Perspective

What is the right measure of UK inflation for Charity investment portfolios?


What is the right measure of UK inflation for Charity investment portfolios? We prefer CPI over RPI as the inflation metric for three main reasons:

1. RPI is not an appropriate measure of UK inflation

The UK Statistics Authority (UKSA) have suggested that the publication of RPI should cease or at the least that it should be aligned with CPI.  Whilst there are various things that need to happen before this is the case, it seems likely that RPI will change materially over the next ten years.

An enquiry by the House of Lords in January 2019 concluded that RPI is not an appropriate measure for UK inflation, and called for the UK Statistics Authority (UKSA) to pursue a programme of improvements.

After much delay, on 4 September 2019 the UKSA and the Chancellor of the Exchequer published a co-ordinated set of responses to the House of Lords’ enquiry. The UKSA’s recommendations were clear. The body said that:

  • publication of RPI should cease (recognising this needed primary legislation and would have significant market impact), and, if this not acceptable, that
  • changes should be made to RPI to align it with consumer prices inflation, including owner-occupiers’ housing costs (as captured in the CPIH measure).

The Chancellor’s response however rebuffed the UKSA’s recommendation to abolish RPI. In its response it:

  • reaffirmed that the Chancellor needed to sign-off changes to RPI before 2030 (this is because documentation for certain pre-2002 index-linked gilt issues requires the Chancellor to sign-off on changes in RPI that cause material detriment to bond holders, and the last of these bonds matures in July 2030);
  • recognised the disruption that changes to RPI may cause, in particular to holders of index-linked gilts
  • proposed that changes to RPI should not occur before February 2025
  • said it would consult on changes in January 2020, promising to publish a response by the time of the Spring Statement
  • confirmed that the Government will continue to issue RPI-linked gilts.

Legally no changes were made to the current approach to constructing RPI inflation. However, it seemed that the Chancellor was allowing the UKSA to align RPI’s calculation with CPIH from 2030, if it so wished.

Given that the UKSA has now made clear its ambition to do this, it seems significantly more likely that RPI will change materially at some point in the next ten years.  The Government and the UK Statistics Authority have now launched a consultation on reforming or discontinuing the long-standing RPI measure, with responses due by the 22nd April.

2. CPI is a more accurate measure of economy-wide inflation

In recent years CPI has increasingly become the standard measure of inflation across the investment industry. RPI data continues to be generated because of the needs of users who have long term contracts linked to it, as well as for index linked government bonds, but it is increasingly a “legacy calculation”.

We recognise that defining what might be considered the “true” rate of inflation is difficult as the basket of goods that might be representative for one social group or age group may not be appropriate to another. It is also the case that inflation rates for charity expenditure also varies. However, assuming that asset returns are based on economy-wide inflation, we believe it is appropriate to use a measure of prices that most closely reflects the wider economy, whilst also being the accepted national standard.

3. The underlying formula for calculating RPI is flawed and leads to a long-term upward bias

There are two main differences between the construction of RPI and CPI: the basket of products (and basket weightings) included in the index, and the statistical method used to construct the indices. The RPI has lost its National Statistics status as the ‘Carli’ formula used to calculate average price changes did not meet international standards. For example, Canada had stopped using the Carli formula in 1978 and of 30 countries surveyed by the Office for National Statistics (ONS) in 2012 none used this calculation.

The 2015 UK Consumer Price Statistics Review conducted by the UK Statistics Authority concluded that the additive nature of the RPI formula leads to a long-term upward bias in recorded inflation, especially when prices fluctuate. This introduces an artificial gap, known by statisticians as the wedge, between the index and the actual level of prices. Statistically, over the long-term, the structural difference between RPI and CPI has been around 0.8% per year.

The opinions contained herein are those of the author and do not necessarily represent the house view. This document is intended to be for information purposes only. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations. Information herein is believed to be reliable but Cazenove Capital does not warrant its completeness or accuracy. No responsibility can be accepted for errors of fact or opinion. This does not exclude or restrict any duty or liability that Cazenove Capital has to its customers under the Financial Services and Markets Act 2000 (as amended from time to time) or any other regulatory system. Cazenove Capital is part of the Schroder Group and a trading name of Schroder & Co. Registered Office at 1 London Wall Place, London EC2Y 5AU. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. For your security, communications may be taped and monitored. 

Contact Cazenove Charities

Achieving your charity's investment objectives takes time and thought. To find out how we can help you please contact:

James Brennan

James Brennan

Portfolio Director james.brennan@cazenovecapital.com