Emerging markets in 'wait for Fed' mode as US central bank scales back interest rate cuts

A delayed Fed complicates the outlook for other economies around the world

The Federal Reserve's delay in cutting rates means the US could be one of the last advanced economies to begin dialling back on its restrictive stance. Reuters

As the Federal Reserve embraces a wait-and-see approach towards interest rate reductions, emerging markets are left with little choice but to tailor their own policy decisions based on the Fed's actions and messaging.

The US central bank last week downgraded its interest rate projection to just a quarter-of-a-percentage point cut this year. By the time the Fed is ready to cut rates, other developed economies like the European Central Bank and Bank of Canada will already be well under way.

“That means the Fed is going to be higher for longer and probably one of the last major central banks to start cutting rates,” said Paul Gruenwald, chief global economist at S&P.

This divergence is unlike what financial markets saw in 2021 and 2022, when central banks more or less acted in synchronicity to aggressively raise interest rates in response to a global surge in inflation.

Now, the Fed is set to keep rates steady for at least several more months.

That delay is already postponing many emerging markets' plans to cut rates as well, and not just oil exporters like the UAE and other GCC countries whose currencies are pegged to the dollar. Emerging markets in the Asia Pacific region are also holding off for now, for fear of moving before the Fed.

Meanwhile, central banks in Sweden, Switzerland, Brazil and Mexico have already begun cutting rates, leading to what Mr Gruenwald calls a “disjointed cutting cycle”.

“It looks like we're going to be going down at different paces. And that's just a reflection of another theme we've been pointing to which is US outperformance,” he told The National.

A slower path

Economists and traders are already pencilling in delayed projections for when emerging markets can reduce rates due to the Fed's own delay.

Most emerging markets tend to fare better in an environment with lower interest rates and a weaker US dollar.

But with the Fed now in higher-for-longer territory, these economies are forced to navigate through higher exchange rates and higher debt levels.

It could also lead to higher capital outflows, as investors pulling capital from emerging markets could weaken economic activity and add to their financial vulnerability.

In the Asia-Pacific region, Mr Gruenwald said central banks are wary of “getting ahead of the Fed” because it could ramp up capital outflows and weaken their currencies.

“They don't want a quick withdrawal of capital. I mean, those can be destabilising,” he said.

This concern led Indonesia to raise interest rates in order to strengthen the rupiah's exchange rate stability. The central bank's governor called this a “pre-emptive” move.

Meanwhile, Latin and South American economies are nearing the end of normalising monetary policy. But the central bank governors of Brazil and Mexico, who responded to the 2022 inflation surge quicker than the Fed, now have to slow their decisions until the Fed acts.

“That kind of illustrates the difficulty for these countries,” said Maury Obstfeld, a senior fellow at the Peterson Institute for International Economics think tank in Washington.

Lowering rates at a time when the Fed adopts a higher-for-longer mindset places more pressure on these countries because, as their currencies depreciate it puts more pressure on inflation.

“I think it becomes a lot harder for them to cut when the Fed is not cutting,” Mr Obstfeld said.

“And what we'll see is sort of a slower pace of interest rate reductions from those economies, until the Fed signals strongly that it's cutting in the near future,” he said.

Banxico, which closely monitors the Fed's decisions to avoid capital outflows, is expected to pause rate reductions after beginning in March. The central bank has insisted its decisions are independent of the Fed's.

Even as they remain wary of the spillovers from the Fed's decisions, many central banks in advanced emerging markets are less vulnerable today than in previous restricting cycles.

“Their central banks really did good jobs in not falling behind the curve. And I think this has served them well as the Fed or the ECB went into their hiking cycles, which … put a lot of stress on these economies.” Mr Obstfeld said.

“It did put stress on them, but we didn't get any large scale debt crises apart from lower income countries.”

Low-income countries to face biggest pressure

While emerging markets may not be as vulnerable to the Fed's decisions like in years past, low-income countries saddled with debt continue to face pressure.

“I don't think it's something that creates an immediate crisis, but it increases pressures on them that they're already feeling,” Mr Obstfeld said.

Low-income markets are typically vulnerable to interest-rate increases, but the global rate hiking cycle in 2022 caused their debt burdens to soar.

More than half of low-income countries face high risk of debt distress, and roughly one-fifth have sovereign bonds trading at distressed levels, the International Monetary Fund reported last year.

Among those facing debt crises are Egypt, Morocco, Lebanon, Pakistan, Tunisia and Zambia.

In the case of Egypt, Cairo's central bank announced a series of austerity measures to help secure an $8 billion loan from the IMF in March. That followed a previous investment from the UAE, as part of a $35 billion deal signed with a consortium led by Abu Dhabi's investment holding firm ADQ.

Egypt is just one example of an emerging market waiting for lower interest rates. Lower US rates would weaken the dollar's value against the Egyptian pound, theoretically boosting economic growth a consumers are able to purchase more.

The IMF noted that some progress had been made by countries like Zambia and Nigeria to build economic resilience, but warned many are still falling behind.

“It may be a sort of slow moving process as the interest charges build up, but it's definitely not a favourable development for them, not a favourable environment,” Mr Obstfeld said.

'A short sleep'

The Fed's slower path to rate cuts plays out differently among oil-importers, whose currencies are pegged to the dollar.

Zubair Iqbal, a non-resident scholar at the Middle East Institute think tank, explained that interest rates in GCC countries tend to fall when the market-setting Federal Reserve reduces rates in the US.

“And the reason, very simply the following, the central banks in these countries tend to determine the rates according to what the market rate is to be used on, and therefore interest rates are adjusted in order to make sure that happens,” he said.

Mr Iqbal said that because these oil-exporting countries have the lower and upper bound rates tied to the dollar – which in the US is currently 5.25 and 5.50 per cent, respectively – they are protected from a scenario in which there is a destabilising flow of funds.

“It's like waking up from a short sleep. Nothing happens,” he said.

And with the region facing economic uncertainty because of potential spillover effects from the Gaza war, trade disruptions, one quarter-rate cut this year will likely have a minimal impact even for low-income countries that are dollar-pegged.

When interest rates fall, it typically eases some of the debt service burden countries face as it allows more room for countries to borrow. But that is not the case for economies impacted by the war in Gaza, Mr Iqbar said, because they will not be in the market to borrow.

“In any case, they will be restraining their spending to adjust to the crisis situation. Little consequences would be attributable to the US interest rate policy,” he said.