Economies are usually regarded as having a trend rate of GDP growth; a level above the trend rate is expected to lead to inflation, while a level below trend for a persistent period of time is disinflationary and might be expected to lead to recession.
An economy growing at below the trend rate has an 'output gap' – that is, the gap between the long-term average level of growth and the actual level of growth.
When an economy is growing at a rate faster than its long-term trend this is called having a 'positive' output gap.
It is when the latter occurs that policymakers think about raising interest rates, in order to prevent the economies overheating and inflation becoming embedded in the system.
When the output gap is negative, and the economy is growing at a rate that is below trend, policymakers focus on cutting interest rates, in order to stimulate demand.
The issue faced by most developed market economies since the end of the pandemic has been that, the inflation which came was not simply the result of economies overheating and the output gap being positive, but also of supply-side factors such as employee shortages and higher energy prices.
The impact of higher energy prices actually reduced the level of demand in the UK economy, as consumers had less discretionary income to spend.
This meant the UK economy moved from having a positive output gap in the immediate aftermath of the pandemic, as people rushed to spend accumulated savings, to a negative output gap as consumer spending declined.
The riddle of Threadneedle Street
And there is the dilemma faced by the Bank of England.
Its mandate requires that it prioritises achieving inflation at or near the 2 per cent target set for it by the government.
With this in mind, the BoE raised interest rates during a period when the output gap was negative, thereby reducing growth in an economy where activity was already slowing.
The two most recent GDP data points for the UK showed growth of 0.6 per cent per quarter, which would equate to 2.4 per cent over a year, considerably ahead of trend.
With inflation already higher than the 2 per cent target, economic textbooks would usually highlight the need for interest rates to rise at this stage, rather than fall, but the most recent action from the BoE has been to cut rates, with the market expecting more rate cuts to come.
This is because the central bank believes inflation is on course for a fall below the 2 per cent limit, whether the output gap is positive or negative.
Guy Miller, head of macroeconomics at Zurich, says the stout level of GDP growth in the UK in 2024 so far is the result of the economy “catching up” on growth that did not happen in 2023, and he expects the growth rate to moderate throughout the rest of this year, but to remain robust.
