The Sahm Rule is an informal economic measure that has been shown to be effective in predicting recessions in the United States.
Developed by Claudia Sahm, an American economist, this rule offers a simplified method to detect the onset of a recession, primarily through changes in unemployment rates.
The Sahm rule was developed as part of her policy proposal to send out stimulus checks automatically to families as soon as a recession starts.
Its original purpose was not to forecast a recession, but now it’s used to identify downturns earlier than traditional assessments.
How the Sahm Rule Works
It is based on the observation that when the three-month moving average of the national unemployment rate (U3) rises by 0.50 percentage points or more relative to its low during the previous 12 months, the economy is in recession, or is about to be.
Sahm came up with this metric based on past recessions. She found that in the months leading up to recessions, the unemployment rate tends to breach this 0.5 percentage point threshold.
Historically, after the Sahm Rule was triggered, unemployment continued to worsen.
The rationale is that small increases in unemployment early in an economic downturn can be a leading indicator that a recession is underway.
This approach is akin to monitoring a vital sign in the economy, offering an early warning of economic downturns.
The Sahm Rule is a relatively simple rule to understand and apply, and it has been shown to be more effective than other recession indicators, such as the two-quarter definition of a recession.
This is because the Sahm Rule focuses on the unemployment rate, which is a lagging indicator of economic activity, but one that is also very sensitive to changes in the labor market.
The Sahm Rule has been used to predict recessions in 1990, 2001, 2008, and 2020. In each of these cases, the rule signaled a recession before the National Bureau of Economic Research (NBER) officially declared one.
The Sahm Rule is not a perfect predictor of recessions, and there have been times when the rule has signaled a recession that did not materialize.
However, the rule has a good track record, and it is a tool used by economists and policymakers as it can potentially provide an early warning sign of weakening economic conditions.
Advantages of the Sahm Rule
- Simplicity and Accessibility: One of the key strengths of the Sahm Rule is it is a simple rule. It relies on easily accessible unemployment data and avoids complex calculations.
- Track Record: It has a good track record of predicting recessions. Since it is based on a lagging indicator, which means that it is less likely to be influenced by noise in the data.
- Ease of Understanding: Due to its straightforward nature, the Sahm Rule is easily comprehensible not just by economists, but also by the general public, enhancing its utility in public discourse.
- Adaptability: While initially tailored for the U.S. economy, the Sahm Rule can be adapted for use in other countries, making it a versatile tool in global economic analysis.
Limitations of the Sahm Rule
Despite its benefits, the Sahm Rule is not without limitations:
- Accuracy Concerns: While the Sahm Rule is a reliable indicator, it is not infallible. Economic conditions are complex, and the rule may occasionally provide false signals. For example, it can be triggered by factors other than a recession, such as a sharp increase in the unemployment rate due to a natural disaster.
- Dependence on Unemployment Data: The effectiveness of the rule is heavily reliant on the accuracy and timeliness of unemployment data, which can sometimes be inconsistent.
- Narrow Focus: The rule is based solely on unemployment rates and does not account for other economic indicators that might provide a more comprehensive view of the economy’s health.
Overall, the Sahm Rule stands out for its user-friendly approach to detecting recessions, making it a valuable tool for policymakers and the public alike.
While it is an efficient early warning system, it is important to use it in conjunction with other economic indicators for a more rounded understanding of economic trends and conditions.