Why Some Economists Are Ignoring Recession Signals

To some top economists, previously reliable recession indicators are beginning to look like smoke detectors with dead batteries—blaring incessantly but not necessarily signaling any real danger. 

The recession outlook has been on a roller coaster ride this month, with fears spiking early in the month and then receding as various reports on the health of the U.S. economy sent conflicting signals. Amid the whiplash, some economists are comfortable ignoring their traditional tools for predicting recessions, including the inverted yield curve and the Sahm Rule.

Forecasters have been questioning whether the U.S. economy will enter a recession since the recovery from the COVID-19 pandemic began. Those arguments got louder in 2021 when the economy accelerated and prices rose rapidly. Spiking inflation is usually followed, sooner or later, by a major economic slowdown. 

Since then, inflation has slowed to near pre-pandemic levels, but the possibility of a recession remains. Because the current economic situation is so different from past recessions, economists find some of their old tools less useful as they enter uncharted territory.

Why the Yield Curve May Have Gotten Things Upside-Down

The most persistent recession alarm comes from the bond market.

Ever since July 2022, the yield on 2-year treasury bonds has been higher than the yield on 10-year treasury bonds. In a healthy economy, it’s the other way around, with longer-term securities having higher yields than short-term ones. When investors believe a recession is ahead, that relationship is reversed, a condition called the inverted yield curve.

Bond traders accept lower yields on longer-term debt when they think a recession is ahead for several reasons. One is that they believe the Federal Reserve will cut its benchmark interest rate in the future—and the Fed often cuts interest rates when the economy is in a recession.

Indeed, Fed rate cuts are on the horizon. Fed Chair Jerome Powell said in a speech Friday that "the time has come for policy to adjust," as inflation continues to moderate and the labor market cools.

In March 2022, the Fed steadily hiked its influential fed funds rate from near zero. That has pushed up borrowing costs on mortgages, car loans, credit cards, and other debt in an effort to discourage borrowing and spending, slow the economy, and quash runaway inflation. In July 2023, the Fed raised the rate to its highest since 2001 and has held it there ever since.

Since then, inflation has cooled nearly to pre-pandemic levels. If inflation slows down to the Fed’s goal of a 2% annual rate without an economic crash, that would be a historical rarity. Usually, when the Fed hikes interest rates to control inflation, a recession has followed. Still, it’s possible that bond investors are anticipating this “soft landing” rather than a recession.

“Investors, as a group, aren’t buying into the U.S. recession story at this point,” Avery Shenfeld, an economist at CIBC, wrote in a commentary. “Instead, the market’s behavior is consistent with our view that rates are coming down because inflation has been vanquished and that an easing in policy would help avoid a true economic downturn.”

The CME Group’s FedWatch tool, which forecasts fed rate movements based on fed funds futures trading data, pegs the fed funds rate in the 3%-3.5% range by September 2025. In past recessions, the Fed has slashed the fed funds rate to near zero to spur the economy back to life with easy money. 

How the Economy May Be Bending the Sahm Rule

Another formerly reliable indicator is the Sahm Rule, named after its creator, economist Claudia Sahm. 

The rule is based on the observation that past recessions have been foreshadowed by a certain uptick in the unemployment rate that quickly snowballs into widespread job losses. An early-August report from the Department of Labor showed the unemployment rate rising just enough to trigger the Sahm Rule. 

That’s bad news for the economy since the Sahm Rule has been accurate when applied to recessions over the last 50 years. But many economists, including Sahm herself, are skeptical that the economy has actually gone into a downturn.

“We are not in a recession now—contrary the historical signal from the Sahm Rule—but the momentum is in that direction,” Sahm told CNBC earlier this month. “A recession is not inevitable, and there is substantial scope to reduce interest rates.”

In past downturns, the unemployment rate has risen because businesses were laying people off. This time, the unemployment rate, which just measures how many job-seekers are out of work, has risen in part because more people are looking for jobs. It may also have been driven up temporarily by storms in July.

Earlier this week, Jan Hatzius, chief economist at Goldman Sachs, dismissed the Sahm Rule’s relevance to the current situation when he cut his recession forecast to 20% at some point in the next year, down from 25%. He noted that several foreign countries, including Canada, have recently experienced significant upticks in their unemployment rates without their economies completely going down the tubes.

Could There Be a Fire After All? 

Not every expert agrees with these dismissive assessments. 

Richard M. Salsman, an economist at the American Institute for Economic Research, a libertarian think tank, said that the persistent signal from the yield curve and the more recent warning from the Sahm Rule should be taken seriously.

“The two measures together are significant and telling,” Salsman wrote in a commentary this week. “First, we get the signal that another recession will arrive within 12-18 months, then we get the signal that says recession is imminent. The door knocks are getting harder and louder. Something’s out there.”

Financial markets are closely watching each new report for signs that one side or the other is correct. The S&P 500 stock index fell sharply in early August after a streak of indicators pointed to the economy slowing down. The market rallied over the next few weeks as reports on retail sales and inflation made a recession seem less likely.

That whiplash could continue as long as the recession outlook stays murky. The Fed’s high interest rates have already had far-reaching impacts, including contributing to a surprising spate of bank failures last year, and still more shoes could drop before interest rates settle at a new normal.

“The risk of recession will remain elevated until past rate hikes finally work their way through the economy,” Robert Fry, an independent forecaster, said in a commentary. “As long as that is true, markets will remain tense and will overreact to data that deviate from expectations.”