The Sahm Rule caused a stir on the markets at the beginning of August. This leading economic indicator was triggered for the first time since the coronavirus pandemic. But what does this rule mean and how meaningful is it actually? In the following blog post, we address these and other questions relating to the Sahm Rule.
Simple recession indicator
The Sahm rule developed by economist Claudia Sahm serves as a simple indicator for the start of a recession in the United States. It is based on changes in the unemployment rate and provides timely insights for policy makers and analysts.
The calculation of the rule is simple for a leading indicator: the difference between the current three-month average of the unemployment rate and its lowest value in the previous 12 months is calculated. If this difference is more than 0.50 percentage points, the rule indicates that the economy is likely to enter a recession.
The Sahm rule is based on the idea that a significant and sustained rise in the unemployment rate is a reliable early signal of an economic downturn. Unlike complex economic models or forecasts, the SAHM rule provides a simple and effective early warning of economic challenges. When the unemployment rate rises and people lose their jobs, consumer spending falls. As a result, the demand for goods and services in the market decreases and can lead to second-round effects (even more job losses).
No false alarm since 1970
Since 1970, the Sahm Rule has consistently detected every recession without triggering a false alarm (although it was very close in 1976). Notably, in 1959 and 1969, the Sahm Rule was triggered outside of a recession – but a recession followed within six months.
The most recent unemployment data in the United States triggered the Sahm Rule with a rounded value of 0.53. This is the first data point above the recession threshold of 0.50. Nevertheless, Claudia Sahm remains cautiously optimistic: “At the moment we are not in a recession,” and she emphasizes that panic is inappropriate.
Is it different this time?
While the Sahm rule has proven its worth in the past when predicting economic downturns based on a weakening of the labor market, Claudia Sahm now believes that the recent challenges in the labor market are more idiosyncratic – i.e. more specific. She explains: “This time could be really different”. Factors such as labor shortages, people leaving the workforce and the current higher rate of immigration can influence the development of the unemployment rate.
The National Bureau of Economic Research (NBER) defines a recession as a “significant decline in economic activity that extends throughout the economy and lasts longer than a few months”. The NBER comes to its official conclusion after analyzing a range of economic data over several months. Currently, most of the data considered by the NBER appears to be quite robust. For example, real consumer spending rose at an annual rate of 2.6% in the second quarter, and the increase in people on nonfarm payrolls has averaged 170,000 over the past three months. However, employment, as measured by the household survey, remains relatively unchanged this year. Despite slower economic growth, the US is still in recovery and not yet in recession. In addition, Federal Reserve Chairman Jerome Powell said that the data shows “a continued, gradual normalization of labor market conditions.”
Sahm argues that the recent rise in the unemployment rate is due to a return to normality from historically low levels and demographic changes rather than broad-based economic weakness. She finds support from the head of research at BCAlpha Research, who claims that the Sahm rule has not technically been triggered. Looking at the unrounded unemployment figures, the Sahm Rule currently stands at 0.49337%, just below the 0.5% threshold. The value of 0.53 % determined by the Federal Reserve (US central bank) is the result of rounding all previous unemployment rates to one decimal place.
Conclusion
The Sahm Rule has always proved to be a reliable recession indicator for the USA in recent decades. Even though the indicator was triggered by the latest US labor market report, this does not necessarily mean that a recession in the United States will follow. According to the inventor of the Sahm Rule, Claudia Sahm, it “could be different this time”.
Apart from that, the Sahm Rule refers primarily to the US labor market. There is no corresponding standardized indicator for Europe or the Eurozone. In my next blog next Friday, I will therefore present an approach on how to analyze the diverse European labor market similar to the Sahm Rule.