Against the backdrop of the ongoing aggressive tightening of Fed policy, this paper explores the impact of rising U.S. interest rates on EMDE financial and economic conditions and fiscal outcomes. In particular, it aims to answer the following questions:

- What mix of inflation, reaction, and real shocks have driven changes in U.S. interest rates in recent years?

- How do the different types of shocks behind changes in U.S. interest rates affect EMDEs financial markets, capital flows, borrowing costs, and fiscal outcomes?

- How do the real, inflation, and reaction shocks behind changes in U.S. interest rates affect the likelihood of EMDE financial crises?

Because each of these questions requires the analysis of different sets of data available at different frequencies, and in order to keep the models used to examine those datasets as parsimonious as possible, the paper employs three distinct empirical methodologies. To identify the mix of real, inflation, and reaction shocks that have been driving U.S. interest rates, the analysis applies a _signrestricted Bayesian VAR model_ to monthly U.S. data on bond yields, stock prices, and inflation expectations. It then estimates _panel local projection models_ to assess the impact on EMDE financial, macroeconomic, and fiscal variables at a quarterly frequency of the different types of U.S. interest rate shocks identified by the VAR model. Finally, a _logit model_ is applied to annual data to determine how these different types of interest rate shocks affect the probability that an EMDE will experience a financial crisis.

The paper reports the following key findings. First, since the start of 2022, rising rates have been driven almost exclusively by continued increases in inflation expectations and a perceived hawkish shift in the Fed’s reaction function as it pivoted toward an exclusive focus on reversing the surge in inflation. Most observers and market participants anticipate some further Fed tightening as inflation remains well above target and the Fed continues to reaffirm that price stability is its highest priority.

Second, the paper confirms the intuition described above that such increases in U.S. interest rates, driven by inflation expectations and changing perceptions of the Fed’s reaction function, are especially detrimental to EMDEs. Inflation and reaction shocks boost local-currency bond yields, widen sovereign risk spreads, depress equity prices, depreciate currencies, and dampen capital flows. These tighter financing conditions lead EMDE governments to cut spending to improve primary budget balances and reduce government debt. Generally, these spillovers appear to be more pronounced for reaction shocks—that is, increases in U.S. interest rates associated with market perceptions that the Fed has become more hawkish—than for shocks to inflation expectations. Reaction shocks also decrease private consumption and fixed investment.

By contrast, real shocks to U.S. interest rates would have been much more benign: They lower dollar-denominated sovereign spreads, increase equity prices, appreciate the real exchange rate, boost real exports, and bolster capital flows. And while real shocks are also associated with an increase in the primary budget balance, this reflects improvements in revenue collection as well as declines in expenditures.

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