start of the pandemic. Investor risk appetite has been sapped by the war in Ukraine, pandemicrelated mobility restrictions in China, a weaker growth outlook, and higher interest rates in advanced economies.

# **4.3 Impact of U.S. interest rate shocks on EMDEs**

This section compares the effects on financial, real, and fiscal variables in EMDEs of the U.S. interest rates shocks identified by the VAR analysis. As discussed above, the estimates of these effects are based on panel local projection models. Figures 4-6 shows the impact of a 25-basispoint shock—real, inflation, or reaction—to U.S. 2-year bond yields on EMDE variables (for additional detail, see also appendix figures A4-A6 for impact up to eight quarters).<sup>10</sup> The size of the shock corresponds to roughly a one standard deviation move in the 2-year yield as measured since the 1980s.

**_4.3.1 Financial markets response._** As shown in figure 4, increases in U.S. interest rates driven by reaction shocks are associated with adverse movements in EMDE financial markets, including significant increases in 10-year yields and sovereign spreads (EMBI+), declines in capital flows, and depreciations of the real exchange rate; in addition, short-term interest rates rise and equities decline, although those movements are not statistically significant. Inflation shocks are also followed by increases in 10-year yields, lower capital flows, a depreciated real exchange rate, and depressed equity prices; however, with the exception of the last of these, the movements are not statistically significant.

In contrast, real shocks to U.S. interest rates tend to be followed by benign short-term movements in EMDE financial markets, including significant declines in sovereign spreads, an increase in capital flows, an increase in equity prices, and an appreciation of the real exchange rate (figure 4). Ten-year government bond yields rise, but this is to be expected, since bond markets are integrated globally, and even the bond yields of advanced economies tend to move together closely.

**_4.3.2 Economic activity response._** The impacts of U.S. interest rate shocks are not restricted to financial variables, as they also have statistically significant impacts on economic activity and consumer price inflation in EMDEs after one quarter, as shown in figure 5. (Appendix figure A5 extends the analysis up to 8 quarters). Reaction shocks are associated with a significant decline in real GDP components, particularly fixed investment and private consumption expenditure (figure 5A).<sup>11</sup> In contrast, real shocks lead to higher real exports and leave other spending components unchanged. This is consistent with positive spillovers of stronger U.S. real activity on EMDE trade. In addition, inflation shocks induce a large and statistically significant increase in domestic EMDE consumer price inflation, while real shocks reduce it (figure 5B).

> 10 The terms “a 25-basis-point increase in interest rates driven by an inflation shock”, a “25 basis point inflation shock”, and an “inflation shock” are used interchangeably in this section. This is equally true of real and reaction shocks. U.S. interest rates reflect changes in 2-year bond yields.

> 11 See Arbatli et al (2022) for firm-level evidence of the channels through which U.S. monetary policy affects investment outcomes in EMDEs.

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