Beyond the dots

Since the last FOMC meeting, we have again heard cries of lost Fed credibility and of general confusion. In contrast, my colleagues and I at the CFE have been arguing for many months now that we would likely see what has in fact transpired. In our view, the Fed’s actions, including those at the March meeting, are consistent with a credible and consistent commitment to begin interest rate normalization while continuing to support continued improvement in the labor market with inflation moving back toward two percent. We suspect this may sound, well, nuts to some readers, but the case is fairly brief, so we invite you to take a look.

After the March press conference, Chair Yellen explained that the FOMC was proceeding cautiously, in order to ‘verify that the labor market is continuing to strengthen despite the risks from abroad,’ and further noted that,

[M]ost Committee participants now expect that achieving economic outcomes similar to those anticipated in December will likely require a somewhat lower path for policy interest rates than foreseen at that time.

Just before the January FOMC, we wrote

[T]he FOMC statement and discussion thereafter is unlikely to imply any fundamental change [in the likely course of policy], instead it may signal a pause to refresh the view on the macro fundamentals….If something like our forecast comes to pass, any pause will evolve into a much slower pace of rate increases than are implied by the FOMC’s December rate projections.

This echoed our prediction on the eve of the December FOMC that we would see a ‘prudent liftoff that is again followed by considerably slower rate increases than those reflected in the median FOMC rate projections.’

While things have evolved very much as we described, much commentary has suggested that the Fed has been confusing, denting its credibility and signaling another major shift in the hawk-dove tug of war that ostensibly dominates policy.[1] As it turns out, we predicted this commentary as well:

[C]ommentators will stumble over themselves in a race to divine whether hawks or doves have taken over the FOMC and will guide policy going forward. In our view, the FOMC statement and discussion thereafter is unlikely to imply any fundamental change…

This last prediction is a no brainer, of course. Commentators stumble in this way after most FOMC meetings, despite the fact that the FOMC never signals fundamental change in a way that requires such divination.

So where does our view differ from that of others? Since I returned to the CFE from the Fed about a year and a half ago, my colleagues and I have been pushing some basic—one might almost say mundane—principles for interpreting the FOMC. Under these principles, the current situation is not so opaque.

1. Policy is driven mainly by macro fundamentals. The best understanding of those fundamentals is pretty hazy but changes little between any two FOMC meetings.

2. The FOMC is a large committee (19 when fully staffed) with membership chosen to include a wide variety of views. Unlike some bodies in Washington, FOMC decisions tend to represent a constructive compromise with broad-based support.

The consensus of a large committee like this tends to change slowly: it is hard to shift a carefully constructed consensus without strong cause, and macro fundamentals seldom give strong cause. Thus, interpretations of FOMC actions that rely on a major shift in the outlook or in the FOMC response to the outlook will very generally be wrong. We need two more principles, however:

3. Periods of heightened stress in financial markets often lead the FOMC to pause plans in order to reassess conditions. Consistent with the first principle, market volatility will not have any lasting effect on the stance of policy unless the disturbing market signals are subsequently confirmed by macroeconomic fundamentals. We discussed this notion more fully in the January post.

4. The FOMC’s Survey of Economic Projections, in general, and the dot plot of policy projections, in particular, should never be taken at face value. Given a choice between taking the dots at face value or ignoring them entirely, you are far better off ignoring them. We have made the case for this view a number of times over the past 18 months.

So let’s look back to just before the December FOMC, when the Fed had clearly signaled that liftoff was likely. We observed that for a very long time, the Survey of Economic projections had paired a sensible macro forecast with a projected path of policy interest rates that seemed more hawkish than could be consistent with the macro forecast. In short, you could have the macro forecast or the hawkish rate path, but not both. Remember that since the inception of the dot plot, this pattern has held—the inaugural dot plot was arguably inconsistent with the Fed’s own forward guidance.[2] After the individuals on the committee make these projections containing these mutually inconsistent elements, the consensus of the FOMC has, each year, chosen to implement a lower rate path in order to support something like the outcomes in the baseline macro forecast.

Our December assessment was nothing more than the prediction that this oddity would continue. The period since December has seen little in the U.S. macro data that would change this view, but the financial volatility would warrant a pause to reassess. Then in the March projections, we added another chapter in the annual downward revision of the dots. This year it seems to have become clear to the FOMC somewhat more quickly than in prior years that the macro forecast would require a more gradual tightening than originally reflected in the dots.

This story holds together, we think, but it does beg the question as to why the dots have this confusing feature. Chair Yellen weighed in on this in 2014 when asked about the hawkish tone of the dots:

I can’t speak for why people write down what they do… I think that one should not look to the dot plot, so to speak, as the primary way in which the Committee wants to or is speaking about policy.

We don’t know what’s behind these projections either. Pressed for a story, however, we offer the following speculation. The dots may have an ‘aspirational’ quality: policymakers, just like the rest of us, hope that desirable macroeconomic outcomes will turn out to be consistent with briskly moving back toward more normal rates. Wouldn’t it be grand if we could normalize rates and still have the recovery we all want? Projections with this aspirational tone can be looked at as conditionally credible: if the economy evolved in a way to allow both the macro outcomes and the rate increases, the FOMC would probably happily deliver. Unfortunately, macro reality has not supported these aspirations, and policymakers again this year are set to deliver a more accommodative path than originally reflected in the dots.

In our view, the FOMC has credibly committed not to a particular path of policy interest rates, but to delivering a stance of policy that leads to continued progress in the labor market and leads—once transitory shocks abate—to inflation returning to 2 percent. The FOMC has behaved in a manner consistent with that view. And those dots? The FOMC may even be signaling that it would prefer quicker to slower normalization, all else equal. But all else is seldom equal and, ultimately, the economy has continued to determine a slower pace of rate increases.

Notes:

1. e.g., the Financial Times on March 17, 2016 quotes an analyst saying,‘I was shocked by the degree of dovishness.’ [back]

2. By April 2012, this problem was sufficiently glaring that Steve Liesman asked the following at the press conference:

Mr. Chairman, according to the latest forecast, 10 members of the FOMC see a 1 percent or higher fed funds rate in 2014; 7 of them see a 2 percent or higher fed funds rate. Under that-those conditions, how can the guidance in the statement, that you remain exceptionally low through late 2014, be justified? And is there a point at which the dissonance between the individual forecasts and the guidance get to a point where one or the other is no longer tenable?  [back]