In the medium term, our real GDP forecast is typically the result of other judgements (in particular, about potential output and the output gap profile), which the BRC then consider and decide whether to make further adjustments:
- We start with our assessment of the current output gap – the amount of spare capacity in the economy or the extent to which it is overheating. That assessment is discussed further in the output gap section.
- We then decide how quickly we expect economic output to return to our assessment of its potential level. This is informed by the outlook for the individual expenditure components of GDP, as well as the conditioning assumptions upon which our economic forecast is based.
- Once the output gap is closed, we tend to assume that GDP grows broadly in line with the economy’s underlying growth potential over the rest of the forecast.
Our forecast for potential growth – the most important element of our forecast – is determined by forecasts for its components: population, participation, employment, average hours and productivity. The expected path of productivity growth is particularly important in determining the rate of GDP growth in the medium term.
We make further adjustments to our forecast to reflect changes in government policy that we consider to be large enough to affect the path of GDP growth materially. One important source of adjustment happens when the Government chooses to loosen or tighten fiscal policy (by spending more/less or cutting/raising taxes). To calculate the size of these adjustments, we use fiscal multipliers that are based on external estimates. More detail on the size and application of these multipliers is available in Box 3.2 of the July 2015 EFO.
In our October 2018 forecast, we estimated that output was slightly above trend in the second quarter of 2018. We expect growth in 2019 to be slightly above potential output growth, pushing the small positive output gap slightly higher, as the impact of the discretionary fiscal loosening in the Budget boosts activity. As the ‘multiplier’ effects of the discretionary fiscal loosening dissipate, GDP growth slows and the output gap narrows. From 2022 onwards, our assumption that potential productivity growth will pick up means we expect GDP growth to rise.
Once we have a forecast for GDP growth we can then make judgements about prices and about the composition of total income and spending in the economy. It is these details – e.g. the split of national income between wages and profits, or of wages into employment and average earnings – that we use to produce our public finances forecasts.