The Fed Wants Markets to Stop Taking the Dot Plot So Seriously

Fed Dots Show Internal Inconsistencies: UBS's Matus
  • Vice Chair Fischer leading efforts to improve rate forecasts
  • St. Louis Fed's Bullard considering withholding his dot

Since the day they were unveiled in January 2012, the Federal Reserve’s interest rate forecasts have been criticized for taking on too much importance and become fodder for mockery in financial markets.

Now, officials are trying to adjust that signal while preserving transparency. One problem: The quarterly forecasts -- arranged in a so-called dot plot where the little circles represent each Fed officials’ projection for the appropriate level of the benchmark federal funds rate -- become stale as new data arrive. Yet they remain out there as the Fed’s best guess about future policy.

What’s more, financial markets often disagree with the dot plot, exposing a gap in communication that can be costly. Market perceptions of the central bank’s intentions help set rates on everything from government bonds to mortgages and car loans, and the Fed wants investors to understand how their views change with new information. The dots can’t do that.

Fed’s March 2016 Dot Plot
Fed’s March 2016 Dot Plot

The rate forecasts “seldom add anything useful beyond the communication already presented by the Fed -- press conferences, the statement, speeches, and testimony,” said Jon Faust, director of the Center for Financial Economics at Johns Hopkins University in Baltimore and a former adviser on communications to Chair Janet Yellen. “We should have all learned that they don’t say where policy is going.”

When Fed officials released a fresh forecast on Dec. 16, the median of their estimates signaled four rate hikes for 2016, whereas investors were much more cautious. Pricing in interest rate futures markets suggested a 9 percent probability that policy makers’ rate-hike outlook was correct, according to date compiled by Bloomberg.

Dissatisfaction with the dots seems to be growing. St. Louis Fed President James Bullard, a voting member of the policy-setting Federal Open Market Committee this year, said in a Bloomberg News interview Wednesday that the rate projections contribute to uncertainty.

Unilateral Withdrawal

“I’ve even thought about dropping out unilaterally from the whole exercise,” he said.

The dot plot is part of a longstanding Fed effort to communicate better about its thinking, driven by the belief that policy is more effective when markets understand where the central bank is heading. It’s a work in progress.

Fed Vice Chairman Stanley Fischer is leading an internal subcommittee which is trying to figure out ways to tell the public that the dots are at best a guess in a moment in time about what rate would best achieve their economic forecasts.

Fan Chart

One proposal, revealed in minutes of the Fed’s Jan. 26-27 meeting, is to use a fan chart to illustrate how much uncertainty there is around the forecast. This could help the public understand that rates could be higher or lower than the dot plot’s median estimate.

Such a move would help diminish the dot plot’s signal, but it also raises the question of whether the Fed should focus on other forms of telling investors how it might react to new information.

Another possibility discussed by academics and former Fed officials is to leave the dots as they are and focus on describing scenarios instead. These would be charts of how policy makers would respond to shocks and surprises that diverge from their baseline outlook, or their best guess about how the economy and policy will develop.

This is, in fact, what they are trying to communicate all the time. The Fed staff, transcripts of FOMC meetings show, already does this with a computer-generated scenario with a fed funds rate path. At the moment these documents are released to the public with a five-year lag.

Easier to Explain

“I like that idea better than a fan chart” around the median dot estimate, said Laura Rosner, U.S. economist at BNP Paribas in New York. Yellen “could walk us through the scenarios in her press conference and discuss how policy might respond.”

Faust, who is in favor of retiring the dots, said they do achieve two of the big goals of former Fed Chairman Ben S. Bernanke.

As a successor to Alan Greenspan, whose views had a big weight in policy decisions, Bernanke set out to invest more authority in the FOMC and boost its accountability. The dots show just how diverse views can be.

In March, for example, the range on federal funds rate estimate was 0.6 percent to 1.4 percent for the end of the year. For 2017 and 2018, the gaps were wider at 1.6 percent to 2.8 percent and 2.1 percent to 3.9 percent.

Not a Pledge

When he introduced the dots in January, 2012, Bernanke was clear that they weren’t “unconditional pledges.”

“There is no mechanical relationship between these projections and the outcomes of the FOMC decisions,” he said.

For her part, Yellen, in her first press conference in March 2014, said: “One should not look to the dot plot, so to speak, as the primary way in which the committee wants to or is speaking about policy to the public at large.” She said investors should look at the statement.

The Fed could also just do nothing at all and let constant forecast misses teach investors that the dots don’t have much predictive value. In March last year, the FOMC predicted the policy rate would end 2015 at 0.625 percent, according to the median estimate. The rate averaged 0.23 percent in December trading.

“I always laughed at the dots,” said Karl Haeling, head of strategic debt distribution at Landesbank Baden-Wuerttemberg in New York. “They have always been overly optimistic.”