A James Alexander post
There has been lots of chatter about the meaning and usefulness of the FOMC’s dot plots indicating future interest rates. Kocherlakota tried to help:
The dot plot has two big perception problems. The first is the belief that it reflects officials’ interest-rate forecasts. It doesn’t. Rather, it shows what each participant thinks the Fed should do, based on his or her individual forecast of how the economy will evolve and what the optimal response would be.
The second issue is that investors tend to see the dot plot as a commitment about the trajectory of rates.
I think the first point is a fairly fine distinction. There isn’t much difference between a forecast result and a recommended result if the forecast is made by someone in a position to influence that result.
The dots seem to me to be a bit of a sideshow, what is really important are the economic forecasts of RGDP, PCE Price Inflation and unemployment. If the FOMC projects that these indicators will all be above target in two years’ time then the market can only draw one conclusion – policy will be tightened.
Even on target projections can provide an interpretative challenge. Are the projections only on target because the FOMC has assumed rate rises to pre-emptively prevent an overshooting of targets?
What rightly concerns the market is that the FOMC appears to think it has to raise rates despite PCE Price Inflation well below 2% now. And, to a lesser extent, that the FOMC unemployment can now only go up from current levels.
The market can only infer that the FOMC thinks PCEPI will rise well above 2% in two years’ time unless it raise rates further, and that employment will not suffer from the rate rises.
The FOMC members must be very confident about the economic recovery and the future path of PCEPI and employment. The dots help the market interpret the confidence of the FOMC in its economic forecasts, with both scenarios of no rate rises and one including rate rises. The fact that the economic projections incorporate projections of rate rises means that the market is right to see the dots as a commitment to the trajectory.
The problem is the FOMC economic projections contrast with the much more cautious view of the market on the economy. Market implied expectations for PCEPI, through looking at always higher implied CPI, are much lower than the FOMC projections. And here lies the interesting and market-moving clash.
Are the FOMC willing to put their money, or rather decisions, where their mouths, or rather projections, are? Will they raise rates and tighten policy thinking that their own inflation projections are so far superior to those of the market?
If they do move to raise rates further this will be seen as damaging the economy as evidenced by the markets dropping further. The FOMC says it is data-driven, but is highly selective in the data it chooses. Historic, open to revision and question, data is OK for them to observe, but data that indicates the best guess of hundreds of thousands of investors about the likely future such as market prices is ruled out. The market then worries that the FOMC will only react to the damage that they have caused when the economic data continues to follow current weak trends, or worse.
Alternatively, if the FOMC holds off from rises then the market will wonder what it is that they are looking at if not their own economic forecasts. This is the heart of the FOMCs credibility problem. The markets see the FOMC as an unreliable friend, the FOMC sees markets as unreliable, period.
The FOMC raises its economic projections above the market´s and then sometimes use them to justify a monetary policy and sometimes lay them to one side. The FOMC may be right to ignore its own projections, Market Monetarists and others certainly think that, but it should then acknowledge that it has done so and that it has become less certain about its economic models. Market Monetarists and the market in general, have seen the Phillips Curve discredited time and time again but the stubborn sticking to it by the consensus at the FOMC and consensus macro means that their credibility is very low, and hence confusion reigns. Confusion about the dots is merely a symptom of this wider confusion. The dots are blameless.
Getting rid of the dots as some have suggested or amalgamating them into one projection will not get rid of the faulty models. And the market will anyway continue to speculate on the future path of the target Fed Funds rate. The UK has no dot plot or rate projection, but the market has created an implied one. The BoE even uses it in its models in a bizarre game of cat and mouse, both steering the consensus and decrying it when out of kilter with its own best guess.