What Is the Ideal GDP Growth Rate?

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 percent-3 percent. 

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

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

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 percent 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 Federal Reserve 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 excess money into mediocre investments. When they lose money, they panic. They 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 percent in the third quarter and a whopping 7.1 percent in the fourth quarter. In 2005-2006, the asset bubble was in housing. The economy grew 4.3 percent in the first quarter of 2005, and 4.9 percent in the first quarter of 2006. During both bubbles, GDP growth spiked above 3 percent 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 percent-3 percent. Between 2003-2005, it was 3 percent to 4 percent. That's well above the 2 percent 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 percent in one quarter and shrank in two quarters.

Healthy Rate of Growth Is 2 Percent to 3 Percent

Economists agree the optimal GDP growth rate is greater than 2 percent but less than 4 percent. In between the two recessions, the annual economic growth rate was healthy:

• 2.5 percent in 2003.
• 3.9 percent in 2004.
• 3.2 percent in 2005.
• 2.7 percent in 2006.
• 2.0 percent 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 percent, but the quarterly rates warned of the impending economic weakness in the second half of the year. The economy grew a mere 0.1 percent in Q3. It was an anemic 2.7 percent in Q4. That occurred 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 percent
• Q2 3.1 percent
• Q3 2.7 percent