U.S. Monetary Spillovers to Emerging Markets: Both Policy Drivers and Vulnerabilities Matter

How do U.S. monetary tightening shocks affect emerging market economies, and how does the impact depend on these economies' own macroeconomic vulnerabilities? We examine this question in a model that combines financial frictions with imperfect anchoring of inflation expectations, a key vulnerability in emerging markets. The degree of anchoring is disciplined using evidence that inflation expectations in emerging markets respond significantly to inflation surprises. Imperfect anchoring amplifies the contractionary effects of U.S. monetary shocks on emerging markets but also generates increases in inflation and nominal interest rates, patterns that we show are consistent with the empirical evidence but are not well explained by existing models. Our analysis also distinguishes between the drivers of U.S. policy tightenings. U.S. interest rate hikes resulting from stronger demand, rather than exogenous policy shocks, lead to modestly positive spillovers for emerging markets with well-anchored inflation expectations, but to substantial slowdowns in those with less-well-anchored expectations.