Two weeks ago I said that I thought that a slowdown in employment growth in the US gave the Federal Reserve room to cut rates. And what we've seen last week is a Fed meeting and the Fed has cut rates.
But what I also learned from last week's meeting by the Fed is something that echoed what Andrew Hauser was telling us when he was here doing a presentation for us. That was that there really is no general theory of the action of central banks. What central banks actually do is they look at the data as it is presented to them at each meeting and then make the decisions.
And I said that we'd see what the impact of that data was from looking at the Summary of Economic Projections, which was released after the Fed meeting. The Summary of Economic Projections shows the combination of the views of all of the people who are on the Federal Reserve Board sitting on Constitution Ave in DC, plus all the independent Presidents of the Federal Reserve, whether or not they were also part of the committee at the time.
What we see is that the actions of the Fed last week were very much how the data had changed since the middle of the year. We can see how the data changes and how it affects their views by looking at the difference between the outlook that was in the June Summary of Economic Projections compared to those for September.
In the September economic projections last week, the first thing was that the expectation of GDP growth for the year fell from 2.1% to 2%. More importantly than that, the outlook for unemployment at the end of the year rose from 4% to 4.4%. I have explained before how when unemployment goes up in our model for the Fed funds rate or for the Australian cash rate, that puts downward pressure on where you think rates should be in the future.
What also happened was that the expectation for inflation in this year fell. So the PCE deflator, which runs about 50 basis points lower than the CPI, instead of an expectation of 2.3% for the year, their expectation fell to 2.1%. That's equal to a CPI of about 2.6% for the full year.
Interestingly, the RBA doesn't expect to get into that range until 2026. At least that's what Michelle Bullock was talking about on Tuesday. For core PCE, the Fed expectation fell from 2.8% to 2.6%, which is similar to 3.1% on the CPI. As a result of that, because of the increase in unemployment which they expected at the end of the year and the fall in inflation that they expected at the end of the year, their expectation of where the Fed funds rate would be at the end of the year changed dramatically as a result of the meeting.
Prior to this meeting, they expected in the June summary of economic projections that the Fed funds rate at the end of the year was 5.1%, which means by the end of the year you're going to get a rate cut of 25 basis points. Now in what they released last week because of that increase in unemployment and fall in expected inflation, they thought that the Fed funds rate at the end of the year would end at 4.4%. That's a 100 basis point rate cut including what they've just done.
Now we had 50 basis points last week. So what we would expect would be another 25 basis points at the November meeting and another 25 basis points at the December meeting to take the total rate cut to 100 basis points.
So in answer to the question, what is the Fed going to do now?
The Fed is going to give us two more rate cuts, one next month and one the year after. And those rate cuts will continue next year. But exactly how big and when? We don't know, but it's important to understand that those cuts in the Fed funds rate are only possible because at the same time, the Fed is continuing Quantitative Tightening. This means they're selling off the bond holdings that they acquired.
They acquired up to $9 billion worth of bonds and other assets to reflight the US economy during the pandemic. And they've been running those assets down at around a trillion dollars a year. Now those assets have fallen to about $7 trillion. We expect they'll continue to run off those assets at least down to $4 trillion. They could go even lower.
That means it's a trillion dollars a year of Quantitative Tightening that offsets the cuts in rates. It generates a basis for the reduced reduction in the money base, which lets the Federal Reserve cut rates.
So it's that combination of things. But it's important if you want to compare the situation that the Federal Reserve is now in to where the RBA is now in, we go back and look at those. That's where the trimmed mean is, and where they expect inflation to be. The trimmed mean in the most recent level of the trimmed mean in the US is for a trimmed mean of 3.2%.
That gives us a model for our equilibrium level including the other components including unemployment, including inflation and inflationary expectations.
This gives us a model estimate for the Federal Funds rate right now of 3.1%.
So there's plenty of room further for the Fed funds rate to fall over the next year.
The problem is with when we do the RBA model, inflation is higher.
Australian core inflation is 60 basis points higher now than it is in the US. That means that the equilibrium level of our cash rate model in Australia is 3.9%. That is only slightly below the 4.35% where the cash rate currently is.
Falling inflation in the US gives it a low equilibrium level for the Fed funds rate model and allows the Fed to cut.
But inflation isn't falling in Australia. That means that our cash rate model estimate is significantly higher.
So therefore it's far more difficult for the RBA to cut than it is for the Fed to cut.
Again, quite dramatic changes in US unemployment expectations.
Unemployment expectations rose from 4% to 4.4%.
But the end of the year the PCE deflator fell with core PCE now expected to be 2.6%, equivalent to 3.1% in the CPI.
And the expected Fed Funds rate at the end of the year fell from 5.1% to 4.4%.
All of this means that the cuts that we've got from the Fed will be followed up by further cuts this year and next year.
Unfortunately inflation in Australia is still too high for the RBA to follow.
