Are dot plots by the Fed a mistake?
The debate
Today morning there was a debate on CNBC on the topic of if Fed providing dot plots is mistake. One person was suggesting that it shouldn’t be done. Other’s were not so sure.
My take
My take is “yes” & “no”.
A central bank being able to provide a guidance for the future should be a good thing, IF they can ensure that their guidance actually materializes (or there isn’t a huge variance). The guidance can calm the markets and all participants to plan better.
But, if the central bank provides a guidance and is not able to ensure that the guidance actually materializes, the guidance becomes meaningless. An occasional failure is sustainable, but repeat mistakes leave market participants worse-off. They have to do the guessing game at their own risk.
The solution
I believe the best way to approach this is by addressing market uncertainty and adjusting for that either in duration AND/OR frequency. What do I mean by that?
Providing guidance for a fixed duration discounts for the fact that predictability of economic condition does not remain the same at every point in time. Sometimes economic condition into the future is more predictable and sometimes it is not. So, forward guidance should reflect that.
Solution - Part 1: As conditions become less predictable, the duration of guidance should reduce (say 1 year), and as conditions become more predictable, the duration should increase (say 3 years).
However, if the guidance is provided at a static frequency (say every 12 weeks), this would result in lesser number of data points and lesser number of opportunities to change the guidance. So, is there a solution to that?
Solution - Part 2: Yes, there is - the frequency of updates should also be adjusted so that when conditions become less predictable, more frequent updates are provided (eg. every 6 weeks), and when conditions become more predictable, less frequent updates are provided (every 12 weeks). That would result in mitigation for two things:
Number of data points don’t get reduced by a great extent
Number of opportunities for change in guidance increases
Conclusion
To conclude, this would be a radical shift on Fed’s communication model, but I believe it can work by being agile and adjusting the communication model to the situation on the ground. We have in fact seen this to work in a somewhat different context - during Covid, most companies withdrew guidance. It must have been a scary decision, but market did understand the reasoning. Based on what I have observed, markets like participants and policy makers adjusting to the realities on the ground. And I believe this kind of an adjustment can work once market understands the reasoning behind it.