This chart should produce howls of outrage. It compares the retail price index (RPI) to the consumer price index (CPI) since 1997, when the Bank of England gained its independence.
The chart illustrates how the RPI measure of inflation has outstripped the CPI counterpart. Today, the RPI is 13 percent higher than the CPI compared to 1997. Why should this be? After all, both measures are supposed to track the same phenomenon - inflation.
There are differences between the two measures which, in a statistical sense, explain this 13 percent divergence. However, a closer examination of these differences reveal that the RPI is a far superior measure of price changes. So what are these differences?
The basket used to calculate the CPI is a much more restricted measure of consumer expenditure. The CPI excludes council tax and mortgage interest payments. Both of these exclusions are highly dubious. The council tax covers essential services such as waste disposal, libraries, and education. If we have to pay more for them because council tax payments have gone up, then it is obvious that we are worse off.
The exclusion of mortgage interest payments is also nonsense. These interest payments represent the cost of home ownership, and if interest payments go up, it is obvious that households are becoming worse off.
The CPI also includes certain financial service charges. In this area, the CPI does capture something that is missing in the RPI, but the loss of information isn't that great since these charges are typically only a small component of overall household expenditure.
The RPI also use a more reliable data source when constructing the actual consumption basket. The RPI weights comes from the expenditure and food survey. In contrast, the CPI weights come from the household expenditure survey, which is primarily used for estimating the National accounts.
The two indices also use different mathematical formulas for combining the price is collected for each item in the basket. This is quite a complex issue, but the bottom line is fairly straightforward. In practice, the CPI formula ensures that the average price for each item is always lower than or equal to the average price for the same item within the RPI. In other words, CPI prices are always lower than or equal to RPI prices. If only this were true in real life.
The RPI tries to track the expenditure of the average household. It therefore sensibly excludes households in the top 4% of the income bracket. It also excludes some pensioners who tend to have highly atypical expenditure patterns. The CPI includes these groups.
As an aside, both measures of inflation are subject to outrageous Hedonic price adjustments. Actual inflation rates are reduced on the basis of arbitrary adjustments that supposedly capture the improved quality of goods. These changes are extremely widespread and have greatly undermined the validity of recent price data.
These differences may seem like an arcane issue that should only concern professional statisticians. Unfortunately, this issue really matters to all of us. The government chose CPI as the inflation target for the Bank of England. Since it produces consistently lower inflation rates, this target is a fix. It is therefore all the more shocking and worrying that the central bank have been unable to meet this relaxed and distorted target.
Measures of inflation based on the CPI are totally unreliable. We all know this to be true. The proof is hammered home every time we reach the supermarket tills and open up our purses. Prices are rising far faster than the headline rate suggests. This should be no surprise, the CPI has been designed to understate the true extent of inflation.