Jobs report: Unemployment rise may mean recession, rule says, but likely not this time

The economy seems to be on solid footing, with the nation’s gross domestic product and employment both notching healthy gains recently.

Yet if Friday’s jobs report reveals that the unemployment rate last month inched up from 4.1% to 4.2% - still a historically low figure -  the U.S., by one measure, will be in the early stages of a recession.

Stay calm. Most economists say the measure - called the Sahm rule – probably doesn’t apply this time because of the unprecedented ways the pandemic upended the economy and labor market.

Still, a 4.2% jobless rate in Friday’s report could roil stocks and signal further weakening ahead in an already slowing labor market.

“I think it would raise some concerns about whether we can indeed pull off a soft landing,” says Sarah House, senior economist at Wells Fargo. A soft landing refers to a Federal Reserve interest-rate hiking cycle, such as in 2022 and 2023, that lowers inflation without tipping the nation into recession.

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Economists expect Friday’s report to show unemployment held at 4.1% last month while the nation added a sturdy 178,000 jobs, according to a Bloomberg survey, though such estimates often miss their mark.

How does the Sahm rule work?

According to the Sahm rule, if the unemployment rate, based on a three-month average, is a half percentage point above its lowest point over the past 12 months, the economy has entered a downturn. If unemployment reached 4.2% in July, the three-month average would be 4.1%, a half point above the 3.6% average a year ago.

The rule, the brainchild of noted economist Claudia Sahm, has correctly predicted each U.S. recession since the 1970s. The reasoning is simple: Rising unemployment generally reflects a surge in layoffs. And laid-off workers tend to pull back spending, hurting businesses, which then cut more workers, perpetuating a negative cycle.

Yet there are several reasons the Sahm rule likely doesn’t apply this time, top forecasters say.

Layoffs recently have climbed to the highest levels in more than a year, based on unemployment insurance claims, but they’re still historically low. That’s largely because employers have been reluctant to lay off workers following severe COVID-related labor shortages, says Ryan Sweet, chief U.S. economist at Oxford Economics.

Why did the unemployment rate go up?

The jobless rate has risen mostly because of a stream of workers into the labor force, or the pool of people both working and looking for jobs. Those include Americans who left during the pandemic for health reasons, to care for children, or to go back to school, along with others who have been drawn into the job market by robust wage growth the past few years, Sweet says.

 More significantly, immigrants have surged into the workforce in recent years,Of the 3 million jobs the nation added in 2023, about a third likely went to newly arrived immigrants, RBC Capital Markets estimates.

Yet many immigrants are more likely to struggle to land jobs the first few years they’re in the country, pushing the unemployment rate higher, Goldman Sachs says.

Also, the pandemic resulted in many mismatches between available jobs and job seekers, Goldman says. Consumer demand has shifted from services to goods (during lockdowns) and now back to services.

Many of the workers who permanently left in-person service jobs during COVID, such as waiters and home health aides, had to be retrained for other fields. And the spread of remote work decimated many downtown businesses, forcing those workers to switch industries.

An unemployment rate that rises because more people are looking for jobs but haven’t found them yet typically results in a less dramatic blow to consumer spending than sudden job losses caused by layoffs.

“I’m not losing any sleep over” an increase in unemployment that could trigger the Sahm rule Friday, said Sweet.

Asked about the threshold at a news conference Wednesday, Fed Chair Jerome Powell said, “It's not like an economic rule where it's telling you something must happen.” He added, “What we think we're seeing is a normalizing labor market and we're watching carefully to see if it turns out to be more."

Even Sahm herself, a former Federal Reserve economist who is now at New Century Advisors, wrote in a recent post, “A recession is not imminent, even though the Sahm rule is close to triggering…The swing from labor shortages caused by the pandemic to a burst in immigration is magnifying the increase in the unemployment rate.”

What does an inverted yield curve tell us?

Since the pandemic, other traditional recession indicators have sent similar signals that may be false alarms. An inverted yield curve – in which rates on 2-year Treasury bonds drift above 10-year notes – historically has foreshadowed a downturn. Yet the yield curve now has been inverted for two years.

Still, the rise in unemployment is signaling a flagging job market that eventually could lead to a recession, economists say.

“I think you’re seeing a material weakening,” House says.

Interest rates have hovered  at a 23-year high of 5.25% to 5.5% since last summer, increasing borrowing costs for consumers and businesses. Inflation of about 3% is well below its 9.1% peak in 2022 but above the Fed’s 2% goal. And low- and middle-income households have racked up near record- credit card debt and historically high delinquencies.

How is the US job market now?

The job market is feeling the effects. Hiring has dipped well below its pre-pandemic level. And the number of people quitting jobs – typically a sign they feel confident about their chances of landing another one - tumbled to 3.3 million in June, the lowest level since 2020.

If layoffs continue to edge up while hiring lags, that could further push up the unemployment rate and even lead to a recession, House says, though that’s not her forecast.

“A recession is not imminent but the risks of a recession have risen,” Sahm wrote.

That's why the Fed should cut interest rates sooner rather than later, Sweet says. Powell said Wednesday the Fed could lower its key rate in September,