Ideal GDP Growth Rate for the Economy

The healthy GDP growth rate is one that is sustainable so that the economy stays in the expansion phase of the business cycle as long as possible. GDP is the nation's gross domestic product. That's the entire economic output for the past year. The GDP growth rate is how much more the economy produced than in the previous quarter. The ideal rate is between 2%-3%.

In a healthy economy, unemployment and inflation are in balance.

The natural rate of unemployment will be between 4.7% and 5.8%. The target inflation rate will be 2.0%.

You'd think the more growth, the better. However, a healthy GDP growth rate is like a body temperature of 98.6 degrees. Obviously, if your temperature is lower than the ideal, you know you're sick. If it's too low, you're near death. But a higher temperature can also mean you're sick. If it's over 100, you have a fever. If it's above 104 degrees for any period, you're deathly ill.

If the economy grows too slowly, or even contracts, it's obviously not healthy. But, if it grows too fast, that's not ideal, either. In fact, if GDP growth starts spiking above 4% for several quarters, it usually means there is an asset bubble of some kind. In the business cycle, the phase that follows expansion is the peak.

The economy goes into recession if the Fed does nothing. That's because when the economy grows too fast, it overheats.

There's too much money chasing too few real growth opportunities. Investors start putting good money into not-so-good investments. When those investments start losing money, confidence is lost. Panic ensues, investors start selling, causing more investments to lose money. It doesn't end until prices are low enough to stop the madness and attract investors again.

For more, see 3 Causes of the Business Cycle.

Examples

Sure enough, in 1999-2000, there was irrational exuberance around high technology stocks. By 1999, U.S. GDP growth was 5.1% in the third quarter and a whopping 7.1% in the fourth quarter. In 2005-2006, the asset bubble was in housing. The economy grew 4.3% in the first quarter of 2005, and 4.9% in the first quarter of 2006. During both bubbles, GDP growth spiked above 3% for several quarters in a row.

When GDP growth is above the ideal, it can also cause inflation. During 1999-2000, U.S. inflation was 2.7%-3%. Between 2003-2005, it was 3%-4%. That's well above the 2% target inflation rate.

Once the bubble bursts, the economy enters the contraction phase of the business cycle. GDP growth usually falls off sharply and goes into negative territory, which signals a recession. During 2008-2009, U.S. GDP contracted in five quarters. Between 2000-2002, it only rose above 2% in one quarter and shrank in two quarters.

Healthy Rate of Growth Is 2%-3%

Therefore, economists agree the optimal GDP growth rate is more than 2%, but less than 4%.

In between the two recessions, the annual economic growth rate was healthy:

2.5% in 2003.
3.9% in 2004.
3.2% in 2005.
2.7% in 2006.
2.0% in 2007.

Annual growth rates mask a lot of monthly volatility. Clues of the impending financial crisis of 2008 appeared in these less-than-ideal quarterly GDP growth rates. For example, the annual growth rate for 2006 looked great at 2.7%, but the quarterly rates warned of the impending economic weakness in the second half of the year. The economy grew a mere .1% in Q3, and an anemic 2.7% in Q4. In fact, this was right after the housing boom hit its peak. The subprime mortgage crisis was the culprit.

In 2007, it looked like the economy was going to recover, and the damage would be confined to housing. Then, growth dropped significantly in Q4:

Q1 0.2%
Q2 3.1%
Q3 2.7%
Q4 1.4%.

During the 2008 recession, GDP growth rates were abysmal. The troubles in housing had spread to the investors in mortgage-backed securities, as the financial crisis infected the rest of the economy.

Q1 -2.7%
Q2 2.0%
Q3 -1.9%
Q4 -8.2%.

Obama Inherited an Unhealthy Economy

The new President launched the Economic Stimulus Program in March 2009 to restore confidence and spur the economy into health. Before it could be implemented, the first two quarters in 2009 were still negative. They returned to positive territory in the third quarter.

Q1 -5.4%
Q2 -0.5%
Q3: 1.3%
Q4: 3.9%.

Growth rates in each quarter of 2010 were positive, but not steadily within the 2-3% range. In 2011, the economy contracted in the first quarter. High foreclosures from the subprime mortgage crisis were preventing the housing market from recovering.

Is The Economy Healthy Now?

Many analysts complain that the current U.S. recovery is tepid, lackluster, and unhealthy. They claim that attempts to spur economic growth have failed. Politicians assert their policies will restore growth to 3-4% rate. But, they don't realize that growth is, for the most part, within a healthy range.

Here's GDP growth by each quarter since 2012. It shows a seasonal drop, due to the fiscal cliff, sequestration, and winter weather, followed by an uptick in the second half of the year. Despite this volatility, annual growth averaged out to within the healthy range. For more, Current GDP Growth Rates.

2012 2.2% Healthy

Q1    2.7%   Healthy
Q2   1.9%   Presidential campaign created uncertainty.
Q3   0.5%   Superstorm Sandy
Q4   0.1%   Fiscal cliff created uncertainty. Sequestration cut defense spending.

2013 1.7% Slow growth

Q1    2.8%   Cold weather didn't have impact on sales, as originally thought.
Q2   0.8%   Effect of elimination of payroll tax exemption.
Q3   3.1%   Healthy
Q4   4.0%   High despite government shutdown. Auto sales spurred by low interest rates.

2014   2.4%   Healthy
Q1   -1.2%   Low due to inventory write down after lackluster holiday sales.
Q2   4.0%   High as growth rebounded from a bad 1st quarter
Q3   5.0%   High due to 16% bump in military spending.
Q4   2.3%   Healthy

2015   2.6%   Healthy
Q1   2.0%   Too low due to winter storms.
Q2   2.5%   Healthy as economy rebounded.
Q3   2.0%   Barely healthy
Q4   0.9%   Strong dollar slows exports, a key component of GDP.

2016
  Q1   0.8%   Stock market falls, reducing business investment.
Q2   1.2%   Strong dollar slows exports, despite strong consumer spending.

GDP Frequently Asked Questions

What Is Real GDP?
What Are the Components of GDP?
What's the Best Way to Compare GDP Between Countries?
What Is GDP vs. GNP?
When Should You Use GDP vs. Gross National Income?
What's a Recession?
What's a Depression?

What Is the Ideal GDP Growth Rate?