Prospects after U.S. interest rate hike: Emerging economies tested by the strong dollar

ITO Hiroyuki
Visiting Fellow, RIETI

The Federal Reserve Board (FRB) raised its policy rate by 0.25% on March 16, bringing to an end the zero-interest rate policy, which had been in place since March 2020 in response to the COVID-19 pandemic.

The latest monetary tightening is in response to the highest level of inflation in nearly 40 years. The U.S. economy has been recovering from the economic bottom in the spring of 2020, and demand for goods and services has been strong as well. After the full-scale rollout of vaccinations in 2021, economic recovery on the aggregate demand side has been robust.

On the supply side, however, there is a severe shortage of labor, causing delays in production and logistics. The global supply chains are not functioning well, which is also affecting the retail industry. In the service industries such as healthcare, food services, and lodging, supply is not keeping up with the strong demand. Since the latter half or 2021, the gap between strong demand and weak supply has manifested itself as the highest inflation since the early 1980s.

Furthermore, since Russia's invasion of Ukraine in February 2022, the prices of crude oil, natural gas, wheat, and other commodities have soared, since both countries are major exporters of natural resources and commodities. This has affected the global economy through high inflation of exports.

The Russian economy has been crippled by a wide range of sanctions, including the exclusion of some of its banks from the SWIFT (the Society for Worldwide Interbank Financial Telecommunications) system, restrictions on trading of the central bank's foreign exchange reserves, the removal of the MFN status on international trade, and the withdrawal of many foreign companies. The ruble exchange rate temporarily collapsed and there has been a widespread concern that high inflation will put pressure on the economy. Many experts argue that the Russian economy may experience an economic crisis, and that some Russian government bonds denominated in foreign currencies (such as those of state-run Russian Railways) may default.

In short, the Russian invasion added fuel to the fire where Western countries had already been facing inflationary pressures.


Like the Fed did, it is a common practice to raise policy rates to tame inflation. It is most effective when economic overheating is driven by the demand side of the economy. However, the current inflation is caused not just by demand-side overheating but also by supply-side issues such as supply chain disruptions, labor shortages, and surging prices of natural resources and commodities. That is, unless each of the supply issues is resolved, it will be difficult to curb inflation through monetary policy alone. Hence, high inflation is expected to persist for an extended period.

The greatest risk to the U.S. economy is stagflation, i.e., a combination of economic stagnation and inflation. In addition to higher financing costs due to higher policy rates, the growing uncertainty associated with the Ukraine crisis could dampen consumer and investment sentiment, leading to a recession.

Tighter U.S. monetary policy could also have a significant impact on emerging market economies (EMEs), especially those with large external debt.

Many EMEs have massive external debt, about 60% of which is denominated in U.S. dollars. That makes these economies vulnerable to the Fed's monetary policy. The Fed's monetary tightening causes the dollar to appreciate, increasing the demand for dollar-denominated assets and causing capital to flow out of EMEs to advanced economies, especially the U.S.

The U.S. dollar has long been the most dominant reserve currency in the international monetary system. Dollar-denominated assets account for a high percentage of the world's financial assets, international trade payments and settlements, and cross-border bank loans. Therefore, economies which cannot easily expand their assets denominated in their own currencies, such as emerging market and developing countries, are affected by U.S. macroeconomic conditions and monetary policy through changes in the exchange rate against the dollar. This affects international asset markets, credit growth, and cross-border capital flows.

Many EMEs were heavily indebted even before the COVID-19 pandemic. After the global financial crisis in 2008, the U.S. and other advanced economies cut policy interest rates, which led to the depreciation of the dollar and other major currencies, lowering the cost of financing in those currencies and resulting in an increase in the external debt of EMEs.

The figure also shows that capital inflows to EMEs increased around 2008, when the relative value of the dollar (real effective exchange rate) declined. Foreign capital inflows increased the appetite for investment domestically and increased the overall debt of the economies: between 2010 and 2019, the ratio of gross debt to gross domestic product (GDP) in EMEs expanded from 60% to over 170%. In 2018, foreign investors held 43% of emerging market government bonds, and the ratio of foreign currency denominated corporate bonds to GDP rose from 19% in 2010 to 26% in 2018.

Figure: Private Capital Inflow and U.S. Dollar Real Effective Exchange Rate
Figure: Private Capital Inflow and U.S. Dollar Real Effective Exchange Rate
[Click to enlarge]
Figure: Private Capital Inflow and U.S. Dollar Real Effective Exchange Rate
Note: Real effective exchange rates are indexed to 2010 = 100.
Source: IMF and BIS.
Note: Real effective exchange rates are indexed to 2010 = 100.
Source: IMF and BIS.

In response to the pandemic, many countries aggressively mobilized their public finances to prevent economic deterioration by providing relief to the infected, protecting their healthcare systems, and supplementing the incomes of individuals and businesses that were negatively affected by the spread of infection. Combined with a decrease in tax revenues, this led to an increase in budget deficits, and countries with initially high levels of debt found themselves with even larger debt as a result of the pandemic.

As noted above, a rise in U.S. interest rates under such circumstances could lead to an increase in the burden of repaying foreign debt.


The Ukraine crisis has also increased the demand for "contingency dollars" as a safe-haven asset. In addition, investors may see a Russian default as a sign of rising risk in EMEs in general. Given all this, the dollar is expected to remain strong for the time being.

If this trend continues, EMEs’ currencies will get weaker, leading to higher prices. Global inflation will reduce the purchasing power of consumers in developing economies, which may increase their debt burden.

Central banks in EMEs will be forced to consider raising policy rates. While this could stop depreciation of their currencies and allow inflation to subside, higher interest rates could also raise financing costs and slow business investment and consumer spending.

In Europe and the U.S., the high third-dose vaccination rates and improved infection conditions have led to strong demand. However, unlike advanced economies, emerging and developing countries have not experienced economic recovery driven by aggregate demand. Among those economies, the rollout of vaccination has been slow, and income support policies have not been implemented broadly. Under these circumstances, raising interest rates is highly risky for EMEs.

EMEs are in a difficult situation irrespective of their own interest rate policies. As the U.S. tightens monetary policy, if EMEs did not respond, inflation would rise through depreciation of their own currencies. In other words, they will end up importing inflation from overseas.

On the other hand, if EMEs raise their interest rates, while it may curb inflation somewhat, higher domestic interest rates may lead to higher interest payments on debt and increase country risk for countries with large outstanding debt.

With the advance of globalization, economic conditions and policies in the U.S. and EMEs are deeply interconnected. When shocks occur, they travel through global financial markets, no matter where the epicenter is. To ensure as much economic and financial stability as possible, financial authorities need to communicate fully with market participants through enhancing information transparency and promoting active information exchange. Information sharing and disclosure among national fiscal authorities and central banks such as the Group of Seven (G7) and Group of 20 (G20) economies would certainly help.

The best way forward is to increase the predictability of the economic outlook and monetary and fiscal policies. This would lead to stability in financial markets and international trade, which would benefit the whole world.

>> Original text in Japanese

* Translated by RIETI.

April 14, 2022 Nihon Keizai Shimbun

July 1, 2022