What is up with the Sahm Rule, and what does it mean for the Fed?

A softer than expected July jobs report has sent jitters through the market this week. As a result, the “Sahm Rule” has dominated financial headlines. A quick Google search will likely lead you to dozens of articles placing it at the center of elevated recession chatter. Let’s break it down.

1. Sahm Rule 101:
The Sahm Rule is an economic rule of thumb created in early 2019 by economist Claudia Sahm. It is meant to serve as a helpful guide for policymakers and intended to act as an “early diagnosis” of possible recession. A recession is defined by the National Bureau of Economic Research (NBER) as a significant decline in broad economic activity lasting more than a few months. The NBER is responsible for determining when the United States has entered a recession, and that often takes a while.

• What it says: The rule is relatively simple. It states that when the three-month average U.S. unemployment rate rises by 0.50% or more from its 12-month low, a recession is underway. Last Friday, the rule was triggered, as the unemployment rate increased to 4.3%.
• Why it anchors on unemployment data: During U.S. recessions from 1947 to 2008 (sans COVID-19), we have seen the unemployment rate increase gradually before picking up substantially. The Sahm Rule was meant to establish a threshold at which policymakers should start to respond to a downturn.
• Why it’s getting so much attention: It has been historically accurate. Since 1970, the Sahm Rule has coincided with every recession without failure.

Bottom line: The Sahm Rule is helpful and has a good track record. Modern economic data is less than 80 years old, and we have seen 12 U.S. recessions. That said, just because something hasn’t happened in that data set doesn’t mean it’s out of the question. Claudia Sahm herself indicated in a timely op-ed that it’s not all black and white. 

2. Could the current environment be the exception to the rule?
We think so. We acknowledge that risks are elevated, and we believe concerns are warranted, but today’s labor market dynamics could be a differentiator.

• The labor market weakening may not be that severe. The July jobs report did indeed show a slowdown in the labor market—but it was the growth, not layoffs, in the labor force that drove the increase in the unemployment rate. Layoffs typically light recessionary flames, but we are not seeing out of control weakness across other data sets. Importantly, companies have not picked up references to job cuts on earnings calls.
• Why did unemployment increase if there are more workers? The civilian population used to calculate the unemployment rate increased by 206,000. With a labor force participation rate of 62.7%, 129,000 jobs were needed to keep the unemployment rate unchanged. In July, the economy added 114,000 jobs, but the labor force increased by 420,000. Thus, the unemployment rate rose due to the increase in workers who haven’t found jobs; layoffs were not a cause.

Bottom line: The Sahm Rule may be overstating recent economic weakness, especially in the labor market. There’s no denying the decrease in jobs being added reinforces a slowing economy, but we think the labor market data is pointing toward an economy that is closer to full employment (with pickups in labor force participation, minimal layoffs and stable aggregate demand), rather than a recession characterized by a pickup in layoffs and a collapse in aggregate demand. The rise in the unemployment rate is due to increased labor supply, not weakening demand for workers—a stark difference from past recessions.

3. Zooming out: What does this mean for the Federal Reserve?
Remember, the Fed has a mandate to ensure labor market health. Chair Powell and team do not want to “mess around and find out” about an impending recession.

• The Fed put is here. The Fed is likely paying attention to labor market data and the recent pickup in volatility. There is a widely held belief that it will jump in to support financial markets and the economy to avoid significant downturns. The Fed has been pivotal in stabilizing the economy during turbulent times. We do not think today is any exception.
• Cuts are the next logical step. If anything, recent data has shown that policy rates have been restrictive. The economy is cooling, but not unraveling. Rate cuts oxygenate the economy and in theory stand to provide immediate support. We expect the Fed to deliver a series of three 25-basis-point cuts through year-end. The big question remains: How quickly can the economy digest the easing and respond?

Our view:
We do not think a recession is imminent. Recent volatility will likely lead the Fed to deliver cuts faster than initially anticipated, but that does not mean the economy has fallen off the rails. That said, the narrative has not changed much. We remain constructive on U.S. equities despite increased volatility, and see opportunity to lock in rates before they fall.