Thu 26 Feb 2015
Inflation has, in recent years, occupied an almost permanent slot in our news headlines. It sits firmly within everyone’s awareness – we all know that prices, and therefore “the cost of living”, are increasing at a certain rate. The prevailing method of measuring this rate is through the Retail Prices Index – RPI – which frequently finds its way into commercial contracts, be they related to development or otherwise. However, a recent report published by the UK Statistics Authority suggests that inherent flaws in the RPI formula means a paradigm shift in the manner in which we measure inflation may be on the horizon.
On 8 January the UK Statistics Authority published Paul Johnson’s independent review of UK consumer prices statistics. The report declares RPI to be an inappropriate measure of inflation, which should, in most instances where it is used, be replaced with the “CPIH” (a variation on the Consumer Prices Index – CPI – which takes into account owner-occupier’s costs).
The hefty report details the exact mathematical flaws in the RPI formula which render it inappropriate. Without delving too heavily into the science, the primary issue identified is the reliance of the RPI formula on the “Carli” index, which itself produces a large upward bias when calculating inflation. To put this in context, in March 2011 the clothing and footwear component of RPI was recording inflation at 12.2 per cent, whilst the CPI was recording the same at 2.1 per cent. These measures were based on the same dataset of prices, collected on the same day, in the same shops.
According to Johnson’s report, the inaccuracy of RPI means government benefits (currently RPI-linked) could cost the taxpayer millions of extra pounds each year due to upward bias. There could also be further cost to the taxpayer through RPI-linked government debt.
The report paints a grave picture of our current use of and reliance on RPI, sentiments already voiced by Chris Giles in an article for the Financial Times over two years ago, stating that “few errors in statistical compilation are quite this serious”. If this is the case, what is to be done to rectify the error?
RPI has, in fact, already been de-designated as a National Statistic (in March of last year), and Johnson’s report goes on to say it should be phased out altogether, but there are obvious practical issues in doing so. Despite its apparent flaws, RPI is the most commonly-used and widely-recognised measure of inflation. Since its introduction in 1947 it has been used, and is still used, to adjust benefit levels, as a basis for wage negotiations, and in hundreds of billions of pounds worth of contracts (in light of which there is national legislation in place controlling its use). A wholesale shift away from the ubiquitous RPI to a new standard measurement of inflation clearly cannot be done overnight.
However, is there anything we – when involved in commercial contracts, whether as drafter or party – could or should be doing in light of Johnson’s report? Wherever an agreement is made for a payment to be made periodically over time or at some future date inflation somehow needs to be taken into account. Do we continue to link to RPI, knowing the resulting figures may well be skewed, but knowing that the index remains well-recognised and that calculations will most likely be consistent with any existing contracts in place? Or do we pioneer use of CPIH as Johnson recommends, and aid the inevitable shift towards a new standard measure?
There are no right answers to these questions – as is commonly the case, the correct approach will vary from contract to contract, and the appropriateness of RPI will depend on a large number of factors, not least the preferences of the parties involved. Businesses will need to take into account marrying new contracts up with existing ones such that the interplay between indices is viable, and will also have to consider any financial instruments they may have in place – a wrong choice of indexation could result in a disparity between revenue and debt repayments which will gradually increase over time.
However, it is also certainly worth bearing in mind in respect of contracts relating to housing and development that, whilst CPI is currently the official headline measure of inflation, it has historically been eschewed in favour of RPI because of CPI’s failure to take into account owner-occupier costs. Now CPIH (with its inbuilt housing element) is firmly on the table as a viable alternative, it is worthy of consideration as a replacement for RPI.
And of course there are a huge number of alternative indices used for the measurement of inflation, varying dependant on the sector from which they derive or to which they relate. These too could be viable alternatives to RPI (to the extent that they are not in use already), although it may be worth considering whether these, like RPI, are derived from the imperfect “Carli index”, which has been abandoned by every other large advanced economy, and which the International Monetary Fund has concluded is inappropriate.
Although one of the clear messages of Johnson’s report is that the phasing out of RPI will be a long and complex process, another message to be taken from it is that RPI should no longer be used simply because it is standard practice. This is a timely moment to reflect on the appropriate measure to be used in each instance. In some cases, for commercial reasons it may be that RPI remains the preferred measure. So, although a death sentence has been served on our standard index, it will be a long time before it is buried.