The Big Idea
Managing the dots
Stephen Stanley | March 26, 2021
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
A flurry of commentary from Fed officials after the March FOMC puts more light on the Fed’s plan to actually see inflation before responding. Projections of inflation might have been enough in the past. Not now. That could explain why the Fed’s fed funds dots looked easy despite a projected rebound. The Fed is trying to keep the market from tightening financial conditions too early. That should make June’s dots an interesting test of whether the Fed is seeing enough to move funds dots higher.
Chair Powell made a point at his March 17 press conference that could have easily escaped notice. It was not made in his opening statement but in response to a question well into the press conference It was arguably the most important thing he or the FOMC said last week. Powell said:
“The fundamental change in our framework is that we’re not going to act preemptively based on forecasts for the most part. And we’re going to wait to see actual data, and I think it will take people time to adjust to that.”
Powell is, of course, referring to the new policy framework announced last year. His point, particularly in regard to how the Fed intends to address inflation going forward, is that it will not be setting policy according to a forecast but will need to see actual data to warrant a response, a strategy that has in the past been referred to as a “whites of the eyes” approach.
Other Fed officials across the hawk and dove spectrum have taken up that idea since Powell’s press conference. On March 23, Dallas Fed President Kaplan on CNBC said he wants to see “actual evidence” that his forecast was going to come to fruition before reducing policy accommodation. “I need to see outcomes, not just strong forecasts. We’re still in the midst of the pandemic right now.” Kaplan revealed in the same interview that he is one of only four FOMC participants projecting a fed funds rate hike in 2022.
Later the same day, St. Louis Fed President Bullard, who is on the other side of the spectrum and revealed he is projecting the funds rate near zero through 2023, also touched on this idea. “I want to see those numbers before we contemplate any changes to monetary policy,” he said “My main concern is that we not start to pull [any move to exit] forward before we see whether the data actually is consistent with the very strong forecast for 2021.” He even extended that idea beyond an eventual rate hike to encompass balance sheet policy, indicating the FOMC will start to debate the timing of tapering “only if we actually see all the good things happening that we’re now projecting to happen.”
Finally, Atlanta Fed President Bostic later in the week tried to discourage discussion of when the first rate hike might come. “We are in a transitional period right now and I think it’s important that we prevent that kind of speculation from potentially undermining the momentum that we have built.”
So, market participants should clearly understand that the FOMC will be setting policy based on actual outcomes, not forecasts, which, of course, substantially diminishes the importance of the FOMC’s quarterly economic projections.
Mapping economic forecasts to dots
At first glance, the most important takeaway from the March 16-17 FOMC meeting was that policymakers sharply upgraded their economic projections, especially for 2021. And yet a sizable majority of officials still expected the funds rate to remain at the lower bound through the end of 2023. After the recent additional commentary, there are actually two competing interpretations of the apparent divergence between the FOMC’s economic forecasts and the dot projections.
The first one is the conventional approach. The upgrade in the economic forecasts without a corresponding change for most officials in their policy projections can be interpreted as a sign of a committee that is far more dovish than in the past. That still seems a valid point. The Fed’s new monetary policy framework was clearly an effort to add some formality to a more dovish approach after the experiences of the late 2010s, when an extremely tight labor market failed to generate any pickup in consumer price inflation.
There is a second possible explanation for the apparent unresponsiveness of the FOMC dot projections to a brighter economic outlook. We know that the Fed has come to view forward guidance as a vital element of policy, especially when the funds rate is stuck at the lower bound. As a result, what the Fed says is no longer just speculation or pontificating. That may now extend, at least for some officials, to their forecasts.
Take Bullard’s comments in particular. Bullard told reporters that his dot would not move forward until he sees actual evidence of strong growth this year. He is unwilling to pull his projection of liftoff forward until his strong 2021 economic forecast is confirmed. Under this framework, Bullard apparently sees value in maintaining a dovish policy projection until there is an actual turn in the economy, even if his dot forecast is inconsistent with his economic outlook. Keeping his dot near zero through the end of 2023 is a signaling device that he is using to try to keep financial conditions more accommodative today because he needs easy financial conditions today to help get the economy back to where he wants it to be. In this framework, even if the economy evolves exactly as he is currently predicting, he could change his dot projections, perhaps even by quite a bit, once the data confirm his forecast.
Bostic was not quite as explicit, but he hints at a similar thought process. He is worried that market speculation about the timing of liftoff could produce a tightening of financial conditions that could “potentially undermine the momentum that we have built.” Like Bullard, he would apparently prefer that, because the Fed is no longer going to be preemptive, the various market participants and economic operators who determine financial conditions also cease to be forward-looking. Since it is evident that is never going to happen, Bullard and Bostic both suggest, though subtly to be sure, that the Fed could offer a dovish policy outlook that may not be an accurate portrayal of their actual forecasts if that is what it takes to help insure the positive outcomes that they desire.
At this point, Fed officials are certainly not engaging in a coordinated effort to try to manipulate financial conditions. Of the three officials quoted above, Kaplan and Bostic appear to be setting their dot projections in a conventional manner, based on what they actually think. Kaplan admitted that he expects a rate hike in 2022, even as he emphasized that he would need to see movement in the actual data to justify such a move. Bostic said that he expects employment to get back to a pre-Covid level by the end of 2022, and he currently expects liftoff to occur in early 2023. In contrast, Bullard appears to be playing a different game, as he says that he will not move his dots until he sees the actual data showing a recovery, which leaves open when he might support liftoff once that bar has been hurdled.
Powell and Fed leadership may be looking at things similarly to Bullard. The FOMC often works backwards from the preferred market reaction to determine the message. If the desired result is easy financial conditions, then the best thing the FOMC could do might be to offer an unrealistically dovish policy projection until the economy begins to gain traction.
Of course, there are surely plenty of Fed officials who truly believe the economic outlook will justify maintaining a super-accommodative policy for years. For example, Chicago Fed President Evans, a perennial dove, also spoke recently and seems to genuinely believe that beyond the brief post-pandemic spurt in prices, inflation will probably settle back to its stubbornly below-target trajectory, which would justify an extended period at the zero bound, even after the economy recovers. His is another of the dots near zero through 2023.
Watch the June dots
If at least some Fed officials are employing the strategy suggested by Bullard, then the June dot projections should be interesting. By June, the Fed should have ample evidence that the economy is on it way back though still far from achieving the dual mandate goals. Will that be enough to get Bullard to consider revising his dot projections? Or perhaps policymakers would want to wait until September, when the economy should have made “substantial further progress,” before determining that it no longer needs to press its thumb on the scale of financial conditions and can offer a candid set of policy projections. In either case, it would seem that the FOMC’s policy expectations could evolve in line with Hemingway’s description of going bankrupt: “gradually, then suddenly.”