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Last Updated: Wednesday, 10 December, 2003, 12:54 GMT
Q&A: UK inflation target change
By Stephen Coulter
BBC Economics Analyst

The Bank of England now has to consider a new measure of inflation when setting UK interest rates.

The new yardstick is the Harmonised Index of Consumer Prices (HICP), which is used by the European Central Bank to set interest rates in the eurozone.

Already being dubbed "hiccup", switching to HICP could mean changes to mortgage costs, and may even influence our chances of joining the European single currency.

Why the switch?

The Chancellor, Gordon Brown, announced last June that we would not be joining the European Single Currency.

At the same time he also said we would be changing the inflation target to make it easier to join in future. The HICP is currently targeted by the European Central Bank.

Old target: 2.5%
New target: 2%
ECB target: 2%
Now he has confirmed that the switch is taking place immediately.

The Bank of England will start using HICP figures when making its assessment of interest rates in January when the Monetary Policy Committee next meets.

What is HICP?

HICP is actually quite similar to the UK's current inflation measure RPIX. Both provide a measure of the changes in the cost of buying a representative basket of goods and services.

But, although they use broadly the same information, there are several key differences.

For instance housing costs - such as buildings insurance and council tax - are given much more weight in RPIX.

Dropping RPIX in favour of HICP could make it harder for the Bank of England to correctly gauge what effect the notoriously volatile UK housing market is having on the economy.

RPIX also excludes spending by the very highest earners.

HICP will make it easier to compare how the UK economy is doing on inflation compared with Europe.

Except for a period in the early 1990s, RPIX has been higher than HICP inflation. This has been because housing costs have soared in the UK.

In November UK RPIX was 1.2% higher than HICP, but the gap may close as UK house price inflation fades.

What does this mean for UK interest rates?

Because HICP is lower than RPIX, switching the measure means adopting a lower target for inflation.

The Bank of England's Monetary Policy Committee has been asked to target HICP inflation of 2%.

Switching to this from an RPIX target of 2.5% will mean that the interest rate policy has been loosened slightly.

Rates will be a quarter point lower than they otherwise would have been through 2004 and beyond as a result of this loosening.

Economists think this could help to prolong the boom in house prices a little bit longer.

People receiving pensions and benefits will not have to worry though. Their payments will be uprated in line with RPI inflation.

So will this make it easier for the UK to join the euro?

Not in itself.

The Chancellor, Gordon Brown, has made it pretty plain that the UK will only join if certain economic conditions are met.

The Treasury delivered its verdict on these last June, when it said that joining the euro would probably boost trade in the long term, but at the cost of greater economic volatility.

This conclusion had little to do with what kind of inflation measure we have.

On the other hand, adopting the HICP might make it easier to justify any future "yes" verdict on adopting the euro.

HICP provides another, more objective, yardstick by which to judge whether the UK economy had converged sufficiently with euroland to make the transition successful.

This is the main justification for switching to HICP.

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