Impact of US interest rates on emerging marketing economies (EME)

Abstract

In today’s interconnected world regarding the flow of trade and capital, the United States (US)’s economy plays a key role and has a large spill-over effect on the world economy. The recent example of the 2007 financial crisis started as subprime lending in the US and later became a global financial crisis, one of the worst world has ever witnessed since The Great Depression of 1929. Emerging economies like India, China which have a significant share of trade and capital flow dependence with the US, are affected most by the US economic policies. One such economic tool which affects these emerging economies and the rest of the world is US interest rates, both short-term, i.e., Fed Funds Rate (FFR), and long-term, i.e., treasury bond yields. Another important policy tool that has been extensively used by the US since GFC to boost the economy whenever its economy slowdowns which also impact the US interest rates indirectly, is the Quantitative Easing (QE) program. The Federal Open Market Committee (FOMC) decides upon the short-term interest rates and quantitative easing program in its meeting, which includes scheduled meetings (it meets eight times ina year) & a few emergency meetings [1]. Now, we are going to study how the change in interest rates affects the emerging market economies & the rest of the world through different macroeconomic indicators. In general, an increase in US interest rates will lead to an appreciation of the US dollar in comparison to the other currencies and adversely impact the EMEs. The rise in interest rates leads to an increase in debt size, especially the dollar denomination, which initiates outflow of capital, including Flls, which cause equity market slumps and overall tightening of financial conditions. Figure 1 shows the incidences of the financial crisis in EMEs coinciding with the increase in Federal Funds Rate, which is shown in the gray areas[6]