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The View | Federal Reserve’s inflation fight leaves emerging markets scrambling for answers
- The US central bank’s aggressive interest rate increases, coming amid the pandemic and Ukraine war, have amplified challenges for emerging markets and started a reverse currency war
- With these markets looking at drastic measures to stay afloat, it’s time for urgent action from international lenders and central banks
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The mood at the annual meetings of the World Bank and International Monetary Fund was all doom and gloom. Global debt is ringing alarm bells. Increasingly restrictive US monetary policy is having an outsize tightening effect on the rest of the world and hitting emerging markets the hardest.
Central banks in emerging markets put an end to extraordinarily low interest rates induced by the Covid-19 crisis much earlier. However, as inflation in the United States continues to surge, the US Federal Reserve’s aggressive rate increases in the last three months have amplified existing challenges for emerging markets, kick-starting a reverse currency war.
Uncertainty sparked by the war in Ukraine and rising US interest rates have driven up the US dollar, squeezing emerging markets that borrow in foreign currencies. The stronger dollar is also intensifying inflation elsewhere by making commodities even more expensive.
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In this context, central banks in emerging markets are stuck between a rock and a hard place. High inflation makes it virtually impossible to let exchange rates adjust external imbalances, causing even more capital to flow out of emerging markets.
At the same time, central banks need to raise their own rates to contain imported inflation, which tightens domestic financing conditions even more. In fact, with public finances stretched because of measures implemented during the pandemic, most emerging markets are leaning on monetary policy to tackle inflationary pressures, which are now expected to peak in early 2023 as the global energy shock has intensified.
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Emerging Europe, Latin America and Africa are expected to see the largest interest rate increases. Emerging markets as a whole are expected to start gradually easing only in mid-2023, though central banks in emerging Europe and Africa, where inflation is likely to be more sticky, will lag behind. In this complicated context, emerging markets are left with limited ammunition against the reverse currency war – more drastic policy measures, such as intervening in foreign exchange markets, or even imposing capital controls.
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