Real interest rate is a reliable tool to assess future market prospects
The Indian and US equity markets have sharply recovered over the past two months. Previously, after peaking in September 2024, Indian equity markets had severely corrected (a 15 per cent drawdown) over the next six months. Similarly, the US markets, which peaked in February 2025, severely corrected (an 18 per cent drawdown) over the next two months. Now, after the sharp recovery of the past two months, the leading question most investors wish to get answered is: “Is the pain behind us?”.
Though major Indian market indices have strongly recovered from the lows of March 3, 2025, they are still 4 to 6 per cent below their September 2024 peaks. Elevated valuation was often cited for the Indian stock market’s underperformance for the past nine months. Indian market valuation has moderated over the past nine months but still remains elevated: Nifty50’s PE ratio declined from 24.25 to 22.22, and its PB ratio fell from 4.25 to 3.60.
In the meantime, India’s CPI-based inflation consistently declined from 6.21 per cent in October 2024 to 2.82 per cent in May 2025, the lowest since January 2019. Moreover, starting from February 2025, the RBI has reduced its policy interest rate (repo rate) by a full percentage point in three tranches, from 6.50 per cent to 5.50 per cent. RBI has informed that it is done with rate cuts and has changed its policy stance from ‘accommodative’ to ‘neutral’.
The differential between repo rate and CPI inflation rate stands at 2.68 per cent today. A differential of more than 2 per cent is considered restrictive for the economy and markets. Therefore, the RBI may have to cut rates further if inflation remains steady at current levels for long.
However, inflation is unlikely to remain subdued at current levels for long. CPI inflation had gone below 3 per cent on two occasions over the past decade. On both occasions, it never stayed there for much time. Instead, inflation abruptly increased beyond the RBI’s target inflation rate (4 per cent) in less than a year.
On the first occasion, in 2017, after staying below 3 per cent for four months (April – July 2017), CPI rose to a peak of 5.21 (December 2017) per cent in five months; repo rate declined 25 bps, from 6.25 to 6.00 per cent, during the period. On the second occasion, in 2018-2020, after remaining below 3 per cent for the six months between November 2018 and April 2019, CPI inflation rose to a peak of 7.59 per cent (January 2020) in seven months; repo rate declined by 135 basis points, from 6.50 to 5.15 per cent, during the period.
No correlation between stock prices and inflation was evident on either occasion; stock prices climbed on both occasions. Moreover, on each occasion, stock prices climbed during both low and high inflation.
However, a different correlation is evident: an inverse correlation between stock prices and interest rates. Stock prices have outperformed during declining interest rates and underperformed during rising interest rates.
After peaking at 8 per cent in 2013, the policy interest rate (repo rate) has been declining since 2014; it had declined to 6.50 per cent by 2016, remained steady at 6.50 per cent until 2018, and then declined swiftly to 5.15 per cent by the end of 2019. The two inflation episodes occurred during declining interest rates, which explains why stock prices climbed on both occasions.
CPI Inflation rate in India went below 3 per cent again last month (May 2025, 2.82 per cent). Over the past decade, on the previous two occasions inflation fell below 3 per cent, it has risen swiftly within a year to levels way above the RBI’s target inflation rate. However, the inflation spike won’t adversely impact stock prices, as is generally thought. Stock prices will be affected only if the RBI raises interest rates to bring down inflation. High or low inflation is inconsequential to stock prices, but how central banks respond to inflation is. That’s what India’s historical experience of the past decade indicates.
The recent performance of European equity markets reflects the inverse correlation between stocks and interest rates. The STOXX Europe 600 Index is up 7 per cent (14 per cent, in dollar terms) so far this year, outperforming the S&P 500’s 2.50 per cent return. The ECB (European Central Bank) had aggressively cut its policy interest rates from 4.50 per cent in March 2024 to 2.15 per cent by June 2025, a cumulative cut of 235 basis points. Meanwhile, the US Federal Reserve cut policy rates by a lesser 100 basis points, from 5.50 to 4.50 per cent.
Central banks intend to regulate liquidity (availability of cash or cash equivalents) in the economy by adjusting short-term interest rates. They raise interest rates to reduce liquidity if the economy gets overheated. Likewise, they reduce interest rates to increase liquidity during economic slowdowns or downturns.
However, interest rate changes do not bring immediate economic results. There is an unpredictable time lag between monetary policy decision and their economic results: the tentative consensus is an average of six months from the first rate cut. This could explain why European stocks have risen, while US and Indian stocks have reeled so far this year. The ECB initiated its rate cuts much earlier than other major central banks.
The ECB made its first rate cut in March 2024, six months earlier than the US Federal Reserve and eleven months earlier than the RBI. Accordingly, the good times for the US and Indian markets are yet to come. The US markets might make new highs in the last quarter of this year, and Indian markets in the first quarter of next year.
Though financial markets reflect economic reality, they often move in advance. It means asset prices fall much before a slowdown in corporate earnings or economic activity becomes evident. Similarly, asset prices would have risen even before signs of recovery in corporate earnings or economic activity are evident. Therefore, equity investors shouldn’t rely too much on short-term corporate earnings performance for their investment decisions. Instead, stock fundamentals, valuation, and macro trends should guide his investment decisions.
The real interest rate (policy interest rate less inflation) is the most reliable economic tool for determining macroeconomic trends. A low real interest rate is good for the economy and markets. Consumers should spend, and businesses should invest, for economic activity to pick up. They are disincentivised to do so if the real interest rate is high. They prefer to save or conserve cash under such conditions.
Again, real interest rates could explain European stocks’ outperformance so far this year. Lately, the EU’s policy interest rate and inflation stand at 2.15 per cent and 1.90 per cent, respectively: the real interest rate is 0.25 per cent – a very beneficial condition for markets and the economy. The ECB seems to have targeted real interest rates in its past year’s interest rate decisions. Meanwhile, the latest real interest rate for the US and India stands at 2.10 per cent and 2.70 per cent, respectively, highly restrictive for their respective markets and economies.
Either central banks should reduce policy interest rates, or inflation should rise for the high real interest rates in the US and India to moderate towards more conducive levels, preferably, to 1.50 per cent or less. Normally, inflation won’t pick up if economic activity remains subdued. Central banks proactively reducing policy rates is the only alternative then.
Central banks normally reduce interest rates to stimulate an economy in a slowdown or a recession. By doing so, they intend to coax consumers and businesses to spend money, instead of hoarding or saving. However, there are occasions when central banks are hindered from reducing interest rates despite subdued economic conditions. They are those rare occasions when high inflation and lower economic activity coexist. Lowering interest rates would then aggravate the inflation problem.
Today, inflation remains low in all major advanced and emerging economies. However, the tariff war unleashed by the US Trump administration through its reciprocal tariff announcement in April 2025, and more recently, the Israel-Iran conflict, have significantly boosted the risk of high inflation globally. The US Federal Reserve governor warned in May 2025, ‘Tariffs are projected to slow US growth, raise inflation.’ Oil prices jumped 7 per cent on the first day of the Israel-Iran conflict. Iran has warned it may block the Hormuz Strait through which one-third of the global oil supply transits if Israel continues the attacks. If Iran follows through on the threat, oil prices could rise to triple digits.
‘Stagflation’ is an economic condition characterised by high inflation and low growth, one of the harshest economic conditions. Some of its aftereffects are volatile asset prices, high unemployment, social unrest, geopolitical conflicts, breakdown in international cooperation, and rise in nationalist sentiments.
The last serious case of stagflation occurred during the 1970s. The breakdown of the Brenton Woods agreement (1971), the Watergate scandal (1972), the Yom Kippur War (1973), the US pullout of Vietnam (1973), the OPEC oil embargo (1973), and the Iranian Revolution (1979) made the decade momentous. Oil prices increased from an average of $2.60 per barrel in the early 1970s to $13.50 per barrel by 1978; in 1973 alone, price more than doubled.
US stocks lost 45 per cent in the 1973-1974 bear market. It took US stocks almost a decade to regain the 1973 highs. The US unemployment rate in the 1970s fluctuated widely but generally rose throughout the decade and averaged around 6.2 per cent. GDP growth in the US and other advanced countries significantly slowed down in the 1970s, compared to the 1960s and 1950s.
During stagflation, central banks face a tough choice. By adjusting interest rates, they can’t simultaneously address high inflation and low growth. Lowering interest rates might revive growth but exacerbate high inflation. Raising interest rates might anchor inflation but dampen growth further.
Stagflation remains at the top of the minds of a few prominent personalities. Jamie Dimon is one of them. ‘Dimon warns of US stagflation risk’, reads a recent Wall Street Journal news headline. (Jamie Dimon is the Chairman and CEO of J P Morgan Chase, the world’s largest bank.) But as of now, it is just a possibility, far from today’s reality. Until it remains so, let us be preoccupied with how the real interest rates evolve going forward, because it seems to be the most consequential metric that could change market fortunes for better or worse.
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