Inflation Measurement and Inflation Targets: The UK Experience

The Retail Price Index is by far the most widely used measure of inflation in the United Kingdom.2 Its components include an index of interest payments on home mortgages, which has a weight of 4.2 percent. Mortgages in the United Kingdom are predominantly at floating— rather than at fixed—interest rates. The index of mortgage interest payments is calculated using a long-term weighted average of a house price index (the term of the weighted average reflecting the average age of home mortgages) and the current level of mortgage interest rates. This procedure means that changes in monetary policy aimed at reducing inflation (by raising interest rates) actually cause the RPI to increase, and this makes the RPI itself unsuitable for inflation targeting purposes.3 The Bank of England has devised another index, Housing-Adjusted Retail Prices (HARP). HARP incorporates an alternative measure of the cost of owneroccupied housing, based on the concept of the user cost of housing. The user cost is the cost of servicing a mortgage, plus the opportunity cost of the equity tied up in housing (net of capital gains on the house), plus depreciation and maintenance costs. The computation of HARP depends on assumptions about borrowing rates, alternative investment yields, and expected capital gains on housing. As a result, HARP probably suffers from greater measurement problems than RPIX. The use of RPIX means that housing costs are under-represented in the inflation target.4 How much does it matter? The question can be addressed by investigating the recent behaviour of RPIX and HARP. Figure 1 shows the recent behavior of 12-month percentage changes of the two indexes, and the table below shows means and standard deviations. The distributions of 12-month changes in both RPIX and HARP during the longer period are bimodal (see Figures 2 and 3). The figures show an abrupt shift downwards in each distribution between the earlier and later parts of the period. This is consistent with the view that a break in the inflationary process occurred during the recession of the early 1990s. Moreover it is clear from Figure 1 that during the 1980s HARP inflation very obviously led RPIX inflation by about two years, but there is no clear parallel lead relationship to be seen in the 1990s. The early-1990s recession hit the housing market particularly hard. This seems likely to have led to the demand for housing as a store of wealth to be permanently lower. That in turn would be expected to lead to a one-off fall in the price of houses and thus the user cost of owner-occupied housing, relative to other prices. It seems likely that this episode changed the relationship between HARP and RPIX—or at least it seems unsafe to 1 The Bank of England held a conference in March 1995 for central banks from inflationtargeting countries. See Haldane (1995).