Why has the US Federal Reserve cut rates again?
The US Federal Reserve lowered its benchmark federal funds rate by 0.25 percentage points to a range of 3.5%–3.75% at its December meeting, marking its third consecutive cut and the lowest level in three years1. The primary driver of the cut was a weakening labour market, with job creation slowing and unemployment rising to 4.4% in September, even as inflation remains above the Fed’s 2% target at 2.8%2.
Fed Chair Jay Powell stressed that the economy faces “downside risks” to employment, prompting the central bank to act pre-emptively rather than wait for additional data delayed by the recent government shutdown. However, Powell also signalled a high threshold for further cuts, noting that rates are now “within a broad range of estimates of neutral value.” The median forecast shows officials expect only one more cut in 2026, though views vary widely, from calls for multiple reductions to projections for hikes.
Importantly, three of the twelve voters on the Fed’s policy-setting committee disagreed with Powell’s decision, the highest level of opposition since 2019, underscoring the depth of debate over how best to balance the Fed’s dual mandate of price stability and full employment. Governors Austan Goolsbee and Jeffrey Schmid both backed a hold and argued that inflation remains stubborn and warned that additional easing could jeopardise progress on controlling prices. In contrast, Governor Stephen Miran advocated for a larger cut, citing mounting evidence of labour market weakness. These opposing positions highlight the Fed’s delicate balancing act between supporting growth and containing inflation.
While markets welcomed the move, pushing the S&P 500 close to record highs, the committee’s disagreements underline lingering uncertainty about the policy path ahead.
Why Is the Reserve Bank of Australia (RBA) holding or tilting hawkish?
In stark contrast, the RBA has held its cash rate at 3.6% at its December meeting and signalled that the next move could be up, not down3. Governor Michele Bullock warned that inflation risks have “gone to the upside,” with headline inflation surging to 3.8% in October, well above the RBA’s 2–3% target band4. Strong consumer spending, resilient employment, and robust economic growth have compounded these concerns.
Markets now price in two to three rate hikes in 2026, with a one-in-three chance of an increase as early as February. This hawkish pivot follows three cuts earlier in the year, which the RBA fears may have loosened policy too much. Bullock’s message was clear: “I don’t think there are interest rate cuts on the horizon for the foreseeable future.”
Australia’s divergence from global peers partly reflects structural factors. Variable-rate mortgages make monetary policy more potent domestically, meaning smaller moves can have outsized effects. Still, with fiscal spending elevated and housing activity strong, the RBA appears determined to prevent inflation from becoming entrenched.
Where else are we seeing divergence?
The US and Australia are not alone in charting different courses. Japanese investors are preparing for another rate hike, with the Bank of Japan (BoJ) expected to raise its policy rate from 0.50% to 0.75%, the highest in 30 years, at its December meeting, in response to persistent inflationary pressures5. This marks a dramatic shift after decades of near-zero or negative rates. Rising Japanese government bond (JGB) yields, now near 2% on 10-year maturities, signal the end of an era of ultra-cheap yen funding.
This matters because Japan has long been the epicentre of the yen carry trade, where investors borrow in yen at low rates to invest in higher-yielding assets abroad. Estimates put the size of this trade in the hundreds of billions, if not trillions, of dollars6. As Japanese rates rise, the economics of the carry trade weaken, potentially triggering capital repatriation and volatility across global markets.
Meanwhile, the European Central Bank (ECB) is leaning hawkish too. Swap markets now imply a small rate increase in 2026, reversing earlier expectations of cuts7. Stronger-than-expected economic data and sticky services inflation have bolstered the case for holding or even raising rates. Similarly, Canada is signalling a pause after multiple cuts, and the Bank of England is nearing the bottom of its easing cycle.
How does policy divergence impact currencies and markets?
Historically, interest rate differentials are a major driver of currency moves. When the Fed tightened aggressively in 2022 while the BoJ held steady, the yen weakened sharply against the USD8. Today, the pattern is reversing: the Fed is cutting while the BoJ and RBA tilt hawkish. Yet the yen remains near multi-decade lows in trade-weighted terms, defying textbook logic. Analysts cite Japan’s cautious pace of normalisation and concerns over fiscal sustainability as factors dampening yen strength.
For the Australian dollar, divergence from the Fed typically supports appreciation. Previous episodes of RBA-Fed policy mismatch have coincided with meaningful AUD gains, benefiting importers and sectors correlated with currency strength. However, global risk sentiment and commodity prices will also play a role.
Bond markets are another pressure point. Rising JGB yields could prompt Japanese investors, major holders of US Treasuries and other foreign bonds, to bring capital home, pushing up global yields. Equity markets, buoyed by Fed cuts, may face headwinds if bond volatility spikes.
While the Fed may pause after its latest cuts, the RBA and other hawkish central banks remain focused on inflation, ushering in a period of policy divergence that could reshape global capital flows and market dynamics in unpredictable ways.
References
- Financial Times, “Federal Reserve cuts rates to three-year low after fractious meeting,” 11 December 2025
- The Wall Street Journal, “Fed cuts rates again, signals it may be done for now,” 10 December 2025
- Australian Financial Review, “Markets bet on several RBA rate rises in 2026,” 10 December 2025
- Australian Financial Review, “Bullock puts nation on notice about rate rises,” 9 December 2025
- Financial Times, “Bank of Japan governor says economy has weathered Donald Trump’s tariffs,” 9 December 2025
- Financial Times, “How will a rise in Japanese interest rates affect global markets?” 4 December 2025
- Financial Times, “Investors increase bets on ECB rate rise in threat to dollar,” 9 December 2025
- Financial Times, “Chart of the Week: The yen-yield break-up,” 6 December 2025