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Mind the gap: the key to the inflation conundrum

by David Campbell on Jun 03, 2014 at 12:35

Mind the gap: the key to the inflation conundrum

If one were to point to a single metric to explain why economics is frequently held in low regard by other scientific disciplines and the man in the street, it would be hard to find a better example than the output gap.

Methodologically torturous? Check. Obscure? Check. Effectively unprovable? Check. Conceptually contentious to the point where entire schools of economic thought dispute its existence? Check and double check.

While it might be tempting to look at the above and conclude this is strictly a debate for academics, to do so would ignore the fact this is now one of the most important questions facing the UK economy and one of the biggest determinants of your future wealth.

The output gap is essentially the difference between real and potential GDP and so the limit beyond which growth begins to get seriously inflationary. That apparent simplicity rapidly gets muddied by the many ways it is possible to measure productivity, the fact that potential GDP is unknowable and any attempt to calculate it is intrinsically speculative.  

The growing urgency of the question is of course due the UK’s suddenly soaraway growth and the BoE’s extended period of easy policy: how long can it sit on its hands without inflationary friction taking root? Or if it acts soon, will the increasing cost of household leverage choke the recovery?

Given the number of variables and the lack of a single universally recognised methodology, the range of opinions on the size of the gap is unsurprisingly large (see chart on opposite page) – basically as large as the number of economists willing to hazard an opinion.

The increasing significance of the output gap can be read in its increasingly prominent place in BoE communications, and the level of disagreement it has generated between policymakers, taking something like a starring role in Monetary Policy Committee (MPC) minutes released last week.

Futures markets brought forward the expected timetable for an increase in interest rates following the minutes, after MPC members said they anticipated spare capacity in the economy equivalent to between 1-1.5% of GDP, but added there was ‘considerable uncertainty around that central estimate, however, and a range of views on the committee’.

If the actual figure was the cause for debate inside the committee, there was considerably less genteel disagreement outside it, ranging from the exceptionally hawkish view of the former BoE economists at Fathom that that the UK is already operating at above nominal capacity and inflation already building, to the doves of Capital Economics, who believe the UK will need years of easy money to approach its potential.

‘With productivity drifting sideways for the past five years, in our judgment the output gap has already closed,’ said Fathom in a recent research note, which predicted consumer price inflation would bounce back to 3% and wage inflation climb to 4% by the end of the year.

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