Interpreting Survey-Based Federal Funds Rate Forecasts: How Accurate Are They in Reflecting Market Expectations?

Abstract

What the market thinks is most likely to occur is not necessarily what the market expects to occur. This note explains why most of the surveys of federal funds rate outlook deviate substantially from the true market expectation, especially as the forecast horizon increases. Surveys often ask participants for their forecast of the “most likely outcome”, which differs from the expected outcome. The latter has to take into account not only the most likely outcome but also those less likely to occur, that is, weighing all the possible outcomes by their probabilities. In a tightening (easing) cycle, the most likely outcome tends to be higher (lower) than the expected outcome, leading to a false impression that the Fed will tighten (ease) more than what the market expects. For instance, the latest surveys suggest market participants believe there will most likely be another two to three rate hikes by the end of 2020, but in fact they expect the rate to stay basically unchanged. As the probability distribution gets more skewed to the left in progressive surveys, the “most likely outcome” forecast is increasingly subject to a greater downside risk. This, coupled with the relatively small increase in the probability at the high end of the forecasting range, means that market participants can progressively see the light at the end of the tunnel, that is, the end of the tightening cycle.