On the long-lasting hit to UK productivity Let's look at the latest from the UK's Office for Budget Responsibility (our emphasis): The combination of more robust employment and much weaker GDP growth than we expected together create a significant "productivity puzzle." Output per hour is much weaker than in previous cycles and than in our June 2010 forecast. Several explanations for the puzzle have been put forward and although we believe that some of the weakness of productivity relative to the pre-crisis trend is likely to be a temporary phenomenon, we also assume that a significant proportion of the hit is likely to be permanent or long-lasting. Our judgement that there is likely to have been a long-lasting hit to the level of productivity is consistent with our view that the same is true for potential output - the level of activity consistent with sustaining stable inflation in the long term. In common with the IMF, the OECD and the European Commission, we forecast in March 2012 that potential output was around 8 per cent below its pre-crisis trend in 2011 and that the gap would widen to around 11 per cent (more in the case of the EC) by 2014. Potential GDP cannot be measured directly, so there are no outturn data to compare our forecasts to. Differences between our forecasts and outturns could be explained in part by monetary and fiscal policies - either because they have been changed since the forecast was made or because a given policy stance has turned out to be more or less contractionary in its impact than we expected. Estimates of multipliers vary widely, so it is clearly possible that the fiscal consolidation exerted more of a drag on growth than we assumed. But persistent inflation is likely to have weakened consumption in 2011 and deteriorating export markets are likely to have weakened net trade more recently. And it is difficult to distinguish the impact of the fiscal consolidation in other areas - such as business investment - from the impact of anxiety about the euro area's future and the ongoing dislocation of the financial system. All of which very beautifully supports the case made by Capital Economics this month, that the UK output gap may be much larger than people appreciate. Depending on how you look at it. The fact that the UK is becoming less productive - even as employment rates are improving - supports the theory that a lack of stimulus and government spending has led the economy to recalibrate itself through lower productivity levels. There is, it seems, little point to over-producing when input costs are such a drag. Yet, because domestic inflation expectations are still significant in the UK (quite the opposite to the situation in the US), employers seem to think it's better to hoard unproductive workers - who can be persuaded to work harder as soon as domestic inflation hits - than to cut jobs permanently. This can be put down to the fact that much of the UK inflation effect is down to external input costs. As a result there is a mismatch between high input costs and companies" ability to transfer those costs onto an ever more competitive domestic market - which is increasingly flooded by secondary market goods which have no input costs at all (think Ebay etc). So, imagine a business which has significant and volatile input costs due to raw material prices and commodity prices, but which cannot raise prices to compensate for the volatility because the market is far too competitive in many areas (and offers easily accessible secondary market alternatives). The corporate belief may be that prices will go up any second. In which case, hoarding labour makes sense because it will allow the corporate to maximise production as soon as price rises hit. Until that time comes, however, the corporate will remain focused on margin compression and controlled output. The dynamics are much like those in the refinery business. A refinery is either incentivised or not incentivised to produce, depending on the margin available in the market for its product. The slack is taken up by the refinery's spare capacity and inventory. As soon as margins increase, refineries up their rate of production, and vice versa. Refineries understand that a certain level of spare capacity is necessary to manage shocks emanating from either the supply or demand-side effectively. But as we've noted the big trend in refining seems to be the move towards a leaner, less inventory-dependent, management system focused on higher utilisation rates (at least for now). You could call it "just-in-time." Though it's important to stress this is very specifically related to the amount of capacity which was mothballed or shut down on a permanent basis during the crisis to overcome negative margins. There's no sign in the UK that inventories have been affected to the same degree. However, the slack may be being managed by the labour component instead. That means - rather than shutting down capacity and infrastructure, or cutting inventories - companies are taking the output hit by means of long-lasting productivity cuts. And if that is the case, the output gap could be lurking within the labour and employment subset of spare capacity, more than anywhere else. The important point to remember, however, is that a permanent cut in infrastructure and physical capacity is very different to a sudden tolerance of low worker productivity. To argue that this is a permanent phenomenon which reduces the output gap is to argue that domestic inflation expectations are unfounded. More poignantly still, that realised inflation will always come in below corporate expectations. On that basis, if and when inflation expectations change, it's very likely that lower productivity levels will simply transform into a higher natural unemployment rate. Of course, if inflation does come in higher than expected, one can assume the opposite will be true - that productivity levels (rather than employment) will rise quickly instead. This, we would say, sums up the current dual nature of the UK output gap. It is both a chasm and a gap, depending on how you view inflation. Related links: Why the UK output gap could be a chasm - FT Alphaville Redefining labour - FT Alphaville The BoE on Britain's productivity puzzle - FT Alphaville Are UK companies hoarding labour? - FT Alphaville