The so-called Sahm rule, created by economist Claudia Sahm, is a recession indicator based on the unemployment rate. The indicator results in a recession signal when the 3-month moving average of the unemployment rate rises by 0.5 points or more above its lowest point over the prior 12 months. The rule was proposed as a tool that policy makers could use to identify recessions in real time, so that they could respond swiftly with stimulative policies early in the downturn, thus preventing economic conditions from deteriorating much further. As the chart below shows, the indicator has historically been very effective, reliably producing a signal for every one of the last 8 recessions, with only one brief false signal (so far, at least) in 2003.
Sahm Rule Recesson Signals Vs Actual Recessions
Source: CWA, Bloomberg, as of 8/21/2024
The Sahm rule is getting a lot of attention lately, given that it triggered a recession signal following the July employment report. The debate among economists and market strategists is ongoing as to whether this means the economy is either already in, or headed for, recession. On one hand, the indicator’s impressive track record speaks for itself, and the words “this time is different” remain some of the most dangerous for investors to pronounce. On the other hand, we see a couple reasons to question whether this time may indeed be different:
- The Sahm rule is not meant to be used as a leading indicator of recession, but only as a confirming indicator that a recession is already underway. On average, over the last 8 recessions, the indicator produced a signal only after the economy had already been in recession for roughly 2.4 months. At the moment, the economy remains fairly healthy, as indicated for instance by strong retail sales reported just last week.
- The increase in the unemployment rate that we have witnessed so far has largely been driven by an increase in labor supply (i.e. new entrants and reentrants into the labor force) rather than a decrease in labor demand (i.e. layoffs). While this is also true of past cycles to some extent, this dynamic has been exacerbated by the Covid-19 pandemic, which caused a larger-than-usual swing in the labor force. As the chart below shows, the US labor force has recently expanded to its largest size ever, while layoff announcements have been falling.
Labor Force Up, Layoffs Down
Source: Bureau of Labor Statistics, Challenger Gray & Christmas, Bloomberg, as of 8/21/2024
The bottom line is that while we shouldn’t write off the latest Sahm rule signal entirely, we should at least be skeptical of it. So far, the rise in the unemployment rate appears to be benign. However, if the next few months show a further acceleration higher in the unemployment rate alongside an increase in layoffs, that would be a reason to turn more cautious.
Sauro Locatelli CFA, FRM®, SCR®
Director of Quantitative Research
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