Humility and Innovation in Economics

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• Is the U.S. economy about to enter a recession? That’s up for debate, but there are leading indicators we can use to make an educated guess — like the Sahm Rule.
• Economist Claudia Sahm developed the rule that bears her name based on the rate of percentage change of the unemployment rate.
• What does the Sahm Rule reveal about the economy’s current condition, and why is this metric so revealing.

“When I went to college, I didn’t even know what an economist was, let alone that I wanted to be one,” says Claudia Sahm, Chief Economist at New Century Advisors, author of the Stay-At-Home Macro Substack and creator of the Sahm Rule.

“Within pretty short order, I was convinced that economists can do good in the world. We have tools to go at problems that are really important.”

Claudia’s perspective on economics highlights the importance of interdisciplinary thinking. She argues that understanding economics isn’t just about studying current theories and data but also involves considering broader contexts. Her emphasis on interdisciplinary thinking — integrating political economy, historical perspectives and practical policy design — provides a more comprehensive, adaptable understanding of economic issues, which is essential for progress.

Claudia joined host Alan Dunne on an Global Macro installment of Top Traders Unplugged to discuss the current macroeconomic outlook, the state of the US labor market, the recent decline in inflation and much more.

Sahm signals

“The origin of the Sahm Rule ties very much into why I’m an economist,” says Claudia, who developed a proposal in 2019 with several other economists on how to prepare better for the next recession. “This was before we even knew that a recession was coming, and the idea was to take policies that we often do (in my case, the stimulus checks) and put them on autopilot; tie them to economic conditions, have them ready to go, and as soon as the economy takes a turn for the worse, get the help out.”

Identifying the economic conditions that could “very predictably” signal a recession is invaluable “because things, once they start going south, can head south fast,” she adds.

The Sahm Rule focuses on changes in the unemployment rate as a leading recession indicator.

“There’s no magic level,” Claudia points out. “The United States has gone into recessions with an unemployment rate of 4% and with the unemployment rate at 8%. It’s really about how things deteriorate. Are they getting worse?”

Data from the past several decades, however, tells us that “it doesn’t take much of an increase in the unemployment rate to tell us we’re in a recession,” she notes.

Forecasting the future

While rooted in economic data, the Sahm Rule’s development was influenced by Claudia’s broader perspective on policy — such as automatic stabilizers that adjust based on economic conditions. Her foresight was particularly valuable during the COVID-19 pandemic, when rapid economic intervention was crucial.

Despite its innovative design, the Sahm Rule has not yet been used to trigger preset economic measures. However, its existence underscores the importance of preparing for economic downturns in advance. By automating policy responses, the rule aims to reduce the lag between economic shocks and government intervention.

One might argue that the Sahm Rule is a model for proactive economic management. By automating certain policies, governments can ensure timely support in response to economic shocks, reducing the impact of recessions.

Are we heading towards a recession?

The relevance of the Sahm Rule is readily apparent in the current economic climate. While we haven’t reached the 5% increase threshold, the unemployment rate is at 4%, indicating that the economy is on shaky ground.

The periodic recession anxiety we’ve seen in recent years has previously been accompanied by a strong labor market. Now, Claudia says we’re “much, much, much closer” to a recession than we’ve been at any point in the post-pandemic recovery.

“The labor market, for the U.S. really, is the linchpin because most Americans spend what they make — either because they have to or they like to,” she argues. “And most Americans, what they have to spend comes from their paychecks. So we’ve seen a very positive virtuous circle between the labor market and the American consumers. If you lose that, then you’re done.”

Alan asks, “What led to this point?”

“Unlike some of our peer countries, we had a very rapid recovery,” Claudia explains. “And not just the inflation came back. The United States last year had above-trend growth. Things were just moving really fast. And we want to get onto a glide path. We want to come out of this in a sustainably good place. When things are running too fast, it’s often not sustainable and you end up crashing.”

The U.S. economy experienced rapid growth, followed by a period of moderation. This transition makes the economy more vulnerable to policy mistakes. Sahm emphasizes the importance of monitoring a wide range of economic indicators, not just relying on a single measure like the Sahm Rule. The labor market, in particular, is a crucial indicator. Strong employment supports consumer spending, which drives economic growth.

Our next cycle, by the numbers

The most recent labor data was “seemingly strong,” says Alan. “But at the same time, the prior numbers were weak. And then you’ve had a recent pickup in jobless claims. At the same time, the jobs have been easing. … Putting it all together, how would you characterize it?”

Claudia points out that the payroll employment number in May was a far bigger increase month over month than expected (although she notes that the payroll employment data was weaker in April).

Although May’s impressive numbers led to a widespread belief that the labor market was strong and defied expectations, the unemployment rate hit 4% for the first time in over two years.

“We’ve had a notable increase in our unemployment rate since the middle of last year,” Claudia says, adding that that 4% figure has “some very clear ties to the jobs number in the [same] survey,” which was “horrible” — down by about 400,000.

Will the Sahm Rule hold true in the coming months?

Time will tell. But Claudia’s approach to economics demonstrates the value of looking beyond traditional boundaries toward a more nuanced understanding of economic issues. As the unpredictable becomes utterly predictable, her insights remind us of the importance of maintaining a broad perspective. By staying open to new ideas and learning from the past, we navigate the complexities of today’s economic landscape with more resilience than ever before.

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This is based on an episode of Top Traders Unplugged, a bi-weekly podcast with the most interesting and experienced investors, economists, traders and thought leaders in the world. Sign up to our Newsletter or Subscribe on your preferred podcast platform so that you don’t miss out on future episodes.