The graph below in different variations have been making its rounds on social media in recent days.

It is somewhat odd that it took so long for the number to get the any attention as the numbers this relateds to have been out for a couple of weeks. But frankly speaking I didn’t notice it either at the time. But I surely did now.

At the time the economists at TS Lombard wrote “The sharp contraction in M1 and broader monetary aggregates points to nominal growth falling below zero, assuming past relationships hold.”

For somebody who has been reading my blog regularly this shouldn’t be all that surprising. This is simply the equation of exchange:

M*V=P*Y

The money supply (M) times money velocity (V) equals nominal GDP (or the price level P times real GDP Y).

So what the graph indicates is that money velocity in China is fairly stable and also that there is some 2-3 quarters lead from money to nominal GDP growth in China.

The interesting thing here is of course that nominal GDP growth now has turned significantly negative and this obviously should worry China policy makers deeply as this indicates that China likely already is in the midst of a rather sharp real GDP downturn and deflation is likely to deep further.

As the graph below shows Chinese inflation has already over the past year been very low and even negative for periods and given the development in money supply growth is very likely that China will relatively return to deflation.

Re-visiting Irving Fisher’s debt-deflation

Yesterday the British economist and fellow-monetarist Tim Congdon in a newsletter highlighted the risk of debt-deflation in the way Irving Fisher – the father of the equation of exchange – called debt-deflation.

I think Tim is right in highlighting the this risk. China’s debt debt problems and the housing crisis are level know and as Irving Fisher highlighted back in 1931 in his famous article The Debt-Deflation Theory of Great Depressions, the two dominant factors in causing great economic depressions are over-indebtedness and deflation. Fisher explained that these two factors interact in a vicious cycle, where efforts to liquidate debt lead to falling prices, which in turn increase the real burden of debt. This self-reinforcing cycle can lead to severe economic downturns, as seen in the Great Depression.

Fisher argued that without intervention to stabilize prices and manage debt levels, economies risk falling into prolonged periods of recession and deflation, exacerbating financial crises.

Or said in another way if China wants to avoid a negative debt-deflation spiral then the People’s Bank of China (PBoC) needs to act so to ensure China moves away from the deflation.

Currency depreciation is the only way out of deflation

Therefore, the PBoC clearly should take action to ease monetary policy significantly. This would cause nominal GDP growth to pick-up, which certainly would ease the pain from the housing crisis and significantly reduce the risk the banking problems in China worsens further.

However, as I noted in an interview back in May this would also imply that the PBoC would have to accept a significant weakening of the Chinese renminbi. Something both the PBoC and the Chinese Communist party (CCP) seem very reluctant to accept.

From a political perspective the CCP and the PBoC are politically stuck between a rock and a hard place. The reason for this is that both structurally (due the a very significant slowdown in potential real GDP) and because of the risk of debt-deflation we should expect a real depreciation of the renminbi.

However, note that I here write REAL depreciation. A real depreciation can happen in two ways. First the “easy” way – simply allowing the currency to depreciate in nominal terms. There is no real economic problem in this – particularly if most of the debt is domestic (as it is in China and has been in Japan that for 30 years have been struggling with similar problems).

The other way to get real depreciation is the way it was done in Japan for more than two decades – trying to get the currency more or less stable (or even ensuring a nominal appreciation) but then having low inflation – or even deflation – than the outside world.

This is of course what happened in Japan which has meant that there has never really been a resolution of Japan’s debt and housing problems.

I my view Chinese policy makers so fast has failed to recognize the real dangers of debt-deflation and to me it looks like the CCP and PBoC are too afraid to do the right thing – push for a NOMINAL depreciation of the renminbi – repeating the mistakes of the Japanese governments and the Bank of Japan over the past 30 years.

But why not do the right thing? The reason in my view is twofold.

First, is “buble regret”. The CCP and particularly president Xi likely have been somewhat disgusted by the fact that many Chinese have been hunting for wealth by investing the property market and they know that it essentially has been wrong to try to keep the economy growth faster than potential growth (which has been slowing fast) by re-inflating the housing bouble. This is exactly what was driving Japanese policy makers for years.  

Second, and likely more important the Chinese Communist party fear the people’s reaction to a sharp depreciation of its currency. Since the early 1990s the CCP’s claim to fame – after the catastrophic Mao years – has been the the CCP has been able to through it’s economic reforms has been able to lift income levels of the Chinese population massively.

However, the free market reforms ways behind China’s growth miracle have clearly been scaled back over the past decade and at the same time the very significant negative demographic headwinds are slowing growth.

And the clearest way to see this is the beginning real depreciation of the renminbi. At least for economists. We understand the real depreciation reflect a gloomier growth outlook. However, to the average Chinese this problem is less visible – at least as long as the NOMINAL currency rate is more or less stable.

It might be the CCP seem to have full control over the Chinse public – China is massively authoritarian – but the CCP clearly fear that one day the Chinese public will rise up against the dictatorship. A nominal depreciation of the renminbi would – at least in the heads of people like President XI – would make such a uprising significantly more likely.

Consequently, the right policy would be currency depreciation, but that it not the preferred policy of the CCP.

Rather it is very clear that the CCP has long ago moved away from the path it took during the 1990s and 2000s where free market reforms and at least particial political liberalization created the Chinse growth miracle. Now the CCP is back to use the heavy hand of government – also to control the economy and in my view we are likely to see more of that going foreward and all indications are that President Xi fundamentally has no economic understand and the economic “understanding” he has is basically not much different from Mao’s Marxist teachings.

Renminbi should be weakening – it is strengthening

Hence, it is very clear that there is a disconnect between what is the right policy and what is being done and recently this seems to have gotten even worse. In fact since we go the very negative M1 numbers for July the Chinse Renminbi has strengthened significantly against the dollar.

This remind me a lot about what was happening to the Japanese yen during the 1990s and early 2000s. Domestic savings was increasing (because of deflation-fears and banking problems) and deflation was become ingrened. This caused the yen to appreciate in nominal terms, which both through lower import prices and increased debt problems and a contraction of the money-multiplier that cause money supply growth to slowing further just made the deflationary problems even bigger.

For years Japanese policy makers refused to do anything about it – it just got worse. A lot of economists for a long time thought that the BoJ would undertake bold steps to ease monetary policy and the Swedish economist Lars E. O. Svensson suggested what he called a fool-proof way out of deflation – simply intervening directly in the currency market to weaken the yen. But the Japanese government and the BoJ for years refused to do that even though it would have been the right thing to do.

Governments and central banks often make mistakes – and sometimes the continue to do so for years. Not because it is good policy but either because they are misguided (that was mostly the case in Japan) or because they have other incentives – like stating in power (that is the case in China).

In the above mentioned newsletter Tim Congdon argues that the Chinese authorities likely will be able to avoid a debt-deflation crisis. While I obviously agree with Tim on the economics of this – we are after monetarists both of us – I disagree on the politics. The Chinese Communist Party has unfortunately long ago reverted back to its Marxist thinking and in my view we are more likely to see a lot more state control of the Chinese and likely also a lot more political repression before the authorities will undertake the right policies to curb the debt-deflation spiral.

If you want to know more about my work on AI and data, then have a look at the website of PAICE — the AI and data consultancy I have co-founded.

On Friday, the headlines were flashing: “Sahm rule triggered”. The reason was that with the US unemployment numbers for July coming out at 4.3%, the 3-month moving average was now 0.5 percentage points higher than its 12-month low.

The Sahm rule has historically been a strong coinciding indicator for recessions in the US – hence the triggering of the rule has clearly sparked recession fears.

While I am personally somewhat sceptical about whether the US economy is in recession, I am nonetheless intrigued by the Sahm rule. In the process of thinking about the Sahm rule, I noticed a comment on X.

A commentator on X wrote something like: “The recession is now a done deal as unemployment has risen for 4 months in a row, and that always means that the US is in recession.”

Unfortunately, I have not been able to find the comment again, and I would like the person who wrote it to get full credit. So if you are that person or somebody who has seen the comment, please drop me an email (LC@paice.io).

Nonetheless, the comment made me think – was it really true that if US unemployment rose four months in a row, it would be a good recession indicator?

I set out to investigate it.

Historical Unemployment Patterns

In the graph below, you see US unemployment since the Second World War, and we see a very clear pattern. It’s hardly surprising that US unemployment has spiked during recessions, marked in the graph with the official recession dating done by the National Bureau of Economic Research (NBER).

In the graph, I have also marked the “trigger dates” from the two rules based on unemployment – the Sahm Rule (red lines) and the 4m-RUIN (blue lines).

4m-RUIN is the name I have given to our X-inspired indicator – it is short for 4-Month Rising Unemployment INdicator.

We see that both the Sahm rule and 4m-RUIN are basically always triggered in the first months of the NBER recessions, but they are rarely leading indicators.

During the 1950s and 1960s, the 4m-RUIN seemed to be a bit more “leading” than the Sahm rule. In 1959, it even “predicted” the 1960 recession. It also sent a recession alert earlier than the Sahm rule in 1973.

Overall, both the Sahm rule and the 4m-RUIN have historically had a very high hit ratio and both have identified nearly all post-Second World War US recessions.

What Happened in 2020?

However, in 2020, when US unemployment spiked more than ever before to nearly 15%, that triggered the Sahm rule, but 4m-RUIN was silent.

Why was that? The reason was that US unemployment only rose two months in a row – March and April – and hence did not trigger 4m-RUIN. One can say that the recession was nearly over before it started.

According to NBER, the recession lasted from February to April 2020. And it was certainly not a “normal” recession. It was a lockdown – and once the lockdown ended, the economy returned swiftly to normal.

Back in May 2020, I wrote the following in my post “When Americans vote in November unemployment will be below 6%”:

“However, where most commentators are wrong is assuming that this has to be seen as a normal recession. I, on the other hand, would argue that this has little to do with a normal recession. In fact, I am increasingly thinking that the use of the term ‘recession’ is a misnomer in relation to this crisis.

…Most people don’t really think about it, but most industrialised economies in the world every year go through large “recessions” in the form of a major drop in economic activity. This happens both on the supply side, as for example Southern Europeans go on Summer vacation typically in August, or with private consumption as it fluctuates wildly before and after Christmas.”

I then went on to argue that unemployment would drop very fast – and it did.

One can, of course, discuss the reason for the 2020 “recession” and whether it was a recession or not, but that’s not really important – 4m-RUIN didn’t get that one “right”, but it got the other “normal” recessions right.

What Normally Happens After 4m-RUIN is Triggered?

Both the Sahm rule and 4m-RUIN are coinciding indicators and as such should not be seen as having any predictive power.

However, we also know that prices and wages tend to be sticky and as a consequence, unemployment is sticky – once it starts to rise (or fall) it tends to do so for a period, and as such, if unemployment has been rising recently, we might take this to be an indication of a further increase in unemployment.

The graph below is an illustration of that.

The graph shows the development in US unemployment prior to and after the 4m-RUIN has been triggered for all the episodes after 1945.

We also see the median of these episodes, and in the “median” episode, unemployment continues to rise around 1 percentage point and remains elevated for around 30 months.

It is, however, also notable that the spread is very large – there are mild recessions (for example 2001) and there are deep recessions (for example 2008-10).

It is also notable that once the 4m-RUIN has been triggered, historically we have already seen a rise in unemployment by more than 1 percentage point prior to the trigger date.

Compared to that, the present episode (the red line) is somewhat milder, and even though unemployment has increased for four months in a row, the accumulated increase in unemployment has been somewhat smaller than during most previous episodes.

And that is, of course, also why this doesn’t really seem like a recession. At least not yet.

The Lucas Critique to the Rescue?

This can, of course, be interpreted in two ways – either this is a mild recession and there is nothing to worry about, or this is just the beginning and we have yet to see the big move in unemployment. But since I am uncertain whether we are in a recession or not (despite the signal from both the Sahm rule and the 4m-RUIN), it makes little sense to speculate about this.

However, there is one thing that makes this even more complicated, and that is that both the markets and policymakers fully understand the message from the US labour market. This is, of course, what we have seen in the market in recent weeks, and compared to, for example, during the 1950s-1970s, the Fed is now forward-looking both in its communication and in the way interest rates are set, and the Fed tends to listen to the markets.

So even though market monetarists like Scott Sumner, David Beckworth and myself are critical about the Fed’s monetary policy framework (we would like to see NGDP level targeting and a market-based approach to implementation of monetary policy), the Fed has nonetheless become increasingly market monetarist in the way it conducts monetary policy.

This means that the Fed is not primarily concerned about the present level of unemployment and inflation, but rather is looking ahead and, among other things, looks at what markets are telling them about the outlook for the US economy. And the signal is pretty clear from the markets – inflation pressures have eased and recession risks have increased.

Consequently, the Fed should cut interest rates.

Markets, of course, also understand this – and therefore, the markets are presently helping the Fed implement monetary easing by pushing down market rates to reflect the expectations of future interest rate cuts from the Fed.

This, however, also illustrates part of the problem with indicators like the Sahm rule or 4m-RUIN. Once the Fed starts to understand them and markets understand that the Fed understands them, then they will become less reliable indicators of future unemployment. This is of course the Lucas Critique – once the Fed using an indicator to conduct policy the indicators stops being a reliable indicator.

Therefore, I am less reluctant to call the recession and fundamentally still believe it can be avoided and that the Fed has the tools to avoid it.

That, however, does not mean that the Fed should ignore the signal from the Sahm rule or the 4m-RUIN, but rather that the Fed should indeed cut rates – and do it soon.

And again, I didn’t come up with the idea for 4m-RUIN – a guy on X did. Could you help me find him?

Note: Illustration created with ChatGPT 4o/Dall-E.

If you want to know more about my work on AI and data, then have a look at the website of PAICE — the AI and data consultancy I have co-founded.

On Friday we got the U.S. labour market report for July. Employment growth and wage growth continue to decelerate, and most notably, the unemployment rate rose to 4.3% in July, up from 4.1% in June.

This increase has triggered a “recession alarm” — at least if one subscribes to the so-called Sahm Rule.

Understanding the Sahm Rule

The Sahm Rule, devised by American economist Claudia Sahm, provides a strong indication of whether the U.S. economy is heading into a recession. It posits that if the three-month moving average of the unemployment rate rises by 0.5 percentage points or more above its lowest level within the past 12 months, it is a powerful signal that the economy is already in recession.

Although I am not necessarily of the opinion that the U.S. economy is in a recession at this moment, high-frequency growth indicators suggest that GDP growth in the U.S. is currently around 2-2.5%.

This implies that unemployment has been “too low” relative to the so-called structural unemployment (sometimes referred to as NAIRU), and a natural and necessary adjustment is taking place. I estimate that NAIRU is around 4.0-4.5%.

The Sahm Rule Triggered

Unemployment is indeed rising, as shown in the graph below, and the Sahm Rule has thus been “triggered”. The three-month moving average (the red line) is now precisely 0.5 percentage points above the lowest point over the last 12 months (the green line).

While I am sceptical that the US economy is actually in recession now, it is nonetheless clear that the US labour market has been cooling. At the same time, it is also clear that historically, the Fed has been too slow in changing direction when warranted and thereby has effectively triggered recessions by inappropriately changing monetary conditions when needed.

However, the purpose of this blog post is to investigate whether the fact that the Sahm Rule has been triggered tells us anything about the future or not.

Therefore, I have looked at all the occasions since 1960 when the Sahm Rule has been triggered and examined unemployment, inflation and the Fed funds rate following the triggering of the Sahm Rule.

The following episodes have been identified using the real-time Sahm Rule indicator:

1. August 1960 to October 1961
2. February 1970 to October 1971
3. July 1974 to January 1976
4. April 1980 to April 1981
5. November 1981 to June 1983
6. August 1990 to July 1991
7. July 2001 to September 2003
8. February 2008 to September 2009
9. April 2020 to May 2020

I now use these dates to identify the beginning of a recessionary episode. These more or less correspond to the dates identified by the NBER, for example.

In the graphs below, we use these starting dates as period “zero” and look at 36 months prior and 36 months after the “trigger time” for unemployment, inflation and the fed funds rate.

We start with unemployment.

We start with unemployment.

If we look at the median across the historical episodes, then we see a gradual but moderate increase in unemployment prior to the “trigger date” (time zero), whereafter the increase in unemployment seems to accelerate. However, we also see that this pattern is far from clear as the “green band” is very wide – both prior to and after the trigger date. The band is +/- 1 standard deviation from the historical median.

But if we assume that the median tells us something about the future, then we should expect US unemployment to continue to increase going forward and at an accelerating rate. Judging from history, unemployment should increase by 1.5 percentage points over the next 10-12 months to just below 6%.

That said, it is also clear that the uptrend in US unemployment has been less strong this time around (the red line) than the historical median (the green line). To me, this is an indication that even though the Sahm Rule has been triggered, a recessionary shock really hasn’t hit (yet?), but that might of course change and this is a purely historical comparison.

Next up – inflation.

The graph shows a rather interesting pattern. Inflation tends to rise until around 20 months prior to the trigger date, whereafter it stabilises, but then around the trigger date, inflation starts to decline. Again, the “band” around the median is quite wide, but the “direction” seems to be clearer than for the unemployment data.

Again, this recent episode that really started with the lockdowns and the unprecedented easing of fiscal and monetary policy in the US in 2020-21 is somewhat different from the historical median. Hence, the increase in inflation was much stronger than historical, but it is in fact even more notable just how much inflation has come down over the past 2 years.

It is therefore also fair to question whether inflation will drop as much as the historical median. That being said, if we look at the first 15-20 months or so, then the historical indication is that inflation should drop by around 1 percentage points, which would mean inflation would drop just below 2%, which doesn’t seem all that far-fetched.

And finally, on to interest rates.

If we look at the Fed funds rate, the development in historical median is a bit messy, but the overall picture is of rising interest rates. This is not surprising as we have seen above rising inflation prior to the “trigger date”. So what we get the indication of is rising inflation followed by interest rate hikes from the Federal Reserve followed by a period where unemployment gradually rises and inflation starts to stabilise.

However, at some point the Fed “overdoes” it in terms of monetary tightening, and this triggers the recession and a sharper increase in unemployment.

It historically has taken time for the Fed to realise its mistake, but at some point quite close to the “trigger date”, the Fed does a U-turn and starts cutting interest rates as we all quite clearly see from the graph above.

In fact, the pattern is a bit clearer for interest rates than for unemployment and inflation, judging from the standard deviation band which is narrower for interest rates than for unemployment and inflation.

What we also see is that the cutting cycle is actually somewhat front-loaded. It might be that the Fed has taken too long to start cutting rates, but once it initiates its cutting cycle, the cuts come pretty fast. In fact, within the first year after the trigger date, the Fed historically has cut the fed funds rate by around 2 percentage points.

In the present situation, that would imply that the Fed would cut the Fed funds rates to 3.25-3.50%. This could seem like a lot, but in fact it is not significantly more than priced by the markets.

Furthermore, if we use the theoretical Mankiw rule that I discussed in my previous post (Eeny, Meeny, Miny, Mankiw: The Surprisingly Accurate Way to Guess Fed Policy) and assume that unemployment, for example, increases from presently 4.3% to 5.8% and PCE core inflation drops from 2.6% to 1.8% over the next 12-18 months, then we should actually expect interest rates to drop by 3-3.5 percentage points – down to around 2%.

Hence, even though market pricing in relation to rate cuts has changed rather dramatically over the past week, the markets are still not priced for median historical recession.

Even though it is a pretty daring assessment to make, based on market pricing and the historical relationship between unemployment and the fed funds rates (for a given inflation outlook), I would estimate that markets are presently pricing US unemployment to rise to around 5.0%.

That surely would be seen as a recession, but in a historical perspective, it would be a quite mild recession.

Overall, if I should compare it to anything, I think this is quite similar to the relatively mild and short recession that also followed a tech-driven stock market boom and where the fed funds rates were at a similar level at the “trigger date” as presently is the case, but where also rates were cut relatively swiftly. However, at that time we also had a massive uncertainty shock as a consequence of the terror attacks against the US on 9/11 – on top of the recession that had already started. Hence, we effectively had a double-shock in 2000-1 and without 9/11, the cutting cycle would likely have ended earlier – meaning that the comparison would have been a total cutting cycle of around 3 percentage points.

The paradox here is that if the Fed takes too long to start cutting rates, it would cause a sharper increase in unemployment and in inflation, which in turn will necessitate an even stronger monetary policy response and deeper rate cuts.

Another policy mistake?

Former IMF chief economist Rudiger Dornbusch is famous for saying that the Fed usually murders the expansion before it gets a chance to die of old age. Our analysis above indicates why this is the case – the Fed simply takes too long turning around and historically has initiated the easing cycle too late.

The good news is, however, as long as the zero lower bound is not hit, the Fed normally corrects its mistake relatively fast, and I am even tempted to say that Fed-chairman Jerome Powell full-well understands this and has the means to ensure “Growth Forever” without a recession.

However, I don’t dare argue that – after all, this is exactly the argument Rudiger Dornbusch made in 1998 in an article with exactly that title – “Growth Forever” – in which he argued that the Fed had now learned how to avoid a recession. But the recession nonetheless came in 2000-1.

And I have long argued that for now, the Fed seems to have managed to engineer a “soft landing”, but I must also admit I am not fully convinced that the Fed will continue to manage well. Even though Powell now clearly has signalled that the Fed will soon start cutting rates, it is also important to understand that we are at a critical point where the Fed should be extremely focused on not getting behind the curve.

The US is still not in recession, but it is also the Fed’s job not to trigger a recession, and the track record is quite bad.

PS the best way to avoid remaking the mistakes of the past is to change the Fed’s policy framework to a market-based and truly forward-looking monetary policy regime.

PPS if you or Jerome Powell is looking for a easy way to calibrate rate policy have a look at my interest rate calculator here. The calculator is created with Claude 3.5 Sonnet.

Note: Illustration created with ChatGPT 4o/Dall-E.

If you want to know more about my work on AI and data, then have a look at the website of PAICE — the AI and data consultancy I have co-founded.