Goldilocks Economy Definition, What Makes It Work

What Is a Goldilocks Economy?

A Goldilocks economy is not too hot or 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. In this perfect state, there is full employment, economic stability, and stable growth. The economy is not expanding or contracting by a large margin.

A Goldilocks economy is thus warm enough with steady economic growth to prevent a recession; however, growth is not so hot as to push it into an inflationary status.

Understanding a Goldilocks Economy

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

• Low unemployment: A low unemployment rate, most commonly known as the U3 rate, defines the number of people willing and able to work but unable to find gainful employment, and who have sought work in the past four weeks. The U.S. Federal Reserve (The Fed) estimates a normal 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 will earmark a Goldilocks economy. This increase is 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 banks charge to lend to one another.
• Low inflation as measured by the quantitative-based—based on a number—consumer price index (CPI) and 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 the Goldilocks economy. GDP is a broad economic measure of the value of all services and finished goods produced in a country and is a direct indicator of the health of an economy.

If GDP growth is too low, the economy can dip into a recession or an economic downturn. When an economy registers two consecutive quarters—or six months—of negative GDP growth, economists say the country is experiencing a recession. Meanwhile, if GDP growth is too fast, it can lead to a surge in prices in an economy or inflation.

Maintaining a Goldilocks Economy

Fiscal spending by Congress is a 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 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, while consumer tax cuts encourage consumer spending. However, the effects of fiscal spending and tax cuts can have mixed results and is rarely a long-term solution to maintaining the Goldilocks economy.

Goldilocks and the Central Bank

Central banks are responsible for regulating the money supply and the banking sector. The banking authority uses monetary policy tools to bring on and maintain a Goldilocks economy. The U.S. central bank is the Federal Reserve. The Fed can cut interest rates, spurring lending in the economy as consumers and businesses increase borrowing to take advantage of lower rates. Conversely, the Fed can increase interest rates if it feels 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 it tends to lead consumers to cut back on spending. Companies get hurt by inflation if their raw materials become too expensive since the added costs eat into their profits. As a result, businesses can cut investment.

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

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

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 may happen during the recovery and growth phases. Also, because of the existence of the business cycles, a Goldilocks economy should be considered a temporary state.

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

However, if GDP grows too quickly and inflation creeps up too rapidly, the economy can overheat. In this atmosphere, asset prices can become overvalued.

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

The economist David Shulman is widely considered to have coined the phrase "Goldilocks economy" in an article published in 1992 called "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. In 2005, the economy grew at 4.3%, putting the Dow Jones Industrial Average (DJIA) near multi-year highs for that time.

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