The Indian stock market’s obsession with the US Federal Reserve is a long-standing saga. Every time the Fed meets to announce its domestic macroeconomic data and interest rates, Indian markets and participants closely scrutinize the proceedings amid considerable volatility.

However, over the past few years, it's not just the US that has adjusted interest rates multiple times. China, the EU, and Japan have also made several changes, impacting the Indian economy whenever significant global shifts in financial flows occur—from increases or decreases in major economies' interest rates.

The Fed's first rate cut in four years boosts global markets, paves way for potential RBI cuts

On September 18, the US Federal Reserve delivered what global markets had eagerly anticipated—a substantial rate cut, the first in over four years. The US central bank reduced its benchmark rates by 50 basis points, providing a significant boost to markets worldwide by reducing borrowing costs for global investors. Prior to this, the Fed had been raising rates at an unprecedented pace since March 2022.

After announcing the rate cut, Fed chair Jerome Powell said in a statement, “Recent indicators suggest that economic activity has continued to expand at a solid pace. Job gains have slowed, and the unemployment rate has moved up but remains low. Inflation has made further progress." The current US inflation rate is 2.5%, which is the lowest it's been since February 2021.

From the perspective of the Indian market, a decreasing interest rate is positive in two key ways:

Developing economies like India stand to benefit from such rate cuts, as foreign investors are drawn to the high returns the Indian economy offers. With US rates expected to drop by over 200 basis points in the next two years, India is likely to experience sustained foreign capital inflows, driven by investors seeking the country’s robust economic growth. 

Secondly, the Fed’s move could pave the way for the Reserve Bank of India (RBI) to implement rate cuts in the coming months. The Fed's rate cut reduces pressure on capital outflows in India and boosts foreign inflows. This can create favorable conditions for the RBI to implement rate cuts by aligning with global trends.

Japan ends its negative interest rate policy, affecting global investments

On another front, the Bank of Japan (BOJ) recently concluded its eight-year policy of negative interest rates. On March 19, 2024, the BOJ raised its benchmark rate to 0.25% from the previous range of 0-0.1%, marking its second rate hike in 17 years. While this increase seems modest, it can have implications for global economies, including India.

A member of the policy board of BOJ, Junko Nakagawa said, "Given real interest rates are currently very low, we will adjust the degree of monetary support, from the standpoint of achieving our 2% inflation target, if our economic and price forecasts are met.” Japan's consumer inflation accelerated to 3% in August, surpassing the Bank of Japan's 2% target and up from 2.8% in July. This rise was fueled by increased prices for food and household durable goods.

Japan has been a key source of global capital because of its very low interest rates, which pushed investors to seek higher returns in other countries. A move to positive interest rates, even if small, could lead to Japanese investors bringing their money back home. This could cause them to adjust their investments in places like India, where they've been active in both equity and debt markets. With domestic Japanese investments becoming more attractive, foreign direct investment (FDI) and foreign portfolio investment (FPI) from Japan into India could slow down.

Indian companies, particularly in sectors such as infrastructure and automobiles, often borrow from international markets, including Japan, due to lower interest rates. A rise in Japanese rates could increase the cost of borrowing for Indian firms, making it more expensive to finance projects and expansions. A hike in Japanese interest rates could also lead to the appreciation of the yen against the Indian rupee. This would make Japanese exports more expensive and Indian imports from Japan pricier, potentially widening India’s trade deficit with Japan. 

Why has India not cut rates despite global trends?

India’s inflation in 2023 exceeded the target range of 4-6%, primarily due to rising food prices and supply-side challenges. Although inflation figures have improved in 2024 and are now well within the target range, the Reserve Bank of India (RBI) has maintained its key interest rate at 6.5% to prevent demand-driven inflation from escalating.

RBI Governor, Shaktikanta Das said, "It is not so much how the inflation is now; we have to look at, for the next six months, for the next one year, what is the outlook on inflation. So I would like to step back and look more carefully at what is the future trajectory of inflation and growth. Based on that, we will make a decision.”

Moreover, with aggressive rate hikes, in the past 2-3 years, in advanced economies such as the US and EU, cutting rates in India could have led to capital outflows, weakening the rupee. A depreciating rupee would have increased import costs, adding more inflationary pressure to the economy.