The Federal Reserve’s interest rate policy has a significant impact on global economic stability, including that of emerging markets. In recent years, the Fed’s moves to raise or lower interest rates have triggered a complex domino effect, reflecting the interconnectedness of the global financial system today.
In cases where the Fed increases its rates, it usually seeks to quell domestic inflation or stabilize US economic growth. Nonetheless, this action tends to affect a much broader scope. Increased benchmark interest rates result in higher returns on US government bonds as they become more attractive.
Consequently, when global capital moves elsewhere in search of better yields, it tends to gravitate back to the US, leaving emerging markets behind.
How Fed Rate Hikes Affect Emerging Markets
In an interview with CNBC, JPMorgan’s Chief Global Economist, Bruce Kasman, explained: “US monetary policy no longer has just a local impact. When the Fed tightens interest rates, the effects ripple around the world, from Brazil to Indonesia, through pressures in bond markets and exchange rates.”
When capital outflows from an emerging economy, the nation faces pressure on its currency. Demand for US dollars is very high, causing the exchange rate to weaken. This adds to the burden of foreign debt, as most debts in emerging markets are denominated in dollar terms. At the same time, import costs increase, which can trigger domestic inflation and reduce people’s purchasing power.
Scenarios like this include the 2022-2023 period, when, in an attempt to tame pandemic-induced inflation, the Fed increased interest rates dramatically.
Turkey, Argentina, and South Africa are among the countries that have suffered a significant decline in the value of their currencies, and domestic bond yields have increased. Indonesia and India were forced to implement monetary tightening policies in Asia in an attempt to alleviate the blow.
The Real Impact: Currency Pressure and Inflation
According to the 2023 International Monetary Fund (IMF) report, “Rising interest rates in the US have historically been associated with increased volatility in capital flows in emerging economies and upward pressure on exchange rates. Countries with weak fiscal fundamentals will feel the impact the most.”
Global investors became more cautious and tended to withdraw their investments from high-risk assets in emerging markets, such as stocks and government bonds. This causes turmoil in local capital markets and exacerbates domestic economic uncertainty.
In some countries, central banks were compelled to raise domestic interest rates more rapidly than necessary to maintain currency stability.
On the other hand, when the Fed cuts interest rates or gives dovish signals, emerging markets tend to enjoy a breath of fresh air. Capital flows back in, strengthening exchange rates and boosting financial asset prices. This allows central banks in emerging economies to focus more on economic growth rather than simply maintaining external stability.
Policy Coordination Is Key Going Forward
However, this reliance creates structural vulnerabilities. Professor Carmen Reinhart of Harvard Kennedy School, former Chief Economist of the World Bank, once warned: “Financial globalization means that a monetary shock in a large country like the US can create shock waves around the world. Developing countries need to strengthen their macro resilience to avoid being constantly swayed.”
In the future, policy coordination across countries and transparency of communication from the Fed will be crucial. Unexpected policy moves could cause panic in global markets, especially when the world economy is still struggling to recover from the pandemic and geopolitical tensions persist.
Thus, the Federal Reserve’s interest rate policy is not only about safeguarding the US economy, but also about maintaining balance in the global financial system.
Emerging markets should continue to strengthen their external resilience through prudent fiscal policy, economic diversification, and adequate foreign exchange reserves to weather any storms that may arise from Washington’s direction.
As interest rates shift again in 2025, global investors and governments alike must stay alert — because when the Fed sneezes, the world still catches a cold.
