'Inflation overstated' finding could ease rates pressure

The rate of inflation is overstated in official figures, according to a recent analysis carried out by an expert at the Office for National Statistics. Inflation could be more than half a percentage point lower than measured by the retail price rice index, currently at 2.9 per cent.

With many economists looking for ammunition to argue that the Bank of England should not raise interest rates again, in the face of the strong pound, the ONS has so far played down these potentially sensitive findings.

The Bank's dilemma was eased a little yesterday when the pound fell sharply against the German mark. It lost more than four pfennigs to end at just over DM3.01 when the Bundesbank sent a veiled signal to the financial markets that it might be prepared to raise German interest rates.

The index of the value of sterling measured against a basket of other currencies fell to 104.6 from 106.2.

Even so, businessmen and economists opposed to further interest rate increases will seize on the ONS's admission it is looking at the extent to which the published RPI figures overestimate inflation. Any alteration to the calculation of the RPI could also save the Government money on uprating benefits and tax allowances to the tune of some pounds 3bn a year. The research carried out at the ONS follows the findings of the Boskin Commission in the US, which calculated that consumer price inflation across the Atlantic could be a full percentage point lower than the published figures. Its work is thought to have influenced the Federal Reserve in its interest rate decisions this year.

In addition, politicians keen to cut the Federal budget deficit would like to use lower inflation figures for the annual uprating of social security benefits, which could save the US government $135bn (pounds 83bn) over six years.

Statisticians say the over-estimation of inflation in the UK is "considerably smaller" than in the US. The main reason is that the weights of different goods whose prices are counted in the RPI are updated every year, compared with every decade in the US. The American price index therefore puts too much weight on items whose price, and therefore share in spending, is shrinking.

But the UK method does share some of the potential biases identified by the Boskin Commission. These include failure to capture the trend towards cheaper out-of-town shopping, not adjusting for improvements in quality or for new goods and services, and flaws in the method of combining separate prices into a single index.

The ONS's recent paper put its initial estimate of the extent to which inflation is overstated at half a point, but said more research was needed.

Separate research by economist Nick Oulton of the National Institute of Economic and Social Research suggests an adjusted inflation measure would save the Government a substantial amount. In a paper for Smithers & Co, he estimates that a 1 per cent a year reduction in measured inflation would reduce government borrowing by more than pounds 6bn by 2002.

But the ONS is likely to shy away from bringing its research to a swift conclusion, and has not endorsed the recent paper.

The measurement of inflation has become a hot potato with views about current inflationary risks sharply divided. Yesterday brought a fresh warning from economists at Coopers & Lybrand that the economy is headed for a cycle of boom and bust. Coopers said interest rates would have to rise from to 7.5 per cent to dampen consumer spending.