Should this way of calculating inflation be scrapped?

The Office for National Statistics (ONS) has warned that the Retail Prices Index (RPI) is a 'very poor' measure of inflation that veers from greatly overestimating to underestimating the cost of living.

But the index, which lost its status as a national statistic in 2013, is still widely used to decide prices on mobile phone bills, rail fares, student loans and 'sin' taxes like alcohol.

Which? explores why getting inflation right is important, how RPI is flawed and asks whether it should be scrapped altogether.

Why measuring inflation matters

Inflation gives us an idea of how much prices have changed over a 12-month period and is used to determine how things like benefits and bills need to change to keep up.

In the UK, we now have three main ways of measuring it: the Retail Prices Index (RPI), the Consumer Prices Index (CPI) and the Consumer Price Index with owner occupier's housing costs - or CPIH for short.

All measure inflation by looking at the changing prices of a basket of around 700 everyday goods and services, but they include different items, cover different parts of the population and are calculated in different ways.

RPI was introduced in 1947 and measures the changing prices of a basket of goods and services, including mortgage interest payments.

In 1996, the Harmonised Index of Consumer Prices (HICP) was introduced to meet European Union standards and was renamed CPI in 2003.

But CPI doesn't take into account housing costs so CPIH was created to address the gap and, in March 2017, the ONS adopted it as its official gauge of inflation.

What's the problem with RPI?

Over the last few years RPI has been around 1% higher than the official measure CPIH.

The reason for the variation is largely down to the different formulas used and how housing costs are incorporated in the basket of goods and services.

According to the ONS the 'Carli formula' is used to determine the RPI inflates the rate by 0.7%, compared to the 'Jevons formula' used in CPIH.

The 'formula effect' means there is an upward bias, which in 2010 produced 'implausible levels of inflation' when the ONS introduced changes to the collection of clothing prices.

The ONS found 20 items where the Carli formula suggested prices had increased by over 100%, despite the typical price of an item increasing by no more than 50%.

The difference is also down to the treatment of housing costs. RPI uses a combination of mortgage interest payments and house prices rather than the costs associated with running a household.

CPIH in contrast evaluates housing costs and answers the question u201chow much would I have to pay in rent to live in a home like mine?u201d

The items used in the RPI are also weighted slightly differently and excludes the top 4% of households by income and some of the poorest pensioner households dependent on state benefits.CPIH includes all private and institutional households, such as university halls in the UK.

What is RPI still used for?

Despite CPIH being the official measure of inflation for the UK,RPI is still used to calculate the annual price adjustments for a number of goods and services including mobile phone bills, student loans, rail fares and 'sin' taxes like alcohol.

And it's costing us a pretty penny. This year EE announced a price hike of 4.1% for customers based on December 2017's RPI figure, while O2 and Three announced a hike of 4% based on January 2018's RPI. Had they used CPIH the rise would be 2.7%.

O2 explained that it felt RPI was more closely aligned to its costs: 'Both RPI and CPI are measures of inflation - but RPI gives a broader picture of inflation compared to CPI. For us, we see our costs relating to our buildings and shops better reflected by the RPI measure.'

However, Ofcom confirmed the use of RPI was an issue on its radar.

Aspokesperson told Which?: 'We introduced rules to protect customers against price rises in the middle of landline, broadband or mobile contracts during 2014.

Since then there has been a move away from RPI, so we are considering whether CPI is the most appropriate index.'

Should RPI be scrapped?

While the ONS discourages the use of RPI, it recognises that there are some legacy needs that mean the measure can't just be scrapped.

RPI is often used by companies to increase the income they pay to people with final salary private pension schemes, as well as to calculate the interest on £400bn of government debt and index-linked bonds.

A switch to the lower CPIH or CPI rate would mean hundreds of thousands of pensioners would see incomes rising at a lower rate, creatinghuge upheaval and potential controversy in switching to a lower measure of inflation.

There is a precedent. The government's decision to switch benefits, including the state pension, from being uprated by RPI to CPI took place in April 2011 - a move that was designed to save the government more than £13bn over a four-year period.

And while some private pension schemes have successfully moved from RPI to CPI to cut costs, some are blocked by the terms they were set up with.

What's not clear is when firms will be pushed to make the switch to using CPI or CPIH to keep pace with rising prices.

John Pullinger, national statistician at the ONS warned:There are other, better measures available and any use of RPI over these far superior alternatives should be closely scrutinised.'

While Chair of the UK Statistics Authority Sir David Norgrove said: 'With this strong evidence for the deficiencies of the RPI, I remain concerned by its widespread use.

'If people want to measure changing prices they should use other indices such as the CPI or CPIH, which do not suffer the technical weaknesses of the RPI.