Sahm Rule and labour supply shocks

Sahm Rule

As a Fed economist, Claudia Sahm designed this recession indicator. Its purpose is to provide economic policymakers with a simple, timely guide for responding to deteriorating economic conditions, in contrast to lagged macro data. The indicator is designed to signal a recession when the three-month moving average of the unemployment rate is 0.5 percentage points higher than the minimum of the three-month averages from the previous 12 months. In essence, the indicator gauges the increase in the unemployment rate. A rise in the unemployment rate indicates a reduction in the number of people in employment, which subsequently limits the amount of disposable income available for consumption. This, in turn, exerts further pressure on the labour market. The 0.5 percentage points level has minimal theoretical significance. A lower critical level increases the likelihood of false positives, while a higher level delays the signal for fiscal stimulus.

Historically, it has been a very reliable indicator of impending recession. Since 1970, the Sahm Rule has correctly predicted every recession and never sent a false signal. Since the Second World War, this has only occurred on two occasions, in 1959 and 1969. However, in both instances, the recession materialised within six months.

Labour supply shocks

However, the unemployment rate and GDP do not always move in opposite directions. When more people enter the labour market or migration increases, it is a normal phenomenon that not all of these people find work immediately. While the economy benefits from this increased labour supply, the unemployment rate rises (at least temporarily). In this instance, the Sahm Rule may provide an erroneous indication of an impending recession in the US. We have calculated a Sahm Rule starting from an unemployment rate from which labour supply shocks have been removed¹. Figure 1 illustrates that the adjusted Sahm Rule demonstrates a lower rate of increase than the original Sahm Rule. This is to be expected. There has been a notable increase in the participation rate and migration in the US in recent years.

August data

Following the release of weaker US employment data for July, the Sahm Rule was activated last month. The unemployment rate fell to 4.2% this month, but the original Sahm Rule increased to 0.57 percentage points. In accordance with the rule, a recession is then anticipated. However, when the impact of labour supply shocks is excluded, the Sahm Rule has risen by a much smaller amount over the past year. The adjusted Sahm Rule currently stands at 0.29 percentage points, remaining below the 0.50 percentage points level with a probability of more than 75%. The uncertainty surrounding this figure is heightened by the fact that not all of the August data is available for the purpose of identifying labour supply shocks. However, if these missing data are filled in with nowcasts, we maintain our median estimate at 0.29 percentage points.

Conclusion

The possibility that the Sahm Rule may generate inaccurate insights about the current state of the US economy is a valid concern. The rise in the unemployment rate is largely attributable to increased migration and rising labour force participation rates. However, the adjusted Sahm Rule has also risen slightly in recent months, indicating a potential slowdown in the US economy. Nevertheless, this deceleration does not yet indicate the onset of a recession.

1 The Sahm rule is recalculated using an unemployment rate that has been adjusted to exclude labour supply shocks. These shocks are calculated on the basis of a mixed-frequency SVAR model, defined as a shock that increases GDP and the unemployment rate while real wages and prices decline.