The Treasury, OECD and IMF believe that the UK “output gap” – the shortfall of GDP from its trend or potential level – is currently between 5% and 7%. Two alternative approaches, however, suggest a much smaller gap, of about 2%, helping to explain why inflation has overshot official and consensus forecasts.

The three organisations estimate current trend output by extrapolating an underlying path based on historical data and applying an ad hoc adjustment for the negative impact of the financial crisis. Such estimates amount to little more than a guess and will be revised, probably significantly, in light of future output developments.

The first alternative approach utilises the "Okun's law" relationship of the output gap and the deviation of unemployment from its non-accelerating-inflation rate (the NAIRU). Based on history, the recent rise in unemployment looks too small to support estimates of a gap of up to 7%, barring an unlikely fall in the NAIRU.

Specifically, an analysis of UK data since the early 1970s indicates that each 1 percentage point rise in unemployment is associated with a 1.56% fall in output relative to trend. The unemployment rate increased by "only" 2.5 percentage points between the first quarter of 2008 – immediately before the recession – and the fourth quarter of last year, suggesting a 3.9% decline in output relative to trend (1.56 times 2.5). The OECD estimates that GDP was 1.9% above trend in the first quarter of 2008. Using this as a starting point, the implied shortfall last quarter was only 2.0% – see chart.

The second approach uses business survey information on capacity and labour constraints to gauge the position of GDP relative to trend. The percentages of CBI manufacturing firms reporting shortages of plant capacity and skilled labour were summed and the resulting series rescaled to match OECD output gap data since the early 1970s. This approach also yields a current estimate of about 2% – the chart shows a full history.  

These alternative approaches imply that either current official GDP figures overstate the decline during the recession or damage to supply capacity from the financial crisis has been greater than assumed by most forecasters. Both are probably true. For the entire divergence to be explained by the supply factor, trend output would need to have fallen by more than 2% between the first quarter of 2008 and late 2009 versus the OECD's assumption of a 3.1% increase.

The Bank of England claims that the current inflation overshoot will prove temporary because a “large amount” of spare capacity will exert downward pressure on domestic price trends. If the output gap is only about 2%, however, the effect will be much weaker than it expects, implying that a tightening of its policy stance will be necessary to secure a return of inflation to target.