Is it plausible to assume a negative output gap after five years?

In early OBR forecasts we estimated a significant negative output gap following the late-2000s recession, which we did not expect to have closed by the end of the forecast horizon. Our March 2013 forecast implied that potential output would be 14.6 per cent below an extrapolation of its pre-crisis trend after five years, with actual output a further 2.3 per cent below that. This box examined the implications of that forecast, as well as the fiscal implications of some possible alternative assumptions.

In normal times it would be unusual to forecast that the economy would be operating with significant spare capacity at the end of a five year forecast horizon. Typically forecasts assume that monetary policy and other equilibrating factors will ensure that economic activity returns to a sustainable level in the medium term.

But in light of the depth of the recent downturn, and the weakness of the subsequent recovery, most major forecasters assume that some negative output gap will persist at the end of their forecast horizon, even though most also assume a significant sustained reduction in potential output relative to pre-crisis trends. Our forecast in this EFO implies that potential output would be 14.6 per cent below an extrapolation of its pre-crisis trend in 2017, with actual output a further 2.3 per cent below that.

How plausible is this combination of a big reduction in potential output and a persistently negative output gap, relative to the alternatives? And what impact would those alternatives have on the Government’s chances of meeting the fiscal mandate?

  1. Some economistsa argue that the current output gap is significantly wider than in our central forecast, judging that there was little or no hit to potential output following the financial crisis. Unless you assume a very strong economic recovery, or a significant and sustained slowdown in potential output growth in future years, this would imply an even larger negative output gap after five years than in our forecast. This would be even more at odds with the usual assumed effect of monetary policy and other equilibrating factors. We find the argument that the output gap is much larger today than in our central forecast hard to square with the recent strength of private sector employment growth, the persistence of above-target inflation and most surveys of capacity utilisation.
  2. One way to avoid having a negative output gap at the end of the medium-term horizon would be to assume an even bigger hit to potential as a result of the financial crisis, and thus a significantly smaller output gap today. Given the relative strength of the labour market, this would imply an even bigger hit to the level of potential productivity – deepening the ‘productivity puzzle’ that most economists are already struggling to solve.b
  3. One way to be more pessimistic about the supply potential of the economy, without having to explain why the financial crisis has done so much to reduce it, would be to assume that the trend growth rate of potential output was significantly overestimated even before the crisis.c Forecasters who derive their estimates of potential output from statistical filters of actual GDP data – or from production functions that use filters to identify the trend path of the different factors of production – will tend to move in this direction over time as the continued weakness of actual GDP mechanically drags down the assumed path of potential output both before and after the downturn. As we can see from the estimates of bodies like the International Monetary Fund and the Organisation for Economic Co-operation and Development (OECD), this implies an increasingly large positive output gap immediately prior to the crisis in 2007. (For example, the latest OECD Economic Outlook estimates that output was 4.4 per cent above potential in 2007, compared to 0.2 per cent in its June 2008 Outlook.) We find a large positive output gap in the period running up to the crisis hard to square with low rates of inflation and other cyclical indicators at that time.
  4. The final way to close the output gap over the five year horizon would be to assume a much stronger recovery in actual GDP. As shown in Chart 3.10 most outside forecasters are expecting relatively weak growth in coming years. Even if we were to combine our estimate of trend output with the strongest forecast for actual output growth from Chart 3.11, we would still have a negative output gap by the end of the forecast horizon.

All these alternatives have different implications for the Government’s chances of meeting its fiscal mandate i.e. balancing the structural current budget after five years. The first alternative would make it easier to meet the mandate, as a wider output gap implies that more of the current deficit is cyclical rather than structural. The second and third alternativesd imply a larger structural deficit and a tougher task meeting the mandate, as they imply a narrower output gap today than in our forecast. The fourth alternative – a stronger recovery – would boost receipts and lower spending, reduce the headline deficit and lower the path for public sector net debt. But this would not increase the chances of meeting the mandate if the improvement was purely cyclical.

a See for example: Capital Economics, 2012, Is the output gap a crack or a chasm, October and Martin and Rowthorn, 2012, Is the British economy supply constrained II? A renewed critique of productivity pessimism, UK-IRC May.

b See for example: Nomura, 2013, The moribund metastable equilibrium, January.

c See for example: OECD, 2012, Economic Outlook, November. d Assuming that the hit to supply following the crisis is not smaller than in our central forecast.