Labor Picture Less Worrisome Than It Appears

Joshua Jammer

Jeffrey Schulze

A rising unemployment rate and triggering of the Sahm Rule in July  spooked financial markets at the time. But a deeper dive into the underlying drivers of the rising unemployment rate showed less reason for worry than it previously suggested at first glance. A more recent recovery in hiring has added further mixed signals on the rule’s efficacy.

The Sahm Rule, first published in 2019, states that “when the three-month moving average of national unemployment is 0.5 percentage point or more above its low over the prior twelve months, we are in the early months of a recession.”

While it is more of an observation than a causal rule, underpinning this “statistical regularity,” as Fed Chair Jerome Powell described it, are real dynamics. One of them is inertia, or the notion that an object in motion tends to stay in motion. Historically, a 0.5-percentage-point increase in the unemployment rate has presaged a much larger, nonlinear increase. Also underlying the rule is the historically tight relationship between labor income and consumption. In other words: An increase in job losses is typically concerning for the economy, as spending would be expected to decline proportionally.

Change to Numerator or Denominator?

The unemployment rate can change for several reasons, however, including a person losing a job or an increase in the number of people who were on the sidelines but have since begun looking for work.

While either of these dynamics can trigger the Sahm Rule, the economic implications of a rising unemployment rate due to an increase in job losses differ from those that are due to an increase in the number of people seeking employment. For one, the former dynamic represents a loss of labor income (reducing the outlook for future consumption), while the latter does not.

In looking at the 12 months prior to past instances of the Sahm Rule being triggered since 1967 (the farthest back the data for these classifications go), our analysis shows that 83% of the increase in the number of unemployed people has come from job losers and job leavers, on average, with just 16% coming from re-entrants and new entrants (the total does not sum to 100% due to rounding).

If the 1981 double-dip recessions are excluded, given that many re-entrants at the time were likely employed prior to the 1980 recession and thus may be more appropriately thought of as job losers than re-entrants, the breakdown would stand at 87% and 12%, respectively.

Today’s Economy

The present situation bears little resemblance to these past periods, however. Over the past year, 32% (twice the historical average, inclusive of 1981) of the increase in unemployment has come from re-entrants and new entrants. If we focus on 2024, specifically—the period when the unemployment rate began to persistently rise—the share from re-entrants and new entrants is even higher at 51%, more than three times the historical norm.

Exhibit 1: Breaking Down Rising Unemployment by Reason For Unemployment

This unique dynamic has even been noted by American economist Claudia Sahm, the rule’s namesake. Specifically, she observed that “[t]he Sahm [R]ule is likely overstating the labor market’s weakening due to unusual shifts in the labor supply caused by the pandemic [re-entrants] and immigration [new entrants].”

A Different Approach

A second approach to understanding why unemployment has risen uses what is known as labor force status flows, or the flow of people moving between states of being employed, unemployed and not in the labor force. This flows approach could be thought of as a bathtub model: the number of unemployed is the water in the tub, while the faucet adds newly unemployed people and the drain simultaneously removes unemployed people (through hires or labor force exits).

The flows approach helps explain why unemployment is rising because, isolating the different states, we can see how much of the change in unemployment is from net hiring, as opposed to people moving in and out of the labor force. What we see here is that, in 2023, far more people cumulatively moved from unemployed to employed than vice versa. This suggests strong net hiring and that net flows into the labor force account for more than all of the increase in the unemployment rate so far this year.

Exhibit 2: Breaking Down Rising Unemployment by Labor Force Status Flows

While historical comparisons are limited here (this dataset only dates to 1990), we believe this approach supports the conclusion that a substantial portion of the increase in unemployment is the result of a growing labor force, as opposed to an increase in job losses, and thus the outlook for future consumption is not as negative as the pickup in unemployment alone would suggest.

Over the past few years, several traditional recessionary signals have become less reliable, posing a challenge for macroeconomists and financial markets. While the Sahm Rule is useful, we have long believed that taking any recessionary signal at face value can be fraught with peril, and we instead seek to understand the “why” behind any indicator.

That has led to our conclusion that the job market today is best characterized as normalizing from extreme tightness in the post-pandemic period.

Therefore, with a minimal increase in workers losing their jobs, we believe the outlook for future consumption should remain supportive and contribute to a continuation of the current expansion.

Jeffrey Schulze, CFA, is a managing director and head of economic and market strategy at ClearBridge Investments. Joshua Jamner, CFA, is a director and investment strategy analyst at ClearBridge Investments.

This feature is to provide general information only, does not constitute legal or tax advice, and cannot be used or substituted for legal or tax advice. Any opinions of the author do not necessarily reflect the stance of ISS STOXX or its affiliates.