World Bank Warns: Fed's Inflation Fight Could Trigger Global Economic Upheaval

The Federal Reserve has raised interest rates 10 times in just over a year, pushing the federal funds rate to a target range of 5% - 5.25% as of May. This represents the fastest tightening cycle since the early 1980s, despite inflation still exceeding the Fed's 2% target. According to Business Insider, the Fed is anticipated to pause its rate hikes at its upcoming policy meeting.

However, the World Bank's recent Global Economic Prospects report highlights that this rapid monetary tightening in the U.S. will particularly impact emerging market and developing economies (EMDEs). This could precipitate widespread financial crises and recessions. As the Fed continues its course, central banks in EMDEs may feel compelled to follow suit, leading to higher domestic interest rates and currency depreciation, which would exacerbate inflation in their own economies. Such conditions make it increasingly difficult for businesses and governments in these nations to borrow and access capital.

The World Bank's findings emerge as it describes the global economy as being in a "precarious state," with rising interest rates already curbing consumer spending and business investment. The report also points to an unstable financial system, forecasting a deceleration in global economic growth to 2.1%, down from 3.1% last year.

The authors of the report expressed concern, writing, "The outlook for EMDEs is somewhat worrying with rising U.S. interest rates – driven largely by inflation – and reactionary shocks." A "reactionary shock" is defined as an interest rate change influenced by shifts in the Fed's stance on inflation. These shocks can severely impact EMDEs by causing stock and currency prices to fall, which in turn drives up the cost of imported goods, including food.

EMDEs with "fragile" fiscal positions and significant macroeconomic imbalances, such as those with low credit ratings or large current account deficits, are deemed particularly susceptible to the effects of Fed rate hikes. The Fed is expected to continue its tightening cycle to cool inflation, even as many EMDEs grapple with record-high debt levels. The report indicates that nearly 60% of low-income countries are currently at high risk of, or already in, debt distress.

Beyond the Fed's direct actions, the recent turmoil within the U.S. financial system, marked by the collapse of several regional banks, also poses a threat to EMDEs. This instability could lead to reduced exports and financial market disruptions for these economies, compounding their already "depressed" growth prospects. Since late 2021, a growing number of EMDEs have faced market insolvency and an increased risk of default.

The World Bank report suggests that monetary authorities in EMDEs might need to tighten their own policies to mitigate sharp rises in inflation or currency depreciation, thereby reducing underlying economic vulnerabilities. The report further stresses the importance of ensuring international financial institutions are adequately funded to support distressed EMDEs. This would necessitate stronger bank capital, improved monetary management, and enhanced liquidity, alongside the potential need for external debt restructuring in some EMDEs.