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Anthony Hilton: To CPI or not to CPI... that is the £90 billion question

Could the retail price index be scrapped?
Could the retail price index be scrapped? / ES
14 January 2020

T is quite unusual for the Government to make a change which might cost pensioners, bond holders and others £90 billion. It is even more unusual for the same sum to flow to the Treasury. You might even think the Government was short of cash.

But a consultation to be launched this month shows that could easily happen. The proposal is esoteric. Most people will ignore it or not even know it is happening. It involves the scrapping of the retail price index (RPI) and replacing it with the consumer price index (CPI) some time between 2025 and 2030 — which is no more than 10 years away.

The retail price index is consistently above the consumer price index. If inflation is at 3% according to the RPI, then the CPI will show it at perhaps 2%. In fact back in 2014 the Bank of England’s Inflation Report suggested that RPI was higher than CPI by 1.3%. But it seems to have come down since.

The CPI is in fact a better guide to inflation, whereas the RPI is flawed in all sorts of ways. But it is the RPI which nevertheless is the benchmark for index-linked gilts, swaps, annuities, pension increases, inflation-linked commercial property, student loans and even rail fare increases. And many of these extend way past 2030.

Interestingly the Bank of England, in a letter last March, said the suggested change would be fundamental and “materially detrimental to the interests of the holders of relevant index-linked gilt-edged securities.” That seems about right.

Assuming this proposal goes ahead unchallenged, the RPI’s replacement by the CPI will lead to an apparent drop in inflation for those who have bought securities specifically to hedge against that possibility. Inflation will be less, so holders of index-linked gilts will suffer a commensurate drop in their holdings. This is because their principal will be less when the bond matures because it is no longer governed by RPI.

How much less? Well, Insight Investment, which has looked closely at this topic, reckons that for a gilt which matures in 2055, with a reduction of 1% because of the change to CPI the impact would be a loss to bondholders of 21%. There are about £700 billion of RPI index-linked gilts outstanding. If inflation is again 1% less under the new measure, then that will lead to a £90 billion loss on the gilts, and who knows how much on swaps or property.

The Government, however, would make a £90 billion gain because it would not have to pay out as much on those linkers. Indeed there is a suggestion of the Government indulging in index shopping. Perhaps it wants consumers to use RPI for increases on student fees or rail fares, but the Government meanwhile would use the CPI when it has to pay out.

David Norgrove, chairman of the UK Statistics Authority, had written to the Chancellor saying that RPI should be abolished because it is flawed, but he specifically also says that his remit does not extend to the consequences of his action on RPI holders of assets. Insight too says that it has no problem with abolishing RPI — indeed it says it makes sense — but it wants compensation for those who suffer so that no one is made worse off by the change.

If, however, the change is pushed through without the consent of bond holders it might in effect be a breach of the contractual obligations governing these issues. Gilts with RPI obligations would no longer be honoured which is behaviour reminiscent of a third world country rather than Great Britain. And it could have long-term implications for further issues of inflation bonds. Investors might wonder what would happen 30 years hence if the Government decided CPI was no longer relevant either? Fearing another haircut, they might shun the gilts.

Compensation as suggested by Insight will of course be hard to assess but it is not impossible.

For example, Network Rail has a proportion of index-linked bonds in its finances, and it has devised a process should RPI be discontinued not to disadvantage borrower or lender. There are, therefore, precedents.

It is important, however, for those affected by the change, including pension funds, annuity holders with inflation adjusted returns, and index-linked investors to make sure that Chancellor Sajid Javid is left in no doubt about the strength of feeling among those affected.