Assessing the Sahm indicator
A new indicator is gaining prominence amongst Fed governors and policymakers. The Sahm indicator is increasingly discussed as a simple real-time indicator for the onset of a recession in the United States. Claudia Sahm used to work at the Board of Governors of the Federal Reserve and is now at the Washington Center for Equitable Growth. In spring last year, she wrote an article on how to start fiscal stimulus payments to prop up an economy in recession. In this article, she developed the Sahm Rule or Sahm indicator. It is simply the three-month average of the unemployment rate minus the low of the unemployment rate over the last 12 months. Whenever the Sahm indicator rises above 0.5 it signals the potential onset of a recession.
Sahm indicator in the United States
Source: Fred, St. Louis Fed.
Claudia Sahm never claimed that the indicator is a leading indicator for a recession, but I have come across some people who start treating it like that. So, I have done two things. First, I have created a UK Sahm indicator to see if it indicates a recession like it does in the United States. Unfortunately, in the UK there is no institution like the NBER that dates the official beginning and end of a recession, so I simply assumed a recession in the UK starts when there are two consecutive quarters of negative growth. With this simplified assumption, the chart for the Sahm indicator in the UK looks like this:
Sahm indicator in the UK
Source: ONS, Investing.com.
Visual inspection of the Sahm indicator shows that in both countries it seems to do its job reasonably well. It rises above 0.5 close to the onset of a recession and then declines again after the recession is over. Claudia Sahm already noted that the size of the spike in the Sahm indicator does not correspond to the severity of the recession, so don’t read anything into that.
But while the charts above look good, a closer inspection of the data reveals some weaknesses of the indicator. In the table below I have calculated how many months before or after the start of a recession the Sahm indicator surpassed the crucial 0.5 level. I have also calculated how many months before or after the stock market peaked and the average performance of the stock market in the six months before and after the Sahm indicator signaled a recession.
Timeliness of the Sahm indicator
Source: Fred St. Louis Fed, ONS, Investing.com.
Note that in the table above, a negative value for the time to recession means that the recession started several months before the Sahm indicator signalled one, while a positive value means that the recession started after the Sahm indicator signalled one. The negative average and median time to recession in the case of the United States shows that the Sahm indicator isn’t even a simultaneous recession indicator. It is a lagging recession indicator. And while the NBER usually determines the beginning of a recession many months later, a three-month lag to the onset of a recession isn’t going to be of much help in real life. In the UK, at least, the Sahm indicator on average indicates two quarters of negative growth a few months ahead of the event, so there seems to be some use for it as a real-time recession indicator.
But for investors, the Sahm indicator certainly isn’t of much help. Stock markets peak many months before the Sahm indicator signals a recession and in the case of the UK, there is literally no connection between stock market peaks and the Sahm indicator. The Sahm indicator may be useful as a policy tool for automatic fiscal payments as Claudia Sahm suggest, but for investors or even economists, it can safely be ignored.