Sahm rule: A real-time recession indicator

Open full sized image

But is it really a recession?

© zef art/stock.adobe.com; Photo illustration Encyclopædia Britannica, Inc.

When a recession appears on the horizon, you—as an investor, business owner, or policymaker—might find yourself needing to take action. You don’t want to wait until the recession is in full swing. But you also want to refrain from jumping the gun, taking evasive action on a contraction that may or may not happen.

Remember the old Wall Street quip: “Economists have predicted nine out of the last five recessions.”

Pinpointing an early-stage recession in real time is what the Sahm rule aims to do. In the olden days, we would wait until the “recession referees” at the National Bureau of Economic Research (NBER) declared an official contraction (or wait for two consecutive quarters of negative GDP). In more recent days, we might look for an inverted yield curve, which often (but not always) precedes a recession. But now there’s the Sahm rule, which is designed to detect a recession in real time by tracking the unemployment rate and following a simple formula.

Developed by economist Claudia Sahm during her tenure in the U.S. Federal Reserve, the Sahm rule formula is pretty simple:

When the three-month moving average of the national unemployment rate (U3) rises by 0.50 percentage points or more relative to the low in the past 12 months, the economy is in a recession.

Sahm also noted that when the unemployment rate exceeds half a percent, it typically starts with a gradual increase before accelerating to a sharp spike (see figure 1). Nearly all recessions since the end of WWII (which marked the beginning of her sample data) displayed this same behavior. The point of the indicator is to identify a recession early on, before the unemployment rate gains speed.

Open full sized image

Figure 1: RECESSION WARNING. When the three-month moving average of the unemployment rate moves up, it’s probably time to plan for a recession. Note that in August 2024, the moving average rose to 0.57%—above the recession indicator threshold—but fell back to 0.50 the following month.

Source: Sahm, Claudia, Real-time Sahm Rule Recession Indicator [SAHMREALTIME], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/SAHMREALTIME, October 23, 2024.

Sahm developed this simple indicator for one simple reason: to give fiscal policymakers the green light for immediate action at the onset of a recession.

When the government ramps up its fiscal engines (i.e., engages in deficit spending), it can spend billions of dollars to stabilize the economy.

By accurately detecting recessions early on, policymakers can implement fiscal policy to stabilize the economy before conditions worsen. And that’s what Sahm aimed to do when she developed her rule in 2019 while at the Fed.

It works best when unemployment is caused by decreased labor demand. The Sahm rule relies specifically on the kind of unemployment that arises from a lack of demand. In other words, companies, experiencing shrinking demand for their products and services, are forced to lay off workers and cease hiring in order to stabilize their cash flows.

When unemployment of this kind takes place across multiple segments of the economy, it typically signals economic contraction (“recession”). That, in essence, is how the Sahm rule uses labor data to detect the early stages of a recession.

It doesn’t work when unemployment is caused by increased labor supply. Not all unemployment is caused by a slack in labor demand; sometimes there’s an oversupply of labor. Historical examples of oversupply include expansions in immigration and increases in the labor participation rate (such as a large generation of new graduates coming of age, or a horde of retirees suddenly reentering the workforce). 

In such instances, it’s not that businesses are laying off workers; it’s that new workers who just entered the workforce can’t find jobs. Under these conditions, the Sahm rule can generate false positives, making it unreliable as a recession indicator.

That’s what happened in the years following the COVID-19 pandemic in 2020. Millions of workers opted out of the workforce during and after the lockdowns, despite high labor demand among businesses (what economists called the “Great Resignation”).

While workers slowly reentered the workforce amid a tight labor market, immigration to the U.S. also ticked up. This oversupply in workers drove the unemployment rate higher, but it wasn’t caused by a lack of demand—the unemployment factors were not the kind suitable for the Sahm rule. Hence, there was no recession in the economy, despite the Sahm rule being triggered in the summer of 2024.

The Sahm rule didn’t give the only false positive. Another widely used recession indicator, the inverted yield curve (typically taken as the yield on a 10-year Treasury note minus the yield on the 2-year Treasury note), also gave a false positive. It stayed inverted for more than two years—the longest period in its history (see figure 2).

Open full sized image

Figure 2: INVERTED YIELD CURVE AND RECESSION. In the postwar period, an inverted yield curve (defined by a 2-year U.S. Treasury note yield that’s higher than the 10-year Treasury rate) presaged a recession by several months. That correlation did not hold in the 2022–24 inversion.

Source: Federal Reserve Bank of St. Louis, 10-Year Treasury Constant Maturity Minus 2-Year Treasury Constant Maturity [T10Y2Y], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/T10Y2Y, October 23, 2024.

To be clear, both the Sahm rule and the 10-2 yield curve inversion are widely regarded as key recession indicators. But the difference between them is that the 10-2 yield curve is a predictive indicator, while the Sahm rule is designed to confirm a current and early-stage recession.

Thanks to the unprecedented distortions brought on by the pandemic years, neither indicator functioned the way most economists had expected, despite their historical accuracy.

The Sahm rule is designed to spot recessions early by tracking the unemployment rate. Claudia Sahm developed this indicator specifically with policymakers, hoping to provide them with an early confirmation signal to begin implementing fiscal stimulus. But the Sahm rule can generate false positives when the unemployment rate rises due to an oversupply of workers rather than a lack in demand among businesses.

Although this indicator was designed for policymakers, investors can also benefit from the Sahm rule by using it to detect shifts in the economic cycle. That, in turn, can help them adjust their investment strategies. For example, at the front end of a recession, a proactive investor might shift from cyclical stocks to defensive stocks, or invest more heavily in fixed-income securities. An experienced trader might consider put options for portfolio protection, and an aggressive, opportunistic trader might turn to short selling in hopes of profiting from a downturn.

This article is intended for educational purposes only and not as an endorsement of a particular financial strategy. Encyclopædia Britannica, Inc. does not provide investment advice.