The Fed's fight against inflation hasn't caused a recession in the US yet, but it could lead to a global downturn

• The Fed's battle against inflation could have economic consequences well beyond US borders, according to a new World Bank report.
• The swift tightening of monetary policy will particularly impact emerging market and developing economies.
• Markets believe it is likely the Fed will pause interest rate hikes at its policy meeting next week.

The Federal Reserve's attempts to quash inflation through interest rate hikes hasn't caused a US recession yet, but a World Bank report released Tuesday shows the US central bank's actions could have economic consequences well beyond its borders.

The Fed is likely to pause its interest rate hikes at its meeting next week, with Fed fund futures as of Friday afternoon showing a 72% chance policymakers hold steady.

The central bank has raised interest rates 10 times in a little over a year, though inflation still remains above the 2% target. In May, the Fed's Federal Open Market Committee increased its benchmark rate by 0.25 percentage points, pushing the federal funds rate to a target range of 5%-5.25%. The latest cycle marks the fastest pace of tightening since the early 1980s.

According to the World Bank in its most recent Global Economic Prospects report, the swift tightening of monetary policy in the US will particularly impact emerging market and developing economies, or EMDEs, and could lead to financial crises and recessions around the world.

Hawkish tightening by the Fed can spillover to EMDEs, which could lead to higher domestic interest rates and currency depreciation exacerbating inflation. This could make it far more difficult for businesses and governments in these countries to borrow money and access capital.

These findings come amid the World Bank's projection that the global economy is in a "precarious state" as rising interest rates decelerate consumer spending and business investment. This suggests a more unstable financial system facing a slowing estimated global growth rate of 2.1%, down from 3.1% last year.

"With the rise in U.S. interest rates being driven principally by inflation and reaction shocks, the outlook for EMDEs is worrisome," the authors wrote.

Reaction shocks, defined as interest rate changes following shifting market perceptions of the Fed's views on fighting inflation, could have particularly costly effects on EMDEs. Reaction and inflation shocks can lower equity prices and depreciate currencies. Currency depreciation could lead to greater costs for food and other imports.

EMDEs with financial vulnerabilities and greater macroeconomic imbalances — such as those with weaker credit ratings and account deficits — may be particularly vulnerable to economic and financial strife caused by US interest rate increases.

Fed policy will likely remain tight as it tries to bring inflation down, and this spillover may occur amid unprecedented high levels of debt in many EMDEs. Nearly 60% of low-income countries are either in or at high risk of debt distress, according to the report.

Aside from the Fed's moves, turbulence in the US financial system in the wake of several bank failures this spring could also threaten EMDEs. As a result of the US's banking strains which have slowed the expected path of interest rates, EMDEs could face reduced exports and disrupted financial markets amid quieting growth prospects. Since late 2021, many more EMDEs have faced a loss in market access and a greater likelihood of default.

The report suggests central banks of advanced countries can communicate "their intentions as clearly as possible and calibrating their strategies so as to avoid abrupt changes in the policy outlook." Additionally, EDME monetary authorities may have to tighten their own policies to avoid drastic increases in inflation or currency depreciation, reducing fundamental economic vulnerabilities.

Policy efforts, the report states, should focus on ensuring international financial institutions receive adequate funding to support EMDEs in distress. This entails more adequate bank capital, better currency management, and stronger liquidity, which go alongside external debt restructuring for certain EMDEs.