What Is an Overheated Economy?

An overheated economy is one that has experienced a prolonged period of good economic growth and activity that has led to high levels of inflation (from increased consumer wealth). This sharp rise in prices causes inefficient supply allocations as producers overproduce and create excess production capacity in an attempt to capitalize on the high levels of wealth.

Unfortunately, these inefficiencies and inflation will eventually hinder the economy's growth and can often be a precursor to a recession.

Understanding an Overheated Economy

Simply put, an overheated economy is one that is expanding at a rate that is unsustainable. There are two main signs of an overheating economy.

Rising rates of inflation are typically one of the first signs that an economy is overheating. As a result, governments and central banks will usually raise interest rates in an attempt to lower the amount of spending and borrowing. While central banks can combat rising inflation through interest rate increases, they can often come too late. Because inflation is a lagging indicator, it can take a while for changes in policy to reduce the rate. 

Between June 2004 and June 2006, the Federal Reserve Board increased the interest rate 17 times as a gradual means of slowing America's overheated economy. However, two years later U.S. inflation hit 5.6 percent, a cycle high. This rapid rise in prices was followed by a crippling recession, which saw inflation plunged below zero within six months. 

The second sign of an overheating economy is an unemployment rate that is below the normal rate for a country. Ideally, full employment should be good news. But full employment also means higher inflation since everyone has a job (meaning productivity is at an all-time high) and money to spend.

In all recessions after World War II, the unemployment rate fell below 5% in the years immediately preceding the period. The Congressional Budget Office (CBO) estimates that the unemployment rate has varied between 4.7% and 6.3% since the Second World War. The unemployment rate fell below 5% in the years before the Great Recession. There are other characteristics of overheated economies, such as abnormally high levels of consumer confidence followed by a sharp reversal. 

Key Takeaways

  • An overheating economy is an economy that is expanding at an unsustainable rate.
  • The two main signs of an overheating economy are rising rates of inflation and an unemployment rate that is below the normal rate for an economy.
  • Causes of an overheating economy range from external economic shocks to asset bubbles.

Causes of an Overheating Economy

The two main signs outlined above are also causes of an overheating economy. Other causes of an overheating economy include asset bubbles and external economic shocks. An example of the latter are the oil shocks that occurred during much of the 1970s and 1980s. They resulted in recessions of varying periods and intensity as America's oil import bill grew to meet increased demand for gasoline.

Asset bubbles are an unsustainable increase in prices for certain assets. This is a sign of overheating. The bursting of the dot com bubble in 2001 resulted in a recession. More recently, the 2008 financial crisis was the result of a bubble in real estate mortgages. The bubble had wide-reaching implications across geographies and resulted in a prolonged recession that spanned multiple geographies.

Example of an Overheating Economy

The Great Recession during the late 2000s was preceded by an overheating economy. The unemployment rate continuously fell till 2007, culminating at a rate of 4.6% (below the normal rate) in that year. Meanwhile, the inflation rate, which had been steadily rising, peaked at 5.25% in 2006, when Ben Bernanke became the Fed Chair and right before the crisis. Another sign of a US economy that was overheating was the real estate asset bubble that burst in 2007 and sent shock waves through the entire US financial ecosystem. Compounding these problems was the government's spending. During President Clinton's years, the federal budget had a surplus. However, President Bush's tax cuts converted that surplus into a deficit. In 2005, the Congressional Budget Office (CBO) estimated that there would be a budget deficit of $368 billion that year and it would be followed by a deficit of $295 billion the next year. In short, the US economy demonstrated the hallmarks of an overheating economy in the years leading up to the recession.