The much-feared taper is finally here. The Federal Reserve on Wednesday last week announced that it will reduce its asset purchases by $15 billion a month in November and December 2021. Unlike in 2013 when a similar announcement led to a ‘tantrum’ across financial markets, markets were well-informed about this taper and have thus taken the news in their stride. With the taper in place, commentators are now looking forward to the actual US Fed dot plot on interest rates.
What is it?
The dot plot is the expected trajectory of interest rate hikes proposed by US Fed members in graphical form. The US Federal Reserve’s Federal Open Market Committee (FOMC) releases its dot plot along with its projections on other major economic indicators like GDP, inflation, etc. Eighteen members that include the Federal Reserve Governors and Presidents of the regional banks participate in this. Every member of the committee offers their prediction on where the policy rate should be over the next three years. Each member’s interest rate forecast is then plotted on a graph in the form of a dot plot.
The policy rate in the US is currently in the 0-0.25 per cent range. So, if FOMC member A predicts that the rates can go up to the range of 0.5-0.75 per cent in 2022, then his forecast will be taken as 0.625 — the median value of the 0.5-0.75 range. The median value of each member’s predicted range is plotted accordingly, to arrive at a graph which will effectively have 18 dots for each year representing each member’s rate forecast. Who has predicted what is kept confidential. The dot plot was introduced by the Fed in 2012. It is published four times a year (once a quarter) in March, June, September and December.
Why is it important?
Financial markets hate surprises especially of the negative kind. The Fed’s dot plot tells the market in advance where interest rates could be heading in future. Though the dot plot may change with each Fed meeting, markets seem to prefer having something to work with rather than groping in the dark.
Today the dot plot is particularly important because the US central bank has been maintaining its interest rates near zero for a prolonged period. The dot plot will give a hint to the markets on when the rate hike cycle may begin and, more importantly, what could be the possible pace of increases in rates.
Why should I care?
Record low interest rates in markets like the US have played a key role in keeping the global stock market rally going. Indian stock markets are at all-time highs. The US stimulus taper is already here. With no known uncertainty in the vicinity for the market, interest rate hikes from the US will be one event that will now be keenly watched by the market.
The dot plot released in June 2021 had shown 12 members out of 18 predicting that rates would remain at the current levels of 0-0.25 per cent. But in September, this had come down to nine indicating that the first-rate hike is possible in 2022 itself. The September dot plot also showed that there could be three rate hikes in 2023. The dot plot that will be released in December will need a close watch. If it indicates more than one rate hike in 2022 or more than three rate hikes in 2023, then that could impact stock and bond prices.
However, investors should be aware that the predictions in the dot plot need not come good and can change based on developments in the US economy.
Connect the dots to know where the interest rates are going to go.
A weekly column that puts the fun into learning