Key Takeaways
- RPI includes mortgage interest in housing costs.
- RPI typically reports higher inflation than CPI.
- Uses arithmetic means causing upward inflation bias.
- Still used in UK legal and contractual contexts.
What is Retail Price Index (RPI)?
The Retail Price Index (RPI) is a UK inflation measure tracking changes in the cost of a representative basket of goods and services, including housing costs like mortgage interest. Unlike the Consumer Prices Index (CPI), RPI covers a narrower population and uses a different formula, often resulting in higher reported inflation. Understanding RPI is essential for grasping macroeconomics and its impact on contracts and government debt.
Key Characteristics
RPI stands out due to its unique coverage, population scope, and calculation method:
- Coverage: Includes owner-occupier housing expenses such as mortgage interest, unlike CPI, capturing broader household spending patterns.
- Population: Focuses on private UK households but excludes the top 4% of income earners and some pensioner groups.
- Formula: Uses arithmetic averages (Carli formula), known for an upward bias called the "formula effect," which inflates reported inflation rates.
- Historical Use: The official inflation measure until 2003, still used in many legal and financial contracts.
- Data Sources: Gathers prices from roughly 20,000 UK retail and non-retail outlets across about 700 goods and services.
How It Works
RPI calculates inflation by comparing price changes over time in a fixed basket weighted by household expenditure patterns. The inclusion of mortgage interest means RPI reacts more strongly to interest rate shifts, affecting its volatility relative to CPI.
The arithmetic mean calculation tends to exaggerate inflation compared to geometric averages used by CPI. This methodological difference, combined with a narrower population, means RPI often reports inflation rates about 0.9–1 percentage point higher annually, influencing par yield curve estimations and bond valuations.
Examples and Use Cases
RPI remains relevant in various financial and contractual contexts despite CPI's official status:
- Government Bonds: Index-linked gilts use RPI to adjust principal and coupon payments, affecting investor returns.
- Utility Pricing: Annual rail ticket hikes and road tax levies often base increases on RPI readings.
- Private Contracts: Lease agreements, pensions, and some student loans adjust payments according to RPI to maintain real value.
- Investments: Companies such as Delta may use inflation data from indices like RPI to inform pricing and cost management strategies.
- Portfolio Strategies: When selecting fixed income assets, you might consider insights from guides on best bond ETFs to balance inflation risks tied to RPI fluctuations.
Important Considerations
While RPI provides valuable inflation insight, its known upward bias and exclusion of some population segments warrant caution. The Office for National Statistics plans to align RPI methodology with CPIH by 2030 to reduce discrepancies, but RPI's entrenched use in contracts means it will remain significant for now.
For long-term investors, understanding the impact of RPI on indexed assets and liabilities is crucial. You may also find data smoothing techniques helpful to analyze RPI’s volatility within broader economic trends, complementing your knowledge of data smoothing methods.
Final Words
RPI tends to show higher inflation than CPI due to its broader coverage and calculation methods, impacting cost-of-living adjustments and financial products. Review your contracts and investments to see if RPI or CPI is the relevant benchmark for your situation.
Frequently Asked Questions
The Retail Price Index (RPI) is a UK measure of consumer price inflation that tracks changes in the cost of a basket of goods and services, including housing costs like mortgage interest. It was introduced in 1947 and was the official inflation measure until 2003.
RPI includes owner-occupier housing costs such as mortgage interest and covers a narrower population, while CPI excludes most housing costs and covers a broader population including institutional households. Additionally, RPI uses arithmetic averages causing a higher inflation reading, whereas CPI uses geometric means for more stability.
RPI tends to report inflation rates about 0.9-1 percentage point higher annually due to its formula methodology, specifically the arithmetic averaging method, which introduces an upward bias known as the 'formula effect.'
Although CPI replaced RPI as the UK's official inflation measure in 2003, RPI remains in use for legal and contractual purposes because of its historical role in things like wage agreements and index-linked securities.
RPI includes owner-occupier housing costs such as mortgage interest payments and maintenance, which are largely excluded from CPI. This makes RPI a broader measure of household spending compared to CPI.
RPI covers UK private households but excludes the top 4% of earners and pensioner households reliant primarily on state benefits, whereas CPI covers all private households, institutional households, and visitors, providing a broader population scope.
Due to differences in calculation formulas and coverage, RPI can show significantly higher inflation rates than CPI for the same items. For example, clothing prices rose 80% under RPI from 2010-2016, compared to 15% under CPI, mainly because of the formula effect in RPI.
If the price of an item doubles and then returns to its original price, RPI might still show a net decrease due to its arithmetic averaging method, demonstrating directional sensitivity. CPI’s geometric method avoids this issue, providing a more balanced measure.
