Government to win from RPI reforms, bondholders to lose - Capital Economics
UK Economics

Government to win from RPI reforms, bondholders to lose

UK Economics Update
Written by Ruth Gregory

The decision to reform the RPI measure of inflation at some point between 2025 and 2030 could reduce RPI inflation by a little under 1ppt a year. That could give the Government a windfall of about £3.2bn per annum at the expense of bondholders and households.

  • The decision to reform the RPI measure of inflation at some point between 2025 and 2030 could reduce RPI inflation by a little under 1ppt a year. That could give the Government a windfall of about £3.2bn per annum at the expense of bondholders and households.
  • The Chancellor has announced that reforms to the beleaguered retail price index (RPI) will take place at some point between 2025 and 2030 and will bring the methodology into line with CPIH (the CPI adjusted to include owner occupiers’ housing costs). There are a whole host of things that need to change, including altering the formula used and removing housing components. It is not clear exactly what effect this might have. But the divergence between the RPI and CPIH since 2006 provides as good a guide as any and suggests that after the reforms RPI inflation could be about 0.8ppts lower than otherwise. (See Chart 1.)
  • The Government will almost certainly win from the change, perhaps making a saving of £3.2bn (0.15% of GDP) a year. After all, the proposal would lead to lower interest payments on the 25% of the debt stock whose value rises in line with inflation (index-linked bonds). According to the Office for Budget Responsibility’s (OBR) ready-reckoner, if RPI inflation were 0.8ppts lower, then borrowing could be about £4.6bn per annum lower. Admittedly, this windfall would be partially offset by reduced revenues from fuel, alcohol and tobacco duties, which are uprated by RPI inflation each year. The Government could lose around £0.9bn a year from this source plus another £0.5bn or so on the interest charged on student loans, some of which is based on RPI inflation.
  • Of course, the Government’s £3.2bn gain will be index-linked gilt holders’ and households’ loss. As both coupon payments and the redemption value of index-linked gilts rise in line with RPI inflation, the change would cause index-linked gilts to be worth less in nominal terms than otherwise. Taking the longest dated index-linked gilt as an example, the principal in 2068 would be £493 if it were uprated using the RPI, but £353 if it were linked to CPIH after 2025. And rather than the market price of £299 prior to the proposals, assuming the required rate of return is unchanged, the net present value would be £224. Given that the price of the bond has already fallen to £260, this suggests there would be a further slump in the price if the reforms are implemented. (See Chart 2.)
  • Households will probably lose out too, although the changes probably wouldn’t make a material difference to the consumer spending outlook. Admittedly, households should benefit from smaller rises in rail fares and from lower interest on student loans. But the RPI is used to uprate certain pension payments, particularly defined benefit schemes. And in recent years about an eighth of all employees have been covered by a collective pay agreement referring to the RPI. That means households’ income may be £1.2bn a year, or 0.1% weaker than it would otherwise have been.
  • All this seems a pretty deft trick on the Chancellor’s part. But to some extent, the decision reverses the unintended consequences of a methodological change that has, since 2010, boosted RPI inflation. And with the fiscal taps now open, what the Government takes by stealth could yet be given back to households in the form of lower taxes and higher government spending.

Chart 1: Possible Impact of RPI Reforms

(Average since 2006, ppts)

Chart 2: Nominal Price of 2068 0.125% Index-Linked Gilt (£)

Sources: ONS, Capital Economics

Source: Bloomberg


Ruth Gregory, Senior UK Economist, +44 20 7811 3913, ruth.gregory@capitaleconomics.com
Andrew Wishart, UK Economist, +44 20 7808 4062, andrew.wishart@capitaleconomics.com