Sacrificing His Core Supporters in a Race Against Defeat
On March 16, Jerome Powell, the chair of the U.S. Federal Reserve, announced that the central bank would hike interest rates to 0.25 percent. It was likely just the first in a sequence of rate increases designed to tame stubbornly high inflation. Since the start of the year, the Fed chair and his colleagues have indicated that the central bank would be raising short-term rates and have reiterated that the Fed was committed to taking “the measures necessary” to reduce inflation.
Economists have debated the extent to which this bout of inflation is the result of expansionary fiscal and monetary policy—low interest rates and large amounts of government spending, particularly transfers to households—or of pandemic-specific factors, including disruptions to global supply chains and, consequently, rising prices for commodities and manufactured goods. It remains unclear whether the rate increases the Federal Reserve has planned out will be sufficient to tame rising prices or the extent to which they will curtail economic growth.
But whatever the impact, rising interest rates will not just affect the United States. Higher U.S. rates raise the cost of borrowing in U.S. dollars on international markets. They also increase demand for U.S. dollar assets relative to assets in other currencies, and they can therefore cause those currencies to fall in value. For countries where external debt is denominated in U.S. dollars, debt repayment will become more expensive.
These consequences are likely to be most severe in some low- and middle-income countries. Relative to wealthier states, these countries generally have worse credit, and it costs them more to borrow. They are also more likely to borrow in U.S. dollars. It will be especially bad for developing and emerging markets that are still grappling with the pandemic’s economic fallout, as well as those that are net importers of food and energy, the prices of which have risen dramatically as a consequence of the war in Ukraine. These countries will likely see more debt distress and large currency devaluations, hampering their economic growth and making it more difficult for them to reduce poverty.
The U.S. financial market is by far the planet’s largest, and the dollar is the world’s principal reserve currency. It is the backbone of international loans and the main currency of use in international trade transactions and internationally traded bonds. As a result, Federal Reserve actions have an outsized effect on the economies of other countries.
That is especially true in emerging markets and developing countries, which often rely on the U.S. dollar for international borrowing. When the Fed raises interest rates to help tame U.S. inflation, external borrowing in dollars becomes more expensive. The hikes can also stoke inflation in other economies: as U.S. assets yield higher returns they become more attractive to investors relative to the assets of other countries, driving up the value of the dollar. This raises the cost of imports, which are often priced in dollars. It also makes it more expensive for governments and firms in developing countries to pay off their existing debts in U.S. dollars. The result can be domestic austerity measures, resulting in lower economic growth. (These effects are more modest in advanced economies, since they borrow primarily in their domestic currency and their domestic prices are less likely to rise when their currencies depreciate.)
The U.S. interest rate increases come in challenging times. To cushion the effects of the pandemic, many poorer countries had to take on more debt, and with the decline in economic activity caused by the pandemic, they are struggling to service or repay that debt. Tourism-dependent economies, for instance, saw their main source of external revenue dry up as international travel came to a standstill. Many emerging and developing economies are also already facing domestic inflation, triggered by pandemic-related production disruptions and rising global energy and food prices. Rising food costs, in particular, stoke inflation in emerging and developing economies, where residents spend a higher percentage of their income on groceries than do residents of richer states. They can also trigger social unrest.
The Federal Reserve, of course, can only directly set short-term interest rates, and U.S. long-term rates—such as the yield on government bonds that mature in ten years—also have an important effect on both economic activity and long-term rates in other countries. This is, again, particularly true in emerging and developing economies. But when the Fed tightens its monetary policy, it can cause these rates to rise, as well. And they are already going up: between the end of 2021 and March 31, 2022, the interest rate on 10-year U.S. Treasury securities rose by one percentage point.
A quick, painless end to U.S. inflation is not a foregone conclusion.
So far, this is a relatively small increase. It suggests that markets currently expect the increase in short-term interest rates is going to reverse at some point—and hence that U.S. inflation will eventually abate. For emerging markets and developing countries, that would be very good news. If the long-term rate increase remains modest, the repercussions for the developing world will be more contained.
But unfortunately, a quick, painless end to U.S. inflation is not a foregone conclusion. The world is encountering its first bout of meaningful inflation in decades, an experience that is compounded by uncertainty around the pandemic and the war in Ukraine. And U.S. inflation has already defied expectations, exceeding 2021 forecasts by a wide margin. If demand remains strong in the United States and if the country’s labor markets remain tight, inflation could prove even more stubborn than most forecasts suggest. The Fed would then have to enact rate hikes that will be more rapid and sharp than the markets currently expect them to be, leading to higher long-term interest rates. The U.S. economy may then slow more sharply, and international financial repercussions would be more severe.
Indeed, the uncertainty itself could harm poor and middle-income countries. During periods of high economic and geopolitical uncertainty, investors tend to withdraw from riskier assets. That includes holdings in emerging markets, which have more volatile economic prospects and higher political and policy uncertainty. The unfortunate end result could again be an outflow of capital from developing countries—the places most in need of investment.
It is hard for economists to predict the future, and analysts need to be modest in their forecasts. No one knows exactly what path U.S. inflation will take, how the Federal Reserve will respond, and what the ultimate consequences will be for other countries.
But the past can provide a guide for what it looks like in the developing world when the United States tightens its monetary policies. In some cases, history offers reason for hope. When the Federal Reserve increased interest rates from one percent to 5.25 percent between 2004 and 2006, emerging market economies did not experience financial turbulence, in part because the U.S. and the world economy were growing rapidly. In mid-2013, investors expected that the Federal Reserve would raise rates (they ultimately didn’t), and as a result, long-term interest rates went up by one percentage point, as has happened so far today. Several emerging markets faced declining purchases or outright sales of their debt securities by foreign residents and saw their currencies lose value. But both effects waned in a few months.
In other instances, rate hikes have had more notable consequences. Between February 1994 and February 1995, the Fed raised short-term interest rates by roughly three percentage points, and long-term interest rates went up by some two percentage points. The increases—together with domestic economic and political factors—led the Mexican peso to collapse, causing a recession in the country. Mexico eventually needed an international bailout to stave off default. Argentina was also severely affected. But even then, there was no wider wave of emerging market crises. Similarly, when the Fed raised its rates between March and December 2018, Argentina and Turkey faced large currency depreciations, but the fallout elsewhere was contained.
Yet rate hikes, if big enough, can lead to broad problems. In the late 1970s and early 1980s, U.S. Federal Reserve chair Paul Volcker nearly doubled interest rates—up to 20 percent—to try and tame persistent inflation in the United States. He succeeded, but the shockwaves of tightening U.S. monetary policy triggered a widespread debt crisis and numerous defaults in emerging and developing economies. Between 1981 and 1983, GDP fell by 2.8 percent in Brazil, four percent in Mexico, 7.5 percent in Venezuela, and an astounding 16 percent in Chile.
Rate hikes, if big enough, can lead to broad problems.
The effect of the current rate hikes today may yet be modest. Many middle-income countries—including most of the largest ones—have stronger economic institutions (including independent central banks) than they did in the 1970s and 1980s, or even the first decade of this century. They are less dependent on borrowing in dollars, and they hold larger foreign exchange reserves. They also allow the value of their currencies to float more than they did in the past, which means they can allow their currencies to depreciate during periods of stress without provoking such severe domestic economic repercussions. In addition, high commodity prices help emerging and developing economies that are commodity exporters, which can now sell their goods at higher prices.
But many poorer countries are not as well insulated, and U.S. inflation is at its highest level in decades. Washington’s policy adjustment may be more abrupt than anything it has done since 1994. The Fed’s actions could be compounded by rising interest rates from other central banks, given that many advanced and emerging economies are also dealing with heightened inflation. And this tightening will come as the world economy is still dealing with the consequences of the pandemic, and as it reckons with the war in Ukraine. That means that, although there is unlikely to be a severe crisis across major emerging economies, there are many vulnerable countries—already facing increased poverty—where high levels of external debt may prove to be unsustainable. An increasing number of countries may approach the International Monetary Fund for a loan, as Sri Lanka did recently, and face debt renegotiations with external creditors.
Since the pandemic began, the World Bank, the International Monetary Fund, and the world’s richest countries have all discussed the need to offer debt relief to the poorest states and to other countries facing the most severe economic consequences of the pandemic. As the Fed works to control U.S. inflation, the necessity of such relief will grow increasingly pressing. The bulk of the developing world may be able to ride out the storm. But should U.S. rates rise sharply, more countries will need international financial support and face debt restructuring to avoid calamitous economic contractions.