The transition from RPI to CPIH indexation for regulated asset bases and revenues of utilities focuses interest on the wedge between RPI and CPIH. For much of 2017 to 2019 this wedge has been relatively at around 1%, but since the deflationary impact of the Covid-19 lockdown, it has fallen to a low of only 0.2% in June this year (the latest data available). However, this low level is not an indication of things to come.

The underlying causes of the wedge are:

· ‘Formula Effect’: RPI uses arithmetic means to average prices whilst CPIH uses geometric means, which means that RPI will tend to give a systematically higher measure for inflation. Although this explains a large proportion of the wedge it is relatively stable at around 0.7-0.8%, but will accentuate at times of pricing variability (e.g. sales discounting);

· Sample weights: the RPI basket weights exclude the 4% highest-income households and lowest spending pensioner households, whilst CPIH captures the whole economy. This has only a minor impact;

· Treatment of owner-occupier housing costs: whilst both RPI and CPIH include housing costs, RPI uses mortgage interest payments that react directly to interest rate changes, whereas CPIH uses a rental equivalence method.

In practice, it is the treatment of housing costs that is responsible for the reduction in the wedge this year as the RPI has reacted sharply to the reduction in housing mortgage costs. We can see this by looking at the alternative “RPIX-CPI wedge” - excluding mortgage interest payments from RPI and housing costs from CPIH. This shows a stable wedge of 0.8%.

Based on Sandbach Economic Consulting’s proprietary model of inflation (https://www.sandbach-group.com/research/rpi-cpi-and-cpih), under a scenario of stable sterling exchange rates and interest rates at their current level, CPIH inflation will return to just under 2% by mid-2021, and we expect to once more see a CPIH-RPI wedge of around 0.8%.