What Is an Overheated Economy?

Definition and Examples of an Overheated Economy

An overheated economy is one in which output is above potential output or unemployment is lower than the natural rate of unemployment (NRU). Both can happen when the economy grows too fast.

Potential output is the output an economy can sustainably produce given the available amount of resources such as workers, technology, and equipment. The NRU is the lowest level of unemployment an economy can have without creating inflation. It is also called “full employment” and it is considered to be between 4% and 6% in the U.S. An overheated economy is one in which the economy is growing beyond a sustainable rate.

An example of an overheated economy is the period surrounding the financial crisis between 2007 and 2009. Prices rose rapidly in the U.S., and annual inflation was 2.9% in 2007 and 3.8% in 2008, which is higher than the target inflation rate the central bank sets at 2%. The unemployment rate was 4.6% in 2007, which was also on the low end of (or below) the NRU. The unemployment rate eventually rose to 5.8% in 2008 and over 9% in 2009 and 2010, and inflation dropped back down below 2%.

How Does an Overheated Economy Work?

Typical signs that an economy may be overheating are rising wages and prices due to an increase in lending. If interest rates are low for a prolonged period of time, consumers and businesses may borrow money to spend on goods and investments. The increased demand for consumer goods and assets leads to higher prices. The rise in asset prices encourages more lending as people feel wealthier, creating a feedback loop than can generate an asset bubble.

For example, the low interest rates preceding the U.S. financial crisis between 2007 and 2009 contributed to an overheated economy as more people borrowed money to buy real estate (due to the lower costs of borrowing). Prices on real estate began to rise, creating an asset bubble—often referred to as the housing bubble.

When an asset bubble bursts, asset prices will collapse, and lenders will cut back on how much credit they let people borrow. The housing bubble ultimately burst, and by 2012, many cities saw home prices fall. From 2006 to 2012, housing prices fell 62% in Las Vegas, 54% in Phoenix, and 50% in Miami. This type of situation not only hurts banks that are not paid back on mortgage loans they extended, but also the economy as a whole as lending and investment fall.

How Do You Cool an Overheated Economy?

One way for central banks to cool an overheated economy is to use tight monetary policy. Tight monetary policy attempts to slow down inflation and make it more expensive for consumers and businesses to borrow money. This will decrease the demand for consumer goods and assets.

An example of tight monetary policy would be raising interest rates. For example, the U.S. central bank (the Federal Reserve) could raise the federal funds rate; this influences other interest rates in the economy, such as mortgage rates and bank loans, to help make it more expensive for consumers and businesses to borrow money. This could help cool an overheated economy.

Is the U.S. Economy Overheated?

The COVID-19 pandemic caused human and economic hardship globally. The Federal Reserve enacted several responses, including cutting interest rates, stabilizing the financial markets, starting a corporate bond purchase program, and its Paycheck Protection Program Liquidity Facility, designed to help businesses with access to liquidity or cash.

Once the economy bounced back and unemployment fell, prices began to rise. While the Federal Reserve maintained that the U.S. economy was not overheating and inflation was temporary in 2021, there were signs that the economy was beginning to overheat.

In a Federal Reserve report from July 9, 2021, the Fed showed the increase in demand for goods and the decrease in the supply of goods due to materials and labor shortages. As a result, prices began to increase, and by the fall, inflation was at a high not seen since June 1982.

In November 2021, inflation reached 6.8%, and the unemployment rate was 4.2%. Global demand also surged in 2021 due to many stimulus measures and low interest rates. This pushed up prices on many consumer goods and assets even more. In response to the added wealth of businesses, the wages of workers increased. Workers had more money to spend by the end of 2021, and demand was further pushed up. In addition, there were and still are supply chain bottlenecks due to a shortage of workers and raw materials, which has further pushed up prices and contributed to inflation. These were all contributing factors to the rapid rise in prices in 2021—a typical sign of an overheated economy.

In December 2021, the Fed released a statement acknowledging the imbalance between supply and demand. While it maintained a low federal funds rate of between 0% and 0.25%, it did state that it was prepared to change that rate if and when the labor market reached levels in line with its ideal employment.

As of March 2022, the unemployment rate was 3.6%, and inflation had increased to 8.5%, which is significantly higher than the normal 1% to 2% inflation rate for the United States. The Federal Reserve needed to reverse course and, in March, began tightening monetary conditions by increasing interest rates and accelerating the end of the Fed's bond purchase program. These actions are designed to slow down the economy and bring down inflation.