Economist Claudia Sahm on CNBC’s The Exchange.
CNBC
The Federal Reserve risks tipping the economy into a contraction by not cutting interest rates now, according to the authors of time-tested rules when recessions occur.
Economist Claudia Sahm has shown that when the three-month average unemployment rate is one and a half percent higher than 12 months, the economy is in recession.
As the unemployment rate has been checked in recent months, the “Sahm Rule” has generated much talk on Wall Street that the strong labor market is showing cracks and pointing to potential problems ahead. The latter has fueled speculation about when the Fed will finally start cutting interest rates.
Sahm, chief economist at New Century Advisors, 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 could potentially force. policy makers to take more drastic measures.
“My base is not the recession,” Sahm said. “But it’s a real risk, and I don’t know if the Fed is pushing to do something risky. I’m not sure if they’re waiting.
“The worst outcome at this point is the Fed causing an unnecessary recession,” he added.
Flashing warning signs
As a numerical reading, the Sahm Rule stood at 0.37 after the May employment report from the Bureau of Labor Statistics showed that the unemployment rate rose to 4% for the first time since January 2022. The highest reading of the Sahm has risen since the early days of the Covid pandemic.
This value essentially shows the difference in percentage points from the average unemployment rate of three months compared to the lowest 12 months, which in this case is 3.5%. A reading of 0.5 will represent an official trigger for the rule; another couple of months of 4% or more reading in the unemployment rate will make that happen.
The rule applies to every recession since at least 1948 and thus serves as an effective warning sign when prices start to rise.
Even with the rising unemployment rate, Fed officials have not worried about the labor market. After last week’s meeting, the rate-setting Federal Open Market Committee labeled the labor market as “strong,” and Chairman Jerome Powell said at a press conference that conditions “are back to where they were on the eve of the pandemic – relatively tight. but not overheated.”
In fact, officials quickly lowered their individual forecasts for rate cuts this year, from the three reductions expected at the March meeting to one this time.
The move surprised the market, which is still priced in two cuts this year, according to CME Group’s FedWatch gauge of fed funds futures contracts.
“A bad outcome here can be bad,” Sahm said. “From a risk management perspective, I find it hard to understand the Fed’s unwillingness to cut and its tough talk on inflation.”
‘play with fire’
Sahm said Powell and his colleagues are “playing with fire” and should pay attention to the rate of change in the labor market as a potential harbinger of danger ahead. Waiting for a “breakdown” in jobs results, as Powell said last week, is dangerous, he added.
“Recession indicators are based on change for a reason. We’ve had recessions with all different levels of unemployment,” Sahm said. “This dynamic feeds itself. If people lose their jobs, they stop spending, (and) more people lose their jobs.”
The Fed, though, finds itself at a crossroads.
Tracing the recession where the unemployment rate started this low requires traveling all the way back to late 1969 into 1970. Moreover, the Fed rarely lowered the unemployment rate to this level. The central banker in recent days, including on several occasions Tuesday, has said that he sees inflation in the right direction but is not yet convinced to start cutting.
According to the Fed’s choice barometer, inflation ran at 2.7% in April, or 2.8% when excluding food energy prices for the core reading that policymakers mainly zeroed in on. The Fed targets inflation at 2%.
“Inflation has come down a lot. It’s not what we wanted, but it’s pointing in the right direction. Unemployment is pointing in the wrong direction,” Sahm said. “Balancing the two, you get closer to the danger zone in the labor market and further away from the inflationary side. It’s pretty obvious what the Fed needs to do.”
