During the past few months, the “Sahm rule” has become a ubiquitous part of the conversation surrounding issues such as the economy, unemployment and the Federal Reserve interest rate policy. The Sahm rule was created in 2019 by economist Claudia Sahm, who sought to build a recession indicator that would not be dependent on the whims of committees or politics. Instead, her rule would be rooted in one of the foundational elements that all recessions share: rising unemployment.
As of Aug. 2, the day of the July jobs report, the Sahm rule was triggered, causing many to believe we are entering a recession.
What is the Sahm rule?
The Sahm rule is simple and straightforward, which adds to its usefulness as a measure of economic and employment health. The Sahm rule states that the economy has entered or is entering a recession when the current three-month average unemployment is 0.5 percentage points higher than the three-month average within the past 12 months.
Rather than using any one month’s reported unemployment rate, the average three-month unemployment rate is used to avoid overreacting to spiking data. With any measurement, avoiding false positives is important for designing accurate policy responses. This rule is meant to be an early warning sign that shows how quickly unemployment is rising over time in the hopes that policymakers will begin to craft a response to correct or dull the effects of worsening economic conditions.
How does the Sahm rule differ from other recession indicators?
Unlike many other metrics and measures meant to predict recessions, the Sahm rule is not a prediction tool at all. Per Sahm herself, her rule is meant to show that a recession may be imminent, and therefore the Federal Reserve and other governmental authorities can begin to fight back.
Claudia Sahm, who writes on the Substack Stay-At-Home Macro (SAHM), explains that the criteria for the measure were to use a simple and highly accurate formula that follows a well-known statistic and will be triggered early in a recession. Her rule meets these criteria. Based on her research, this rule has been triggered early on in every recession since 1970 and, most importantly, never outside of one.
This can be compared to one of the other popular leading recession indicators, the inverted yield curve, which has alluded to past recessions but has not proven perfectly accurate. While an inverted yield curve has preceded recessions, it has not done so with any predictable time frame. Over the past 60 years, there have been recessions that take place concurrently with the inversion as well as recessions that have lagged by 30 or more months. This makes the yield curve inversion an imprecise trigger for economists and investors alike.
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Why does the Sahm rule matter?
After 27 straight months of unemployment below 4% (February 2022 through April 2024), unemployment has risen the past three months. It is the speed of this rise that the Sahm rule is most focused on, rather than the absolute number reported.
In May, unemployment measured 4.0% for the first time since January 2022. This is still a historically low number and well below the 5.69% average since 1948. However, since May, unemployment has continued to rise and hit 4.3% in the July report, triggering the Sahm rule’s threshold for a 0.5 percentage point rise on the three-month average unemployment rate.
Since its creation, this will be the first significant test of the Sahm rule under relatively normal circumstances. During the economic shock that followed the response to the COVID pandemic, the rule was also triggered, but it was during a time when businesses were being forcibly shuttered and demand for many businesses dried up inorganically. If the rule proves accurate under more normal circumstances, then it means that we are likely in a delicate economic position today — albeit, one that still has many bright spots, including low unemployment and a brisk GDP growth rate.
How should investors respond?
It is not time to panic nor predict forthcoming doom even if (or when) the markets continue to respond negatively.
It is important to realize that no one indicator is perfect, because many measures of our economy are also not perfect. No one data point can be used in isolation to build or change an investment thesis. As more economic data becomes available in the coming months, we will have more certainty about the direction of the economy and how policymakers will respond.
How you should respond will depend greatly on how you invest today. If you are trading on news, you will have your fill of it through the end of the year and may find that this will be a boon for your strategy. If you are investing for the long term, this is one of many future bumps in the road, and you should be well-prepared. Maintain a disciplined risk management strategy and seek professional advice if you are anxious about your current financial standing.
