UK economic analysis creates Goldilocks dilemma


Goldilocks knew. The first bowl of porridge was too hot, the second too cold, but she was sure the third was just right when she tasted it.

Policymakers overseeing the UK economy would love to be as decisive as Goldilocks.

They regularly need to take the economy’s temperature. If it is running too hot, they consider higher interest rates and tighter government budgets to calm things down. If it is too cold, they eye looser monetary and fiscal policies to stimulate spending by consumers and businesses.

But unlike Goldilocks, policymakers in the government and the Bank of England cannot be so certain.

Using judgment rather than hard and fast rules, policymakers rely on estimates of the output gap — a concept that seeks to compare actual gross domestic product with what it might be if all of the country’s resources were fully employed — to reach a verdict on the state of the economy, and whether it has any spare capacity.

Right now, estimates of the UK’s output gap vary markedly, leading to very different prescriptions for monetary and fiscal policies.

At the time of chancellor Philip Hammond’s Spring Statement in March, for example, the UK fiscal watchdog reported that independent economists’ estimates of the output gap for 2019 ranged from Oxford Economics’ -1.7 per cent of GDP to Heteronomics’ +0.8 per cent.

If Oxford Economics is right about the economy’s weak state, the BoE should be cutting interest rates to encourage borrowing and spending and Mr Hammond should splash the cash. But if Heteronomics’ view of an overheating economy is accurate, the BoE should be raising rates and there would be much less leeway in the public finances for budgetary largesse.

With the rationale behind both consultancies’ calculations being plausible, it is perhaps not surprising that output gap estimates for 2019 by the BoE and the Office for Budget Responsibility sit in the middle of the independent figures — suggesting the economy is neither too hot or too cold, with demand and supply broadly in balance.

The underlying problem the BoE and the OBR face is that official data show the UK economy with a split personality — exhibiting sluggish GDP growth and labour market strength.

Almost all employment indicators suggest the economy is close to overheating. Business surveys pinpointing recruitment difficulties and industries facing capacity constraints are far above normal. By contrast, economic growth data — both in surveys and official figures — are much more subdued, suggesting there is room for expansion.

Oxford Economics and Heteronomics used similar data to come to their conclusions on the output gap. Andrew Goodwin, associate director at Oxford Economics, said that despite the buoyant labour market, unemployment could fall a lot further without creating inflationary problems.

Philip Rush, founder of Heteronomics, said his view of an overheating economy was guided partly by very rapid growth in jobs, and temporary factors depressing wage increases. At some point soon he expected “inflation to rise but, maybe not just consumer price inflation — it might show up in asset prices”.

The confusing picture in the data leads many economists to go about their output gap estimates in a curious manner, according to George Buckley, economist at Nomura.

“A common way for economists to estimate output gaps is essentially to reverse engineer their results, by looking at what’s happening to wage growth and inflation and backing out their estimates from these indicators,” he said.

But this is a risky strategy and leaves policy prone to big errors if, for example, inflation is not accurately defining the economic temperature.

In 2007, Mr Buckley noted the International Monetary Fund thought the UK output gap was roughly zero. In reality, Britain’s economic structure was unsustainable and heading for a financial crisis. The latest IMF estimate is that the UK economy was overheating to the tune of 3.75 per cent of GDP in 2007.

Regular revisions to the output gap raise fundamental questions about the usefulness of it as a policy tool if no one can know its real value until years later. 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 over the output gap at the moment must be colossal”.

Revisions and uncertainties are, however, far from the only concerns about policymakers’ reliance on the concept in setting monetary and fiscal policies.

Simon Wren-Lewis of Oxford university expressed worries there is a fundamental problem in the underlying economic model for estimates of the output gap, which is likely to be most serious after a long and slow recovery.

Current techniques might correctly measure a gap of zero, he said, but more demand would still be sustainable because there was a massive backlog of potentially profitable capital projects. “If demand did rise in a way that appeared sustainable, firms would not raise their prices but would instead raise investment,” he added.

Robin Brooks, economist at the Institute of International Finance, the global body representing the finance industry, voiced concern that published output gaps are inherently political and often chosen to rationalise existing policies, rather than to set the correct prescriptions.

He has launched a “campaign against nonsense output gaps” on Twitter, highlighting how damaging economic policy can be if output gap estimates are wrong.

With such fundamental concerns, it is natural to wonder why policymakers venerate the concept.

According to Mr Buckley, economists stick with the output gap because they cannot think of a better way of taking the economy’s temperature. “The problem is that economists and central bankers cannot ditch models based on output gaps even if they’re not as effective as they once were — without some measure of slack you don’t really have a model of the economy,” he said.


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