The Fed Fails to Connect the Dots
Not a helpful picture.
Monetary policy works best when financial markets understand the central bank's intentions. That's the correct thinking behind the Federal Reserve's forward guidance -- and it's why one aspect of its approach needs to change.
The Fed regularly publishes a closely-watched "dot plot" of interest-rate projections. Even if correctly understood, this conveys little or no useful information. Usually, though, it's misunderstood. Tweaks have been suggested that could make the dot plot less confusing -- but the best thing would be to drop it altogether.
The dot plot shows what individual Fed officials believe the short-term interest rate ought to be in the future, assuming that the economy evolves as each of them thinks it will. So it doesn't show individual forecasts of the rate, much less a collective forecast. Least of all are the plots meant to express any commitment to set certain rates. Nonetheless, when the dot plot changes, Fed policy is deemed to have changed, and the central bank's credibility gets called into question.
This week James Bullard, president of the St. Louis Fed, told Bloomberg that changes in the dot plot probably contributed to the market sell-off at the start of the year. He said he was concerned that it was sending the wrong message; he'd "even thought about dropping out unilaterally from the whole exercise."
From investors' point of view, a dot plot with opt-outs would hardly constitute an improvement. In an article for Bloomberg View, former Fed policy maker Narayana Kocherlakota offered two other suggestions. First, delay publication of the dot plot to coincide with release of the Fed minutes: That way, it would be seen in the context of the Fed's internal debate on policy, rather than as part of its collective judgment on interest rates. Second, release a collective medium-term forecast of output and employment, modeled on the Bank of England's so-called fan charts.
Those ideas would help. But it would help more to stop releasing information that begs to be misunderstood as a commitment to a specific path for interest rates, when the Fed is making no such commitment.
The first rule of forward guidance is do no harm. The dot plot breaks that rule and needs to go.
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