The Fed is 'playing with fire' by not cutting rates, says creator of 'Sahm Rule' recession indicator

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Economist Claudia Sahm on CNBC's The Exchange. CNBC The Federal Reserve is risking tipping the economy into contraction by not cutting interest rates now, according to the author of a time-tested rule for when recessions happen. Economist Claudia Sahm has shown that when the unemployment rate's three-month average is half a percentage point higher than its 12-month low, the economy is in recession. As the jobless level has ticked up in recent months, the "Sahm Rule" has generated increasing talk on Wall Street that what has been a strong labor market is showing cracks and pointing to potential trouble ahead. That in turn has generated speculation over when the Fed finally will start reducing interest rates. Sahm, chief economist at New Century Advisors, said the central bank is taking a big risk by not moving now with gradual cuts: By not taking action, the Fed risks the Sahm Rule kicking in and, with it, a recession that potentially could force policymakers to take more drastic action. "My baseline is not recession," Sahm said. "But it's a real risk, and I do not understand why the Fed is pushing that risk. I'm not sure what they're waiting for." "The worst possible outcome at this point is for the Fed to cause an unnecessary recession," she added. Flashing a warning sign As a numeric reading, the Sahm Rule stood at 0.37 following the May employment report from the Bureau of Labor Statistics that showed the unemployment rate rising to 4% for the first time since January 2022. That's the highest the Sahm reading has been on an ascending basis since the early days of the Covid pandemic. The value essentially represents the percentage point difference from the three-month unemployment rate average compared to its 12-month low, which in this case is 3.5%. A reading of 0.5 would represent an official trigger for the rule; a couple more months of 4% or better readings on the unemployment rate would make that happen. The rule has applied for every recession dating back to at least 1948 and thus works as an effective warning sign when the value starts to increase. Even with the rising jobless level, Fed officials have expressed little concern about the labor market. Following its meeting last week, the rate-setting Federal Open Market Committee labeled the jobs market as "strong," and Chair Jerome Powell at his press conference said conditions "have returned to about where they stood on the eve of the pandemic — relatively tight but not overheated." In fact, officials sharply lowered their individual forecasts for rate cuts this year, going from three expected reductions at the March meeting to one this time around. The move surprised markets, which still are pricing in two cuts this year, according to the CME Group's FedWatch measure of fed funds futures market contracts. "The bad outcomes here could be pretty bad," Sahm said. "From a risk management perspective, I have a hard time understanding the Fed's unwillingness to cut and their just ceaseless tough talk on inflation." 'Playing with fire'