Post date: Thu, Apr 10, 2025
Category: Output Gap
By: Maureen Barasa,

Introduction

This note outlines our first analysis of the output gap and its implications for forecasting inflation for 2025.

Theory

The objective of assessing any output gap is to understand causes of inflation, in this case for Kenya.

The core notion is that if demand exceeds supply, prices are expected to rise.  So, if total demand in an economy surpasses its total supply capacity—its potential output—at any point in time, that is a positive output gap, and we expect prices/inflation to rise in that context. In this case, the excess demand exerts an upward pressure on prices resulting in a demand-pull inflation.

When demand falls below potential output, this creates a negative output gap, reducing inflationary pressures. Nevertheless, inflation can come from supply-side factors such as disruptions in production, rising input costs, or external shocks such as sharp and abrupt increases in oil prices, weather shocks or currency depreciation. When this happens, inflation is expected to rise even if demand remains stable resulting in cost-push inflation. By analyzing Kenya’s output gap, we can determine whether inflation has been driven from supply or demand factors.

The notion of potential output, from which the output gap is calculated, is not to be confused with how much Kenya can produce under optimal policies and structures. Instead, it reflects what Kenya can realistically achieve with existing policies and structures, even if they are inadequate.

As with many core macro-economic concepts, potential output, though critical to analysis, cannot be observed and it must be estimated.

The purpose of estimating the output gap is to attempt to isolate the demand side role in driving inflation in Kenya

Inflation Trends in Kenya

According to historical data from the IMF World Economic Outlook Fall 2024, Kenya, to a great extent, has experienced moderate inflation with notable spikes in certain years such as 1992, as is shown in the chart 1 below.

This moderation implies that the output gap for Kenya is expected to be relatively small usually since high inflation is associated with large output gaps and associated wage-price spirals.

But inflation responds to causes other than the output gap. Specifically, the food prices in Kenya are susceptible to exogenous shocks such as rainfall patterns and drought. Ideally, a refined analysis of the output gap would use core rather than headline inflation as its focus, excluding volatile food and fuel prices. However, due to data limitations, this initial study is only able to utilize overall inflation rates.

First estimate of potential output

As the relatively moderate inflation rates indicate that Kenya’s aggregate demand and supply are not very far apart, one may estimate the capacity of supply by using historical GDP data by fitting a curve over it. Here, a three-order polynomial is used to estimate potential output because of relatively smooth trend of the data with one clear turning point in early 2000s.  The estimated equation is reported in the upper left of the chart.

The gap between the red (real GDP) line and the fitted trend (the three-order polynomial) is the implied output gap.

The gap will be measured as the deviation of GDP from the trend line (potential output) at any point in time expressed as a percentage of potential output.

Does this measure of the implied output gap make sense?

If it makes sense, then we would expect to see a relationship between the proposed output gap and the change in inflation.

So, if there is a negative output gap proposed by this measure, then we would expect to see inflation falling.  And if there is a positive output gap proposed by this measure, we would expect to see inflation rising.

The chart above plots the proposed measure of the output gap in each year since 1980 against the change in inflation.

What is observed?

• In the 1980s, broadly, negative output gaps where demand was below supply coincided with declining inflation.
• In the late 1980s and early 1990s, when demand exceeded supply, inflation increased rapidly, particularly in 1992.
• In the mid 1990s, while the output gap shrank and turned negative, inflation fell sharply.
• Between 2010 and 2019, moderate but persistent positive output gaps were accompanied by relatively stable inflation during the Jubilee Administration. This is consistent with our view that demand was strong in this period, forcing the CBK to tighten monetary policy to stem inflation, causing a sustained appreciation in the Ksh.
• More recently in the 2020s, inflation fell with, apart from 2020 (Covid) a moderate negative output gap.

So far so good.

But the mid-2000s present an anomaly despite a large persistent negative output gap, inflation did not follow the expected pattern. Two external factors explain this deviation:

1.Drought: Agricultural contraction reduced real output, widening the output gap, but shortages of food drove inflation higher.

2.Global Oil Prices: A significant rise in global oil prices during this period contribute to inflationary pressures, offsetting the deflationary effect that should have resulted from the negative output gap. The chart below illustrates the significant rise in global WTI Crude Oil Prices in the mid-2000s.

2024

The 2024 output gap is estimated to be negative and larger than that of 2023, assuming real GDP growth of 4.6%. This outcome aligns with the argument that monetary policy in Kenya has been too tight in 2024, and therefore low inflation in 2024. This does not definitively prove the case but provides further corroboration.

Implications for Long-Term Productivity Growth

Expressing potential output on a per capita basis provides additional insights.  Chart 5 below shows Kenya’s output potential per capita from 1980 to 2024. The per capita potential growth was low and actually turned negative in the 1980s and early 1990s, reflecting the detrimental effects of poor policies in the KANU Administration. It picked up in the late 1990s and early 2000s but remained sluggish, with per capita potential output ranging around 2% comparable with that of the advanced economies but inadequate for a developing economy.

By 2024, per capita potential output had risen to 3.2% but ideally should be closer to 5% to achieve Kenya’s development potential. The findings highlight the need for policy reforms to enhance long-term growth prospects.

 

Implications for 2025

Given our estimate of the output gap in 2024 of 0.6% of GDP, GDP would have to grow by 5.7 % in 2025 in order to close the output gap in that year.  Given the tight stance of monetary policy and some likelihood of a further tightening in fiscal policy alongside, this seems highly unlikely.  So, the implication is that demand will continue to exercise strong downward pressure on inflation, making it likely that apart from further supply shocks (perhaps again in foods), headline inflation will remain in the lower half of the CBK target band, and underlying (non-food, and core) inflation will remain below the target band.

Extensions to this work

This analysis is an initial step and relies on judgment-based assumptions regarding potential output. Future adjustments could involve:

• Incorporating backdated data for core inflation, excluding food and fuel, to refine the estimates, and in particular to confirm the understanding of 1999-2009.
• Exploring alternative functional forms for potential output estimation. If comprehensive core inflation data become available, this analysis will be updated accordingly.

This analysis demonstrates that Kenya’s inflation trends are largely explainable through macroeconomic principles. Future refinements subsequently will make it more accurate and insightful, finally contributing to effective economic policymaking.

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