Former Fed Communications Adviser: The Markets Aren't Paying Enough Attention to the Hawkish Dot Plot

A collision awaits.

Are Markets Misinterpreting Yellen's Comments?

The market is dismissing the hawkish implications of monetary policymakers' preferred trajectory for interest rates, according to a former special adviser to Ben Bernanke and Janet Yellen.

In an interview on Bloomberg TV, Dartmouth Professor of Economics Andrew Levin warned of a possible "collision" between market expectations and the actual path higher for the federal funds rate.

Levin was an adviser to the Federal Reserve's Board of Governors from 2010 to 2012, a time when then-Vice Chair Janet Yellen was in charge of the FOMC subcommittee on communications. The professor helped Bernanke and Yellen craft their communications strategy amid this period of unconventional monetary policy, which included the rollout of the dot plot. He has written in detail on this topic since leaving the central bank.

The Fed's December Summary of Economic Projections, released on Wednesday, showed that the median monetary policymaker thinks it would be appropriate for the federal funds rate to end 2016 at close to 1.4 percent. Meanwhile, financial markets are implying a slower pace of tightening, as shown in the purple line below.

Bloomberg

The dot plot was largely an academic exercise until liftoff actually occurred, but now the prophesied path of interest rates has greater significance, said Levin.

The professor cautioned that market participants are underestimating monetary policymakers' resolve to raise interest rates four times next year, as the median projection in the dot plot implies.

"The extent to which members of the FOMC today wrote down the same funds rate projections they wrote in September and that many of them wrote in June means they have pretty strong views that they do think they're going to hike again in March and again in June," he said. "And if that happens the markets will be surprised in March and surprised again in June and surprised again in September because in the end the FOMC is the decider, not the markets."

The widespread belief that the voting members of the FOMC in 2016 lean more hawkish than the current slate of voters serves only to reinforce Levin's conclusions.

Of course, as Janet Yellen indicated during the press conference, the realization of the glide path implied by the median dot requires incoming economic data to be close to monetary policymakers' projections. Forecasting, to be sure, has not been a particularly strong point for the FOMC in recent years.

In the event that everything goes right—that is, according to the Fed's plan—the market needs to recalibrate its expectations lest it be in for a rude awakening, according to Levin.

"I think the markets, I believe, are misreading today the extent to which 10 out of 17 FOMC committee members expect the funds rate to [be] up at 1.5 percent by the end of next year," he said.

There was, however, a more subtle dovish aspect to the dot plot.

The average dot declined by more than the median dot over the projection horizon, as Bloomberg's Matthew Boesler observed, positing that the Fed Chair was able to bring hawkish outliers more in line with the consensus view.

"Compared with the projections made in September, a number of participants lowered somewhat their paths for the federal funds rate, although changes to the median path are fairly minor," Yellen said during the press conference in reference to these shifts.

On the other hand, this also suggests that monetary policymakers have coalesced around the ideal trajectory for rates should incoming data align with their projections.

The desired gradual path higher by the Federal Reserve remains much less gradual than the market anticipates, setting the stage for a showdown among monetary policymakers, financial markets, and economic realities in 2016.

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