In a concerning development for the US economy, economist Claudia Sahm has warned that the Federal Reserve's hesitation to cut interest rates now could potentially lead the country into a recession. Sahm, known for her time-tested rule for predicting recessions, has raised concerns as the unemployment rate inches up, indicating potential cracks in the strong labor market.

According to Sahm's rule, when the three-month average unemployment rate is half a percentage point higher than its 12-month low, the economy is considered to be in a recession. The recent uptick in joblessness has triggered discussions on Wall Street about the possibility of trouble ahead and the timing of the Fed's decision to reduce interest rates.

Expressing her concerns, Sahm, who serves as the chief economist at New Century Advisors, pointed out the significant risk the Federal Reserve is taking by not implementing gradual rate cuts. By failing to take proactive measures, the Fed exposes itself to the triggering of the Sahm Rule, potentially forcing policymakers to adopt more drastic actions to combat a recession.

While Sahm considers a recession not to be the baseline scenario, she emphasizes that the risk is real and questions why the central bank is pushing that risk. "The worst possible outcome at this point is for the Fed to cause an unnecessary recession," she added.

Presently, the Sahm Rule stands at 0.37, as per the latest May employment report from the Bureau of Labor Statistics which indicated a rise in the unemployment rate to 4%, the highest since January 2022. A reading of 0.5 would officially trigger the rule, and a few more months of 4% or better readings would make that a reality. The Sahm Rule has consistently applied to every recession dating back to 1948, making it an effective warning sign as the value starts to increase.

However, despite the rising jobless levels, Fed officials seem unperturbed by the condition of the labor market. Following their recent meeting, the Federal Open Market Committee described the jobs market as "strong," with Chair Jerome Powell stating that conditions were similar to those on the eve of the pandemic, relatively tight but not overheated. In fact, officials surprised the markets by sharply revising their individual forecasts for rate cuts this year, going from three anticipated reductions in March to only one in the current round.

This unexpected move has left market participants still anticipating two rate cuts this year, as indicated by the CME Group's FedWatch measure of fed funds futures market contracts.

Sahm expressed her concern that Powell and his colleagues are "playing with fire" and should be closely monitoring the rate of change in the labor market as a potential indicator of impending danger. Waiting for deterioration in job gains, as Powell mentioned, could be risky, she warned. Sahm highlighted that the recession indicator is based on changes for a reason and that recessions have occurred at different levels of unemployment. The dynamics can create a vicious cycle where job losses lead to reduced consumer spending, causing further job losses.

However, the Federal Reserve finds itself at a crossroads. The last time the unemployment rate was at this level, requiring interest rate cuts to avoid a recession, was in the late 1969s to 1970. Historically, the Fed has rarely decreased rates with unemployment at such levels.

Central bankers have recently stated that they observe inflation moving in the right direction but are not yet confident enough to initiate rate cuts. The preferred inflation barometer for the Fed, excluding food and energy prices, stood at 2.8% in April, slightly above the central bank's target of 2%.

Sahm argued that considering the downward trajectory of inflation and the upward trend of unemployment, the Fed should be taking a clear course of action. Balancing these aspects, it becomes increasingly apparent what the central bank should do.

As the debate intensifies, economists and market participants eagerly await the Fed's decisions, hoping that the risks of a recession can be effectively managed and mitigated.