Why the Fed's economic forecasts aren't always forecasts for the Fed
22 Sep 2023
Alongside its policy decision on Wednesday, the Federal Reserve will announce updated economic forecasts offering investors its best guess at where economic growth, inflation, unemployment, and interest rates will land in the coming years.
And with the CME's FedWatch tool showing a 99% probability rates do not change, it's this last piece of the outlook where investors are likely to focus most of their attention for two key reasons.
The first is that in June, the Fed's interest rate outlook — offered in its so-called "dot plot" — suggested two more rate hikes would be necessary through the end of 2023. So far, the Fed has raised rates once more.
And with Wednesday expected to see the Fed sit tight, there are three choices facing the central bank over the balance of the year: raise rates in November, raise rates in December, or change its forecast.
Which way the Fed breaks on this question will likely shape much of the market's reaction on Wednesday.
The second is that investors love to challenge the Fed's outlook.
What the Fed calls its "projections of the most likely outcomes" for the economy are often framed as stone cold forecasts later used to show that the central bank doesn't have a clue.
Of course, as an arm of the government — and one comprised of appointed, rather than elected, officials — the Federal Reserve is designed to be criticized. And there are few places you can find a more robust, data-driven series of disagreements and critiques than financial markets.
But over the years, the market has consistently bet against the Fed and done so in the same way. Essentially, the market thinks the Fed will stop doing what it is doing sooner than the Fed eventually does it.
The following chart is a throwback from 2019, surfaced for Yahoo Finance by TKer's Sam Ro, which comes from a chartbook published by Torsten Sløk, then the chief economist at Deutsche Bank. (Sløk is now the chief economist at Apollo; Yahoo Finance is owned by Apollo Global Management.)
In Sløk's chart we can see what economist Ed Nosal called in a 2001 paper the market's tendency to "overpredict" interest rates based on whether they are rising or falling.
When rates are falling, investors bet they will stop falling sooner than they do; when rates are rising, investors bet they will stop rising sooner than they do.
Generally, we see the latter tendency in today's Fed conversation.
In a client note back in August, the team at Capital Economics outlined its view the Fed will need to be more aggressive in easing policy next year than currently priced in by markets and forecasted by the dot plot.
"We continue to expect the Fed’s next move to be a rate cut in early 2024, with a rapid decline in inflation convincing officials to cut more aggressively than markets are pricing in," wrote Andrew Hunter, deputy chief US economist at the firm, in a note last week.
The challenge for investors today, however, is that while rates have inched up over the last several months, Fed Chair Jerome Powell and other Fed officials have been laying the groundwork for an extended period of rates remaining at or near current levels.
As Powell said in a speech last month in Jackson Hole, the Fed is prepared "to hold policy at a restrictive level until we are confident that inflation is moving sustainably down toward our objective."
In a rising rate environment like the present, "overpredicting" the Fed would mean betting on lower rates sooner than they materialize, suggesting persistent bets on rate cuts are likely to feature during an extended hold from the Powell Fed.
All of which makes the dot plot less a tool for understanding the Fed's next move, and more of a roadmap for the market's next big story.
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