Amid wartime disruptions, most emerging-market central banks will follow the Fed

A main takeaway from last week's spring meetings of the International Monetary Fund (IMF) and the World Bank is that emerging-market and developing economies (EMs) will suffer more than high-income countries from the repercussions of the Iran war. Compared with the IMF's January 2026 predictions, its April World Economic Outlook forecast downgraded expected 2026 economic growth in EMs from 4.2 percent to 3.9 percent while maintaining advanced economies' expected growth rates roughly constant at 1.8 percent. Downside possibilities look worse.

EMs will also suffer from higher inflation. The IMF raised its advanced economy inflation forecast for 2026 from 2.2 percent to 2.8 percent but raised expected EM inflation slightly more, from 4.8 percent to 5.5 percent. The inflation outlook may push many EMs to tighten monetary policy even as economic growth struggles. A major factor for all will be the US Federal Reserve's response and the effects on the dollar.

Emerging markets on guard

Emerging markets face a double threat. Most salient is the menace from higher prices for energy and fossil fuel–based products such as fertilizers. Another risk comes from the inflationary impact of the dollar, which rose against EM currencies upon the war's outbreak, after falling steadily from a recent peak in January 2025, and remains volatile, heavily dependent on the Fed's next moves. Strong monetary policy frameworks in many emerging markets helped them contain output losses during the 2021–23 global inflation surge and will likely help them again to navigate the current crisis. If the crisis persists, however, and causes a hard pivot to more restrictive monetary policies globally, the costs to economic growth may be bigger this time. EM central banks may tighten monetary policy even while facing more severe real GDP shocks than the advanced economies.

Until the Iran war broke out on February 28, emerging-market central banks had been on course to continue the series of cuts in monetary policy interest rates that many of them began in late 2023 or 2024, even before the Fed started lowering rates in September 2024 (see figure 1). That has abruptly changed. In March, when the South African Reserve Bank held rates steady, Governor Lesetja Kganyago said, "We warned of elevated risks, and we have been proceeding cautiously in our rate setting. Now a crisis has hit, this prudent approach is proving appropriate." In early April, the Reserve Bank of India likewise held its policy rate constant, with Governor Sanjay Malhotra stating that the bank's monetary policy committee thought "it is prudent to wait and watch the changing circumstances and the evolving growth-inflation outlook." While a few central banks—notably those of Brazil, Mexico, and Russia—proceeded with planned rate cuts in March, many other EM central banks are moving with greater caution.

Through the start of the Iran war, participants in US financial markets were predicting two 25 basis point Fed interest rate cuts by the end of this year. Coupled with tepid growth in emerging markets and a tame inflation outlook, these pre-war predictions encouraged EM central bankers to expect they might cut their own rates further this year. But by the end of March, market predictions even allowed for the possibility of Fed rate hikes this year. Many EM central banks have hit the brakes.

Following the Fed

EM central banks have long taken their cues from the Fed. In a recent paper, two of us (Mendoza-Fernández and Pelin) assemble detailed data on 9,500 monetary policy meetings across 59 economies between August 1990 and December 2024. The data reveal that across the world, central bank policy meetings are disproportionately scheduled to follow meetings of the Fed's rate-setting Federal Open Market Committee (FOMC) rather closely (often within two weeks). Furthermore, EM central banks tend to follow the Fed's actions: The unconditional probability of an EM central bank moving in the same direction as the Fed at its next meeting is about 60 percent.[1] For their part, the central banks of advanced economies are much less likely to follow the Fed.

Figure 2 further illustrates the linkage between Fed monetary moves and reactions by EM central banks. The figure divides up the observations corresponding to prior FOMC rate changes in multiples of 25 basis points (horizontal axis) and plots those points against the mean central bank response in their next meetings (vertical axis). The positive correlation between FOMC decisions and EM responses is evident.

The unconditional relationship in figure 2 does not reflect the strength of the causal impact of Fed cuts, because Fed monetary policy responds to a range of factors with diverse impacts on different EM economies' monetary stances. Adjustments for this statistical problem show that on average, a 100 basis point Fed hike, holding other economic factors constant, would cause a 50 basis point hike by EM central banks. Additionally, EM interest rates depart from their previous trends for up to a year following such a Fed monetary shock. This causal effect can be thought of as a measure of a Fed hike's effect on EM central banks' incentive to tighten monetary policy, where the Fed hike is not due to developments in US macroeconomic conditions and is unanticipated by the market.

Why do EM central banks so often follow the Fed?

A large body of research shows that emerging markets' economic activity slows and currencies depreciate when the Fed tightens. The reverse occurs when the Fed loosens.[2] An EM central bank that prioritized GDP and employment might respond to a Fed hike by lowering its interest rate, contrary to the Fed's action, but this is not what the data show. The main reason is that for EM economies, which often are quite open, Fed hikes and the currency depreciation they cause have strong effects on inflation and inflation expectations.

Currency depreciation directly raises import prices, boosting consumer inflation while raising businesses' expenses for imported inputs. Prices of domestic goods that are substitutes for imports will also rise. To the extent that firms finance working capital through dollar borrowing, higher dollar interest rates feed directly into marginal production costs, creating even more price pressures down the road.[3]

An EM central bank fearful of losing hard-won inflation credibility will therefore respond to a tighter Fed policy by raising its own policy interest rate. Moreover, policies that dampen currency depreciation may have beneficial collateral effects by offsetting the adverse income distribution effects of currency depreciation.[4]

The role of the dollar exchange rate

Sometimes, EM central banks respond to changes in the US dollar's overall strength, rather than directly to US interest rates. They do so because of the dollar's strong causal effect on the global financial conditions that EM economies face as well as its direct effect on inflation. In these cases, EM central banks effectively anticipate rather than follow the Fed, because dollar movements typically reflect expected future, in addition to actual, Fed policy shifts. This is further evidence that a key reason EM central banks often follow the Fed is the effect of its decisions on the exchange rate.

A recent example is the generalized tightening of EM monetary policies as global inflation rose in 2021, notably before the Fed and most other advanced economy central banks started tightening. Despite having reduced inflation substantially since the 1990s, often with the help of inflation-targeting frameworks, EM central banks have shorter track records than their advanced economy counterparts, and many operate in more volatile political environments. The dollar's appreciation starting in 2021 added to EM inflation, which was already high because of the global supply and demand imbalances that arose as the pandemic waned. EM central banks therefore moved promptly to get "ahead of the curve" rather than risk destabilizing the private sector's inflation expectations.

The panels in figure 3 illustrate these dynamics. The figure shows that the average EM policy rate (in panel a) broadly tracked the dollar's exchange rate against advanced economy trade partners (in panel b) into the fourth quarter of 2022.[5] The world price of oil (panel b) was a less consistent driver of monetary policy: Even as oil prices reversed in mid-2022, EM interest rates continued to move upward in sync with Fed policy and the dollar. Finally, starting early in 2022, EM interest rates also track the expected federal funds rate (panel b), which moved up ahead of the restrictive Fed actions that began in March 2022.

Immediate pain versus longer-term gain

EM policy responses to the Fed and the dollar have served them well over several crises in keeping inflation expectations anchored. Many EM central banks will retain the approach in the current crisis, giving priority to containing inflation over maintaining short-term growth by closely tracking US monetary developments and exchange rates.[6] Some may even tighten monetary policy ahead of the Fed, as the central bank of Singapore has done. The challenge for EM governments will be to use fiscal and structural tools in an environment of limited policy space to mitigate the pain of lower real activity and preserve social stability. The more persistent war-related disruptions are, the greater that challenge will be.

So far, markets seem to have confidence in that policy playbook. The JP Morgan emerging markets bond index plus (EMBI+) of sovereign spreads (a standard measure of EM default risk on dollar bonds) has barely ticked up during the Iran war and is not elevated by historical standards. That could change, and indicators of average spreads hide individual countries' idiosyncracies. But if past experience is a guide, an approach that keeps inflation expectations in check will be better for growth over the longer term than more accommodative policies, despite immediate pain.

Notes

1. With random decisions, the probability of moving in the same direction as the Fed would be only 1/3. Estimates of several different probability models confirm that this relationship is highly statistically significant. Several academic papers, in contrast, find no link between Fed moves and the contemporaneous reactions of EM central banks. The reason is that standard monetary policy datasets are constructed at monthly frequency rather than at the level of policy meetings. This temporal aggregation introduces timing misalignment between Fed actions and EM responses, adding measurement error that biases estimated relationships toward zero.

2. Influential studies include those by Silvia Miranda-Agrippino and Hélène Rey and by Şebnem Kalemli-Özcan.

3. This effect reflects the "cost channel" of monetary policy explored by Marvin J. Barth III and Valerie A. Ramey and by Federico Ravenna and Carl E. Walsh. These effects were explored earlier in the context of EMs by writers such as Domingo Cavallo, Michael Bruno, and Sweder van Wijnbergen.

4. First highlighted in the EM context by Carlos F. Díaz Alejandro, these effects have received renewed attention in recent papers by Adrien Auclert and others, Rodolfo Campos and Peter Paz, and Haonan Zhou.

5. The reason for focusing on the dollar's exchange rate against advanced economy partners is that this rate is less likely to reflect developments in EM economies that might disguise the dollar's causal impact.

6. This prediction assumes that there is no near-term change in the Fed's ability to operate independently of political pressures.