Reflections on output gapology
Friday, October 30, 2009 at 10:51AM
Simon Ward

Proponents of keeping Bank rate at its current 0.5% level for a sustained period argue that substantial economic slack will bear down on inflationary pressures, risking an undershoot of the 2% target over the medium term. There is no dispute that output is currently below potential; the issues are the size of the gap, its "coefficient" in an inflation model and possible offsets from other factors.
 
Most methods for estimating potential output assign a large weight to recent actual data. This is problematic during recessions, when some business activities contract on a permanent basis as capacity is scrapped. Unusually severe credit restriction in the current downturn may have magnified this capacity effect.

Some recent business surveys cast doubt on claims that companies have scope to boost output significantly, at least without a rise in marginal costs. In the latest CBI industrial trends survey, for example, the percentage of firms citing plant capacity as a factor limiting output was close to its long-run average. The implied disagreement with output gap estimates, such as those produced by the OECD, is unusually large – see chart. (There is a similar divergence between US gap estimates and ISM survey evidence of lengthening delivery times, indicating supply bottlenecks.)
 
A generalised "Phillips curve" inflation model should include not only the output gap but also its rate of change, inflation expectations, the exchange rate, global commodity prices and the real level of indirect taxes. The last three factors have been the key drivers of inflation movements in recent years. If sterling continues to weaken, commodity prices remain underpinned by rapid emerging-world growth and indirect tax increases bear a significant burden of necessary fiscal adjustment, these factors may continue to outweigh the disinflationary impact of economic slack.

Article originally appeared on Money Moves Markets (https://moneymovesmarkets.com/).
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