How the Fed’s Most Important Message Became Enshrined in Dots
In early 2011, Federal Reserve officials were winding down the second round of their post-crisis bond-buying program known as quantitative easing and plotting an exit strategy from their unprecedented monetary stimulus.
At the same time, Janet Yellen, then-Fed vice chair, and her subcommittee on communications strategy were working on a way to convey to the public more information about the central bank's view of the future, at a time when many expected that a major shift in its policy stance was not too far off.
If you work in the capital markets, there's a good chance you have become familiar with the result of that work: the Federal Reserve's "dot plot."
The chart released by the central bank four times a year has since become a market-mover. For investors, the appeal is simple. It answers the key question of where policymakers expect to take interest rates over time.
Officials on the policy-setting Federal Open Market Committee meet eight times a year to formulate their monetary policy. Before every other meeting, they submit updated forecasts for economic growth, unemployment, and inflation a few years ahead. The dots show the interest rate projections underlying those forecasts—the policy rate each official expects to set in order to make a given forecast a reality. The Fed’s dot plot is a little hard to read. So we took a stab at a more user-friendly version that let's you compare the current rate forecast to previous ones.
Forecasting the Future: The Fed’s Dot Plot
By the time the first dot plot was released in January 2012, the Fed was no longer expecting to chart an exit from stimulus soon. The economy had taken a turn for the worse; in fact, additional bond-buying was on the horizon.
Then-Fed Chairman Ben Bernanke consequently downplayed the dots, a tradition that Janet Yellen continued when she assumed leadership of the Fed at the beginning of last year. At times, the chart—with its 17 disparate projections of the future path of policy—can conflict with the unified message the committee is trying to send.
In her first press conference as Fed chair in March 2014, Yellen told reporters "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 policies to the public at large.”
At the time, the dots were rising as members of the committee were marking up their projections of where interest rates would be in 2015 and 2016. Over the last several quarters, however, the dots have come back down, suiting Yellen's message that the pace of tightening to follow what would be the Fed's first rate increase in nearly a decade will be gradual.
So Yellen has turned back to the dots as "Exhibit A" for investors. During her press conference in June of this year, she pointed to it repeatedly when asked about the central bank's likely course.
Now investors aren't just seeking clues about the pace of rate increases likely to follow a rate increase. They are also looking at what the dot plot says regarding when officials expect to make that first rate increase in almost 10 years.
While the median official's projection was unchanged in its expectation of two rate increases in 2015 when the latest set of dots was released in June, market participants homed in on the fact that seven officials were now projecting fewer than two rate increases this year. That was up from only three officials making such projections in March.
Why dots anyway?
"We looked at lots of other ways of conveying the individual projections," said Andrew Levin, a former Fed economist who assisted Yellen and Bernanke in designing the dot plot while serving as a special adviser from 2010 to 2012. "This one turned out to be a good way of showing the distribution, but where—if a bunch of people have similar views, and a bunch of dots are close together—it draws your attention."
With only two meetings left in 2015 after this week's gathering, the new set of dots will send a strong signal as to what policymakers expect to happen over the next few months.
If the Fed doesn't raise rates and the dots still show one increase penciled in for this year, investors will assume that the Fed is planning to raise rates in October or December. If the Fed does raise rates and the dots show that only one increase was expected, investors will assume that the Fed has no plans to raise rates again until 2016.
"Sometimes it seems like the only way that people can really understand what the committee's views are," Levin said. "The dot plot was meant to increase transparency, not shape views on policy. It's like a very thin reed that is suddenly carrying a huge amount of weight."