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PROBLEMS IN MEASURING UK INFLATION. Presentation to Occupational Pensioners’ Alliance 3 rd November 2011 Jill Leyland Vice President, Royal Statistical Society. Outline of presentation. About the RSS The issues with the Consumer and Retail Price indices What needs to be done - PowerPoint PPT Presentation
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PROBLEMS IN MEASURING UK INFLATIONPresentation to Occupational Pensioners’
Alliance3rd November 2011
Jill LeylandVice President, Royal Statistical Society
Outline of presentation• About the RSS
• The issues with the Consumer and Retail Price indices
• What needs to be done
• Hedonic regressions in price indices
About the RSS
• Only learned society in UK representing statistics and statisticians
• Founded 1834• 6,000+ members, around one quarter
overseas• Anyone with an interest in statistics can
join – you do not have to be a professional statistician
The Statistics User Forum• Organisation for statistics users
• Auspices of RSS, funds from UK Statistics Authority and ESRC
• Currently for professional statistics users but intention to develop into forum for all including “citizen users”
RSS Getstats campaign• 1 0 year statistical literacy campaign
• Numbers are everywhere. Getstats aims to give everyone the skills and confidence to use numbers well
• Launched on 20th October 2010
• www.getstats.org
Measuring inflation often controversial – in any country• People have different spending patterns
– so different inflation experiences• Notice price rises more than price falls• Conceptual problems• Calculation issues
– no single “right” way of compiling index numbers and
– different approaches give different results
In the UK• Two different “consumer” price indices,
each with some variants:
• Consumer price index (CPI)– originally called the Harmonised Index of Consumer Prices (HICP). First published 15 years ago in 1996
• Retail price index (RPI)– long standing and familiar. First published in 1950s; also earlier versions
Why two?• Different EU countries calculated price
indices in different ways• Need for “harmonised” indices for EU and
eurozone purposes• CPI therefore developed on harmonised
definitions• UK obliged by EU law to calculate and
publish CPI• Not obliged to use it for any particular
purpose
UK government decided• In 2003 to use Harmonised Index of
Consumer Prices as Bank of England’s target• Renamed it the CPI (unusual step)• 2010 June budget decided to uprate
benefits, tax credits, public sector pensions by CPI rather than RPI from April 2011
• From 2012 tax bands to be linked to CPI• Private sector pensions depends on scheme
rules but some influenced by govt changes
15 years of the two price indices
90
100
110
120
130
140
150
160
Apr-96 Apr-98 Apr-00 Apr-02 Apr-04 Apr-06 Apr-08 Apr-10
Apr 1996 = 100
Consumer price index (CPI)
Retail price index (RPI)
Source: Office for National Statistics (ONS)
Impact on pensionsTwo people, A and B , retired 15 years ago in 1996 on pension of £5,000. A’s pension is uprated annually by CPI, B by RPI
• In 2001: A gets £5,341; B £5,672B is 6% better off• In 2006: A gets £5,778; B £6,438B is 11% better off• In 2011: A gets £6,778; B £7,680B is 13% better off
Why the difference?• The items included in the index
• How they are calculated – “formula effect”
• Difference in items included normally makes RPI grow faster than CPI but not always
• But formula effect always makes RPI grow faster
Differences in items included• CPI excludes some owner occupier housing
costs including mortgage interest• Also council tax, Vehicle Excise Duty, TV
licenses, Trade Union dues• Includes UK spending by overseas residents• Insurance premiums lower weight in CPI• Plans to include some measure of house
ownership but designed for macroeconomic purposes. Not entirely suitable for “cost of living” measurement.
Which means...• CPI coverage in RSS view therefore not
appropriate for wage negotiations, pensions and benefits uplift etc
• But CPI covers all population; RPI excludes the richest, some low-income pensioner, and those living in institutions plus some items relevant to those people
• Neither ideal for pensions uplift, wage negotiations etc
Calculation differences; when constructing a price index1) Decide:
– what items to include and their weight in the overall basket
– base period (set as 100)
2) For each item:– collect prices from different shops etc every month– calculate “average” % increase (or decrease)
between base period and current month (calculation step 1)
3) Calculate weighted “average” percentage increase (decrease) for ALL items – (calculation step 2)
But...
How to calculate the “average”?Many methods – choice a matter of
judgement. Most common for indices:
– Arithmetic mean (two variations): add up the n items and divide by n
– Geometric mean: Multiply the n items together and take nth root of the result
Key point: assumption about degree to which people switch to lower priced items
Formula effect occurs in stage 1• CPI : geometric mean – assumes some
switching to lower priced items • RPI uses arithmetic mean – assumes no
switching to lower price items, probably overstates inflation
• Formula effect made average difference of 0.5 to 0.6 percentage points on annual inflation rate (much higher than in other countries)
• Now formula effect around one percentage point
The impact of the formula effect
NB: rough and ready adjustment
95
100
105
110
115
120
125
Dec-04 Sep-05 Jun-06 Mar-07 Dec-07 Sep-08 Jun-09 Mar-10 Dec-10 Sep-11
CPI, RPI and RPI adjusted, (Dec 2004 = 100)
CPIRPIRPI adj
Are they fit for purpose?• CPI fine for macroeconomic purposes (eg
inflation targeting, international comparisons)
• But coverage not suitable for other uses including wage negotiations, pensions/benefits uplift etc
• But RPI not perfect. Better coverage but excludes part of population; could well overstate inflation
How did we get here?• Fundamental problem: overly dominant
influence of central government on official statistics generally
• This is changing but slowly• For RPI and CPI meant macroeconomic
needs dominant • Initial “user group” meeting on
November 18 – could be breakthrough
What needs to be done• An index reflecting typical household
budget – probably a family of indices for different household groups (eg pensions uprating, wage negotiations etc). Based on expressed needs of users.
• To eliminate the formula effect: proper assessment of extent to which consumers switch to lower priced items; appropriate index treatment for different items selected. Some work now underway.
Hedonic regression• If new product comes onto market at
higher price but with improved quality, how much of the rise is due to improved quality and how much a “true” rise?
• Generally dealt with by looking at similar products with unchanged specification
• But this does not work well when rapid and frequent quality changes eg computers
Regression enables a “best fit” to be calculated
• Does not have to be linear, can be other mathematical functions
• Often multi-dimensional y = coo + c1x1 + c2x2 + c3x3 + ...etc
For hedonic methods• “Hedonic” as based on utility, value or
pleasure items gives customer• Approach looks at characteristics - eg for
computers: memory, processing speed, monitor size etc
• Using regression, develops a “predicted price” in any period as function of these characteristics
In Hedonic methods (2)• When quality change occurs, take ratio of
predicted price for new item to predicted price for old item and apply this to actual price in previous period
• Used in UK for computers, digital cameras, pre-paid mobile phones
• Other countries vary: can be used for clothing (to deal with fashion changes), or household rents
Advantages and disadvantages• Can provide solution when traditional
methods fail• Requires a lot of information• More opaque as a method, raises
suspicion in some minds
• Conclusion – useful when used sparingly (case in UK)