Goldilocks knew. The first bowl of porridge was too hot, the second too cold, but she was sure the third was right when she tasted it.
The policymakers who oversee the UK economy would like to be as decisive as Goldilocks.
They regularly need to take the temperature of the economy. If it’s too hot, they consider higher interest rates and tighter government budgets to calm things down. If it is too cold, they are considering looser monetary and fiscal policies to boost consumer and business spending.
But unlike Goldilocks, policymakers in the government and the Bank of England can’t be so sure.
Using judgment rather than strict rules, policymakers rely on estimates of the output gap – a concept that seeks to compare real gross domestic product with what it might be if all the country’s resources were fully utilized – to decide on the state of the economy and whether it has spare capacity.
Currently, UK output gap estimates vary widely, leading to very different requirements for monetary and fiscal policies.
During the time of Chancellor Philip Hammond Spring declaration in March, for example, the UK budget watchdog reported that independent economists ‘estimates of the output gap for 2019 ranged from -1.7% of Oxford Economics’ GDP to + 0.8% d ‘Heteronomics.
If Oxford Economics is right about the weak economy, the BoE should cut interest rates to encourage borrowing and spending and Mr Hammond should spend money. But if Heteronomics’ view of an overheating economy is correct, the BoE would have to raise rates and there would be much less fiscal room for fiscal largesse.
Since the rationale for the calculations of the two consulting firms is plausible, it is perhaps not surprising that the output gap estimates for 2019 by the BoE and the Office for Budget Responsibility are in the middle of the independent figures, suggesting that the economy is neither too hot nor too cold. , with demand and supply in overall equilibrium.
The underlying problem facing the BoE and OBR is that official data shows the UK economy has a split personality, showing slow GDP growth and labor market strength.
Almost all employment indicators suggest the economy is on the verge of overheating. Business surveys highlighting recruitment difficulties and industries facing capacity constraints are well above normal. In contrast, data on economic growth – both in surveys and official figures – is much more subdued, suggesting there is room for expansion.
Oxford Economics and Heteronomics used similar data to draw their conclusions on the output gap. Andrew Goodwin, associate director of Oxford Economics, said that despite the dynamic labor market, unemployment could fall further without creating inflationary problems.
Philip Rush, founder of Heteronomics, said his vision of an overheating economy was in part guided by very rapid job growth and temporary factors depressing wage increases. At one point, he expected “inflation to rise, but maybe not just consumer price inflation – it could show up in asset prices.”
The confusing picture of the data leads many economists to make their estimates of the output gap in a curious way, according to George Buckley, an economist at Nomura.
âA common way for economists to estimate output gaps is to essentially reverse engineer their results, looking at what’s going on with wage growth and inflation, and overriding their estimates based on them. indicators, âhe said.
But it is a risky strategy that leaves political policy prone to big mistakes if, for example, inflation does not accurately define the economic temperature.
In 2007, Buckley noted that the International Monetary Fund believed the UK’s output gap to be close to zero. In reality, Britain’s economic structure was unsustainable and headed for a financial crisis. The latest IMF estimate is that the UK economy was overheating to the tune of 3.75% of GDP in 2007.
Regular reviews of the output gap raise fundamental questions about its usefulness as a policy tool if no one can know its real value for years. James Smith, research director at the Resolution Foundation, a think tank, said that with Brexit and the conflicting data signals surrounding the economy, “the degree of uncertainty about the output gap at this time must to be colossal “.
Revisions and uncertainties, however, are far from the only concerns about the dependence of policymakers on the concept in setting monetary and fiscal policies.
Simon Wren-Lewis of the University of Oxford expressed concern that there is a fundamental problem in the underlying economic model for the output gap estimates, which will likely be most severe after a long and slow recovery.
Current techniques could properly measure a zero gap, he said, but greater demand would still be sustainable because there was a massive backlog of potentially profitable investment projects. âIf demand increased in a way that seemed sustainable, companies would not increase their prices but rather increase their investments,â he added.
Robin Brooks, an economist at the Institute of International Finance, the global body representing the financial sector, expressed concern that published output gaps are inherently political and often chosen to rationalize existing policies, rather than to define the right prescriptions.
He launched a “campaign against absurd production gaps” on Twitter, emphasizing how damaging economic policy can be if output gap estimates are wrong.
With such fundamental concerns, it is natural to wonder why policymakers revere the concept.
According to Buckley, economists are sticking to the output gap because they can’t think of a better way to take the temperature of the economy. âThe problem is that economists and central bankers cannot abandon models based on output gaps, even if they are not as efficient as they once were.