The Treasury has substantially cut its estimate of the economy's speed limit - the potential output growth rate - over the next four years.

Potential output is how much the economy can produce before capacity constraints start to generate inflationary pressure. The rate at which it grows depends on growth in the supply of labour (how many people are available to work and how many hours they are prepared to put in), the capital stock (plant and machinery, buildings, computers and so on) and productivity (how effectively labour and capital are combined).

If actual output is less than potential, which has been the case since the recession, inflation pressure will be weak and policy should be stimulatory. When actual output exceeds potential it is inflationary and unsustainable, and policymakers have to hit the brakes.

The Treasury's half-year economic and fiscal update last month embodied potential growth rates averaging 2.2 per cent a year over the next four years - 0.6 percentage points per annum lower than assumed in last May's Budget.


It would be an improvement on 2011 and 2012 (1.3 and 1.4 per cent respectively) but slower than its estimate of the average potential growth rate between 2000 and 2010, which is 2.6 per cent. The cumulative effect is to reduce estimated potential output by 2016 by 2 per cent.

The Reserve Bank made a similar adjustment in its June monetary policy statement.

The Treasury expects the labour force to grow by an average of 1.1 per cent per year for the next four years, and labour productivity to rise at a similar rate. It says labour has been making smaller contributions to potential growth since 2006 as population growth has slowed and average hours worked have fallen.

Since the global financial crisis the "natural" rate of unemployment (the rate below which inflation will gather pace) has gone up, reflecting increased long-term unemployment and greater skill mismatches between the demand and supply sides of the labour market.

On the capital front, business investment fell sharply during the recession and remains significantly below pre-crisis levels.

But because the capital stock is large and investment flows small by comparison, weak capital growth is likely to account only partially for weak labour productivity growth since 2009, the Treasury says.

If the weakness in credit growth evident since 2009 is indicative of tougher lending standards on the part of banks, then this may inhibit the growth of riskier but on average more productive businesses, it says.

"Likewise if the low interest rate environment is allowing unproductive firms to stay in business this could be interfering with the process of creative destruction which allocates capital to new and more productive firms."