Market Economics | Interest Rate Strategy - BNP PARIBAS ...

ebounded from -13% y/y to +8%. That has added
another percentage point to headline RPI inflation.
These developments have neutralised the
contribution from housing and explain why RPI
inflation is no longer below CPI inflation, but not why
RPI inflation is now above CPI inflation. There are
two main reasons for the near 2pp overshoot of RPI
inflation relative to CPI inflation.
The first is the formula effect i.e. the different
averaging technique used in calculating the index.
This is pretty stable through time at around 0.5pp,
though currently accounts for 0.8pp of the differential.
The other key contributor to the current gap is
differences in weights between the two series. A
good example of this is alcohol and tobacco. In the
CPI this component has a weight of 4%, while it is
more than double that (9.1%) in the RPI. Alcohol and
tobacco inflation has been accelerating much more
quickly than average over the last year, which, given
the higher weight in the RPI helps to explain why RPI
inflation has risen by more than CPI inflation.
Which way now?
We expect the gap between RPI and CPI inflation to
narrow over the next 12 months to almost zero
before widening again during 2012. More specifically,
we expect a slowdown in the components such as
alcohol that have accounted for much of the current
gap between RPI and CPI inflation. Similarly, slowing
house price inflation should bear down on RPI
inflation, also contributing to the narrowing gap with
CPI inflation.
Thereafter we expect interest rate hikes during 2012
to drive a wedge between the two series. Given the
extremely low level of mortgage rates, a small
interest rate hike is likely to have a big effect on RPI
inflation.
By way of example, the current level of the average
mortgage rate according to the BoE is around 3½%.
If the BoE were to hike Bank Rate to 2% by end-
2012 (i.e. in line with market expectations), given the
typical 70% passthrough to mortgage rates, that
would represent a 30% increase in the MIPs
component. In turn, that would add around 1.5pp to
RPI inflation.
from the MIPs component and hence the gap
between RPI and CPI inflation. Unless Bank Rate
continues to rise for ever, that contribution from rising
mortgage rates should at some point begin to fade –
2014 in our view. Although we would envisage the
gap narrowing at that point the formula effect should
ensure that the gap between CPI and RPI inflation
stabilises at around 0.5-0.75pp.
Changes to the index
One potential additional influence on this gap is the
inclusion of some measure of house price inflation in
the CPI. When this does happen, it should help to
narrow the gap between RPI and CPI inflation.
However, this change has been a long time coming
and we gather is unlikely before 2012.
Conclusion
Over the longer run, the gap between RPI and CPI
inflation is likely to narrow relative to current levels to
reside closer to 0.5pp y/y. However, over the shorter
term, the gap is likely to remain variable not least
when the BoE eventually begins to raise Bank Rate.
While this presents a potential headache for private
sector pension funds in adjusting to the new rules,
the adoption of the CPI for indexing public sector
pensions was a master stroke by the Chancellor. It is
likely to save the government around GBP 6bn per
year by 2014-15.
Clearly, there has been some discontent expressed
by those who will be receiving less from their state
pensions. However, few (if any) have acknowledged
that this year’s increase was well above RPI inflation.
September is the reference month for public sector
pensions and benefits. Last September, RPI inflation
was around -1½% y/y. However, because of the
2.5% floor applied to public sector pensions this
year’s increase was 4pp above RPI inflation. The
bottom line is that public sector pension payments
may well miss out on the boost to RPI inflation (of up
to 4pp) once Bank Rate begins to rise. However, we
suspect a spell of amnesia will block out memories of
the RPI increase awarded in April 2010.
Alan Clarke 16 July 2010
Market Mover
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