Economic Capacity: Limited Slack Being Quickly Absorbed

BMI View: Assessing the amount of slack in the UK economy remains a contentious issue and one which has created an air of uncertainty over the shape and speed of the recovery. Far from being just an abstract concern, excess capacity has a direct bearing on growth, inflation and the design of fiscal and monetary policies. While survey-based measures and our own model estimates suggest that there is only limited excess capacity in the economy (at most), this will not necessarily translate into near-term policy tightening. Instead, much will still depend on price stability and the vulnerability of mortgagors to a rise in lending rates.

Since the financial crisis uncertainty over the amount of spare capacity in the UK economy has proved to be an elusive 'known unknown', which has confounded policymakers and clouded analysis of the macro environment. Equally bewildering is the range of perspectives on spare capacity, ranging from those that believe no slack exists to those that see a gap so large as to justify open-ended quantitative easing in a bid to readdress the balance. Much depends on whether changes in operating capacity during the recession are viewed as structural or cyclical, and whether future growth potential has been irreparably damaged by the financial crisis.

While some of the economic concepts concerning capacity are abstract, the implications are not. The amount of slack in the economy has a direct bearing on the pace of economic growth and the trajectory of inflation, and is a central element in the design of fiscal and monetary policies. Moreover, with the Bank of England's poorly executed foray into forward guidance and unemployment targets disintegrating into a more vague objective of keeping rates low until economic slack is eradicated, the issue of spare capacity is firmly in focus.

Potential GDP Profile Has Weakened
UK - Real & Potential GDP, Constant Prices, GBPbn

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Related sectors of this article: Economy, Finance, Economic Activity, Economic Policy, Fiscal Policy, Monetary Policy
Geography: United Kingdom