Economic chatter in the United States and beyond has started to coalesce around the “Sahm rule,” a historically prescient indicator of whether the economy is tipping towards a recession.
“Folks in the U.S. are, quite frankly, freaking out right now over the economy. And it’s been quite the change just over the last week,” says Alicia Planincic, director of policy and economics at the Business Council of Alberta.
Planincic points to the triggering of the Sahm rule following the latest U.S. jobs numbers as a key cause for concern that helped stir up a global selloff in equity markets around the world.
Friday will mark Canada’s turn at the plate with fresh labour force data set for release.
So what is this Sahm rule, and what does it mean — or not mean — for economic prospects in Canada and the U.S.?
What is the Sahm rule?
The Sahm rule is closely monitored by economic policy wonks because it has been “exceptionally predictive” of recessions, Planincic explains, particularly in the U.S.
Over the past few decades, every time the Sahm rule has been triggered, it has been followed by a recession, she says.
The rule was crafted by economist Claudia Sahm, chief economist at New Century Advisors and a former official at the U.S. Federal Reserve.
If the three-month moving average unemployment rate rises 0.5 percentage points over its low point in the preceding 12 months, the Sahm rule is triggered.
Planincic explains that Sahm developed the rule to differentiate between “small wobbles” in the labour market and sustained movements that suggest a more serious deterioration in the economy is coming.
Lately, the U.S. economy has been a “standout” on the world stage, Planincic notes. Solid gross domestic product results and a resilient labour force suggested that the U.S. was headed for the coveted “soft landing,” avoiding a recession even as inflation cools.
But after the U.S. non-farm payrolls report last Friday saw the jobless rate unexpectedly jump to 4.3 per cent, the conditions for the Sahm rule were met.
“That’s got people quite worried,” Planincic says. “The fact that that warning sign is blinking red and it has never, ever in the past incorrectly signalled a recession.”
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Starting on Friday and continuing Monday, stock markets around the world reacted sharply to the renewed recession fears in the U.S., alongside negative impacts to a more technical correction to the carry trade in Japan.
Sahm herself recognized that her eponymous rule had been triggered. But in an interview with Bloomberg, she also urged caution in reading too much into any single indicator, even one as reliable as the Sahm rule.
“All is not lost. The bottom is not falling out. We should never panic,” she said last Friday.
While the latest jobs figures do indicate negative momentum for the U.S. labour market, Sahm noted that the U.S. Federal Reserve has the ability to lower its benchmark interest rate and bring the damage under control — though it’s a move she argued the Fed should’ve taken at its decision last week, rather than waiting until September as many economists now expect.
What does it mean for Canada?
For anyone fretting about whether Friday’s jobs figures could portend a similar fate for the Canadian economy as the U.S. faced a week earlier, worry not: Canada already triggered the Sahm rule months ago.
Planincic wrote in June that the indicator was “blinking red” north of the border.
The Sahm rule is slightly different for the Canadian context, triggering at a 0.6 per cent rise in unemployment, but by June the differential was nearly at a full percentage point already.
Canada’s unemployment rate stood at 6.4 per cent for June, up from 5.4 per cent in 2023 and from the record lows of 4.9 per cent seen two years earlier. This comes as the Canadian economy has struggled to grow over the past 12 months, prompting the Bank of Canada to deliver back-to-back interest rate cuts over June and July in a bid to relieve some pressure on growth.
Planincic notes that there are some important caveats for the Sahm rule that Canadians ought to keep in mind before ringing the recession bell. For one, it’s not perfect in the Canadian context, having misjudged the start of a recession already once before.
The Sahm rule also doesn’t take into account the nature of rising unemployment. The jobless rate in Canada has risen over the past two years as employment gains have failed to keep pace with a rapidly growing population, rather than being spurred by widespread layoffs.
Canada’s economy has so far remained out of a recession when looking solely at quarterly real gross domestic product figures, supported largely by that same population growth.
Newcomers might also take longer to “get integrated” into the Canadian economy, Planincic notes, which can have an outsized impact here compared with the U.S. because of where Canada is sourcing its labour force growth.
Canada’s workforce is undergoing a series of shifts in the wake of the pandemic, so Planincic argues the Sahm rule’s lens might not be a perfect predictor for this moment in history.
“The past four and a half years have been particularly weird and unprecedented,” she says. “So it wouldn’t be crazy for it to break the rule for the first time in the U.S. and the second time in Canada.”
Sahm herself penned an op-ed for Bloomberg on Wednesday arguing her rule, while still relevant, was “meant to be broken.”
What will Friday’s jobs report mean for the Bank of Canada?
The other difference between the U.S. and Canada is that the central bank north of the border is already two interest rate cuts into its easing cycle. Earlier signs of weakness in the Canadian economy have the Bank of Canada ahead of its counterpart in the U.S.
Economists are expecting continued signs of slowing in the July jobs report due out Friday. Royal Bank of Canada is forecasting another uptick in the unemployment rate to 6.5 per cent despite a gain of around 15,000 jobs.
Benjamin Reitzes, director of Canadian rates and macro strategist at BMO, told Global News earlier this week that Canada is “already experiencing what the U.S. is just starting to see.”
“So we’re not expecting anything new. It’s just going to reinforce the trend, and it’s going to reinforce the fact that the Bank of Canada should feel at ease with pulling rates down from here,” he said.
Planincic also expects that Friday’s jobs report will “give the Bank of Canada permission” to continue cutting its benchmark interest rate in September.
The central bank is forecasting growth will pick up in the second half of 2024 and into the following year.
But Planincic also warns that, like the U.S., Canada is not home free when it comes to the soft landing.
Consumers in Alberta in particular are pulling back on discretionary purchases as the economy slows and more homeowners renew their mortgages into the higher interest rate environment, she notes.
“I think we’re not out of the woods in terms of that impact.”