The Sahm rule: What to know about the recession indicator that has Wall Street talking

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That was close.

After the U.S. unemployment rate climbed to 3.9% in October, stoking fears that the labor market might finally be starting to crack under the weight of the Federal Reserve’s interest-rate hikes, economic data released Friday showed that unemployment retreated to 3.7% in November.

That means the Sahm rule, an indicator devised to sniff out a recession long before one is officially declared, is now even further from triggering, after nearly brushing up against the threshold last month.

And according to the rule’s creator, former Federal Reserve economist Claudia Sahm, perhaps it won’t trigger, at least not during this cycle.

“I am more optimistic today that it doesn’t trigger,” Sahm told MarketWatch during a phone interview Friday.

What’s the Sahm rule, and why should we care about it?

Wall Street and social media were abuzz with talk of the Sahm rule last month as the rising unemployment rate sparked a debate about whether a recession had begun.

The increase brought the Sahm rule indicator to 0.30, according to data available on a Federal Reserve branch website, bringing it closer to triggering than at any time during the past two years. It also sparked a brisk conversation among professional economists and amateur market watchers about what the Sahm rule is, how it works and why investors should care about it.

After Sahm declared that the rule hadn’t triggered, some on social media accused her of misrepresenting her own rule, said the economist, who now runs her own consulting business.

She was surprised by this, she told MarketWatch, since she thought the rule’s simplicity was one of its most important features.

It was initially devised with lawmakers in mind, intended to become an automatic mechanism to send out stimulus checks more quickly as a recession begins, thus helping to shield workers from some of the worst financial consequences.

But the debate has helped her realize that perhaps the rule’s dynamics aren’t clearly understood by all.

To try to remedy this, she published a step-by-step guide explaining how the Sahm rule is calculated, or at least how Sahm and the Fed calculate it. Economists are free to devise their own variations on the rule. Here are some key points:

  • The Sahm rule uses the three-month average of the monthly unemployment rate, instead of taking the latest rate in isolation.

  • The current average is then compared with the lowest three-month average from the past year. Right now, that stands at around 3.5, Sahm said.

  • The 12-month low is subtracted from the current three-month average, and if the difference is 0.5 percentage point or greater, it means the rule has triggered. The rule is based on history and it has a strong precedent, meaning that almost every time unemployment has risen past this threshold, a recession has ensued.

The snowball effect

The logic undergirding the rule is pretty straightforward, Sahm said: The rule is grounded in the notion, supported by historical data, that once employment starts to rise, it often snowballs.

Typically it increases by anywhere between 4 and 6 percentage points during a recession, Sahm said.

But just because the rule has held in the past doesn’t mean it always will. Sahm has previously said that she wouldn’t be surprised if the rule were to break because of pandemic-related distortions in the global economy.

She affirmed on Friday that she still believes this to be the case, although she doubts the rule will trigger this cycle.

That is largely because, as Sahm sees it, the rise in the unemployment rate has been driven not only by slowing job creation, but by workers returning to the workforce, a sign that supply-and-demand dynamics in the U.S. labor market are coming back into balance, and that maybe employers won’t need to be as precious about hiring in the future.

“If [the rebalancing] happens fast enough, then we won’t trigger. But if it slows down, then maybe we’ll trigger, but we’ll likely see unemployment move sideways before coming back down,” Sahm said.

Labor Department data showed the U.S. economy added 199,000 jobs in November, surpassing economists’ expectations for 190,000 new jobs. The number was also higher than the 150,000 created during the previous month.

See: Job report shows gain of 199,000 in November. Wages are still hot.

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