As is always the case, considerable controversy surrounds what the Federal Reserve should do regarding the federal funds target rate for the remainder of the year. Many suggest the Fed should be aggressive by lowering its target at each of the remaining decision points (Oct. 29 and Dec. 10).

This would signal market participants to lower their interest rates—particularly Treasury, commercial bank, and mortgage rates. The hope is that such moves would speed up what many believe is a slowing economy.

On the other hand, some believe inflation remains a considerable risk to the economy and that lowering the target would only worsen the situation.

The challenge facing the Fed is that Congress has mandated that it pursue the dual goals of full employment and stable prices. The Fed’s favored price measure is the change in the Bureau of Economic Analysis’ Personal Consumption Expenditures Core Price Index (PCE core inflation), which reflects overall prices excluding the more volatile food and energy components. Success regarding employment is measured by avoiding recessions, during which unemployment can rise dramatically.

In light of the inherent tension between these two goals, does history provide any guidance on what might be the “right” federal funds rate given the current situation? The following chart provides some insight into this question.

Source: AthenaInvest

From 1980 through 2024, the fed funds rate exceeded PCE core inflation (measured as six months before and six months after each month) by an average of 1.60%. In addition, we can see that the 30-year mortgage rate closely tracks the fed funds rate, averaging 3 percentage points higher over that time.

The fed funds “real rate” is thought to be an important signal for both the Fed and the economy. The prevailing view is that high positive real rates are restrictive—leading to lower inflation but potentially a slower economy—while negative real rates do just the opposite. For this reason, the real rate is frequently the focus of both the Fed and its many critics.

The real rate has been far from consistent over time. From 1980 through 2009, the fed funds rate exceeded inflation nearly every month, resulting in large real rates—as high as 10% in the early 1980s. During this period of tight money, the U.S. experienced five recessions, with the unemployment rate hitting a high of 10% in both 1982 and 2009.

By contrast, from 2010 through 2024, the fed funds rate spent the vast majority of months below inflation, resulting in negative real rates as low as -5.50% in 2021. The most distressing event during this period was the brief COVID-induced recession in 2020. Unemployment reached 15% in April of that year, and PCE core inflation climbed to nearly 6% in 2021. That combination represented the worst of both worlds: high inflation accompanied by historically high unemployment.

Currently, the real rate is right around its long-term average of 1.60%. Based on that comparison, there isn’t a strong case for lowering the fed funds target. The preceding chart also shows that the economy has performed well when the real rate was both strongly positive and negative, contrary to the prevailing wisdom about its importance. So, there’s no convincing evidence for or against a rate cut based on the current fed funds rate relative to inflation.

But the Treasury market does provide some insight into future changes in the fed funds rate. While the Fed has considerable sway over very short-term interest rates through monetary policy, longer-term rates are the result of market activity, somewhat independent of the Fed’s target range, particularly for the longest maturities.

It turns out the best predictor of next month’s fed funds rate is the current month’s change in the one-year Treasury bill rate. Even for this short maturity, the market helps determine what the rate should be beyond the Fed’s decision.

The directional “batting average” for this predictor is 66%. In other words, the direction—up or down—of the current monthly change in the one-year T-bill rate correctly predicts the direction of next month’s fed funds rate change 66% of the time. Note that the funds rate can move up or down even when the target range has not been officially changed, as it can fluctuate within the range.

The one-year T-bill rate dropped by 19 basis points in August 2025, correctly predicting the Fed’s 25-basis-point rate cut in September.

By the way, I am rooting for additional cuts—so I am closely monitoring the one-year rate.

The opinions expressed in this article are those of the author and the sources cited and do not necessarily represent the views of Proactive Advisor Magazine. This material is presented for educational purposes only.