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Net Net: Promoting innovation and managing change

Fedspeak 3.0: The 'dot plot'


If you think Federal Reserve speak can get arcane and obtuse, you haven't seen anything yet.

For years investors have had to acclimate themselves to discussions about quantitative easing—or QE—along with zero-bound interest rates and the financial repression that has underscored central bank policy for the past six years.

Now, get ready for the "dots."

We first heard discussion about the dreaded dots back in March when some Fed-watchers noticed an upward drift in the—wait for it—"dot plot" that accompanied the end-of-quarter economic projections the Fed's Open Market Committee statement. The move sent a tremor through the markets as some worried the Fed was on a faster-than-expected course toward raising interest rates.

And that's pretty much what the dots do—they display expectations from individual FOMC members about the direction of interest rates, which in turn will help determine the direction of markets. (For a display of the dots in all their glory, see above from the Fed's last statement or click here, then scroll down to the second chart on the third page.)

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That part about individual expectations is important, though. While each Fed member has his or her own estimates about economic growth and what rate policy should be, the board almost always moves in unison, something unlikely to change with the addition of three new board members, including vice chairman Stanley Fischer. And this board remains in a decidedly dovish stance.

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A team from Bank of America Merrill Lynch including Michael Hanson, Priya Misra and Ian Gordon explain the dot deal well:

"Of all the attempts at greater transparency by the Fed in recent years, the dot plot of policy-rate projections is the most beguiling. It is not a formal policy tool: voters and non-voters alike record a set of dots; they are submitted before the meeting; they are not subject to consensus agreement; and they reflect each participant's own interpretation of 'appropriate policy.'"

The BofAML group warns not to make too much out of the dot plot, yet fears the market may do just that, particularly if the sum total moves at all toward a hawkish rate stance.

"As in March, there is once again the risk that the market may read a hawkish message into the dots — despite what is widely expected to be a status quo meeting with yet another small taper of ($10 billion) and unchanged forward guidance language. There are two main sources of uncertainty around the dots at the June FOMC meeting: new voters and new forecasts. The changes within each should largely be offsetting, but the dispersion of the dots could well increase."

Being that there's little question the Fed will continue to unwind its monthly bond-buying program, a flurry of notes over the past several days from economists and strategists shows that focus has turned to the dots and their implications for interest rates.

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Generally speaking, Wall Street expects the Fed, based on developments since the March meeting, to reduce its projections for the unemployment rate and gross domestic product—once again the Fed finds its GDP estimates too optimistic—while increasing its inflation expectations.

The unemployment and inflation projections moving to a more bullish basis would be the main drivers behind expectations for higher rates, as Deutsche Bank economists Carl Riccadonna and Joe LaVorgna explained:

"The fact the unemployment rate will reach the FOMC's projected range of full employment much sooner than previously expected means the fed funds "dot plot" could potentially show higher rates in both 2015 and 2016 compared to previous expectations. ...

"The evolution of policymakers' economic forecasts is critical, because it could foreshadow an eventual shift in the 'dot plot' toward a more aggressive (i.e. earlier and/or faster) tightening cycle."

However, Sharon Stark, markets and fixed income strategist at D.A. Davidson, believes the Fed in fact will look to soothe markets about the pace of rate hikes, with the possibility that the dots actually could move lower:

"The March forecast showed the greatest number of members expecting a 1.0 percent borrowing rate by the end of 2015. We believe this could move to 0.75 percent for 2015, and a long range target rate to 3.75 percent from 4.0 percent in the previous forecast. These may seem like minor adjustments, but portfolio managers have lengthened durations in anticipation of a longer period of Fed accommodation and delay in the first rate hike to the second half of 2015."

Even if there is a slightly upward skew to the dots, it probably would be for good reasons and not indicative that the Fed is willing to tighten anytime soon, according to an analysis by Goldman Sachs economist Sven Jari Stehn:

"These upgrades would, by themselves, suggest that the funds rate projections (or 'dots') might drift up and that the press conference might accordingly tilt towards the hawkish end. Three considerations, however, would point to a more neutral message. ...Taken together, we therefore expect a broadly neutral message at the upcoming meeting. Our financial conditions rule would suggest that such an outcome would be desirable, as highly accommodative financial conditions remain appropriate to support the ongoing recovery."

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By CNBC's Jeff Cox