FOMC Preview: Forward Guidance Is Out, Will the Dot Plot Survive?

Summary

• A 75bp hike is likely at the FOMC meeting on 20-21 September.
• The Fed has already communicated that it had ended forward guidance.
• This creates a risk that the dot plot could go since it constitutes a form of longer-term forward guidance.
• If the Fed keeps the dot plot, I expect the 2023 dot to be increased by about 50bp, i.e., marked to market, while the overall SEP macro scenario would remain a soft landing.

Market Implications

• Limited impact since 75bp is priced in.
• If the Fed ends the dot plot (not my base case), market reaction is likely to be negative.

I Agree With Market Pricing Until End-2022

Following the August CPI, markets are now pricing 175p by end-2022, roughly 75bp in September and 50bp in November and December (August 2022 CPI: In line With Macro Drivers).

This has been my view since the July meeting (FOMC Review: Less Guidance, More Evidence) based on:

1. The Fed wants growth below trend in H2. As Chair Jerome Powell explained, the current Fed focus is bringing ‘demand and supply into better balance’. Since the Fed has limited impact on the supply side of the economy, Powell explained, ‘this is likely to require a sustained period of below trend growth’.

2. The economy is returning to (but not slowing below) trend. As, for example, Fed Governor Christopher Waller stressed, the labour market is still too strong for inflation to return to target, and there are signs of a rebound in consumption.

3. The doves will likely argue the federal funds rate (FFR) is already at neutral and, because of the variable lags in monetary policy transmission, the Fed must proceed cautiously to avoid overtightening. This makes a 1% hike unlikely.

I see greater uncertainty around the Summary of Economic Projections (SEP), especially as forward guidance is now out.

Forward Guidance Is Out

Unlike previous meetings when the Fed telegraphed its decision beforehand, this time the Fed has given up on forward guidance. The past three weeks saw policy speeches from Powell, Waller, and Vice Chair Lael Brainard; none provided much guidance on next week’s hike. 

Waller also titled his speech ‘Time to Let the Data Do the Talking’ and stated that ‘forward guidance is becoming less useful at this stage of the tightening cycle’. 

The backdrop to this change in communication strategy is the June meeting. Powell had telegraphed a 50bp hike ahead of the pre-meeting blackout. However, a large positive CPI surprise during it saw the Fed indicate, two days before the actual meeting, a 75bp hike through its usual media channels.

Before the July meeting, a public debate among FOMC members on 50bp vs 75bp still provided ‘informal’ forward guidance.

A week ago, Cleveland Fed President Loretta Mester explained, ‘we want to convey our reaction function so that people know how we are likely to react, conditional on the economy moving in one way or the other, even though we don’t necessarily know exactly how the economy is going to move.’

How credible is this abandonment of forward guidance? We cannot know until the Fed gets tested, i.e., the market prices in an outcome different from what the Fed wishes. This does not seem to be the case this time, though, as the market is pricing 85bp.

Will the Dot Plot Survive? 

That said, the abandonment of forward guidance is likely to hit its first challenge with the dot plot. This is a form of forward guidance – albeit longer term than the meeting-by-meeting guidance provided until recently. Therefore, a risk exists that the Fed could end the dot plot at this month’s meeting. 

Most global central banks publish a macro scenario of sorts, but not all of them publish a policy rate forecast (Table 1). This suggests the Fed will more likely end the dot plot than the SEP altogether. Publishing a macro forecast rather than a dot plot would be consistent with the Fed communicating its reaction function.

That said, even without a dot plot, the SEP macro forecast makes the Fed’s work more difficult. With runaway inflation, the SEP forces the Fed to choose between either publishing a realistic assessment of the employment cost of lowering inflation or losing credibility. In other words, the SEP’s transparency makes the Fed’s policy mistakes more immediately apparent.

Market reaction to an end of the dot plot would likely be negative. I think this would mainly be because the decision would constitute a further signal of the end of the Fed put. The end of the dot plot itself may add little market uncertainty: the twists and turns in the Fed’s forward guidance have meant the dot plot noise-to-signal ratio has become highly unfavourable.

Overall, therefore market reaction may neither be violent nor last long.

Regardless, with inflation showing no sign of slowing, the Fed needs tighter financial conditions and could be less concerned by market reaction (Chart 1). 

Overall, I assign a probability of near but less than 50% that the Fed will end the dot plot next week. If it does not, the Fed must show an FFR trajectory that does not cause financial conditions to ease.

SEP to Follow Markets

Following the August CPI print, markets are now pricing a terminal FFR at 4.4% in March 2023, compared with 3.8% before the print. This is followed by rate cuts, with the December 2023 Fed funds futures contract pricing around 3.9%.

If the FOMC shows a terminal rate well below the market, it risks further undermining its credibility. This could lead to the market pricing deeper cuts in 2023 or even an easing of financial conditions. 

The Fed believes policy tightening gets transmitted through financial conditions. An easing of financial conditions is what the Fed wants to avoid as inflation is rebounding and growth remains strong.   

Therefore, I expect the 2023 dot to be lifted near current market pricing: for example, 4.3%, from 3.8% in the June SEP.

Meanwhile, the Fed will likely stick to its soft-landing scenario. That is no significant increase in unemployment and a smooth easing of inflation over the projection period. Under the Fed’s soft-landing scenario, policy tightening would not last beyond 2023. Consequently, the 2024 and 2025 dots (the SEP will extend to 2025) are likely to show a gradual return to the long-term dot.

There is a risk that, following Jackson Hole discussions and Powell’s recent Q&A (and to signal the risk of a less favorable post-pandemic inflation backdrop), the long-term dot could increase by 12.5 or 25bp (Key Takeaways From Powell’s Q&A Point at Hawkish Fed Over the Medium Term and Jackson Hole: The Mountain That Will Bring Forth a Mouse?). The Fed lowered the long-term dot to the current level of 2.5% in March 2019. Before that, it was 2.75% (Chart 2).

Even without forward guidance, we have just witnessed another iteration of the by-now familiar movie: the Fed intends to stick to its soft-landing scenario, the inflation data comes out stronger than expected, the market reprices the Fed, and the Fed has no choice but to follow the market.

This is unlikely to be the last iteration. My conviction on the terminal FFR at near 8% remains strong.

Market Consequences

The 75bp I have been expecting has now been priced in. The risk to the market therefore comes from the Fed ending the dot plot. That is not my base case, but it is possible.

Dominique Dwor-Frecaut is a macro strategist based in Southern California. She has worked on EM and DMs at hedge funds, on the sell side, the NY Fed , the IMF and the World Bank. She publishes the blog Macro Sis that discusses the drivers of macro returns.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)