A post in January 2010 suggested that the UK "output gap" (i.e. the shortfall of GDP relative to normal supply capacity) was about 2% rather than 5-7%, as estimated by various official forecasting bodies (i.e. the OECD, IMF and Treasury). The Bank of England seemed to share the official assessment, judging from MPC communications. (The Bank refuses to disclose its own estimate, believing the information too hot for markets to handle.) The post argued that overstatement of the gap had contributed to the Bank's big inflation forecasting miss.

The official bodies have since significantly reduced their output gap estimates. The OECD now believes that the GDP shortfall was 4.6% in 2009, rather than 6.4% as indicated a year ago, and will average 3.1% in 2011, despite forecast sluggish growth. Similarly, the IMF's 2011 projection is 2.6% while the Office for Budget Responsibility has estimated that the gap was about 3% in the third quarter of 2010. The Bank, of course, never admits that it was wrong but a comparable reassessment is implied by a sizeable upward revision to its medium-term inflation forecast.

The methods used to generate a 2% estimate in early 2010, however, now suggest a smaller or even closed gap. The first method utilises the "Okun's law" relationship between the GDP gap and the deviation of unemployment from its non-accelerating-inflation rate (the NAIRU). An analysis of UK data since the early 1970s indicates that each 1 percentage point rise in the unemployment rate has been associated, on average, with a 1.56% fall in GDP relative to trend. The unemployment rate has risen by 2.4 percentage points since the first quarter of 2008, suggesting a 3.8% decline in output relative to trend (1.56 multiplied by 2.4). The OECD's revised figures imply that GDP was 2.7% above trend in early 2008. Using this as a starting point, the implied shortfall currently is only 1.1%. (This assumes an unchanged NAIRU; the estimate would be smaller if this has risen.)

The second approach uses business survey information on capacity constraints to gauge the position of GDP relative to trend. The percentages of CBI manufacturing firms reporting shortages of plant capacity and skilled labour were summed and the resulting series rescaled to match OECD output gap data since the early 1970s. This approach suggests that GDP moved above potential this spring, despite still being far below its pre-recession peak (by 4.1% as of the first quarter). If correct, this would be profoundly depressing, implying that the NAIRU has risen above the current unemployment rate of 7.7%. The survey-based measure, however, may be less reliable than the Okun's law estimate because of the recent relative strength of manufacturing and its focus on short-run production constraints, as well as CBI data volatility.

A post in late March suggested that equities and other risk assets faced increasing monetary headwinds:

• A slowdown in G7 real narrow money in late 2010 signalled an imminent loss of economic momentum.

• Six-month growth in G7 real money had fallen below that of industrial output – often a warning signal for equities.

• A surge in bank reserves at central banks seemed to be ending, with a further injection by the Federal Reserve likely to be offset by the Bank of Japan withdrawing liquidity added after the 11 March earthquake and tsunami.

• The US Dow Industrials Index was higher than at the equivalent stage of five out of six prior recoveries that followed a decline of about 50%, suggesting a correction.

The Dow continued higher until late April but the recent set-back has taken it below the level in late March. The correction may have further to run but monetary indicators have improved since the earlier post:

• Six-month G7 real narrow money expansion has revived from a low in February, hinting at a recovery in economic momentum later in 2011 – see Monday's post.

• The real money / output growth gap has turned positive again, partly as a result of Japan-related production weakness.

• Central bank reserves have edged up, reflecting the final tranches of US QE2 and a stabilisation in Japan – see first chart.

The Dow, however, is still 6% above the "six-bear average" of the prior recovery paths, as of yesterday's close – second chart. The average, moreover, falls over the summer, bottoming in late October. While monetary factors are improving, equities may need an extended period of consolidation before embarking on another upward push.



Markets have suddenly woken up to a slowdown in global industrial activity that has been under way for several months. The downturn, as usual, was signalled by monetary trends. Six-month growth in G7 real narrow money peaked in July 2010 at 3.3% (not annualised) and fell to 1.4% by February. The Friedmanite rule is that monetary changes lead output by about six months and prices by about two years. Accordingly, six-month G7 industrial output expansion reached a high of 2.6% in December and fell to zero by March (the latest available month). A slump in purchasing managers’ surveys in May indicates further weakness over the summer, consistent with the monetary rule*.

While the usual cast of bears is talking up a “double dip”, however, monetary trends have recently taken a turn for the better, with six-month G7 real narrow money growth recovering to 2.1% by April – see chart. Real money, therefore, has not contracted as it did before the 2008-09 recession and is starting to suggest a revival in industrial momentum later in 2011. The near-term output downturn, moreover, has been exacerbated by supply-chain disruption caused by the 11 March Japanese earthquake and tsunami. Japanese manufacturing output plunged by 15.5% in March but started to recover in April, rising 1.0%, and is expected to climb 16% in May-June, according to a METI survey.

The Japan effect, in other words, may have served to concertina output weakness warranted by the late 2010 real money slowdown into an unusually short period. The monetary drag will continue to operate over the summer but could be offset by a normalisation of production schedules as Japanese supply comes back on line. On this interpretation, purchasing managers’ new orders indices may bottom out at or around May levels before recovering later in the summer rather than continuing down as the bears predict. This could come as an unwelcome shock to interest-rate markets that have rallied strongly on the view that official rate rises have been further pushed back and economic weakness could yet provide a pretext for another QE sugar rush.

The key risk to this scenario may lie in emerging economies, where – in contrast to the G7 – real money growth is still slowing and inflationary concerns are likely to preclude early policy easing. A revival in G7 industrial momentum later in 2011, in other words, could be offset by emerging-world weakness. Real narrow money has slowed sharply in China over the last six months while contracting in India and Brazil, suggesting bumpy landings in late 2011 / early 2012. A further deceleration of “E7” industrial output, however, would contain a silver lining in the form of likely downward pressure on commodity prices. (Six-month changes in E7 output and industrial raw material prices have shown a 0.87 correlation over the last 15 years.) A reversal of the commodity-price drag on G7 real incomes would boost prospects for domestic demand, possibly neutralising the direct negative impact of the E7 slowdown.

 * Keynesian attempts to pin the blame for the slowdown on fiscal tightening are unconvincing: the G7 structural deficit is forecast by the IMF to expand by 0.1% of GDP in 2011, with loosening in the US and Japan offsetting European restriction.

A post in January 2010 suggested that the UK "output gap" (i.e. the shortfall of GDP relative to normal supply capacity) was 2% rather than 5-7%, as claimed by official forecasters at the time. This was a key reason for expecting inflation to continue to overshoot official and market expectations.

Forecasters, similarly, believed that the US output gap was large in early 2010 and would exert significant downward pressure on "core" inflation. This prediction, for a while, proved more successful than its UK equivalent – the annual increase in the CPI excluding food and energy slowed from 1.8% in December 2009 to 0.6% in October 2010.

CPI ex. food and energy inflation, however, has rebounded since late 2010, reaching 1.3% in April. An alternative core measure also excluding housing costs is running at 1.6%, in the middle of its range in recent years – see first chart.

The failure of core inflation to sustain a significant decline suggests that, as in the UK, the US output gap has been overestimated. This is supported by survey evidence. The second chart shows the OECD's estimate of the gap – representative of the consensus view – together with an economy-wide operating rate derived from the ISM's semi-annual business survey (a weighted average of manufacturing and non-manufacturing rates). The two measures have diverged since late 2009, with the current ISM reading consistent with an output gap of only about 1% rather than more than 3%, as claimed by the OECD.

Spare capacity, therefore, may offer limited check to an upswing in core inflation caused by monetary loosening and associated dollar weakness.

The government has been able to continue to fund the large budget deficit at low interest rates in recent months because banks and building societies have stepped up gilt purchases, compensating for a reduction in demand from non-bank domestic investors and overseas residents.

Banks and building societies bought £7.7 billion of the £12.8 billion of new gilts sold in April. Over the last six months, their purchases have totalled £36.1 billion, up from £11.4 billion in the prior half-year and equivalent to 91% of net issuance of £39.8 billion.

Overseas buying of gilts, by contrast, fell to £12.4 billion in the six months to April from £33.5 billion in the prior half-year, probably reflecting a slowdown in capital flight from struggling peripheral Eurozone economies. Non-bank domestic investors, meanwhile, sold £8.2 billion of gilts in the latest six months.

Banks are buying gilts partly under regulatory pressure but also because private sector demand for bank loans remains weak. Any revival in credit demand would probably slow the rate of purchases and put upward pressure on gilt yields. For the moment, banks are effectively delivering the QE2 stimulus sought by MPC arch-dove Adam Posen.

Monetary statistics for April also released today show continued weakness in the broad money supply (i.e. M4 excluding money holdings of intermediate other financial corporations, or M4ex). 12-month growth was unchanged at 1.5% while M4ex contracted by an annualised 2.0% in the latest three months. This weakness, however, is probably consistent with a continued economic recovery and inflation overshoot:

• Annual M4ex growth remains within the 0.5-2.5% range in operation since mid-2009. This has been associated with solid expansion of nominal demand and GDP – gross final expenditure rose by 6.2% in the year to the first quarter. The velocity of circulation of money, in other words, has risen and may continue to trend higher as long as real deposit interest rates remain heavily negative.

• The contraction of M4ex over the last three months was caused by money-holders switching into foreign-currency deposits (not included in M4ex), possibly in anticipation of sterling weakness. The addition to such deposits (excluding intermediate OFCs) was an unusually-large £22 billion over February-April. An expanded measure (i.e. M4ex plus foreign-currency deposits) rose by 3.2% annualised in the three months to April.

• Narrow money trends still appear satisfactory: "non-interest-bearing M1" (i.e. currency plus traditional interest-free current accounts) rose by 9.7% in the year to April.