that historically the RPI tended to be 0.5% a year higher than the CPI. Thus, when Gordon Brown switched the BoE inflation mandate from an objective of 2.5% on the RPI, it became 2.0% on the CPI.

To illustrate this formula effect, consider a prices index, calculated monthly, with just two components, say strawberries and batteries over just two months. In both months the price of batteries is unchanged but the price of strawberries doubles in the first month and then halves in the second month. Over the two months combined, the geometric-weighted CPI will show that the rate of price inflation is zero, since all prices are the same as when the index began. However the arithmetic-weighting methodology of the RPI means that it will have risen and the rate of inflation will be deemed to be positive. Thus the RPI has an inherent upward bias compared to the CPI.

Since 2010 when changes to the RPI’s measures of clothing and footwear prices were made, the size of this formula effect has grown to almost 1.0% per year, and is in danger of creating mistrust in the statistics, which is why the ONS is seeking to change the methodology. Doing so would, however, have important effects on all those areas of British life which are referenced to the RPI.

In particular the expected returns of index-linked bonds (currently worth £280bn) would be 0.5-1.0% lower each year. At a time of very low government bond yields, this is significant. Should the BoE determine that the proposal amounted to a “fundamental change” that would be “materially detrimental” to the bondholders, then investors could, under the issuing terms of index-linked bonds,  demand their money back from the government. However, they would only be entitled to the par value of their bonds uplifted by inflation, which in general is well below their current market value.

The implications for markets are that by making this proposal the ONS has introduced a new risk factor for index-linked bonds that did not exist before – the measure of the rate of inflation used for returns may be lower than before. Ordinarily that should lead to lower prices. However, this news has come out at the same time as the Federal Reserve’s decision to engage in open-ended Quantitative Easing, which represents a clear shift in policy target away from controlling inflation and towards lower unemployment. This has boosted longer term inflation expectations in markets, and pushed up prices of index-linked bonds.

Index-linked bonds still provide investment portfolios with the most direct insurance against future inflation, but the effective payout on that insurance may be about to be cut. As with any insurance policy the balance between insurance premium, insurance payout and probability of payout has to be kept under review – recent events are tilting that balance away from having too much of this insurance in a portfolio. Globally, those investors who are not in countries with index-linked bonds have historically opted for gold as their inflation insurance.