Bloomberg columnist Clive Crook writes that, given the Federal Reserve's communication failures in the most recent December meeting, the review of the Federal Reserve's monetary policy framework should seriously consider the idea of eliminating the "dot plot."

The Federal Reserve is about to begin a review of "monetary policy strategy, tools, and communication." This month's rate cut and the market reaction to it highlight the need for such a review.

Looking back at the Federal Reserve's recent policy decision, this decision was composed of three main parts. First, the Federal Reserve lowered the policy interest rate by 25 basis points, bringing it down to a range of 4.25%-4.5%. Second, it stated that progress in curbing inflation has been slower than expected. Third, it anticipates that the rate cuts next year will be less than previously expected. Investors viewed this policy mix as a "hawkish shift"—indicating that despite the rate cut, the policy is tightening—and sold off Stocks.

Crook commented that it seems the communication of the Federal Reserve has failed. He stated that although he greatly admires the progress Fed Chairman Powell and his colleagues have made towards a "soft landing," the way the Federal Reserve signals policy changes and implements those changes is making an already difficult task even harder.

Prior to the December policy meeting, the financial markets had almost completely priced in the expectation of a 25 basis point rate cut by the Federal Reserve, largely due to the information transmitted earlier by the central bank. Therefore, investors paid less attention to recent data that showed inflation progress was slower than expected.

However, in the recently concluded meeting, the Fed's summary of new economic forecasts raised the core PCE inflation (the Fed's preferred inflation indicator) for 2024 from 2.6% to 2.8%; lowered the unemployment rate from 4.4% to 4.2%; and significantly raised the forecast for USA GDP growth from 2% to 2.5%.

In light of these expected adjustments, according to the Taylor rule, the Fed should have kept interest rates unchanged at the December meeting, rather than lowering them. Crook believes one of the reasons the Fed ultimately took action was that since the market had already priced in the expectation of a rate cut, pausing the rate cut would effectively tighten the policy.

Note: The Taylor rule is one of the commonly used simple monetary policy rules proposed by Taylor in 1993 based on actual data from the USA. The Taylor rule describes the criteria for how short-term interest rates adjust in response to changes in the inflation rate and output. Economists have long been divided on the pros and cons of using such rules for automatic policy formulation, but most agree it should be part of the discussion on how to set interest rates.

Before the Fed's December policy meeting, changes in data already showed signs that the Fed might pause rate cuts. In the press conference following the announcement of the rate cut, Powell was asked why the Fed decided to cut rates. However, his answer was not very clear. He stated that the Fed wants the policy rate to be closer to what is referred to as the neutral rate, which neither restricts nor stimulates demand. But his response sidestepped a question: if inflation might stabilize above the 2% target, why assume the policy rate is too tight? When asked for his current estimate of the neutral rate, the chairman smiled and said that, in reality, no one knows.

The Fed likely expects future inflation and employment data to return to the anticipated track, so why not wait until that day arrives before further loosening policies? Meanwhile, the new economic forecast summary shows that even considering potential rate cuts this year and next year, the core PCE inflation rate is expected to be 2.5% by the end of 2025, rather than the previous estimate of 2.2%; for the end of 2026, it is expected to be 2.2%, not 2%.

Crook stated he believes his colleagues correctly interpreted the Fed's trade-off: considering market expectations, keeping rates unchanged effectively amounts to tightening - although the Fed might prefer to pause rate cuts, it believes current tightening of policy is unwise.

This means that if investors had not previously priced in a rate cut, the Fed will keep the policy rate unchanged at the December meeting, thereby aligning better with the latest data. However, why is the expectation of a rate cut inconsistent with the latest data? At least part of the reason is that they are too focused on the Fed's previous economic forecast summary, which indicated another rate cut by the end of the year.

Such confusion continues. The new forecasts tell investors to expect a policy rate of 3.9% by the end of 2025, rather than 3.4%. Not to mention that this 'hawkish' shift has already unsettled investors, more importantly, this latest policy forecast is likely to conflict with the recommendations of the Taylor rule at some point again, just like last time, and again push the Fed away from what it believes the data implies for the path of interest rates - cutting rates or raising rates as circumstances dictate.

Of course, it is a good thing for investors' expectations to align with the intentions of the Federal Reserve. However, the market should also pay attention to the upcoming data and its implications for policy, rather than being overly concerned with the Fed's predictions based on outdated information.

Crook believes that one way to solve this problem is to reform the economic forecast summary, including the elimination of the 'dot plot' that forecasts future interest rates. The 'dot plot' has always been easily misunderstood, to the point that the Federal Reserve repeatedly insists that the 'dot plot' is not a plan or commitment, but merely a forecast. In fact, it is not even a prediction in the usual sense because it does not represent a consensus; it is simply individual officials making what they deem to be 'appropriate' predictions based on their differing, and possibly incompatible, beliefs about what is going to happen.

For the Federal Reserve, no matter how well their policy predictions are designed, strictly adhering to these predictions is not the best way to align market expectations with new data, as complexities and unexpected events frequently occur.

In summary, Crook's viewpoint is that the Federal Reserve should focus more closely on the data obtained rather than on plans and commitments regarding the interest rate path. If the Fed takes one or two steps in this direction, particularly by discarding the 'dot plot', it will benefit greatly.

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