In recent days, several people have asked for my updated view on the Federal Reserve and the Fed funds rate, as well as the outlook for the Australian cash rate. I thought I’d walk through our model for the Fed funds rate and explain our approach to the RBA’s cash rate.
It’s fascinating to look at the history of the current tightening cycle. The Fed began from a much higher base than the RBA, and in this cycle, they reached a peak rate of 535 basis points, compared to the RBA’s peak of 435 basis points. For context, in the previous tightening cycle, the RBA reached a peak of 485 basis points.
The reason the RBA was more cautious this time around is largely due to an agreement between Treasurer Jim Chalmers and the RBA. The goal was to implement rate increases that would not undo the employment gains made in the previous cycle. As a result, the RBA was far less aggressive in its approach to rate hikes.
This divergence in peak rates is important. Because the Australian cash rate peaked lower, the total room for rate cuts and the resulting stimulus to the economy is significantly smaller than in previous cycles.
The Fed, on the other hand, peaked at 535 basis points in August last year and began cutting rates shortly after. By the end of December, they had reduced the rate to 435 basis points, where it has remained since.
Recent U.S. labour market data shows a clear slowdown. Over the past 20 years, average annual employment growth in the U.S. has been around 1.6 percent, but this fell to 1.0 percent a few months ago and dropped further to 0.9 percent in the most recent data.
This suggests that while the Fed has successfully engineered a soft landing by slowing the economy, it now risks tipping into a hard landing if rates remain unchanged.
Fed Funds Rate Model Update
Our model for the Fed funds rate is based on three key variables: inflation, unemployment, and inflation expectations. While inflation has remained relatively stable, inflation expectations have declined significantly, alongside the drop in employment growth.
As a result, our updated model now estimates the Fed funds rate should be around 338 basis points, which is 92 basis points lower than the current rate of 435. This strongly suggests we are likely to see a 25 basis point cut at the Fed’s September 17 meeting.
There are two more Fed meetings scheduled for the remainder of the year, one in October and another on December 10. However, we will need to review the minutes from the September meeting before forming a view on whether further cuts are likely.
Australian Cash Rate Outlook
Turning to the Australian cash rate, as mentioned, the peak this cycle was lower than in the past, meaning the stimulatory effect of rate cuts is more limited.
We have already seen three rate cuts, and the key question now is whether there will be another at the RBA’s 4 November meeting.
This decision hinges entirely on the September quarter inflation data, which will be released on 29 October 2025.
The RBA’s strategy is guided by the concept of the real interest rate. Over the past 20 years, the average real rate has been around 0.85 percent. Assuming the RBA reaches its 2.5 percent inflation target, this implies a terminal cash rate of around 335 basis points. Once that level is reached, we expect it will mark the final rate cut of this cycle, unless inflation falls significantly further.
So, will we see a rate cut in November?
It all depends on the trimmed mean inflation figure for the September quarter. If it comes in at 2.5 percent or lower, we expect a rate cut. The June quarter trimmed mean was 2.7 percent, and the monthly July figure was 2.8 percent. If the September figure remains the same or rises, there will be no cut. Only a drop to 2.5 percent or below will trigger another move.
We will have a much clearer picture just a few days before Melbourne Cup Day.
