In the February 2014 Inflation Report the Bank of England published more information about its assessment of spare capacity. This box compared that assessment with our own output gap estimate at the time, highlighting some conceptual differences between the two.

The February 2014 Inflation Report saw the Bank of England publish more information about its projections and increase transparency over its assessment of spare capacity. This has prompted external commentators to compare the Bank’s assessment of spare capacity with our estimate of the output gap, which are both around -1½ per cent of GDP at the beginning of 2014. In making such comparisons, it is important to recognise that the Bank’s estimate of economic slack is conceptually different to the one we use to adjust the fiscal position for the effects of the economic cycle.

We are interested in what might be considered a long-term measure of spare capacity, which we call the output gap. This gives an indication of where the level of output might settle once all shocks have worked their way through the economy. The Bank is more concerned with what could be called a medium-term measure of spare capacity or economic slack, which is what can be expected to influence inflation over its shorter term policy horizon.

For example, long-term unemployment picked up over the course of the recession and around a third of those currently without jobs have been without one for six months or more. To the extent that these individuals have become disconnected from the labour market, there may be less room for employment to grow before exerting upward pressure on wages, and therefore inflation. Taking this into account, the Bank currently judges that the medium-term equilibrium unemployment rate is 6 to 6½ per cent and therefore unemployment currently lies around ¾ to 1¼ percentage points above this.

But, in the fullness of time, many of the long-term unemployed are likely to find their way back into work, and spending on out-of-work benefits and receipts from income tax will come to reflect that. So to estimate the structural fiscal deficit, we need to take a longer view – we judge that the long-term structural unemployment rate is around 5¼ per cent and unemployment is around 1¾ percentage points above it. This assessment is broadly consistent with the Bank’s view that the medium-term equilibrium unemployment rate will fall as demand recovers.

Similarly, average hours worked have trended downwards for as long as the ONS has recorded them and we expect this long-run decline to continue, bearing down on tax receipts. But there may be more room to expand average hours over the Bank’s policy horizon without generating inflationary pressure. And while both we and the Bank expect productivity per hour to pick up as demand recovers, we see more scope for output to expand without employees putting in more hours.

So, while ‘slack in the economy’ sounds very much like ‘output gap’, it depends on the time horizon under consideration and, for this reason, our estimates and those of the Bank are not directly comparable. As it happens, both estimates currently lie at around -1½ per cent of GDP, but this masks a number of differing judgements over both where slack lies and the overall scope for growth in the medium term.

This box was originally published in Economic and fiscal outlook – March 2014

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