The Fed Dot Plot Explained

It has now been over nine years since the U.S. Federal (Fed) Reserve started to ease monetary policy in June 2007 in response to a slowing US economy and the unravelling of the US subprime housing loan market that eventually led to a global credit squeeze and financial contagion. During this period of distress central banks around the globe followed the Fed’s lead and reduced interest rates rapidly (as Figure 1 shows) in an attempt soften the crisis. The Reserve Bank of Australia (RBA) followed suit, dropping the Australian cash rate by 4.25% between September 2008 and April 2009. Due to the prolonged impact of the Global Financial Crisis (GFC) the Fed then began to implement unprecedented unconventional monetary policies known as Quantitative Easing (QE), Zero Interest Rate Policy (ZIRP) and Operation Twist in an attempt to force longer term interest rates lower with the aim of shifting the entire yield curve down. Figure 1. Central banks around the globe slash interest rates between mid-2007 & mid-2009. Source: Bloomberg Eventually the central banks won the battle and financial markets began to calm down as the economy started to benefit from the unprecedented levels of monetary stimulus leading to signs of a Green Shoots recovery. Encouraged by this the Fed began to consider unwinding some of the unconventional monetary policies that they had introduced (as they were only to be short term in nature). In early 2011 as the Fed were winding down the second round of QE and plotting an exit strategy, the then-Fed vice chair (Janet Yellen) together with a sub-committee were working on a communication strategy to convey to the public more information about the Fed’s expectations for the future. The chart the sub-committee came up with ‘The Fed’s Dot Plot’. As the Fed’s latest monetary policy thinking is critical to all of the global financial markets, any insight they provide always gains a great deal of attention from investors. As a result, the Fed dot plot has become one of the most-watched news releases during the course of the past year. The dot plot, which is published after each Fed meeting, shows the projections of the 16 members of the Federal Open Market Committee (FOMC), the rate-setting body within the Fed. Each dot represents a member’s view on where the fed funds rate should be at the end of the various calendar years shown, as well as the “long run” – the peak for the fed funds rate once the Fed has finished tightening (or “normalizing”) policy from its current ultra-low levels. The dot plot represents the Fed’s ongoing efforts to become more transparent with respect to its policies and helps set market expectations. More important than the absolute number for FOMC members’ projections is the direction of movement. In short, investors want to know whether the FOMC is leaning towards looser monetary policy (reducing rates) or tighter policy (raising rates). The Fed’s latest dot plot (Figure 2) shows that policy makers expect one 0.25% rate increase this year, with Fed Officials also scaling back their expectations for interest rate hikes in 2017 and over the longer term. This resulted in the Fed leaving its policy rate unchanged for a sixth straight meeting on 21st September. Figure 2. The Fed’s Dot Plot Chart (21 September 2016) of the Implied Federal Funds Rate Source: Bloomberg From the RBA’s point of view, any indication from the Fed that they are preparing to raise US interest rates would be welcomed as this would in turn lead to the US dollar appreciating (and therefore the Australian dollar depreciating. As a result, the RBA will feel less pressure to continue cutting the cash rate. When looking at the chart, it is important to keep in mind that each dot represents a member’s view of where interest rates should be at that point in the future. As the Fed are data dependant it is also important to remember that they will also adjust policy based upon economic trends, inflation, and global events and members may shift projections from the levels seen above. As a result, longer-term projections on the dot plot carry less weight than those which are more recent due to greater uncertainty. Another factor that can impact dot plots are FOMC membership changes and the rotation among the various member banks in the system, i.e. the people behind the dots can change (another potential source of shifts in the dot plot). Not only that, but there is currently no way to tell which dot belongs to which member, meaning that investors do not have a sense of how much weight to attach to a dot that is an outlier with the range for a certain period, nor is there any indication which dot belongs to the Fed Chair, Janet Yellen. Bond investors should therefore expect that this release will be a cause a new surge of market volatility after each Fed meeting. However, Yellen herself has warned that people “should not look at the dot plot as the primary way in which the Committee is speaking to the public at large.” The bottom line is that investors consider the dot plot as another input to use when making investment decisions, but (as is the case with any single indicator) should be careful not to get caught up and forget the wider economic circumstances.