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Mind the gap: the key to the inflation conundrum

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

‘Labour shortages have become more widespread, and are feeding through to higher wage inflation. If we are right about the output gap and the MPC’s reluctance to respond with interest rates – then sterling will fall sharply from today’s levels.’

The MPC clearly leans closer to this view than the most dovish end of the spectrum – hence at least two members beginning to talk about a ‘more balanced’ view of rate policy. But a significant number believe that falling unemployment will only begin eroding unused capacity once they begin to utilise the underemployed and those registered as ‘self-employed’. About 40% of part-time workers say they would like to work more hours. 

The argument that the crash and subsequent depression destroyed much of the UK’s potential output is a central plank of the hawk’s argument. But the persistence of under-employment is, among other reasons, why doves such as Capital Economics argue this idea is overdone.

‘Underemployment, where people are in employment but want to work more hours, reached a record high in the first half of 2013,’ wrote Martin Beck of Capital Economics.

‘This means there is more slack in the labour market than the unemployment rate suggests and implies wages will recover more slowly than in past recoveries. The fact that falling underemployment is likely to slow the decline in the unemployment rate should also push back the date at which the MPC considers raising interest rates.’

There is the risk, though, that regardless of the state of the economy, belief in the existence of an output gap can easily become a self-fulfilling prophecy – if business managers are convinced that they have to add additional capacity, then they create their own bottlenecks.

‘The [Office for Budgetary Responsibility] remains cautious about the remaining scope for expansion given the rapid decline in unemployment and continuing weak productivity performance,’ said Andrew Smith, chief economist of KPMG.

‘But this “output gap pessimism” risks being self-fulfilling – if there is actually more spare capacity and we don’t use it, we will indeed lose it.

‘No-one really knows how much headroom there is and the cost of underestimating productive potential in terms of permanently lost output and jobs, not to mention unnecessary austerity measures, would be unacceptably high.’

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