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Output gap mythologies

The prospect of rising inflation is from one perspective a puzzle – because the dominant way of forecasting inflation before the pandemic predicts that it should now be very low.

I’m thinking of output gap theory. This says that inflation should fall if GDP drops below its potential level, where that potential is measured by its trend rate of growth. And GDP is now a long way below trend. Back in November 2018 Mark Carney, then the Bank of England Governor, said that “demand and supply are currently broadly in balance” and that trend supply growth was 1.5 per cent a year. Since then real GDP has fallen by 2.7 per cent while trend supply should have risen 3.8 per cent, implying output is now more than 6 per cent below trend. Pre-pandemic orthodoxy predicts that this should cause falling inflation.

Which it is not. Yes, the first impact of the pandemic was to depress inflation, as output gap thinking predicted. But despite a still-high gap, inflation is rising. So, what went wrong?

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