By Kate Davidson 

Two of the biggest challenges of fighting a recession are knowing when you're in one and deciding what to do next. When economic data weaken, it's impossible to know in real time whether it's a blip or something more prolonged. The official declaration usually comes a year or more after a recession starts.

Now, a Federal Reserve economist has come up with a simple rule based on movements in unemployment to rapidly determine when a recession is under way. In conjunction with that rule, Claudia Sahm has also proposed policies to immediately soften the downturn without the political hurdles that usually slow stimulus efforts.

For now, the so-called Sahm rule is sending a reassuring signal: The economy may be slowing but no recession has begun. Nonetheless, it is generating excitement among economists and at least one presidential contender looking for new ideas on how to combat future recessions at a time when the Fed lacks its normal ammunition since interest rates are already so low.

Policy makers need to know when a recession has begun before they can act to prop up the economy, said Jay Shambaugh, director of the Hamilton Project, a liberal think tank that included Ms. Sahm's proposal in a book this year on preparing for the next downturn. "Knowing that in as close to real time as possible is a huge advantage over waiting, say, for Congress to act over a six- to eight-month period," he said.

In January 2008, Fed officials projected the flagging U.S. economy would avoid a recession. Fed staff believed the probability of recession within the next six months was 45%, according to a policy meeting transcript.

In fact, a recession had begun the previous month, a determination the official arbiter, the National Bureau of Economic Research -- a nonpartisan, nonprofit academic network -- would take almost a year to make. It took six to 21 months to call previous recessions.

"That's too long for stabilization policy to wait," Ms. Sahm said on Twitter earlier this year. "Stimulus early could help reduce the severity of a downturn."

The unemployment rate has risen sharply in every recession, and thus economists have long looked for recession signals in its behavior. Ms. Sahm spent weekends playing with a massive spreadsheet, testing different rates of increase over varying periods of time, to arrive at the following formula: If the average of unemployment rate over three months rises a half-percentage point or more above its low over the previous year, the economy is in a recession.

Her formula would have accurately called every recession since 1970 within two to four months of when it started, with no false positives, which could trigger unnecessary and costly fiscal stimulus.

Ms. Sahm says her rule is based on historical relationships in the U.S. and thus can't be applied to other countries or individual states, whose labor markets may behave differently.

Nor should it be used predict recessions, as are some indicators such as an inverted yield curve, when long-term interest rates fall below short-term rates. The Sahm rule only determines when one has started. Yet that is potentially quite valuable.

Ms. Sahm received her Ph.D. at the University of Michigan then joined the Fed in 2007 where she studied the effects of fiscal policy on households. She and others have found that sending lump-sum payments to individuals, as the government did in 2001 and 2008, had a bigger effect on spending than spreading the money out across paychecks by lowering tax withholding, as Congress did in 2009.

By automating such payments, and designing the size, structure and funding ahead of time, policy makers could avoid those difficult decisions in a crisis, Ms. Sahm wrote in "Recession Ready," the book published by the Hamilton Project and Washington Center for Equitable Growth, a left-leaning think tank where Ms. Sahm will soon move to become director of macroeconomic policy. The book discussed how to improve automatic stabilizers, the safety-net programs that kick in when the economy weakens, such as unemployment insurance and food stamps.

Ms. Sahm proposed that the Treasury begin sending payments to households equal to 0.7% of gross domestic product, or 1% of consumer spending, when the Sahm rule trigger is met, and extend those payments in subsequent years if the unemployment rate increases at least 2 percentage points above the level at the time of the first payment, then gradually scaling them back as the jobless rate declines.

Under her proposal, payments in the last recession would have started in April 2008 and continued into 2013, after the last of the big household stimulus programs expired. The boost to spending in 2008 and 2009 together would have been about 50% larger than under the stimulus actually enacted, she estimated.

Expanding automatic stabilizers this way could have drawbacks, warns Douglas Holtz-Eakin, president of the American Action Forum, a right-of-center think tank, and former Congressional Budget Office director. They would boost mandatory spending, which already weighs on the federal budget, and lawmakers would still face political pressure to respond with additional discretionary stimulus, he said.

Since its release in May, Ms. Sahm's rule has been flagged in Wall Street research notes and news reports, and added to the Federal Reserve Bank of St. Louis's free economic database, known as FRED. Lawmakers on Capitol Hill have asked for briefings on the proposal, and Sen. Michael Bennet (D., Colo.), who is running for president, highlighted it along with others in his campaign's economic platform.

"The reason it's been getting attention is it is simple, it is understandable, it is something people can observe themselves," Mr. Shaumbaugh said.

It also helps that Ms. Sahm, unusual for a Fed staffer, is active on Twitter, where she has discussed the Sahm rule -- and noted the name wasn't her idea. "[In my opinion] 'unemployment change rule' is a better label," she tweeted.

Write to Kate Davidson at kate.davidson@wsj.com

(END) Dow Jones Newswires

November 03, 2019 09:14 ET (14:14 GMT)

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