A higher level of potential output for a given level of GDP will mean a more “negative” output gap—implying (other things being equal) inflation below the 2 per cent target, greater economic slack and a possible need to ease the policy rate—and vice versa. Along with the output gap, expectations of inflation are also important in explaining current inflation.
As inflation targets have become more credible, expectations have become better anchored at the target rate and, in turn, have had a larger influence on inflation itself.xiii To illustrate the relationship between the output gap and inflation, consider Chart 6.