The U.S. Federal Reserve (the Fed) has in our opinion made a mistake by not cutting rates and they are likely to remain cautious in adjusting rates lower in the face of mixed data. The FOMC can easily justify up to 50bps of cuts as a corrective action: since the hiking cycle formally ended, we have seen approximately 50bps of tightening. Inflation expectations have declined, raising real rates and implicitly tightening policy.

However, triggering the Sahm Rule alone does not necessarily signal recession, although we see risks increasing. The markets appear to have forgotten the relative strength of other measures in the economy that instead point to a continued, if ugly, normalization period. In this monthly, we argue that generalized anxieties are driving the market overreaction.

Sahm Alarm

The Sahm Rule has been triggered: the three-month moving average unemployment rate has risen by 50 bps above its minimum in the last 12 months. The labor market historically reaches a tipping point—triggering the Sahm Rule—after which unemployment rises abruptly. Triggering the Sahm rule typically coincides with recession onset.

There’s no economic theory behind this rule, and nothing that “requires” or forces a recession. Indeed, this time could be different as the economy continues to normalize from the pandemic. But the rule neatly captures the way labor markets can suffer a sudden change: from a 50 bps increase in the unemployment rate versus the year before, the Sahm rule can presage double or triple that pace the following year.

If the Sahm Rule is correct in signaling a recession, then history would guide us to perhaps a 5% unemployment rate by year end 2025 and 5.5% over the next year.

Mimicking the unemployment path of the mildest recession over the last 50 years would still see peaks above 5%. We do not expect this as a base case but acknowledge increasing risks.

A note on soft landings, during the one “soft landing” that the Fed has managed in recent decades (a hiking cycle from 1993-1995), the unemployment rate never rose by more than 0.2 percentage points over the 12 months prior.

The markets, as usual, overreacted to the Sahm rule trigger. However, they are right to be more worried about unemployment than inflation: according to the U.S. Bureau of Labor Statistics (BLS), recent changes to nonfarm payrolls additions have been highly concentrated in just two sectors, and initial jobless claims continue to ratchet upward.

Not So Clear Cut

Despite the Sahm rule indicating a potential recession, the recent market volatility, calls for as many as four rate cuts by December, and fears of a downturn could all be more attributable to overwhelming uncertainty more than economic data.

The election has created fiscal and regulatory policy uncertainty, a potential mistimed Fed pivot has created monetary policy uncertainty and anxiety about whether the economy has truly escaped recession, and tension in the Middle East has elevated geopolitical uncertainty.

The Sahm rule simply tells us that unemployment has accelerated up from recent record lows. Even as the unemployment rate rises (to “only” 4.3%), the Job Openings and Labor Turnover Survey (JOLTS) job openings rate has been stable the last three months above pre- pandemic levels. Qualitative data including comments on ISM surveys, regional Federal Reserve surveys, and the Beige Book also indicate that manufacturing firms are still having difficulty finding adequately qualified workers to fill open positions. Firms responding to the most recent ISM services survey noted that labor was in short supply and going up in price. If labor demand is still strong, then the rise in unemployment may be a normalization and not a sign of “real” economic weakness.

Other economic data points remain stable too. U.S. Bureau of Economic Analysis data shows GDP for the second quarter grew 2.8%, with Private Domestic Final Purchases (PDFP), the more stable component of GDP reflecting domestic consumption and investment, accelerating to 2.7%. The ISM services index moved back into expansion territory in July, and the services sector has expanded for 47 out of the last 50 months. Corporate profits, which in theory support employment, remain strong despite mild softening in the second quarter.

U.S. Outlook Summary

We continue to expect growth in 2024 to be softer than 2023 but remain at or above long-term trend growth with no recession this year. Second quarter GDP was strong, particularly with respect to private domestic final demand. Investment has been mixed this year, with Non- Residential Fixed Investment (NRFI) disappointing in Q1 and residential investment disappointing in Q2. Election uncertainty and Federal Reserve policy may dampen investment until there is more clarity around both.

The labor market has triggered the Sahm rule by rising to 4.3% unemployment in July. Although not a guarantee of a recession, this is certainly a warning to the Fed that labor market weakness has become urgent.

We continue to expect the Fed to cut rates by a total of 75 bps by year end. Recent pricing of as many as five cuts by year end are likely an overreaction to the coinciding poor employment report and lack of a Fed cut.

Risks to the Outlook

Recession risk has risen slightly. The Fed has already likely made a mistake, due to their desire to progress in a deliberate, foreseeable, and data-dependent way. They are likely to remain cautious in adjusting rates lower in the face of mixed data.

The labor market is in a precarious place but may be helped by the Fed, resilient profit margins, and wealthier consumers. Risks of a re-emergence of inflation remain a possible concern, although these risks are coming into greater balance with downside risks to economic growth.

The economy may be stronger than the recent rise in unemployment indicates, making the case for quickly loosening monetary policy not so clear cut.

Both geopolitical and political uncertainty remains elevated even though several of the many elections set for this year have already taken place—e.g. in Taiwan, India, U.K. and France. The long run fallout of these is still very unclear. Another key uncertainty is the potential spread of the conflict between Hamas and Israel.

Perhaps most consequentially for the U.S. economy, uncertainty around the U.S. elections has increased relative to early summer. The Democratic switch from the incumbent President Biden to Vice President Harris, and the additions of JD Vance and Tim Walz to the tickets have made both election outcome and the likely policies implemented more uncertain.

Polling is highly volatile now and we expect that polling starting in September will be more likely to provide a clearer view of election outcomes.

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