Gilty opportunism?

Posted by Tracy Alloway on Nov 06 09:50.

Here’s a thought from Monument Securities’ Marc Ostwald.
The UK’s Office for National Statistics has just published a consultation on proposed changes to the measurement of mortgage interest payments within the Retail Prices Index — one of the main inflation rates in the UK; the other one being the Consumer Price Index.
Crucially, unlike CPI, RPI includes mortgage interest payments, so changes in interest rates affect it. For instance, if interest rates are reduced, mortgage payments fall, and RPI declines.
RPI is also the inflation measure used for index-linked gilts. In exchange for the loan, the UK government pays you interest and a redemption value that is linked with the inflation rate. So any changes in the way RPI is measured, which could have an impact on the measurement itself, will also feed into the index-linked gilt market and the payments HM Treasury has to make on the bonds.
As previously mentioned, the ONS, in conjunction with the Consumer Prices Advisory Committee, reviews RPI periodically and has just issued its latest proposal. In the document, the Committee recommends that:
a.The Office for National Statistics changes the interest rate measure used in the calculation of mortgage interest payments in the RPI from the Standard Variable Rate (SVR) to an Average Effective Rate (AER) and that the choice of rate should be kept under review in future and changed, if necessary, at the annual RPI reweighting.
b. The AER should be introduced into the published RPI in March 2010, at the same time as the annual update of the basket of goods and services that underpin the RPI (and CPI).
The measure of mortgage interest payments currently included in the RPI is based on the SV rate of interest from the main bank and building society providers using data supplied by the Bank of England. By contrast, the AE rate has been jointly developed by the ONS and the BoE. According to the Committee, it’s “more representative of mortgage rates available” than the SVR, which doesn’t reflect the average rate borrowers are actually paying.
Anything suspicious in that?
Here’s what Ostwald says:
This will bear down on RPI going forward, and looks to us to be a way of saving the Treasury money surreptitiously. Take a look at the chart on page 10 of the attached PDF document, which shows the differential between using the SVR and AER rates. Isn’t it just a little bit too convenient that having effectively reaped the benefits of the much sharper fall in the SVR on the fall in rates, it now wants to move to shift to the AER as base effects are just about to exercise very large upward pressure on RPI. Of course it can be argued that the greater stability in the AER make it a better metric, but the timing of the move looks to be the sort of very ugly opportunism for which the current government has become notorious.
Here’s the chart:

Now any changes to RPI are likely to provoke suspicion given that it’s linked to gilts, not to mention various taxes and benefits. In 2005, when the ONS proposed changing the way it accounts for laptops and pre-pay mobile phones, for instance, there was also a bit of scepticism.
However, there is a sort of process to determine whether alterations to RPI are “materially detrimental” to gilt-holders, as this 2005 HM Treasury press release on the laptop/phone changes suggests there is a sort of process:
The prospectuses of a number of index-linked gilts contain a redemption clause that requires that the Government must offer to redeem the relevant gilt (at inflation-adjusted) par if there is a change to the way that the RPI is constructed that “in the opinion of the Bank of England, constitutes a fundamental change in the Index which would be materially detrimental to the interests of stockholders”.
And here’s a bit more info we picked up from a 2001 ONS report on the inflation target:
With respect to index-linked gilts, the terms of the prospectus16 state that if the coverage or the basic calculation of the index is changed in a way that is ‘fundamental’ and ‘materially detrimental’ to the interests of holders of the particular index-linked stock, in the opinion of the Bank of England, then HM Treasury is obliged to offer the stock holders the right to redeem their stock at the uplifted par value.17 The amount of principal due on repayment and of any interest which has accrued will be calculated on the basis of the Index ratio applicable to the month in which repayment takes place. In practice, the Bank has to date [2001] not found any changes that have been fundamental and that would have been materially detrimental to the interests of the relevant stockholders.
So there is a process to deal with inflation-linked gilts being affected by the change. It’s just a process that to our knowledge has so far never generated a “materially detrimental” result.
What might happen if that were to be the case?
We note this bit from the 2007 Statistics and Registration Services Bill:
This is because, among other things, the RPI is used to calculate returns on ILGs, which are government securities issued by the Treasury under its borrowing powers in section 12 of the National Loans Act 1968. The prospectuses of ILGs first issued before July 2002 provided as follows:
“If any change should be made to the coverage or the basic calculation of the [Retail Prices] Index which, in the opinion of the Bank of England, constitutes a fundamental change in the Index which would be materially detrimental to the interests of the stock-holders, Her Majesty’s Treasury will publish a notice in the London Gazette immediately following the announcement to the relevant Government Department of the change, informing stockholders and offering them the right to require Her Majesty’s Treasury to redeem their Stock in advance of the revised index becoming effective ..”.
89. The prospectuses of eight gilts with maturities ranging from 2009 to 2030 currently contain this redemption clause and the aggregate outstanding amount of these gilts is very substantial. The rationale of the redemption clause was to protect holders against arbitrary changes in the nature of the RPI. However, depending on the nature of the change to the RPI and on market circumstances at the time, the triggering of the clause could have a significant impact on financial markets and potentially on the public finances.
Interesting stuff.