When is an economy overheating: Yahoo U – Yahoo Finance

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Can an economy pop from too much stimulus? Thats the concern behind overheating, a term thats been the center of economic debate as the $20 trillion U.S. economy re-opens and recovers from the COVID-19 pandemic.

With trillions in stimulus coming from both the federal government and the U.S. central bank, some are concerned that the economy will grow too fast and spur unwanted levels of price inflation.

As Treasury Secretary Janet Yellen once said, expansions dont die of old age.

Overheating is one way for an economic expansion to end. There is no official economic definition for overheating. But one oft-cited indicator of overheating is inflation, or rising prices.

In a healthy economy, unemployment should fall (as people find jobs) and GDP should rise (as economic activity grows). Employed and with income, consumers will demand goods and services.

Producers may adjust prices to capitalize off of the increased demand (and pay for any associated increases in production). In turn, employees of those producers may ask for pay raises that net them more income. Those households can then demand more goods and services, rounding the cycle of wages and prices.

An illustration of a wage-price spiral.

In an overheating economy, this loop repeats several times, leading to rounds of markups in prices and fueling runaway inflation. The so-called wage-price spiral was one of the factors in double-digit price inflation in the 1970s, the most notable example of economic overheating.

Runaway prices can quickly erode the purchasing power of a household. But its not the inflation itself that causes a recession.

To tame the hyperinflation beast, then-Federal Reserve Chairman Paul Volcker dramatically lowered the money supply and ratcheted up short-term borrowing costs, triggering a sharp pullback in economic activity.

The worry is that runaway inflation will again force the Federal Reserve to pump the brakes to dampen inflationary pressures, raising interest rates in a way abruptly ends the recovery.

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Economists have different definitions on what level of inflation constitutes overheating.

One challenge is parsing out true inflationary pressures from those that may be temporary or transitory.

If inflation is rising because of short-term constraints that are likely to fade in a few months, high inflation readings may not be of much concern to policymakers.

But if inflation is due to the wage-price spiral, a deeper, more entrenched dynamic may be at play.

This is why it is difficult to say that a reading of 4% or 5% year-over-year inflation means overheating, since it is all about the persistent nature of the price pressures leading to those readings.

Fed officials have leaned into the transitory side of the debate, saying they expect inflation readings to rise as a result of measurement effects and bottlenecks in the international supply chain.

The Bureau of Economic Analysis publishes the Personal Consumption Expenditures Index, a major source of inflationary data. Since the last crisis, year-over-year inflation in the PCE index have been low compared to growth rates seen in decades before that. Source: Bureau of Economic Analysis

The Fed has also taken note of the fact that inflation has been persistently low since the last crisis, which explains their new framework that will tolerate inflation moderately above its 2% target.

In other words, high monthly inflation readings in the early months of the pandemic recovery are not of immediate concern to policymakers.

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When is an economy overheating: Yahoo U - Yahoo Finance