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Federal Reserve cuts rates to three-year low after fractious meeting

Michael Parkin

The Federal Reserve has cut interest rates to a three-year low … by a quarter point to between 3.5 to 3.75 per cent. Two of the 12 FOMC members objected to the cut and one wanted a larger cut.—Financial Times, December 10, 2025

The Questions

  1. What is the Fed’s dual mandate?
  2. Which inflation measurement does the Fed watch?
  3. What were the inflation rate and the unemployment rate in the most recent available month to the Fed?
  4. What is the Fed’s interest rate instrument and what does the range 3.5 to 3.75 per cent mean?
  5. What is the real federal funds rate?
  6. What is the Taylor Rule benchmark rate?

The Answers

  1. What is the Fed’s dual mandate?

The Fed’s “dual mandate” is goals of maximum employment and stable prices. The “maximum employment” goal means keeping the unemployment rate close to the natural unemployment rate and minimizing the output gap, the gap between real GDP and potential GDP. The “stable prices” goal means keep­ing the inflation rate low and predictable. Success in achieving this goal also ensures “moderate long-term interest rates.”

  1. Which inflation measurement does the Fed watch?

The Fed regards price stability as being achieved when the core inflation rate, measured as the annual percentage change in the Personal Consumption Expenditure Price Index (PCEPI) excluding the prices of food and energy, is 2 percent a year.

  1. What were the inflation rate and the unemployment rate in the most recent available month to the Fed?

The Bureau of Economic Analysis reported the core PCEPI was 2.8 percent year-over-year in September 2025, the latest release before the Fed’s December interest rate decision.

The Bureau of Labor Statistics reported the unemployment rate was 4.4 percent when the Fed when it made its decision.

Figure 1 shows the data for the most recent six months.

  1. What is the Fed’s interest rate instrument and what does the range 3.50 to 3.75 per cent mean?

The Fed’s monetary policy decision was announced as a 25 percentage points fall in the target range of the federal funds rate to a new range of 3.50 to 3.75 percent.

Supply and demand in the federal funds market—the interbank market for overnight loans—determine the federal funds rate, but the Fed keeps it in the target range by setting three other interest rates, the discount rate, the interest on reserve balances (IORB) RATE and the overnight reverse repurchase (ON RRP) rate.

Figure 2 describes the relationships among these interest rates. The discount rate is the interest rate at which a bank that is short of reserves can borrow from the Fed. The Fed’s Board of Governors sets this interest rate at the upper limit of the federal funds rate target. After the December rate cut, it was 3.75%.

The IORB rate is the interest rate that banks earn on their reserves held on deposit at the Fed. The Board of Governors sets this interest rate at the discount rate minus 0.1 percentage point.

The ON RRP rate is the interest rate earned by a non-bank financial institution when it uses a special facility to deposit reserves at the Fed overnight and get them back the next morning with interest. The FOMC sets this rate at the IORB rate minus 0.1 percentage point.

The effective federal funds rate is 3.64%.

  1. What is the real federal funds rate?

The real federal funds rate is the effective nominal federal funds rate minus the inflation rate, which is 3.64% – 2.8% = 0.84%. The average of the real federal funds rate over the 65 years since 1960 is 1.50%.

  1. What is the Taylor Rule benchmark rate?

The Taylor Rule achieves 2 percent inflation and full employment by setting the federal funds rate to neutral at 4 percent a year. A 1-percent deviation of the inflation rate from the target and a 1-percent deviation of real GDP from potential GDP moves the federal funds rate up or down by 0.5 percent. In December 2025, the Taylor Rule sets the federal funds rate at 4.15% or a target range of 4.00 to 4.25%.

So, the Taylor Rule agrees with the two FOMC members who voted against the cut in December 2025.

Now take a short quiz to ensure you understand what you just read.

Answer the following questions to check your understanding of the story.

How does the discount rate stop the federal funds rate from rising above the upper limit of the target range?

The discount rate stops the federal funds rate from rising above the upper limit of the target range because _____________.

Wrong! - Don’t banks always borrow reserves overnight at a rate lower than the discount rate? When more and more banks become short in reserves, that the borrowing pressure pushes the federal funds rate toward its upper limit, and the Fed’s role as the lender of last resort comes into play.

Well Done! - A bank will not borrow reserves overnight from another bank at a rate higher than the federal funds upper limit when it can get them from the Fed at exactly that upper limit.

Over what range of interest rates would banks actually make overnight loans to each other after the Fed sets the federal funds target range at 3.50% to 3.75%?

Wrong! - Doesn’t IORB (3.65%) and the discount rate (3.75%) set the floor and the ceiling of the federal funds target range, respectively? You are asked to identify a range of interest rates.

That's Right! - A bank would not lend reserves to another bank at below 3.65% when Fed is ready to offer 3.65% (IORB) for those reserves and will not borrow reserves at above 3.75 %, when it can get them from the Fed at 3.75% (discount rate).

Why does the Fed watch a core inflation rate instead of the overall inflation rate when making monetary policy decisions?

The Fed watches a core inflation rate because ____________.

Wrong! - A core inflation rate is less volatile and a better measure of price stability. Both overall and core inflation rates are published monthly and available to the Fed for monetary policy decisions. Why would monetary policy not influence prices of food and energy?

Correct! - The Fed watches core inflation because it excludes food and energy prices, which are prone to temporary shocks, such as adverse weather and OPEC’s decisions, that would dissipate on their own even without Fed intervention.

How does the dual mandate ensure moderate long-term interest rate?

A dual mandate ensures that the ____________, which in turn ensures moderate long-term interest rate.

Wrong! - Expected short-term interest rates are high if expected inflation is high or an inflationary gap is huge and low if expected inflation is low or a recessionary gap is huge. Are these situations likely under a dual mandate? Do interest rates prevailing in the markets today determine the long-term interest rates?

Good Job! - A dual mandate ensures stable inflation and a stable economy which means expected short-term rates are neither high nor low. The long-term interest rates, an average of expected future short-term rates plus a risk premium, are also moderate.

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