The Sahm Rule could overstate economic weakness

Since our last update, the narrative of the Fed delivering rate cuts has gained momentum, as the July Jobs Report came in weaker than expected. Nonfarm payrolls (NFP) stood at 114k (cons: 175k), and the June figure was revised down by 27k. At the same time, wage pressure eased further, declining to 0.2% m/m SA from 0.3%. Notably, the Sahm rule for recession was triggered (3M MA unemployment rate 0.5% above its 12M low), as the unemployment rate increased to 4.3%. We agree the labour markets are cooling but are not yet convinced the economy is facing a deeper slowdown.

While difficult to quantify, the weak July NFP print was likely affected by hurricane Beryl as the data collection coincided with the negative effect seen in Texas jobless claims. If these disruptions were temporary, they could possibly impact the August NFP data positively offsetting some of the recent weakness.

Some leading indicators also stood in contrast to the weak NFP figures. Data from NFIB signalled that job openings and firms’ hiring plans remained steady compared to the previous month, while most of PMI employment indices continued to increase.

The ratio of unfilled vacancies per unemployed remained near the pre-pandemic level of 1.2. BLS’s labour force flow data signalled a significant flow from employment to unemployment, but alternative indicators for actual layoffs still remain very low. Strong labour productivity growth has also helped to alleviate firms’ labour cost pressures.

The uptick in unemployment largely reflected the ongoing recovery in labour supply, which was attributed to both prime-age (25-54y) and foreign-born workers joining the labour force. Over the Sahm rule’s 3-month lookback period, immigration added 792k new workers to the work force, and 765k came from the prime-age group. While markets have been ringing the recession bells, the increasing labour supply is positive for growth over the long term, especially in a macro environment that has been affected by labour shortages.

Looking ahead, we believe labour supply will continue to recover, with immigration playing a key role. National immigration inflow for the fiscal year of 2024 (Oct23- Sep24) has so far exceed the level of the same period in prior years. Combined with the delayed issuance of work permits for immigrants, this inflow of immigrants will likely further boost labour supply and ease labour market tightness.

Accordingly, we agree the cooling tide is prevailing and will continue, but do not expect a recession on the horizon for now. Today’s labour market dynamics, characterized by growing labour supply, are different from what caused previous recessions. Historically, these have been triggered by weakening demand for workers, suggesting that this time the Sahm rule might be overstating the recent economic weakness. We still expect the Fed to cut rates by 25bp in September and December. If data continues to cool, policymakers could opt for a more traditional easing cycle with cuts in every meeting, but we think the bar for 50bp reductions remains high for now.

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