The figure shows that in all cases, the estimated longer run steady state level of interest rates is about 2.5% (and, as expected, very close to the average dot for the longer run). Furthermore, the slopes of the curves appear similar, implying that the speed of adjustment to the longer run is broadly similar. Finally, the midpoint of the adjustment appears to vary. In June 2020, half the adjustment was expected to be achieved in 36 months, rising to 60 months in September the same year. It then started to fall, reaching a little less than 24 months by December 2021.
The longer-term interest rates, speed of adjustment and distance to the midpoint are all estimated directly when fitting the curves. Speed is here measured by the number of years it takes to move from ¼ of the adjustment to ¾, and the midpoint is measured by the number of years it takes for ½ of the adjustment to the longer-run level of interest rates to be reached.
As already seen, the longer-run interest rate is estimated to be about 2.5% and the speed of adjustment about 1.5 years, except in December 2020 when it is estimated to be 1 year. By contrast, the estimated number of years to the midpoint varies between 1.5 and 5 years.
The determinants of the changing curves
Having estimated the three variables that determine the shape of the curve, it is natural to ask how they vary with the state of the economy. A simple way to do so, is to compute the correlations between these three quantities and the rates of inflation and unemployment the month before the FOMC meetings (to account for reporting lags).
While most of the correlations are insignificant, there is a strong negative (-0.76) and significant correlation between PCE inflation and the time to the midpoint of the adjustment. With inflation below 2%, the dot plots of June 2020 – March 2021 signalled no interest rate increase for at least the coming three years. However, as inflation rose increasingly above 2%, the dot plots of June – December 2021 signalled that interest rate adjustments were imminent. Thus, the Fed’s thinking in this period about when to start raising interest rates appears largely determined by inflation.
Conclusions
With the FOMC ready to start the process of raising interest rates, market attention will focus on the dot plots associated with future FOMC meetings. The evidence to date suggests that the federal funds rate is likely to be changed imminently and eventually plateau at 2.5%, and that the Fed is reactive to changes in the inflation outlook. Whether this will continue to be the case remains to be seen.
