In the world of finance, finding a perfect leading indicator that can accurately predict the future is like searching for the Holy Grail. It may seem unattainable, but investors and analysts are always on the lookout for a tool that can provide valuable insights into what lies ahead. Enter the Sahm rule, developed by Claudia Sahm, a former economist at the Federal Reserve, in 2019.
What makes the Sahm rule stand out is its ability to identify every recession since 1960 in its early stages, without any false positives. This is quite an achievement, considering that the official declaration of a recession often requires a full year of data. In contrast, the Sahm rule typically needs just a few months to make a call.
So, how does the Sahm rule work? It’s simple and straightforward. If the unemployment rate increases by half a percentage point from its lowest point in the past 12 months, it signals that the economy is in a recession. To account for fluctuations, both the current unemployment rate and the lowest point are measured as three-month moving averages. Currently, the Sahm indicator stands at 0.33 percentage points, and a small increase can push it over the half-point threshold.
However, as with any rule, there are exceptions. Ms. Sahm herself points out that her rule is based on empirical regularity, not an indisputable law. The unique circumstances of the post-pandemic economy may not align with the conditions the rule was designed to capture. With the increase in the jobless rate driven by an expansion in the labor force rather than a reduction in demand for workers, the current situation may not fit the traditional pattern of a recession.
The sudden prominence of the Sahm rule has brought unexpected challenges for Ms. Sahm. Originally intended to establish a benchmark for automatic payments to individuals during a recession, her focus was policy-driven rather than market-timing. However, the attention her rule has received has shifted the conversation towards forecasting and market timing, diverging from her original intent.
In the current political climate, the question arises as to whether policymakers will take action if unemployment continues to rise in the coming months. Ms. Sahm finds herself in the unusual position of hoping that her own rule is proven wrong, as she recognizes the potential consequences of a recession in the absence of swift policy responses.
While the Sahm rule has garnered attention for its potential to predict recessions, it’s important to remember that it is not infallible. At best, it offers a valuable tool for understanding economic cycles and informing policy decisions. As Ms. Sahm reflects on the reception of her rule, one thing becomes clear: the focus should not be solely on predicting the future, but on understanding the actions that can be taken to mitigate its impact.
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