MNI INSIGHT: UK Close To Overhauling Linker Inflation Measure

By David Robinson

     LONDON (MNI) - The UK government is close to announcing steps towards

overhauling its issuance of inflation-linked bonds, which would mean that fresh

gilt issuance eventually ceases to track the Retail Price Index, widely seen as

flawed, MNI understands.

     While the political storm over Brexit raises doubts over the ability of the

government to push forward key projects, an announcement could conceivably come

as soon as the Chancellor of the Exchequer Philip Hammond presents his Spring

Statement on Wednesday. It is still unclear what would replace RPI, but

officials intend to release a map in the near future laying down a route away

from the measure, including examination by an expert group of possible

alternatives such as CPIH, a consumer price index incorporating housing costs.

     UK statistics and debt issuance authorities have been wrestling with the

dilemma that while there is a deep and liquid market for RPI-linked gilts,

statisticians, including the national Statistics Authority, accept that RPI

systematically overstates inflation.

     The House of Lords Economic Affairs Committee said in a report in January

that the Statistics Authority was at risk of breaching its statutory duty by not

correcting the known errors in the index, and a response from the National

Statistician, John Pullinger, is expected to be published soon.

     In his evidence to the committee, Pullinger advocated caution over partial

RPI reform, which would address distortions including an exaggeration of

clothing costs, pushing down the headline rate and narrowing the gap with the

consumer price index but leaving its overall framework intact. Such a move would

add the complication of having to pay existing gilt linker bondholders for loss

of income.

     --AVOID COMPENSATION

     Hammond is only likely to back moves to link fresh issuance to another

index, avoiding any question of compensation for existing holders.

     Bank of England Governor Mark Carney has made the case for a gradualist

approach, moving to a single inflation measure, whether that be CPI, CPIH or a

successor. RPI is currently used for gilts, as well as for adjusting the prices

of rail tickets and student loans, while the Bank of England's inflation target

is defined in terms of CPI.

     "Transition is important, but transition with a sense of the end

objective," Carney told the Lords on January 28.

     He said that CPIH looked promising but that further work was needed to road

test it.

     "One would hope there would be a broader study before moving to the next

phase of adjustment to confirm the appropriateness of that [CPIH] measure. But

it is the most promising option in my personal view and, more importantly, from

the perspective of the experts in the Bank of England," he said.

     The final decision lies with Hammond, whose Spring Statement is being

overshadowed by key Brexit parliamentary votes this week, with defeat seemingly

looming for the deal agreed by Prime Minister Theresa May.

     The Debt Management Office is expected by market participants to stick with

RPI linkers in its 2019-20 fiscal year issuance. The DMO, however, is expected

to continue to wean investors off RPI linkers by reducing their proportion of

total issuance, to something maybe a shade under 20%, the lowest level since

just after the depths of the global financial crisis.

--MNI London Bureau; tel: +44 203-586-2223; email: david.robinson@marketnews.com

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