How to asset allocate in the face of an output gap

The output gap sounds like one of those obtuse concepts bandied about by professional economists to confuse the hell out of ordinary folk.

In reality it is a very simple idea with absolutely enormous importance to any UK-based investment professional – the size of the gap should give us an indication of how to mix inflation-proof assets against other risky assets within a portfolio. This gap describes the relationship between actual GDP and the theoretical capacity of the UK economy. It matters because it crystallises the ‘slack’ in the system that can be used before we start to hit the inflationary buffers. If there is a lot of slack – measured, for instance, by unemployed workers – we should reasonably expect a strong...