Ahead of rate meetings, the Fed faces a whipsawing dilemma each time. Can they raise rates considering the current state of the banking market and impending credit issues? But equally, can they afford not to with inflation still running so far above target?

The two most recent Fed meetings saw the interest rate increasing by 25bp, in March and earlier this month. This was in the wake of a perceived banking crisis, which saw yields seesawing and the market pricing in no change at one point.

Ahead of the 22nd March increase, the minutes from the meeting showed that some Fed members had discussed pausing but, with a degree of calm returning to the markets in the days prior to the decision, the overriding need to fight inflation prevailed and as the Fed took advantage of the opportunity to continue raising rates.

Conversely, the overall sentiment in the run up to the upcoming Fed rate decision on the 3rd May was more subdued when compared to the volatility we saw in March. Medium-term yields have moved back up, implying a more stable interest rate environment going forward, and equity markets have moved up from the lows seen in mid-March. Earnings results from JPMorgan, Citibank, and Wells Fargo have indicated that the big systemic banks are in good shape, calming markets further.

As such, we saw that curbing inflation remained the Fed’s priority, with a 25bp rise. The inflation picture is improving but is still a long way away from where it needs to be, and the job market remains resilient.

Chairman Powell has stated that he sees room for one more rate rise, and other Fed speakers have varied between one and two more increases. Projections now suggest that any recession will be shorter and shallower than previously feared.

Rate cuts for this year are still being priced in by the market with the projected year-end Fed rate lower than where we are now. However, Fed speakers have been quick to dismiss the idea that they will cut rates in 2023. This poses a threat to the equity markets, where much of the bounce has been based on a lower interest rate environment going forward. Not only that, it also raises questions about the impact of the rate hike on emerging or hard-to-reach markets.  

Why the Fed balancing act shouldn’t ignore the Global South 

The Fed certainly faced a tricky balancing act as they prepared to deliver another interest rate increase in May, as Colby Smith rightly notes in his article “Fed weighs impact of banking turmoil on next interest rate moves”.

However, this is not the only balancing act that needs to be considered.

They say that “when the US sneezes the whole world catches a cold”. Emerging markets are heavily impacted by sharp increases in US interest rates.

The Global South in particular has struggled with the spiralling cost of debt, weakening currencies, and the knock-on effect on local bond yields. Many of these regions have their own internal challenges which have been compounded by the increase in the cost of debt in major markets.

Whilst the dollar index has moved significantly lower from the highs seen in 2022, emerging market currencies have struggled to recover. Exchange rates in these regions continue to run at all-time lows to attract much needed dollars.

The Fed has so far dismissed the idea that they may cut rates this year and if the US does avoid a recession, it is likely that rates will remain at elevated levels for some time to come. If it does fall into recession, it is likely the rest of the world will follow.

The current projection is for a softish landing and shallow recession. It is hard to evaluate what the best outcome for emerging markets will be – it is clearly finely balanced.