We're Better Off With the Fed's Dot Plot
The Federal Reserve’s dot plot has come under harsh criticism of late, with some notable economists calling for its termination. The opposition even includes a contributor to the dot plot -- Federal Reserve Bank of St. Louis President James Bullard, who openly questioned whether he should continue submitting his projections. Although this communications tool may be imperfect, and is imperfectly understood by some market participants, its benefits far outweigh the costs.
The dot plot, showing where top Fed officials think interest rates should be at various points in the future, not only elevates the Fed’s transparency, it augments the central bank’s sway over the financial markets, thereby strengthening monetary policy. In the long run, we probably could get by without the dot plot. But in the nearer term, getting rid of it could impair the Fed’s ability to manage a smooth liquidation of the assets it purchased during quantitative easing.
To be sure, the importance of the dot plot may wane as the economy recovers and the Fed funds rate rises. In a stronger economy, it will be less critical because the central bank will have the capacity to offset an economic slowdown by lowering rates. However, it is far too soon to bid the dot plot farewell, particularly since policy will remain in uncharted territory as the Fed moves to reduce the size of its balance sheet, in effect instituting a reverse QE.
There are two camps critical of the Fed in this debate -- those opposed to so-called forward guidance on rates and those who specifically object to the dot plot.
In the case of the former, if the markets respond to interest-rate guidance by ignoring subsequent macroeconomic developments, then the criticism is justified. Similarly, if central bankers feel obligated to deliver on prior guidance based on a certain timeline, they risk ignoring incoming data. That would make their responses not only less transparent, but also less well-calibrated.
Some critics have suggested that long-term rate guidance means the Fed will pursue a course regardless of economic developments. If this were true, it would undermine the goal of setting policy that depends on economic data. But the evidence doesn’t support this. Policy makers have been willing to adjust their expected interest-rate trajectory in response to the health of the economy.
The rate-setting Federal Open Market Committee, which meets today and tomorrow, can nullify these criticisms by:
- Being willing to reassess policy prescriptions in response to economic developments, regardless of market perceptions of timing;
- Reassessing these prescriptions as if policy makers weren’t publishing interest-rate guidance, and;
- Assuring financial markets that it is truly data-dependent, not bound by the calendar, and that guidance isn’t an ironclad commitment.
The second camp, which is critical of the dot plot alone, emphasizes the potential to misunderstand how the Fed reacts to economic developments. Two dots in the same place, for instance, may reflect very different underlying economic projections. Analysts can misconstrue what these imply for growth, unemployment and inflation forecasts. And since the dots don’t distinguish between voting and non-voting members of the FOMC, the median dot doesn’t necessarily represent the central view among voting members of the committee in a particular period. In the past, this has resulted in misleading interpretations of guidance.
While the dot plot has some obvious shortcomings, these merely justify improvements, not abandonment. There is significant value for market participants to know the “clustering” of the dots around a particular rate view, not merely the range and median. This conveys a valuable signal about the likely future path of monetary policy, as well as the Fed’s reaction to economic developments. Case in point: The March dot plot showed nine meeting participants supporting the median outcome for 2016 -- a strong consensus -- whereas only one dot occupies the median for 2018, thereby revealing considerable uncertainty.
As long as the Fed can convey the data-dependent nature of these projections to the markets, thereby stamping out perceptions that there’s a set timetable for rate action, this can be a powerful policy tool. As Fed Governor Jerome Powell noted, data-based forward guidance -- of which the dot plot is a key component -- enable markets do some of the heavy lifting for the Fed by adjusting to incoming information. The dot plot helped the markets to embrace the full extent of the Fed’s gradualist approach to raising rates for the first time in nine years, when it increased the fed funds rate by a quarter-point in December 2015. It has served the same role amid sluggish economic growth in the first part of this year.
Interest-rate guidance in general, and the dot plot in particular, prevented the markets from assuming the Fed would follow its first rate hike with a quick succession of additional increases. That was a mistake market participants made in earlier rate cycles. Given the current environment, the Fed can’t afford clumsy policy implementation, which could have had consequences that might not be easy to correct. Terminating the dot plot would blunt the effectiveness of monetary policy at a time when precise implementation is critical, particularly since shrinking the Fed’s balance sheet looms on the horizon. Some economists may dislike it, but the dot plot is a powerful tool when properly used. Let’s keep it.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
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