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Retail Price Index (RPI): The Gauge of Price Changes

The Anatomy of the Retail Price Index

Think of the RPI as a giant, virtual shopping basket. This basket doesn't contain actual groceries, but it represents everything an average household spends its money on in a year. Statisticians fill this basket with hundreds of items, from bread and milk to bus fares, cinema tickets, and, crucially, housing-related expenses. Every month, they "go shopping" by checking the prices of these items all over the country. By comparing the total cost of the basket this month to its cost in a base month (the starting point), they calculate how much prices have changed overall. This percentage change is the inflation rate as measured by the RPI.

The RPI basket is divided into major categories, each with a specific weight. The weight shows how important that category is in the average household's budget. For example, if people spend more on food than on clothing, food gets a higher weight in the index.

RPI vs. CPI: The Housing Cost Divergence

The most talked-about alternative to the RPI is the Consumer Price Index (CPI). While they seem similar, key differences lead to different inflation numbers. The most important difference is in housing.

• RPI includes: Mortgage Interest Payments (MIPs), council tax, house depreciation, and other housing costs like building insurance and repairs.
• CPI excludes: Most of these owner-occupied housing costs. It treats housing as an investment, not a consumption item, and uses a complex method called "rental equivalence."

This inclusion means RPI is directly sensitive to changes in interest rates. When the Bank of England raises interest rates to control inflation, mortgage payments go up. The CPI might not show a big change, but the RPI will jump because it counts those higher mortgage costs. This can create a paradox: an action meant to reduce inflation (raising rates) can cause a short-term increase in RPI inflation.

Other differences include the population covered (RPI excludes the top 4% of earners and pensioner households relying on state benefits) and, most technically, the formula used to average prices.

How the RPI is Calculated: A Step-by-Step Walkthrough

Let's break down the calculation with a super-simple example. Imagine a country where households only buy three things: Loaves of Bread, Movie Tickets, and they pay Mortgage Interest.

1. Choose a Base Year: We set our starting point. Let's say the base year is 2020.
2. Define the Basket & Weights: Surveys show the average household spends their money like this:
   • Bread: 40% of spending (Weight = 0.4)
   • Movies: 40% (Weight = 0.4)
   • Mortgage Interest: 20% (Weight = 0.2)
3. Record Base Year Prices:
   • Bread: $2 per loaf
   • Movie Ticket: $10
   • Monthly Mortgage Interest: $500
4. Record Prices in the Current Year (2024):
   • Bread: $2.20 (a 10% increase)
   • Movie Ticket: $11 (a 10% increase)
   • Monthly Mortgage Interest: $600 (a 20% increase due to higher interest rates)
5. Calculate Price Relatives: Divide the current price by the base year price for each item.
   • Bread: $2.20 / $2 = 1.10
   • Movies: $11 / $10 = 1.10
   • Mortgage: $600 / $500 = 1.20
6. Calculate the Weighted Index (Using the RPI's arithmetic mean): Multiply each price relative by its weight and add them up. 
   $(1.10 \times 0.4) + (1.10 \times 0.4) + (1.20 \times 0.2)$ 
   $= 0.44 + 0.44 + 0.24 = 1.12$
7. Convert to an Index Number: Multiply by 100. Our RPI for 2024 (with 2020=100) is 112.
8. Calculate Inflation: The inflation rate is the percentage change from the base year. 
   $(112 - 100) / 100 \times 100\% = 12\%$.

Notice how the 20% surge in mortgage costs pulled the overall inflation up to 12%, even though bread and movies only went up 10%. This shows the power of including housing costs.

The RPI in Everyday Life: Pensions, Trains, and Student Loans

Even though the UK government no longer uses RPI as its main inflation measure, it is still deeply embedded in the economy. Here’s where you might encounter it:

• Index-Linked Gilts: These are government bonds where the value and the interest paid rise with the RPI. If you invest in these, your return is protected against RPI inflation.
• Private Sector Pensions: Many company pension schemes increase their annual payouts each year in line with the RPI, often with a cap (e.g., up to 5%).
• Rail Fares: Historically, the government regulated annual increases in rail ticket prices using the July RPI figure. This has been a point of controversy, as it often led to above-inflation fare rises.
• Student Loans (Pre-2012 in England): The interest rate on these older loans was set at the rate of RPI inflation (or RPI plus a bit more).
• Mobile Phone Contracts and Other Bills: Some long-term contracts include a clause allowing prices to rise annually by the RPI inflation rate plus a few percent.

Because RPI is usually higher than CPI, its use benefits those receiving payments linked to it (like pensioners with RPI-linked pensions) and costs more to those paying amounts linked to it (like train commuters or the government paying interest on index-linked gilts).

Important Questions

Footnote

¹ CPI (Consumer Price Index): The primary measure of inflation used by the UK government and many other countries. It tracks changes in the price of a basket of goods and services but uses a different population base and mathematical formula (geometric mean) than the RPI, and it excludes most owner-occupied housing costs.

² CPIH (Consumer Price Index including Owner Occupiers' Housing Costs): The ONS's preferred measure of inflation. It is identical to the CPI but includes a measure of the costs associated with owning, maintaining, and living in one's own home, known as "Owner Occupiers' Housing Costs" (OOH). This is calculated using rental equivalence, not mortgage interest payments.