Episode 33
Episode summary
Perhaps the best indicator of a recession is known as the Sahm Rule. But it’s little known outside the economics world. So what is it and how can regular everyday businesses make use of this esoteric economic indicator? Caleb and Liz talk it out.
Shownotes
Personal Consumption Expenditures: Chain-type Price Index [FRED]
The Federal Reserve’s Dual Mandate [Chicago Fed]
Full Employment [Econ Focus/Richmond Fed]
Sahm Rule Recession Indicator [FRED]
The Sahm rule: step by step [Stay-at-Home Macro]
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Transcript
Liz Wilke (00:00:31) – Hi, I’m Liz Wilke.
Caleb Newquist (00:00:35) – And I’m Caleb Newquist.
Liz Wilke (00:00:37) – And this is the Gustonomics Podcast. In each episode, we bring you a little bit of economics knowledge so you can be more informed, use the information in your business or work. But please, please don’t listen to us while you’re lighting off fireworks. That requires full concentration.
Caleb Newquist (00:01:00) – Please remember to rate, review, and subscribe to the show or share it with an economics curious friend. Anything you can do to spread the word about the podcast is greatly appreciated. Hello, Liz.
Liz Wilke (00:01:10) – Hello, Caleb.
Caleb Newquist (00:01:13) – What’s on your mind? Anything interesting on your mind, Liz?
Liz Wilke (00:01:18) – Well, I’ve been thinking a lot recently about the Fed’s June meeting and what they signaled for a rate cut towards the end of the year. And I have also been thinking a lot about a little-known rule outside of the economics profession called the Sahm rule.
Caleb Newquist (00:01:34) – Oh, I like the sound of that. Okay, so first things first, when was the Fed meeting and what came out of that meeting?
Liz Wilke (00:01:44) – The Fed meeting was on June 12th. That is, again, if you all remember when Chairman Jerome Powell and his 12 governors get together and they hem and haw over much economic data and decide what they are going to do about the Federal Reserve policy rate, which determines all of the other interest rates that we know and love. Everybody was hoping, I think, for a cut or a signal that cuts were coming. And instead, they declined to make a cut and to keep the policy rate where it is, and hence all other interest rates more or less where they are.
Liz Wilke (00:02:20) – And everybody on that news basically decided that instead of the three cuts that we were hoping for at the very beginning of the year, if you all remember, we may only get one cut if that by the end of the year.
Caleb Newquist (00:02:34) – Yeah, so is it fair to say that this was kind of disappointing news for a lot of people? Like for Fed watchers who wanted a rate cut, were people disappointed or they’re like, because it seems like that managing expectations is a weak spot for the Fed lately. And this seems to be another one of those instances where people were kind of anticipating something and they got something else. So I’m just just curious what your read on that is.
Liz Wilke (00:03:09) – To be honest, I think most Fed watchers got about what they expected. So the Fed has been very clear that it’s not going to cut a rate unless one of two things happens. One, they get very close right to their long term inflation target of 2% or the labor market falls off a cliff and they have to do some re-pivoting. Right.
Caleb Newquist (00:03:34) – So just for the record, what’s the most recent inflation number?
Liz Wilke (00:03:42) – The preferred measure by the Fed is called the Personal Consumption Expenditures Price Index, PCEPI. And it came in at 2.8% year on year in the last print. So it’s pretty good. It’s not that far off of 2%, especially when you think about what it was last year.
Caleb Newquist (00:03:59) – Sure, yeah. OK, so that’s pretty good, but not good enough for a rate cut.
Liz Wilke (00:04:05) – It’s not good enough for a rate cut, right? So the Fed has been consistent over and over and over again, right? These huge hikes for longer, and we’ve made, I would say, inching progress towards this long term inflation goal. And the Fed has been really clear. They’re like, we’re not cutting it until we get there, right? The Fed actually has a dual mandate, right?
Caleb Newquist (00:04:26) – Yep.
Liz Wilke (00:04:27) – Stable inflation and full employment. But as long as the labor market is posting hundreds of thousands of jobs a month, and the unemployment rate is sitting at around 4%,… 4%, the unemployment
Liz Wilke (00:04:39) – there is no very good reason for the Fed to worry that it’s gonna sacrifice the full employment mandate in favor of the pursuit of the inflation mandate. So the Fed’s like full speed ahead. There is no reason to slow down now.
Caleb Newquist (00:04:52) – Okay, and just for the listeners at home, full employment is what?
Liz Wilke (00:04:59) – Great question, Caleb, thank you. Full employment is an economics jargony term that I just used, and what I really mean is in an economy, it’s the rate of unemployment that you think of as being kind of natural. So at any given time, somebody is looking for a job, right? Because you are a student and you graduated and you’re on the job market, or you got let go, or you jumped to another job and you’re just looking for another job. That’s transitional unemployment, right? And it’s pretty expected, right?
Liz Wilke (00:05:33) – Because not everybody stays in their job for their whole lives. And so when an economy is at full employment, it means that the only unemployment that exists is basically that sort of naturally occurring unemployment. Everybody else who wants a job can basically have a job.
Caleb Newquist (00:05:51) – Can have a job, right, okay, cool, very good. All right, and is there a magic number for full employment like there is for the inflation rate?
Liz Wilke (00:06:03) – There is and there isn’t. There is a hypothetical number at which full employment occurs. There’s not a number in a textbook, right, that says this is determined to be the rate of full employment. However, over time, that number has centered about 4% when people have tried to measure it, right? So basically we’re there, right? And in fact, the economy with its very low unemployment rate in the threes over the last 27 months has been above full employment, right?
Liz Wilke (00:06:38) – You in fact pulled some people into the labor market or sort of the economy was sort of running above its long-term abilities.
Caleb Newquist (00:06:46) – Yeah, and just a little sidebar here. There is a point where unemployment can actually be too low. Is that correct?
Liz Wilke (00:06:57) – Yeah, I mean, some economists disagree about this, right? Economists that are really sort of on like nobody should be unemployed, right? That sort of everybody should be able to be matched. Very few people actually think that there’s not like a natural transitional rate of unemployment where people are just looking for jobs and that’s normal. But there’s lots of economists who disagree that it can’t be lower and that’s a problem, right? That it’s a problem if it’s lower.
Liz Wilke (00:07:25) – I think what happens, right, or what most economists think happens is that the lower the unemployment rate gets, the more you pull people into the labor market who maybe aren’t as good at working, right? So lots of people who have trouble getting jobs, who have trouble remaining employed, who maybe are new to not have a ton of skills or who aren’t really fit for the kinds of work that are out there, right? They get pulled into the labor market when the labor market is very, very tight, right?
Liz Wilke (00:07:55) – And that is sort of considered, I’m not sure that I would call it a problem per se, but it is something that is thought to happen, right? When the labor market, excuse me, when the unemployment rate gets too low is that it sort of sucks people into the labor market who otherwise may not be the most productive workers.
Caleb Newquist (00:08:14) – Got it, okay. Thanks for indulging me there. All right, so we’re talking about interest rates, we’re talking about inflation, we’re talking about unemployment. And you mentioned something called the Sahm rule. So what exactly, Liz, is the Sahm rule? And why have you been thinking about it?
Liz Wilke (00:08:33) – Well, I’m gonna go back a little bit and sort of plant us back at the Federal Reserve meeting and say, from their perspective, the economy is posting good job numbers and employment is pretty low. We have a very stable labor market. So they’re not worried about that first side of their mandate, which is full employment. And they are very worried, right, about inflation getting out of hand again if they reduce the rate, et cetera. So they’re thinking we’ve got tons of space to play with.
Liz Wilke (00:09:01) – Now, the thing that will change that, right, is if the economy sort of falls off a cliff faster than anybody expects, right? The Fed is counting on a really strong labor market and a pretty strong consumer to give them the runway that they need. So the big question is, how close are we to a much softer economy than we think? Because the economy can actually turn relatively quickly in the numbers, because the numbers are lags, they don’t always show up at the time in the data, right? So there’s a sort of inherent noisiness around reading this data.
Liz Wilke (00:09:34) – So everybody’s question is, well, how close are we, right, to a weak economy or an economy where the labor market gets really weak really fast?
Liz Wilke (00:09:42) – Enter the Sahm rule. So the Sahm rule is named after economist Claudia Sahm. She used to work at the Federal Reserve. She now owns a consulting business that’s independent. She’s a very good economist.
Liz Wilke (00:09:56) – And she made up this rule that basically is a very historically accurate recession predictor.
Caleb Newquist (00:10:03) – A harbinger, if you will.
Liz Wilke (00:10:05) – A harbinger, if you will. Yeah.
Liz Wilke (00:10:07) – So without getting too much into the math of it, I’m going to get into the math of it.
Caleb Newquist (00:10:13) – Oh, good.
Liz Wilke (00:10:14) – So basically, the Sahm rule says that when the unemployment and when the change in the unemployment rate goes up too fast relative to its average over the last year, then you are in a recession.
Liz Wilke (00:10:33) – Or you are entering a time of economic trouble. That rule has basically been accurate in predicting all of the recessions since 1949, with the slight caveat that technically it predated the 1949 recession by, I think, six months. I might be a little mistaken about that.
Liz Wilke (00:10:55) – But so just sort of jump the gun on that one. We didn’t actually enter a recession when the Sahm rule said we would. We entered a recession six months later. So everybody’s looking to the Sahm rule and this number and thinking, how close are we to triggering this highly accurate recession predictor?
Caleb Newquist (00:11:14) – Right. And if I may just confirm my understanding of this, you’re saying when the unemployment rate exceeds the trailing 12-month average of unemployment, that is when the Sahm rule is triggered. Do I have it right?
Liz Wilke (00:11:32) – That is a mathematical inaccuracy. But the concept is basically right.
Caleb Newquist (00:11:37) – I think I’ll take it.
Liz Wilke (00:11:39) – Let me put it in the show notes. If you’re interested in the math, we will put a link to Claudia Sahm’s article where she explains exactly how to calculate this number so that you can watch it for yourself. It’s very easy to calculate.
Liz Wilke (00:11:55) – Or you can go to the Federal Reserve data system, which is called FRED. And you can just look it up because they have a Sahm rule indicator in FRED.
Caleb Newquist (00:12:05) – Yeah, OK. Yeah, we will stick those in the show notes. OK. Yeah.
Caleb Newquist (00:12:08) – All right. So what’s going on with the Sahm rule right now? Has it been triggered?
Liz Wilke (00:12:13) – Well, I in fact, it has not. For the record, it has not been triggered. But I was playing around with the numbers. I was doing my own fun Sahm rule calculations this morning. And the current value, the current Sahm value is 0.37.
Liz Wilke (00:12:33) – And the trigger is 0.5. So we are moving towards that threshold. And it has been increasing over the last six months or so. Let’s see. So in January of this year, the Sahm value was 0.2. And so basically in the five, six months since January, the Sahm value has nearly doubled or closed two- thirds of the distance to the trigger.
Liz Wilke (00:13:10) – So that’s got everybody a little bit nervous.
Liz Wilke (00:13:12) – Next month could be the trigger. And so that’s really the question that everybody is grappling with. Is it next month? Are we going to trigger it? Is it maybe two months from now? And the associated question, is the Fed being too hawkish about the rate? Because this number suggests that we might be closer to a weak economy than the current numbers, which are lagged, suggest. That’s the crux of the thing right now and that’s the relationship between the Sahm rule and right the Federal Reserve meeting.
Caleb Newquist (00:13:46) – All right. So with respect this is pretty inside baseball. So I’m just curious how is how do you like if you’re talking to a small business owner what would you tell them to think about this like you’re you’re kind of impressing them with all this kind of knowledge and data and things. How should how should a small business owner think about these kinds of things. I mean this is the question that we come to for every episode. So like what what what’s your response to that.
Liz Wilke (00:14:21) – Well my first response would be the Sahm rule itself routinely makes headlines and so for anybody who sees a headline that says the Sahm rule or economists that created the Sahm rule or highly accurate recession indicator says that is what they are talking about. And now the triggering value is 0.5. And then when you read that article hopefully you’re not wondering WTF is this? Right? You’re thinking I know what this is and now I know how to interpret it.
Liz Wilke (00:14:51) – So that’s the first thing is just trying to like this number is going to show up a lot more right in the headlines. In fact the reason that we’re talking about it this episode is because my spouse who is definitely not an economist said hey why don’t you talk about the Sahm rule today because it showed up in my headlines and I didn’t know what it was.
Caleb Newquist (00:15:10) – Great suggestion Jeff. Thank you.
Liz Wilke (00:15:15) – Yes.
Caleb Newquist (00:15:15) – Yeah.
Caleb Newquist (00:15:17) – Saved our bacon today.
Caleb Newquist (00:15:19) – Yeah.
Liz Wilke (00:15:20) – So so I think the second thing is right. It adds a lot of color to the conversation about when is the Fed going to cut rates.
Caleb Newquist (00:15:28) – Yeah.
Liz Wilke (00:15:28) – OK. So when the Sahm rule gets triggered for most people the conversation is likely to change. Right. One because it gets triggered when the unemployment rate goes up. So the top line unemployment rate is just going to go up and the Fed will see that and they’ll think ooh maybe it’s not quite as good. Right.
Liz Wilke (00:15:46) – And then that should change the conversation about the balance between cutting the interest rate versus keeping the interest rate which is all to say for small businesses if the Sahm rule continues to head in this direction we will probably see some rate cuts this year. Right. Because the Fed will have to start managing that other side of its mandate which is full employment.
Caleb Newquist (00:16:08) – Right. So again just to confirm my understanding the next time the Fed has a meeting if we’ve hit if the Sahm rule has hit point five those hawkish Fed governors they don’t have as much of a they don’t have as strong of a case for not cutting rates is essentially what you’re saying.
Liz Wilke (00:16:27) – I think that’s right.
Caleb Newquist (00:16:28) – Yeah. Yeah.
Liz Wilke (00:16:28) – I think that’s right. Now again with yet another caveat.
Caleb Newquist (00:16:33) – That’s why Liz is here everybody. Just just tagging tagging my commentary with caveats.
Caleb Newquist (00:16:40) – Telling like it is with caveats with caveats. The creator of the Sahm rule, Claudia Sahm, has herself said, hey, this number is highly accurate on historic data.
Caleb Newquist (00:16:55) – Yep.
Liz Wilke (00:16:56) – And all of the time basically since COVID has not really fit our understanding historically about what economies do and how they act. So if there was ever a time for the Sahm rule not to be a highly accurate recession predictor now would be that time. So she herself wants to be cautious about placing too much confidence in this indicator just because we may be in a situation where the reality doesn’t fit. I think it’s important to recognize that.
Liz Wilke (00:17:29) – However, I also think that if we trigger that Sahm rule right and we still get some good inflation numbers that is really going to change the balance of the conversation right at the policy level about whether or not to keep these interest rates stronger for longer or to start reducing them right a little bit faster to try and really hit again, hit that soft landing that everybody wants and is hoping for.
Caleb Newquist (00:17:52) – That’s it for this episode. We hope you learned something new and useful for yourself or your business. The Sahm rule maybe, huh? Please let us know what you think of the podcast by leaving a review or sharing it with a friend or colleague who might enjoy it. I’m Caleb Newquist.
Liz Wilke (00:18:08) – And I’m Liz Wilkie. Thanks for listening.
