“shocks”—that is, changes in monetary policy that do not represent a response to changes in the U.S. macroeconomic environment. However, as noted by Nakamura and Steinsson (2018), Cieslak and Schrimpf (2019), and Jarociński and Karadi (2020), changes in interest rates in response to Fed announcements may reflect the market’s interpretation of the motivation for those announcements, e.g., changes in prospects for economic activity, prospects for inflation, or shifts in the Fed’s reaction function. Only a few papers have examined how differences in these types of shocks, as identified using financial market data, may lead to different spillovers to EMDEs.

Arteta et al. (2015) decompose daily movements in 10-year yields into two components: one reflecting real U.S. growth shocks and another reflecting U.S. monetary shocks (that is, both inflation and reaction shocks), based on a vector autoregressive (VAR) model with sign restrictions. The study then uses a panel VAR to show how these shocks impact EMDE indicators, finding that adverse U.S. monetary shocks lead to higher EMDE bond yields, lower equity prices, and weaker currencies, whereas positive U.S. real shocks raise EMDE equity prices and industrial production. Hoek, Yoldas, and Kamin (2021, 2022) categorize changes in U.S. Treasury yields around FOMC announcements as either real, inflation, or reaction shocks, based on the simultaneous movements in equity prices and inflation compensation in TIPS markets. They find that monetary surprises generated by rising inflation expectations have the greatest impact on EMDEs exchange rates, equity prices, bond yields, and CDS spreads, whereas real shocks are generally benign. IMF (2021) looks at the impact of U.S. employment and CPI releases on U.S. and EMDE financial conditions. Consistent with Arteta et al. (2015) and Hoek, Kamin, and Yoldas (2022), it finds that good employment releases that boost U.S. interest rates have benign effects on EMDEs, but unlike the previous studies, it finds little effect on EMDEs of inflation shocks.

Finally, rapidly rising borrowing costs amid elevated EMDEs debt levels, often in combination with other vulnerabilities, can result in financial crises. An extensive literature looks at the correlates of crises and finds that government debt—particularly, external debt—is an early warning indicator of financial crises (Kraay and Nehru 2006; Manasse and Roubini 2009). Kose et al (2020) find that rapid debt accumulation is often accompanied by financial crises. These crises can be very costly, with output 10 percent lower, on average, eight years after a debt crisis and the fiscal cost of resolving a banking crisis at 13 percent of GDP (Furceri and Zdzienicka 2012; Laeven and Valencia 2020).

In terms of the specific impact of rising interest rates on the probability of crisis, studies that link U.S. interest rates to crisis events include Kose et al. (2020) and Manasse and Roubini (2009). In Manasse and Roubini (2009), increases in the U.S. Treasury bill rate are usually observed in the years preceding a crisis. Kose et al. (2021) find that a 2-percentage-point increase in U.S. real interest rates increases the probability of entering a currency crisis the next year by almost 50 percent.

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