Unemployment, Interest Rates, and the Sahm Rule

Today’s jobs report was the worst in a while, with employment increasing by 114,000 jobs in July and the unemployment rate increasing to 4.3 percent. A year ago, the unemployment rate was 3.5 percent, and a month ago it was 4.1 percent.

This will increase pressure on the Federal Reserve to cut interest rates. The July jobs report triggered the Sahm rule, named for former Federal Reserve economist Claudia Sahm, which is a recession indicator.

The Sahm rule says that a recession is beginning when the three-month average of the unemployment rate is 0.5 percentage points greater than the twelve-month low point. Now we know that the average of May, June, and July is 0.53 percentage points greater than the twelve-month low point.

One purpose of the Sahm rule is to allow for a more forward-looking recession indicator. Other recession indicators, such as two consecutive quarters of GDP contraction, are by definition backward-looking. The Business Cycle Dating Committee of the National Bureau of Economic Research is primarily engaged in economic history, not policy-making. The Sahm rule is supposed to help the Fed and Congress to respond to the economy in real time.

Embedded in that idea is the assumption that the Fed and Congress are capable of actually tailoring monetary and fiscal policy in real time to respond to recessions before they get out of hand. The historical evidence on that is, well, slim. And current fiscal irresponsibility is such that if you knew nothing other than the federal deficit, you’d assume the U.S. has been in a massive recession for at least the past two years.

Regardless, the Sahm rule has a very good historical record of predicting recessions, so it’s not insignificant that it has been triggered. But there are two other historical issues that complicate things.

The first is that, prior to basically right now, nobody would think that a 4.3 percent unemployment rate was a worrying sign of impending recession. For decades, about 4 percent was considered full employment. It was feared that going below that would cause an increase in inflation. Also, there will always be unemployed people, even in a really good economy, because people will still switch jobs and be unemployed briefly in between.

The unemployment rate took a long time to come down after the Great Recession, but as it came down, it kept steaming right past 4 percent. The unemployment rate was at or below 4 percent for every month from March 2018 to February 2020, right before the pandemic recession. After that recession, the unemployment rate went right back to where it was. It was at or below 4 percent every month from December 2021 through May 2024.

For perspective, the unemployment rate never went below 5 percent in the entire decade of the 1980s. We today remember the mid ’90s as good economic times, but the unemployment rate then was between 5 and 6 percent. So sounding the recession alarm at 4.3 percent is historically very unusual.

The second issue is that interest rates are not historically high. They’re pretty normal now. They only feel high because they were historically low in the 2010s.

Again, compared to the mid ’90s, generally viewed as a good time economically, the federal funds rate, the rate the Federal Open Market Committee targets, is basically identical to what it is today. The span from 2008 to 2016, when money was basically free (interest rates are the price of money, and they were pretty much zero in that span), is the anomaly.

Today’s average 30-year fixed mortgage rate of 6.73 percent is lower than it was at any point from when data begin in 1971 all the way through October 1998. The average mortgage rate was right around 6 percent for most of the 2000s. The borrowing costs homebuyers currently face are not unusual. What was unusual was the free-money period of the 2010s.

Money is supposed to have a price. Zero interest rates were a vacation from reality. The U.S. should not go back to that, and Americans should not expect that to return.

That doesn’t necessarily mean a rate cut would not be justified. The NGDP gap is the difference between actual total spending in the economy and expected spending. When it is positive, monetary policy is too loose. As measured by the Mercatus Center, the NGDP gap was still increasing through the beginning of 2023. But it has since peaked and is now declining. That indicates that monetary policy is finally tightening, though the NGDP gap is still positive, so it is not tight per se. Monetary policy affects the real economy with lags, so it could be time to cut rates soon to keep it from getting too tight in the future.

But those decisions should be informed primarily by metrics such as the NGDP gap and inflation expectations, not by an unemployment rate of 4.3 percent or historically normal interest rates.