Goldilocks Economy: Definition and What Makes It Work

What Is a Goldilocks Economy?

A Goldilocks economy is not too hot nor too cold but just right, to steal a line from the popular children's story "Goldilocks and the Three Bears". The term describes an ideal state for an economic system. There's full employment, economic stability, and stable growth in this perfect state. The economy isn't expanding or contracting by a large margin.

A Goldilocks economy is warm enough with steady economic growth to prevent a recession but growth isn't so hot as to push it into an inflationary status.

Understanding a Goldilocks Economy

There's some debate among economists as to the exact characteristics of a Goldilocks economy but it's safe to say that there should be a balance between growth, employment, and inflation. The ideal conditions are typically characterized by:

• Low unemployment: A low unemployment rate, commonly known as the U3 rate, defines the number of people who are willing and able to work but unable to find gainful employment. They must have sought work in the last four weeks. The U.S. Federal Reserve (The Fed) estimates a normal unemployment rate to fall somewhere between 5% and 6.7%.
• Asset price inflation: An increase in the prices of stocks, derivatives, bonds, real estate, and other assets earmarks a Goldilocks economy. This increase can be difficult to see when using broader measures that gauge real economic growth.
• Low market interest rates: These rates are the percentage of a dollar amount that a lender will charge a borrower when they lend money. Market interest rates have a basis on the overnight rate set by the Fed which dictates the rate that banks charge to lend to each other.
• Low inflation: This is measured by the quantitative-based (on a number) consumer price index (CPI). The producer price index (PPI) also identifies this golden economic state. Inflation describes the purchasing power of a nation's money.
• Steady gross domestic product (GDP) or economic growth: This is the most cited indicator of a Goldilocks economy. GDP is a broad economic measure of the value of all services and finished goods that are produced in a country and it's a direct indicator of the health of an economy.

The economy can dip into a recession or an economic downturn if GDP growth is too low. Economists say that the country is experiencing a recession when an economy registers two consecutive quarters or six months of negative GDP growth. But it can lead to a surge in prices in an economy or inflation if GDP growth is too fast.

Maintaining a Goldilocks Economy

Fiscal spending by Congress is one way to help create and manage a Goldilocks economy. Governments can boost their spending through infrastructure projects such as the creation of roads and bridges as well as by writing government contracts with private companies.

The use of taxes is also a tool employed to manage an economy. The reduction of taxes on businesses encourages business investment. Consumer tax cuts encourage consumer spending. But fiscal spending and tax cuts can have mixed results. They're rarely a long-term solution to maintaining the Goldilocks economy.

The U.S. economy typically goes through five phases as part of the business cycle. These stages are growth or expansion, peak, recession or contraction, trough, and recovery. A Goldilocks economy might happen during the recovery and growth phases. It should be considered a temporary state because of the existence of the business cycles.

Goldilocks and the Central Bank

Central banks are responsible for regulating money supply and the banking sector. The banking authority uses monetary policy tools to bring on and maintain a Goldilocks economy.

The Federal Reserve (Fed) is the U.S. central bank. The Fed can cut interest rates, spurring lending in the economy as consumers and businesses increase borrowing to take advantage of lower rates. It can increase interest rates if it feels that the economy is growing too hot and inflation is rising at a faster rate than the Fed's inflation target.

Rising prices can hurt an economy because they tend to lead consumers to cut back on spending. Companies get hurt by inflation if their raw materials become too expensive because the added costs eat into their profits. Businesses can cut investment as a result.

Central banks such as the Fed react by increasing interest rates to slow the growth in an economy, which ultimately slows or prevents inflationary pressures. But their actions can trigger an economic slowdown if they raise interest rates too soon or by too much.

Economic conditions abroad and the response from foreign governments and other national central banks can also influence whether an economy can reach a Goldilocks state.

The Goldilocks Economy and Investing

A Goldilocks economy is ideal for investing. Stocks perform well as companies grow and generate positive earnings growth. The investor gains through share price appreciation and dividends in some cases as the business returns profits to its shareholders. Fixed-income investments such as bonds will hold their value in the absence of inflation.

But the economy can overheat if GDP grows too quickly and inflation creeps up too rapidly. Asset prices can become overvalued in this atmosphere. The Fed may raise interest rates to try to cool down the economy. Rising interest rates break one of the key pillars of the Goldilocks economy and are usually a precursor to its end.

Real-World Examples

Economist David Shulman is widely considered to have coined the phrase "Goldilocks economy" in an article published in 1992, "The Goldilocks Economy: Keeping the Bears at Bay." The U.S. economy of the middle to the late 1990s was considered a Goldilocks economy because it was "not too hot, not too cold, but just right," a phrase that has been used to describe the ideal economy for investors.

The term has also been used to describe the U.S. economy as it recovered from the bursting of the dot-com bubble between 2004 and 2005. The economy grew at 4.3% in 2005, putting the Dow Jones Industrial Average (DJIA) near multi-year highs for that time.

Market participants considered it to be a Goldilocks economy in 2017 with the economy growing at nearly 4%, employment between 3% and 4%, and no real inflation in sight. The Fed hiked interest rates later that year to keep inflation and growth at moderate levels. The global economy was averaging over 3% GDP growth at the time.

The Bottom Line

It can be challenging for central bankers and governments to engineer a Goldilocks economy because many factors must come together for this economic state to exist. The unemployment rate, the inflation rate, market interest rates, inflation rate, and gross domestic product (GDP) must all be in ideal, healthy condition. It can’t just be a flash in the pan but should be a steady economic environment.

A Goldilocks economy can provide an ideal time for investing but be cautious and keep an eye on the contributing data.