The UK output gap: is it narrower than the Bank of England thinks?

Over the last year, the UK economy has recorded four decent quarters of positive growth. That is good news. At the same time, if this growth continues, then it hard to see how real sector developments will exert any downward pressure on inflation.

In justifying their negative bank rate policy, the Bank of England has placed great emphasis on the output gap - the difference between actual and potential output. When this gap is large, and there are a lot of unemployed resources, which should bear down on prices and squeeze out inflationary pressures.

In recent inflation reports, the Bank has reiterated its belief that the output gap remains large and negative. This belief is also based on the magnitude of the recession, which was extremely deep. The recent upswing in growth has a long way in order to achieve the level of growth enjoyed in 2007.

But suppose the financial crisis has permanently reduced potential output. Then benchmarking the output gap on 2007 would be a dangerous mistake. It would over-estimate the size of the gap. If the gap is narrower than the Bank thinks, then recent growth could be contributing to higher price pressure.

The appalling December inflation number suggests something is not quite right with the Bank of England's output gap story.