How hot is your porridge, Canada?

A Goldilocks economy is when growth isn't too hot, causing inflation, nor too cold, creating a recession. It has an ideal growth rate of between 2-3 percent, as measured by GDP growth. It also has moderately rising prices, as measured by the core inflation rate. The U.S. Federal Reserve has set this target inflation rate at two percent. Ideally, you want to create enough demand to keep the economy humming at a healthy pace.

This state is ideal for investing, because as companies grow and generate positive earnings growth, stocks perform well. In the absence of inflation, fixed income investments such as bonds will hold their value. If GDP grows too quickly, however, and inflation creeps up too rapidly, the economy can overheat and a bust can result as asset prices become overvalued. Central bankers will react by increasing interest rates to try and stem inflationary pressures. Rising interest rates break one of the key pillars of the Goldilocks Economy and usually are a precursor to its end.

There are many factors that need to come together for this economic state to exist. Specifically, central bankers need to conduct a monetary policy that prevents inflation and promotes economic growth. If bankers raise interest rates too soon, it can trigger an economic slowdown. Raising interest rates too late can allow inflation to get out of control.

The BoCjust raised its benchmark rate last week prompting discussion around Goldilocks in the Canadian context. In my opinion, the next move will be critical. Turn down the heat on the economy too much or too quickly, and the porridge could easily get too cold. Business investment is already slowing, and higher rates would support the already-strong dollar, hurting exports. Even worse, the withdrawal of rate stimulus might not just shrink the household debt bubble, but burst it. How far can the Bank raise rates before Canadian consumers find they can’t pay their bills or sustain their home equity lines of credit? If the bears lose their highly leveraged house, Goldilocks won’t even have a place to break into.

If President Donald Trump makes good on his continuing threats to pull out of NAFTA (now under difficult renegotiation), Canadian exports, imports and GDP growth will all take a hit, even as consumer prices are likely to soar. If the Bank of Canada tightens just as NAFTA disintegrates, watch out; on the other hand, a one-per-cent policy rate doesn’t leave the Bank much room to ease if NAFTA falls.

In 2017, remarkably calm financial markets and steady real estate fundamentals co-existed with high and rising real estate prices and geopolitical turmoil. The question is if this would continue in 2018-19. As a base case, benign macroeconomic conditions could be characterized by steady global growth, gradual increases in interest rates/inflation, and continued relative calm in the capital markets across all asset classes.

Lastly, while Goldilocks didn’t end up with more than a scare as she hopped out of the window, we’ll need to remember that Goldilocks moments tend not to last. The only real question is how they end.