After its policy making committee met this week, Fed chair Jay Powell told us that while rates would remain steady, a September cut was a possibility.
We could look to their “dot plots” for more information.
Federal Reserve Dot Plots
To know how the Federal Reserve feels about short-term interest rates, we can look at their dot plot. The dots display what members believe is the most appropriate rate for achieving their inflation and employment goals. The key word is “appropriate.”
In a 2016 talk, former Fed Chair Ben Bernanke warns us that the dot plot (formally known as SEP, the Summary of Economic Projections) is not a policy commitment nor is it an economic policy forecast. Since it expresses what members believe is “appropriate,” it reflects the “range of sentiment.”
This dot plot from 2016 shows the interest rate trend they thought was appropriate. I’ve drawn the pink arrows and note:
2016
Now, reversing the trend, this week’s dot plot shows the declining interest rate they think is appropriate. As above, I’ve added the pink arrows and note:
2024
Knowing the “range of sentiment,” we can better understand where Fed policy is trending.
Our Bottom Line: The Fed Funds Rate
So yes, a dot implies what policy should be. But HOW? What are their policy tools?
To move interest rates, the Fed targets a fed funds rate–an overnight bank-to-bank lending rate (the reference point for all other interest rates). It’s a target range because they cannot actually mandate what the rate should be. The main tool is interest on reserves and then also overnight purchases and sales:
- Reserve Interest Rates: Through the interest that the Fed pays banks on their reserve balances (IORB rate), they influence the fed funds rate. When the Fed raises its interest rate on reserves, then a bank has the incentive to keep more in reserve. So banks lower the supply of loanable funds and interest rates trend upward. The opposite happens when the interest rate on reserves drops. Then banks have the incentive to keep less and loan more.
- Overnight Purchases and Sales: Similar to the IORB, again there is a target range for fed funds. But this time, the Fed buys and then sells a financial institution’s securities. The price difference implies an interest rate. Establishing a floor, the tools are called repo and reverse repo operations (RRPs).
Through the IORB and RRP, the fed funds rate has ascended beyond 5%:
Before concluding, we should note two other tools. When banks borrow money from the Fed (which they hesitate to do) the interest is a discount rate. Predictably, what a bank pays to borrow establishes a ceiling for its own rate. And then we should add Jay Powell said the Fed would continue diminishing its balance sheet by selling securities it had accumulated through Quantitative Easing. When the Fed sells securities, it “sinks” (sell, sink) the economy by reducing banks’ available funds.
My sources and more: My goal today was to explain the “dot plot.” For the details, this Ben Bernanke talk came in handy as did these articles, here and here. (I was horrified that my AI Google explanation was outdated. Based on what is called ample reserves, the Fed switched tools in 2008.)
