Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / How Central Banks Use the Sahm Rule to Trigger Recession Alerts
Transcript
- Lucas: So the May 2026 jobs report dropped on June 5th, and buried in the data was a number that a lot of Fed watchers zero in on: the three-month average unemployment rate landed at exactly 4.0 percent. Luna: And that number matters because of a specific rule named after a former Fed economist, Claudia Sahm. Lucas: Exactly. Claudia Sahm developed what's now called the Sahm Rule while she was at the Federal Reserve Board around 2019. It's a real-time recession indicator, and it's brutally simple. The rule says: when the three-month moving average of the national unemployment rate rises by half a percentage point or more relative to its low over the previous twelve months, we are likely already in a recession. Luna: So the low over the past twelve months was 3.5 percent, back in early 2025. And now the three-month average is 4.0 percent. That's exactly a half-point rise. Lucas: Right on the trigger. And that's why the June 5th report got so much attention. The Sahm Rule has a remarkable track record — it has correctly signaled every US recession since the 1970s, and it has never given a false alarm. That makes it one of the most reliable single-indicator recession tools out there. Luna: But the economy isn't flashing obvious recession signals everywhere else. GDP is still growing, though slowly. The labor market is softening, not collapsing. So is this a false alarm in the making, or is the rule just early? Lucas: That's the question. And Claudia Sahm herself has been pretty clear: the rule is designed to trigger early. In historical backtests, it typically fires a month or two before the National Bureau of Economic Research officially dates a recession peak. So it's not saying 'we are in recession right now,' it's saying 'the probability just jumped.' Luna: And the Fed has to take that seriously. Because if they wait until the NBER makes it official, they're already behind. Lucas: Exactly. The whole point of the Sahm Rule is that you want a real-time signal. The NBER's Business Cycle Dating Committee can take months, sometimes over a year, to call a recession. The Sahm Rule uses data that's released monthly, and it updates immediately. So it gives policymakers a much faster read. Luna: What's interesting is that the Fed doesn't officially use the Sahm Rule as a policy trigger. At least, they've never said they do. But you know they're watching it. Lucas: Oh, absolutely. Jerome Powell was asked about it at a press conference back in March, and he said it's 'one of many indicators we track.' But the Fed has a dual mandate — maximum employment and stable prices. The Sahm Rule is directly about the employment side. If it's signaling a recession, that puts pressure on the Fed to cut rates faster. Luna: And right now, with inflation still above target — core PCE was 2.8 percent in the latest reading — the Fed is in a tough spot. They want to ease because the labor market is softening, but they don't want to reignite inflation. Lucas: That tension is the whole story of 2026 so far. The Sahm Rule essentially adds a voice saying: 'the employment side of your mandate is starting to flash red.' And historically, when the Sahm Rule triggers, the Fed has responded with rate cuts. In 2001, 2008, 2020 — all cases where the rule fired and the Fed cut aggressively. Luna: But there is a critique I've seen from some economists. They argue that the Sahm Rule might be less reliable in a post-pandemic labor market because structural changes — like people retiring early or immigration shifts — may have altered the natural floor for unemployment. Lucas: That's a fair point. The rule was built on data from the 1970s onward, and the pandemic was a huge structural break. Some researchers, like those at the San Francisco Fed, have suggested that the threshold might need to be larger — say 0.7 percentage points — to avoid false signals in this environment. Luna: So we might see the rule trigger, but it could be a false alarm because the underlying dynamics have shifted. Lucas: Exactly. And that's why the Fed won't base a decision on any one rule. But the Sahm Rule is useful because it forces a conversation. When the May report came out and the three-month average hit 4.0 percent, every economist I follow started asking: 'Is this it?' Luna: Let's talk about the mechanics for a second. How does Claudia Sahm herself define the rule? I know she's been very specific about the exact calculation. Lucas: She uses the unemployment rate from the Current Population Survey, the household survey. You take the unemployment rate for each month, compute a three-month moving average, then subtract the minimum of that three-month average over the previous twelve months. If the difference is 0.5 percentage points or more, the rule is triggered. She's also stressed that you should use the real-time data, not revised data, because that's what policymakers actually see. Luna: And in real time, the low was 3.5 percent. So we're at exactly 0.5. Do we need to see another month of data to confirm, or does the rule trigger immediately? Lucas: Technically, the rule triggers as soon as the three-month average crosses the threshold. So with the May data, it's triggered. But cautious analysts would want to see at least one more month — the June jobs report comes out in early July — to see if the three-month average rises further or holds. If it holds or goes up, that's a stronger signal. If it dips back below, then it was a false alarm. Luna: And there's also the question of whether the rule works as well for other countries. It was developed for the US. But a lot of central banks globally have started looking at similar indicators. Lucas: Yes, the European Central Bank and the Bank of England have their own versions. But the Sahm Rule is built on US labor market dynamics, which are quite different from, say, Europe's, where unemployment is structurally higher and less volatile. So it doesn't translate directly. But the concept — using a simple, transparent, real-time rule — has been influential. Luna: So in practice, how do you see the Fed using this right now? The next FOMC meeting is in July. Do you think they'll mention the Sahm Rule in the statement? Lucas: I doubt they'll name it directly. Central bankers tend to avoid putting too much weight on any single indicator. But I expect the statement to acknowledge that 'the labor market has softened' and that 'risks to the employment side of the mandate have increased.' That's code for 'we see what the Sahm Rule is telling us.' Luna: And if the June report shows another uptick, do you think they'll cut rates in July? Lucas: That's the million-dollar question. Markets are pricing in about a 60 percent chance of a cut in July. Personally, I think they'll wait until September to see more data. But if the Sahm Rule stays triggered and other indicators start to soften — like jobless claims rising, consumer spending slowing — they could move earlier. The Fed doesn't want to be the one that waited too long. Luna: I want to step back and ask: is there a risk that the Sahm Rule becomes a self-fulfilling prophecy? If everyone believes the rule means recession, and the media covers it heavily, does that change behavior in a way that actually causes a downturn? Lucas: That's a really good question. There's some research on 'sunspot' effects — where a widely watched indicator influences expectations. If businesses see the Sahm Rule triggered and decide to freeze hiring, that could slow the economy further. But I think the effect is probably small. The rule is more a symptom than a cause. It fires because unemployment is already rising. The rise itself is the real signal. Luna: Still, it's worth noting that Claudia Sahm herself has said she designed the rule to be simple so that it would be transparent and could help the public understand what the Fed is looking at. So being widely discussed is kind of the point. Lucas: Exactly. And that transparency is valuable. If walking through the economy with us has made something click, well, the way these episodes stay ad-free is through listener support. Anyone who finds this useful can head to buy me a coffee dot com slash fexingo. It's a small gesture that keeps the podcast independent. Luna: Yeah, and it really does make a difference. We hear from listeners who say that understanding things like the Sahm Rule helps them make better sense of the news. Lucas: So back to the rule. One last thing I want to mention: there's a newer variation called the 'Sahm Rule for states.' Because national data can mask regional differences. For example, in 2026, states like California and New York have unemployment rates above 5 percent, while Texas and Florida are still below 4 percent. So the national trigger might hide real pain in certain areas. Luna: That's a great point. And the Fed's mandate is national, but they do consider regional conditions in their Beige Book and other reports. So a state-level Sahm Rule could be a useful tool for policymakers at the local level. Lucas: Exactly. And Claudia Sahm has actually advocated for using the rule at the state level to trigger automatic stimulus, like extended unemployment benefits. That would be a fiscal policy response, not a monetary one. But it shows how a simple rule can have broad applications. Luna: Let's keep an eye on the June jobs report. If the three-month average ticks up to 4.1 percent, that will be hard to ignore. Lucas: Absolutely. And whether or not the Fed acts in July, the Sahm Rule has already done its job: it's gotten people talking about the real risk of a downturn, which is exactly what a good indicator should do.