From low to high inflation: Implications for emerging market and developing economies

Jongrim Ha, M. Ayhan Kose, and Franziska Ohnsorge

8 April 2022

Photo by engin akyurt on Unsplash

In February 2022, global inflation rose to its highest level since 2008. Year-over-year inflation in advanced economies rose nearly ten-fold over the past year. That was before Russia’s invasion of Ukraine set commodity prices soaring. High and rising inflation has already been prompting many emerging market and developing-economy (EMDE) central banks to tighten monetary policy.

As the recent decision by the U.S. Federal Reserve shows, the economic fallout of the war in Ukraine is unlikely to derail announced plans of some major advanced-economy central banks to tighten monetary policies to rein in inflation. Should such policy tightening be faster than expected, it could lead to a sharp repricing of financial market risk in EMDEs and stifle economic recovery.

Rising inflation

After declining in the first half of 2020, inflation in the majority of advanced economies and EMDEs rose sharply in 2021 and early 2022 on the back of the release of pent-up demand, persistent supply disruptions, and surging commodity prices. The inflation rise has been broad-based: around nine tenths of the countries experienced an uptick in inflation last year. Rising inflationary pressures have pushed up near-term inflation expectations in many countries, in particular after the war in Ukraine; in some economies, long-term inflation expectations have also crept up.

In advanced economies, after a gradual response initially, central banks have recently embarked on policy tightening cycle or are expected to begin to do so soon. On March 16, the U.S. Federal Reserve raised the fed funds rate by a widely-expected 25 basis points, and signaled a string of rate hikes by the end of 2022. Financial markets have significantly raised their expectations for the trajectory of policy rates at major central banks.

Tightening monetary cycle

Global consumer price inflation is envisioned to peak later this year and then decline gradually, helped by well-anchored expectations in most economies. Easing inflation is in line with the anticipated global growth slowdown over 2022-23, from an exceptionally strong rebound in 2021. However, inflation is already above target in over nine tenths of advanced economies and two thirds of EMDEs that adopt inflation targeting. There is also a risk that inflationary pressures do not abate in the near term, and instead cause a steady rise in inflation expectations.

If this risk materializes, advanced economy central banks may have no choice but to increase policy rates more rapidly than currently anticipated. A sudden upward shift in interest rate expectations in the United States could lead to a sharp repricing of risk by financial markets. The macroeconomic effects of an abrupt tightening of global financial conditions, as well as weaker consumer and business confidence, would compound the unwinding of global fiscal support and deepen the global slowdown underway. This could interact with heightened macroeconomic vulnerabilities in EMDEs to trigger an even sharper slowdown in growth as negative spillovers via confidence, trade, and commodity price channels would reduce private sector activity.

These countries would experience capital outflows in response to heightened investor risk aversion, leading to currency depreciation, which in turn would worsen debt burdens and further boost inflation. Foreign currency-denominated debt accounted for one-half or more of government debt in one-half of EMDEs in 2020. Even when not denominated in foreign currency, government and private debt at multi-decade highs makes these economies vulnerable to rising borrowing cost and rollover risk.

Adjusting policy responses

EMDE policymakers need to focus on calibration, credibility, and communication of their policies. This approach can go a long way in making these economies more resilient to sudden shifts in global financial markets.

For monetary policy, calibrating policy levers to get ahead of inflation without stifling the recovery will be key. For EMDEs, communicating monetary policy decisions clearly, leveraging credible monetary frameworks, and safeguarding central bank independence will also be critical to manage the cycle. On the financial side, policymakers must work to rebuild reserve buffers and realign prudential policy—including capital and liquidity buffers. In addition, they will need to bolster risk monitoring and enhance bankruptcy regimes.

With respect to fiscal policy, the message is much the same. The pace and magnitude of withdrawal of fiscal support must be finely calibrated and closely aligned with credible medium-term fiscal plans. Moreover, policymakers need to address investor concerns about long-run debt sustainability by strengthening fiscal frameworks, enhancing debt transparency, upgrading debt management functions, and improving the revenue and expenditure sides of the government balance sheet.

The findings, interpretations, and conclusions expressed in this blog are entirely those of the authors. They do not necessarily represent the views of the World Bank, its Executive Directors, or the countries they represent.