Connecting the Dots: Understanding the Fed Dot Plot
The Federal Reserve has received a lot of attention this year as it continues to raise interest rates, aiming to combat the persistent inflation we’ve seen. The Federal Open Markets Committee (FOMC) – part of the Federal Reserve – meets eight times each year. It releases something known as the dot plot each quarter.
Many market participants and investors are interested in the dot plot. What exactly is it, why was it created, and what can it tell us?
What is the Fed’s Dot Plot?
The Federal Reserve’s dot plot is a chart that shows each member of the Federal Reserve’s forecast for the Federal Funds Rate, the central bank’s key short-term interest rate. The dots represent what each U.S. central banker believes will be the appropriate midpoint of the fed funds rate at the end of each calendar year for the next three years, assuming the economy evolves as they expect.
Officials also include a dot for the longer term, representing the so-called “neutral rate of interest.” This is significant because it is the expected rate at which monetary policy is neither stimulative, which may cause an economy to overheat and lead to inflation, nor restrictive, which may slow the economy resulting in job losses and possibly a recession. The neutral rate directly ties into the FOMC’s dual mandate assigned by Congress: to control pricing pressures that can occur when aggregate demand is greater than supply and to maximize employment.
Each dot represents one Fed official — from Fed Chair Jerome Powell to board member Lael Brainard, from New York Fed President John Williams to Chicago Fed President Charles Evans. In total, when fully staffed the dot plot has 19 individual projections. Vacancies or projection omissions may result in a lower number of dots. Because the dot plot selections are kept secret, no one knows which official is linked to which dot.
Fed Funds Framework
The Fed Funds Target Rate is the short-term borrowing rate determined by the FOMC. This rate is used as an input for a wide range of financial instruments, from U.S. treasuries and equity pricing models to financial derivatives. When the Fed raises rates, it intends to raise the cost of short-term borrowing across the economy. This, in turn, reduces the supply of credit and raises the cost of loans for borrowers. Reducing the amount of money flowing through the economy can help control rising inflation.
Why and When Was the Dot Plot Created?
Fed officials first used the dot plot in 2012, when the economy was still recovering from the Great Recession and interest rates were near zero. The Fed wanted to give market participants an early look at what Fed officials were thinking before making any official policy decisions. The idea was that an open and transparent Federal Reserve could be just as effective at guiding investors’ expectations as the rate decision itself.
What the Dot Plot Can Tell Us
The dot plot can highlight where most Fed officials believe interest rates will be at a given point in time. For example, if multiple Fed officials expect rates to be higher than they currently are, we can infer they plan to increase interest rates and are concerned about inflation. This is colloquially known as “acting hawkish.” That is, their attention is focused on the negative impacts rising inflation can have on the economy. If multiple dots are below current rates, we can conclude that Fed officials are focused on stimulating the economy and are thus less concerned about inflation. This is referred to as a “dovish Fed.” Market participants generally pay more attention to the vector, or direction of interest rates, than the level of interest rates suggested by the dot plot. Knowing whether it might increase or decrease tends to be more pertinent than the exact possible rate.
If you or anyone you know is curious about how the dot plot may impact your financial future, Savant’s advisors can help. Our goal is to discuss your risk levels, how your investments may help you with a plan to pursue your financial goals, and answer questions regarding investing and the economy.
Source: Bloomberg
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Matthew M. Gavel
Lead Portfolio Manager