What is the UK’s non-inflationary trend rate of GDP expansion? The Office for Budget Responsibility (OBR) suggests 2.35% per annum. The Bank of England, naturally, refuses to reveal its estimate. The view here is that trend growth is below 2%, possibly 1.8-1.9%.

The OBR bases its 2.35% figure on trend productivity expansion of 2.0% and a projected rise in hours worked of 0.35%. On first inspection, the 2.0% productivity assumption looks reasonable. GDP per hour rose by 2.0% per annum between 1997 and 2008, years in which capacity utilisation in the economy was probably similar – the unemployment rate averaged 6.4% in 1997 versus 6.2% in 2008.

Measured productivity expansion over 1997-2008, however, is likely to overstate future potential, for two reasons. First, growth was artificially boosted by an outsized contribution from “financial intermediation” due to the credit boom. Financial intermediation accounts for 8% of GDP and productivity in the sector rose by 5% per annum over 1997-2008 versus an increase of 1.75% in the rest of the economy.

Financial intermediation GDP correlates with inflation-adjusted bank lending to the private sector. Output has slumped with credit since the financial crisis and – in contrast to the rest of the economy – has yet to recover, consistent with the view that part of the prior increase represented a bubble. Despite a larger cut in hours worked than in other sectors, productivity in financial intermediation is now a drag on the economy-wide trend.

A reasonable – optimistic? – expectation is that credit will revive and expand in line with overall GDP over the next 5-10 years. In that case, productivity growth in financial intermediation might converge with the rest of the economy, suggesting a trend rise in output per hour of 1.75% rather than the OBR's 2.0%, based on experience over 1997-2008.

A second reason for doubting the OBR's extrapolation is the recent revelation that the Office for National Statistics (ONS) underrecorded clothing inflation over 1997-2009, implying that it may have overestimated real GDP expansion. According to the Bank of England, the increase in the CPI for clothing may have been understated by 5.5 percentage points per annum, with double the impact on the RPI. With the RPI used to deflate consumption, this suggests that GDP growth was overstated by up to 0.4 percentage points, based on a 3.5% share of clothing spending.

In practice, the distortion should be smaller because the ONS calculates GDP incorporating output and income as well as expenditure data while its real GDP calculation is based partly on volume information, not only nominal inputs deflated by prices. A plausible guess is that GDP growth was overstated by 0.2-0.3 percentage points over 1997-2009, an error that will have fed into estimates of trend productivity expansion by the OBR and others.

The underrecording of clothing prices coupled with “phantom” financial-sector output gains due to the credit bubble, therefore, suggest that current trend GDP expansion is 1.8-1.9% per annum rather than the 2.35% estimated by the OBR. This would be consistent with recent evidence: unemployment has fallen slightly over the past year while survey-based measures of capacity utilisation have risen despite GDP growth of only 1.8% in the year to the first quarter, or 2.0% excluding volatile oil and gas production.

This is bad news for policy-makers. Trend expansion of 1.8% rather than 2.35% implies a GDP “pie” that is 5% smaller in 10 years’ time. Future economic expansion, in other words, may contribute less than hoped to reducing the fiscal deficit and consumer gearing. The inflation-growth trade-off, meanwhile, is likely to be less favourable than the MPC has assumed – consistent, of course, with recent experience. Interest rates may need to be raised despite “unsatisfactory” economic expansion – if the Committee wishes to adhere to its remit.