The increase in interest rates by the Federal Reserve may curb inflation in the United States, but for other countries, particularly developing nations, higher interest rates may create financial risks. Cristina Bodea, professor of political science in Michigan State University’s College of Social Science, is an expert on economic policy and shares how inflation and increased rates can affect countries worldwide.
Responses are excerpts from an article originally published in The Conversation.
How would you describe the current level of inflation here in the U.S.?
The campaign to fight U.S. inflation by upping interest rates has been going on for a year and a half — and its impacts are being felt around the world.
On July 26, 2023, the Federal Reserve announced another quarter-point hike. That means U.S. rates have gone up 5.25 percentage points over the past 18 months. While inflation is now coming down in the U.S., the aggressive monetary policy also may be having significant longer-term impact on countries across the world, especially in developing countries.
How could low-income nations be harmed?
Monetary policy decisions in the U.S., such as raising interest rates, have a ripple effect in low-income countries — not least because of the central role of the dollar in the global economy. Many emerging economies rely on the dollar for trade, and most borrow in the U.S. dollar — all at rates influenced by the Federal Reserve. When U.S. interest rates go up, many countries, especially developing ones, tend to follow suit.
This is out of concern for currency depreciation when currency falls in terms of its exchange rate. Raising U.S. interest rates has the effect of making American government and corporate bonds, or loans, look more attractive to investors. The result is capital that can be moved out of emerging markets that are deemed riskier. This pushes down the currencies of those nations and prompts governments in lower-income nations to scramble to mirror U.S. Federal Reserve policy. The problem is that many of these countries already have high interest rates and further hikes limit how much governments can lend to expand their own economies — heightening the risk of recession.
Then there is the impact that raising rates in the U.S. has had on countries with large debts. When rates were lower, a lot of lower-income nations took on high levels of international debt to offset the financial impact of the COVID-19 pandemic and then, later, the effect of higher prices caused by war in Ukraine. But the rising cost of borrowing makes it more difficult for governments to cover repayments that are coming due now. This condition, called ‘debt distress,’ is affecting an increasing number of countries. More broadly, any attempt to slow down growth to lower inflation in the U.S., which is the intended aim of raising interest rates, will have a knock-on effect on the economies of smaller nations.
Could other countries be vulnerable?
This is not just theory — history has shown that, in practice, rate hikes make other countries vulnerable.
When then-Fed Chair Paul Volcker fought domestic inflation in the late 1970s and early 1980s, he did so with aggressive interest rate hikes that pushed up the cost of borrowing around the world. It contributed to debt crises for 16 Latin American countries and led to what became known in the region as the ‘lost decade’ — a period of economic stagnation and soaring poverty.
The current rate increases are not of the same order as those of the early 1980s, when rates rose to nearly 20%. But rates are high enough to prompt fears among economists.
How do higher interest rates affect the wealth gap?
Income inequality is at an all-time high — both within individual countries and between the richer and developing countries. The 2022 World Inequality Report notes that, currently, the richest 10% of individuals globally take home 52% of all global income, while the poorest half of the global population receives a mere 8.5%. Such a wealth gap is deeply corrosive for societies. Inequality of income and wealth has been shown to both harm democracy and reduce popular support for democratic institutions. It also has been linked to political violence and corruption.
Financial crises, such as the kind that higher interest rates in the U.S. may spark, increase the chance of economic slowdowns or even recessions. Worryingly, the World Bank has warned that developing nations face a ‘multi-year period of slow growth’ that will only increase rates of poverty. These effects are compounded by government policies, such as cuts in spending and government services, which disproportionately affect lower-income people.
So, in a very real sense, a period of higher interest rates in the U.S. can have a detrimental effect on the economic, political and social well-being of developing nations. There is a caveat, however. With inflation in the U.S. slowing, further interest rate increases may be limited.
It may be the case that regardless of whether Fed policy has threaded the needle of slowing the U.S. economy but not by too much, it has nonetheless sown the seeds of more potentially severe economic — and social — woes in poorer nations.