The ONS puts consistency first

Mathematician writes out formula on a blackboard

Britain's Office for National Statistics has decided, when it comes to inflation, it's better to be consistent than to be right.

It is not going to seriously change the way that Britain's oldest inflation index is calculated, even though that goes against the recommendation of its own Advisory Committee and many international bodies such as the International Monetary Fund.

Those in the financial markets who had bet on a different outcome will be disappointed. So too will the Chancellor - who stood to save billions a year in debt interest from the change.

Economists and statisticians who think the Retail Prices Index (RPI) is seriously flawed won't be happy either. Many of them thought a change was long overdue.

But, anyone with a pension or investment that is still linked to the RPI will be deeply relieved. There are nearly £300bn-worth of index-linked government bonds, or gilts. Countless other investments and pensions are linked to it as well.

If you're dependent on an index-linked annuity, the change being contemplated by the ONS could have cut its value by 15% over 20 years, with the cost widening every year.

Coming on top of the other savings that the government has been making, that would have been a serious blow. Even if many economists would say that the change had made the index more accurate.

Carli v Jevons

If we were creating the Retail Prices Index from scratch, the National Statistician, Jil Matheson, admits that we would not design it the way it is now.

The Carli formula - which is used to generate nearly 30% of the RPI - has some strengths, but is not used by any other serious statistical body in the world because it tends systematically to overstate inflation, especially when prices for a certain good are highly variable.

If the prices of clothes rise very sharply, then come back down to where they were, you might think that an inflation index should show no overall change. That is what the Jevons method - used in the Consumer Prices Index (CPI) and around the world - would show.

But the Carli formula would say there had been some inflation - even though prices are back to where they were at the start.

The Jevons (geometric) method also takes greater account of the fact that consumers tend to switch to other products if one becomes more expensive. Whether that makes it better than the Carli depends on the good you're talking about, but many statisticians consider it another plus.

So much for the statistical niceties. What difference does it make?

By itself, this difference in formula has tended to make the RPI 0.9 percentage points higher than the CPI, on average, since 2010. (That was when they changed the way they collected price data for clothes. Before that, the formula effect led to a difference of around half a percentage point.)

Remember, that's independent of any difference between them that is caused by the fact that more housing costs are included in the RPI.

That sometimes makes it lower than the CPI and sometimes makes it higher. You might remember that RPI inflation rate went negative in 2009, when interest rates were falling sharply, whereas the CPI measure never went below 1%.

Serious consideration

The point about the formula effect is that it systematically pushes the RPI higher, relative to the other index, when inflation is positive.

So, time for a change, many people thought. But in weighing this decision, the ONS also had to weigh the interests of the millions of people who hold investments and pensions that are linked to the RPI.

In effect, Ms Matheson has decided to put them - and the historical integrity of the index - before anything else.

As I said, it will be a shock for the City: the shorter-term index-linked bonds, which have suffered in the past few months as a result of the consultation, will probably go up today. But some inside the ONS will not be surprised.

I served briefly on the Consumer Prices Advisory Committee, set up a few years ago to advise on such changes, along with other outsiders like the FT Economics Editor and representatives of the Bank of England and the CBI.

I left before they got into discussing this issue. But even from the few meetings I attended, it was clear that people at the ONS take the historical consistency of the RPI very seriously indeed.

I often have to explain why GDP and other economic statistics have been revised down - or up. You might have noticed that that never happens with the CPI or RPI. There is just too much money riding on them.

Once released, the inflation numbers stand for all time, even if it turns out someone has made a mistake. The RPI does not get revised. And looking ahead, the ONS has decided it's not going to be seriously updated, either.

Update: 11.28 GMT

The FT's Economics Editor, Chris Giles, has been much more pointed in his coverage of the RPI decision. (As I mentioned earlier, he still serves on the Consumer Prices Advisory Committee, which favoured a change in the RPI formula).

He says he "cannot think of another occasion when national statisticians have discovered a major conceptual error and decided to do nothing about it".

He also disputes my suggestion that the RPI has been historically consistent, pointing out there have been many changes over the years, like the introduction of mortgage interest payments, which make it very different today from when it started in the late 1940s.

This paper from the ONS outlines the history of these changes, some of them fairly significant.

Looking at the list, it's hard to see a change that systematically affected the value of the entire index, in a single direction, as much as dumping the Carli formula would have done.

Still, you might say the size of the change doesn't matter. The point is that they have made changes before, in order to make the index more accurate, even at the cost of making it less consistent over time.

If the ONS believed this change would also improve the quality of the index - why not go ahead?

In looking for an answer, it's hard to escape the conclusion that the size of the change did matter, a lot. The National Statistician looked at the sheer scale of the financial impact, and the public response to the consultation (more than 80% opposed the change, almost always for financial reasons), and just couldn't stomach it.

Some will find the decision welcome, and understandable - especially those who think the RPI and the CPI are both a poor reflection of the inflation faced by pensioners.

As Robert Peston has pointed out, holders of indexed gilts could argue that they paid for the inflation protection offered by the traditional RPI, and they are legally entitled to get it.

Others will say the ONS chickened out.

But critics of this decision are right to emphasise one point. It's not just the Chancellor that loses out - it's all of us, in our capacity as taxpayers.

If, as the ONS itself accepts, the RPI has an "upward bias", then we as taxpayers have been over-compensating investors for the impact of inflation, to the tune of billions of pounds a year.

Thanks to this decision, we're going to carry on overcompensating them.

It's worth pointing out that any young person with a student loan will also lose out, because their official loans are indexed to the RPI. Rightly or wrongly, the ONS has put the interests of pensioners and bondholders first.

Stephanie Flanders, Economics editor Article written by Stephanie Flanders Stephanie Flanders Former economics editor

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  • rate this

    Comment number 53.

    Do you honestly believe that they are going to tell the truth. Politicians won’t let them. Personal Inflation varies depending upon age, gender and status with pensioners and low income families suffering the highest levels. In the 70s a national newspaper published a weekly shopping basket and monitored the prices and if that was repeated today inflation would well into double figures.

  • rate this

    Comment number 52.

    #48 John

    I agree with your view on debt/house prices.

    Either govt debt "paid off" with inflation/printing money. Probably house prices won't change much in nominal terms but big decline after inflation taken into account

    Or debt paid off honestly - but a long hard road. Cost of living in the UK out of kilter with wages - don't know when but something has to give and that includes house prices

  • rate this

    Comment number 51.

    When true capitalism is working well: prople are working, people receive adequate pensions; the economy is functioning as it should. So, my opinion is: the more explanatory statistics that a country needs, the more intervention into capitalism there has been (like bailouts & artifically holding down inflation), the less well is its "capitalism" functioning.

  • rate this

    Comment number 50.

    Stephanie - a minor point:

    You point out that the Jevons index allows for product substitutability.

    However, para 42 of the ONS's consultation noted :

    "the use of the Jevons index over the use of the Carli index or vice versa [has sometimes been justified] depending on how much substitutability exists...This is a misintepretation of the analysis that is presented in this section of the Manual."

  • rate this

    Comment number 49.

    The concept of inflation implies belief in arbitrage to equilibriate between markets in a context where China and central banks are controlling prices to create heavy distortions. A sample of essential spending by people would diverge sharply from a sample of essential goods highlighting methodological issues in a timely manner, therefore sample both people and goods.

  • rate this

    Comment number 48.

    The terribly consequence of the ONS being pressurise into leaving housing costs out of the index will be haunting us for another two decades. This allowed to BoE to fool itself and the people that they had set proper interest rates to avoid creating a bubble economy.

    Any index that lets the idiots in HM Treasury off the hook must be bad. No more bubble economies.

    Debt/house prices MUST fall!

  • rate this

    Comment number 47.

    No - this is really amateurish.

    Let alone index-linked gilts, pensions, govt benefits etc. so many commercial contracts rely on inflation indices in their terms

    These contracts routinely take into account back-dated adjustments to these indices. What is unacceptable is the possibility of a long term systematic error which is not corrected. This could mean expensive litigation, renegotiations etc

  • rate this

    Comment number 46.

    Where did all these statistics come from - when, where, by whom and for what reason? Does capitalism need all these statistics in order to function as capitalism...or do all these statistics cause artifical interventions to make it appear that capitalism is working?
    Mind-boggling! This statistic is off; this one was wrong; this one was right: Here are the 25 excuses: All this time being wasted.

  • rate this

    Comment number 45.

    This 'coalition' have trouble interpreting the statistics as they stand now, never mind trying to manipulate them any further.
    For the benefit of Cameron and Osborne. When a line on graph is flat lining or going down like the one showing growth, there's a problem. When the line is going up on the inflation graph, there's another problem.
    Maybe these two idiots have their graphs upside down?

  • rate this

    Comment number 44.

    What you post is broadly true (could also apply to 1902- if you both had work & 'had a good WW2') but there are exceptions within those bands.

    Another poster pointed out there have been severe bumps along the way for 'boomers'. Prob more so than for 1986-2006. So, babes of 1968-1980 have done well, too, as long as well paid & no 2007/09 losses.

  • rate this

    Comment number 43.

    Neither CPI or RPI reflect genuine inflation rates experienced by the poorest who spend most of their money on essentials. Single person pensioner's inflation rates hit 10% in 2008 when the official RPI was about 5% :-

    CPI is meaningless to most. A good decision from an establishment body, how refreshing.

  • rate this

    Comment number 42.

    We all know the inflation figures have no real meaning to us ordinary folk. Everyday essential items which we need and cannot really do with out, have been rising in price far more than the inflation figures state. On a weekly basis, most people don't buy Champagne, Marriage licences, Dating agency fees, Sleeping bags, Golf Course fess, Door handles, etc, yet these are in the inflation basket.

  • rate this

    Comment number 41.

    Why not link pensions and investments etc to one of the money supply measures, and preferably available currency + deposit accounts.

    After all, it is changes in this that (eventually) lead into changes in inflation.

    Much more logical and simpler in my opinion.

  • rate this

    Comment number 40.

    Is the ONS being consistent in this view?

    Are they right in being so?

  • rate this

    Comment number 39.

    This will please those who receive feed in tariff (FiT) payments in return for their investment in alternative energy sources eg solar photovoltaics - rightly or wrongly the annual increase in the FiTs is linked to RPI

  • rate this

    Comment number 38.

    Better to be consistent than to be right ...

    There's a wonderful book-sorry, title forgotten-about air disasters mostly in the period 1939-45. Several of the short tales [it's a great bathroom book ;-) ] involve navigational mistakes with planes flying in direction 180 degs opposite to flight plan. In some, fortunately, the mistake is realised & corrections made.

    In others ...

  • rate this

    Comment number 37.

    There is immense political interest in having official inflation figures lower than reality

    Inflation boosts the GDP £ number (Nominal GDP) but not the real value produced. To compensate, nominal GDP is corrected using official inflation numbers to make the published, Real GDP

    If official inflation numbers understate real inflation, that pound devaluation from inflation creates fake GDP growth

  • rate this

    Comment number 36.

    Re FrankieBoy @17

    I think all Government pensions are now linked to CPI. My NHS one certainly is.

  • rate this

    Comment number 35.

    'it's better to be consistent than to be right'

    Certainly a mantra repeated in many public sector entities. Especially the BBC.

  • rate this

    Comment number 34.

    @20 & 24
    An EPI Index would weight a pint of milk or loaf of bread more highly but indicate what is necessary for survival and legality. [Am sure the ONS calcs would take care of whether loaf was high end, artisan shop or low end sliced white or something in between]

    If the EPI was constructed properly I would have thought it would help inform and adjust, as necessary, the Benefits sytem.


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