When Good News Is Bad News

By Sachchidanand Shukla 

That the global economy has been surprisingly resilient, despite sharp interest rate hikes from central banks to tame price pressures is not news anymore. But a while back, most forecasts, backed by models, had a sense of gloom and were pencilling in recession in the US, EU and then later changed it to slower growth and finally capitulating to robustness in growth. Economic models and assumptions bring rigor to policy but unavoidably, they also bring mortis!

Two economies– the US and India in particular have shown significant positive surprises in their underlying data and growth forecasts as compared to expectations. In fact, the strength of the US economy is now spawning new theories of what might be the reason for the growth surprises. Sample this: Some experts in the US have started to ask a question that may sound quirky. They ask, what if all those interest-rate hikes in the past two years are actually boosting the economy? They aver that the US economy isn’t booming despite higher interest rates that jumped 5x in a short time but rather thanks to them!

But such theories are still par for the course as economists and researchers are known to come up with theories even more esoteric. Remember MMT a while back? Going back a bit in time, in 1978, a young researcher embarked on a study titled: Understanding interstellar trade theory, how should interest be charged on goods when they travel at the speed of light. The research was done under the aegis of Princeton University and guess who the author of that research was - it was Paul Krugman, who won the Nobel in Economics in the year 2008.

In case of the US, the robust performance has been driven by stronger than expected private consumption, along with a tight labour market. Employment has remained robust adding 303,000 jobs in March, the largest gain in more than a year and the unemployment rate also edged lower, to 3.8 per cent. Corporate profits have remained strong.

Let us look at India now. The IMF raised its forecast for India’s GDP growth in FY24 by a sharp 110 bps to 7.8 per cent which incidentally is even higher than the expansion rate of 7.6% seen by the NSO in its second advance estimate. It also upped the GDP growth projection for FY25 by 30 bps to 6.8 per cent and retained the forecast for FY26 at 6.5 per cent. We have seen the likes of OECD, World Bank, S&P and Fitch etc up their forecasts one after the other lately.

But is there a problem with the spate of good news ie strong growth data, upward revisions et al? The issue is – it all sounds positive, but all these trends may not necessarily be “good news” for markets that have been hoping for rate cuts since H2 of 2023. The US Fed has been trying to slow the economy through aggressive rate hikes, but the continued resilience may even force it to raise rates instead of a cut – a move that could crater growth and trigger job losses. Continued strong growth, easing of labor shortages, jump in productivity are signs that there may be further latent inflationary pressures in the pipeline and that will have to be accounted for by the central bank.

Late last year, markets were pencilling in around 150 bps of rate cuts from the Fed in 2024. Now that has gone down to < 50 bps for most and even to Zero for a few. In India too the futures are not pricing in rate cuts in the near term.

The missing link in these explanations could be the role of fiscal spending. In 2024, a record number of countries, with more than half of the world’s population, are holding elections. The IMF shows that governments tend to spend more and tax less during election years and hence deficits tend to exceed forecasts by 0.4 percentage points of GDP, compared to non-election years.

The US has an uncharacteristically lax fiscal policy with fiscal deficit reaching alarming levels. Loose financial conditions have neutralised the aggressive rate hikes from the Fed. As the pandemic passed, fiscal policy was widely expected to be in need of tightening. However, the IRA, and the CHIPS Acts, partially reversed the fiscal tightening process and led to an increase in the federal government deficit from 5.3 per cent to 6.3 per cent of GDP.

The IMF in its latest report avers that the world needs fiscal restraint in biggest-ever election year and governments should stay the course on fiscal consolidation amid mounting debt. Fiscal policy became expansionary last year after a rapid improvement in debt and deficits in the prior two years but only half of the world’s economies tightened fiscal policy in 2023, down from about 70% in 2022.

However, it must be highlighted that India stands out with its ‘smart’ spending fiscal approach that eschews typical election-year extravagance, marking a notable departure. Fiscal deficit has been brought down from a peak of 9.2 per cent of GDP during the pandemic to a targeted 5.1 per cent in FY25. At the same time, India’s growth is being driven by ‘good’ fiscal spending ie strong public investments in infrastructure. Centre’s budget allocation to capital expenditure has doubled from ~1.6 per cent of GDP in FY19 before the pandemic to 3.4 per cent of GDP in FY25. States have also been incentivised to spend more on capex. Capital expenditure provides a bigger and higher quality bang for the buck via 3x higher multiplier and should continue to keep India in good stead vis a vis the rest of the world.

Sachchidanand Shukla (Group Chief Economist, L&T. Views personal)