Trend Output and the Output Gap in the UK

This note looks at estimates of the current scale of the output gap in the UK and at the factors that affect estimates of the trend rate of growth. These issues are central to the debate on macroeconomic policy, both in the short and the long run. The speed at which the economy returns to full capacity, along with the scale of the output gap, will be important factors affecting average growth over the next five years. In the longer term, trend growth at full capacity is not immutable, but rather depends upon the rate of labour augmenting technical progress and the growth of the labour force. In the medium term these factors can be added to by temporary bursts of capital augmenting technical progress and by changes in the user cost of capital that may change the optimal capital-output ratio. Other factors, such as the cost of materials, also affect potential output. Over the past few months there has also been a significant rise in oil prices, and we judge this to have a strong permanent component which will reduce trend growth in the short term and trend output in the longer term. Its implications are more fully discussed in Barrell, Delannoy and Holland in this Review.