Economist Saham, who invented the recession rule, says the Fed is 'playing with fire'

The Fed risks pushing the economy into deflation by not cutting interest rates now, according to the author of the time-tested rule about when a recession hits.

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

As unemployment has risen in recent months, the “stock rule” has sparked growing talk on Wall Street that the strong labor market is showing cracks and pointing to potential problems ahead. This, in turn, has given rise to speculation about when the Fed will finally start cutting interest rates.

Saham, chief economist at New Century Advisors, said the central bank is taking a big risk by not acting now with the gradual cuts: By not taking any action, the Fed risks triggering the Sahm rule and, with it, a recession that could impose on makers. Policies take more radical action.

“The baseline for me is not a recession,” Sahm said. “But it's a real risk, and I don't 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 numerical reading, the stock's base hit was 0.37 after the Bureau of Labor Statistics' May employment report showed the unemployment rate rising to 4% for the first time since January 2022. This is the highest reading for a stock on the upside. Since the early days of the Covid pandemic.

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

This rule has been applied to every recession dating back to at least 1948, so it serves as an effective warning sign when the value starts to rise.

Even with unemployment rising, Fed officials have not expressed much concern about the labor market. After its meeting last week, the Federal Open Market Committee, which sets interest rates, described the jobs market as “strong,” and its Chairman Jerome Powell said in his news conference that conditions were “back to where they were on the eve of the pandemic — relatively tight.” But not overheated.”

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

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

“Bad outcomes here could be very bad,” Sahm said. “From a risk management perspective, I have a hard time understanding the Fed's unwillingness to cut and their never-ending tough talk on inflation.”

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 the danger ahead. She added that waiting for job gains to “deteriorate,” as Powell spoke last week, is dangerous.

“The recession indicator is based on changes for a reason. We went into a recession with all different levels of unemployment,” Sahm said. “These dynamics feed on themselves. If people lose their jobs, they stop spending, (and) more people lose their jobs.”

However, the Fed finds itself at a crossroads.

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

By the Fed's preferred measure, inflation was 2.7% in April, or 2.8% when excluding food energy prices for the core reading on which policymakers are particularly focused. The Federal Reserve targets inflation at 2%.

“Inflation has come down a lot. It's not where we want it to be, but it's pointing in the right direction. Unemployment is pointing in the wrong direction,” Sahm said. “Balancing those two things, you're moving closer and closer to the danger zone in the labor market and further away from it in terms of inflation. It's pretty clear what the Fed should do.”