"Saw Rule" Proposer: The US job market has changed. The "Saw Rule" as a "recession indicator" has become ineffective

On August 6th, Claudia Sahm, the proposer of the "Sahm Rule" and Chief Economist of New Century Advisors, participated in an interview to discuss the Sahm Rule and its impact on the job market.

Claudia Sahm believes that considering the changes in the current U.S. job market, the Sahm Rule has become ineffective and cannot prove that the U.S. economy has entered a recession.

Sahm believes that the current rise in the unemployment rate is no longer due to a weakening demand for workers in the market, but rather due to an increase in labor supply. For example, the surge in U.S. immigrants post-pandemic has facilitated the recovery of the job market, causing the unemployment rate to rise, which can no longer be used as an indicator of a recession.

Key points of the conversation are as follows:

1. The reason for the existence of the Sahm Rule is that it is just a supporting role in research, mainly to ensure that the government commits to implementing well-designed and effective fiscal policies during a recession and to activate them immediately when macroeconomic conditions require it.

2. The change in the unemployment rate is a very powerful dynamic formula.

3. If the current three-month average is 0.5 percentage points or more higher than the lowest three-month average of the past 12 months, this will mark the early stage of an economic recession.

4. There are two basic reasons for the rise in the unemployment rate: a decrease in demand for workers and an increase in labor supply.

5. A significant reason why the current Sahm Rule indicator reading is unsettling is that it views the increase in labor supply as a bad thing.

6. "So when I look at this Sahm Rule indicator, I say it has become ineffective as an indicator of a recession, because we know a lot of other information about the U.S. economy, and right now we are not contracting."

7. Although the probability of a recession is increasing, I believe it will not become a significant reason for my basic assumption, as the Federal Reserve has enough room to ease, and I expect them to start easing before September.

The full interview is as follows, with some content omitted:

The Sahm Rule aims to prompt the government to take action promptly when the economy requires it

Josh Brown:

Claudia, you are the creator of the Sahm Rule, which is said to be an early recession economic indicator. You are now very much in the spotlight. As the biggest star in the economic world for the summer of 2024, how does it feel?

Claudia Sahm:

First of all, thank you for inviting me. It would feel better if there were good reasons for it. So, having a recession indicator and triggering its appearance, I will definitely talk about what that means, not because it's the focus. But I'm here to provide assistance, which is why I created this indicator, and I will talk about its origins.

Josh Brown:

I guess we are now discussing it because we are trying to figure out if the Federal Reserve is too tight, and if the economy will start to slide before the Fed starts to ease. That's why everyone is talking about the Sahm Rule. I'll try to explain it as succinctly as possible, and if I miss any important information, please let me know The Sahm Rule is a recession indicator. You created it about five years ago. Basically, you calculate the three-month moving average of the national unemployment rate. So it's not just the number from last month, but the average of the most recent three months, compared to the lowest three-month moving average of the past 12 months.

If the current three-month average is 0.5 percentage points or more higher than the lowest three-month average of the past 12 months, it signals the early stages of an economic recession. We can discuss how early the recession is, but this would be the so-called trigger. I'm glad to have you here today because based on the latest employment report we received, the three-month average in Los Angeles is now more than 0.5 percentage points higher than our lowest three-month average ever. So, the Sahm Rule is triggered. We all need to put on our helmets, and then you tell me what to do next. What should we do now?

Claudia Sahm:

Right. So, I want to go back to why the Sahm Rule exists. My first prediction was when the recession started in 2008, the Federal Reserve entered recession prediction mode. I studied fiscal responses and monetary policy responses during the Great Recession. Honestly, this area is lacking, especially on the fiscal side, causing a lot of harm. I am an expert in consumer and household aspects, which is also a key focus of my research and policy work after the Federal Reserve.

The reason the Sahm Rule exists, it's just a subplot in the research, the idea is that when we are in an economic recession, let the government commit to implementing well-designed, effective fiscal policies and have them commit to launching them immediately when macroeconomic conditions require it.

Josh Brown:

Are you looking for signals indicating when to take action?

Claudia Sahm:

And, this signal, I pay particular attention to fiscal policy. If you are going to give people hundreds of billions of dollars to stabilize the economy, you should do it when the economy needs stabilizing. So, in a recession, the threshold is very high. So this is largely a review of history, all the different types of recessions we have been through, there are many different types of recessions. The change in the unemployment rate is a very powerful dynamic formula, just like the Sahm Rule appeared, it really did, and others make predictions.

I did not invent the dynamics of the U.S. labor market. I'm just capturing it. But specifically, like what the formula is, how the threshold is set, I want to find an indicator that can be activated as soon as possible in an economic recession, because then you have the opportunity to do some good. But in an economic recession, there are no false positives. But that's not the case now.

Sahm believes: Although the probability of a U.S. recession is rising, it has not yet entered a recession

Josh Brown:

According to your research, the Sahm Rule has been able to accurately predict every actual recession since the 1970s in backtesting, without any false positives outside of recessions. It's interesting that you created this indicator for fiscal policy while working at the Federal Reserve Claudia Sahm:

Yes, as one of the analysts analyzing consumer spending in 2008, I understand how consumers handle tax refund checks or subsequent tax offsets. The Federal Reserve is working on the margin strategy adjustment. In the staff forecasts, there are estimates of the impact of fiscal policy on the economy, which the Federal Reserve can consider when conducting monetary policy. So, although this may seem somewhat counterintuitive, it is a very important part of economic health to understand consumer behavior.

Therefore, I would say that looking at that experience made me think about improving policies for the next time. The Sahm Rule is part of a policy paper on how to design various automatic stabilizers in early 2019, it is just a part of it. It did pass the test in 2020, accurately predicting that recession, but anyone could have done that.

However, there are some very unusual circumstances in this cycle. In my opinion, although the Sahm Rule now indicates that the U.S. economy is in recession, I do not believe that the U.S. economy is currently in a recession. It failed, I think it still tells us something, but similar to our most famous indicator of a recession, which is a technical recession where real GDP declines for two consecutive quarters.

Josh Brown:

Unfortunately, you will find out much later.

Claudia Sahm:

You will find out much later. That's why I didn't use it in my proposal. That's also why I need a faster indicator like the Sahm Rule. And in the first half of 2022, we had two quarters of GDP decline, but no recession. You have to go back to 1947 to find a similar situation in the United States.

Josh Brown:

Let's put this chart up. This is what the real-time Sahm Rule indicator looks like, we are using Fred data. You just mentioned the example of 2020, obviously, that was not subtle. It was the highest peak in unemployment rate ever, hopefully the largest peak ever in such a short time. What's happening now is subtle, we just crossed the so-called trigger point. Is there any issue with looking at this chart this way? Would you not combine it like this for some reason?

Claudia Sahm:

I do like to use back-tested data for testing, which means I use the unemployment rate that was published at the time, which is slightly adjusted with seasonal adjustments. Therefore, the two false positives of the real-time Sahm Rule indicator occurred before 1970, and in both cases, a recession quickly followed. There was a very close case in 1975 as well. I don't want to discuss accuracy issues. It does fluctuate around 0.5, which is a historical pattern Josh Brown:

However, if we look at this chart again, 0.5 during the period we studied, it almost never or never reversed without a recession. So, this is worth noting, right?

Claudia Sahm:

There is a reason why this indicator is attracting attention. Yes, I did not consider predictive factors when setting up this indicator. I set a high threshold, thinking that false positives could be excluded. When talking about why it may not be signaling the same as in the past, you need to delve into it, it's a very simple rule. This indicator is designed for fiscal policy, which will enter the legislative process. It is a sacrifice for its simplicity, because the situation behind the U.S. unemployment rate is not like an economic recession, which I think may reverse.

The U.S. job market has changed, and the "recession indicator" of the Sahm rule is no longer effective

Josh Brown:

The pandemic has actually disrupted every economic indicator to some extent, some more severely than others, but some of the economic indicators or empirical rules we have relied on for the past 100 years have become completely invalid after the pandemic. So, I think many things, such as the reliability of how we think the economy operates, have been absolutely changed. You have also pointed this out in public. So, what's different about the current unemployment situation, what might be different this time?

Claudia Sahm:

Yes. There are two basic reasons for the rise in the unemployment rate, one is the weakening demand for workers. The rise in the unemployment rate is very consistent with the dynamics of a recession. This is the historical accuracy source of the Sahm rule indicator.

Another reason for the rise in the unemployment rate is the increase in labor supply, which pushes up the unemployment rate. What's worse for the Sahm rule indicator now is that in the early stages of the pandemic, we had millions of workers leaving the labor market directly. Then, because they did not return as quickly as customers, we had a labor shortage, which pushed down the unemployment rate, which may be unsustainable because we don't have enough workers. In recent years, we have also seen a surge in immigration, and the labor market is also recovering.

So, not only is there a change in labor supply, but there are two quite significant changes. I think we have learned a broad lesson, that anytime we have a very sudden and drastic change, adjustments may take a long time.

Now, with the arrival of these immigrants, this solves the problem of labor shortages, which is a good thing, especially as we have many aging people, which helps us maintain growth, which is a good thing.

But during this time, they are still looking for jobs, the pace of job growth has slowed, leading to an increase in the unemployment rate. If this is just about supply adjustments, it is temporary, ultimately a good thing because we have more workers. But that doesn't mean everything is fine now, just like the Sahm rule indicator and as you pointed out, it is right on the edge of its trigger point, a lot of things are happening.

Josh Brown:

We can see it as the denominator. As a denominator, the number of people in the labor market is not static. So, the numerator changes, of course, the unemployment rate itself is a ratio, and its denominator is also changing Claudia Sahm:

Now, this may get very complicated, but essentially, one major reason the current Sahm Rule indicator reading is unsettling is that it views an increase in labor supply as a bad thing.

The problem is, as you mentioned, all these indicators are running into a lot of trouble, and here we have two things happening at the same time. So when I look at this Sahm Rule indicator, I say it has failed as a recession indicator because we know a lot of other information about the U.S. economy, and we are not contracting right now. However, there is enough weakness, enough risk of rising unemployment rates due to a slowdown in demand for workers, which increases the risk of a recession in the next three to six months.

The U.S. may ease before September

Josh Brown:

I want to show you a conversation that summarizes the debate around the Sahm Rule indicator itself, its current usefulness compared to past instances. Here is a tweet from David Rosenberg. David says, the Sahm Rule indicator triggered a recession signal today. Barry Ritholtz says, for those who have been wrongly waiting for a recession for two years, they think this is a godsend. More likely, it will extend their record of failed predictions. This is a conversation between David Rosenberg and Barry Ritholtz, not necessarily about who is right or wrong, but what conclusions do you draw from this disagreement?

Claudia Sahm:

I am on the same side as Barry, we are not in a recession right now. A recession is not my current baseline assumption. Although the probability of a recession is rising, one important reason I do not expect it to become my baseline assumption is that the Fed has enough room to ease, and I expect them to start easing before September. So, I do expect them to do that.

The Sahm Rule indicator itself, even in real-time, has false positives. And the bigger conversation is that history may not repeat itself. Barry's point is that you need to go back further in history, sometimes we enter a recession with low unemployment rates, but that is not common. We have a lot of mixed factors, I talked a lot about the situation with labor supply, which is definitely in there.

We also have some other factors, I spent some time looking at the contributions of different types of unemployment. You can be unemployed because you were laid off, or because you are new to the labor market, or because you quit. The changes we see are quite different. Right now, there are more job seekers who are new to the labor market, and their contribution is greater than most recessions. But if you go back to the 70s, the labor market was not that different. So, it's hard to tease that out.

I don't think a recession is a certainty. However, I do think there are real risks, as Barry does. In 2022, what I can say is, look at the labor market, look at consumers. I think we are still in a favorable position, but the momentum is not good. Josh Brown:

Regarding what we should do or what should happen, I want to ask you another question. The irony of the SAM rule you have constructed is that if they follow your advice and act quickly, then your rule will be proven wrong because we will avoid an economic recession. You need to accept this. It's like, they followed my advice, and the result was a wrong trigger point because fiscal spending offset the potential economic downturn, which is a bit like the plot of a superhero saving the world.

Claudia Sahm:

What concerns me more is that there is a recession indicator that has been very accurate in the past, but now there may be some issues that are fueling or exacerbating concerns about the economy. This is the situation I don't want to see and the situation I am trying to avoid.

I and others working in policy consulting have learned a lot, well, humbly, because we have made a lot of mistakes, such as thinking about how to achieve this. So, I won't go back and do the same thing again.

The original intention of the SAM rule is to encourage action. I think the irony is that it may instead encourage monetary policy because currently monetary policy is the lever that can be effective.

Frankly, the Federal Reserve should be forward-looking. If they are going to take action to support the labor market, waiting until the economic recession is already too late