The output gap: What do the OBR forecasts really tell us?
22 March 2012
Yesterday’s budget was meant to put Britain back on the path to growth and recovery. The Office of Budget Responsibility (OBR) has set out in its forecasts what that path might look like. As the government’s watchdog on public finances, its primary function is to ensure that the government is meeting its fiscal mandate during this period of austerity. But as the governments’ fiscal target is to eliminate the structural deficit by 2016/17, one of the key judgements they are required to make is the size of the output gap.
The output gap reflects the underlying capacity for the economy to grow without giving rise to inflation, debt imbalances or other factors that could cause a subsequent correction in the future. And its size is a key judgement for the OBR, because as it determines how much of the deficit is cyclical and how much of it is structural, it has important implications for the government’s fiscal target.
The size of the output gap also has important implications for the sustainable growth rate for the economy – if the amount of spare capacity in the economy is very limited, then the growth prospects in the medium term will be limited as well. In their forecasts released yesterday, the OBR has suggested that the output gap is marginally smaller than their previous estimate in November 2011, however, they estimate that the economy will not enter a technical recession.
We should not ignore the impact on employment and inflation. A part of the total output gap is accounted for by spare capacity in the labour market, either in terms of productivity (output per worker) or the employment rate. The OBR believes that the bulk of spare capacity is in the diminished level of employment in the labour market and not falling productivity, implying that once the economy is in a strong recovery, unemployment would begin to fall. This is reflected in unemployment forecasts, which fall substantially over the time horizon as people get back into work.
But the OBR also believes that inflation is falling over the medium term, back to its targeted level at 2% by 2014. If the output gap in the economy is as small as the OBR says it is, then surely, nominal GDP growth should translate into higher inflation and not rises in real GDP. In the Public Finances Databank released today we see that Money GDP is rising very quickly in the next few years – if this is correct, then either we should expect there to be rising inflation in the medium term or the output gap is larger than the OBR estimates.
In my opinion, falling unemployment, falling inflation and diminished growth prospects in the medium term cannot possibly constitute an equilibrium in the current circumstances – specifically, the reason why these three conditions cannot exist in tandem in the current circumstances is that when the capacity for the economy to grow sustainably is very low, any growth tends to be quite inflationary. If this is not the case, and if the economy has a diminished capacity to grow in the medium term, then, given the high level of indebtedness we should expect to see an inexorable rise in household financial distress. Some 12% of mortgages are already in forbearance. That figure will escalate if there is not real growth or high inflation, leading to widespread defaults, resulting in higher unemployment. Therefore, either unemployment should be expected to rise in the medium term, or inflation should be expected to rise, or one should expect there to be a greater underlying capacity for the economy to grow than suggested by the OBR.
As the fiscal watchdog, it may make sense for the OBR to be conservative with its forecasts for the output gap – they would rather the government overshoot their fiscal targets as opposed to undershoot. However, the spare capacity question remains crucial for fiscal policy, monetary policy and a programme for growth. Getting this right is absolutely critical for the OBR – particularly understanding why the underlying capacity for the economy to grow is so diminished is very important. The OBR has concluded that the only viable explanation for the drop in spare capacity was the damaging effect of the financial crisis. There may be something in this explanation, but far more work is needed to understand why the output gap appears to be so small. This is an area we will be looking into very soon.