What’s this Fed ‘dot plot’ anyway? Why has it rattled markets

On Wednesday, the central bank surprised, but did not shock, the market when its members predicted as many as two interest rate hikes in 2023, a year earlier than the previous estimate. While the market’s initial reaction was to press the ‘sell’ button, they quickly recouped most of their losses as the Fed’s message got broken down further.

There are a few things that need to be understood from Wednesday’s meeting that have implications for investors from New York to Mumbai.

What’s the dot plot?
Ever since Wednesday’s meeting, the ‘dot plot’ has replaced ‘transitory’ as the new buzzword in markets and monetary policy circles. In its basic form, dot plot is a tool for visualizing data on a chart with a horizontal axis and vertical axis.

Every quarter, the members of the US Federal Reserve’s Federal Open Market Committee submit their predictions for where interest rates should be, where inflation will be and how much growth the economy will see going ahead. Each of these predictions by the 18 members of the FOMC is then plotted on a chart with each member’s forecast represented by a dot. A gathering of dots around a particular estimate, say, for interest rate, is seen as the consensus view.

In the latest ‘dot plot’ released by the FOMC on Wednesday, it was noticeable that the median view of the 18-member committee was for two interest rate hikes in 2023.

‘Dot plot’ is as good as exit polls?
While media and investment community’s attention was drawn to the change in the ‘dot plot’, it was noticeable that the Chairman Jerome Powell went out of his way to almost dismiss the inference from the simple graph.

Powell stated that the ‘dot plot’ ought to be taken with a “big grain of salt” and that in the current circumstances caused by the pandemic economic forecasters have a lot to be “humble about”.

“I like to compare the dot plot with the exit polls of elections in India. These are discussed intensively. They impact the market for two days, but there is little evidence to suggest that exit polls have a strong correlation with the actual election results,” said Amit Kumar Gupta, head of PMS at Adroit Financial Services.

For Indian investors, while it is important to take note of the shift in the Fed’s timeline for rate hikes, it is also pertinent to remember that Powell himself categorically said that the Fed is nowhere close to even discussing an interest rate hike. “…That will be extremely premature,” Powell said.

The inflation conundrum
We all can see it. Companies are talking about it. And the media is shouting about it. Inflation is here, that’s undisputed. But is it here to stay and should central banks be bothered, that is where there is a lot of dispute.

Prior to Wednesday’s meeting, Fed was certain in its judgement that inflation in the world’s largest economy was “transitory”, meaning, it was only driven by the fact that producers of goods were not able to meet demand as their capacity was being constrained by pandemic-related factors like local restrictions, low availability of labour etc.

For those who track the Reserve Bank of India, this argument has also been used by our own central bank in explaining currently high retail and factory inflation. “With declining infections, restrictions and localised lockdowns across states could ease gradually and mitigate disruptions to supply chains, reducing cost pressures,” RBI had said.

Fed’s Powell also stated the same logic that as the pandemic-related issues with supply ease, the Fed actually expects inflation in the US to fall in 2022 to around 1.9-2.3 per cent from 3.1-3.5 per cent in 2021. However, Powell said as the labour market becomes stronger, long-term inflation should inch higher, but he termed it as “good inflation” as it will signal a strengthening economy.

So will rate hikes hit my portfolio?
There is no black and white answer here. If you believe the Fed and much of what other investors have to say, any interest rate hike in the US going ahead will only be a sign of a strengthening economy instead of an overheated one on which the central bank will slam the brakes.

“It appears to be hugely ironic to me when people fear about interest rates moving up, liquidity getting sucked out and therefore, that being negative for the markets. To my mind, it is a net positive event. It is an endorsement of the fact that the economy is on the right path,” Ajay Tyagi, equity fund manager at UTI MF, said.

The equity market’s reaction to the projection of liftoff in rates today has in its own way answered the question for investors. Market is confident this time around that the buoyancy in the economy and corporate earnings will take any steady rise in interest rate in its stride.

If earnings and economic growth are led by fundamental factors like strong labour market and demand, consumers and companies are often fine to pay a few basis points higher on their loans since they are optimistic of future income just like they were in the golden period of 2003-07.

That said, at home, RBI has stated categorically at its June meeting that any talk of rate hikes is premature since it is focused first on ensuring that economic recovery is strong and durable.

Tapering is coming soon
Even though Powell did dismiss interest rate hikes, he did confirm that the Fed will finally start pondering over the right time to trim down the amount of bonds it will buy. The central bank is currently buying $80 billion of Treasury bonds every month. If the Fed tapers going ahead, it will have implications for the US dollar.

A stronger US dollar due to high demand for the currency could lead to volatility in the currency markets in emerging economies, and that is negative for foreign investors. A depreciating rupee against the greenback, for example, hurts the returns FPIs can make on their Indian investments and therefore, could slow their net inflows to the Indian market.

In the near term, the US dollar’s reaction to the changes in the Fed’s bond buying will increase the volatility for Indian markets. “A strong US economic recovery is good for the global economy and markets. Continuing low rates and comfortable liquidity for next one year should continue to support the risk trade. Rest all is the TV discussion on exit polls,” Gupta said.