Wednesday, October 12, 2016

The Real Value of the Federal Reserve's Interest Rate Projections

Every word from the Federal Reserve's "mouth" is parsed by the global financial markets which are looking for some hint of what lies ahead for the economy.  These relatively simple words have the power to drive the global stock and commodity markets either positively or negatively.  A recent posting on the Mises Institute website gives us a pretty good sense of how much weight we should put on the "words of wisdom" from the sages at the Fed.

As many of us who follow the Federal Reserve's pronouncements are aware, the Fed provides the outside world with dot plots, the mechanism by which the Fed telegraphs the interest rate projections of the 16 members of the Federal Open Market Committee (FOMC), the braintrust that is responsible for setting the federal funds rate.  Here is the most recent quarterly dot plot from the FOMC for September 2016:

As you can see from the plot, each of the 16 members interest rate projections for the future are represented by a dot.  For example, for 2017, the FOMC members project that the target level or interest rate midpoint for the federal funds rate will range from a minimum of between 0.5 percent and 0.75 percent (2 members) and a maximum of between 2.0 percent and 2.25 percent (1 member) with the majority of members projecting that rates will be between 1.0 and 1.25 percent (7 members).

Obviously, one can accumulate all of these projections and show how the FOMC's interest rate projections have morphed with time.  Thankfully, Jonathan Newman at the Mises Institute has provided us with a graphic that shows us the true value of the Federal Reserve's interest rate midpoint projections:

Note that the actual history of the effective federal funds rate is represented by a dashed black line that falls pretty close to the X-axis.  As the author of the graph, Peter Hooper, noted, the Federal Reserve has projected that there would be a lot of rate hikes since 2013 with long-run rates rising as high as nearly 4 percent in March 2016 as shown on this dot plot:

From the summary graphic which shows the history of the Fed's projections, it is very clear that the Federal Reserve's ability to project its own future interest rate policy is pathetic at best.  One has to suspect that there are two forces at work:

1.) the Fed is practicing garbage economics.

2.) the FOMC is composed of eternal economic optimists who pray that a return to a "normal" interest rate environment lurks just around the corner, a reality that will allow them to finally extricate themselves from their extended zero interest rate policy corner.

Either scenario should be less than reassuring to investors and speaks volumes about the real value of the Federal Reserve's projections. 

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