For more than two years, the US Federal Reserve has been pushing interest rates up to slow inflation while hoping they don’t tip the economy into a recession. It’s a high-wire act that would be easier if there were a reliable gauge of where the recession risk stands at any particular moment. Anxieties prompted by a weak July jobs report were heightened by the fact that the data triggered what’s known as the Sahm rule, devised by and named after economist Claudia Sahm. But Sahm is one of a number of economists who argue that this time might be different — that the uptick in unemployment may have more to do with the aftermath of the pandemic.
1. What is the Sahm rule?
The Sahm rule states that when the three-month moving average of the unemployment rate (that is, an average that combines the rate of the three most recent months) rises by half a percentage point or more from its lowest level over the past 12 months, the US economy is in the beginning of a recession.
That wire was tripped when the unemployment rate in the July jobs report rose to 4.3%. That put the average of the May, June and July jobless rates at 4.1% — 0.6 percentage points higher than the low of 3.5% in the July 2023 labour market report.
2. Does it work?
Generally, it seems to. Sahm, chief economist at New Century Advisors and a columnist for Bloomberg Opinion, developed her eponymous indicator in 2019, when she was a staffer at the Federal Reserve. It hinges on a critical fixture of how unemployment behaves. It goes up slowly before the start of a recession, but ratchets up very quickly once a downturn is imminent or underway.
A look back over the past 50 years of economic data shows the rule has played out accurately, with unemployment zooming up at the start of each downturn.
3. Why are rules like this important?
Monetary policy works slowly. Central banks often fall behind in fighting inflation, as happened with the Fed in 2021, or keep rates high for too long as the economy weakens, thereby causing recessions or making them worse. So a timely warning light can be a huge help.
Economic “rules,” of course, are not like the laws of physics. They are observations about the effects of human behaviour, so their accuracy can change over time as trends shift or when something external or unexpected — bad or good — disrupts an economy significantly. Economists and policymakers largely use them as guideposts but don’t always heed their suggestions closely.
Economists have been closely watching the Sahm rule over the past year as the unemployment rate has gradually risen. While it hasn’t surged to concerning levels yet, experts are worried the labour market could be on the precipice of more accelerated job losses. Economists often say the unemployment rate goes up like a rocket and down like a feather.
4. What happened in the labour market?
The unemployment rate in July came in at 4.3%, the highest level in almost three years and up from a post-pandemic low of 3.4% reached at the start of 2023. But even with that increase, it’s still at a very low level historically. The average jobless rate over the past 50 years is above 6%; rates below 4% hadn’t been seen since the late 1960s.
Digging beneath the hood of the topline unemployment number, many components of the labour market remain healthy. Layoffs are still low and job vacancies, while down, remain elevated. Moreover, the July jump in unemployment was partly driven by a tick up in the participation rate, or the number of Americans who are either employed or actively looking for a job. That’s generally regarded as a positive. It means many of the newly unemployed are coming off the economy’s sidelines, not losing their jobs.
But the latest unemployment figure exceeded estimates from both economists and Fed policymakers. Job creation has also slowed, to an average pace of 170,000 over the last three months, down from nearly 300,000 per month last year.
5. What about the rest of the economy?
The economy as a whole was chugging along at a decent clip, though pockets of weakness were starting to emerge. Growth clocked in at 2.8% in the second quarter, a level that’s consistent with the historical norm. But lower-income Americans weren’t faring as well. Consumer spending was down, and, as pandemic savings became depleted, defaults on credit cards and auto loans started to rise.
One thing that worries some is the Fed’s interest rate, which they’ve held at a 23-year high for a year now. With unemployment rising, concern is mounting that when policymakers do begin easing policy, it’ll be too late.
6. What does Sahm say?
That the recovery from Covid has been as unusual as the pandemic itself. The massive layoff of workers in very specific sectors (anything involving in-person interaction) in 2020 and then the scramble to rehire them as restrictions were lifted has some managers more apprehensive about letting people go. That could keep the unemployment rate lower. In addition, the US has seen a huge increase of migrants entering the country over the past few years, with Goldman Sachs Group Inc estimating that 2.5mn arrived in 2023 alone. That influx has likely driven higher growth in the US, economists say, and could help lower the unemployment rate in coming months as the labour force continues to absorb those new entrants.
Sahm has said these factors may mean that her rule is overstating labour market weakness. She also points to the still-low level of layoffs and robust participation levels as indicators that the labour market may not be pushing the economy to the verge of a recession.
“The US is not in a recession, despite the indicator bearing my name saying that it is,” Sahm wrote in an August 7 Bloomberg Opinion column. Still, Sahm argues, it’s a relevant indicator and shows the Fed should start cutting interest rates.
7. How has the Fed reacted?
Fed officials, who until recently were laser focused on cooling inflation, are now paying more attention to the labour market.
“What we think we’re seeing is a normalising labour market and we’re watching carefully to see if it turns out to be more,” Fed Chair Jerome Powell said in a July 31 press conference, before the latest jobs report was published. If “it starts to show signs that it’s more than that, then we’re well-positioned to respond.” Powell and others have indicated the first rate cut could come as soon as September. After the July jobs report was released in early August, futures markets began betting Fed policymakers will deliver larger-than-normal cuts at each of their three remaining meetings this year.
