Economist: The Fed Should Kill the Dot Plot
Derek Holt, vice president of economics at Scotiabank, doesn't mince words with his thoughts about the Federal Reserve's now-infamous "dot plot."
"The Federal Reserve should cease to publish its 'dot plot' of fed funds forecasts and end attempts at providing policy rate guidance," he wrote in a note to clients. "The exercise has been marked by monumental forecast inaccuracy measured not in mere basis points on individual rate moves but in orders of magnitude on full cycle guidance, and guidance has not helped markets to formulate views on near- to medium-term policy exercises."
Included in the central bank's quarterly summary of economic projections is each monetary policymaker's estimate for the appropriate level of the federal funds rate over the next few years, as well as in the long run.
The number of conditions attached to a given set of dots—which assume no negative or positive shocks arise and are dependent on the realization of each individual's view of what transpires in the real economy as well as in financial markets—make it difficult for investors to judge what, if anything, ought to be inferred from this relatively new tool.
Holt's not the first to question the utility of the dot plot. Strategists at HSBC Bank Plc deemed this attempt at increased transparency to be deceptive and ridden with survey design issues. In the wake of the Federal Reserve's latest decision, bond traders have also contended that the dot plot seems to contradict the central bank's most consistent claim on what drives the formulation of monetary policy—namely, "data dependence."
Holt employed a so-called Medusa chart showing the point-in-time trajectory for the federal funds rate implied by the median projection, to show just how far off the mark monetary policymakers have been since the initiation of the dot plot:
One could make the case that inasmuch as market participants believed that the general course of normalization outlined at the end of 2014 would come to pass, the Fed unintentionally put upward pressure on short and medium-term bond yields.
Some bond traders, including Pacific Investment Management Co. and BlackRock Inc., have therefore eschewed the dot plot, citing its horrific track record as a forward indicator of the federal funds rate. Others, notably former Fed communications guru and Dartmouth Professor of Economist Andrew Levin, have argued that the significance of the dot plot has increased after liftoff.
Holt refers to the dot plot as the Fed's "it's not-a-forecast forecast" for rates, a characterization that seems to capture the market's mounting frustration with this part of the Summary of Economic Projections. Last week's press conference with Fed Chair Janet Yellen further reinforced the difficulty the central bank has had in steering market participants toward its convoluted interpretation of the dot plot.
During her opening statement, Yellen said that "the median should not be interpreted as a committee-endorsed forecast."
The first question Yellen faced during the press conference was on the subject of central bank credibility, prompting her to repeat that "the paths that the participants project for the federal funds rate and how it will evolve are not a preset plan or commitment or promise of the committee" and "the median [dot] should not be interpreted as a committee-endorsed forecast."
In a sign that the Fed realizes it and the markets may always be fated to connect the dots in different ways, monetary policymakers are discussing using a "fan chart" in tandem with their statements "to illustrate the uncertainty surrounding the path of the policy interest rate."
Holt laments that the Fed should have known that deploying forecasts of the policy rate would end in tears. The Riksbank's own fan chart estimates for its repo rate (which has an absurdly large range over the forecast horizon), the Reserve Bank of New Zealand's rate projections, and the Bank of Canada's brief foray into calendar-based forward guidance offer examples of the folly of central bankers trying to guide market participants, he argues.
"Some things in life don’t need to be seen," the economist concludes. "Central bankers forecasting their own policy rates belong on this list."