There has been considerable market and press debate in the UK in recent weeks about potential changes to the Retail Prices Index, and as usual, various disastrous scenarios have been foretold. Jonathan Gibbs (pictured), Investment Director and Head of Real Returns at Standard Life Investments, attempts to separate the truth from the scare mongering, and assess likely outcomes…
￼ Inflation data are high up the watch-list for investors and policymakers around the world. Are price trends contained, opening the door for further monetary easing, or do CPI numbers give warning signs, putting policy on hold? Complications arise though when questions begin to be asked about either the accuracy of data, or definitional change are mooted which could materially change the future inflation path.
In the UK, for example, there has been considerable market and press debate recently about potential changes to the Retail Prices Index (RPI); indeed, various disastrous scenarios have been foretold. The issues are certainly technical, but the implications for holders of inflation linked bonds, for pension funds and for the government could be significant.
In 2010, the Office of National Statistics (ONS) changed its sampling methodology for clothing and footwear, in order to correct for a distortion caused by the January sales. A side effect of this change has been to widen the ‘formula effect’ i.e. the difference between the RPI and the Consumer Prices Index (CPI) that can be ascribed to mathematical methodology. This change has also sparked a bigger debate regarding the statistical anomalies of the RPI index, one of the oldest continuously produced indices in the world.
In particular, there have been questions about the merits of the RPI index’s method of calculation. It primarily uses an arithmetic mean (where increases are added together and divided by the number of increases) rather than a geometric mean, (where increases are multiplied together and the nth root is taken – where n is the number of increases). The latter approach is employed by the new kid on the block, the EU ‘harmonised’ CPI. Statisticians at the Office for National Statistics are keen to learn from its success. While the two indices measure different baskets of goods targeted at different demographics - and should not necessarily yield similar inflation rates - it is the perceived ability of the CPI index to minimise the vagaries of these mathematical differences that is attracting interest from the ONS.
Of course, any attempt to introduce ‘improvements’ to the RPI index methodology is complicated by its considerable importance to financial markets. The most obvious dependent would be the sizeable RPI-linked gilt market, worth GBP347 billion. However, many commercial property assets, PFI-related structures and infrastructure vehicles have liabilities or cashflows explicitly linked to the RPI. In addition, utility companies’ pricing structures are statutorily linked to RPI and, of course, many pension schemes are still linked in some way to the index.
There are practical implications of any shift in the conventional calculation of the RPI. Indices based on arithmetic means will almost always yield a higher year-on-year inflation rate than geometric means (except in the rare situation when prices are not changed at all). Hence, increased use of the latter will reduce reported inflation rates and, therefore, expected and realised nominal returns on inflation linked bonds. This matters a great deal to hard pressed pensioners and pension funds. Unsurprisingly, an intense level of scrutiny is likely for any proposed changes to RPI which could be announced by the statisticians, in the form of the Consumer Prices Advisory Committee (CPAC), on 18 September.
What appears clear, even at this stage, is that rumours regarding a ‘nuclear’ scenario appear to be misplaced. The prospectuses of almost all of the inflation-linked gilts issued before 2002 state that if the Bank of England deems a change to the RPI to be both fundamental and materially detrimental to bondholders, then it must offer voluntarily to redeem these bonds at real par, immediately and on demand. In reality, the likelihood of such a facility being used appears exceptionally low as market prices are far above real par (real yields are close to or below zero and real coupons on the affected bonds all above 2%), suggesting that no rational investor would apply at the current levels!
However, a more likely, although still far from certain, scenario is that such changes to RPI reduce the year-on-year inflation rates, and thereby the long term nominal returns of all inflation linked gilts, regardless of prospectus detail. Real yields and returns would not change, as the definition of real is predicated on the RPI, in whatever form it takes at the appropriate time. Nominal returns on these bonds would of course fall though. Any expectation of these changes being material may lead to index linked gilts underperforming nominal gilts and other markets.
As always, the market has got wind of this early on, and UK index linked gilts have indeed underperformed in the last few weeks. Breakevens (broadly the difference between real and nominal yields of bonds of similar maturity) initially fell, but have rallied quite sharply in recent weeks, along with other global inflation markets, leaving little ‘CPAC' risk priced in.
For the government, there is a clear advantage though in any RPI changes that reduce its expenditure going forward. If suddenly inflation is deemed to be, say, 2.5% pa rather than 3% pa in future, then coupon payments on a big chunk of its debt would fall. Of course, the government through its various agencies is deeply complicit in this potential change, however much at arm's length it tries to make the process. If the Chancellor were to invoke his over-ride clause, as is his right, the arm’s length argument is obliterated.
Perhaps not surprisingly, it has been suggested publicly by one very large institutional holder of inflation linked gilts that this would amount to an implied default event. This is probably rather an intemperate interpretation, but it highlights the vulnerability of the UK government to questions over its credibility, and the possible implications for its crucial safe haven status. If the UK was to be seen to be moving the goalposts on a large chunk of its debt – in effect massaging inflation rates lower to help deal with a massive debt pile - this could affect the whole gilt market, not just linkers. As a result, any savings induced by revising RPI calculations could be more than wiped out if the safe haven status of the UK is compromised by these actions.
As for the fate of pensioners and pension funds, the implications of such a change to RPI may prove somewhat contradictory. Real returns on an RPI basis would be unaffected for RPI linked liabilities, as one would move with the other. Pension funds with CPI linked liabilities would though see a fall in expected real returns on their portfolios, although arguably their assets would be a better match for their liabilities. Those with RPI linked liabilities who are fully hedged would see no difference at all, even if their pensioners would.
Pension funds which are under-hedged against inflation, however, would see a fall in their deficit, and this would be highly advantageous. Here we would see a conflict of interest between pensioners and pension funds. The former want higher real and nominal returns, the latter simply want their funding level to rise against whatever is the measure of their real liabilities. It is unlikely therefore that the National Association of Pension Funds would actively oppose such changes, as their members are the funds, not the pensioners, but the Pensioners' Alliance may be vocal in its opposition.
Finally, if such changes were to go through, it is likely that the correlation of the RPI and CPI, already very high, would become even higher. An implication of this could be to reduce the likelihood of the government issuing CPI-linked bonds, even if the majority of the pensions market had switched to CPI-linked liabilities.
At this stage the final outcome of these deliberations is hard to ascertain. This could be a one-off change or the start of a series of moves. At the moment little is priced in to the market in terms of inflation expectations, implying a low risk premium for inflation protection. However, how that inflation measure is to be calculated remains unclear. This autumn, the authorities have bigger fish to fry, with an economy in double-dip recession and an Autumn Statement fast approaching. Nevertheless, political decisions on technical changes to inflation indices could have profound effects on a range of assets, funds, investors and pensioners for years to come.