How Do Rising U.S. Interest Rates Affect Emerging and Developing Economies? It Depends

Abstract This paper examines the implications of different types of interest rate shocks in the United States for emerging market and developing economies (EMDEs). We first classify changes in U.S. interest rates into those caused by changes in inflation expectations (“inflation” shocks), changes in perceptions of the Federal Reserve's reaction function (“reaction” shocks), and changes in real activity (“real” shocks). Our analysis attributes the sharp increases in U.S. interest rates since early 2022 mainly to inflation and, especially, reaction shocks. These types of shocks are associated with adverse effects: EMDE financial conditions tighten, consumption and investment fall, and governments cut spending to improve budget balances. By comparison, rising U.S. interest rates stemming from real shocks are not only associated with benign outcomes for EMDE financial conditions but also improvements in budget balances that reflect higher revenues as well as lower expenditures. Finally, this paper documents that rising U.S. interest rates driven by reaction shocks are especially likely to push EMDEs into a financial crisis.