Verbal Question of the Day Chat Group

Someone, please explain the main idea of the passage

The US Federal Reserve started the long-awaited cycle of rate cuts by reducing the Fed funds rate by 50 basis points (one basis point is one-
hundredth of a per cent) in an 11-1 vote on Wednesday, with the lone dissenter recommending a 25bps cut.
What has driven the change? The Fed pursues a dual mandate of ’maximum employment and price stability’. Its statement noted that risks to achieving its employment and inflation goals were "roughly in balance", with progress on inflation, but slowing job gains and rising unemployment.
Markets also take cues from economic projections published by committee members, and changes versus last published forecasts in June 2024. Inflation forecasts for 2024 and 2025 are lower, and expectations of the unemployment rate at the end of 2024 and 2025 are higher. The revised expectation of 4.4% unemployment rate in 2024 and 2025 is above ’normal’, currently estimated to be around 4.2%. Not surprisingly, therefore, their projection of end-of-the-year Fed funds rate (shown through ’dot plots") for the next few years was reduced by 70bps each for 2024 and 2025.
Very little of this was a surprise to the market: post the announcement US govt bond yields rose instead of falling, and
stocks, which are anchored to rising when rates fall, fell
marginally. Markets, in fact, currently expect the pace of cuts to be faster than what the Fed’s dot plots signal. The dis- connect seems to be on expected growth.
In our view, the worldview underlying the Fed’s projections (low inflation, steady growth) is what used to be called ’Goldilocks’ (not too hot, not too cold): that the decline in inflation can be achieved without much impact on growth. GDP growth forecasts were unchanged at 2% for each of 2024, 2025 and 2026. This may be too optimistic.
Last year, US economic growth was supported by an increase in the fiscal deficit, which offset the impact
of higher rates. The fiscal impulse last year around this time was a strong 3% of GDP, as the deficit was ex- panding. An increase in primary deficit adds to growth, a decrease is a headwind, and no-change is neutral. As the deficit has plateaued at an annual rate of $2tn (nearly 6.5% of GDP- very high), the impulse is now close to zero and is likely to turn negative in the coming months. Thus, the recent deceleration in US growth is likely to continue, further weakening labour markets. This would expose new risks to the US fiscal balance, as policy has been pro-cyclical (high fiscal deficits when unemployment was low means deficits will rise further with unemployment), and raise questions on the extent to which Fed funds rates can fall without a recession. Even the Fed’s dot plot raised the long-term Fed funds rate closer to 3%, the highest since June 2018.
Though the Fed signalled a 200bps cut in rates over the next two years, we believe effective funding rates, which are dependent on yields on longer-dura- tion govt bonds, are unlikely to fall meaningfully from here, unless a recession occurs. This is due to the changed fiscal stance and ballooning debt-to-GDP. Further, using a risky if not a dangerous stratagem, the US Treasury has been funding a worryingly large proportion of its deficit through short-term borrowing. Whereas on average long-term bonds account for 80% of its borrowing. in the last two years this ratio is nearer 30% on average. As the issuance of longer- duration bonds increases inevitably, there may not be enough buyers, pushing up yields.
Whereas central banks in several large economies like China and Europe have already cut rates, given the dollar’s dominance in global finance, the end of monetary tightening in US is an impor tant milestone for financial conditions globally. These had already eased mea ningfully after the Fed’s pivot in Dec 2023, but the decision on Wednesday and the associated guidance cements this trend.
What does this mean for the Indian economy and the Indian markets? The Indian economy has slowed meaning- fully in the last few months due to three major factors. First, the election-related delay in ramp-up of central and state govts’ spending has delivered a negative fiscal impulse as large as 3% of GDP. Second, growth of money supply in the economy has slowed sharply. Third, weakening global demand and competi tion from China has hurt exports.
Of these, the first should get addressed as the year progresses, and early signs are visible in an improvement in tendering activity by govts. The second headwind was partly an outcome of the fear that easy liquidity allows a build-up of specu lative positions which can make the currency vulnerable in a tight global funding environment. By keeping overnight liquidity in surplus for more than two months, RBI has already signalled a change of stance. As the financial system has not responded to this yet, the start of monetary easing by Fed should allow RBI room for stronger measures or communi- cation to improve money supply
As US bond yields are considered risk-free rates when valuing financial assets globally, the rate cuts, in theory, should be supportive of stock prices. However, as discussed above, bond yields are unlikely to fall as much. Furt her, with the dominant incremental flow now coming from domestic investors, the valuation benchmarks may have shifted for Indian equity markets, limiting impact of Fed rate cuts.