NS&I Question 2

Sumsio

The new UK VAT rate of 20% came in to effect on 4 January 2011. This meant that prices were 2.5% higher if the costs are passed on to the consumer. RPI may therefore only be 2.8% without the VAT rise.

The NS&I cert tracks the "value of the basket" two months prior to the date the cert was taken and then the "value of the basket" on the year anniversary.

In a year surely the RPI will not be the same as the 2.5% increase would already have been taken in to account when the cert was taken out. Therefore at the year anniversary of the V.A.T rise inflation level (RPI) should fall back to the true rate of 2.8% (as RPI is currently 5.3%).

If this is the case then is the NS&I as good as it looks? correct me if I've missed something.

dtsazza

It's crystal ball time, basically. The ILSCs will yield whatever the difference in the RPI figures is - the "only" hard part is guessing what the RPI figure will be in March 2012.

VAT is certainly one aspect of inflation, and you're right that it's affecting current inflation figures, but won't be part of next year. This is just a corollary to the fact that you should ignore current inflation figures, since the March 2010 RPI level has absolutely no bearing on the performance of the certificates.

Mervyn King has stated that he expects inflation to stay high for the next year or more, and since he's in charge of lowering it I think that's a decent clue that it's likely to stay reasonably high. If you expect it to drop lower than the yield you can get on alternatives, then by all means go for those. This question is identical to the "to fix or not the fix" questions (except here you're fixing to a floating rate) - again, if it was obvious which one would outperform, there wouldn't be much debate at all.

Sceptic001

The theory would only work if all prices in the RPI index were subject to standard rate VAT, which they are not.

There is an interesting Office for National Statistics paper on the composition of the CPI/RPI baskets here: http://www.statistics.gov.uk/articles/nojournal/CPI_and_RPI_The_2010_Basket_of_Goods_and_Services.pdf

Note in particular the importance of Housing in the RPI table (23.7%). This is why RPI is so sensitive to changes in mortgage interest rates. So, contrary to the popular view that increased interest rates will make index-linked certificates less attractive, a rise in interest rates will significantly increase RPI, ensuring they remain competitive with other savings products.

JamesU

Sceptic001 wrote: »

Note in particular the importance of Housing in the RPI table (23.7%). This is why RPI is so sensitive to changes in mortgage interest rates. So, contrary to the popular view that increased interest rates will make index-linked certificates less attractive, a rise in interest rates will significantly increase RPI, ensuring they remain competitive with other savings products.

Sceptic, are you sure that figure is the correct one to use? I thought the mortgage component of the RPI basket was around 3-4% since the BoE rate decreases? But I am struggling to find the specific data on ONS.

JamesU

Sceptic001

JamesU wrote: »

Sceptic, are you sure that figure is the correct one to use? I thought the mortgage component of the RPI basket was around 3-4% since the BoE rate decreases? But I am struggling to find the specific data on ONS.

JamesU

http://www.statistics.gov.uk/articles/nojournal/CPI_and_RPI_The_2010_Basket_of_Goods_and_Services.pdf
The data is taken from Table 2: High level RPI weights since 1987 (page 9)

CLAPTON

Sumsio wrote: »

The new UK VAT rate of 20% came in to effect on 4 January 2011. This meant that prices were 2.5% higher if the costs are passed on to the consumer. RPI may therefore only be 2.8% without the VAT rise.

The NS&I cert tracks the "value of the basket" two months prior to the date the cert was taken and then the "value of the basket" on the year anniversary.

In a year surely the RPI will not be the same as the 2.5% increase would already have been taken in to account when the cert was taken out. Therefore at the year anniversary of the V.A.T rise inflation level (RPI) should fall back to the true rate of 2.8% (as RPI is currently 5.3%).

If this is the case then is the NS&I as good as it looks? correct me if I've missed something.

you can't simply deduct 2.5% VAT increase from the 5.3% as all goods and services are not subject to VAT at 20%

examples are

food VAT free
gas electricity are only 5% VAT
insurance is VAT free

JamesU

Sceptic001 wrote: »

http://www.statistics.gov.uk/articles/nojournal/CPI_and_RPI_The_2010_Basket_of_Goods_and_Services.pdf
The data is taken from Table 2: High level RPI weights since 1987 (page 9)

But that data must refer to all housing costs. Need to find breakdown of these for the housing component that relates to mortgage payments specifically.

Update: mortgage interest payment component of the RPI basket on p.11 in link

2007 55/1000 = 5.5% of RPI index
2008 6.0%
2009 4.1%
2010 3.4%
2011 3.2%

http://www.statistics.gov.uk/articles/nojournal/updating-weights-2011.pdf

So presumably increases in BoE rates will have most effect by increasing this 3.2% mortgage interest component rather than the 23.7% combined household RPI weighting.

JamesU

Sumsio

CLAPTON wrote: »

you can't simply deduct 2.5% VAT increase from the 5.3% as all goods and services are not subject to VAT at 20%

examples are

food VAT free
gas electricity are only 5% VAT
insurance is VAT free

That is true...was gas and electricity affected by the 2.5% increase? If so, this would have an indirect affect on the cost of food and so on.

But, thank you for your comment because I did not think of this factor.

Sceptic001

JamesU wrote: »

But that data must refer to all housing costs. Need to find breakdown of these for the housing component that relates to mortgage payments specifically.

Update: mortgage interest payment component of the RPI basket on p.11 in link

2007 55/1000 = 5.5% of RPI index
2008 6.0%
2009 4.1%
2010 3.4%
2011 3.2%

http://www.statistics.gov.uk/articles/nojournal/updating-weights-2011.pdf

So presumably increases in BoE rates will have most effect by increasing this 3.2% mortgage interest component rather than the 23.7% combined household RPI weighting.

JamesU

Thanks for that link, JamesU.

This illustrates my point regarding the impact of mortgage interest on the RPI. The effect of plummeting interest rates nearly halved the cost of mortgage interest (from 6% in 2008 to 3.2% in 2011). This explains the dramatic fall in RPI in 2009 compared to the CPI:

YEAR RPI CPI
2008 4.0% 3.6%
2009 -0.5% 2.2%
2010 4.5% 3.3%

Conversely if base rates/mortgage rates were to revert to pre-2008 levels this would bump up the RPI by a similar amount.

Sceptic001

CLAPTON wrote: »

you can't simply deduct 2.5% VAT increase from the 5.3% as all goods and services are not subject to VAT at 20%

examples are

food VAT free
gas electricity are only 5% VAT
insurance is VAT free

ONS published this article which calculates the effect of the 2011 VAT increase as 0.76 on the January CPI (it doesn't mention RPI).

JamesU

Sceptic001 wrote: »

This illustrates my point regarding the impact of mortgage interest on the RPI. The effect of plummeting interest rates nearly halved the cost of mortgage interest (from 6% in 2008 to 3.2% in 2011). This explains the dramatic fall in RPI in 2009 compared to the CPI:

YEAR RPI CPI
2008 4.0% 3.6%
2009 -0.5% 2.2%
2010 4.5% 3.3%

Conversely if base rates/mortgage rates were to revert to pre-2008 levels this would bump up the RPI by a similar amount.

Interesting read in the May 2011 Halifax report on housing costs, link below. Various inflationary house cost increases across the board over a 3yr period but mostly masked by the overall drop in mortgage interest payments.

BoE rates decreased from 5% to 0.5% between Sep 08 - Mar 09 onwards, with deflation between approx Oct/Nov 08 - Nov 09. But between Mar 2008 and Mar 2011 household mortgage interest payments are only 21.3% lower in the report (Table 1 in link).

If mortgage payments (not BoE rates) were to increase to pre-deflation levels (say Mar 08), they would therefore need to increase by 21.3%. But given the mortgage interest component in the RPI index is around 3.2% at present (see post #7 and link to ONS), a 21.3% increase in this component would only represent a %RPI increase of 0.68%??

If the 0.68% increase is in the right ballpark, that would suggest future increases in BoE rates will not lead to a significant increase in future RPI inflation due to increases in mortgage payments (even a sharp one month rise of 0.68% is not overly significant, and the effect of a phased increase over 12-24mths with gradual BoE rate rises is minimal).

Would be interested in views on this in case the calculations above are in error, or anything else that has been overlooked.

http://www.lloydsbankinggroup.com/media/pdfs/halifax/2011/Cost_of_housing_rises_to_three_year_high.pdf

JamesU