WHAT’S THE DIFFERENCE BETWEEN CPI and RPI INFLATION?

This is what matters

The Office for National Statistics (ONS) announced last week that UK’s annual inflation rate, as measured by CPI, fell to 2.7%.

Do you know what is the difference between the consumer price index (CPI) and the retail price index (RTI). I am regularly asked this question and the quick answer is that they include slightly different things; with the key difference being that RPI includes the costs of housing while CPI does not.

However it isn’t that simple, if it was, we would have seen RPI fall below CPI as mortgage rates collapsed from 2008. The complicated bit comes in how the two indices are calculated. The RPI is an arithmetic mean, in other words the prices of everything to be included in it are simply added up and divided by the number of items. The CPI is a geometric mean and is calculated by multiplying the prices of all the items together and then taking the nth root of them, where “n” is the number of items involved.

As you can see, understanding RPI is relatively easy, but the complicated methodology in compiling the CPI is as clear as mud to most people. As the CPI tends to be lower than the RPI, many of the conspiracy theorists amongst us see this as an evil government plot to paint things as better than they really are. Whilst I don’t believe this to be true, I think a simpler explanation might help.

The key differences Between RPI & CPI

1. Different Data: Two basic types of data are needed to construct the CPI: price data (as in the RPI) and weighting data. The price data for both indices is collected the same way by taking a representative sample of the goods and services we buy, from a wide range of sales outlets in a number of locations. The weighting data are estimates of the percentage share of the different types of expenditure in the total covered by the index. These weighting percentages are usually based upon expenditure data obtained from expenditure surveys for a sample of households.
2. Population Coverage: The CPI covers all private and institutional households; it also includes spending in the UK by foreign residents. The RPI excludes the top 4% of households by income and pensioner households where ¾ or more of income comes from the state. It excludes institutional households and foreign residents. By excluding the richest and the poorest, the RPI reflects the notion that inflation should be looked at as experienced by the majority of the population. This is why RPI was (and still is) often used as a benchmark in wage negotiations, pensions uplift, business contracts etcetera.
3. Inclusions and Exclusions: The CPI does not cover most owner occupier housing costs (mortgage interest, house depreciation & council tax), or vehicle excise duty, TV licences and trade union dues. It does include spending by foreign residents while in the UK, foreign students’ university tuition fees, university accommodation fees, investment costs (unit trust charges etc), all of which are excluded from the RPI. The RPI includes mortgage interest payments and house depreciation, council tax, vehicle excise duty, TV licences and trade union dues, but excludes university accommodation fees, spending by foreign residents, foreign students’ university tuition fees and investment costs.
4. Housing: The best known and biggest difference between the two indices is the exclusion of most owner occupier housing costs from the CPI. Their exclusion is primarily due to lack of agreement between EU countries on how they should be dealt with. Since house ownership provides not just “current” benefits – somewhere to live – but is also a capital investment, many would argue that it does not automatically have a place in an index which looks at current costs.

The ONS have made it clear that they prefer the CPI as they believe it can better reflect changes in consumer spending patterns relative to changes in the price of goods and services. That may well be true, but the real advantage to the government of using a geometric mean is that it is always below or equal to the arithmetic mean; so much so that the so called “formula effect” tends to produce a difference of approximately 1% in the different indices.

This is why the government likes to link the payments it makes (pensions, unemployment benefit etc) to the CPI and the payments it receives (taxes and so on) to the RPI. So I guess, the conspiracy theorists may well have a point.

David Jones is the Senior Partner and Founder of Morgan Jones & Company. Born in Liverpool and a graduate of Liverpool Collegiate Grammar School, David spent twenty years working for the Customs & Excise in London then Shrewsbury before starting his own business. David’s depth of knowledge of the UK tax system and his ability to communicate this learning has seen Morgan Jones & Company grow into Shropshire’s most respected Accountancy Practice. Email David