The output gap, a way of measuring how far an economy is from its full capacity, has gained some ubiquity of late.
Central bankers from Bernanke to Bean are using it as evidence of the risk of deflation, citing the amount of ‘slack’ in the economy. Slack occurs when the output gap is a negative number — when the economy is below its potential — and implies deflationary risks as companies cut prices and jobs to deal with the spare capacity.
So, it was interesting to see, in the otherwise unsurprising minutes from the UK’s Monetary Policy Committee, the following:
Despite the latest fall, inflation had been surprisingly high over a number of months given both the VAT cut and the large degree of slack that the Committee thought had opened up in the economy. CPI inflation was higher than in the other major economies. The depreciation of sterling was, plausibly, one factor that helped to explain this. Indeed, the profile of CPI inflation in the United Kingdom was similar to those in a number of other developed economies that had recently experienced large exchange rate depreciations. But it was also possible that those factors that were pushing down on inflation, including the recent rise in the degree of slack in the economy, were taking longer than expected to influence the path of inflation.
Another potential factor that could explain the resilience of inflation was that the supply potential of the economy may be lower than assumed. Economies that had had significant financial crises in the past seemed to have suffered large and persistent supply contractions. The Committee had already assumed in its May Inflation Report projections that the growth of potential supply was likely to weaken considerably. But it was impossible to judge the scale and timing of any effects from the current financial crisis and the recession on the UK supply side with any precision.
That’s basically a tacit admission by the BoE that the output gap may not be as wide as it thought. And it’s something of a big deal since the output gap is a rather large factor in the central bank’s inflation targeting. Here’s Monument Securities’ Stephen Lewis on what exactly it might mean:
If the loss of supply potential had been a one-off event, there might be grounds to hope that, as data accumulated, it would be possible to assess how large it had been. This estimate might then be used to adjust the Bank’s forecasting equations.
However, it seems more likely that the destruction of supply potential will be a continuing process as long as abnormal conditions persist in the financial sector and while there remain pressures to adjust global imbalances. The minutes suggest the MPC engaged in an in-depth discussion of the problem of the global imbalances. It is encouraging to find policymakers are taking this matter seriously, even if market participants appear now to have forgotten the part the imbalances played in bringing about the financial crisis. The key point, though, is that if the rate of loss of potential supply is variable, the MPC may not be in a position, for some time to come, to form a reliable view on the inflation outlook on the basis of its assessments of current and future output. It is hard to see how, in such circumstances, the central bank’s commitment to inflation targeting could continue to serve as an anchor for inflation expectations.
Related links:
Sticky inflation, redux – FT Alphaville
Slackers at the Fed – FT Alphaville
The economics of global output gap measures - BoE paper