Ever felt that financial forecasters are making it up as they go along?

If so, you are worryingly accurate, as the most important economic measure can only be guessed at

Economics Editor

What do you suppose is the most important statistical measure for those in charge of setting economic policy? GDP growth? The inflation rate? Unemployment? Guess again.

The figure is the level of slack in the economy, also known as the "output gap", or "spare capacity". Presented as a percentage of GDP, it represents the gap between the level of output and the economy's non-inflationary potential. When the figure is positive the economy can grow strongly without setting off an inflationary spiral. When the figure is negative, the economy is overheating and a damaging surge in prices is a danger.

Earlier this month the Governor of the Bank of England, Mark Carney, said the level of slack in the economy was greater than previously believed. That sent City traders scrambling to change their bets on the likely date of the first hike in interest rates by the Bank, pushing it back to next May. The value of sterling against the dollar also dropped sharply, again reflecting a sudden shift in market expectations.

The Office for Budget Responsibility (OBR), George's Osborne's official forecaster, has also been making waves over the past four years with its revisions of the size of the output gap. A succession of downgrades of the level of slack in the economy by the OBR have pushed up the size of the hole in the public finances and compelled the Chancellor to pencil in more future cuts in order to balance the budget. These revisions are a big part of the reason why a five-year programme of public sector austerity is now projected to last for just short of a decade.

George Osborne George Osborne The trouble is that economic slack can't be directly measured. Its size can only be inferred from other indicators. And those indicators are rather unsatisfactory, generally consisting of surveys of firms and workers. To put it crudely, policymakers have to guess.These guesses are contentious because of what happens if they are wrong. The Bank of England's latest collective estimate is that economic slack is about 1 per cent of GDP. But what if spare capacity is bigger than this? That implies the Bank could hold interest rates down for longer than the financial markets expect. That would result in faster growth, which would not be excessively inflationary. That, in turn, should mean faster wage growth. The Bank could harm living standards unnecessarily by tightening monetary policy prematurely.

Similar issues attend the OBR's estimate of the output gap. Technically this is a somewhat different concept from the Bank of England's slack measure because the OBR is looking at supply capacity over the long-term, rather than being focused on near-term inflationary pressures. But the general principle is the same.

The forecaster has put a figure on the output gap of 1.8 per cent of GDP. Yet the average of external forecasters is 2.7 per cent of GDP. And some put the gap as high as 6 per cent of GDP. Using the OBR's own calculations of how this affects the size of the hole in the public finances the Institute for Fiscal Studies has performed some interesting calculations. It found that if the consensus on the output gap is correct George Osborne is planning austerity that is around £11bn more than is needed to balance the budget. And if the higher end of output gap estimates is right the excess austerity amounts to around £48bn. Considering we have experienced cumulative austerity worth around £90bn since 2010 these are clearly non-trivial sums. Andrew Goodwin of Oxford Economics, a consultancy which thinks the output gap is bigger than the OBR's estimate, explains it thus: "The medicine of austerity could end up being applied in a dose higher than the patient actually needs."

It is striking how wildly estimates of the output gap swing over time. Before the financial crisis forecasters at the OECD think tank said that the UK was running very slightly below capacity. In 2007 its estimate of the output gap was 0.2 per cent of GDP. Now, by contrast, the OECD says that the UK's output gap in 2007 was a minus 4.9 per cent of GDP. Today it says the economy was far too hot on the brink of the global financial crisis. But it didn't think so at the time.

There is no easy solution to this. Policymakers will always need to estimate the output gap. And disagreement about which indicators to study, and which to ignore, is inevitable. There is bound to be disagreement, too, over the potential growth rate. Pessimism will always vie with optimism. One can only hope that policymakers and forecasters produce their estimates with an appropriate level of humility and open-mindedness. As for the rest of us, we should probably keep in mind just how much economic policymaking hinges on educated guesses.

Hamish McRae is away

Start your day with The Independent, sign up for daily news emails
ebooks
ebooksA special investigation by Andy McSmith
  • Get to the point
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating
and  

By clicking 'Search' you
are agreeing to our
Terms of Use.

iJobs Job Widget
iJobs Money & Business

SThree: Trainee Recruitment Consultant

£20000 - £25000 per annum + OTE £45,000: SThree: SThree Group have been well e...

Ashdown Group: IT Manager / Development Manager - NW London - £58k + 15% bonus

£50000 - £667000 per annum + excellent benefits : Ashdown Group: IT Manager / ...

Recruitment Genius: Sales Consultant / Telemarketer - OTE £20,000

£13000 - £20000 per annum: Recruitment Genius: Scotland's leading life insuran...

Ashdown Group: Training Programme Manager - City, London

£40000 - £45000 per annum + benefits : Ashdown Group: Training Programme Manag...

Day In a Page

Where the spooks get their coffee fix: The busiest Starbucks in the US is also the most secretive

The secret CIA Starbucks

The coffee shop is deep inside the agency's forested Virginia compound
Revealed: How the Establishment closed ranks over fallout from Loch Ness Monster 'sighting'

How the Establishment closed ranks over fallout from Nessie 'sighting'

The Natural History Museum's chief scientist was dismissed for declaring he had found the monster
One million Britons using food banks, according to Trussell Trust

One million Britons using food banks

Huge surge in number of families dependent on emergency food aid
Excavation at Italian cafe to fix rising damp unearths 2,500 years of history in 3,000 amazing objects

2,500 years of history in 3,000 amazing objects

Excavation at Italian cafe to fix rising damp unearths trove
The Hubble Space Telescope's amazing journey, 25 years on

The Hubble Space Telescope's amazing journey 25 years on

The space telescope was seen as a costly flop on its first release
Did Conservative peer Lord Ashcroft quit the House of Lords to become a non-dom?

Did Lord Ashcroft quit the House of Lords to become a non-dom?

A document seen by The Independent shows that a week after he resigned from the Lords he sold 350,000 shares in an American company - netting him $11.2m
Apple's ethnic emojis are being used to make racist comments on social media

Ethnic emojis used in racist comments

They were intended to promote harmony, but have achieved the opposite
Sir Kenneth Branagh interview: 'My bones are in the theatre'

Sir Kenneth Branagh: 'My bones are in the theatre'

The actor-turned-director’s new company will stage five plays from October – including works by Shakespeare and John Osborne
The sloth is now the face (and furry body) of three big advertising campaigns

The sloth is the face of three ad campaigns

Priya Elan discovers why slow and sleepy wins the race for brands in need of a new image
How to run a restaurant: As two newbies discovered, there's more to it than good food

How to run a restaurant

As two newbies discovered, there's more to it than good food
Record Store Day: Remembering an era when buying and selling discs were labours of love

Record Store Day: The vinyl countdown

For Lois Pryce, working in a record shop was a dream job - until the bean counters ruined it
Usher, Mary J Blige and Will.i.am to give free concert as part of the Global Poverty Project

Mary J Blige and Will.i.am to give free concert

The concert in Washington is part of the Global Citizen project, which aims to encourage young people to donate to charity
10 best tote bags

Accessorise with a stylish shopper this spring: 10 best tote bags

We find carriers with room for all your essentials (and a bit more)
Paul Scholes column: I hear Manchester City are closing on Pep Guardiola for next summer – but I'd also love to see Jürgen Klopp managing in England

Paul Scholes column

I hear Manchester City are closing on Pep Guardiola for next summer – but I'd also love to see Jürgen Klopp managing in England
Jessica Ennis-Hill: 'I just want to give it my best shot'

Jessica Ennis-Hill: 'I just want to give it my best shot'

The heptathlete has gone from the toast of the nation to being a sleep-deprived mum - but she’s ready to compete again. She just doesn't know how well she'll do...