The Treasury, OECD and IMF believe that the UK “output gap” – the shortfall of GDP from its trend or potential level – is currently between 5% and 7%. Two alternative approaches, however, suggest a much smaller gap, of about 2%, helping to explain why inflation has overshot official and consensus forecasts.

The three organisations estimate current trend output by extrapolating an underlying path based on historical data and applying an ad hoc adjustment for the negative impact of the financial crisis. Such estimates amount to little more than a guess and will be revised, probably significantly, in light of future output developments.

The first alternative approach utilises the "Okun's law" relationship of the output gap and the deviation of unemployment from its non-accelerating-inflation rate (the NAIRU). Based on history, the recent rise in unemployment looks too small to support estimates of a gap of up to 7%, barring an unlikely fall in the NAIRU.

Specifically, an analysis of UK data since the early 1970s indicates that each 1 percentage point rise in unemployment is associated with a 1.56% fall in output relative to trend. The unemployment rate increased by "only" 2.5 percentage points between the first quarter of 2008 – immediately before the recession – and the fourth quarter of last year, suggesting a 3.9% decline in output relative to trend (1.56 times 2.5). The OECD estimates that GDP was 1.9% above trend in the first quarter of 2008. Using this as a starting point, the implied shortfall last quarter was only 2.0% – see chart.

The second approach uses business survey information on capacity and labour 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 also yields a current estimate of about 2% – the chart shows a full history.  

These alternative approaches imply that either current official GDP figures overstate the decline during the recession or damage to supply capacity from the financial crisis has been greater than assumed by most forecasters. Both are probably true. For the entire divergence to be explained by the supply factor, trend output would need to have fallen by more than 2% between the first quarter of 2008 and late 2009 versus the OECD's assumption of a 3.1% increase.

The Bank of England claims that the current inflation overshoot will prove temporary because a “large amount” of spare capacity will exert downward pressure on domestic price trends. If the output gap is only about 2%, however, the effect will be much weaker than it expects, implying that a tightening of its policy stance will be necessary to secure a return of inflation to target.

Eurozone broad money M3 fell by an annual 0.2% in December but the decline was entirely due to a contraction in financial institutions' money holdings: M3 held by households and non-financial corporations rose by 3.6% – see first chart.

Within non-financial M3, corporate money growth picked up further to an annual 5.5%. With debt repayment continuing, measures of the corporate liquidity ratio have surged, suggesting improving prospects for business investment and hiring – second chart.

Previous posts discussed the notion – originally advanced by Andy Kessler in a Wall Street Journal article last year – that changes in the Fed’s liquidity supply, reflected in the US monetary base, were driving market movements. The recent swoon in equities and rally in the dollar followed a contraction in the base between late November and early January – see first chart.

Previous commentary downplayed, wrongly, the significance of this decline because it reflected a build-up of cash in the US Treasury’s account at the Fed, partly due to TARP repayments, rather than efforts by the central bank to drain liquidity. This effect was expected to reverse in early 2010 as the Treasury ran down its cash balance to finance the swollen deficit.

The latter process is under way and the monetary base has risen for three consecutive weeks. The Treasury’s balance in its “general account” at the Fed has fallen from $187 billion at the end of December to $127 billion yesterday but should decline significantly further over coming weeks – the balance averaged about $45 billion last autumn. Coupled with the cash injection from securities purchases, this should more than offset any liquidity contraction caused by an unwinding of the Fed's special operations.

The equity market set-back has resulted in sentiment measures shifting from overbought to – in some cases – significantly oversold. The annual rate of change of G7 real M1 remains, for the moment, above that of industrial output, implying a still-supportive macro liquidity backdrop. With the US monetary base recovering, the odds favour a rally in markets into the spring, possibly accompanied by a reversal or consolidation of the dollar’s recent gains.

This assessment would be wrong if the economy were tipping over into a “double dip” – liquidity would then flow into bonds rather than equities while the dollar might benefit from a flight to (perceived) safety. The recovery, however, appears on track, with early figures suggesting another solid gain in G7 plus emerging E7 industrial output in December – second chart.

The MPC’s inflation-targeting remit contains an ambiguity: it requires the Committee to achieve the target “at all times” while allowing for temporary departures due to “shocks and disturbances”. Judging from remarks in a speech last week, Bank of England Governor Mervyn King plans to exploit this ambiguity to underreact to this year’s inflation overshoot.

Extending arguments in his five explanatory letters of 2007-09, Governor King absolves the MPC of responsibility for higher inflation due to “temporary price level factors”, which he defines to include exchange rate depreciation, global commodity price rises and indirect tax hikes. Such effects, he suggests, can be ignored as long as there is a “large amount” of spare capacity and monetary growth is low.

The speech does not address the issue of why the disinflationary impact of the “output gap” has, to date, been much weaker than the Bank forecast. The assertion that low money supply growth ensures that inflation will return to target is also simplistic – an alternative view is that there is “excess” money despite slow supply expansion because the demand to hold money is falling in response to negative real interest rates and reviving risk appetite.

The phrase “temporary price level factors” is misleading: sterling depreciation, commodity price gains and excise duty increases, unless reversed, have a permanent impact on prices. Governor King means, of course, that the effect on inflation is temporary. Yet these factors will plausibly continue to exert upward pressure over the medium term.

Take sterling. The real effective exchange rate is currently 8% below its pre-crisis long-term average (calculated over 1970-2006). Suppose, reasonably, that it returns to this average in five year’s time. If the nominal exchange rate is stable, this implies UK manufacturing prices rising by 1.7% per annum more than in competitor countries. Such a differential would lift UK CPI inflation by about 0.5% pa relative to the overseas trend (based on the 31% weight of “non-energy industrial goods” in the CPI).

Commodity price gains in recent years have been largely driven by industrial expansion and rising food spending in emerging economies, trends that will persist. Fiscal adjustment, meanwhile, will necessitate further hikes in indirect taxes, with a rise in the standard rate of VAT to 20% widely expected during the next parliament.

In sum, the three factors could plausibly boost the CPI by about one percentage point per annum over the next five years. If the MPC were to exclude the effect when setting policy, this would imply a de facto raising of the inflation target from 2% to 3%.

How the MPC interprets its remit may be as important for the interest rate outlook this year as the evolution of inflation and output. In effect, Governor King is advocating downgrading the “at all times” requirement while shifting to a “core” inflation operational target (i.e. a Canadian-style approach). This warrants wider debate, both within and outside the MPC.

The preliminary GDP estimate for the fourth quarter was disappointing, showing growth of only 0.1%, although there are grounds for expecting an upward revision. A key issue is whether supply-side weakness is contributing to the sluggish recovery – this implies a deterioration in the growth / inflation trade-off.

Key points:

• GDP was held back by a decline in North Sea production: gross value added excluding oil and gas rose by 0.2%.

• The preliminary estimate appears to incorporate an assumption of a fall in GDP in December after rises in September and November and a flat October. A monthly GDP proxy based on services and industrial output data was 0.2% above its third-quarter average in October / November combined – see chart. The assumed December decline is based on limited information and may be revised away. (The third-quarter preliminary estimate also incorporated a fall in the final month of the quarter, subsequently revised to an increase.)

• Quarterly growth of only 0.1% sits uneasily with labour market data. The last post drew attention to a significant rise in vacancies in the fourth quarter; in addition, aggregate hours worked in the economy grew by 0.7% in the three months to November from the previous three months. Barring a significant upward revision to GDP, this suggests a further fall in productivity last quarter: official figures show a 1.6% decline in economy-wide output per hour in the year to the third quarter. Poor productivity performance has contributed to the recent rise in inflation by pushing up unit labour costs despite slowing wage growth.

• The key policy variable for the MPC is not real but nominal GDP – a fourth-quarter nominal estimate will be published in a month's time (26 February). In the third quarter, nominal GDP rose by 1.1%, or 4.5% annualised, even as real output contracted by 0.2%. Inflation indicators suggest another strong increase last quarter despite a disappointingly small recovery in real activity.