Developed by former Fed economist Claudia Sahm, the rule is based on the idea that, when people start losing jobs, they cut back on spending, and this causes more job losses. Often, the downturn starts slowly. A small rise in unemployment can seem trivial in a labor force of 168 million people. But layoffs can escalate quickly, which is why this indicator has been so accurate over time.
After Friday’s jobs report, the Sahm Rule rose to 0.43. This is uncomfortably close to the recession trigger of 0.5. And it’s more than double the 0.2 level at the start of the year. To put it another way, 800,000 more people are unemployed now than a year ago.
It’s true that, in many ways, the U.S. economy looks great right now. Growth is solid. Inflation has come way down. The stock market is at a record high. Unemployment is a mere 4.1 percent. The economy just added more than 200,000 jobs in June, and more people are looking for jobs now than a year ago. Plus, most workers are seeing their paychecks grow more than inflation. Summer vacation travel is also booming, one of the clearest signs households are doing pretty well.
But it’s important to understand that the economy typically looks fine until a crisis hits. The very fact that the economy is in a good place now is reason to take the warning signs seriously — and act to prevent further deterioration.
“We are in the yellow flag category,” Sahm told me. “We should be having a recession risk discussion. It has crossed that threshold.”
Sahm is adamant that the key takeaway from where her rule is now, along with other indicators that the economy is starting to slow — such as rising credit card debt and shoppers spending less — is that the Federal Reserve should cut interest rates. She doesn’t expect the Fed to lower the nearly 5.5 percent rate at its upcoming July 30-31 meeting, but she hopes Fed board members have a serious discussion about a September cut.
“By the time it is blatantly obvious we are in a recession, it’s too late for the Fed’s tools to work,” said Sahm, who is now chief economist at New Century Advisors and founder of Sahm Consulting.
Fed leaders keep arguing that it’s better to be done with inflation once and for all, even if they overdo things by keeping rates too high for too long and trigger a recession. It will be interesting to listen to Fed Chair Jerome H. Powell when he testifies before Congress this week. A month ago, he called the job market “strong.” Will he downgrade that to “solid”? And will he start to emphasize the risks of a downturn if the Fed is too stubborn to alter its course?
Perhaps the toughest question is whether the Sahm Rule might be wrong this time due to the immigration surge in recent years. Business leaders and economists are quick to point out that immigrants have helped the economy excel lately. They have filled jobs that no one else wanted and allowed companies to expand. But immigrants are harder to measure accurately. They are some of the least likely people to respond to government surveys. The unemployment rate is based on a survey of households, and response rates have declined a lot since the pandemic. It’s possible that the unemployment rate would be lower if immigrants were better counted. In any case, unemployment has been slowly rising for a year now, and this makes the trend harder to dismiss.
If it were possible to hit “pause” on the economy right now and keep it about where it is, most people would say do it. The economy is growing at a healthy rate, and there are still a lot of jobs. Inflation has cooled off, and consumers are even finding some falling prices and bargains again. Unfortunately, it’s impossible to hit pause when the Fed is still squeezing the economy.
The Fed has the tool to avoid a recession and save jobs. It can start lowering interest rates.
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