A post in January 2010 suggested that the UK "output gap" (i.e. the shortfall of GDP relative to normal supply capacity) was about 2% rather than 5-7%, as estimated by various official forecasting bodies (i.e. the OECD, IMF and Treasury). The Bank of England seemed to share the official assessment, judging from MPC communications. (The Bank refuses to disclose its own estimate, believing the information too hot for markets to handle.) The post argued that overstatement of the gap had contributed to the Bank's big inflation forecasting miss.
The official bodies have since significantly reduced their output gap estimates. The OECD now believes that the GDP shortfall was 4.6% in 2009, rather than 6.4% as indicated a year ago, and will average 3.1% in 2011, despite forecast sluggish growth. Similarly, the IMF's 2011 projection is 2.6% while the Office for Budget Responsibility has estimated that the gap was about 3% in the third quarter of 2010. The Bank, of course, never admits that it was wrong but a comparable reassessment is implied by a sizeable upward revision to its medium-term inflation forecast.
The methods used to generate a 2% estimate in early 2010, however, now suggest a smaller or even closed gap. The first method utilises the "Okun's law" relationship between the GDP gap and the deviation of unemployment from its non-accelerating-inflation rate (the NAIRU). An analysis of UK data since the early 1970s indicates that each 1 percentage point rise in the unemployment rate has been associated, on average, with a 1.56% fall in GDP relative to trend. The unemployment rate has risen by 2.4 percentage points since the first quarter of 2008, suggesting a 3.8% decline in output relative to trend (1.56 multiplied by 2.4). The OECD's revised figures imply that GDP was 2.7% above trend in early 2008. Using this as a starting point, the implied shortfall currently is only 1.1%. (This assumes an unchanged NAIRU; the estimate would be smaller if this has risen.)
The second approach uses business survey information on capacity 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 suggests that GDP moved above potential this spring, despite still being far below its pre-recession peak (by 4.1% as of the first quarter). If correct, this would be profoundly depressing, implying that the NAIRU has risen above the current unemployment rate of 7.7%. The survey-based measure, however, may be less reliable than the Okun's law estimate because of the recent relative strength of manufacturing and its focus on short-run production constraints, as well as CBI data volatility.