What Is a Goldilocks Economy?

A Goldilocks economy describes an ideal state for an economy whereby the economy is not expanding or contracting by too much. A Goldilocks economy has steady economic growth, preventing a recession, but not so much growth that inflation rises by too much.

Goldilocks Economy Explained

Goldilocks economy is an economy that's operating in an optimal state by providing full employment and economic stability. The ideal conditions are typically characterized by a low unemployment rate, increasing asset prices such as stocks and real estate, low-interest rates, steady GDP or economic growth, and low inflation.

GDP is the Gross Domestic Product and is a measure of the production of goods and services in an economy. If growth is too low, the economy can dip into a recession or an economic downturn, which is characterized as two consecutive quarters or six months of negative GDP growth. If GDP growth is too fast, it can lead to a surge in prices in an economy or inflation.

The U.S. economy typically goes through five phases as part of the business cycle: growth or expansion, peak, recession or contraction, trough, and recovery. A Goldilocks economy may occur during the recovery and growth phases.

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.

Key Takeaways

  • A Goldilocks economy describes an ideal state for an economy whereby the economy is not expanding or contracting by too much.
  • A Goldilocks economy has steady economic growth, preventing a recession, but not so much growth that inflation rises by too much.
  • A Goldilocks state is ideal for investing because as companies grow and generate positive earnings growth, stocks perform well.

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 roads and bridges as well as government contracts with private companies. Governments also cut taxes of businesses, and consumers to encourage business investment and consumer spending. The effects of fiscal spending can have mixed results and is rarely a long-term solution to maintaining the Goldilocks economy.

Central banks, which regulate the money supply and the banking sector in an economy can use monetary policy tools to bring on and maintain a Goldilocks economy. The U.S. Federal Reserve bank or the Fed can cut interest rates, which spurs lending in the economy as consumers and businesses increase borrowing to take advantage of lower rates.

Conversely, the Fed can increase interest rates if 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 consumers tend 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 central banks can also influence whether an economy can achieve a Goldilocks state.

It can be challenging for central bankers and governments to engineer a Goldilocks economy since there are many factors that need to come together for this economic state to exist.

The Goldilocks Economy and Investing

A Goldilocks state is ideal for investing because as companies grow and generate positive earnings growth, stocks perform well. In the absence of inflation, fixed income investments such as bonds will hold their value. If GDP grows too quickly, however, and inflation creeps up too rapidly, the economy can overheat, and asset prices can become overvalued. Rising interest rates break one of the key pillars of the Goldilocks Economy and are usually a precursor to its end.

Real World Example of a Goldilocks Economy

The economist David Shulman is widely considered to have coined the phrase "Goldilocks economy." The U.S. economy of the mid- to late-1990s was considered a Goldilocks economy because it was "not too hot, not too cold, but just right"—a phrase that's been used to describe the ideal economy for investors.

The Goldilocks term has also been used to describe the U.S. economy as it recovered from the tech bubble burst in 2004–2005 as reported by CNN Money. In 2005, the economy grew at 4.3% putting the Dow Jones Industrial Average near multi-year highs for that time.

In 2017, with the economy growing at near 4%, and at full employment or 3-4%, and with no real inflation in sight, market participants considered it to be a Goldilocks economy as reported by CNBC. The Federal Reserve went on to hike interest rates to keep inflation and growth at moderate levels. The global economy was averaging over 3% GDP growth at that time.

Because of the existence of business cycles, a Goldilocks economy should be considered a temporary state.