Download the full response (pdf format, 150kb)

Summary
The RSS considers that the ongoing investigation into the formula effect being carried out by the ONS is (or will be) an excellent and comprehensive piece of work. While individual parts of it may appear to throw limited light on the issue, collectively they are starting to build a good picture of the reasons for the formula effect and ways to minimise it.  The research is also providing indications of the impact of potential changes, not just on the formula effect, but on the actual inflation rates shown by the indices.

The RSS has argued for some time that the formula effect should be eliminated or reduced to a minimal level and we welcome the efforts that the ONS has been making towards this end. But the ultimate aim is to measure inflation, according to the definition adopted, as accurately as possible. The changes being tested by the ONS are likely to improve the accuracy of both indices as well as reducing the formula effect. Further, the impact of any formula depends also on the sampling scheme, price collection methods, choice of base month etc., precisely the factors being tested by the ONS research. Ideally therefore all these items should be considered together. It was recognised right from the early days after the introduction of the Harmonised Index of Consumer Prices (now called the CPI in the UK) that the size of the formula effect was dependent on these factors as a 1999 paper by David Fenwick showed [1].

The formula effect is particularly marked in clothing, an area where large price swings in individual items make assessing inflation particularly difficult, and ONS research has therefore rightly been largely focused in this area. Not only is the formula effect in clothing large but past experience has shown that its size is dependent on sampling and price collection design. It widened substantially after the changes introduced in 2010 and the Fenwick paper, cited above, also reports a similar occurrence in the 1990s. So again this points to the need to consider these factors alongside choice of formula.

We would like to see the ONS bring together the collective results of its work and its assessment of the average long-term changes they might make to the series. Pending this, a very tentative assessment has been made and is attached as an appendix. This is subject to many qualifications and much of the work is inevitably based on very limited information and therefore should be considered only indicative evidence but it does start to give a picture of changes which would narrow the gap with CPI inflation overall moving up and RPI inflation moving down (the downward movement in RPI inflation being greater than the net upward movement in CPI inflation).  A formula effect would remain but it would be considerably reduced, making it easier to manage or eliminate, and making both series a better measure of the unknown “true” rate of inflation. 

In summary we feel that statistically and presentationally it would be desirable to wait a further year (to March 2014) before making any substantial changes. As well as completing the current research we also think it is necessary to test the impact of much greater tightening and sub-division of clothing and perhaps some other categories than currently tested. Making all the changes to both the RPI and the CPI implied by the research programme as well as changing the formulae would be a more measured and statistically satisfactory way to deal with this complex issue.

Once all the research, including the need for more homogenous elementary aggregates has been completed, the remaining formula gap is likely to be considerably smaller. The choice of formula then is by definition less contentious. If changes to the formula are made in isolation then there is a risk that subsequent changes might alter the inflation rate in the opposite direction engendering a yoyo effect. This would not increase confidence in the index among users and would be unnecessarily disruptive for holders of index-linked gilts.  A large adverse change one year, followed by a favourable change the following year would, in our view, cause more reputational damage than a single, well-founded set of changes.