RPI vs CPI, Price Indices, and How Inflation Targeting Works
So you know what inflation is and what causes it. But how do you actually measure it?
Turns out there’s more than one way. And the differences between those measurements matter a lot more than you’d think.
This is the second part of Chapter 4 from Trading Economics by Trevor Williams and Victoria Turton. It covers the different price indices used in the UK, how inflation targeting works, and the pros and cons of both inflation and deflation.
The UK’s Price Indices
The UK has several ways to measure inflation. Each one captures something slightly different.
RPI (Retail Prices Index)
This is the oldest measure. It’s been around since the 1940s. RPI tracks the prices of a basket of goods and services that a typical household buys.
Here’s what makes RPI unique: it includes mortgage interest payments. So when the Bank of England raises interest rates, RPI actually goes up because mortgages get more expensive. That’s a bit weird if you think about it. Raising rates is supposed to fight inflation. But it makes RPI go up in the short term.
RPI is still used for some important things. Index-linked government bonds (gilts) are tied to RPI. Many pensions are adjusted using RPI. Some rail fare increases are linked to it too.
CPI (Consumer Prices Index)
CPI is the one that really matters for policy. It’s the Bank of England’s official inflation target.
CPI is the EU harmonized measure. It was designed so you can compare inflation across European countries using the same methodology. The big difference from RPI is that CPI excludes housing costs like mortgage interest payments and council tax.
The Bank of England has targeted CPI since 2003. The target is 2% per year.
RPIJ
This was an attempt to improve RPI by changing the formula. Instead of the arithmetic mean (which RPI uses), RPIJ uses the geometric mean (which is what CPI uses).
The geometric mean tends to produce a lower number. It’s considered more statistically sound by most economists. But RPIJ never really caught on and it’s more of a footnote than anything.
GDP Deflator
This one measures inflation across the whole economy, not just consumer goods. It covers everything that goes into GDP. Business investment, government spending, exports.
The GDP deflator is useful when you want to convert nominal GDP (the raw number) into real GDP (adjusted for price changes). It gives you a broader picture of price changes than CPI or RPI.
PPI (Producer Prices Index)
I mentioned this in the previous post. PPI tracks factory gate prices. Both input prices (what manufacturers pay for materials) and output prices (what they charge for finished goods).
PPI is forward-looking. Changes in producer prices eventually feed through to consumer prices.
The Formula Effect: Why RPI and CPI Disagree
Here’s something that trips people up. Even when RPI and CPI look at the same products, they give different numbers.
The difference is about 0.5 to 1 percentage points. RPI almost always comes in higher than CPI.
Why? It’s the formula effect.
RPI uses an arithmetic mean. You add up all the price changes and divide by the number of items. CPI uses a geometric mean. You multiply the price changes together and take the nth root.
The geometric mean is always equal to or lower than the arithmetic mean. That’s just math.
So even before you account for the different items in the baskets (RPI includes mortgage costs, CPI doesn’t), the formula alone creates a gap. This matters because if your pension is linked to RPI, you get a slightly better deal than if it were linked to CPI.
How Inflation Targeting Works
In 2003, the Bank of England switched its inflation target from RPIX (RPI excluding mortgage interest) to CPI. The target was set at 2% per year.
Here’s how the system works.
The Monetary Policy Committee (MPC) meets every month. It’s made up of nine members. They look at the latest economic data, discuss where they think inflation is heading, and then vote on what to do with interest rates.
The logic is straightforward. If inflation is above target, the MPC raises interest rates. Higher rates make borrowing more expensive, which cools spending, which should bring prices down.
If inflation is below target, the MPC cuts rates. Lower rates make borrowing cheaper, which encourages spending, which should push prices up.
There’s an accountability mechanism built in too. If CPI moves more than 1 percentage point away from the 2% target (so above 3% or below 1%), the Governor of the Bank of England has to write an open letter to the Chancellor of the Exchequer. The letter has to explain why inflation missed the target, what the Bank is doing about it, and how long they expect the deviation to last.
It’s a pretty elegant system. Clear target. Regular meetings. Public accountability.
The Case For (and Against) Inflation
You might think inflation is just bad. Prices going up means your money buys less. But it’s not that simple.
Advantages of Inflation
It reduces real debt. If you owe $100,000 and inflation is 5%, after a year your debt is worth less in real terms. The money you’ll pay back buys less than the money you borrowed. This helps borrowers (including governments with large debts).
Mild inflation encourages spending. If you know prices will be a bit higher next year, you’re more likely to buy now rather than wait. This keeps the economy moving.
It allows real wage adjustments. Here’s a subtle one. It’s really hard to cut someone’s pay. Workers hate it. But if inflation is 3% and you give someone a 1% raise, their real wage actually fell by 2%. Inflation lets the economy adjust wages downward without anyone technically getting a pay cut.
Disadvantages of Inflation
It erodes purchasing power. This is the obvious one. Your savings buy less over time. Especially bad for retirees on fixed incomes.
It hurts savers. If your savings account pays 1% interest but inflation is 3%, you’re losing 2% in real terms every year.
It creates uncertainty. When inflation is high and unpredictable, businesses struggle to plan. Should they invest? What will their costs be next year? Uncertainty paralyzes decision-making.
It can become self-reinforcing. Once people expect inflation, they act in ways that create more inflation. The expectations become a self-fulfilling prophecy.
The Case For (and Against) Deflation
Deflation sounds great at first. Prices falling. Your money buys more. What’s not to like?
Advantages of Deflation
Increased purchasing power. Your money goes further. You can buy more with the same income.
It can signal productivity gains. If prices fall because companies got better at making stuff, that’s actually healthy. Think about how the price of electronics keeps dropping while quality improves.
Disadvantages of Deflation
It delays purchases. Why buy a car today if it’ll be cheaper next month? And cheaper the month after that? When everyone thinks this way, spending collapses.
It increases real debt burden. This is the mirror of inflation reducing debt. If prices fall, the real value of your debt goes up. You’re paying back money that’s worth more than what you borrowed. This can crush borrowers.
Deflationary spirals. Prices fall, so people wait to buy. Businesses see less demand, so they cut prices more. Workers get laid off. Spending falls further. Prices fall further. It feeds on itself and it’s very hard to stop. Japan dealt with this for over two decades.
How to Use Inflation Data
Williams and Turton make a practical point about how to extract value from inflation numbers.
Inflation trends tell you about interest rate direction. And interest rates affect pretty much every financial market.
If inflation is rising, the Bank of England may need to raise rates. That’s bad for bonds (prices fall when rates rise), potentially bad for stocks (higher borrowing costs), and generally supportive of the currency (higher rates attract foreign capital).
If inflation is falling, rate cuts may be coming. That’s good for bonds, potentially good for stocks, and could weaken the currency.
The key word there is “may.” Central banks look at a lot of things beyond just the headline inflation number. But inflation is one of the biggest inputs into their decisions.
The Bottom Line
Neither inflation nor deflation is inherently better than the other. What matters most is stability and predictability.
A little bit of inflation (the 2% target) is considered the sweet spot. It’s enough to keep the economy moving, allow for real wage adjustments, and gradually reduce debt burdens. But it’s low enough that it doesn’t create the problems of high inflation.
The entire inflation targeting framework is built around this idea. Keep things stable. Keep things predictable. Let businesses and households plan for the future with reasonable confidence.
Next up, we’ll look at monetary statistics, money supply, and quantitative easing.
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