The markets have been really volatile the last couple of weeks as a US interest rate decrease is now not only all but guaranteed in September, but there is a really good chance that the cut is bigger than predicted, i.e. 50 basis points. There are also a lot of people explaining how and why the US has officially entered a recession…with this in mind, I wanted to share an interesting recession indicator I read about, namely the “Sahm Rule”.
The Sahm Rule is a simple but effective economic indicator developed by economist Claudia Sahm to identify the start of a recession in the United States. The rule is based on changes in the unemployment rate and is intended to provide a timely signal of economic downturns.
How does it work and what are its implications?
Sahm Rule Formula: The Sahm Rule states that a recession is likely underway if the three-month moving average of the national unemployment rate (U3) rises by 0.5 percentage points or more above its lowest point in the previous 12 months. The formula can be expressed as follows:
Recession Indicator =Current 3-Month Moving Average of Unemployment Rate−Minimum Unemployment Rate in Last 12 Months
If the result is 0.5 percentage points or higher, it signals a potential recession.
Interpretation and Use:
Timeliness:
The Sahm Rule is designed to provide a timely recession signal, often before official declarations from bodies like the National Bureau of Economic Research (NBER).
By using real-time unemployment data, the rule helps policymakers and analysts react more quickly to economic downturns.
Historical Accuracy: The rule has been historically accurate in signalling the start of recessions. Claudia Sahm’s research indicates that the rule would have identified all recessions in the post-World War II period with minimal false positives.
Policy Implications:
The Sahm Rule can be used to trigger automatic fiscal policy responses, such as increasing unemployment benefits or implementing other counter-cyclical measures. It helps policymakers decide when to implement stimulus measures to mitigate the effects of a recession.
Advantages
Simplicity: The rule is easy to understand and apply, making it accessible to both economists and non-economists.
Timely Signal: It provides a more immediate recession signal compared to some other indicators that may lag.
Policy Tool: It can serve as a trigger for automatic stabilisers in economic policy.
Limitations
Single Indicator: The rule relies solely on the unemployment rate, which may not capture all aspects of economic activity or structural changes in the labour market.
False Positives/Negatives:
While historically accurate, no indicator is perfect. There is always a risk of false signals, especially in periods of unusual economic conditions.
Recent Context
During the COVID-19 pandemic, the Sahm Rule was closely watched as unemployment rates spiked rapidly. The rule helped highlight the severity of the economic downturn and the need for swift policy responses.
The Sahm Rule is a valuable tool for detecting the onset of recessions using changes in the unemployment rate. Its simplicity and historical reliability make it a useful indicator for policymakers and analysts to respond to economic downturns effectively.
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