Inflation measures explained

The recent change in the inflation target, alongside a proliferation of acronyms, has complicated the inflation picture for many. We consider the range of different measures available and assess what they, and the new target measure, mean for those involved in wage bargaining.

In December 2003, the annual inflation rate was 1.3% and stable, 2.8% and rising quite steeply, or 2.6% and rising modestly. Confused? Don't be. Depending on which measure is used, the rate of inflation can indicate an apparently contradictory picture in any given month.

National Statistics publishes three inflation measures that are commonly referred to, as well as several others that are less widely publicised (see box ). Each represents an alternative way of looking at the inflation picture. The "all items retail prices" index ("headline" or RPI inflation) is the most widely recognised yardstick. It considers the annual rate of increase in the prices of"all items" in the notional basket of goods and services bought by consumers.

The "all items excluding mortgage interest payments" (RPIX or "underlying") measure - as its name suggests - ignores the effect of changes in mortgage costs when interest rates rise or fall. Until December 2003, this was the Bank of England's official target measure, used to guide the interest rate decision-making process.

The new "consumer prices index" (CPI) measure - formerly known as the harmonised index of consumer prices (HICP, or "hiccup" as it was colloquially referred to) - became the new official target measure in December 2003. It excludes the effect of mortgage interest payments and - crucially - the impact of house price appreciation.

Although the inflationary climate as a whole is fairly subdued, there has commonly been a degree of divergence between the various inflation measures in recent years (see chart 1). The gap between the RPIX and CPI measures (the previous and new target measures), for example, ranged between 0.7 and 1.7 percentage points during 2002/03 and averaged 1.2 percentage points. The average difference between the RPI and RPIX measures, meanwhile, was smaller, at around 0.2 percentage points.

These gaps are mostly due to differences in the coverage of each index, and to a lesser extent, to differences in the way they are calculated. The December 2003 inflation figures illustrate the point clearly¹. The headline rate of inflation accelerated by 0.3 percentage points, to 2.8%, due largely to the impact of higher mortgage interest payments following the November hike in interest rates. In contrast, the underlying (RPIX) measure rose by just 0.1 percentage point, to 2.6%, while the CPI measure remained steady at 1.3%.

Inflation and pay bargaining

As the key economic variable impacting pay settlements, the inflation rate is keenly watched by both sides of the bargaining table. More than three-quarters (76%) of the private-sector employers responding to our annual pay prospects survey cited it as likely to influence their pay settlement in 2003/04. For those involved in bargaining, the "headline" rate of inflation (RPI) is the most commonly monitored measure. However, with such a variety of measures available, is this really the best inflation indicator for those involved in wage bargaining? And, does it give a true reflection of the rate of inflation faced by those on both sides of the bargaining table? As we discuss below, while headline inflation is likely to remain the key yardstick, it is but one way of looking at the inflation picture that is often more complex than the "headline" figure suggests.

Other inflation measures

Alongside the three noted above, there are other, less well publicised, measures of inflation. Here, we discuss four of them, as well as two sub-indices derived from the headline (RPI) measure.

The "all items excluding interest payments and indirect taxes" (RPIY) measure excludes the effect on prices of changes in interest payments and indirect taxes, such as council tax, VAT and excise duties. Due to its similar coverage, it closely tracks the "underlying" (RPIX) measure and rarely strays from it by more than 0.5 percentage points. It is currently pitched at 2.2%. Meanwhile, the tax and prices index (TPI) measure includes the effect of changes in direct taxes, such as income tax. By adjusting for changes in taxation, these indices more accurately describe changes in consumers' purchasing power. As such, they are of interest to employees concerned with maintaining the real value of their incomes, and to their representatives charged with securing a corresponding pay settlement. Despite this, they have not become common currency in the bargaining arena, and most inflation-linked pay settlements refer to RPI, rather than the RPIY or TPI measures.

There are also inflation measures that track the rate of increase in manufactured goods prices and those of services, as well as the price of manufacturers' inputs. While of interest mainly to economists and analysts, they also serve as important indicators of inflationary pressures in different sectors of the economy, and are therefore of some interest to those engaged in pay negotiations.

The "producer price index" (PPI) measure of inflation tracks the rate of price increases in the manufacturing sector. Both "output prices" (or "factory gate" prices) are monitored, as well as those of raw materials and other inputs purchased by manufacturers. Changes in the PPI rate of inflation can often precede similar changes in the rate of headline inflation, once the changes in input prices and factory gate prices filter through to the consumer.

Finally, the Corporate Services Price Index (CSPI) measure aims to provide an indication of inflationary pressures in the service sector. Produced on a quarterly basis and based on prices charged by service providers to other businesses and the government, this index is still in the development phase and as yet, coverage of the service sector is incomplete. However, once more service industries are added, this index will provide an important barometer of inflationary pressures in the service sector as a whole.

Different inflation rates, different bargaining pressures

National Statistics also sub-divides the "all items" (RPI) measure into rates of"all goods" and "all services" inflation. In the last two years, these rates have varied markedly, reflecting divergent circumstances in different sectors of the economy (see chart 2). While the "all items" inflation rate has been in the 1-3.2% range, the "all services" component has been between 3% and 4.8%, and the "all goods" inflation rate has been at 0.7%, or below, throughout this period. In fact, for much of 2002, the pace of goods inflation was negative, indicating deflation (or falling average prices) in this sector.

Deflation (where the "all items" average price level is falling), of the type that has afflicted the Japanese economy for many years, is not a problem in the UK as a whole, but it has been a reality for many manufacturers. This has important implications for wage bargaining. Employees in manufacturing naturally tend to focus on the "all items" (RPI) rate of inflation (currently 2.8%) when negotiating their pay rise. In contrast, their employers are commonly faced with much lower increases (currently 0.7%) in the prices they receive for their products and this adversely impacts their ability to award pay rises.

Other things being equal, a manufacturer faced with goods prices that are rising only slowly, remaining static or falling, will be less able to afford a pay rise than a services provider that is seeing his prices charged rising at 3%, 4% or more a year. The high incidence of pay freezes indicated in the January 2004 EEF survey of manufacturing pay settlements is evidence of this process at work². More than one in five (22%) deals recorded by the EEF in the three months to December 2003 were pay freezes. The CBI's December 2003 pay settlement survey paints a similar picture, with more than two in five (41%) manufacturers citing pricing constraints (ie an inability to raise their product prices) as having pushed down their latest pay award³.

The Bank of England's shift to CPI

Since December 2003, a new inflation measure has risen to prominence in the UK - the consumer prices index (CPI). Although its name is new, the index has previously been published in the UK as the harmonised index of consumer prices (HICP). This measure is used across other countries in the EU and makes for more accurate international comparisons of inflation rates.

When the Bank of England was granted independence in 1997 and interest rate decisions were placed in the hands of the Monetary Policy Committee (MPC), the official inflation target measure was"underlying" or RPIX inflation. The MPC was charged with keeping this rate of inflation within one percentage point of 2.5%. Despite considerable success in the meeting of this target, December 2003 saw the target changed to the CPI measure. At the same time, a new target rate for CPI of 2% was announced, which the MPC is now obliged to target.

Several reasons were given for this policy shift. The CPI measure, according to the Chancellor of the Exchequer, Gordon Brown, is "a better measure". He noted that it is the "internationally recognised index of consumer prices, used by every other G7 nation but Japan". He also suggested that targeting the CPI measure would improve the quality of the inflation target, excluding as it does, the impact of house price inflation that has often been high and variable in the UK.

Does the change in the target measure and a 0.5 percentage point reduction in the target rate indicate a tighter inflation target? The answer is broadly "no". Over the longer term, the difference between the CPI and RPIX measures is around 0.5 percentage points, due largely to differences in the coverage of the indices. While other estimates that take into account technical factors put the gap at around 0.8-1 percentage points, targeting a CPI rate of 2% is still roughly akin to targeting a RPIX rate of 2.5% and no substantive difference in the monetary policy stance is implied.

Recently, the gap has been wider, due largely to the rapid growth in house price inflation that is included in the RPIX measure but not in the CPI measure. It was 1.3 percentage points in December 2003. As the rate of house price growth slows, it is expected that the gap between the RPIX and CPI measures will return to its long-run level of around 0.5 percentage points.

What is significant is the fact that inflation has moved from being "above target" on the old 2.5% (RPIX) measure, to "below target" on the new 2% (CPI) measure. This does present the MPC with some difficulties in deciding the course of interest rates in the coming months, as the new target measure is bedded in.

The Chancellor also confirmed in his December announcement that the value of pensions and other benefits, as well as index-linked gilts, will continue to be uprated by the rate of headline (RPI) inflation, rather than the (lower) level of inflation indicated by the CPI measure. The RPI (or its derivative indices where applicable) will continue to be used for the indexation of tax credits and tax allowances.

Implications for wage bargaining

While the change in the target measure does not represent any significant tightening or loosening of monetary policy, the shift does have some important implications for wage bargaining, mostly for those in the public sector.

In the private sector, our annual survey of pay prospects suggests that the shift in the inflation target will not impact bargaining. When asked in August 2003 "will your organisation use any inflation measure(s) to guide pay awards in the coming wage round?", almost four-fifths (78%) of the 254 respondent employers replied "yes". When asked "If yes, which measure(s) of inflation will you use?" (respondents could indicate as many measures as they wished), just nine noted the HICP (now CPI) measure.

In contrast, 170 respondents cited the "all items retail prices index" (RPI - the "headline rate"), while 43 respondents noted the RPIX measure (the "underlying rate"). As the survey was conducted before the official announcement of the switch to CPI was made in December, it will be interesting to see to what extent the CPI measure rises in importance to wage bargainers, now that it has supplanted RPIX as the target rate.

These results suggest that it may well take some time for the CPI to become "common currency". Moreover, it is unlikely to ever become the most important inflation measure to pay negotiators, particularly in the private sector, and will remain a measure of peripheral interest to them. Its use as a bargaining benchmark is likely to be particularly resisted by employees and their representatives.

As the national statistician, Len Cook, conceded in December: "A long-standing strength of the RPI is its widespread familiarity and credibility based on a much longer history. Inevitably, it will be some time before the CPI becomes as widely recognised, but the paper I am publishing today will help to raise understanding of the UK's new target measure."⁴

Public sector

The situation in the public sector may be different. In his pre-Budget speech in December, Gordon Brown expressed his desire for the CPI measure to become a key benchmark for public sector pay bargaining. He said: "Because discipline in pay setting is essential in both private and public sectors, I have written to the public sector pay-review bodies informing them that our inflation target is 2%."

The public service unions are, not surprisingly, aghast at the prospect of the new inflation target rate, that is 0.5 percentage points below the former RPIX target rate, becoming the focus of pay negotiations. As the CPI level of inflation has been consistently below the RPI and RPIX measures, unions fear that the switch in the official target measure will provide an excuse to hold down public sector wage increases. TUC general secretary, Brendan Barber, commented: "If this is going to be used to hold down wages it would send alarm bells ringing throughout the public sector."

1. Consumer price indices, December 2003. National Statistics, www.statistics.gov.uk .

2. EEF pay bulletin, January 2004. www.eef.org.uk .

3. CBI pay settlements survey, December 2003. www.cbi.org.uk .

4. The New Inflation Target: the Statistical perspective. National Statistics, December 2003. An executive summary of the paper is provided at www.statisitcs.gov.uk/StatBase/Product.asp?vlnk=10913  and the full text is available on the National Statistics website.