The Fed is ‘playing with fire’ by not cutting rates, says creator of ‘Sahm Rule’ recession indicator

By Jeff Cox of CNBC. Excerpt:

"The Federal Reserve is risking tipping the economy into contraction by not cutting interest rates now, according to the author of a time-tested rule for when recessions happen.

Economist Claudia Sahm has shown that when the unemployment rate’s three-month average is half a percentage point higher than its 12-month low, the economy is in recession.

As the jobless level has ticked up in recent months, the “Sahm Rule” has generated increasing talk on Wall Street that what has been a strong labor market is showing cracks and pointing to potential trouble ahead. That in turn has generated speculation over when the Fed finally will start reducing interest rates.

Sahm, chief economist at New Century Advisors, said the central bank is taking a big risk by not moving now with gradual cuts: By not taking action, the Fed risks the Sahm Rule kicking in and, with it, a recession that potentially could force policymakers to take more drastic action.

“My baseline is not recession,” Sahm said. “But it’s a real risk, and I do not understand why the Fed is pushing that risk. I’m not sure what they’re waiting for.”

“The worst possible outcome at this point is for the Fed to cause an unnecessary recession,” she added.

Flashing a warning sign

As a numeric reading, the Sahm Rule stood at 0.37 following the May employment report from the Bureau of Labor Statistics that showed the unemployment rate rising to 4% for the first time since January 2022. That’s the highest the Sahm reading has been on an ascending basis since the early days of the Covid pandemic.

The value essentially represents the percentage point difference from the three-month unemployment rate average compared to its 12-month low, which in this case is 3.5%. A reading of 0.5 would represent an official trigger for the rule; a couple more months of 4% or better readings on the unemployment rate would make that happen.

The rule has applied for every recession dating back to at least 1948 and thus works as an effective warning sign when the value starts to increase."

"“The bad outcomes here could be pretty bad,” Sahm said. “From a risk management perspective, I have a hard time understanding the Fed’s unwillingness to cut and their just ceaseless tough talk on inflation.”

‘Playing with fire’

Sahm said Powell and his colleagues “are playing with fire” and should be paying attention to the rate of change in the labor market as a potential harbinger of danger ahead. Waiting for a “deterioration” in job gains, as Powell spoke of last week, is dangerous, she added.

“The recession indicator is based on changes for a reason. We’ve gone into recession with all different levels of unemployment,” Sahm said."

One possible optimistic data is the % of 25-54 year olds employed.

One weakness of the unemployment rate is that if people drop out of the labor force they cannot be counted as an unemployed person and the unemployment rate goes down. They are no longer actively seeking work and it might be because they are discouraged workers. The lower unemployment rate can be misleading in this case. People dropping out of the labor force might indicate a weak labor market.

We could look at the employment to population ratio instead, since that includes those not in the labor force. But that includes everyone over 16 and that means that senior citizens are in the group but many of them have retired. The more that retire, the lower this ratio would be and that might be misleading. It would not necessarily mean the labor market is weak.

But we have this ratio for people age 25-54 (which also eliminates many college age people who might not be looking for work).

It was 79.875% for all of 2022 & 80.667% for all of 2023. The average over the first five months of 2024 is 80.72%. So it does seem to be trending up, if only slightly.

Related posts:

What Causes Recessions? What Do Recessions Look Like? (2023)

The Sahm rule and recessions (2020) 

What ends expansions? (or what causes recessions according to Alan Blinder and Austan Goolsbee) (2019)

Are business cycles imbedded in longer cycles called financial cycles? (2019)

Monetary Policy and the Great Crash of 1929: A Bursting Bubble or Collapsing Fundamentals? (2018)

Some Bad News for Good News — Optimistic Forecasts Create Recessions (2018)