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What is the US Fed Dot Plot and How to Interpret It?

What is the US Fed Dot Plot and How to Interpret It?

The Fed dot plot summarizes the FOMC’s expectations for the future federal funds rate. Investors and traders around the globe closely watch changes in the dot plot to clue in upcoming changes in the Fed’s policy, which is critical for the financial markets. 

What is the Fed Dot Plot? 

The Fed’s dot plot is a chart that maps out policymaker’s outlook for where interest rates will be in the future, represented by dots. Each dot on the chart represents projections of committee members. 

The dot plot was first introduced by the Federal Reserve in 2012 as a communication tool in the aftermath of the 2008 global financial crisis. It reflects the Fed’s effort to become more transparent regarding its policies. The Fed implemented the dot plot to act as a guidance to future policies considered by the policymakers over the short and long term horizon. 

Understanding the Fed Dot Plot

The vertical line reflects the implied fed funds target rate, and the horizontal one shows the projection year end. Each blue dot represents the projection of a FOMC member for implied funds rate. 

Let’s take the latest dot plot published in December 2021 as an example. As outlined, all FOMC members expected the funds rate to remain at its current range between 0.00% and 0.25%. While for 2022, one member supports only one hike, 5 members supports 2 rate hikes, 10 supports 3 hikes and only two forecasts 4 hikes. This shows that the majority of the committee advocates 3 hikes by the end of 2022. The same applies to the rest of the forecast horizon. 

The Federal Open Market Committee (FOMC)

The FOMC is the body of the Federal Reserve System that sets national monetary policy by directing open market operations (OMOs). The committee decides the appropriate stance of monetary policy to achieve policy mandates of price stability and maximum employment. The FOMC committee moves the federal funds rate to achieve the bank’s dual mandates. The committee typically meets eight times each year, and at other times as needed.

Source: Federal Reserve

Check How Central Banks Affect Your Forex Trading Decisions?

The Federal Reserve System is the central bank of the United States. The Federal Reserve sets the nation’s monetary policy to achieve maximum employment and stable prices, promotes the stability of the financial system and minimizes systemic risks. 

The FOMC committee consists of twelve voting members. However, the dot plot includes the opinion of all members regarding the policy outlook. Dots represent the view of committee members of the range where interest rates are expected to be at that time, and don’t target specific levels of interest rates. The overall direction of funds rates reflects the intention of future policy. 

Typically, intending to hike interest rates or maintain neutral levels is good for the currency. In contrast to when a central bank intends to cut interest rates or maintain high levels.

The Fed is known for being data dependent. It means that the policy path is adjustable based on economic activity, achieving policy mandates and financial conditions. Short-term forecasts tend to be more valuable for investors, as longer-term views are more vulnerable to change. 

When the Fed Publishes its Dot Plot? 

The Federal Reserve publishes its updated dot plot on a quarterly basis (March, June, September and December) included in the Summary of Economic Projections (SEP) which includes forecasts for key economic indicators like inflation, unemployment and GDP for up to three years later. 

All policymakers provide forecasts for inflation, unemployment and economic growth based on individual assumptions of appropriate policy. 

How Does the FOMC Set Interest Rates? 

To achieve its policy mandates, the Fed uses monetary tools mainly to control the interest rates, inflation levels, money supply, lending to commercial banks, and reserve requirements. The FOMC sets an inflation target at 2%, based on the view that maintaining price stability, through controlling inflation levels, contributes in achieving long-term economic growth. 

Interest rates are the primary influencer of investment flows. Central banks decide the appropriate level of interest rates depending on the economic situation. The path of interest rate usually follows the economy’s direction. Interest rates are used by central banks as the main tool to control the national economy and facilitate optimum economic conditions in accordance with monetary policy objectives. A major factor in deciding the interest rate path is Inflation or price stability. Ideally, central banks aim to achieve steady economic growth while stabilizing prices. But, when the economy’s conditions get out of control, the interest rate interferes to get things right.

The Fed sets higher interest rates in order to tame inflation and economic growth. It is because higher rates make borrowing more expensive and sitting on cash becomes more attractive. On the other hand, lower interest rates tend to encourage consumers and businesses to borrow more. It is usually coupled with easing lending requirements, which helps in boosting borrowing and spending, thus stimulating growth in case of downturns.

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