When the Federal Reserve announces its next interest-rate decision, you want to hold off on connecting any dots.
That’s because U.S. central bankers are about to update 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. It’s notable because it’s the first time officials will be updating their projections since December.
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 – have questioned 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 has said in multiple different remarks, the most recent being at a press conference following the Fed’s June 18-19 rate-setting meeting.
Officials’ quarterly forecasts for policy in both 2019 and 2020 didn’t predict the direction the Fed would ultimately take. U.S. central bankers entered 2020 with a make-no-move policy posture. Then, the U.S. economy was hit with the worst economic crisis in generations thanks to a threat that was unanimously unforeseen: a global pandemic. U.S. central bankers cut interest rates at two emergency meetings within 13 days of each other. After the Fed’s second coronavirus-driven emergency rate cut, Powell told journalists writing down a forecast “could have been more of an obstacle to clear communication than a help” because the path forward is unknown.
Even though officials are bringing these forecasts back, there’s a risk in taking the dots too seriously. Fed officials’ projections are never set in stone, and they could continue to evolve as more information about the economy’s recovery comes in.
Still, they’re an important piece of Fed communication. If U.S. central bankers signal no rate moves for years to come, it at least means they’re willing to keep interest rates low.
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, currently in a target range between 0-0.25 percent, the lowest since Great Recession-era levels. (Fed officials are expected to leave it alone when their two-day meeting wraps up Wednesday in Washington).
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 will be the appropriate midpoint of 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 December 2019, Fed officials mostly expected to keep rates on hold until 2021. Four officials, however, penciled in one rate hike, bringing the fed funds rate midpoint to 1.875 percent.
Over the longer-run, also referred to as the neutral rate of interest that neither speeds up nor slows down the economy, officials expect the fed funds rate to be 2.5 percent. That could be adjusted as officials updated their forecasts come the June decision.
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.
But there are obvious caveats. The Fed was seen as holding rates steady, but it cut interest rates down to the lowest levels officials want it to be. This shows that the dot plot was unable to predict the Fed’s course of policy.
Why the dot plot was created
Fed officials started using the dot plot in 2012 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.
During the economic recovery from the financial crisis, the dot plot’s usefulness was challenged. The economy improved, with the unemployment rate nearing its lowest level since 1969. The expansion would also go on to last for the longest stretch of time in records dating back to the 1800s. Still, the economy had different dynamics than it did before the global financial crisis of 2008. It meant officials’ ideas about how low unemployment could get before triggering inflation were changing, meaning forecasts were shakier than usual.
Some of that might be changed, given that the U.S. economy is officially in a recession. The case for “aggressive forward guidance” that was necessary in the recovery of the Great Recession might have returned.
Still, the path forward is more uncertain than usual, given that it largely depends on the path of the virus. A second wave of infections that could prompt another round of nationwide shutdowns, as well as a vaccine, may all dramatically shift the recovery period, and thus, the Fed’s rate hike plans.
“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. “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 long stressed that they’re going to be “data dependent” when deciding it’s time to make a rate hike after the global pandemic. That means officials aren’t going to be in any rush to hike rates without backing it up, meaning they won’t stick with a predetermined path for interest rate adjustments.
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.
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 has been reviewing 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.”
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). One dot is also missing from the Fed’s longer-run projections — St. Louis Fed President Jim Bullard, who has been vocal about wanting to omit his projections.
“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.”
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(Featured image by Pen Cristobal / Bankrate)