Accuracy of inflation measures

Firstly I should declare an interest. This story affects my well-being in retirement and I'm not very happy about the pension changes currently proposed by the Government.

But the economics of this story, whether CPI or RPI should be used to annually adjust public sector pensions, is a relevant economic issue.

All price index's are compromises. They are based on the cost of a 'typical' basket of goods, discovered by a survey of consumer spending. However there are no 'typical consumers' the basket of goods is just an average. For some households the cost of living rises faster, for others slower.

The CPI was introduced when there were thoughts Britain might join the Euro (although it was never a serious option) and became the UK's 'official' measure of inflation. The CPI is more comparable with other EU countries measurement of inflation, but the British spend their money on slightly different things. So to construct the CPI the basket of goods had to be adjusted, reducing the impact of housing costs and including other items that did not actually affect UK residents.

The CPI is statistically more elegant. It reduces the effects of rouge price changes and deals with complex goods, such as the price of 'white bread' with its many varieties and easy substitution in a way that makes the RPI look clumsy, if not crude. But CPI will usually give a lower inflation rate than RPI (initially estimated at 0.5% it has actually been 0.75% since 2003).

The result of indexing pensions by CPI and not RPI will then lead to a 0.75% smaller rise in pensions each year and will save the Treasury £40bn in this parliament alone.

Actually neither CPI or RPI are the right measure to adjust pensions. A Pensioner Price Index should be used based on the typical basket of goods a pensioner household buys. For example fewer pensioners have mortgages and so both CPI and RPI overstate the effects of the housing market and mortgage rates on them. A Pensioner Index (PePI) is child's play to construct and indeed one already exists!

Of course the PePI may actually give smaller rises to pensioners!

The Guardian cover the story here