A year after playing down the Federal Reserve’s interest-rate projections, Chair Janet Yellen looks to have embraced the so-called dot plot as a new form of forward guidance on the central bank’s intentions.
Yellen highlighted the newest quarterly rate forecasts, which dropped markedly from December, in her opening comments at her press conference Wednesday in Washington, saying they were in line with the policy path the Fed envisages. That contrasts with her remarks in her first press conference as chair a year ago, when she cautioned against looking to the dot-plot for guidance on Fed policy.
Investors took note of the change, which saw the median forecast for the federal funds rate at year-end drop to 0.625 percent from 1.125 percent in December, putting it much closer to market expectations based on eurodollar futures contracts. Stock and bond prices promptly rose, even though the Fed opened the door to a rate increase as early as June by dropping its assurance that it would be “patient” in beginning to tighten credit.
“The dots are the only thing left that serves as forward guidance,” said Stephen Stanley, chief economist at Amherst Pierpont Securities LLC in Stamford, Connecticut. “As we get closer to the likelihood of a rate move, the information value of the dots increases.”
For investors, the dots take on more importance in the absence of more explicit forward guidance. For more than six years the Fed had been making extraordinary commitments to keep rates low, sometimes ruling out increases for specific periods of time, in order to push down longer-term borrowing costs.
That era ended this week when the Fed dropped its promise to be “patient,” a phrase Yellen said earlier meant that a rate rise was unlikely for the next two meetings. Starting in June, officials will make decisions meeting-to-meeting based on incoming economic data.
Even so, the new projections indicate that once they start moving, the Fed won’t be in a hurry to tighten. The dot plot lowered officials’ rate forecasts for the end of 2016 to 1.875 percent, compared with 2.5 percent in December, and for the end of 2017 to 3.125 percent from 3.625 percent.
The shift in Yellen’s description of the dots carries risks. It could end up wrong-footing the markets if investors think the Fed will continue to change its forecasts to meet theirs, said Erik Weisman, a bond fund manager at MFS Investment Management in Boston.
It also raises questions about what exactly was behind the change in the Fed forecasts and whether Yellen will continue to embrace them when they’re inevitably altered in the future.
Game of Chicken
“The market will conclude from this that when the market and Fed are playing a game of chicken, the market can win,” said Weisman, manager of the $1.2 billion MFS Inflation-Adjusted Bond Fund. He said this “could be a very dangerous lesson” if the market ignores Fed signals it will tighten and gets a surprise when rates are raised faster than expected.
Yellen argued the shift in the dots reflected changes in the economy since the committee last issued forecasts in December.
She said committee members had made a “meaningful downward adjustment” to their inflation forecasts and dropped their projections for the longer-run rate of unemployment.
“I think both of those things would point to a downward revision in the funds rate path,” she said.
Michael Feroli, chief U.S. economist at New York-based JPMorgan Chase & Co., questioned whether the reasons outlined by Yellen fully explained the markdown in policy makers’ rate projections.
“The revision to the dots seemed a lot larger than the revision” to the Fed’s economic forecasts, said Feroli, a former researcher for the Fed Board in Washington.
He suggested that concern about the rising dollar played a role. “It does look like there was something else seeping in there,” he said. “I’m sure the dollar was a factor.”
The Bloomberg Dollar Spot Index, which tracks the U.S. currency against 10 major peers, has climbed more than 20 percent since the middle of last year as the Fed signaled its intention to raise rates this year while the European Central Bank and the Bank of Japan acted to aggressively ease policy.
The currency’s strength affects the economy in two main ways: It holds back economic growth by reducing the competitiveness of U.S. exports while depressing inflation by pushing down import prices.
Lou Crandall, chief economist at Wrightson ICAP LLC in Jersey City, New Jersey, wondered how long Yellen’s embrace of the dot plot would last.
“The Fed chair will highlight the dots if and only if they serve to illustrate the particular policy narrative she wants to deliver,” he said in a note today to clients.
This week, they performed that task. A year ago, they did not. Back then the rate projections rose at the same time that the Fed was seeking to assure investors that it would keep credit ultra-easy for a considerable time.
“The challenge for the FOMC at this point is to strengthen the dot-plot forecast process in order to make it a better reflection of the committee’s expectations,” Crandall said.