The Fed is 'playing with fire' by not cutting rates, says creator of 'Sahm Rule' recession indicator

The Federal Reserve is risking tipping the economy into contraction by not cutting interest rates now, according to the author of a time-tested rule for when recessions happen.

Economist Claudia Sahm has shown that when the unemployment rate's three-month average is half a percentage point higher than its 12-month low, the economy is in recession.

As the jobless level has ticked up in recent months, the "Sahm Rule" has generated increasing talk on Wall Street that what has been a strong labor market is showing cracks and pointing to potential trouble ahead. That in turn has generated speculation over when the Fed finally will start reducing interest rates.

Sahm said the central bank is taking a big risk by not moving now with gradual cuts: By not taking action, the Fed risks the Sahm Rule kicking in and with it a recession that potentially could force policymakers to take more drastic action.

"My baseline is not recession," Sahm said. "But it's a real risk, and I do not understand why the Fed is pushing that risk. I'm not sure what they're waiting for."

"The worst possible outcome at this point is for the Fed to cause an unnecessary recession," she added.

As a numeric reading, the Sahm Rule stood at 0.37 following the May employment report from the Bureau of Labor Statistics that showed the unemployment rate rising to 4% for the first time since January 2022. That's the highest the Sahm reading has been on an ascending basis since the early days of the Covid pandemic.

The value essentially represents the percentage point difference from the three-month unemployment rate average compared to its 12-month low, which in this case is 3.5%. A reading of 0.5 would represent an official trigger for the rule; a couple more months of 4% or better readings on the unemployment rate would make that happen.

The rule has applied for every recession dating back to at least 1948 and thus works as an effective warning sign when the value starts to increase.

Even with the rising jobless level, Fed officials have expressed little concern about the labor market. Following its meeting last week, the rate-setting Federal Open Market Committee labeled the jobs market as "strong," and Chair Jerome Powell at his press conference said conditions "have returned to about where they stood on the eve of the pandemic — relatively tight but not overheated."

In fact, officials sharply lowered their individual forecasts for rate cuts this year, going from three expected reductions at the March meeting to one this time around.

The move surprised markets, which still are pricing in two cuts this year, according to the CME Group's FedWatch measure of fed funds futures market contracts.

"The bad outcomes here could be pretty bad," Sahm said. "From a risk management perspective, I have a hard time understanding the Fed's unwillingness to cut and their just ceaseless tough talk on inflation."

Sahm said Powell and his colleagues "are playing with fire" and should be paying attention to the rate of change in the labor market as a potential harbinger of danger ahead. Waiting for a "deterioration" in job gains, as Powell spoke of last week, is dangerous, she added.

"The recession indicator is based on changes for a reason. We've gone into recession with all different levels of unemployment," Sahm said. "These dynamics feed on themselves. If people lose their jobs, they stop spending more people lose jobs."

The Fed, though, finds itself at a bit of a crossroads.

Tracking a recession where the unemployment rate starts this low requires a trip all the way back to the latter part of 1969 into 1970. Moreover, the Fed rarely has cut rates with unemployment at this level. Central bankers in recent days, including on several occasions Tuesday, have said they see inflation moving in the right direction but don't feel confident enough to start cutting yet.

By the Fed's preferred barometer, inflation ran at 2.7% in April, or 2.8% when excluding food energy prices for the core reading that policymakers especially zero in on. The Fed targets inflation at 2%.

"Inflation has come down a lot. It's not where you want it to be, but it is pointed in the right direction. Unemployment is pointed in the wrong direction," Sahm said. "Balancing these two out, you get closer and closer to the danger zone on the labor market and further away from it on the inflation side. It's pretty obvious what the Fed should do."