Despite a slightly higher-than-expected payroll job gain, the June employment report was on the soft side, with downward revisions to payroll gains from prior months, a drop in temporary employment and only modest gains in wages. However, the weakest aspect of the report was the unemployment rate, which edged up from 4.0% to 4.1%. This, in itself, wouldn’t be particularly notable were it not for the fact that the unemployment rate has now risen steadily over the past 14 months from a 54-year low of 3.4% set in April of last year.

Historically, a significant rise in the unemployment rate from its cyclical low has been a warning sign of imminent recession and can be added to others, such as a falling index of leading economic indicators or an inverted yield curve, that have been predicting recession for some time. On balance, we still don’t think recession is just around the corner. However, a rise in the unemployment rate provides further confirmation that economic momentum has downshifted to a lower gear, suggesting a need for increased vigilance by investors in making sure portfolios are not too exposed to a economic downturn.

The Sahm Rule

The Business Cycle Dating Committee of the National Bureau of Economic Research has the responsibility for declaring when the U.S. economy enters and exits a recession. They define a recession as being: “….a significant decline in economic activity that is spread across the country and lasts more than a few months.” In evaluating “economic activity” they look at real retail and wholesale sales, industrial production, real personal income apart from transfers, real consumer spending and employment, as measured by both the household and payroll surveys. Unfortunately, many of these data are published with a lag and the committee usually takes many further months before announcing that the economy has entered or exited recession. For both investors and policy-makers it would be nice to have a simpler rule or indicator to provide a heads-up that recession is imminent.

For many years, the best known rule of thumb, was that when the index of leading economic indicators, now compiled by the Conference Board, fell for three consecutive months, the economy would shortly slip into recession1. However, the index has now fallen steadily since December 2021 without any recession materializing. This indicator appears to be broken both because of an over-emphasis on manufacturing, in an increasingly service-dominated economy, and because of problems with index construction that have added a downward bias to monthly numbers.

Another rule was that an “inverted yield curve”, defined, in this case, as 3-month Treasury bill yields being higher than 10-year Treasury bond yields, signaled a recession starting within a year2. However, by this measure, the yield curve has now been inverted for 20 straight months with, again, no sign of imminent recession. The failure of this recession predictor may simply be due to a decline in the impact of interest-rates on aggregate demand or a side-effect of significant Fed operations impacting the long end of the bond market.

A third rule, based on the unemployment rate, has been proposed by a Federal Reserve economist, Claudia Sahm, as a way to be relatively sure that the economy was, in fact, slipping into recession3. Sahm suggested that the rule could be used as an automatic trigger for stimulus payments rather than waiting on the “analysis and deliberation” of economists and policymakers in determining the start of a recession and deciding what to do about it.

The Sahm rule says that economy is entering recession when a three-month moving average of the unemployment rate has risen by at least 0.5% above the minimum three-month average seen over the prior twelve months.

Retrospectively, it has provided a pretty accurate signal of recession. The Sahm rule would have been triggered in all 12 of the recessions seen in the United States since 1947, albeit with the signal kicking in, on average, 3.5 months after the recession had started. Moreover, there have only been two brief instances, in late 1959 and mid 2003, when the rule implied a recession that didn’t actually transpire.

It should be noted that the Sahm rule was not triggered by Friday’s June jobs report, since, although the unemployment rate is 0.7% above its minimum for this expansion, the three-month moving average of the unemployment rate is only 0.4% above the minimum three-month moving average over the 12 months ended in May. However, if the unemployment rate were to edge up by just 0.1% over the next few months, from 4.1% to 4.2%, the economy would be, according to the Sahm rule, entering recession.

The Reason for Rising Unemployment

Given our proximity to a recession signal from the unemployment rate, it is worth asking: what exactly is boosting the unemployment rate?

First, looking at other economic data suggests that it is not due to a general slowdown in aggregate demand. Real GDP grew by an above-trend 2.9% in the year that ended in the first quarter, hardly a sign of a faltering economy. It is true that annualized growth in the first quarter was just 1.4% and we expect about 2.0% growth in the second. However, GDP growth impacts employment with a lag, so this recent downshift shouldn’t be responsible for a rise in the unemployment rate over 14 months.

The rise probably can’t be blamed on surging immigration either. As we have mentioned before, we do think that rising immigration has prevented the unemployment rate from falling further. However, this likely just offset chronic weakness in labor-force growth among the native-born population. It is worth noting that the unemployment rate among immigrants is essentially the same as among the native-born population so the fact that immigrants have dominated labor-force growth shouldn’t, in itself, have boosted unemployment rates. It should also be recognized that the six states with the fastest growth in unemployment rates in the year ended in May were Rhode Island, Washington State, Connecticut, Ohio, Oregon and Maryland – none of which are on the front lines of the immigrant surge.

So, if it’s not collapsing demand or surging immigration, what has boosted the unemployment rate?

The answer may be more micro-economic than macro-economic and probably stems from the nature of the super-heated labor market in April 2023, when the unemployment rate fell to its cyclical low of 3.4%. At that time, there were still 9.9 million job openings despite payroll job growth over the prior year averaging 320,000 per month. Wages were up 4.7% year-over-year. While all of these numbers were lower than their cyclical peaks, the reality is that it was very easy to find a job and businesses were hiring furiously.

But in such a labor market, both businesses and workers can be a little too optimistic. Some people may have been hired who simply did not have the skills or work habits to do the job. Equally, some people may have tried to add a job to a hectic lifestyle that just couldn’t be sustained.

Two pieces of evidence seem to support this idea.

First, between April 2023 and June 2024, while the number of people unemployed for less than 15 weeks rose by 261,000 or 14%, the number unemployed for more than 15 weeks climbed by 766,000 or 42%. In an economy with still over eight million job openings, this climb in long-term unemployment suggests that there are many workers who, in anything other than a frenzied job market, just have a hard time getting hired or holding down a job when they do get hired.

Second, between April 2023 and June 2024, according to the household survey, the number of part-time workers rose by 912,000 while the number of full-time workers shrank by 675,000. Both of these numbers are very likely underestimates due to faulty population counts produced by the Census Bureau. However, the trend towards more part-time employment is likely genuine. Part-time workers tend to have higher unemployment rates than full-time workers and strains related to day-care, transportation, illnesses and shifts that just don’t work out may be leading to more unemployment among this group.

In other words, some of the move back to a roughly 4% unemployment rate may just reflect the reality that while, in a white-hot jobs market both employers and employees can make optimistic plans, in the longer-run there are some workers whose skills and circumstances will leave them unemployed some of the time in a normal economy.

A Downshift in Growth

If this perspective is correct, then the recent rise in unemployment doesn’t suggest imminent recession and wouldn’t, even if the Sahm rule is triggered by a further small increase in the unemployment rate next month.

However, the rise in the unemployment rate has occurred at a time when payroll job growth and real GDP growth appear to be slowing. Consumer spending on non-durable goods is also slowing while credit card and auto-loan delinquency rates are rising. All of this suggests that the economy is downshifting to a lower gear and we now expect that real GDP growth, which was 3.0% in the year ended in the fourth quarter of last year will be between 1.5% and 2.0% by the fourth quarter of this year.

This downshift in growth, combined with further moderation in inflation (which should be visible in this week’s CPI report), gives the Fed ample grounds for beginning an easing cycle in September, a move that would generally be welcomed by markets. However, it does also make the economy a little more vulnerable, increasing the risk that some shock could trigger a recession. Because of this, while neither 4.1% unemployment nor other leading indicators suggest a quick end to this expansion, investors should make sure that their portfolios are sufficiently balanced to weather such a possibility.

[1] See commentary on the recent failings of the Index of Leading Economic Indicators in “Leading Indicator Still Misleading”, by Ed Yardini,, February 2024.

[2] See “Yield Curve and Predicted GDP Growth”, and data.

[3] See “Direct Stimulus Payments to Individuals”, by Claudia Sahm, Board of Governors of the Federal Reserve System in “Recession Ready: Fiscal Policies to Stabilize the American Economy”, The Hamilton Project, 2019.