The Dot Plot. It sounds like a nefarious scheme hatched in a spy novel. But its power to move markets is greater than any other piece of data released by the Federal Reserve at meetings of its Federal Open Market Committee, which is responsible for setting interest rates. Each quarter, the 19 members of the FOMC are asked to forecast gross domestic product, unemployment, inflation and, most important, the federal funds rate (the rate at which banks lend excess reserves to each other overnight, and the key interest rate the Fed uses to set monetary policy). Funds-rate forecasts are plotted as dots on a graph. The resulting “dot plot” is the Fed’s best predictor of the future path of short-term interest rates, which are critical for both the stock and bond markets.
The dot plot released in September was jarring to a number of market watchers. Only one FOMC member expected interest rates to rise by the end of this year. But rates are expected to rise significantly in 2015. By the end of next year, most committee members think the funds rate will be about 1.25% (up a full point from 0.25% currently), and by the end of 2016, the average forecast is nearly 3%. By the end of 2017, most members anticipate that the rate will be very close to their long-term target of 3.75%.
Those forecasts are troublesome because they are well above what the market expects the federal funds rate to be. In the fed funds futures market, which is a guidepost to future rates, the December 2015 contract trades at just 0.75%, about 0.5 percentage point below the FOMC’s expectation. And the December 2016 contract trades about 0.75 percentage point below Fed expectations. The longest-dated futures contract (August 2017) trades at just 2.40%, more than one whole percentage point below the Fed’s prediction for the end of that year.
Sign up for Kiplinger’s Free E-Newsletters
Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.
Profit and prosper with the best of expert advice - straight to your e-mail.
Some critics have complained that the Fed is “behind the curve” by holding the funds rate near zero for too long. That may have been true in the past, but it’s no longer the case. The Fed’s interest-rate outlook is far more hawkish than that of investors in the futures market, who bet substantial amounts of money on what the rate will be.
Which prediction should we believe? Looking ahead to the next year, I think the Fed’s more aggressive view is right. Economic growth will be 3% or higher over the next several quarters, which means the Fed will have to raise interest rates sooner rather than later. However, over the longer run, I think the Fed’s interest-rate forecasts are far too high. As I said in my Going Long column last June, powerful economic forces—sharply slower growth in the labor force, declining commodity prices and an aging population of investors who prefer the lower volatility of bonds to stocks—are pushing interest rates down.
The Fed’s mistaken long-term forecasts hark back to the period from 1960 through the 1990s, when gross domestic product grew, on average, more than 3.5% a year and inflation averaged 4.5%. In those decades, the fed funds rate averaged 6.7%, about two percentage points above inflation. But today, with long-term GDP growth forecast to drop to 2% annually with a much lower inflation rate, the fed funds target rate should settle somewhere between 2% and 3%. That means the futures market, and not the Fed, is closer to being right about the level of rates long term. If the Fed ultimately tries to lift the fed funds rate higher than the futures rate, it risks triggering a recession.
Eventually, the Fed will have to alter its forecasts when it confronts the fundamental forces pushing interest rates lower. As Fed chairman Janet Yellen emphasizes, all of the Fed’s interest-rate forecasts depend on the evolution of the data. Any good plan must adapt to changing circumstances, and the dot plot is no exception.
-
What Is a Qualified Charitable Distribution (QCD)?Tax Breaks A QCD can lower your tax bill while meeting your charitable giving goals in retirement. Here’s how.
-
Embracing Generative AI for Financial SuccessGenerative AI has the potential to reshape how we approach learning about and managing our personal finances.
-
Fed Sees Fewer Rate Cuts in 2025: What the Experts Are SayingFederal Reserve The Federal Reserve cut interest rates as expected, but the future path of borrowing costs became more opaque.
-
Europe Faces Economic and Political Headwinds Next YearThe Letter Challenges for Europe: Potential tariffs, high energy prices and more competition from China will weigh on the bloc in 2025.
-
CPI Report Casts Doubt on Rate Cuts in 2025: What the Experts Are Saying About InflationCPI November Consumer Price Index data sealed the deal for a December rate cut, but the outlook for next year is less certain.
-
Rebound in Jobs Growth Keeps Fed on Track: What the Experts Are SayingJobs Report No nasty surprises in the November payrolls data leaves a quarter-point cut in play.
-
Don't Sleep on Japan's Economic TransformationThe Letter After almost three lost decades, Japan — one of the world's biggest economies — is finally showing signs of life.
-
October CPI Report Hits the Mark: What the Experts Are Saying About Inflation
CPI While the current pace of rising prices appears to have leveled off, the expected path of rate cuts has become less certain.
-
Fed Cuts Rates Again: What the Experts Are Saying
Federal Reserve The central bank continued to ease, but a new administration in Washington clouds the outlook for future policy moves.
-
Market Reaction to Election Results: What the Experts Are SayingJobs Report Election uncertainty has been removed from the list of investors' worries, helping equities soar.
