Goldman Sachs interviews the founder of the Rule of Sam: A strong non-farm payroll report will make me more worried about a recession

As the Federal Reserve's focus shifts from inflation to employment, a recession indicator called the "Sahm Rule" is becoming more well-known. After the unexpected rise in the U.S. unemployment rate to 4.3% in July, this rule has been triggered.

The Sahm Rule is based on changes in the unemployment rate to predict economic recessions. According to this rule, when the three-month moving average of the U.S. unemployment rate rises by 0.5 percentage points or more from the lowest point of the past 12 months, it signals that the U.S. has entered the early stages of an economic recession.

The founder of this rule is Claudia Sahm, currently serving as the Chief Economist at New Century Advisors. Previously, she held a position as a section chief at the Federal Reserve Board.

In an interview with Goldman Sachs, Sahm herself pointed out that although the U.S. economy may not be in a recession currently, the Federal Reserve should take prompt and decisive action to avoid further unnecessary weakness in the labor market.

Here is the full content of the Goldman Sachs interview:

Goldman Sachs: You created the Sahm Rule, which predicts U.S. economic recessions based on labor market conditions. Why did you create this rule, and how reliable has it been historically as a recession indicator?

Sahm: I developed this rule in early 2019 as part of an effort to improve fiscal stimulus programs. The goal was to identify a recession indicator that could trigger automatic stabilizers like stimulus checks. This indicator needed to be highly reliable, as it would initiate large-scale fiscal stimulus plans, and also detect recessions early to minimize the pain and severity of economic downturns. When I examined economic recessions in U.S. history, I found that an indicator based on real-time changes in the unemployment rate could meet both criteria. The beauty of using the unemployment rate as a recession indicator is that small increases in the unemployment rate often evolve into typical large increases during a recession.

In fact, a signal of recession is sent when the three-month moving average of the unemployment rate rises by 0.5 percentage points from its 12-month low. Therefore, when the threshold of 0.5 percentage points is reached, the Sahm Rule is triggered, which typically occurs around four months after the start of a recession, meeting the "early" requirement. The rule is designed very accurately. Since 1970, the Sahm Rule has accurately indicated every U.S. economic recession and no recession has occurred without triggering the rule. Although it incorrectly triggered in 1959 and 1969, recessions occurred within six months in both cases.

Goldman Sachs: The recent increase in the U.S. unemployment rate has triggered the Sahm Rule. So, is the U.S. economy currently in a recession?

Sahm: Despite what the rule indicates, it is highly likely that the U.S. economy is not in a recession. Most of the economic data considered by the National Bureau of Economic Research in determining economic recessions looks robust. Real GDP in the U.S. grew at an annual rate of 3% in the second quarter. Real personal income excluding transfer payments increased by 1.6% year-on-year in July. Consumer spending remains strong, as indicated by recent July retail sales data The average number of new jobs added per month in the past three months is 170,000. This does not seem like a sign of economic contraction.

Goldman Sachs: So, does the triggering of the Sam Rule misleadingly depict the health of the U.S. labor market, thereby affecting the judgment of the economy?

Sam: The recent rise in the unemployment rate conveys a more pessimistic view of the current and future state of the U.S. economy than the actual situation. Typically, a decrease in labor demand—whether manifested as increased layoffs or reduced hiring—will drive the unemployment rate up. This decrease in demand may be self-reinforcing, as workers without wages or with reduced wages will reduce spending, leading to a decrease in demand for other workers, who will then also reduce spending—this is the strong feedback loop on which the Sam Rule relies, ultimately leading to an economic downturn.

However, the rise in the unemployment rate may also be for good reasons, such as an increase in labor supply, and these additional labor forces may not be absorbed by the economy today but can be in the future. Once job opportunities are sufficient to accommodate these new job seekers, the unemployment rate will decrease, and more labor will eventually promote economic growth. Therefore, supply dynamics may be an important factor driving the rise in the unemployment rate, which is the current situation.

Due to the surge in immigration and workers re-entering the labor market after the pandemic, the increase in labor supply accounts for about half of the recent rise in the unemployment rate, a proportion significantly higher than in previous recessions, when most of the rise in the unemployment rate came from workers temporarily or permanently laid off. This has always been a fatal flaw in using the unemployment rate as a recession indicator, as it cannot distinguish between demand and supply factors. Like other important economic concepts, such as the most widely used recession indicator—GDP growth declining for two consecutive quarters, and the Phillips curve, the Sam Rule is also a story about the demand side. If there's one thing we've learned from the 4.5 years since the outbreak of the pandemic, it's that the supply side is equally important.

Nevertheless, I always hesitate to claim "this time is different," especially when this indicator has been running accurately for decades. The situation in the labor market is much more complex than the relatively mild rise in the unemployment rate, and other data are sending more worrying signals. Two important labor market strength indicators—hiring rates and quit rates—have both declined, as employers, faced with reduced labor demand, rely more on reducing hiring rather than increasing layoffs—hiring rates are now back to the low point of 2014, while layoff rates remain at historically low levels—employees are also becoming less willing to quit.

We should not be too comforted by the fact that layoff rates have not risen. Due to the difficulty of rehiring employees after the pandemic, employers may currently be unwilling to lay off workers, but even in a typical economic recession, layoffs are one of the last resorts for employers to use; layoff rates have never been an early warning indicator. Therefore, even though the Sam Rule may currently exaggerate the weakness in labor demand, it still provides us with useful information about the health of the U.S. labor market.

Goldman Sachs: So, how concerned are you about the prospect of an economic recession in the U.S. in the coming months? Sam: I have become more concerned in recent months. Throughout the economic cycle, I have always believed in the possibility of a "soft landing", and I have been very confident in refuting the market's widespread recession expectations in 2022 and 2023, as I believe that the supply chain disruptions during the pandemic will eventually ease, which will greatly help reduce inflation. Additionally, the labor market is strong, and household financial conditions are good, all of which will help the economy withstand the pressure of the Federal Reserve's rate hikes to curb inflation. As we discussed, the U.S. economy is currently in a relatively good state.

But the future trends are worrying. While job growth remains steady, it has slowed down in the past few months, and recently we learned that employment figures may be revised downward. Although the unemployment rate remains low, it has been steadily rising since March. It needs to be made clear that my basic expectation is still that there will be no recession, as the current slowdown in the U.S. economy is a result of policy choices.

The Federal Reserve has intentionally put downward pressure on the economy in its fight against inflation, as Federal Reserve Chairman Powell stated at the Jackson Hole meeting, it is time to relieve some pressure by cutting interest rates. However, the Federal Reserve has not taken action yet, despite the deteriorating economic outlook, and the labor market and household balance sheets are not strong enough to continue supporting the economy against high interest rates. Therefore, my current expectation of an economic recession is the highest throughout the cycle - about 25%.

Goldman Sachs: So, is the Federal Reserve lagging behind in cutting interest rates now?

Sam: Whether the Federal Reserve is lagging behind is somewhat irrelevant, as the Federal Reserve cannot go back to cutting rates in July, and the answer will only be clear in a few months, by which time it will be too late due to the long-term and variable lag effects of monetary policy. A better and more actionable question is whether the current monetary policy stance is reasonable, and the answer is obvious: it is unreasonable. The only reason for the Federal Reserve to raise and maintain interest rates above any reasonable neutral level is to reduce inflation, and once the Federal Reserve goes too far in pursuit of this goal, it is excessive.

The U.S. labor market is currently experiencing a completely unnecessary slowdown. Inflation is steadily returning to target, with the latest CPI and PPI data providing more evidence. So, if the economy enters a recession in the next year, it is not because the Federal Reserve has no choice but to induce a recession to curb inflation, but because of a major policy mistake. Therefore, regardless of whether the Federal Reserve is lagging behind, it is now clear what policymakers must do: cut interest rates.

Goldman Sachs: How much should the Federal Reserve cut interest rates, and at what speed?

Sam: The Federal Reserve cannot afford to move slowly, such as cutting rates once every quarter, but must quickly achieve its dual mandate. The Federal Reserve has made it clear over the past year that it wants to see more good inflation data before starting to ease policy, and it seems to believe it has plenty of time because the labor market is very strong. But **data is inherently lagging, and the Federal Reserve previously chose to wait until the downward trend in inflation was very clear in the data before acting, leading to the need for decisive action now **

I have always believed that using the labor market as a safety net for policies is a very risky practice, and recent data further proves this. Therefore, the Federal Reserve must now start a series of steady rate cuts. I currently believe that there is no need to take extreme measures, such as consecutive cuts of 50 or 75 basis points, let alone emergency cuts. A 25 basis point cut may be enough to avoid the worst economic outcomes, but these cuts must be implemented decisively, rather than gradually.

Goldman Sachs: What do you think is the likelihood of the Federal Reserve taking these measures? How would your recession expectations change if they don't?

Sam: Powell clearly acknowledges the need to start cutting rates now, which is reassuring, and due to recent inflation and labor market data - we know the Fed closely monitors these data - I think the likelihood of consecutive rate cuts is higher than it was a month or two ago. The Fed has also used a risk management framework for most of this cycle, which tends to support a series of small rate cuts rather than periodic large cuts, as the latter could have a disruptive impact.

Nevertheless, I am still concerned that the Fed's actions may not be fast enough. Atlanta Fed President Raphael Bostic spoke after the soft July employment report, reiterating that one of the worst outcomes would be the Fed cutting rates but inflation rebounding. I disagree with this. The worst outcome is the U.S. economy unnecessarily entering a recession to lower inflation. The Fed is essentially a slow-moving and conservative institution, which is usually a good quality as policymakers should be thoughtful. But now, as we have discussed, the path ahead is clear, and the Fed needs to act swiftly. Failing to do so will needlessly increase the risk of a recession.

Goldman Sachs: If the August employment report is stronger than expected, how would your views on the Fed's path and the probability of a recession change?

Sam: I might be more concerned about a recession, as a strong report could slow down the Fed's actions. The Fed may not see the July employment report as a serious recession signal. A robust August employment report would only confirm this belief, especially as temporary layoff factors that led to the rise in the July unemployment rate dissipate. Therefore, a robust employment report would give policymakers a false sense of confidence and reduce the urgency of rate cuts, which would be a mistake.

The labor market is still cooling, which is concerning, and unless a strong reason can be provided to show that the labor market has stabilized, Fed officials must act decisively. Therefore, I will not be reassured unless the federal funds rate is significantly lower than the current level, or unless there is a change in economic fundamentals that would allow the economy to withstand higher rates. And at least for now, there is not enough reason to support the latter view