Why the Sahm rule might not matter this time

The Sahm rule, devised by former Federal Reserve economist Claudia Sahm, is, nominally, a way of timing the onset of recessions. The rule states that when the three-month moving average of the unemployment rate is 0.5% higher than the lowest three-month moving average of the preceding 12 months, a recession has begun.

The July labor report that came out at the beginning of August was closely watched by those who fear a recession may be around the corner. There was a good reason for this: the unemployment rate had been creeping higher in recent months and a bad report would trigger the Sahm rule, potentially meaning a downturn was underway. In the event, the July labor report revealed that the economy created 114,000 new jobs (well below the expected 175,000) and, critically, that the unemployment rate rose to 4.3%. And so the Sahm rule was triggered.  

Wall Street sold off sharply that day, with the S&P off 1.8%, the Nasdaq down 2.4% and the small cap Russell 2000 (beneficiary of a “great rotation” in July) selling off 3.5%. Bond prices jumped in response, with rates on 10-year Treasuries falling 18 basis points to 3.8%.

Fortunately, though it’s generally been accurate, there is good reason to doubt the Sahm rule narrative this time. How the Sahm rule gets triggered may matter more than that it gets triggered. Why? The 0.5% level is not magic. Looking back in time, one can see that recessions don’t generally begin with Sahm indicators slowly going from 0.4% to 0.5%. Instead, they typically go in a flash from well below 0.5% to well above it.

We might ask how quickly the labor market sours once the Sahm rule has been triggered. In recessionary periods since 1960, only twice has it taken the Sahm indicator more than four months to get from 0.50% to 1.0%. In 1970 and 1974, it took six and seven months, respectively. Sometimes it’s only taken a month or two. In recessions, the Sahm indicator doesn’t usually creep through the 0.5% level; it flies past it.

Furthermore, other data has mostly (though not universally) been positive lately. Second quarter gross domestic product (GDP) came in significantly stronger than expected at 2.8% versus the 2.1% forecast. The Atlanta Fed’s GDPNow site currently projects a 2.0% GDP growth rate in the third quarter. The economy continues to add jobs, and, importantly, layoffs have been modest.

Claudia Sahm devised her eponymous rule as part of an unrealized proposal to make stimulus payments routine at the beginning of recessions. Keynesian theory says that timely distribution of stimulus payments can reduce the severity of recessions. To that end, a heuristic was needed, a bright line to signal the start of recessionary conditions.

As for Claudia Sahm’s view of the current state of affairs? She has said that recession risks are elevated but that a recession is not foreordained. Also, Sahm hailed the Federal Reserve’s recent dovish turn, citing in particular this line from Fed Chair Jerome Powell’s Jackson Hole speech: “We do not seek or welcome further cooling in labor market conditions.”

It may be that, much like with the yield curve inversion, the generally reliable Sahm rule has met its match in the post-Covid environment. Is a recession possible? Sure, but then it’s always possible. Rate hikes are clearly taking a toll on the economy – there’s a reason the unemployment rate has been inching higher. Following the July labor report, the Fed is likely to cut at a less leisurely pace than it otherwise might have. But on its own this labor report does not mean that we are now in a recession.