rpi vs. cpi - magic new formula will lead to shrinking wedge

RPI VS. CPI

MAGIC NEW FORMULA WILL LEAD TO SHRINKING WEDGE

OCTOBER 2012

www.redington.co.uk/www.pensioncorporation.com 1

Executive Summary

Background

The difference between RPI and CPI as inflation measures has been a statistical nuisance to

understand and explain for the UK government for some time.

The difference stems from two factors:

1) Composition; CPI excludes housing and council tax

This has historically accounted for the larger part of the difference though the

effect can be in either direction.

2) Formula Effect

This has accounted for a smaller part of the difference, but the effect consistently

biases RPI above CPI. The effect increased in January 2010 to around 100bps,

driven largely by changes to the methodology in the measurement of clothing

and footwear 1 .

.

The Consumer Prices Advisory Committee (CPAC), whose role is to advise the UK

Statistical Authority (UKSA) on the measurement of inflation, has initiated a managing the

formula effect (MFE) programme to “identify, understand and remove unjustified causes of

the formula effect gap”. This is important as approximately 75-100bps of the “wedge”

between CPI and RPI is derived from the difference in the formula chosen to assess and

collect data.

In light of their findings, the CPAC are in consultation to reduce and potentially eliminate the

gap through data stratification and/or changing the current RPI methodology. Four

options are being assessed ranging from “do nothing” to “full alignment between RPI and

CPI”. Expected from 2013, it is anticipated that there will be some convergence with the

effect of reducing the RPI. General market expectation is a long term fall in RPI of around

50-75bps. The 15-year RPI expectation implied by index-linked gilts market has fallen to

around 2.35% p.a which is 70bps below its peak from its peak in April this year and about

50bps below the position on 18 May 2012 when the consultation was announced.

Possible impact

Any moves to narrow the RPI/CPI wedge could impact:

Issuers of index-linked bonds – both Government and private sector

Buyers who may start pricing in a “political risk” of further future changes to

calculation methodologies.

Holders of the £177billion of index-linked gilts (“linkers”) in issuance

1 ONS – CPI and RPI: increased impact of the formula effect in 2010


RPI swaps participants

Pension schemes with RPI liabilities

Pensioners with RPI-linked benefits

Key considerations for pension schemes

This possible change, like the previous move to change statutory indexation from RPI to

CPI, highlights the need for pension schemes to fully understand the financial implications of

inflation on their liabilities and to hedge them.

Lower inflation and expectations of future inflation will, other things being equal, lead to a

decrease in scheme liabilities. To the extent that schemes have hedged their exposure to

inflation, they will of course neither participate in the positive effects of falling inflation or the

negative effects of rising inflation.

The Redington/PIC survey published in 2011 highlighted that on average, UK pension

schemes had hedged only 25% of their inflation exposure. This leaves them significantly

exposed to moves in inflation.

Recent Developments

Latest September CPAC minutes announced a consultation commencing 8 October

2012 to invite users’ views on the options for the way RPI is calculated. The options

presented were:

1. No change

2. Change approach to averaging prices for some categories

3. Change approach to averaging prices for all categories that use the

CARLI or arithmetic averaging approach (see section 1 for more

details)

4. Change RPI so formulae fully align with CPI

The consultation is expected to run to the end of November 2012 at which point, the

CPAC will reconvene to consider the responses including any recommendations by

the National Statistician.

Market pricing is likely to build in changes when they become likely, ahead of actual

implementation.

Recent fall in market implied inflation (20-25bps) between April 2012 and 1 October

2012 could be attributed in part to expectations of CPAC action.


Next Steps

If changes were to be proposed, these would be introduced with the annual update of

the RPI when it is published on 19 March 2013.

Although the Chancellor of the Exchequer must gives its final approval to any

proposed changes to RPI methodology should the Bank of England find them

“materially detrimental to the interests of the holders” of index-linked gilts, this is not

an insurmountable condition to getting the RPI to narrow towards CPI.

It is unclear whether there has been any precedent for what constitutes “materially

detrimental” in such circumstances. However, changing RPI and by implication

lowering it towards CPI would potentially bring into opposition the interests of linker

holders and HM Treasury. Assuming the CPI target is not revised higher to

compensate the loss of the formula effect wedge, then all other things being equal,

the future value of RPI cashflows (and hence linkers, and breakeven inflation swaps)

should fall.


Table of Contents

1. BACKGROUND .............................................................................................................. 5

2. THE ONS, CLOTHING AND WEDGES .......................................................................... 7

3. ENTER CPAC ................................................................................................................. 8

4. CONCLUSION .............................................................................................................. 11


1. Background

History of CPI vs. RPI2

Fundamental differences between the Consumer Price Index (CPI) and Retail Price Index

(RPI) as measures of inflation can be outlined as follows:

1. Composition Effect – Housing costs and council tax are not included in CPI,

whereas it is included within RPI.

2. Formula Effect - CPI uses a geometric mean of relative prices whereas RPI uses

either an arithmetic mean of relative prices OR a ratio of average prices between

months.

The key point is that the differential or “wedge” between the CPI and RPI has meant that for

a 2% CPI target in steady state, you can expect a higher RPI level of c.100bps3. This is

partly a mathematical effect. The gap in individual years is volatile and can be materially

higher or lower than 100bps. Indeed, CPI has exceeded RPI in several individual years. But

averaged over the long term RPI (if methodology is unchanged) is very likely to exceed CPI.

The Formula Effect

The first few steps of the calculation of inflation between two periods involve the collection of

a number of price quotes in both periods from retailers or suppliers. These quotes are then

in some way averaged and a relative change established from one period to the next.

There are several mathematical approaches to the averaging and ratio calculation, which are

used both within the RPI and CPI methologies in addition to standard weighted averaging :

CARLI – Average of price relatives

Takes the ratio of a matched pair of prices in both periods and takes the

arithmetic average of all ratios in a well defined group of products

JEVONS – Ratio of average prices

Geometric mean of price ratios or ratio of geometric mean prices

DUTOT – Ratio of average prices

Takes an arithmetic average in both periods, of all prices in a well defined

group of products and takes the ratio of those averages

Source: ONS user engagement July 2012

2 Please refer to section 3 of our December 2011 paper - “UK Final Salary Pension Schemes: Inflation Hedging

and the change in Indexation from RPI to CPI survey results”, which discusses these differences and their contribution to CPI/RPI basis risk in more detail. 3 ONS: Economic and fiscal outlook March 2011.


The application of the different methodologies as a proportion of the RPI and CPI is

compared below:

CPI RPI

30% JEVONS 25% CARLI

30% DUTOT 30% DUTOT

40% Weighted average 45% Weighted average

Source: ONS user engagement July 2012

The formula effect arises due to the difference in the JEVONS and CARLI methodologies

used within 25-30% of each index. A large part of the methodologies behind each index are

in fact the same.

Other countries around the world, particularly the EU, use methodologies similar to the

JEVONS.


2. The ONS, Clothing and Wedges

Back in 2010, the Office for National Statistics (ONS) changed the methodology for

collecting clothing prices. They applied a less stringent standard to allowing items to enter

the clothing basket by allowing price comparisons to be included where there had been a

small change to the characteristics of a piece of clothing from one month to the next. The

reasoning behind this being - fashions change, so why only include items that are stuck on

the rails from last month? In addition, seasonal items were also included (boots, beachwear

etc) rather than only items that were likely to be featuring in the basket throughout the year.

Sale items were also included in the price quotes.

The impact of the 2010 changes in including changing fashions and seasonal items was to

make the basket of goods more variable month on month and that variability broadly

translates into a larger CPI vs. RPI wedge. This is because, while the RPI and CPI have the

same clothing basket, increased variability accentuated the formula gap by increasing the

dispersion of the price relatives. In monetary terms, the 2010 changes were seen by some

investment banks as causing the move in size of the formula effect from approximately

50bps since 2009, to 100bps in 2011 of RPI over CPI4. At the time, the changes were

intended as a way of drawing more items into the “basket” to create a more representative

sample for RPI/CPI calculations.

4 Morgan Stanley – February 2012: A New RPI-CPI Wedge?


3. Enter CPAC

The Consumer Prices Advisory Committee (CPAC) began investigating the formula effect

in May 2011. This became a programme of managing the formula effect (MFE) with the

purpose to “identify, understand and remove unjustified causes of the formula effect gap

between the CPI and RPI”5.

The minutes of the July 2012 CPAC meeting noted that the CPAC are making progress with

the MFE programme. Any recommendations from the CPAC to change the UK inflation

measures in light of their findings could have implications for several areas if such

recommendations are then adopted by the ONS and approved by the Bank of England

(BOE) and UK Government.

Minutes Release – Impact on Gilt Breakeven Inflation

Figure 1: 15-Year Gilt Breakeven Inflation (as at 2 October 2012)

Source: Bloomberg, Redington

In the two weeks following the release of the CPAC minutes on 18 May, 15-year breakeven

inflation dropped by more than 25bps in anticipation of a narrowing gap between the RPI

and CPI. Though the downward trend continues, other factors have also weighed on the

decline of breakeven rates such as the renewal of BoE quantitative easing programme and

recent sharp falls in oil prices. US and European markets have also seen sliding inflation

from respective policy interventions interacting with economic outlook.

5 CPAC Papers – April 2012 meeting: Progress Update on Managing the Formula Effect

2.3

2.4

2.5

2.6

2.7

2.8

2.9

3.0

3.1

%

18 May 2012: CPAC minutes released

18 Sep 2012: CPAC minutes released


What can you “improve” if you want to have a smaller formula effect?

Stratification

One way of managing down the price variability is to stratify the data. For instance, by

differentiating between supermarkets, departments stores, discount outlets, online etc rather

than simply by “independent” and “multiple” retail outlets as is currently the case.

Unfortunately, stratification by itself only removes a small part of the formula effect.

Formula

The second way of reducing the formula effect is to change the methodology. For example,

by calculating RPI using the geometric rather than the arithmetic average.

Out of the September CPAC meeting, a consultation document is to be published on 8

October 2012 to invite users’ views on a range of options, ranging from no change to a full

alignment of the RPI formulae to CPI6.

It is important to note that there is more than one change being proposed here. Firstly

stratification and secondly changing the actual calculation for RPI from an arithmetic mean to

geometric mean. Although both will have the impact of reducing the formula effect, the

compositional impact remains from housing prices in RPI. This had been anticipated by the

CPAC and in June 2012, the ONS announced a consultation on the inclusion of housing

costs in CPI7.

Hurdles to RPI changes

There are hurdles to simply changing RPI methodologies, not least the impact on the UK

index-linked gilts market. The formal process differs for some traditional 8-month lag linkers

versus the newer 3-month lag linkers, however, in summary the parties involved in the

decision process are the UK Statistical Authority, the Bank of England and, ultimately, the

Chancellor of the Exchequer.

Bondholder Protection

The Statistics and Registration Service Act which covers changes to RPI provides some

protection to bondholders. Investors holding the traditional 8-month index-linked gilts will be

able to redeem their bonds. However, it seems they would only receive the accrued index

ratio to date. In the current low yield environment, redeeming these bonds which, in most

cases, had been issued with a coupon higher than current rates, would mean the investor

will receive a price less than the actual market value of the bond.

6 ONS – CPAC September 2012 Meeting Summary Note

7 ONS: Consultation on the recommended method of reflection owner occupiers’ housing costs in a new

additional measure of consumer price inflation, and the strategy for Consumer Price statistics


However, the protection for the 3-month linker holders is less than that of the 8-month linkers

and in summary, there is nothing in the documents that prevents a change to the index.

Nevertheless, before making any changes to the RPI, the UKSA must “consult the BOE as

to whether the change constitutes a fundamental change in the index which would be

materially detrimental to the interests of the holders” of index-linked gilts. If the BOE does

consider the changes to be materially detrimental then the UKSA may not make the changes

without approval from the Chancellor of the Exchequer.

It is unclear whether there has been any precedent for what constitutes “materially

detrimental” in such circumstances. However, changing RPI and by implication lowering it

towards CPI would potentially bring into opposition the interests of linker holders and HM

Treasury. Assuming the CPI target is not revised higher to compensate the loss of the

formula effect wedge, then all other things being equal, the future value of RPI cashflows

(and hence linkers, and breakeven inflation swaps) should fall.


4. Conclusion

Where does it lead?

The face value of the UK linker market stands at £177bn8 and given the potential cost and/or

need for compensating bond holders, one would think that much will depend on approval

and consultation. However, given the level of access of the CPAC to the Bank of England

and HM Treasury to discuss the issue, this gives the impression this process is being taken

seriously and that legislation has a chance of passing.

If the CPAC is successful in achieving its mandate of “identifying and eliminating unjustified

differences” between CPI and RPI, the formula effect will effectively be eliminated, and a

major precedent will have been set.

Key considerations for Pensions

At a fundamental level, the indices are alternative measures which is why we have two

rather than one inflation index. Without getting into the argument here of which is a better

representation of the cost of living for retirement benefits, the likely effects of eliminating

“unjustified” differences from the formula effect are:

The convergence of the RPI and CPI index, most likely in the direction of RPI

decreases rather than CPI rises

Market expectations of moves in inflation will continue to be priced and reflected

within the respective bonds and swaps markets

While liabilities remain indexed against the RPI, index-linked gilts and RPI swaps will

continue to function as liability matching instruments.

Although the extent and timing of the changes are liable to remain uncertain in the coming

months, the narrowing of the RPI to CPI wedge highlights the reality that general inflation

risk poses a much greater risk to most schemes than the basis risk between the two. The

industry revisits a question raised by the previous move to change statutory indexation from

RPI to CPI; are trustees / sponsors truly aware of the overall financial implications of inflation

on their pension scheme liabilities?

Lower actual inflation as well as expectations of future inflation will, other things being equal,

lead to a decrease in scheme liabilities. To the extent that schemes have hedged their

exposure to inflation, they will neither participate in the positive effects of falling inflation or

the negative effects of rising inflation.

At first thought, there may be an inclination to wait in the idea that inflation hedging will be

cheaper in the near future, given the anticipated fall in the relative index. However, markets

also react to information and there is evidence that inflation markets (e.g. Index-linked gilts,

8 DMO – June 2012: Index-linked gilts in issue.


swaps) have already begun to price in the possible changes. Attempting to call the inflation

market is therefore no easier now than it was before.

The Redington/PIC survey published in 2011 highlighted that on average, UK pension

schemes had hedged only 25% of their inflation exposure. Irrespective of the outcome of the

current consultation, this leaves them significantly exposed to moves in inflation.

The priority of these schemes should be to increase overall levels of inflation protection.

There is a risk that the current uncertainty over the RPI calculation method will lead to

inaction in the hope of cheaper hedging opportunities in the future. Instead, schemes should

recognise that inflation is one of their largest unhedged risks. As demonstrated by the break-

even charts, hedging instruments such as index-linked gilts and inflation swaps have already

allowed for the expected/possible change in RPI calculation methodology.

A more significant problem posed may be the limited supply of hedging instruments

available on the market. Currently, versus a total pensions liability of c.£7 trillion9, the UK

only has £335 billion of inflation-linked gilts, c.£30 billion of UK corporate index-linked bonds

(e.g. utility companies), and a further estimated £100 billion in the inflation swap market.

9 ONS, A fuller picture of the UK’s funded and unfunded pension obligations, April 2012


Disclaimer

© Redington Limited and Pension Corporation LLP 2012. All rights reserved. No

reproduction, copy, transmission or translation of this publication may be made without

Redington and Pension Corporation’s status as the authors being acknowledged .

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