This is part of a series, “Economists Exchange”, featuring conversations between top FT commentators and leading economists
Perhaps no question about the world’s largest economy is as divisive as whether it is poised to tip into a recession following the Federal Reserve’s historic battle to tame the worst inflation problem in decades.
Since March 2022, the US central bank has rapidly lifted its benchmark policy rate above 5 per cent to the highest level in 22 years. Much to policymakers’ surprise, the economy has largely digested higher borrowing costs with relative ease, maintaining a resilience that only now is beginning to show more notable, broader signs of strain.
In recognition of this, the Fed recently extended a pause in its monetary tightening campaign, opting this month against another rate rise for its second meeting in a row.
While officials have stopped short of calling an end to increases altogether, chair Jay Powell has given little indication that there is an urgent need to restrain the economy further. Rate cuts, however, are not yet being considered, he has indicated, cementing the Fed’s commitment at this stage to a “higher for longer” policy approach.
Having created one of the most accurate predictors of a recession, Claudia Sahm, who worked as an economist at the Fed before founding Sahm Consulting, is uniquely positioned to assess the current state of the US economy. Her so-called Sahm Rule links the start of a recession to when the three-month moving average of the US unemployment rate rises at least half a percentage point above its low over the past 12 months.
In this discussion, she talks about the rule’s applicability in an economic environment as abnormal as the one that has emerged in the post-pandemic era, the tough task ahead for the Fed and why forecasting has been so difficult.
Financial Times: At the moment, how strong would you say the world’s largest economy is?
Claudia Sahm: The pandemic was extremely disruptive both to the US economy and the global economy, and it caused the typical relationships that we would have looked at to make the judgment of whether we are in a strong place or if we are going into a weak place to not work so well.
As someone who is viewed as an expert on recessions, it has been a wild ride. It ebbs and flows how much people think we’re headed into one and how many people think we need one.
What I do know is that the US economy is leaving 2023 in a better place than when it came into it, and a better place than the vast majority of commentators thought it would be in.
On balance, inflation is still higher than we had expected, but for almost two years running we’ve had unemployment below 4 per cent, [strong] inflation-adjusted GDP growth and real consumer spending, too. So if you take it all together, that’s really good. And the thing that happened this year that wasn’t supposed to happen was inflation came down markedly and unemployment stayed low.
That opens up a conversation of whether we need to have a recession. I have said the whole time that we do not need a recession, but we may get one.
FT: Do you expect, though, that going into 2024 and throughout the next 12 months, some of that resilience that we’ve seen in the US economy will start to fade on the margins?
CS: The US economy has been in a period of rebalancing, working through disruptions. And there have been a lot of them. It wasn’t just supply chains. It was people leaving the labour force and this massive shift in spending from services to goods, which was compounding the problem because there were fewer goods. There’s just a whole list of issues that came up that we’re starting to work off, and it’s taken so much more time than most people expected.
If you look at the economy right now, yes it is strong, but it’s not in a place where we can say, “This looks like normal”. One example is credit card delinquencies, as measured by the Federal Reserve Bank of New York. Those actually fell in the [Covid-induced] recession, which is unheard of, except that we got relief to people. There was just a whole list of things that were helping people with less means.
At this point, basically all of the pandemic relief is behind us and credit card delinquencies are moving up to about where they were before the pandemic. Then, we were in a really good place, years into one of the longest expansions that we’ve ever had.
The question is, as credit delinquencies move up, is it really just rebalancing and they settle in a place that would be consistent with getting back into a solid expansion, or do they continue to rise?
Going into the second half of the year, we’ve gotten very mixed signals. Are things strong and picking up again or is this the last hurrah and they’re going to weaken?
The economy has shown staying power because of the labour market, which has been working for workers in a way that hasn’t been true for a very long time. If people have pay cheques and those pay cheques are getting bigger, they’re going to be able to spend more.
If you lose the labour market, you lose consumers, and if we lose consumers we’re done because they’re two-thirds of the US economy.
After such a severe recession, if we’re able to maintain something that looks like this, then we’re doing well. If it all falls apart, then clearly the rebalancing wasn’t successful. That’s entirely possible and it’s why I watch the labour market very carefully.
FT: Amid all these mixed signals, people have turned to the Sahm rule for guidance, given that it’s become so influential as a reliable predictor of recessions. Just taking a step back from the current outlook, what did you learn about recessionary dynamics when creating it?
CS: I developed the Sahm rule in 2019 as a trigger when a recession has started. It’s not a forecast, it’s an indicator. My policy proposal was to send out stimulus cheques to families automatically.
I had no intention of getting into the business of, “Is a recession here or is one coming?” I’m focused on helping families in a recession. But that said, I needed an indicator that was always accurate if we’re talking about sending out hundreds of billions of dollars.
The logic of the Sahm rule is that once the labour market starts to slip, if you’re looking at the unemployment rate, it keeps going.
This has been true for a really long time. If you start having workers lose their jobs and their pay cheques, they cut back on their spending and that means they spend less at the grocery store, for example. Well then that means the grocery store doesn’t need to have as many clerks and so those people get laid off, and then they have to cut back on their spending. So it creates this cycle that once it gets going, it’s very hard to stop.
The rule has worked in every single recession since the 1970s and basically everything going back to the second world war — it doesn’t turn on outside of recessions and it doesn’t fail to turn on in a recession. And it shows up early, so it’s highly accurate.
FT: You’ve remarked in the past that if there was ever a moment for this rule to break, it would be in this very abnormal economic environment we’ve found ourselves in, in the aftermath of the pandemic. What exactly do you mean by breaking?
CS: I spend a lot of time reminding people that the Sahm rule is an empirical regularity. It is not a law of nature. Just because it worked in the past to signal early in a recession does not mean that it will necessarily work this time, because all kinds of empirical regularities have broken down in the post-pandemic recovery.
So the Sahm Rule breaking would be if it hits half a percentage point, which would be consistent with unemployment running about 4 per cent for three months, but we don’t see a broad-based contraction.
In fact, if you look at the forecasts that Federal Reserve officials have been writing down for quite some time now, essentially they have the Sahm Rule being triggered but no recession: the unemployment rate rises above 4 per cent and then it goes sideways.
You can tell a story right now as to what keeps it in bounds, but we’ve never seen it. The impossible is possible though and that’s been the theme of this year.
The other empirical regularity had been the two quarterly declines in GDP growth, and that happened and we didn’t have a recession.
FT: Looking at the latest payrolls report, we saw lower monthly jobs growth and the unemployment rate rising to 3.9 per cent. Given the low in joblessness this year was 3.4 per cent, the natural question that comes up is, if this is sustained, does this mean we’re headed for a recession? What is your assessment and what is it about the current backdrop that makes you question the rule’s applicability here?
CS: The reading on the Sahm Rule in October was 0.3 percentage points and while it has been moving up, particularly in the second half of the year, that level would not always indicate we are in, or going into, a recession. There have been periods where that has occurred and then it stepped back. But, it is disconcerting — the unemployment rate is going up.
One of the concerns that was raised about the Sahm Rule during this cycle — and it’s a valid one — is that we had a big drop in the labour force right as the pandemic started, and it’s been a very slow recovery.
We’ve seen the labour force participation rate come up and that can be a good reason for the unemployment rate to go up as more people come in and have trouble getting jobs. The reverse is true, too. It could be that the [earlier] 3.5 per cent unemployment rate may not have been telling us the same thing that 3.5 per cent would have told us in the past.
Rebalancing is not, and has not, been a linear process. Remember, we’ve had these swings that make things look like they were going really well and then it shifted to concern about a recession, so we could get into a period where we have in this rebalancing a temporary period of weakness.
The reason the story of the Sahm Rule breaking without a recession has any credibility is the fact that we’ve had such a disrupted economy since the pandemic and the disruptions are not gone. And, we have deeply misjudged how long it would take to unwind them.
FT: This high degree of uncertainty is clearly making the Fed’s job figuring out whether it needs to further restrain demand all the more difficult. We saw them opt against raising interest rates for a second straight meeting this month and Powell has done very little to suggest there is a lot of appetite to tighten monetary policy further from here. Is holding the policy rate steady at these levels, given the mixed signals that we’ve just been talking about, the right call?
CS: I applaud the Fed for moving into a place where, as Powell has said, the risks are more balanced — as in there is a risk of the Fed doing too much and by raising rates more than we needed to, the economy contracts and people lose their jobs who didn’t need to lose their jobs because we were going to beat inflation anyway.
It’s only been recently that the Fed has made this statement so clearly and that must be coming largely from the fact that inflation has come down notably this year.
The labour market is moving back to something that looks like normal rather than something weaker than normal. So, they’re looking at a difficult constellation of data, some of which was very strong at the time of the latest policy meeting.
In a way that was not the case last year or maybe even earlier this year, the Fed is looking through a lot of these gyrations. Cautious and careful are buzzwords that keep coming out of their mouths.
They will raise interest rates again if inflation gets stuck or moves up again. Powell did not say, “We promise we’re done.” They don’t know and we don’t know how the economy is going to develop in the coming months.
The other piece of this that has been notable is that through much of this recovery, they’ve been willing to be patient. I know they keep saying, “We’re going to fight inflation”, but they know how to get inflation to 2 per cent really fast and they have chosen not to.
They’ve never written down a forecast that is just a massive rapid decline in inflation, so that’s heartening because that hasn’t been the case in other episodes like with former chair Paul Volcker [in the 1980s]. That was a very different setting. Inflation was high for a long time and they were really trying to slow it down really fast.
I give the Fed a lot of credit now.
FT: It seems like much of the argument to go on an extended pause at this stage hinges in some part on the tightening of financial conditions we’ve seen over the course of recent weeks. Obviously it will depend on whether this move doesn’t completely retrace if it can really obviate the need for more rate rises, but how are you thinking about potential substitute effects?
CS: Inflation is a really complex beast, and financial conditions are a piece of this.
At this point, the Fed just wants to see inflation come down, hopefully without a recession. We can tell stories about what has been boosting inflation or not boosting it, but it’s extremely complicated.
The one important channel is how interest rates move through mortgage rates or small business loans and then that turns into less demand, people lose their jobs and that then spreads into the rest of the economy.
The interest-sensitive sectors of the economy are not particularly large. It’s clear that they have shown some real weakness and the rates are showing up there. But just because the rates start showing up in terms of home sales or investment, for example, it’s not clear how exactly it works its way through the rest of the economy. Some people have buffers, they have extra income, firms are making money because they have customers.
You could argue that the very low interest rates earlier in the recovery had a big effect on, say, residential investment and the real estate market in general. But there is no way you would look at that and say that was the primary piece. You had fiscal stimulus and you had all kinds of disruptions in production and the labour market. We were going to have high inflation anyway. The Fed could have hiked all it wanted to in 2021.
With financial conditions, those fall in a similar bucket in terms of the effects on the economy. We know the direction of this, but it doesn’t let the Fed off the hook going forward because those financial conditions are not on their own likely to be enough.
Outside of a lot of pain, there are parts of inflation the Fed can’t touch — the same parts of inflation it always says are most important like food, housing and energy.
FT: The Fed clearly sees monetary policy as still having some work to do, which is why we hear about this “higher for longer” narrative and we’ve heard Powell say the Fed is not thinking about rate cuts. What do you think officials need to be keeping in mind as that debate gets under way, and how long can they really wait before having to provide some relief?
CS: The Fed right now is asking, “Do we need to raise interest rates again? How much is enough?” Going into next year, if inflation continues to move down, even if in a bumpy way, they are going to get into a conversation about whether it is time to start unwinding some of this.
A piece of the conversation is if inflation continues to fall, if they hold the federal funds rate constant, in inflation-adjusted terms, it is rising. That is what should matter.
“Higher for longer” can be interpreted in different ways. It’s high relative to the neutral rate — we’ve been told multiple times they don’t know where that is. And then the question is, “Are we looking at the inflation-adjusted rate or the nominal rate? What are we using here as the benchmark of higher?” By having somewhat squishy terms, it gives the Fed leeway in the future to reinterpret what they are saying.
That’s where I’m a bit worried because they’re putting a lot of pressure on the interest-rate sensitive sectors of the economy. Taking a little bit of pressure off is not the same thing as throwing it into another gear.
They will cross that bridge when they come to it, but that discussion about when to cut is going to be difficult. It’s one thing to pause and raise again, but to cut and then start raising, that can get pretty messy.
FT: Just on the long-run neutral rate — a level that neither stimulates nor suppresses growth — do you think that it has risen compared to its pre-pandemic norm?
CS: There are very fancy models to estimate the neutral rate. No matter how fancy the model, it’s basically looking at the data and then backwards engineering it.
So the Fed raised interest rates by over 5 percentage points and real GDP grew [strongly], alongside consumer spending, while the unemployment rate stayed below 4 per cent. If you look at all of that, you have to say the neutral rate must be higher because you’ve put an immense amount of pressure on the economy and it is still booming. How else are you going to explain this?
But that doesn’t mean that we know what neutral is. It just means that we’re backwards engineering it off what’s already happened. These concepts get adjusted after the fact. This is ex-post explaining how this year rolled out, which was different than we thought it would be.
Everything that Powell has said about the neutral rate, I am in full agreement with. It can be a useful way of thinking and conceptualising what is going on and how all these pieces are coming together and yet it is not stable or precise enough to help make certain policy decisions.
FT: Should the inflation target eventually be raised, perhaps in the 2025 policy review, to reflect the possibility that the neutral rate has risen and the fact that we are in a world of more frequent supply shocks and greater economic fragmentation, which could mean that inflation just naturally stabilises at a higher level?
CS: Anything is possible in terms of what happens in 2025. The Fed is adamant they will get inflation back to 2 per cent and they know how to do that. So there’s a question about what the Fed will do and what is the appropriate target.
They could have a discussion once they get back to 2 per cent about whether that’s the right place to have the target. They don’t want to have that discussion now, and I think that’s completely appropriate.
In some sense, 3 per cent is as arbitrary as 2 per cent, because we really don’t know a lot of these fundamental facts about the economy. It is complex, and we don’t really know where it wants to settle.
There are conditions under which it would make economic sense for it to be 3 per cent, but it’s just very hard to judge if we check all the boxes. That would be an argument that we’ve gone through a permanent or at least highly persistent change in the underlying structure of the economy. That happens sometimes, but it doesn’t happen very often and the Fed would put a very high bar on that.
It’s not a conversation we need to have right now. The Fed is going to get inflation back to 2 per cent come hell or high water.
FT: On your point about us not even knowing where things have settled, this speaks to the current problem that economists are facing, which is that it’s just really challenging to forecast anything, from growth to inflation to the labour market. Projections have been so off the mark. What has made this moment so particularly difficult and do you anticipate track records to improve from here?
CS: Not in living memory have we had to deal with a pandemic, and we dealt with it with a very aggressive response on a lot of fronts — we sent people home, the government sent out money, the Fed set up every lending facility imaginable and took interest rates to zero.
And a lot of the ripple effects from the pandemic were not ones we had seen or have had to deal with, like supply chain disruptions. The tools of the Fed are about demand and the tools that the federal government often uses in recessions are about demand, and we ended up with problems that weren’t about demand. On top of that, we didn’t even realise what the problems were, how to understand what they are or even track them. We also wildly underestimated how long it would take to unwind the disruptions.
It becomes really hard to do policy if you don’t really know what is going on.
This whole discussion about whether the Fed has done enough or done too much is always unanswerable because we can’t see the future, but it’s doubly so right now because we don’t even understand the present or the recent past.
The above transcript has been edited for brevity and clarity
Source: Economy - ft.com
