The measure
of inflation used: RPI, RPIX, HICP and whether to include the
first-round effects
3.17 It could be argued that the price level
is whatever is measured by a price index, and inflation is the
rate of change of that index. The trouble with that interpretation
is that we would then have as many inflation concepts as we have
indices. An alternative is that we recognise that individual prices
change, and we wish to measure the extent to which they move together.
The purpose of a price index is to measure as best we can, but
surely imperfectly, that general movement. Different price indices
are then essentially measures of the same thing. That, of course,
leads to the problem of deciding whether and in what sense one
index is better than another.
3.18 It is against this background that the real
debate about the inflation target has taken place. At the moment,
the inflation target is set using the RPIX measure. RPIX is derived
from the Retail Price Index, the main domestic inflation measure
for the United Kingdom. The RPI measures the average change from
month to month in the prices of goods and services purchased by
most households. RPIX is constructed in the same way but it excludes
mortgage interest payments. According to the Office for National
Statistics (ONS), "It is a more appropriate tool for monetary
policy purposes because by excluding mortgage interest payments
it does not reflect the direct impact of interest rate changes
made to control inflation." (p 218)
3.19 It has been suggested to us that a more
appropriate measure to target would be the Harmonised Index of
Consumer Prices (HICP). This is the index that is used by the
European Central Bank to measure price stability across the euro
area, but it is also calculated in the United Kingdom for purposes
of comparison. A detailed analysis of the differences between
the two measures is printed in Appendix 3. We now list the principal
differences between RPI and HICP.
3.20 RPI is calculated as an arithmetic mean,
whereas HICP is calculated as a geometric mean. That is the essential
difference. In Appendix 3 the nature of the indices is explained
further. It is also shown that the difference between the two
is larger, the greater the variation across the inflation rates
of the individual components. Thus a shock affecting some prices
much more than others, will cause the RPI to exceed the HICP.
3.21 In addition to that fundamental consideration,
the coverage of the two indices is different. HICP excludes a
number of RPI series, most notably those relating to owner-occupiers'
housing costs and some health, education and insurance expenditure,
but includes other items such as air fares which are excluded
from the RPI. Also HICP measures the cost of new cars, while the
RPI measures the cost of used cars.
3.22 Dr Tim Holt, speaking as Director of the
ONS, told us that HICP "is economically narrower for the
United Kingdom than the RPI or RPIX; there are differences and
it only covers about 87 per cent or so of the consumption that
would be covered by something like RPIX." (Q 967) In practice,
we can calculate each index with the same coverage, whether it
be the broader or the narrower one.
3.23 HICP is a new and evolving series, which
started in January 1996. The RPI is an established series. HICP
is, as the ONS pointed out, in a state of flux: some items are
to be added in December 1999. It is generally accepted in the
European Union, where it produces figures close to those produced
by more traditional consumer price indices; as M Trichet told
us, "The United Kingdom is perhaps the only country in the
entire Euro 15 with a substantial difference between RPI and HICP."
(Q 1353)
3.24 That difference amounts in general to between
0.5 per cent and 1 per cent, with RPIX being the higher. On 20
April 1999, the day that Dr Holt gave evidence to us, RPIX
was 2.7 per cent and HICP was 1.7 per cent. He told us that "roughly
speaking about half of that 1 per cent difference is ascribable
to differences in the actual formula of calculation and the other
half per cent is ascribable to the differences in the coverage
of HICP to RPIX." (Q 974) In other words, if the RPIX measured
the same items that HICP measured, or was measured geometrically
rather than arithmetically, one could expect inflation to fall
to roughly 2.2 per cent. If both of these took place, inflation
would be 1.7 per cent.
3.25 What meaning then is to be attached to inflation
in the United Kingdom as measured by HICP apparently being lower
than inflation measured by RPIX even when the two have the same
coverage? Is there any sense in which one overstates or the other
understates "true inflation"? (This is different from
the overstatement phenomenon as discussed in Boskin. If, for example
RPIX overstates inflation for what might be called Boskin reasons
of quality change, substitution questions, and the like, we would
expect HICP to overstate it for the same reasons.) The difference
between the two should be attributable not to coverage, but to
something very different, namely the mathematics of geometric
versus arithmetic means. We did not receive any fundamental analysis
of any of this in evidence, and it is a topic that needs to be
returned to. What also needs to be examined at a later stage is
the significance of the point raised in the appendix, namely that
HICP is intrinsically more stable as an index than RPIX.
3.26 What cannot be argued is what some witnesses
get close to saying, namely that a good reason for switching to
HICP is that inflation is slashed at a stroke without having to
raise interest rates by a single basis point and enabling the
target itself to be reduced! We do recognise the appeal of harmonising
the measurement of inflation so as to compare inflation with that
in the rest of Europe, and one can see very clearly the reasoning
put forward by Sir Brian Moffatt:
"since the United Kingdom economy is increasingly
locked into that of the rest of the EU, we should use where possible
the same measures to avoid the spurious differences distorting
policy perceptions, and lower target and actual measures of inflation
would help remove the inflationary expectations still alive in
the United Kingdom." (p 285)
3.27 Lloyds TSB agree, but go further: their
analysis is that:
"On current and
likely future inflation trends, the reduction in targeted inflation
from 2.5 per cent for RPIX to 2 per cent for HICP should imply
no major change in the stance of policy, given the way that RPIX
overstates inflation. But the change would bring two benefits.
If the MPC was successful in hitting its new target, recorded
United Kingdom inflation would be very similar to the EMU average
- helping to ensure convergence, and possibly stabilising the
exchange rate along the way. And the change to a lower target
should help to reduce inflation expectations by changing public
perceptions about true inflation, thereby reducing the short term
output and employment costs of hitting the target." (p 206)
3.28 As can be seen, we concur with some of this,
but not all. We would wish to be very careful before committing
ourselves to what is to be called true inflation. We would be
extremely wary of doing anything in the area of measurement which
would lead the public to believe that any tricks were being played
on them.
3.29 Certainly it must be said that not everyone
is convinced by the sort of position adopted by Lloyds. The argument
that "HICP is still in a relatively experimental stage"
was used by Professor Bean when he told us that he did not "think
it should be introduced and used as an excuse for having a more
relaxed monetary policy." (Q 1412) This caution is reflected
by the Treasury and the Bank and it is very much our view.
It should also be said that the perception that inflation
would be reduced as a result of switching from RPIX to HICP is
actually an illusion since the inflation rates of the individual
items will be unaffected. There is also concern about the implications
for contracts and pensions indexed on the RPI. Nonetheless, Mr
Gus O'Donnell, Head of the Government Economic Service, said that
he personally favoured geometric means for price indices. (Q 166)
3.30 We emphasise that many contracts are set
out in terms involving RPI and RPIX. This is largely to do with
the updating of nominal values. Decisions are taken in anticipation
of uprating by the RPI, and in consequence of that. Increasingly,
we believe, decisions are being taken at all levels in the economy
on the assumption that the inflation target is set in RPIX terms.
We do not doubt that change in due course may be desirable, but
we utter a word of caution, there must be a great deal more preparation
and public discussion before final choices are made.
The choice
of a symmetric target
3.31 The target for inflation of 2.5 per cent
has a threshold of one per cent either side of it. If inflation
exceeds 3.5 per cent or falls below 1.5 per cent the mechanism
whereby the Governor must write an open letter is activated.
It is important to remember (and this will be discussed later)
that, as put by the Chancellor in his remit for the MPC:
"The thresholds
do not define a target range. Their function is to define the
points at which I shall expect an explanatory letter from you
because the actual inflation rate is appreciably away from its
target."
3.32 He also has made clear that the deviations
from the target are to be discouraged whether they are above the
target or below it. He told us:
"I would emphasise also
that it is a symmetrical inflation target and therefore we want
that target to be achieved. It is not 2.5 per cent or less, it
is not simply low inflation, it is 2.5 per cent. That is why
the second part says subject to achieving the inflation target
to pursue the Government's objectives of growth and employment.
In other words, to under-achieve or some people may say over-achieve
on the target to have far lower inflation would not necessarily
be pursuing the Government's objectives of growth and employment."
(Q 3)
3.33 The Bank is under instructions to ensure
that any anti-inflationary aggression should be tempered by a
concern for growth and employment. The Bank accept the principle,
and in the 1999 Annual Report, the Governor drew attention to
the rapid reduction in interest rates from 7.5 per cent to (at
the time of his writing) 5.25 per cent, saying:
"we have, I believe,
demonstrated convincingly the merits of a symmetrical inflation
target, delivering on the promise made in a speech to the TUC
last September that we would be just as vigorous in cutting rates
if the evidence pointed to undershooting the target as we had
been in raising rates when the balance of risks was on the upside."[15]
We are inclined to agree, but continue to emphasise
that it is too early to make a final judgment on any of these
matters.
The relation
between a symmetric target and the distinction between short and
long term inflation objectives
3.34 The Chancellor's symmetric target leaves
in practice a 2 per cent zone within which the Governor is excused
from writing an open letter to the Chancellor. In addition, it
has been emphasised that a breach of the threshold will not always
constitute a failure of monetary policy: as put by the Chancellor
in his remit to the MPC:
"The framework takes
into account that any economy at some point can suffer from external
events or temporary difficulties, often beyond its control. The
framework is based on the recognition that the actual inflation
rate will on occasions depart from its target as a result of shocks
and disturbances. Attempts to keep inflation at the inflation
target in these circumstances may cause undesirable volatility
in output."
We agree with this and elaborate further in Chapter
7. It is certainly our view that the event of an open letter
is not, on its own, to be considered a failure on the Bank's part,
at least by the Treasury.
3.35 The issue of shocks will be considered in
more detail in the next chapter, but it is worth considering the
question of how quickly the MPC is required to act in the event
of difficult inflationary pressures. The dilemma of short-term
versus longer-term requirements was summarised by Professor Bean:
"If inflation is
above target, the MPC can seek to get it back to target quickly,
but only if they are willing to incur a sharp recession. Alternatively
they can do it more gradually, so limiting the depth of any recession,
but inflation will be away from the target for longer." (p
303),
adding in his oral evidence that "it is a recipe
for very bad monetary policy if you are completely obsessed with
inflation even in the very short term." (Q 1424)
3.36 Drawing on his recent Antipodean experience,
Professor Bean compared the recent experience of Australia, with
its medium term target and New Zealand, with its short term target:
"a very tight objective
for inflation like that of New Zealand may have the effect of
encouraging the central bank to place too little weight on smoothing
output. Some support for this view comes from the fact that the
variability of output there in recent years has been roughly twice
that of either Australia or the United Kingdom, whilst the variability
of inflation has been correspondingly lower." (p 304)
15 Bank of England Annual Report, p.4. Back
