When the Federal Reserve announces its next interest rate decision, you might want to hold off on connecting any dots.
That’s because U.S. central bankers could likely reference — or get asked about — their Summary of Economic Projections (SEP), as well their heavily scrutinized “dot plot” chart. This graphic indicates to consumers just how much each Fed official thinks it will cost to borrow money in the future.
But even though it seems comparable to getting a sneak peek at the winning lottery numbers, you should still proceed with caution. Many experts – including members of the Fed itself – are questioning the predictive power of this tool.
“If you pay too close attention to the dots, then you may lose sight of the larger picture,” Federal Reserve Chairman Jerome Powell told journalists at a press conference following the Fed’s June 18-19 rate-setting meeting, referring to the forecast’s granular view of policy.
Taking those precautions could be even more important this time around, with the chart in new territory. For the first time in its history, Fed officials have signaled to markets and Fed watchers alike that they expect to cut interest rates. Typically, the Fed has only used this form of communication to signal when the public can expect a hike.
Whether that happens or not, here’s everything you need to know about the dot plot, including what it is, how to read it – and why you might want to take it with a grain of salt when it’s updated.
What is the dot plot, and how do I read it?
The dot plot is a chart that records each Fed official’s forecast for the central bank’s key short-term interest rate. (That’s also known as the fed funds rate, which is expected to fall by a quarter of a percentage point to 2 percent and 2.25 percent at the conclusion of the Fed’s meeting Wednesday).
Each dot represents one Fed official – from Powell to Governor Lael Brainard, from New York Fed President John Williams to St. Louis Fed President James Bullard. Of course, it’s all kept anonymous, and no one knows which official is which dot.
The dots reflect what each U.S. central banker thinks would be an appropriate target range for the fed funds rate at the end of each calendar year, should the economy evolve as they expect. Officials also provide a dot for three years into the future, as well as a dot for the longer run.
On the Y-axis is the fed funds rate, and on the X-axis is the year for which officials gave their forecast.
By looking at the chart, you can identify where the clusters are, which in turn allows you to infer where the Fed’s bias may lie.
For example: You can tell that, as of June 19, eight Fed officials expected to reduce the fed funds rate. One thought that reduction would only be 0.25 percent, bringing the fed funds rate down to 2.125 percent. Seven officials, meanwhile, thought interest rates would fall to 1.875 percent. And on the top end of the spectrum, one official was still forecasting one quarter-point hike.
This shows that Fed officials are seeing an increased case for more accommodative policy.
Even though that’s the case, it wasn’t enough to bring down the median forecast for the fed funds rate a year from now. That estimate shows the fed funds rate at 2.375 percent, where it is now.
You can also see that the median forecast among Fed officials called for a benchmark interest rate of 2.125 percent in 2020 and 2021. That means officials widely expect to cut rates at some point in 2020 and hold them at that rate a year later.
Over the longer-run, also referred to as the neutral point of interest, officials expect the fed funds rate to be 2.5 percent.
It may sound daunting, but if you have a high-yield savings account or are carrying credit card debt, the chart offers clues about where rates might be a year or two from now, from the officials in charge of making those decisions.
Why the dot plot was created
After all, it was created in 2011, at a time when the economy was still recovering from the Great Recession and when interest rates were still near zero. The central bank wanted to give Fed watchers an advance look at what officials were thinking before they made any official policy decisions.
It was a form of “aggressive forward guidance,” a concept that former Chairman Ben Bernanke created to prepare markets for the Fed’s movement away from the unconventional support measures it introduced to keep the economy afloat, according to Ryan Sweet, director of real-time economics at Moody’s Analytics, who also heads its monetary policy research.
But the backdrop since introducing the dot plot has changed. The economy is in better shape now compared to a decade ago, with an unemployment rate near the lowest level since 1969 and an expansion that’s about to become the longest on record.
But the outlook is becoming a lot more difficult to forecast, with trade tensions clouding the picture. There’s of course the chance that a deal with China could be reached. There’s also, however, the risk that the tensions could worsen, causing a devastating blow for the U.S. economy.
“You have to remember with the dot plot that this is, in many ways, officials’ base case scenario – if everything unfolds the way they expect,” says Sarah House, director and senior economist at Wells Fargo. “Trade assumptions are very important” to that outlook, “but more than anything, it’s changing very rapidly.”
Why you might not want to place too much focus on the dot plot
Fed officials have stressed since January that they’re going to be “data dependent.” While the economy sends off some conflicting signals, officials say they won’t have a predetermined path for interest rate adjustments.
“In the face of heightened risks, policymakers can be patient, waiting to see additional incoming data to better discern the direction of the economy before taking any further monetary policy action,” said Eric Rosengren, president and CEO of the Boston Fed, who has a vote on rate decisions, in a March 5 speech to business leaders.
Officials are also “closely monitoring” risks to the economic outlook, such as trade tensions, with Powell noting that they’re ready to “act as appropriate to sustain the expansion.”
But being highly reactionary means forecasts will likely change, suggesting that the dot plot might have a quick expiration date.
“To be more data dependent, the Fed needs a lot of flexibility,” Sweet says. “The dot plot isn’t a forecast. It’s not a commitment. Interest rate projections change as the economy changes, as developments in financial markets change. The dot plot gets dated pretty quickly.”
The uncertain backdrop diminishes the dot plot’s predictive power even more, according to Julia Coronado, president and founder of MacroPolicy Perspectives, who used to work for the Fed’s board of governors.
“In a slowdown, the SEP gets harder to manage,” Coronado says. “There’s nowhere in the SEP that they can express that uncertainty.”
There’s also the chance that it can be misinterpreted – or ignored. Wall Street panicked in December, after the Fed delivered a hawkish post-meeting statement that called for “further, gradual increases” and published a dot plot that mapped out two more increases in 2019.
Though Powell emphasized that the Fed’s policy decisions “are not on a preset course and will change if the incoming data materially change the outlook,” the meeting still helped send stocks to their worst December since the Great Depression.
The number of dots – normally at 19, but right now at 17 due to the two vacancies on the Fed’s board of governors – might mean it’s more noise than signal, says Jonathan Wright, professor of economics at Johns Hopkins University. There’s no telling how each leader arrives at his or her own forecast, and only 12 members have a vote on the Federal Open Market Committee (FOMC).
“You think more information is good, but you’ve got 19 people with very different models of the economy all simultaneously submitting their forecasts and not all of them vote on monetary policy, and they all appear,” he says. “Is that really conveying useful information? That’s very debatable. Some people think it just creates confusion or a mixed signal.”
Why the dot plot might soon be revamped (or eliminated)
Minutes from the Fed’s January meeting show that some officials are questioning the usefulness of the Fed’s dot plot.
“A few participants expressed concerns that in the current environment of increased uncertainty, the policy rate projections prepared as part of the Summary of Economic Projections do not accurately convey the Committee’s policy outlook,” records of that meeting said.
The Fed in June completed a review of its monetary policy framework and communication strategies, after which it could choose to alter – or get rid of – this projection tool. That likelihood, however, remains unclear. Though Powell said during the Fed’s June 19 news conference that it can lead to confusion, he also said the dot plot “can be a constructive element of comprehensive policy communication” if it’s properly understood.
A lot of people on the committee also like it because it gives the public a chance to see the full range of views. Regional presidents who don’t have a vote, for example, like that their input is still heard, Coronado says. And in an era of presidential backlash, the dot plot also increases transparency and trust in the institution, she says.
“The Fed feels like it really does need to explain and justify why it’s doing what it’s doing. The dot plot and the SEP is one element of a policy of transparency,” Coronado says. “But that doesn’t mean it’s useful for the public or for markets. It can be confusing, and it can be misleading.”
Updating those projections more than just once-a-quarter could improve the reliability of the chart, Sweet says, but so could taking it away and bringing it back during another downturn.
“Some approaches the Fed has taken are better than others, and given where we are in the cycle, we don’t need the dot plot right now. That doesn’t mean it can’t come back down the road,” Sweet says. “They’re normalizing the balance sheet, normalizing the interest rate, and they can kind of get back to normalizing their communication, getting it back to where it was before.”
- 5 ways the Fed’s decision on interest rates affect you
- Watch for these 6 indicators to know when a recession could be coming
- If the Fed cuts interest rates, expect it to be an ‘insurance’ cut — here’s what that means