Economist Claudia Sahm created one of the most accurate recession predictors. Here's why she's getting worried.

By Greg Robb

Sahm has been calling on the Fed to cut interest rates since December

Closely followed measures of U.S. inflation have come in hotter than expected so far this year, and economist Claudia Sahm is getting nervous: A recent batch of economic reports implies that pricing pressures aren't abating steadily, which could give the Federal Reserve an excuse for what she views as "foot-dragging" on cutting the interest rates that have made mortgages, car loans and credit-card balances more expensive.

"I would really have them take 25 basis points off next week," Sahm said in mid-March, after the release of the February consumer-price index.

In a series of conversations with MarketWatch over the past month, Sahm said she wants the Fed to ease rates - which are currently in the range of 5.25% to 5.5% - ASAP. She's not advocating for a dramatic cut but says the Fed needs to get the ball rolling on easing the tight monetary policy it has implemented over the past two years to help cool the economy and quash out-of-control inflation.

Given everything she's heard from policy makers in recent weeks, Sahm suspects that the first cut might not come until July. The delay raises the risk that the Fed will cut interest rates too late and cause a recession, she said, by leaving a too-restrictive policy in place for too long. The Fed's interest-rate increases have softened consumer demand as intended, mainly by raising borrowing costs.

Right now, the economy appears to be in a good place. More than three-quarters of business economists surveyed by the National Association for Business Economists on Feb. 12 forecast that the U.S. can avoid an economic recession even as inflation recedes.

But recessions are like snowballs, Sahm said: They start very small but can grow big enough to trigger avalanches, which can then sweep down on the economy - wiping away jobs, economic growth and income for millions of people.

"They are taking risks that I have a hard time wrapping my head around," she said of the Fed, which is led by Jerome Powell.

Sahm knows a thing or two about how recessions begin. The economist and former Fed staffer created the Sahm rule, a popular indicator that is considered the best - and earliest - warning system for recessions.

She noticed that recessions, both severe and mild, shared one characteristic: They started when the three-month average of the unemployment rate rose by at least half a percentage point from the minimum three-month average of the previous 12 months.

A slight uptick in unemployment in February's jobs report - from 3.7% to 3.9% - immediately brought the Sahm rule back into discussion early this month. Sizable downward revisions to December and January job growth, which some economists said resembled recession-type weakness, added to the concern.

Jason Furman, a former White House chief economist who served in the Obama administration, said in a post on X this month that the "balance of worry" in the February jobs report tilted "ever so slightly away from inflation and towards recession."

Economists have generally been expecting a recession since the Fed started raising interest rates in spring 2022. When the unemployment rate jumped a few times last year, most notably in May and August, talk of the Sahm rule resurfaced. But in both instances, the rise in the jobless rate reversed.

'Once that snowball gets going downhill, nobody can stop it'

Today, the three-month moving average of unemployment is 3.8%. That average minus the lowest three-month moving average of the past 12 months stands at 0.27 percentage point, well below the Sahm rule's trigger of 0.5 percentage point.

Deterioration in the labor market can be slow at first, Sahm said, but it has the potential to steadily accelerate.

"The labor market's bottom [won't] fall out all of a sudden," she said. "But if the bad momentum gets going and you wait to see it clearly in the data, you've probably waited too long. Because once that snowball gets going downhill, nobody can stop it."

Other areas of the market that are sensitive to interest-rate changes, such as the insurance industry, have already started to show signs of the stress created by restrictive rates, she said.

Read more: Fed still on track for June rate cut, and 2 other takeaways from Powell's press conference

Powell's press conference last week and Fed officials' projections point to three rate cuts this year, maintaining hope for a series of cuts that Sahm said would alleviate some of the stress from higher rates.

"I had no hope they would cut, because they weren't going to cut," she said after the Fed meeting. "But I got what I wanted, which is no drama."

That said, nine out of 19 Fed officials are skeptical about the need to cut rates in June.

Who is Claudia Sahm?

Sahm, who was raised on a pig farm in Indiana, studied economics at Denison University in Ohio and earned her Ph.D. in economics from the University of Michigan.

After more than a decade working at the Federal Reserve, Sahm stayed in Washington, D.C., to try to influence the debate over economic policy, rather than going to Wall Street as most former Fed economists have.

She admits this undertaking has been difficult. "It's been an awful ride," she said. "I'm not a very good D.C. person."

The old gag is that economists have two hands, always saying "on the one hand ... and then on the other," but Sahm is viewed as an economist who wears her heart on her sleeve.

Her tendency to advocate for marginalized people has made her a target of abuse by anonymous posters on a well-known website used for discussing the economics profession and job market. A study last year by Yale School of Management researchers found a huge amount of problematic content on the site, including sexist, racist and bigoted comments and attacks on individual people.

"They really don't like me," Sahm said.

In summer 2020, Sahm penned a blog post titled "Economics is a disgrace," in which she said that a lack of diversity and inclusion in the field had fostered a toxic culture, driven away talented early career professionals and diminished the quality of economic-policy advice. The post, which in its original form named several prominent economists, was the result of pent-up frustration at hearing stories from students and young economists about how they were treated, Sahm said.

The resulting controversy basically got her fired from the progressive think tank where she worked, she said. At the time, the think tank denied it had retaliated against her over the blog post.

Nearly four years later, Sahm has stopped publicly waging the war for inclusion. "I can only fight so many battles," she said. "In 2020, I was fighting on the policy and I was fighting on diversity. ... I was getting this double whammy - arguing with people that are very prominent about the merits, the economics, and in private dealing with students who were getting totally beat up."

She's not very optimistic about the profession.

Women, Black and Latino people, and lower- and middle-income people remain underrepresented in economics. The profession has gone from being late to making itself more inclusive to being at the vanguard of trying to turn back the clock, Sahm said. She points to complaints in recent commentary about "woke" Fed policies, a term used by detractors to refer to the central bank's initiatives on systemic racism and climate change.

From the archives (March 2023): 'Woke' is being used to describe everything and nothing. What does it actually mean?

Sahm now works independently, publishing a layperson-friendly Substack about economic policy and macroeconomics - called Stay-At-Home Macro, or SAHM for short - and advising federal and state legislators, as well as foreign governments, on fiscal policy.

'An exciting time for developing fiscal policy'

Sahm's work from 2007 to 2019 at the Fed, where she helped track consumer spending during the financial crisis, sparked her interest in automatic stabilizers.

The basic idea behind automatic stabilizers is that Congress would put parts of the federal budget on autopilot when there is risk of recession, eliminating the need for direct intervention by lawmakers. As it does with unemployment insurance, the federal government would automatically send out checks to people at the first sign of a recession, in order to prop up the economy and help it run more smoothly.

Sahm designed her eponymous recession indicator to answer the question of what would trigger that burst of spending.

With all the recent talk about the Sahm rule, she said, she's discouraged that no one in Congress has been talking about setting up automatic stabilizers. Congress will need to play a larger role in managing the economy in the future, she added, arguing that the pandemic was a dress rehearsal for the supply-chain shocks that climate change will create.

"I want it to be an exciting time for developing fiscal policy," Sahm said. "You have got to get away from the view that the Fed can do everything."

Despite her worries, Sahm said she still believes there will be a soft landing for the economy and continued low unemployment. Inflation is on track to reach the Fed's 2% target by the end of the year, which will allow the central bank to cut rates three or four times this year. But the later the Fed starts cutting, the fewer cuts it will make.

"My main risk for the Fed is the Fed - that they just go too slow," she said. "Every time they wait, they are turning up the dial on a recession risk, which they cannot stop once it gets going."

More from the archives (December 2022): Former top Fed staffer Claudia Sahm now 'cautiously optimistic' U.S. will avoid recession

-Greg Robb

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