Four times a year, the Federal Reserve (Fed) publishes projections of key economic variables by the members of its policymaking Federal Open Market Committee (FOMC). The projections include the so called dot plots, where each dot represents an FOMC member’s expectation of where the benchmark Federal Funds Rate will be for the current year, a few years out, and over the long run.
With FOMC members meeting in Washington, DC, this week to determine whether it’s time to raise interest rates or stay on hold, we would offer this recommendation: Abolish the plot chart of dots because it has outlived its usefulness.
The dots were introduced in 2012, when the Fed’s policy rate was at the zero bound and not expected to go up for a while. At the time, the dot plot was a useful tool that enhanced the Fed’s forward guidance: When there was a large slack in the economy, high unemployment, and very low inflation, investors and consumers could credibly expect the Fed to keep interest rates low for a long time.
To be sure, this was never a full commitment by the Fed, but it was close enough. It was an indicator that served as encouragement to the private sector to go and spend and borrow at low rates. Forward guidance, as well as the dot plot, helped to significantly reduce uncertainty about future policy rates.
But the dot plot is not a symmetric tool that is helpful at both ends of an interest rate cycle. It may be useful at the zero bound but is counterproductive during a hiking cycle, which is what we are in right now.
As an illustration, the following chart from Fed Chair Janet Yellen’s speech at the Kansas City Fed symposium last month in Jackson Hole, Wyoming, is telling (Exhibit 1).
It shows FOMC participants’ median projections for the Federal Funds Rate through the end of 2018, as well as a very wide confidence level of 70% around that median, which ranges from 0.16% to 4.6%. In other words, the chart shows that Fed policymakers don’t have a crystal ball, in case you didn’t know it.
In a hiking cycle, projecting the future path of policy rates is much harder than at the zero bound. FOMC participants need to forecast a set of macroeconomic variables, and based on those variables, form their projections for a path of policy rates years out. Each step of this projection process is subject to high uncertainty and very hard to do. At the end, in our view it is not clear what guidance this process provides to the markets.
The current hiking cycle started with dot plots suggesting four Fed rate hikes this year, a much more aggressive tightening than the markets predicted, spurring market volatility early in the year. Reacting to this shock, FOMC members then cut back on their projections for the number of interest rate hikes in 2016, thus the number of dots, restoring an easy message and calm to markets. However, we believe this reduced the Fed’s credibility and minimized the benefits of the dot plot as a communication tool.
Drop the dot plot now. You can always bring it back later, at the zero bound, if needed.
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These views represent the opinions of Portfolio Managers at OppenheimerFunds and are not intended as investment advice or to predict or depict the performance of any investment. These views are as of the publication date, and are subject to change based on subsequent developments.