Public & private

On 10 December 2003, the chancellor changed the government's inflation target to a new base. The Bank of England now measures inflation by using the harmonised index of consumer prices, already used widely in Europe and the USA. This was developed in the EU in 1997 to measure inflation convergence and was used by the European Central Bank to assess price stability in the eurozone.

Its name has been changed to the "consumer prices index", but it operates in a similar way: inflation is worked out by measuring the increase in cost of a fixed collection of retail items over time. Some 120,000 prices are collated every month for 650 representative items. The shift to the CPI has led to the widespread belief that it replaces the other main inflation basis – the retail price index. But is that true?

RPI was first used as the main domestic measure of inflation in 1956. It is still widely used in the private sector as a benchmark for contract price increases and the government uses it in the operation of benefits, tax allowances and thresholds, index-linked gilts and in the regulation of privatised utilities.

There are two variants of RPI:

• RPIX, which was introduced in 1975, is the RPI excluding mortgage interest payments. Because it excludes these payments, it is much less affected by interest rate changes.
  
• RPIY, which was introduced in 1995, is RPI excluding mortgage interest payments and price changes resulting from indirect taxation. RPIY, therefore, measures movement in underlying prices.

It is the first of these, RPIX, that has been replaced by the CPI. The main difference between the two is that RPIX includes council tax and a range of owner-occupier housing costs, such as buildings insurance, that are not covered by CPI. Consequently CPI is, on average, 0.56 percentage points lower than RPIX. Also, the calculations use different mathematical bases (RPI uses arithmetic means and CPI uses a geometric mean) which has further lowered the CPI rate by 0.51 percentage points since 1997.

It is the variant index RPIX – not the retail price index – that has been replaced as the government’s inflation base

CPI has the advantage of greater links with other macroeconomic data, and its use of the geometric mean technique is increasingly preferred internationally. But RPI's history and familiarity currently give it a strong advantage.

In time, the RPI may either evolve or become sidelined. So, what effect will this have on housing finance documents referring to RPI?

Such documents can include:

• loan agreements that may provide advances for which interest is calculated by reference to RPI-linked rates
  
• annual property security valuations that will typically analyse house prices calculated against RPI
  
• in some securitisations, borrowers can access a portion of their funds providing that their borrowing obligations are otherwise satisfied. The ring-fenced pool is often increased annually by reference to RPI.

In the unlikely scenario that RPI is abolished, these agreements should generally not be affected, though it would be wise to check.