American economist Claudia Sahm, best known for developing the Sahm rule recession indicator, which identifies signals related to the start of a recession, calmly assessed that “the U.S. is not in a recession.”
“The Sahm rule is a simple indicator based on the unemployment rate, but it’s too simple for the complicated economic situation the U.S. is in right now,” said the former Federal Reserve economist during a recent video interview with the WEEKLY BIZ, just before the Fed cut interest rates by a half percentage point. “This has been an unusual cycle in many ways.”
The Fed uses the Sahm rule to detect signs of a recession by tracking unemployment trends. An economy is considered to have entered a recession when the three-month moving average of the national unemployment rate rises by 0.50 percentage points or more relative to its low during the previous 12 months.
The indicator has proven mostly accurate over the past 50 years. But Sahm claims the rule does not apply this time—like a prophet denying her prophecy.
“Part of the reason the unemployment rate is rising in the U.S. is because of the influx of more people wanting to work, which is a good dynamic,” she explained. “It’s different from past recessions, when businesses held back from hiring and unemployment went up.”
A weak employment report recently fueled recession fears in the U.S. The U.S. unemployment rate, which remained in the 3% range since February 2022, climbed to 4.3% in July this year. In July, the average unemployment rate over the last three months was 0.53 percentage points higher than the three-month moving average of the previous 12 months, exceeding the 0.5 percentage point threshold that the Sahm rule uses to determine a recession. Last month, the figure rose to 0.57 percentage points.
Moreover, a lower U.S. GDP growth forecast and waning expectations for manufacturing activity have also rekindled worries that a recession may be imminent. Despite these concerns, Sahm expects the U.S. is headed for a soft landing, not a full-blown recession.
“The rule may not apply this time”
Why do you believe the Sahm rule may not apply this time?
“In the four and a half years since the COVID-19 pandemic began, economic indicators have become more erratic than in the past. With heightened uncertainty, the relationships between these indicators have not made sense. The Sahm rule triggering when there is no recession is just another in a very long list of macroeconomic rules of thumb that have fallen apart in this cycle.”
Is it not true that the rising unemployment rate is a basis for the law of three?
“It is true that the U.S. unemployment rate is increasing, and the labor market is cooling down. However, the low unemployment rates we saw in recent years due to labor shortages were unlikely to last. Instead, we should view this period as a return to normalcy. Recently, unemployment has increased because people who left the workforce during the pandemic are now actively seeking jobs again. Additionally, the rise in immigrant inflow, as lockdown measures have eased, could also be contributing to higher unemployment. The current participation rate in the labor market is at its highest in recent years, indicating a robust labor market.
However, if corporate profitability declines or if consumers reduce spending, leading to a decrease in employment, it could trigger a recession. But the current increase in unemployment is somewhat different. If hiring demand continues to rise in line with the labor market supply, the Federal Reserve does not need to be overly concerned about this strong labor market.”
Concerns about a recession grew as the July unemployment rate rose to 4.3%.
“The significant reaction to the July unemployment rate stemmed from it being worse than expected (the market had anticipated 4.1%). The August unemployment rate (announced after the interview as 4.2%) is also not ideal, as the labor market has been cooling for several months. However, the July unemployment rate of 4.3% is historically low. It is challenging to determine a recession based solely on the unemployment rate. There have been times when the unemployment rate was below 4% while the U.S. was in recession, and times when it was between 7-8% but was not considered a recession. While the unemployment rate is a useful indicator, relying on it alone can oversimplify the causes of a recession.”
Do you believe the U.S. economy can avoid a recession based on the unemployment rate alone?
“If the current increase in the unemployment rate remains at this level, it would be difficult to consider the situation a recession. Typically, during an actual recession, unemployment rises by at least 2 percentage points and can rise up to 4 percentage points compared to pre-recession levels. However, it is also important not to dismiss the current rise in unemployment. We need to continuously evaluate the potential for a recession given the small fluctuations in this indicator.”
Sahm expects a soft landing ahead
The recent economic outlook has worsened.
“I still expect the U.S. economy to achieve a soft landing and do not anticipate a recession. The manufacturing purchasing managers’ index (PMI), a key indicator of the manufacturing outlook, has deteriorated. (This index dropped from 50.3 in March to 46.8 in July, falling below the recession benchmark of 50. If manufacturing remains sluggish, employment could worsen.) However, this index has been poor for the past two years. There are also concerns that the GDP growth rate forecast for the third quarter has dropped to the low 2% range. Nonetheless, indicators related to industrial production and domestic wages are not showing signs of contraction. The underlying strength of the U.S. economy remains robust and is performing better than most other economies.”
With rising oil prices due to Middle Eastern conflicts, won’t that lead to inflation?
“The Federal Reserve seems to believe there is no immediate need to worry about inflation. Their current focus is more on employment than on inflation. This doesn’t mean there are no inflation risks, but inflation has become a lower priority in their objectives. The inflation rate is still above 2%. There are risks of inflation from rising oil prices due to geopolitical conflicts. Moreover, with the November elections approaching, the policies proposed by candidates from both parties include measures that could drive up prices (such as tax cuts or expansions in social security, which increase disposable income).”
Are there other risks to the U.S. economy?
“My biggest concern is that efforts to control inflation could unnecessarily slow down the economy. This could reduce the demand for labor and leave capable and willing workers without jobs. In that sense, a recession is close to being ‘pure evil.’ Historically, we’ve been caught off guard in the financial sector. Last year, there were worries about commercial real estate shaking the U.S. financial markets. Today’s economy is highly dependent on financial assets, and everyone is making bets based on their predictions. Sometimes, these bets can go wrong, potentially leading to economic or financial crises. Policymakers should not take the strength of the U.S. economy for granted. The U.S. economy is not ‘recession-proof’ in any way. I’m also not saying there’s nothing to be concerned about regarding the current economic situation.”
Sahm recalls Powell as an excellent communicator with an open mind
How would you evaluate Jerome Powell’s leadership as the Fed Chair?
“The Fed is a smaller organization than people think. Although I didn’t serve directly as an aide to Chair Powell, I had several opportunities to meet him. When I left the Fed, I wrote an article for The New York Times about him, where I pointed out what many others did: ‘Powell is not an economist; he’s a lawyer.’
However he’s incredibly smart and has made a significant effort to understand economic models. The fact that he wasn’t an economist might have actually been an advantage, as it kept him open-minded and prevented him from getting stuck in dogma. Most importantly, Powell is an excellent communicator. The Fed has been given a large ‘megaphone’ that allows them to influence economic and financial markets, and Powell’s straightforward manner of speaking makes his remarks much easier to understand compared to his predecessors. At times, it feels like Powell is playing both the role of referee and commentator for the financial markets.”
There’s criticism that Powell’s words have an outsized influence on asset markets. What are your thoughts on this?
“It’s true that in today’s economy, financial markets play a huge role. Powell often takes on a ‘leading actor’ role in these markets. Treasury Secretary Janet Yellen also has a major influence on the financial markets, as do several other key players. The Fed’s policy objectives are maximum employment and price stability, but their tools, like interest rates, work through financial markets. This means the Fed and financial markets are naturally interconnected. Ideally, the Fed Chair’s words shouldn’t cause the market to fluctuate too much, as it’s not an ideal situation.”
☞ The Sahm Rule
The Sahm Rule is a U.S. economic recession predictor created by former Federal Reserve economist Claudia Sahm in 2019. According to the rule, if the average unemployment rate over the last three months increases by more than 0.5 percentage points compared to the lowest average rate of the previous 12 months, it signals that the U.S. economy has entered a recession.
☞ Claudia Sahm
Claudia Sahm is a former economist at the U.S. Federal Reserve and currently serves as the chief economist at the investment firm New Century Advisors. During her time at the Fed from 2007 to 2019, she analyzed employment and household spending. She gained attention for devising the ‘Sahm Rule’ in 2019, which uses unemployment rates to detect recessions. This rule is currently maintained as official economic data by the Federal Reserve. Sahm holds a Ph.D. in economics from the University of Michigan and has also worked at the Brookings Institution and the White House Council of Economic Advisers (CEA).
