The magnitude of recent market reactions to the Fed’s comments makes it clear that communication between the Fed and markets isn’t working: the market is too focused on the Fed—and not enough on the economy. One solution? The Fed should stop giving forward guidance about rates—and eliminate the “dot plot.”

Not long ago, forward guidance was a useful tool for the Fed. It was arguably the primary tool of monetary policy when the target rate was at zero—even more than quantitative easing. But with rates now well off the zero boundary and heading higher, it seems that forward guidance has become counterproductive.

The Two-Way Street Between Policymaking and the Market

In an ideal world, communication between the Fed and the market would be a two-way street. The Fed would describe its outlook for the economy—not make interest-rate projections. The market would do its work of probability-weighting the path of interest rates based on economic expectations. Incoming data would adjust those probabilities, giving the Fed valuable information that could inform its monetary policy decisions.

In this world, the market can do much of the Fed’s work for it. If incoming data were strong, interest rates would rise and financial conditions would tighten. If incoming data were weak, rates would fall and financial conditions would ease—all without the Fed having to do anything at all. Asset prices adjust to a changing economy every day, as probability estimates change. This back and forth makes both markets and the economy more stable.

Taking Fed Watching to a New Level

The last few weeks have made one thing clear: Today’s trouble is that the market, by and large, isn’t responding to economic data. Instead, it’s trading the Fed, resulting in much larger and faster adjustments. That’s because the Fed, unlike the economy, doesn’t generate new information daily.

The result is that adjustments have become sharper and more painful than they need to be—a logical consequence of providing forward guidance. The market has gotten used to waiting to hear the Fed’s spin on new information instead of making up its own mind. Then the market adjusts, all at once instead of gradually.

The Fed should look to the market for a diverse, robust set of economic analysis and expectations. Today, we fear that the Fed looks into the market and sees only a distorted reflection of its own views. Asset prices reflect the market’s take on what the Fed is saying, rather than what the economy is doing. That disconnect robs the Fed of a crucial analytical tool, and it makes markets choppier and more volatile than the underlying economy is.

The Fed’s insistence on providing explicit forward guidance about the path of rates—including the iconic dot plot of board members’ interest-rate expectations—leads to the market hanging on the Fed’s every word, rather than on economic developments. We think this situation could become more problematic in the future.

What happens when it isn’t clear whether the next rate move is likely to be a hike or a cut? How will the market react when the dot plot shows some members expecting hikes and others cuts? What if most members expect cuts? Will that mean the Federal Open Market Committee is forecasting a recession? The potential volatility around these issues should give the Fed pause.

Saying Goodbye to the Dot Plot

Doing away with forward guidance and the dot plot would undoubtedly cause some short-term volatility. After all, a generation of market participants is used to the Fed’s hand-holding; without it, they’ll have to adjust to a brave new world.

But we think it’s a price worth paying if it normalizes the relationship between the Fed and the market. The Fed may be aware of this already: it recently announced a plan to review how it communicates with the market, and the forward guidance it provided at this week’s meeting was less precise than in the past.

That’s a good start. But we think the Fed should go further and force the market to think for itself again.

If and when the Fed finds itself back at the zero bound, there’s no reason it can’t return to providing forward guidance, as it did in this cycle. But running the same playbook in today’s economy could be doing more harm than good.

Strong relationships are built on listening and mutual communication. In our view, if the Fed would talk less and listen to the markets more, the conversation would be more productive—and cut down on the volatility.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.

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