. . . the risks to the Committee’s central view of a gradual recovery of output remain to the downside.
That’s Bank of England governor Mervyn King testifying to the UK Treasury Committee about the February inflation report. The output gap has become something of a catchphrase for Monetary Policy Committee members at the BoE, and for some Federal Reserve board members too.
Here are some additional headlines from the BoE statement to parliament:
*BEAN SAYS OUTPUT WILL BE BELOW PREVIOUS PEAK `FOR SOME TIME’
*KING SAYS ECONOMY OUTPUT STILL BENEFITING FROM POUND DROP
*KING SAYS SERIOUS DOWNSIDE RISKS ARE NOW ELIMINATED
*KING SAYS QE SO FAR HAS FILLED A HOLE, MORE IMPACT IN NEXT YEAR
* BOE’S KING- IF WE FELT RISKS TO CPI WERE TO THE UPSIDE OF TARGET, TIME TO THINK OF TIGHTENING
The output gap is basically an estimate of the amount of `slack’, or spare capicity, in the economy. When there’s slack in an economy, it may suggest deflationary risks as companies trim prices and jobs to deal with the spare capacity. The difficulty, however, is in accurately gauging the output gap.
The below chart, from Deutsche Bank, is illustrative.
That’s differing estimates for Britain’s output gap from the UK Treasury and other organisations.
As Deutsche Bank’s Mohit Kumar puts it:
Whichever way we attempt to slice the cake, the policy bias appears to be inflationary, or at least tolerant of higher inflation. A scenario of keeping rates lower for longer combined with a weaker sterling and the £200bn of QE should fuel, over time, inflationary pressures. The lack of precedence of QE policy makes it difficult to calibrate the inflationary impact of QE. High output gap appears to be the only argument against inflation but we would argue that over-reliance on this measure is also inflationary
Market reaction to King’s testimony: