How low can the Fed go?

How low can the Fed go? We think that the effective Fed Funds rate will fall to 3.85% by April 2025.

I have spoken before about the Reserve Bank of Australia and the Federal Reserve. The easiest way to understand what central banks are doing is to look at employment growth. When employment growth is higher than the long-term median, central banks tend to either hold rates where they are or to tighten. When employment growth is lower than the long-term median, central banks tend to cut rates.

So, today we will look at where things are and explain why the Reserve Bank of Australia held rates where they were, and why the Fed cut rates by 25 basis points. In the first slide, what you see is the rate of growth of employment in Australia. The long-term median is 2.3%, but the current rate of employment growth is 2.97%. So, it is above the long-term median, and that is strong. This is due to support from the federal government employing people in the public sector, but as the Deputy Governor of the Reserve Bank says, these are still real jobs. For that reason, the RBA is holding rates steady until inflation falls, or unemployment rises. This means that if unemployment rises, we can expect inflation to fall in the future.

The Federal Reserve, on the other hand, has a different story. When we look at the rate of growth of employment in the US, the level of actual employment year-on-year growth is 1.38%. Employment growth has been slowing as we go through the year, and it is lower than the long-term median of 1.6%. At the previous meeting, the Fed cut by 50 basis points. I had forecast at that time that it would continue cutting rates in November and December this year, and we just recently saw a 25-basis point cut in November.

At the Fed Reserve press conference after the Fed statement was released, Jay Powell said that geopolitical risks to the US economy were elevated. Still, he said that when we look at the US economy, it is very sound, with sturdy growth, a strong labour market, and inflation coming down. When he was asked about the US national debt, Powell said the national debt is sustainable, but the path of the growth of that debt is unsustainable. In other words, the size of the US deficit is too large. If the growth in US Debt continues, Powell warned, it will be a threat to the economy.

Since the election of Donald Trump, we have seen that there is a considerable number of supporters in the House of Representatives of proposals to cut spending. Suggestions for cuts could come from figures like Elon Musk, while Robert F. Kennedy Jr. has advocated closing whole sections of the Food and Drug Administration. These budgetary savings could help reduce the size of the budget deficit, but we will have to wait and see how it plays out.

Powell currently holds his appointment until May 2026. He was asked twice during the press conference whether he would resign. He replied with a simple "no" when asked if he would resign if President Trump asked him to resign. When asked again if he or other board members could be fired by the President, Powell said, "No, it is not permitted by law." So, unless Powell is impeached by both houses of Congress-which is incredibly unlikely-he will certainly serve his term through 2026.

When a reporter asked Powell about the neutral rate, or the natural rate of interest, he said that it is difficult to pinpoint. The natural rate was defined in the 19th century by Swedish economist Knut Wicksell. Powell acknowledged that we will eventually know the neutral rate "by its works." Based on our models, we believe the neutral Fed funds rate is 3.85% right now, considering where US employment, inflation, and inflation expectations stand in the US. We think the Fed funds rate will continue to fall until it reaches that level of 3.85%.

As I predicted, the Fed cut rates by 25 basis points in November, bringing the effective funds rate down to 4.6%. We believe there will be another rate cut in December, bringing the effective Fed funds rate to 4.35%, which will be equal to the Australian cash rate. We do not think rates will stop there. We expect another rate cut on January 28th, bringing the Fed funds rate to 4.1%. Following that, there will be a Fed meeting on Saint Patrick's Day, where we expect another rate cut, bringing the Fed Funds rate to 3.85%. This is where our model suggests the neutral Fed funds rate should be. Any changes to that forecast will depend on the direction of inflation, unemployment, and inflation expectations in the US. If inflation goes down, unemployment rises, or inflation expectations decrease, rates could be cut further.

Still for now, we think the bottom of the Fed funds rate will be 3.85% by March next year. Interestingly, the Fed is not just cutting rates; it is also doing quantitative tightening at a rate of $25 billion per month. That means the size of the Fed's balance sheet is falling by $25 billion each month.

At that rate, it will take 10 years for the Fed's balance sheet to fall back to the $4 trillion it was at in 2019. So, while the Fed may continue cutting rates next year, quantitative tightening is likely to continue for many years to come.