Plotting the dots – crucial or cryptic?

With the U.S. Federal Reserve Bank (Fed) chairman, Jerome Powell, signaling a faster pace of tapering or reduction of monthly bond purchases (liquidity support) ahead of Wednesday’s FOMC meeting, in response to hotter than expected inflation, market watchers and investors anxiously awaited the Fed’s next big reveal– the FOMC dot plot. So, what are the Fed’s dot plots and how useful are they for investors? 

The Fed’s dot plot is a chart showing estimates of the mid-point of the range for Federal Funds rates or policy rates in the future. Every quarter since 2012, each member of the rate-setting Federal Open Market Committee (FOMC) assign a dot that represents his or her view of where the mid-point policy rate should be at the end of each of the next three years and over the longer run. The longer run rate is usually the terminal or peak rate after the Fed has finished tightening or "normalizing" policy from current levels. There are currently 18 members of the FOMC and so 18 dots will be depicted for each of the relevant period. Investors and economists however focus on the median dots to discern clues about the trajectory of interest rates. 

The median dots at Wednesday’s meeting were as follows: 0.875% for 2022, 1.625% for 2023, 2.125% for 2024 and 2.5% for the long run or terminal rate. The current range for Fed funds is 0% to 0.25% which translates into a mid-point rate of 0.125%. The current dot plots therefore suggest three 25bps (0.25%) rate hikes in 2022 and 2023 with the pace declining to two rate hikes in 2024 and the rate hike cycle concluding with another one or two increases thereafter. It should however be noted that the Fed is mostly data-dependent and constantly adjusts its forecasts and projections which may result in a different set of dots at the March 2022 meeting. Consequently, some observers conclude that the dot plots are meaningless since the Fed is not bound by these projections which are merely conjectures based on the prevailing environment. Additionally, the dots are anonymous and so the dot for the influential chairman, for instance, will not be known.

Nevertheless, it is however obvious from the faster taper decision and the current dots that the consensus view within the Fed is that tighter monetary policies are necessary to address persisting high inflation which has been manifested in consumer price inflation hitting a 39-year high of 6.8% in November. Consequently, market volatility is likely to increase overtime on account of a more “hawkish” Fed and a seemingly never-ending pandemic. Undoubtedly, despair may arise for some investors due to some financial assets falling in price to reflect the reality of higher interest rates, but opportunities will also arise as lower prices offer better entry points. Higher yields should also translate into larger income on new investments. Bonds will therefore continue to play an important role in an investor’s portfolio particularly during periods of elevated volatility. 

It is also noteworthy that while the Fed is expected to begin its rate-hiking cycle next year, it appears that it may be another shallow one like the last one which began in December 2015 and ended December 2018. If such is the case, then the Fed funds rate may only elevate to the 2.0% range which would be considerably below historical levels. This should therefore make it easier for the U.S. economy to continue its economic expansion and avoid a recession.

Eugene Stanley is the VP, Fixed Income & Foreign Exchange at Sterling Asset Management. Sterling provides financial advice and instruments in U.S. dollars and other hard currencies to the corporate, individual, and institutional investor. Visit our website at www.sterling.com.jm

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