Viewpoints

Several years ago, when inflation had decelerated from its high peaks, I published an article in the Wall Street Journal about inflation and the Fed. It’s always an honor to get a piece in the WSJ, but one of the hazards is the WSJ holds the right to put any title on the article that it wishes. In almost all cases, the WSJ’s title is far better than the ones I have submitted. For my article on October 26, 2023, I liked my title, “Lower Inflation but Higher Prices” more than the title the WSJ used: “We’re Still Paying for the Federal Reserve’s Blunders”.

Both titles still apply to the current situation. PCE inflation is 2.7% and CPI inflation is 3.0%--which may seem modest, but the cumulative increase in prices for goods and services is the primary focus of consumers. It directly influences their standards of living, their perceptions of confidence and their assessments of government leadership. Meanwhile, the focus of financial markets and the Fed is nearly exclusively on the rate of inflation and changes in the rate, to the tenth of a percent and beyond. Presently, even amid lack of government data, the focus in financial markets is the extent to which PCE inflation is above the Fed’s 2% target, and what is the appropriate policy rate that would eventually reduce inflation to 2%.

This note considers the cumulative increase in the level of price increases in recent years and adds in an important element—how relative prices of different goods and services have changed, particularly some of the things we purchase on a regular basis—food and drink. Prices of some goods and services have gone up much more or less than others. Presumably, this is affecting household pocketbooks and our spending patterns.

The trend in inflation. As shown in Charts 1 and 2, CPI and PCE inflation have settled down but the cumulative increase in the general price level has been striking—since pre-Covid, measured as 2019Q4, the CPI is up 26.9% and the PCE is up 22.3%. That’s the biggest cumulative increase in prices over a short number of years since the 1970s. (It’s nearly unimaginable that during the Great Inflation between 1966 and 1982, the CPI rose 300%...while the S&P500 rose 150%). Nevertheless, the recent surge in the general price level comes as a rude awakening following the stable and relatively low inflation that persisted in the decade following the Great Financial Crisis.

Two quick footnotes. First, while the PCE Price Index provides a more comprehensive measure of inflation by including prices of all goods and services consumed, the CPI is a much better measure of consumers’ out-of-pocket expenses. The PCE is a price index of all consumption, whereas the CPI does not include prices of goods and services that are financed by third party payers, including health care services financed by Medicare, Medicaid and employer health insurance. Accordingly, the CPI has a significantly higher weighting of housing services (rental costs and owners’ equivalent rent of residencies, or OER) while the PCE has a much higher weighting of health services.

India remains an equity overweight, but the shine has faded from both its cyclical recovery and its structural growth story. Two issues stand out: the country is lagging badly in the AI revolution, and the corporate investment cycle—despite strong macro conditions—has failed to ignite.

AI: A Race India Is Not Winning

India has attracted several high-profile announcements. Google plans to invest US$15bn over five years to build an AI data centre. Microsoft has committed US$3bn over two years, Amazon US$12.7bn by 2030, and the government’s latest budget allocates US$1.25bn to develop the domestic AI ecosystem.

On paper, this sounds substantial. In reality, it pales next to the intensity of global AI investment. The big four US hyperscalers—Amazon, Microsoft, Google and Meta—are currently spending around US$90bn per quarter on AI. Even compared to peers like China, the gap is stark. Over the past decade, state-backed venture capital in China has channelled roughly US$912bn into strategic industries including AI. China now hosts over 4,500 AI enterprises, accounts for 45% of global computing power, filed 60% of AI patents in 2024, and is expected to invest US$85–98bn in AI capex in 2025 alone.

India’s GenAI Landscape: Growing, but Too Slowly

The domestic AI start-up ecosystem is expanding. As of 1H25, India hosts more than 890 generative AI start-ups, up from 240 a year earlier, with cumulative funding of US$900m. The funding mix, however, shows a narrow focus: 88% into AI infrastructure, 8% into services and only 4% into applications. Karnataka dominates with 39% of AI start-ups, followed by Maharashtra (14%), Delhi (9%) and Telangana (7%).

India’s AI market is forecast to grow at a 25–35% CAGR, reaching roughly US$17bn by 2027. NASSCOM, the industry body for the tech sector, estimates data and AI could contribute US$450–500bn to GDP by 2025––approximately 10% of the country’s original US$5trn target.

But scaling remains slow relative to the global frontier. India’s AI spending is small, investor appetite is weak, and the ecosystem faces structural barriers.

The Challenges

1. Lack of Regulatory Clarity Policy uncertainty has deterred funding, especially for deep-tech. Capital inflows remain limited, forcing start-ups to operate under severe funding constraints. Although 25+ new GenAI firms launched last year, both seed and late-stage investment have contracted sharply.

2. Talent Is Scarce Demand far exceeds supply. NASSCOM estimates India suffers one of the world’s highest AI talent shortages—around 50%. With insufficient advanced training capacity, scaling becomes difficult.

3. Government Response Is Reactive Thus far, policy has focused on short-term fixes and pilot initiatives. What is missing is a coordinated long-term strategy. According to NASSCOM, India needs large-scale public–private co-investment to de-risk innovation. But resistance to policy change and bureaucratic inertia remain barriers.

India is positioned to participate in the AI economy, but not to lead it. And without leadership or scale, the structural growth narrative weakens.

The Business Cycle: Why Hasn’t Investment Turned?

The second problem is more puzzling. India’s corporate investment cycle should be rising strongly, given macro conditions. Instead, it remains in a downtrend—even before pandemic disruptions and well before Trump’s 50% tariff shock.

The Good News

Growth momentum is solid. GDP has accelerated since 4Q24, powered largely by private demand—especially consumption in 2Q25 (Figure 1). The economy expanded 7.6% YoY on average in 1H25, outperforming regional peers and handily beating China.

It is generally understood that Gross Domestic Product (GDP) does not include the value of imports. It is, however, less well appreciated that in the System of National Accounts tariffs are treated as domestic value added. That is, customs duties are included in GDP.

From the first to the second quarter of this year customs duties surged $170.7 billion, from $97 billion at an annual rate to $267.7 billion -- an annualized growth rate of 5700%! -- as new tariffs imposed by the Trump Administration took effect. All else equal, if that increase in tariffs had immediately passed through to prices faced by final demanders of domestic product, the annualized rate of change in the GDP price index would have spiked nearly 3 percentage points in the second quarter. As it happened, GDP inflation in the second quarter was tame at 2.1%. Obviously, there were tariff slips twixt cup and lip.

Europe recovery to continue

The euro area’s economic performance in 2025 has been uneven. The year began on solid footing, with GDP expanding by 0.6% QoQ in Q1, only to lose momentum in Q2 as growth slowed sharply to 0.1% QoQ, with output contracting in both Germany and Italy. This slowdown coincided with the peak of the U.S.-led trade war, which weighed heavily on net exports after their strong rebound earlier in the year.

Despite the softer second quarter, Europe’s business cycle upswing remains intact. As shown in Figure 1, the average return on equity for listed European firms moderated in the first half of the year compared with the same period in 2024. Yet the corporate profit cycle, which began in 2021, continues to advance. Key indicators—EBITDA, free cash flow, and retained earnings—remain well above pre-pandemic averages. Although earnings per share and cash flow softened slightly in 1H25, corporate balance sheets remain healthy and capable of supporting further investment in production capacity and employment.

From January to August the average tariff rate on all imported goods increased 9 percentage points, from 2.3% to 11.3%, while the price of those imports, recorded by the Bureau of Labor Statistics (BLS) excluding tariffs, was essentially unchanged. Hence, the price of imports, including tariffs, rose 1.113/1.023 - 1 = 8.5%, reflecting the full amount of the increase in tariffs (Chart 1, solid lines). This suggests the cost of the tariffs has been borne entirely by American businesses and consumers, with none of that cost passed backwards to foreign suppliers.

State real GDP growth rates in 2025:2 ranged from -1.1% in Arkansas (Mississippi fell at a 0.9% rate) to 7.3% in North Dakota. States in the Plains benefited from a turnaround in farm output after declines in the first quarter, and there were also increases in mining output in some of those. Arkansas and Mississippi were dragged down by losses in farm output. Strong increases in finance and information helped boost growth in states such as California, New York, and Massachusetts.

Personal income growth rates ranged from 10.4% in Kansas to 0.9% in Arkansas. In the majority of states, perhaps most notably Massachusetts, increases in transfer payments significantly swelled the income gains related to state GDP growth. Much of the transfer growth reflected the recent retroactive payments to some Social Security beneficiaries.

This release also included estimates of consumer spending by state for 2024. Given the marked lag in the release of these numbers, and their annual frequency, they are likely not of much interest in assessing current and perspective conditions, either for the nation as a whole or for individual states, though they may be of help in modeling state revenues.

The Federal Reserve Bank of Philadelphia’s state coincident indexes in August were on the soft side, but a touch better than the initial July results. In the one-month changes, while four states (Kentucky, Rhode Island, Colorado and Alabama) had increases above .50 percent, seven were down. Over the three months ending in August, Alabama was on top, with two other states (Kentucky and Colorado) also seeing increases above one percent. Five states saw declines, with Maryland down .60 percent. Over the last twelve months, Iowa was down, and four others saw increases of less than one percent. Alabama was the only state with an increase higher than four percent (Idaho was up 3.62 percent), and eight others were at or higher than three percent.

The independently estimated national estimates of growth over the last three and twelve months were, respectively, .38 and 2.25 percent. Both measures appear to be a bit lower than what the state numbers would have suggested.

The AI boom has revived the old promise that a wave of general-purpose technology will lift labour productivity everywhere. But sector mix matters. The chart below shows where recent job growth has actually happened: healthcare and social care. Since end-2023, employment in that sector has grown 3–4x faster than overall payrolls in the US, UK and Japan, pushing healthcare’s share of total jobs toward 14–15%. The euro area has been softer, but the direction is similar. Ageing populations and long-COVID backlogs are doing the heavy lifting. But the composition effect is awkward for macro optimists: healthcare is labour-intensive, highly regulated and only partly tradable—characteristics that usually come with lower measured productivity growth.