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Potential Global Downturn Looms as the Fed Battles Inflation Without Triggering a US Recession

New World Bank Report Highlights Global Ramifications

14 June 2023


Jayashri Ghorpade

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  • According to a new World Bank report, the Federal Reserve's fight against inflation may have economic implications that extend far beyond the borders of the United States.

  • Emerging market and developing economies will be particularly affected by the swift tightening of monetary policy.

Despite the Federal Reserve's ongoing efforts to curb inflation by raising interest rates, a recent World Bank report suggests that the economic repercussions of the US central bank's actions could extend far beyond its borders, even if a recession within the United States has not yet materialized.

With the meeting approaching next week, it is expected that the Federal Reserve will likely halt its interest rate hikes. As of Friday afternoon, Fed fund futures indicate a 72% probability that policymakers will maintain the current rate, suggesting a potential pause in their actions.

Despite the central bank raising interest rates 10 times in a little over a year, inflation continues to exceed the 2% target. In May, the Federal Open Market Committee of the Federal Reserve increased the benchmark rate by 0.25 percentage points, resulting in a federal funds rate target range of 5%-5.25%. This current tightening cycle represents the fastest pace of tightening since the early 1980s.

The World Bank, in its most recent Global Economic Prospects report, warns that the rapid tightening of monetary policy in the United States will have a particularly significant impact on emerging market and developing economies (EMDEs). It suggests that this tightening could potentially trigger financial crises and recessions worldwide.

The hawkish tightening by the Fed has the potential to spill over to EMDEs, leading to increased domestic interest rates and currency depreciation, which in turn could worsen inflation. This situation would create significant challenges for businesses and governments in these countries, as borrowing money and accessing capital would become more difficult.

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These findings align with the World Bank's projection that the global economy is currently in a "precarious state." As interest rates rise, consumer spending and business investment are slowing down, indicating a less stable financial system. The estimated global growth rate is expected to decline to 2.1%, a significant drop from last year's 3.1%. The authors of the report expressed concern about the outlook for EMDEs, attributing the rise in U.S. interest rates primarily to inflation and reaction shocks.

The impacts of reaction shocks, characterized by interest rate fluctuations resulting from market perceptions of the Federal Reserve's stance on combating inflation, can be especially detrimental to Emerging Market and Developing Economies (EMDEs). These shocks, combined with inflationary pressures, have the potential to decrease equity prices and devalue currencies. Consequently, currency depreciation may lead to increased costs for essential imports like food. EMDEs that exhibit financial vulnerabilities and significant macroeconomic imbalances, such as weaker credit ratings and account deficits, are particularly susceptible to economic and financial challenges resulting from US interest rate hikes.

Considering the Federal Reserve's commitment to tight monetary policy aimed at reducing inflation, these spillover effects could arise amidst the backdrop of historically high levels of debt in numerous EMDEs. As indicated by the report, almost 60% of low-income countries either face or are at a high risk of debt distress.

The potential threats to EMDEs go beyond the Federal Reserve's actions, as turbulence in the US financial system, triggered by recent bank failures, could also pose risks. The US's banking strains have resulted in a slower trajectory of interest rates, which in turn may lead to reduced exports and disrupted financial markets for EMDEs, dampening their growth prospects. Consequently, since late 2021, a growing number of EMDEs have encountered difficulties in accessing the market and faced a higher likelihood of default.

The report emphasizes the importance of clear communication and calibrated strategies by central banks in advanced countries to avoid abrupt shifts in the policy outlook. Additionally, EMDE monetary authorities may need to tighten their own policies to mitigate the risks of significant inflation or currency depreciation, thereby reducing their fundamental economic vulnerabilities.

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