A research note in January 2010 suggested that the UK “output gap” (i.e. the shortfall of GDP relative to normal supply capacity) was 2% rather than 5-7%, as claimed by official forecasters at the time. This was a key reason for expecting inflation to continue to overshoot official and market expectations..…
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• Forecasters, similarly, believed that the US output gap was large in early 2010 and would exert significant downward pressure on “core” inflation. This prediction, for a while, proved more successful than its UK equivalent – the annual increase in the CPI excluding food and energy slowed from 1.8% in December 2009 to 0.6% in October 2010.
• CPI ex. food and energy inflation, however, has rebounded since late 2010, reaching 1.3% in April. An alternative core measure also excluding housing costs is running at 1.6%, in the middle of its range in recent years.
• The failure of core inflation to sustain a significant decline suggests that, as in the UK, the US output gap has been overestimated. This is supported by survey evidence. The chart shows the OECD’s estimate of the gap – representative of the consensus view – together with an economy-wide operating rate derived from the ISM’s semi-annual business survey (a weighted average of manufacturing and non-manufacturing rates). The two measures have diverged since late 2009, with the current ISM reading consistent with an output gap of only about 1% rather than more than 3%, as claimed by the OECD.
• Spare capacity, therefore, may offer limited check to an upswing in core inflation caused by monetary loosening and associated dollar weakness.
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