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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?

It’s that we cannot infer the level of potential output from trend growth. The pandemic has reduced this potential. Many migrant workers have returned home, causing shortages of lorry-drivers and hospitality workers – shortages exacerbated by the pingdemic. Whist these effects are temporary – hence the Bank’s relaxed view of inflation – others might not be. The pandemic has left small firms with debts that are preventing some from expanding and forcing others to close. It has also exacerbated structural forces for lower capital spending: business investment is almost 20 per cent down from its 2017 peak. Both mean less capacity.

Potential output, then, is lower than trend growth implies, meaning the output gap is smaller.

How much smaller? Nobody knows. Which is one reason why the output gap was a daft idea in the first place. True knowledge of the economy’s aggregate potential lies in the minds of millions of managers who know by how much they could expand production if they needed to.  This knowledge, which is vague, imperfect, tacit and fleeting, cannot be known by any single mind. As Friedrich Hayek pointed out, economic knowledge is inherently dispersed. Macroeconomists’ claim to know the size of the output gap was always a pretence of knowledge.

That’s not the only problem with output gap thinking. The notion of capacity constraints makes less sense in the intangible economy: what is Spotify’s capacity, or that of the computer games industry? And even in the old economy, firms do not always respond to capacity constraints by raising prices. Instead, they find ways of increasing efficiency to get more from existing capacity.

Given these problems, its not surprise that the output gap has been a lousy predictor of inflation, and not just in the UK: before the pandemic, the ECB consistently over-predicted inflation because of its reliance upon the idea.

This isn’t to say the output gap is always a dangerous idea. Quite the opposite. It gives the Bank a good reason to cut interest rates in downturns as it can claim that an output gap will reduce inflation. As an actual predictor of inflation, however – or as a description of reality – it is a silly idea. If we’re lucky, one legacy of the pandemic will be that economists abandon it.