Ernie Tedeschi on the US Safe Harbor Premium and the Current Path of R-Star

Ernie Tedeschi is the Direct of Economics at the Budget Lab and is a visiting fellow at the Psaros Center for Financial Markets and Policy. Recently, Ernie was a chief economist at the White House’s Council of Economic Advisors, and he is also a returning guest to the podcast. Ernie rejoins Macro Musings to talk about the CEA and some of his recent work on the political risks to the US safe harbor premium and R-star. David and Ernie also discuss the benefits and healing properties of a high employment economy, Ernie’s favorite measures of the labor market, the current and past trends in the path of R-Star, and more.

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Read the full episode transcript:

Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected].

David Beckworth: Ernie, welcome back to the program.

Ernie Tedeschi: Thanks, David. Happy to be part of the two-mug club now.

Beckworth: Yes, you are part of an elite club, and what was interesting, in preparing for the show, [is that] I went back and looked at your previous time, and it was February 2020.

Tedeschi: Oh my gosh.

Beckworth: You were the last person to record here in the studio before the pandemic hit, little did we know.

Tedeschi: Sorry folks. It was all my fault.

Beckworth: Well, fortunately, you had a great program, and we ended on a high note before we went home and we started recording podcasts that way. But a lot has happened since then, obviously the pandemic, but you, yourself, you were in the private sector at the time. Then, you went to the CEA, spent some time there, and now you're outside at some think tanks, at the university. I'm curious to hear about your time at the CEA. In fact, you just stepped down, right?

Tedeschi: That's right, back in March.

Beckworth: Okay, so, you saw the inside workings of the White House, at least the economic policy side. So, tell us about the CEA and what it's like to work there.

Ernie’s Experience at the CEA

Tedeschi: The CEA was one of the most incredible experiences of my life, as an institution [and] two reasons for that, mainly. One [is] just the extraordinary people that are there. So, the CEA has a group of economists. There are senior economists, who tend to be academics on leave from their jobs, or high-ranking government economists at places like [the] Census [Bureau] or the Federal Reserve who take a one-year leave of absence or two-year leave of absence to join the CEA. The senior economists were among the foremost experts in their field.

Tedeschi: Then, you have junior economists who are either recent undergraduates of undergrad programs or are in the middle of PhD programs currently who— statistically speaking, one of them will win the Nobel Prize one day, just in terms of ability, are almost unbelievable in terms of how they think, what they're capable of. Then, you have the leadership. I was hired by [Cecilia] Rouse, who's a wonderful economist and a dear mentor. Then, Jared Bernstein became Chair later on in my tenure, who I worked very closely with, and [who is] just a superb public official.

Tedeschi: Then, we had the two members, who are sort of like deputy chairs, Heather Boushey, [and] Jared was a deputy before he was elevated to chair. Now, it's Kirabo Jackson, who's the other member, both incredibly smart and dedicated officials. So, the people were one big part of the positive experience there. The other part was just the work, which is, probably, what I expect you'll ask about. But briefly, I joined in March of 2021 and left in March 2024. So, I was there for some of the most interesting, uncertain times in terms of the path of the recovery from the pandemic.

Tedeschi: When I got there, the labor market was more of a concern than inflation was. We were still unsure that the labor market was going to be back on a steady path. Then, later on in the year, the inflation data started heating up, and the labor market data got extraordinarily better and more stable. And so, our perspectives on that reversed. Then, of course, all sorts of other things happened. The war in Ukraine, forcing us to think about how that was going to feed into price pressures and other economic pressures, and all sorts of policy issues that came up over that time, too.

Beckworth: What was a typical day like for you? What were you doing? Were you creating reports for the president? How does that work?

Tedeschi: So, a typical day— I don't know how typical any single day is at CEA. Think of CEA as the internal think tank of the White House and the administration. One of CEA's many duties is interpreting economic data for the president, and as part of those duties, CEA gets every economic data release, the day before it's released to the public. So, that was one of the most interesting parts of the job, because we would get, say, the jobs report the day before or the inflation report the day before. But unlike most economists or even the general public, we didn't have the benefit of looking around at what other commentators were saying.

Tedeschi: We were the only ones, other than the reporting agency, that had seen the data. So, it was almost like a funny little experiment, like, were we interpreting the data the same way that the mass brain of commentators would interpret it the next morning? We would write memos to the president outlining what the data release said, putting it in the broader context of the economy. And when the president had questions, we would answer those questions. So, that was certainly not the totality of what we did, but that was a big part of, especially what I did at CEA.

Beckworth: So, you had memos and updates on regular occurring data releases, but I imagine, also, special projects came up as well on certain topics.

Tedeschi: Right. So, oftentimes, the White House or other agencies would have economic questions for us, and they would want the benefit of in-house economists to think about that. And that's really where CEA's expertise was so important to the administration. So, I mentioned that we had senior economists who were the foremost experts in their field, junior economists who were incredibly capable, and that was, really, CEA's value add, I think, to internal economic policy conversations. There are very few things that CEA has to do. I think that the only thing, by law, that we have to do is publish the Economic Report of the President every year.

Tedeschi: Everything else is optional. We don't need to be invited to policy conversations or meetings unless the people convening those meetings think that we add value. And so, it's very important that CEA play a role in the room. And when I was there, we saw that role as the economists in the room offering independent perspectives on economic costs and benefits, economic implications of what was being talked about, in a way that would, hopefully, make the conversation more rigorous and well-informed.

Beckworth: Okay, so, you were in the old executive building, and that's right next door to the White House, and for listeners who don't know, there's the White House compound, which is the White House, Treasury on one side, all of the executives. So, you're right there, and you could see the White House, right?

Tedeschi: That's right. So, on that side of the building, we can see the West Wing, right there.

Beckworth: And you, I imagine, had many trips into the West Wing?

Tedeschi: Not all of the time, but we did have meetings in the West Wing. I was lucky enough to get to brief the president a couple of times during my tenure there, which was another incredible experience that, fair to say, will not be matched in the rest of my career.

Beckworth: So, you had to pinch yourself, “Wow, I'm giving the president a briefing on the economy.”

Tedeschi: One time, I participated in a briefing to the president in the Oval Office, came out of the Oval Office, and there was this giant pile of West Wing cookies there. And I was looking like, “Are those for me?” And it was Secretary Yellen, who was ahead of me, that turned to me and said, "Ernie, don't you have four kids? Take all of the cookies you want and bring them home." I'm like, "Okay, Secretary Yellen is telling me to take chocolate chip cookies." So, I took a bunch of them home, and I gave one to my oldest. He's looking at this, and he's like, "What is this?" I'm like, "That's a West Wing cookie." And he took a bite of it, and he said, "Yes, okay, that's pretty good."

Beckworth: Fantastic. Well, let's move from the CEA to some of the issues you have worked on. Last time we were on the show, we talked a lot about labor markets, output gaps, [and] the real economy. We're going to do that again today, kind of an update from the last time we were together. And one of the things that I want to touch on is the health of the labor market. You had a tweet recently that I loved, but you used the “man standing up” meme. I think it's a Norman Rockwell painting. Basically, it's this guy standing up, saying something contrary or something he believes in, and you had that picture. Then, you wrote this: "Low unemployment and high prime age employment are good things that reflect people being better off and are worth celebrating." So, I agree. Full employment, that's a virtuous thing to seek after. What were you trying to articulate and share in that tweet?

The Benefits and Healing Properties of a High Employment Economy

Tedeschi: I think what I was trying to articulate with that tweet is, look, especially in an election year, we hear a lot about the things that people don't like about the economy, and, in particular, price levels and inflation, which is, I want to emphasize, completely understandable. I have four kids. Costco runs are a lot harder than they used to be. So, I completely understand that. However, we should not lose sight of the good things about the economy, the extraordinarily good things about the economy. We know, from prior cycles, prior recessions, that when unemployment is high, people don't like that.

Tedeschi: People don't like the uncertainty of not knowing if they're going to have a job a year from now. That is far less of a problem now than it has been at almost any other time in recent history. The unemployment rate has stayed below— So, we're recording this where we're going to get a jobs report this coming Friday. We don't know what it says yet. But as of now, the unemployment rate has been below 4% for 28 months, which is a more than 50-year record. That is extraordinary, and we should not be afraid to tell people the truth that, yes, concerns about cost of living prices are valid, but there are legitimately, objectively good things about the economy, too, that people need to know about.

Beckworth: Absolutely. So, I think it's a great point that, when we evaluate the current situation we're in, to do the right counterfactual. We didn't repeat what happened in 2008, or after 2008, and that was a possibility. It could have happened, and, I think, some might criticize, maybe we went too far, which, I think, is also fair, but we should take the win. Just speak briefly about the fact that a high employment economy, or unemployment rate as low as it is, actually has healing properties in terms of pulling people into the workforce who otherwise wouldn't be there.

Tedeschi: So, I will not match the depth of analysis that is in Chapter 1 of this year's Economic Report of the President. I encourage all people who are interested in the topic of full employment to read Chapter 1 of the 2024 Economic Report of the President that CEA publishes. But just to summarize, I like to think of full employment as having benefits that are more than the sum of its parts. An economist would say nonlinearities. In other words, when we start getting to what we think of as full employment, which is— it's unknowable. It's always uncertain what that threshold is.

Tedeschi: But I think it's safe to say that, being below 4% unemployment with prime age employment rates being as high as they are, we are in the ballpark of full employment right now, if not there. And that means, in particular— It means benefits for people who are traditionally marginalized from the labor force. So, for example, you see people with disabilities having record high labor force participation and employment rates right now, and a lot of that is because we are at full employment. Same for workers of color, lower income workers who have done much better in this cycle than in most other recessions and business cycles that the United States has had.

Tedeschi: I think that is, in large part, due to the emphasis on full employment policy this time around. You mentioned that we didn't want to make the mistakes that we had in 2008, and there's always a question of, okay, but how far is too far? I would argue that we can put the politics of it aside, but in terms of the substantive economics of it, erring on the side of doing too much so that we can ensure that those benefits accrue to, traditionally, more marginalized groups, is worth the tradeoff. It's an asymmetric outcome that, I think, we should be comfortable with as policymakers.

Beckworth: And to be fair, we have talked about 2021. Did we overdo it? But I also think it's fair to say that no one really knew where we were in 2021, either. So, the amount of stimulus that was added— We really did not know that we'd have this recovery. We didn't know about the vaccines coming out. There was a lot of uncertainty at the time. So, I think that we need to be fair there, too.

Tedeschi: I agree, and I think that we have to consider all of the factors in the 2021 and 2022 experience. I do think that the big thing, at least internally— and, in here, I'm speaking more personally. What I did not appreciate, in real time, at CEA, looking at the inflation data coming in in 2021, was the contribution of the supply side to that. And to be very fair, there were economists early on in 2021 who had talked about the supply side. So, when you look at the debates around the American Rescue Plan, before it was actually passed by Congress— so, here, I'm thinking January 2021, February 2021— people were talking about the supply side as constrained, and in particular, Larry Summers, who was absolutely right to bring it up. But we didn't really have the tools or the metrics to really think about it. And you can see that by going back to those debates, and people who were raising concerns about the supply side were, more often than not, citing CBO's measure of potential GDP. Well, potential GDP, put out by CBO, is a wonderful metric. It's extremely thoughtful. [But] it has nothing to do with the short run supply constraints of the economy.

Tedeschi: CBO potential GDP is a medium to long run measure that is driven by population growth, productivity, immigration, [and] structural factors in the economy. It is not driven by, do we have vaccines for this pandemic? Are the lockdowns that we put in going to be lifted anytime soon? Are shipping containers getting [to] the place that they need to be? Are warehouses overflowing? All of these short run factors that, I think, were creating a ceiling or a constraint on the economy, in 2021, that, in the end, drove a lot of the inflation that we ended up seeing.

Beckworth: Tell me about your favorite measures of the labor market and full employment. What do you turn to, to get a sense of where the labor market is?

Ernie’s Favorite Measures of the Labor Market

Tedeschi: If I had to pick one simple measure of employment, I would pick the prime age employment-to-population ratio. So, that is workers 25 to 54, the percent of the population that is employed. I like that more than labor force participation, because there is evidence from economists, over the last 10 years, that people go in and out of the labor force, and just for listeners, the official definition of when I say “labor force” is that you either have or you're actively looking for a job. And it turns out that more and more people, as time has gone on, are sort of flowing in and out of actively, or not actively, looking for a job.

Tedeschi: So, the labor force is still a helpful metric, but it's a little bit more in the eye of the beholder. Whereas employment— if you do have a job, that's a little bit more cut and dry and, I think, objective. And when you look at the prime age employment-to-population ratio right now, we are above where we were, pre-pandemic. We're not quite where we were back in 2000, but that leads me to what is probably my favorite metric, but it's not quite as simple, which is, I like to take total employment. So, not prime age, so, everyone now, but then I age adjust it.

Tedeschi: So, you pick a year, you pick a time period, and you say, “Assume that the demographic or age profile of the American population always looks like that year.” That's really important, because, over the last couple of decades, baby boomers have been aging. The population, as a whole, has been getting older. This is not just an American phenomenon. This is worldwide. Every country is experiencing this aging phenomenon, to a certain extent.

Tedeschi: When that happens, you expect official employment rates to drift down over time, because older people are more likely to be retired. That's not a sign of economic weakness or policy failure, that's just organic demographics at work. And so, if you're thinking historically, like, “How do I compare where we are in 2024 to where we were in 2000?” The way I like to do it is [to] look at everyone, 16 years and older. That's the way the official data is set up. Then, strip out the effect due to aging. When you do it that way, the age-adjusted employment-to-population ratio, right now, is about at where it peaked in 2000. And because, before 2000, women were gradually entering the labor force as they had more and more opportunities, that probably means that the employment level— again, age-adjusted, right now— is probably close to the highest it's ever been in the United States, absent extraordinary periods like World War II, say.

Beckworth: So, Ernie, we've been talking about inflation, labor markets, and the debate that surrounded it, and here we are now. Inflation is down close to 2%, a little above 2%, but we're making a lot of progress. And another debate, sometimes contentious, was the one over soft landings. I bring that up because it also was tied to another measure of the labor market, and that's the vacancies or job openings over the unemployment rate. And it seems to be a very popular measure in the literature. Academics, big guns in the field, they like to invoke it.

Beckworth: And so, Larry Summers and Olivier Blanchard wrote an article for the Peterson Institute where they used this, and they said, "Look at the Beveridge curve and some other indicators. We're going to have to have some pain before we get inflation back down." Then, lo and behold, Governor Chris Waller and one of his economists at the Fed, they wrote another paper saying, "No, not so fast. Actually, we can have a soft landing." They invoked, I think, a nonlinear idea, that you can actually bring inflation down without throwing a lot of people out of work. 

Beckworth: And I just want to read an article from around that time to help motivate this. This article was written in August 2022. The title is, *Summers, Blanchard Say Waller’s ‘Soft-Landing’ Paper Has Errors.* So, here we go, first paragraph: "Economist Olivier Blanchard and Lawrence Summers said a paper by Federal Reserve Governor Christopher Waller that found a soft landing is a plausible outcome for the labor market, ‘contains misleading conclusions, errors, and factual mistakes.’"

Beckworth: They go on to criticize it and say that this guy, he's just not there. It's not realistic. Well, let's go forward to February of this year, and there was a nice long article on Governor Waller. The title of it was, *The Fed Governor Who Proved Larry Summers Wrong.* So, it recounts this whole debate about v over u, and can we bring that thing down without throwing a lot of people out of work? Now, I've heard some people that say it's not the best measure, but what is your sense, one, of the measure, and [then], of the debate?

The Broader Debate Surrounding Labor Market Measures

Tedeschi: Look, I think that there is a lot of signal in vacancies and job openings. It is not my favorite measure from the JOLTS report. I like quits a little bit better, and the reason is that I think that job openings are a little bit harder to measure in a survey. It's a little bit more ambiguous and not as cut and dry, what an opening is, at the establishment level. Now, the Bureau of Labor Statistics that conducts the JOLTS survey does heroic work to try to clarify that and use a uniform definition. But even given that, when you look at openings, it's still a volatile measure.

Tedeschi: And we've seen some changes, some drift in openings over time that may not be due to economic cycles. I like quits better, because I think that when a person voluntarily leaves their job, we know from other data that, in 90% of cases, you voluntarily leave a job because you're going to another job, which means that there's another job there, and you feel secure enough and confident enough to go into that other job. Oftentimes, that involves a rise in wages as a result of that. So, when quits are high, that's usually a good signal that there's heat in the labor market.

Tedeschi: Then, when quits are down, that's usually a vote of no confidence in the economy. I don't want to overemphasize how much better one is [than] the other. They're highly correlated, vacancies and quits. To get, though, to the specific question of this debate, at CEA, we followed it very closely. Remember, this debate was arising in '21 and '22, when inflation was heating up and there was still a great deal of uncertainty about the labor market. I guess that my perspective at the time— and I think that this was partially validated— was the gravity question, which is, well, if something can go up, why can't it come back down at the end?

Tedeschi: And I think that that's actually what ended up happening. I mentioned earlier about the supply side, and how I felt like, in 2021, what I missed, personally, was the role of the supply side in the acceleration of inflation over the course of 2021 and early 2022. Well, there's a flip side to that coin on the other side, which is that when supply chains heal, when, suddenly, warehouses have enough capacity, ships are able to get to where they need to go, goods are able to get to the places where people demand them, factories are open, stores are open—

Tedeschi: You can have a great deal of disinflation, a fall in inflation, without needing a rise in the unemployment rate, because, now, goods and services are flowing more freely than they did before. And when you look over 2022 and 2023, that's exactly what happened. Measures of short run supply pressures, like the New York Fed's very helpful Global Supply Chain Pressure Index, fell precipitously over that time. I, personally, had a modified Phillips curve model that took traditional Phillips curve approaches that looked at slack, added in the short run supply chain measures, and that model was telling us that most of this disinflation was because of healing on the supply side. So, I think that that's what Chris Waller's prediction and measure of where the Beveridge curve would go was really capturing in all of this, which is that, as those inflationary factors healed, we'd be able to get a cooling in the labor market without a commensurate rise in the unemployment rate.

Beckworth: Yes, so, that debate is another great example of why we will always have work, Ernie, because there's these big questions. They get contentious, strong views, and it takes time for the results to come out. And so, I’m sure that there will be more big questions in the future. You'll come back on the show, and we can talk about them. Okay, let's move to some of your recent research that you have done, and you have a paper with the Budget Lab. The title is, *Political Risks to the US Safe Harbor Premium.* Let's begin with a very basic question. What is the US Safe Harbor Premium?

The Basics of the US Safe Harbor Premium

Tedeschi: Yes, that's a great question. So, different investors will give you different answers, but the way that we think of it is that it's basically the premium that investors are willing to pay for investment in the US because of a multitude of factors: the soundness of our political institutions, the safety and liquidity of our Treasury securities, the fact that we have the world's premier reserve currency, and the fact that we emphasize rule of law and have relatively free democratic elections. I think that all of those things go into, for lack of a better phrase, a culture of safety in investment that an investor with a global perspective is willing to pay a little bit more for, relative to maybe riskier countries.

Beckworth: And what has happened to that? What has happened to it in recent times? Is it something that we should be watching closely?

Tedeschi: So, it's actually an interesting question, because risk analysis is something that global investors have to do often. If you are thinking about investing in a project in an emerging market, for example, you often have to weigh the risk of a political regime that seizes property, or of a military coup, or all sorts of financial and political and economic risks. Country risk is, by its nature, a relative measure. It's hard to think of financial risk in absolute terms. You always have to think of it relative to somewhere else. And the way that country risk analysts often think about country risk is relative to the United States, as a benchmark.

Tedeschi: So, the United States is implicitly thought of as having zero risk, which makes a lot of sense in a lot of contexts, again, liquidity of Treasuries, premier reserve currency. But it creates a blind spot for investors, which is, if political risk is rising in the United States, investors might miss that. And that's what the report tries to overcome. So, what we do in the report is that we make a note of this fact that zero political risk is a standard assumption for the United States. But then, we note these other political risk measures that are put out by different groups.

Tedeschi: There's a quasi-academic group called Varieties of Democracy. There is a private sector risk analysis firm called The PRS Group that puts out indices of rule of law and democracy. IMF and the World Bank put out financial and political and economic risk measures. And when you composite them— so you don't rely on any one, you take the totality of all of them— they all suggest that political risk in the United States has been rising over the last several years, which I think, intuitively, is what a lot of people think and feel.

Tedeschi: I think that as I explain this, say, to my family, that makes sense to them, but it's something that financial risk analysis often misses about the United States. So, what we did was we looked at those other metrics, and we said, okay, so, ignore the United States for a moment. Assume that some country in the world had political rule of law [and] financial, economic risk measures that looked like the United States did right now. What would we expect their country risk premium to be that an investor would take into account? The answer is not zero.

Tedeschi: The answer that we found was that it was more like 25 to 35 basis points. So, to someone who has no idea what I'm talking about, what does that mean? Well, to put that in perspective, Aswath Damodaran— who's a financial economist at New York University— He judged the country risk premium for the UK in the wake of Brexit, in 2017, to be 50 basis points. That's relatively low among all advanced economies. So, we're not saying that the United States is at the level of an emerging market. We're not even saying that it's at the level of a peripheral advanced economy like Italy or Greece.

Tedeschi: But we are saying that it appears not to be zero, and the political risk here seems to be on par with about half of where the UK was in the wake of Brexit, which, when we found that, it felt very plausible to us. The last thing that I'll mention, too, is that it's been rising over time, especially over the last eight years. So, like I said, we use the compositive metrics. We entered into this very hands-off and just went where the data told us, and the data were telling us that political risk troughed in 2016 and has been rising since then, pretty concertedly.

Beckworth: So, let's park [for] just a few minutes in this idea of political risk, because sometimes we think of the US as having this other advantage called the exorbitant privilege, which I'm sure overlaps, but it's slightly different. We have lower financing costs, because the dollar, as the reserve currency, is everywhere. What linkages would you see and what differences do you see between the two notions?

Political Risk vs. Exorbitant Privilege

Tedeschi: That's a great question, and, actually, let me back up a second and talk just briefly about what I mean by risk in this context. So, there are the direct economic effects of bad, risky events that can happen [like] a default on the debt, [and] in an emerging market, a military coup, those sorts of things. One can use event studies to figure out what effect that has on markets overnight, and they all have very different effects. But investors who are anticipating the possibility of those things start pricing in higher risk premia even before they happen.

Tedeschi: That's what we're talking about in this paper, that there is this sense that it is slightly more likely that bad things could happen in the United States, a whole wide variety of bad things with different effects, and investors are starting to price that in. The real crux of the paper toward the end is that the reason people should be concerned about this is that it weighs on our well-being over time. An investor, domestic or global, is going to be a little bit more hesitant to invest in the United States. That means we have a lower capital stock over time, and it means that, ultimately, our well-being, our output, our GDP is slightly lower over time because of this. When it comes to the dollar, the dollar is one of those, I think, specific risks that we need to think about as an implication of what we're measuring in this paper. Even there, it's really hard to wrap our heads around [it]. So, I mentioned the UK before and Brexit, for example, or the recent Truss budget that was passed in 2022 that ultimately led to Prime Minister Truss's resignation, are very salient recent examples of an advanced economy going through these risk motions.

Tedeschi: And yet, as helpful as that is, the UK was not nearly as central, in 2016 or in 2022, to world financial markets as the US is today. So, one of my worries is that an increase in US risk might punch above its weight, in a sense, because if the role of the dollar deteriorates, if US Treasuries are looked upon a little bit more skeptically by global investors, [then] that has major implications for the collateral that financial firms use. The day-to-day economic transactions, internationally, where people use dollars as a medium of exchange has huge implications.

Beckworth: So, the stakes are higher, not just for us, but for the world, given the reach of the dollar and the global networks that are shaped around the dollar.

Tedeschi: Exactly.

Beckworth: So, related to that, another notion is this idea of a term premium, like on a 10-year Treasury. We think of a 10-year Treasury as the expected average short term rate over that period, plus some added compensation for someone to hold a bond for that many years, because anything could happen, from high inflation to instability. Now, the term premiums have gone up, I think. So, is this related to what you're telling, the story?

Tedeschi: Yes, it is related. So, we frame this paper in terms of equity risk, because that's often the way that investors think about it, but bonds have risk as well. I think that in our space, where we think a lot about macro [and] public finance, we probably deal with bond risk, debt risk, [and] term premium much more often. And yes, it is. There are risks to US bonds that will be familiar to many of your listeners; the fiscal trajectory of the United States. There are positive risks, as well, to bonds that don't necessarily flow into the term premium.

Tedeschi: We can talk about this more with R-star, but things like, if growth and productivity are stronger than we thought that they would be. But I think another factor in the term premium is political risk. And am I as confident that this Treasury market— which, right now, is what I consider to be the safest, most liquid market in the world— is it going to be that way 10 years from now? And I think that investors, not just in the fiscal context, but in the broader political and institutional context, have a right to ask those questions more and more.

Beckworth: Okay, so, let's go through some scenarios where political risk could really take off. One that we just went through, and probably will go through again in the near future, is a debt ceiling crisis. So, imagine a debt ceiling crisis where we actually do, technically, default. Again, there's no reason why we should default. We could always print money to pay the bill. So, there's no reason why we need to default, but there could be a technical default. And as we've talked about on the show, and as many listeners already know, there's just a whole cascading chain of events that could occur from such a development, but it seems like it's possible that as we get more and more polarized and nobody wants to give another side, would that be an example of what you're worried about?

Debt Ceiling Crises as a Political Risk Scenario

Tedeschi: Oh, absolutely, and, in fact, so much of the risk that we're worried about is outside of the lived experience of the United States, but that is one that is very much within the recent lived experience of the United States, as you point out. What's particularly interesting about the debt ceiling, and here, I'm thinking about what we went through in 2011, is, if folks recall, we had a deadline of August 2nd, 2011. That was the X date where Treasury was going to run out of extraordinary measures. Negotiations between President Obama and House Republicans went down to the wire.

Tedeschi: Then, on July 31st, so three days ahead of the deadline, Speaker Boehner and President Obama announced a deal that would resolve the budget impasse, and I can't remember if they raised or suspended the debt ceiling, but it alleviated the immediate crisis in 2011, and markets seemed to be fine with that. S&P downgraded our debt several days later, on August 5th. Now, there was bad math involved in their initial report, but even despite that, they stuck with the downgrade, and markets didn't really react until the downgrade.

Tedeschi: So, risk premia in day-to-day markets hadn't really spiked in late July, July 31st, et cetera. They seemed to be relatively tame. It wasn't until this outside ratings agency came in and said, “No, actually, persistent risk in the United States is higher than we thought,” that markets suddenly started pricing in that risk. And that's what really worries me about the United States context, is that we are so used to thinking about the United States as, effectively, a zero-risk economy— at least in a global sense, in a relative sense— that it's going to take until we not even get close to the risks, but go over those risks, experience those risks, before markets are finally going to get it and start pricing in what smart politics and smart economic observers have been saying for years now.

Beckworth: So, here's another risk that could be on the horizon, and that's fiscal dominance. And so, there was an article— actually, two articles on a future Trump Administration and one article in The Wall Street Journal outlined that he wanted to basically have someone there— or himself have an ex officio role to [the] FOMC, so, basically, push rates where he wanted it to go. That was one of the allegations in this Wall Street Journal article. There's another article that came out that talked about how he wanted to punish countries that did not use the dollar in invoicing, internationally. So, even though he's against, maybe, a strong dollar, he wants everyone to keep using it.

Beckworth: But those would be very disruptive, and they might lead to a situation where there's more political risk, but I think that a more general point that comes out of that is that he would do that in order to support, maybe, more aggressive fiscal spending. So, one concern that comes up, and I give President Trump [the benefit of the doubt], but I want to be fair, though [that], in general, we continue to run large deficits. Is this something that also worries you going forward, that, at some point, the Fed, whether from President Trump or some other president, has to keep rates artificially low to keep the financing costs of the government down, to keep it solvent? That's fiscal dominance.

Fiscal Dominance as a Political Risk Scenario

Tedeschi: So, we just went through a cycle where, if anybody forgot how much consumers hate inflation and high prices, we were violently reminded of that very quickly.

Beckworth: Yes, indeed.

Tedeschi: That is what is at stake here. And so, yes, in general, loss of Fed independence is something that worries me. One of the things that I was proudest of at CEA when I was there, was that, internally, we were consistent and forceful whenever the Fed came up in internal conversations. We would say that part of our inflation-fighting strategy has to be to let the Fed do its job, and so, don't comment publicly on the Federal Reserve. Obviously, we're all observing the same economy, but when it comes to monetary policy, we need to be hands-off as an administration. And that was taken to heart, because I think, in particular, CEA was so insistent about that over time.

Tedeschi: We don't need a fancy model or a lot of creativity to know what Fed capture means for the economy. It's part of what we went through in the early 1970s, when the Fed did not respond as forcefully to burgeoning inflationary pressures because there was political pressure being put on the Fed. Then, we ended up with stagflation later in the '70s. There was a supply-side element to that, but there was also unaddressed demand-side inflationary pressures as well.

Tedeschi: What I would tell the average person that's wondering why [they] should care about Fed independence is to remind them that, look, the Fed has a dual mandate. And I would say, in particular, that this Fed and recent Feds have been remarkably embracing of the employment side of their mandate, in a way that is laudable and is a good thing. But at the end of the day, they still have a dual mandate between maximum employment and price stability, and people don't like high prices. And so, if the Fed is under pressure to de-emphasize one in favor of the other, almost certainly de-emphasizing inflation in favor of higher employment, [then] that's going to mean higher prices for people in the long run, and they are less well-off because of that.

Beckworth: So, do you take the CBO's forecast of these incredible budget deficits seriously? I know you probably don't, but I guess the threat of them— Do you think it's something that we can't meaningfully address in our current political system? Then, as a result, we get fiscal dominance, regardless of who's in office. Just the idea that, in order to keep the government solvent, the Fed would have to start either buying up debt and keeping rates— kind of like World War II, yield curve control of some kind. Do you see that as a serious problem that we will have a hard time addressing, the sustained budget deficits, going forward?

Tedeschi: Look, I think that the debt trajectory is literally unsustainable, and that is a mathematical statement. 90% of my short-run fiscal worries are debt ceiling impasses. Maybe 10% is another flash crash-type plumbing [issue]— which, I think, in the short run, the Fed could address, but I have serious worries about the long-run fiscal trajectory and the long-run role of monetary policy. And I agree with you that if we keep relying on the Fed more and more to use monetary policy to address all of these different important issues in the economy, then, number one, I'm sorry— And I know that the Fed's toolkit is broader than it used to be, now that they've embraced unconventional measures, but there's still only so much that the Fed can do on everything, right?

Tedeschi: This brings me back to the idea of the Fed emphasizing climate in monetary policy, and it's like, no, no, there are lots of important things in life and in economics that the Fed just can't address. Like, I want my kids to get a good education. Interest rate policy can't really help that. Climate is the same thing. So, yes, I worry about overburdening the Fed, in terms of achieving its dual mandate, [but] I just also worry that going back to— it's sort of the same worry that I have with political risk in the United States, that a rising debt burden is a claim on future real resources in the United States, future economic growth.

Tedeschi: I am worried that if the debt trajectory is unsustainable for too long, that— forget a crisis. When I hear the word crisis, I think of waking up in cold sweat in the middle of the night, panicking. It doesn't even have to be that. It's just that we're a little bit poorer. We are a little bit less well-off over time, and that wedge grows as debt grows. There are, absolutely, trade-offs involved, in terms of stabilizing the debt trajectory, that we need to take seriously. I think that we need to think hard about efficient ways of taxation and where cuts are necessary. What are the least economically impactful cuts that we can make? But if it goes unaddressed, then it's going to have a burden over time.

Tedeschi: And I'm a little bit more Pollyanna-ish than a lot of people on this. I will say that President Biden, himself, believes strongly that an unsustainable deficit trajectory is important. He was adamant that— In the presidential budgets that come out every year, he would propose policies that would pay for what he was proposing and then have some leftover for deficit reduction. People, obviously, may agree or disagree with what he proposed. That's a valid, separate conversation to have, but in terms of the unsustainability of the debt trajectory, I think that he thinks that it's an important priority. And increasingly, I hear from Republicans as well, that they think it's an important priority, so much so that they're willing to entertain, at least, a debate over things like higher revenue, as a way of addressing it.

Beckworth: Okay, well, that was your first paper that we're going to talk about. Now, that's with the Budget Lab. Its title is, *Political Risk to the US Safe Harbor Premium.* Now, you have another interesting paper. This is with the Psaros Center for Financial Markets and Policy at Georgetown University, and the title of this paper is, *Recent Movements in [R-star]: The Most Important Interest Rate That You Have Never Heard Of.* Now, you and I have heard of it before, obviously, in our crowd.

Tedeschi: Unfortunately.

Beckworth: But what I like about this paper, though, Ernie, is that you do something that I think is often missed, even by people who should know better— people on Twitter, sometimes financial reporters— and that is that there's a distinction between a short-run R-star and a medium to long run [R-star]. So, maybe walk us through that.

Outlining the Distinction Between Different R-Stars

Tedeschi: Sure. So, more often than not, when we talk about R-star— And let me back up. So, when we're talking about R-star, we're talking about the neutral interest rate. So, the best definition that I've heard of it [is that] it's the interest rate that neither expands nor contracts the economy against its potential, over time. So, if you thought that nominal R-star was 2.5%, then you would reasonably think that, if interest rates were at 2.5% in the long-run, that the economy would be growing at its normal trend, a sustainable rate, and that inflation would be at target. So, that's what we're talking about, and the most commonly followed measure of R-star, I think, is the survey of the Federal Open Market Committee participants in their Summary of Economic Projections. The famous dot plot will give a sense of where they think short-run appropriate interest rate policy is, and then they'll survey the participants on where they think appropriate long-run interest rate policy is. And the median has been around 2.5%, I think, for the entire pandemic, in nominal terms, so [it’s] kind of remarkable, the stability in that.

Tedeschi: But that's R-star after everything in the short-run has worked itself out. There are all sorts of other factors that mean that R-star could be higher or lower in the short-run. That's important because if we're trying to judge where today's monetary policy is— So, currently, nominal interest rates, the fed funds rate is between 5.25% and 5.5%. Is that tight? Is that loose? You could do worse than judging that against long-run R-star, but there are short-run frictions in the economy that we would want to think about and that we should incorporate into thinking about whether that's tight or loose policy. And so, I think that that's where short-run R-star is a more appropriate concept to bring in.

Beckworth: And you estimate one in your paper, but just one example to illustrate why a short-run version of a stabilizing interest rate is different than the long-run is mortgages in the US, right? I'm a prime example. I refinanced in 2021, 3.5%.

Tedeschi: Yes. Me, too.

Beckworth: And I'm not affected by the Fed's rate hikes. And so, it may be that they have to, at least temporarily, really jack those rates high before they begin to really hit me hard.

Tedeschi: Exactly. It's interesting. So, that's one clear way where there's an implication between long and short-run R-star. I will say, too, that— this is a little bit off-topic, but when we think about vibes and surveys of consumer sentiment, one hypothesis that we often hear is that people are trying to get into homes, and that's why sentiment is so low. As I constantly point out, yes, I'm sure that there are consumers for whom that is true, but most Americans own their home, and like you and me, they probably took out their mortgages before rates went up. So, for me, high home prices are definitely a positive when it comes to my sentiment. Anyway, sorry—

Beckworth: Well, that's true. The only downside to me is that I have no incentive to move, even if a great job opened up somewhere.

Tedeschi: 100%, right.

Beckworth: So, I'm kind of locked in, and I'm happy that I have a 3.5% mortgage. So, the short-run is important, and I think it really helps us understand why the Fed can raise rates so dramatically, so sharply, and yet the economy still continues to be relatively healthy.

Tedeschi: That's right. I get this question a lot, do I think that monetary policy has lowered inflation? And I think that the answer is yes. I think we can see that in terms of the timing of inflation. When we dig in, we see very clear evidence of effects of higher interest rates on interest rates-sensitive sectors, like home construction, for example. But one of the ways in which US monetary policy might be a little less effective than monetary policy in other countries is that mortgage channel, where we have these 30-year fixed-rate mortgages that are so much more pervasive here than they are in many other countries. Whereas in a lot of countries, they have adjustable-rate mortgages, where everybody feels the impact of rate hikes, if not immediately, then very shortly after. And that effect on household balance sheets is a real consideration for other central banks in a way that it's just not for the Federal Reserve here.

Beckworth: Absolutely. Now, in the paper, again, you distinguish between short-run and long-run, and in your long-run discussion, you list a number of measures, and some of them are well-known. The Laubach-Williams measures is well-known. There are some other ones, less well-known, but still, again, people in our space would know these. You include TIPS. But you list 12. There are 12 different measures, and it's a great table. I encourage listeners to check it out. We'll provide a link in the show notes to it. You take the average and the median, but I think it's a useful exercise. And you look at the change, and there has been a change, but let me go back in time, back to 2008.

Beckworth: So, right now, we're talking about, has the medium to long-run R-star gone up? And most of these indicate some change, but there was an even, I think, sharper fall in 2008. It was a sudden and sharp fall. We have a decade where rates are low. Now, they're going to pop back up. Does that whole episode [not] strike you as strange, somewhat, like it could fall suddenly and go up suddenly?

Past and Current Trends in the Path of R-Stars

Tedeschi: It's so interesting. So, look, I don't want to under-emphasize the uncertainty with all of these measures. R-star is, in many ways, just a made-up number, and we have rigorous ways of figuring out what that made-up number is, but it is still, at the end of the day, a made-up number that we can't observe directly. So, people should take many grains of salt when thinking about R-star. That said, I think that it does make intuitive sense that there is an equilibrium neutral interest rate. If we think that monetary policy has an effect on the economy, then there must be a neutral interest rate at which it no longer has an effect on the economy.

Tedeschi: And I think that what affected R-star in the 2008s was very similar to what was happening in longer-run interest rates more generally, ones that we can observe. The structural decline in interest rates that was— I think [the fact that] we are more confident, in retrospect, now, was due to many different factors; so, demography, an older population that was more likely to save. Your saving profile over your lifespan is a bit like a parabolic curve. So, you reach maximum savings, and then you reach retirement age, and suddenly, you're back into dissavings again. So, the American population has been aging, but we're still, on average, near that peak of saving, rather than crossing over to where we're dissaving again. So, that has reduced interest rates. I think that, especially in the wake of the Great Recession, there were concerns about long-run growth prospects, long-run productivity, long-run consumption growth. And so, investors were beginning to price in more pessimistic growth projections as a result of that. And especially, given how sluggish the recovery was for the first five years of the Great Recession, that's very understandable, in retrospect.

Beckworth: That's fair.

Tedeschi: So, I think that those things were affecting R-star as well. I think that the rise in R-star that we've seen recently is— I say in the paper that there's no silver bullet, definitive way of knowing what's going on, and there are positive and negative stories. A couple of positive stories [are that] we've had upside growth surprises recently. Again, in late 2022, the consensus was that we would have no real growth over the course of 2023. We had 3% growth instead. That's a massive miss in terms of expectations, and [there are] all sorts of different reasons for that that we can get into later, but that was a big surprise. And so, if you are more optimistic on just the fundamentals of growth in the United States than you were, you think interest rates will be higher as well, especially since that growth surprise in 2023 was, in large part, driven by higher productivity than expected, which, I take productivity with— especially short-run productivity— with a grain of salt. Our first hypothesis should always be that it's mismeasurement or noise.

Tedeschi: But we had a couple of straight quarters of strong productivity, so I think that there is a higher likelihood that there is something, if not persistent, then at least real and tangible going on with productivity. We have also had stronger labor supply growth than was expected, as well. A large part of that story is because of higher immigration than was expected. And, in fact, there's a debate about whether we're even fully capturing all of the immigration surprise that we've had in household survey data that give us the unemployment rate and the labor force participation rate.

Tedeschi: Putting aside all of the other aspects of the immigration debate, when it comes to aggregate growth, a higher labor supply is good for growth. Your population is bigger, number one, but it also just means that businesses have an easier time hiring and expanding, and it pays these aggregate growth dividends, especially over time. There are some negative stories, too. We increased debt. We had an extraordinary response to the pandemic, an extraordinary fiscal and monetary policy response to the pandemic that has a lot to recommend, in retrospect, but one of the consequences of that response was a higher debt-to-GDP burden.

Tedeschi: So, relative to pre-pandemic, if you think that debt is higher, there's a great deal of evidence that says that the term premium goes up as debt rises. It's just a little bit. It's two to four basis points, I think, [that] is the central estimate. But I think I say in the paper that, where we ended up— currently, CBO projects, I can't remember the exact number, but I think what I say in the paper is that, in 2024, where CBO is currently projecting we'll end up on debt-to-GDP is 25 percentage points of GDP higher than what they were projecting for 2024, before the pandemic. 

Tedeschi: And so, two to four basis points, that suggests to you 50 to 100 extra points to the term premium, which would explain a lot of what we've seen, if you took that mechanically, when you look at the rise in these different R-star measures. And then there's the political risk argument that we talked about earlier. This is partly an empirical question, [but] I don't know how much that is being priced in. In fact, one of the premises of my Budget Lab report on the safe harbor premium is that it's not being priced in right now by markets. But if there are higher political concerns than there were before, that could also be affecting R-star.

Beckworth: Well, let's focus on the positive stories for now. Let's be eternal optimists here.

Tedeschi: Okay, great.

Beckworth: I want to ask you, in closing, a question related to that. Let's say that we do have a sustained productivity surge, so, the productivity growth rate will be permanently higher. So, maybe it's AI. Maybe it was a perfect storm of strong aggregate demand. Maybe it was a shock from the pandemic to slap the economy in the face and reallocate industries and labor. So, it could be a number of these things coming together. Does any of this, for you, shed light on the debate we had prior to the pandemic that if you run the economy hot, the supply side will actually innovate endogenous growth, from stronger, hotter demand side policies?

Assessing the Sources of Higher Productivity

Tedeschi: I think it does, and I think it does in relation to my hypothesis about what's going on in productivity. So, you'll notice that we had— in the pandemic, earlier on, we had a rise in quits, in job-to-job transitions among people. Well, think about what happens when you quit a job and you go to a new job. When you're at your new job, initially, you're [at] lower productivity than you were. You're figuring out how your new workplace works. You're sometimes learning how to turn on your computer. You're not as effective at your job as you used to be. But if that new job is a better match for you than your previous job was, then, over time, your productivity should be higher than it was before.

Tedeschi: In fact, I have a paper coming out that shows, empirically, almost in an impulse response relationship, a shock to quits does exactly that. Productivity is a little bit lower, initially, and then it's substantially higher, two to three years out after that. I think that what we're seeing now with productivity is the echo of that earlier rise in quits, and that earlier rise in quits was made possible, in large part, because of our emphasis on full employment policy. Because we were trying to get to full employment, people who were in jobs that were suboptimal for them felt confident that they could leave their jobs and be able to find another one and get competitively compensated for it. And I think that we started seeing that rise in quits in late 2020, 2021, I believe. And so, I think, now, three to four years later, we're beginning to see the effect of that come through on the productivity side as well. Now, to follow that through to its logical conclusion, that's not a persistent effect on productivity. That's a short-run response surge.

Beckworth: A level effect.

Tedeschi: Exactly, a response surge to productivity. I'll be perfectly honest, I don't think that AI is playing much in the role of measured productivity right now.

Beckworth: As of yet, maybe.

Tedeschi: As of yet, no, exactly, and I want to emphasize measured productivity.

Beckworth: But if we put [in] that level effect story you just told us, about a one-time shock, better reallocation of labor, so we're more productive, and then AI truly does bring in additional gains… Man, what a positive story.

Tedeschi: If that story played out, where we would expect to see it would be in a higher R-star over time, and it would be a higher R-star with, obviously, a good story behind it. And it would be too simplistic to say, "Well, okay, we're getting this positive growth story to R-star, but that means higher interest rates, which means that the fiscal situation would be worse over time." Higher R-star, for that reason, also means that the denominator of debt-to-GDP is higher as well. So, it's a little bit more ambiguous. We would have to think through what the dominant effect [is] there. I welcome higher R-star due to the factors that you mentioned. I think that that would be spectacular, and it's a good problem to have.

Beckworth: Yes. If we are growing faster because of productivity gains due to, again, better-allocated labor and AI making meaningful, real changes to the economy, R-star is higher, but so is our ability to pay down our debt, [and] so is our ability to deal with an aging population and any other number of problems. Economic growth is a solution to many, many problems.

Tedeschi: That's right. I hope that that's the story that's going on here.

Beckworth: Yes. Well, on that optimistic note, our time is up. Our guest today has been Ernie Tedeschi. Ernie, thank you so much for coming on the program.

Tedeschi: Thanks for having me again, David, and sorry again about the pandemic.