Policy Research Note No.2: The Coming U.S. Interest Rate Tightening Cycle: Smooth Sailing or Stormy Waters?



Financial conditions are on the cusp of becoming more challenging for emerging and frontier market economies (EFEs) as the U.S. Federal Reserve will soon embark on its first tightening cycle in almost a decade. This will take place in a difficult global context for EFEs, with subdued world trade and low commodity prices. Moreover, many EFEs are struggling with weakening growth prospects and lingering vulnerabilities that constrain their policy options. The taper tantrum episode of May-June 2013 is a reminder that even a long anticipated change in Fed policies can surprise markets and trigger substantial financial market volatility in EFEs. This volatility could combine with underlying weakness into a “perfect storm” in some of the most fragile countries.

This paper analyzes the changes in global conditions since the taper tantrum, risks of disruptions during the upcoming Fed tightening cycle, potential implications for EFEs, and possible policy options. Specifically, it addresses the following four questions:

  • How have growth prospects and policies in advanced countries changed since the taper tantrum?
  • How have growth prospects and vulnerabilities in EFEs changed since the taper tantrum?
  • What are the major risks associated with the tightening cycle for EFEs?
  • What policy options are available for EFEs to prepare for risks around the tightening cycle?

This note in part of the Policy Research Notes (PRN) series. Policy Research Notes are prepared under the direction of the World Bank Chief Economist and Senior Vice President for Development Economics. PRNs combine and distill existing and new research to inform discussion on topical policy issues. They are aimed at a broad audience interested in economic policy.

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