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The markets are calling it the “everything” rally. The US leading index S&P500 is near its all-time high. The Nasdaq Composite and the Dow Jones Industrial Average hit new all-time highs in midweek. In India, the Nifty50 is hovering around its high of 22,526. The theory is that there is a connection between the prices of gold (and Bitcoin) and stocks, and it appears to be dissolving. Gold prices hit a new high of $2,222.49 an ounce this month. Bitcoin, that enigmatic article of faith, is recovering from its record price of $73,797 reached on March 14th. It seems as if financial markets have discovered an antidote to gravity.
Fluctuations in financial markets are based on estimates and expectations about the cost of money. Every central bank in the world is avowedly data dependent. This effectively means that it will cut interest rates or not based on incoming data on inflation, employment and growth.
This week the US Federal Reserve presented the summary of economic forecasts for 2024, 2025 and 2026. U.S. GDP is estimated to grow 2.1 percent, faster than the December estimate of 1.4 percent. Unemployment will not fall as expected. Inflation was 3.2 percent in March, core inflation will remain at 2.6 percent and remain well above target until 2026. Regardless of reality, the federal funds rate is expected to fall to 4.6 percent from the current 5.25 to 5.5 percent.
Naturally, excited by the forecast, the market expects three rate cuts this year. But what explains the reason for expecting a cut when none of the moving parts of the economy are flashing yellow or red? The decline in inflation is caused by supply-side improvements – in the availability of goods and labor through increases in immigration.
The euphoria in the markets is strange as the Fed yield curve remains between 3.4 and 4.1 percent in 2025, which corresponds to a higher neutral rate. When Fed Chairman Jerome Powell was asked about the gap between target and stance, he remarked: “The markets believe that we will achieve this target, and they should believe that, because that is exactly what will happen over time.” Even Alan Greenspan , who confused the markets with his articulation, would have been confused!
Why is all this important for India? More than three decades ago, in February 1990, Don Brash of the Bank of New Zealand introduced the idea of targeting 2 percent inflation. Powell's use of the phrase “over time” suggests that the Federal Reserve is comfortable with above-target inflation. And what happens in the US doesn't stay in the US, as the Federal Reserve practically calls the shots. In fact, a day later, Bank of England Governor Andrew Bailey signaled that interest rate cuts were imminent.
Tolerance for higher inflation leads to higher costs of capital worldwide. This has implications for India and other developing countries. First, the longer-term higher global regime is dashing the hopes of those who expect the Reserve Bank of India to cut interest rates following the decline in core inflation – something that was already unlikely in April may not happen in June either.
Currently, the RBI's repo rate is 6.5 percent, the yield on ten-year Indian government bonds is around 7 percent and the key interest rates for prime loans are over 9 percent. The expectation has both political and economic elements – particularly given the narrative of lower private final consumption relative to overall GDP and the plight of companies facing a decline in demand at the edges of the bottom quintiles.
Every economy is defined by politics. It is clear that maintaining growth and employment is paramount for advanced economies as these countries enter demographic downturns. Higher growth in the US, for example, is made possible by tax spending under the Inflation Reduction Act to subsidize outsourcing of investment – the US can afford to add $1 trillion to its debt every 100 days because the dollar is exceptionally privileged enjoy.
In advanced economies it is about maintaining consumption. The concern for India and other developing countries will be to sustain investment. The government's strategy to stimulate investment to mobilize private sector capital expenditure is linked to public programs.
India increased total public sector capital investment from Rs 5.6 billion in 2014-15 to Rs 18.6 billion in 2023-24, which had a visible impact on GDP growth. A report released by CRISIL shows that India will spend Rs 143 million on infrastructure by 2030 – double the Rs 67 million spent since 2017. It is true that robust tax revenues – GST and direct taxes – have enabled expansion of investments in infrastructure.
It is also obvious that the cost of capital plays a role. The ambitious fiscal deficit target of 5.1 percent and the push for a better rating from global agencies require a revival of idle ideas – from privatization and asset monetization to resource sourcing.
India has won awards for managing macroeconomic fundamentals. The context requires that the new government's 100-day program takes into account the specter of higher capital costs in the longer term and sets a timetable for deficit reduction and deleveraging when drawing up the roadmap for Viksit Bharat.
Shankar Aiyar
Author of The Gated Republic, Aadhaar: A Biometric History of India's 12 Digit Revolution and Accidental India
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