Introduction
The FOMC dot plot has become the quintessential tool for transparently guiding monetary policy. A change to the median dot seems to represent a shift in the balance of thinking for this important decision-making body. The dot plot represents an assessment of the expected target for appropriate monetary policy over different time periods. While the near-term forecasts tend to move markets, the longer-run projections are also insightful.
FOMC participants’ assessments of appropriate monetary policy on December 13, 2023.
The FOMC Dot Plot
The dot plot is only one element of the Summary of Economic Projections and is now almost 12 years old. It was introduced as a means to communicate its goals more clearly to the public and enhance the transparency of the committee. The one message that has been clear and persistent from the first communique has been the inflation target of 2 percent. By anchoring expectations for personal consumption expenditures at 2 percent the FOMC judges that it can foster price stability and maximum levels of employment and thereby fulfill its mandate.
Changes to near-term projections can quickly translate into a re-pricing of the futures market as market participants adjust expectations for when and how much the FOMC will adjust its target level for the federal funds rate (fed funds). The longer run estimates garner fewer headlines and are currently more divergent, suggesting less consensus on the level of the neutral rate of interest required to anchor inflation at its 2 percent target.
The neutral rate (or natural rate or r-star) is interesting as a starting point to build a ‘neutral’ yield curve. If inflation sticks to the 2 percent anchor, where should fed funds target to support the anchor? And where would that put 10-year bond yields? Interestingly, the first dot plot at the start of 2012 had only one estimate below 4 percent for the longer run. For context, that was between QE2 and QE3 and probably the middle of Operation Twist.
Data Review
When looking for insight, it is important to see what the data tells us. By excluding periods when inflation was outside of a ‘neutral’ range of 1 to 3 percent we find that fed funds averaged about 3 percent since 1962 during the periods of neutral inflation. Net of PCE, the Real rate is just over 1 percent. Adding the average 10-year spread to average fed funds yields 4.45 percent as a representative ‘neutral’ 10-year bond yield.
Data representative of “Neutral” yields since 1962.
Reviewing the data with context, particularly the Great Financial Crisis, provides further insight. In the 60’s the inflationary pressures were building and real fed funds averaged 2.08 percent. During the 70’s and 80’s there was little data in the neutral category. The period of ’91-’98 represents a time of economic growth and price stability with a higher level of real yields. The ‘99-‘07 period could be considered a time when low rates contributed to excess credit that led to the GFC. The period after 2008 was clearly influenced by the aftermath of the GFC and the introduction of Quantitative Easing.
The exercise is simplistic without considering the impact of a greater number of economic variables. This includes demographics, labour force growth and productivity that have influenced monetary policy. However, much was written about these and other factors which could lead to the conclusion that forecasting R-star is largely an academic exercise. For our purpose, we will stick with a quantitative analysis.
Takeaways
If there is a conclusion to this exercise, it lies in where we would place our long run dot, work our way back to expectations for 2024, and build a yield curve around these metrics. It leads us to be critical of the research that goes into all the dots below 3 percent and wonder out loud whether such a low terminal rate for fed funds is why the bond market seems expensive in anticipation of rate cuts in 2024.
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