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OPINION

Uses of the output gap

Uses of the output gap
February 3, 2016
Uses of the output gap

It used to think that inflation was due in large part to an output gap - the difference between actual output and potential. When output was well below potential, it thought, inflation would fall. And when it was at or above it, inflation would rise.

However, Stephen Millard, an economist at the Bank, has challenged this. He says: "If we are interested in an indicator of inflationary pressure, attempting to calculate potential output (and the output gap) is not the way to go." He would prefer to look for indicators of rising costs and profit margins.

I half-agree with this. Certainly, for me, the output gap is a very dubious idea for at least three reasons.

First, the notion of potential output is unclear. Companies often don't know what their capacity really is. As they approach it, they often discover ways of squeezing more output from existing equipment and workers - which means that potential output isn't independent of actual output.

Secondly, in an open economy the link between the output gap and inflation is weak. For one thing, high demand and a small output gap might suck in imports rather than cause inflation. And for another, inflation will depend upon prices overseas and the exchange rate, not just (or even mainly) upon the health of the domestic economy. This is a big reason why inflation has recently been around zero in the UK, despite a small output gap and falling unemployment.

Thirdly, the link between the output gap (or its close correlates, unemployment or capacity utilisation) and inflation can vary. If wage- and price-setters are risk-averse - say because they have been scarred by memories of recession - they might not use their market power to push for higher wages or prices. But if they are more confident, they will.

These thoughts might help explain an awkward fact - that the link between unemployment (the most easily measured variation on the output gap) and subsequent inflation has been the opposite from what output gap theory predicts. Since 1997 there has been a positive correlation (of 0.35) between the unemployment rate and CPI inflation in the following 12 months. In other words, low unemployment - and presumably, a small output gap - has led to low inflation, not high.

You might think, therefore, that I would welcome any retreat from output gap thinking.

You'd be wrong. To see why, think back to 2008-09. It was obvious then that the economy was nose-diving and needed help. A rigid and accurate inflation-targeting Bank might not, however, have been able to give this: inflation in 2010-11 turned out to be well above target partly because the Bank did cut rates but also because there were inflationary pressures even in 2009. However, pointing to the emergence of a big output gap justified rate cuts and QE. That justification might have been wrong, but the policy was, I think, correct.

In this sense, the idea of an output gap can be helpful. It allowed the Bank to stabilise output under the guise of targeting inflation. And perhaps it will do so again in future. Ideas don't need to be true to be useful.