Inflation, Fed policy and emerging markets: the good, the bad and the ugly

Steve Kamin explores the global implications of rising inflation and interest rates in the US
Clint Eastwood
Clint Eastwood, star of 'The good, the bad and the ugly'

Financial markets are fixated on prospects for US inflation and Federal Reserve policy, and appropriately so. Rising interest rates may exacerbate already-elevated debt burdens and put pressure on business and government finances around the world. If higher rates are driven mainly by prospects for a brisk economic recovery, rising debt-service payments should be offset by higher profits and tax revenues. But if rising interest rates reflect prospects for sustained higher inflation, the damage will be far worse: higher rates will not only boost debt burdens, but also restrain GDP and profits while boosting deficits.1

Many emerging market economies (EMEs) are especially exposed to the spillovers of US monetary policy as a result of their fragile public finances, precarious access to international capital markets, and prior history of defaults. But, again, the reason for the rise in US rates matters. A rise in interest rates driven by favourable US growth prospects is likely to be relatively benign, since the benefits of higher exports to the US and stronger investor confidence should mute the costs of higher rates. Conversely, if higher rates are driven by worries about inflation, or perhaps a hawkish turn in Fed policy, this will likely be much more disruptive.

Research by Jasper Hoek, Emre Yoldas and I confirm that the reason for changes in US rates matters for EMEs.2 We looked at changes in US Treasury yields following meetings of the Federal Open Market Committee.3 We classified its announcements according to whether they primarily conveyed “growth” news (i.e. information about future growth prospects) or “monetary” news (i.e. information about future inflation or the Fed’s reaction function), based on the reaction of the S&P 500 equity index. FOMC announcements were categorised as conveying primarily growth news if the Treasury yield and the S&P 500 index moved in the same direction. For example, an FOMC communication that increased investor confidence about US growth might cause both US Treasury yields and stock prices to rise. Conversely, we classified FOMC meetings as conveying primarily monetary news if yields and equities move in opposite directions. For example, an FOMC announcement referencing rising inflationary pressure might cause yields to rise and the S&P index to fall as higher discount rates weigh on stock valuations.

With this classification in hand, we then estimated how asset prices in 22 emerging markets over the past decade responded to movements in US Treasury yields. The results are shown in the figure below, which indicates the effect of a 100 basis-point rise in the 10-year Treasury yield, following an FOMC meeting, on EME asset prices. It is clear that increases in interest rates driven by growth news are much less disruptive for emerging markets than increases driven by monetary news. In response to growth news, currencies appreciate (a rise indicates depreciation), equities rise, CDS spreads are unchanged and bond yields move up only moderately. Conversely, in response to growth news, all of these asset prices move sharply and adversely.

1. Effect of 100-basis point increase in 10-year US Treasury yield on EME asset prices

Kamin 28/06/2021

Our findings provide a strong basis for the market’s intuition that rising interest rates and Fed tightening driven by above-expectation inflation pose a material threat to financial stability, especially in emerging markets. But they do not tell us whether that situation will actually materialise, and I doubt that any economist’s crystal ball is working well these days. So in thinking about the implications of the economic outlook for EMEs, I prefer to focus on several alternative scenarios.

In the good scenario, inflation remains sufficiently contained that the Fed is able to credibly stick to its intentions, as summarised in its just-released June Survey of Economic Projections, to keep interest rate at near-zero levels for a couple of years. For example, having registered 3.8% in May, core (excluding food and energy) CPI inflation might ease a bit later this year, and subside more substantially thereafter, as supply capacity expands and pent-up demand from the pandemic eases. Assuming markets agree with the Fed that the inflation surge is temporary, longer-term yields move up only slowly. With strong US growth propelling only-gradual rises in interest rates, most emerging market economies are able to transition relatively smoothly to the post-pandemic environment.

In the bad scenario, huge fiscal stimulus plus the release of pent-up private demand push core inflation substantially above 4% for the next couple of years amid rising wages and inflation expectations. The Fed tapers its asset purchases and raises interest rates far earlier than expected – Treasury yields soar, corporate high yield spreads widen and equities plunge. Consistent with our research, this is clearly bad news for emerging market economies, and they experience widespread financial stress, recession and defaults.

Finally, we come to the ugly scenario: core inflation surges well above 4%, as above, but it subsides some time next year as supply constraints ease and demand pressures wane. Correctly assessing the price spike to be temporary, the Fed holds tight to its accommodative policy. But markets aren’t so sure, and longer-dated Treasury yields spike, triggering global financial volatility. Eventually, markets calm and yields fall back as inflation comes back down, but it still means depression and defaults for the more vulnerable EMEs.

While all three of these scenarios are possible, the good seems too benign and the bad seem too extreme to be the most likely outcomes. Which means that things may be about to get ugly…


  1. I am indebted to John Kearns for excellent research assistance on this article.
  2. Hoek, Jasper, Steve Kamin and Emre Yoldas (2021), “Are rising US interest rates destabilizing for emerging market economies?”, FEDS Notes. Washington: Board of Governors of the Federal Reserve System, June 23, 2021. Similar findings are reported by the International Monetary Fund (2021), “Chapter 4: shifting gears: monetary policy spillovers during the recovery from Covid-19,” World Economic Outlook, April.
  3. We performed a similar analysis, and made similar findings, using US payroll reports.
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