Yahoo U: what is the dot plot

Yahoo Finance’s Brian Cheung joins the Yahoo Finance Live panel for today’s Yahoo U: Fed dot plot.

Video Transcript

AKIKO FUJITA: Well, if you've been following our Fed coverage here on Yahoo Finance, and we hope you have, you probably heard a lot of references to the dots. After the Fed meeting on Wednesday, we know the dots are moving closer, but what exactly do those dots represent? And what does the Fed dot plot show? For that, we turn it over to Professor Brian Cheung for this week's lesson in Yahoo U. Brian,

BRIAN CHEUNG: Well, Akiko, class is in session, and everyone is talking, like you mentioned, about those dots that we got from the Federal Reserve earlier this week. But it's a bunch of grown adults right now and trillions of dollars freaking out about some dots. But they do tell us something really important. They can show us a projection for where the Federal Reserve may take interest rates in the future.

But there's also good reason not to hold the dots up as canon. But first, let's take a look at the dots that we got from this week. Again, these come out quarterly. And what you're looking at right now is where the 18 members of the Fed's policy setting committee see interest rates going over the next few years. And then also over the longer run, but let's kind of ignore that for right now.

So people saw rate hikes coming in 2022 or 2023 possibly. So you can kind of see right here. I'm going try to draw this. Well, actually, that line came out kind of nice. But basically, it's showing where interest rates could go in the future. Seven of the 18 members in 2022 seeing a possibility for a rate hike, and then in 2023, 13 of the 18 members seeing a rate hike.

But people tend to look at the median member of that 18-member committee for where interest rates could be going. So if you look at the median dot for 2022, that's about this guy right here, which would show no interest rates. It's still pinned at near zero. But if you look at the median dot for 2023, it's about that one, which shows two interest rate hikes over that period of time. And this is the dot that got people freaked out. The last time we got this projection, which was in March of this year, the median dot was showing no rate hikes through 2023.

Now we've seen this, the dot plot, a million times. But you probably haven't seen this chart, which actually is also part of the dot plot document. And the purple line is a historical account of the midpoint target range. You can kind of ignore that. The light blue line is what we want to look at here. That shows the median dots in the latest dot plot print, which again, as I just showed you, no interest rate hikes, which is what the median says, in 2021 or 2022. The median dot showing two interest rate hikes by the end of 2023.

But the orange shading that you're looking at shows the uncertainty around this forecast. So basically, the Fed looks at errors in forecasts for interest rates that were made over the previous 20 years and it draws this 70% confidence interval for the Fed's current forecast, which means that these forecasts not only have a risk of being off, but they had a history of being off.

And this is the track record of the dot plot. Now it's a lot to look at, I'll walk you through it. But what we want to evaluate here is the accuracy by which these dots predicted rate liftoffs since these dots were invented back in 2011. Now we know after the last financial crisis, interest rates were also backed up to near zero. Very similar situation to where we are right now.

So the colored lines, the orange, blue, red here, they're going to show you the projections as of December in previous years. So the projection in December 2013, which is the light blue line that I'm kind of pointing out right here, is kind of the projection as of the end of December '13 for where rates would go through 2016. And the median dot at that time said that the first rate hike would happen by the end of 2014. Didn't happen. The purple line shows the actual timing of the policy change. And people know that the first rate hike didn't happen until December of 2015.

Now when the liftoff happened in December 2015, policymakers thought it'd be steady on the way up. So the red line shows the dot plot projections as of that December 2015 meeting, and they said in just the year following they'd hike rates another four times. Didn't happen. They only raised rates once, as you could see right there. So this chart is from some time ago I want to point out, and the dots did kind of get better at predicting where rates would go if you kind of follow the green and then the gray lines in 2016 and 2017.

But again, we're interested in the liftoff, not necessarily the middle of the hiking cycle. Now I acknowledge I probably lost some people right now. So let's think about this a different way, OK? Let's go to Yahoo U art school. Now take a look at this and tell me what you see. It's a bunch of dots, right? You can kind of make it out, might be like a flower or something. If you stare at it long enough though, it's kind of a Rorschach test. It could become many things. But it's bigger. It's a part of a bigger painting.

This comes from George Seurat in his 1884 piece, "A Sunday on La Grande Jatte." And you can see that little bit that I showed you was a bouquet being held by the person there. Now again, the dots are cool, they're the basis of that style of pointillism, at least Wikipedia says. But the dots are not the whole picture. And the same goes with the dot plots. Economic forecast can't be boiled down to dots, because forecasts are rife with errors. And economists are often wrong.

And I bring up this comparison not because it's mine, but because it's Jay Powell's. He presented this comparison in 2019 in saying the dot plots are not the best forecasts and take it with a grain of salt, something that he again said this week, and worth watching as bond markets continue to get royal. Now we'll watch how the Fedspeak develops over the next few weeks, but always kind of a good reminder to remember that the dot plots are not necessarily canon, guys. But that wraps up this week's Yahoo U.