The transmission channels of geopolitical risk

Samuel
Smith
and
Marco
Pinchetti

Recent
events
in
the
Middle
East,
as
well
as
Russia’s
invasion
of
Ukraine,
have
sparked
renewed
interest
in
the
consequences
of
geopolitical
tensions
for
global
economic
developments.
In
this
post,
we
argue
that
geopolitical
risk
(GPR)
can
transmit
via
two
separate
and
intrinsically
different
channels:
(i)
a
deflationary
macro
channel,
and
(ii)
an
inflationary
energy
channel.
We
then
use
a
Bayesian
vector
autoregression
(BVAR)
framework
to
evaluate
these
channels
empirically.
Our
estimates
suggest
that
GPR
shocks
can
place
downward
or
upward
pressure
on
advanced
economy
price
levels
depending
on
which
of
the
two
channels
the
shock
propagates
through.

The
channels
of
GPR

To
assess
the
effects
of
geopolitical
tensions
on
the
macroeconomy,
it
is
first
necessary
to
quantitatively
measure
GPR.
Our
approach
to
measuring
GPR
follows
the
work
of
Fed
researchers

Caldara
and
Iacoviello
(2022),
who
develop
an
index
GPR
based
on
the
number
of
articles
covering
adverse
geopolitical
events
in
major
newspapers.
This
index
reflects
automated
text-search
results
of
the
electronic
archives
of
10
major
western
newspapers.
It
is
calculated
by
counting
the
number
of
articles
related
to
adverse
geopolitical
events
in
each
newspaper
for
each
month
(as
a
share
of
the
total
number
of
news
articles).

Chart
1
shows
the
behaviour
of
the
GPR
index
from
1990
to
2023.
The
index
is
relatively
flat
during
large
parts
of
the
sample,
and
spikes
around
major
episodes
of
geopolitical
tension,
such
as
the
outbreak
of
the
Gulf
War,
9/11,
the
beginning
of
the
Iraq
invasion
in
the
2000s,
and
the
Russian
invasion
of
Ukraine
in
2022.

Chart
1:
The
GPR
index

Source:

Caldara
and
Iacoviello
(2022).

In
the
same
paper,

Caldara
and
Iacoviello
(2022)
show
that
on
average,
an
increase
in
the
GPR
index
is
associated
with
lower
economic
activity,
arguing
that
these
effects
are
associated
with
a
variety
of
macro
channels,
ranging
from
human
and
physical
capital
destruction,
to
higher
military
spending
and
increased
precautionary
behaviour.

However,
episodes
of
geopolitical
tension
often
involve
increased
concerns
about
the
supply
of
energy
to
global
markets.
Chart
2
shows
the
cumulated
percentage
change
in
the
three
months
ahead
West
Texas
Intermediate
(WTI)
futures
around
key
geopolitical
events.
Oil
future
prices
rose
following
most
of
these
episodes,
potentially
reflecting
expectations
of
supply
cuts
to
energy
production
or
disruption
of
the
flow
of
energy.

Chart
2:
WTI
futures
three
months
ahead
prices
during
the
30
days
following
major
recent
geopolitical
events
(associated
with
tensions
on
energy
markets)

Source:
Refinitiv
Eikon.

This
suggests
that
GPR
can
also
transmit
via
an
additional
energy
channel,
whose
effects
are
more
akin
to
an
adverse
supply
shock.
Whether
the
shock
transmits
through
this
channel,
and
how
strong
it
is
relative
to
the
macro
channel,
will
depend
on
the
wider
context
and/or
location
of
the
events
relating
to
the
shock.
Disentangling
the
two
effects
is,
therefore,
important
for
correctly
assessing
the
economic
consequences
of
a
GPR
shock.

Measuring
geopolitical
surprises

We
begin
our
analysis
by
constructing
a
series
of
exogenous
surprises
in
(i)
GPR,
and
(ii)
oil
prices
that
can
be
assumed
to
be
entirely
driven
by
geopolitical
events
to
a
reasonable
degree
of
approximation.

In
order
to
construct
our
surprise
series,
we
adopt
a
selection
of
43
main
GPR
events
from
1986
to
2020
proposed
by

Caldara
and
Iacoviello
(2022),
which
we
update
to
include
four
important
events
that
have
occurred
in
the
past
three
years:
the
escalation
of
the
Afghanistan
Crisis
in
August
2021;
the
Russian
invasion
of
Ukraine
in
February
2022;
the
Istanbul
bombings
in
November
2022;
and
the
events
in
the
Middle
East
in
October
2023.

We
compute
the
GPR
surprise
as
the
daily
log
difference
in
the
GPR
index
around
these
events.
For
the
oil
price
surprise,
we
compute
the
daily
log
difference
in
WTI
future
prices
from
one
to
six
months
ahead
around
the
same
dates.
We
then
take
the
first
principal
component
of
these
to
capture
movements
in
energy
prices
driven
by
the
geopolitical
shock.

Decomposing
the
macro
and
energy
supply
components
of
geopolitical
surprises

We
then
use
our
event-study
data
set
in
a
Bayesian-VAR
setting
for
the
euro
area,
the
UK,
and
the
US
from
January
1990
up
to
October
2023
to
disentangle
the
effects
of
the
macro
uncertainty
channel
from
the
energy
supply
channel
of
GPR.
We
adopt
the
two-block
VAR
structure
proposed
by

Jarociński
and
Karadi
(2020),
which
uses
high
frequency
data
combined
with
narrative
and
sign
restrictions
to
identify
shocks.

Within
the
high-frequency
block,
we
include
our
surprise
series
of
(i)
log
changes
in
the
GPR
index
in
the
main
geopolitical
event
days,
and
(ii)
the
first
principal
component
extracted
from
changes
in
WTI
futures
from
one
to
six
months
ahead
in
the
main
geopolitical
event
days,
both
cumulated
at
monthly
frequency
in
case
of
multiple
events
occurring
in
one
month.
Within
this
block,
we
impose
the
sign
restrictions
at
the
core
of
our
identification
strategy,
which
we
outline
in
Table
A.

We
impose
that
the
response
associated
with
the
macro
channel
drives
upward
surprises
in
the
GPR
index
and
negative
surprises
in
the
oil
future
curve
during
the
first
day
the
news
is
reported,
as
oil
prices
drop
following
a
contraction
in
economic
activity.
Conversely,
we
impose
that
the
response
associated
with
the
energy
supply
channel
drives
upward
surprises
in
the
GPR
index
jointly
with
positive
surprises
in
the
oil
future
curve
during
the
first
day
the
news
is
reported,
as
precautionary
oil
demand
rises
in
response
to
concerns
about
future
supply
cuts
or
shipping
disruption.

Table
A:

The
sign
restrictions
associated
with
each
channel
of
GPR

	GPR Macro	GPR Energy
GPR surprises	+	+
WTI surprises	–	+

In
our
monthly
frequency
block,
we
include
the
GPR
index
in
logs,
real
Brent
crude
prices
spot
in
logs,
real
natural
gas
spot
prices
in
logs
(as
measured
by
the
IMF
benchmark),
and
the
monetary-policy
relevant
price
indices
in
levels
(in
deviation
from
their
long-run
trends,
as
is
standard
in
the
VAR
literature).

Identifying
two
distinct
channels
of
GPR

Chart
3
plots
the
response
to
a
geopolitical
shock
that
leads
to
a
100
basis
points
increase
in
the
GPR
index.
The
first
row
reports
the
responses
of
oil
and
natural
gas
prices
to
an
‘average’
geopolitical
shock,
which
does
not
disentangle
the
effects
of
the
macro
and
the
energy
channel,
along
the
lines
of
Caldara
and
Iacoviello’s
work.
The
second
and
the
third
rows
display
the
responses
when
we
assume
that
all
of
the
increase
in
the
GPR
index
propagates
via
just
the
macro
channel
and
just
the
energy
channel
respectively.

Chart
3:
Impulse
response
functions
associated
with
an
‘average’
100
basis
points
GPR
shock,
as
opposed
to
a
100

basis
points
shock
acting
exclusively
either
through
the
macro
or
the
energy
channel­

In
the
‘average’
case,
the
real
Brent
price
spot
rises
by
about
10%
on
impact,
before
then
dropping
of
beyond
10%
after
around
six
months.
However,
these
dynamics
mask
the
two
underlying
channels.
On
the
one
hand,
the
energy
supply
channel
is
associated
with
a
rapid
20%
surge
in
the
oil
price.
On
the
other,
the
macro
channel
is
associated
with
a
more
gradual
decline
of
beyond
20%.

The
response
of
gas
prices
tends
to
be
more
persistent
than
oil
prices:
the
effect
of
the
energy
channel
on
oil
prices
is
concentrated
in
the
first
six
months
whilst
the
effect
on
gas
prices
wanes
only
during
the
second
year
after
the
shock.

The
response
of
price
levels
across
regions
follows
a
pattern
that
is
broadly
consistent
with
energy
price
dynamics.
As
Chart
4
shows,
inflation
unambiguously
drops
in
the
‘average’
case:
the
price
level
drops
persistently
by
about
0.1%
in
the
US,
and
shortly
by
about
0.25%
in
the
euro
area,
while
the
response
is
not
statistically
significant
for
the
UK.
This
finding
is
consistent
with
the
interpretation
of

Caldara
and
Iacoviello
(2022)
of
geopolitical
shocks
behaving,
from
an
empirical
perspective,
as
contractionary
demand
shocks.

However,
this
similarly
masks
the
effects
of
the
different
underlying
channels.
On
the
one
hand,
the
pure
macro
channel
gives
rise
to
a
more
pronounced
drop
in
the
median
price
level
than
in
the
case
of
the
‘average’
GPR
shock,
reaching
-0.5%
in
the
US
and
the
UK,
and
-0.4%
in
the
euro
area.
On
the
other
hand,
the
response
associated
with
the
energy
supply
channel
is
inflationary,
with
the
price
level
rising
persistently
by
about
0.5%
in
the
US,
0.7%
in
the
UK,
and
0.6%
in
the
euro
area.

Chart
4:
Impulse
response
functions
associated
with
an
‘average’
100
basis
points
GPR
shock,
as
opposed
to
a
100

basis
points
shock
acting
exclusively
either
through
the
macro
or
the
energy
channel

Summing
up

This
analysis
highlighted
the
existence
of
two
separate
and
intrinsically
different
transmission
channels
of
GPR:
(i)
a
deflationary
macro
channel,
and
(ii)
an
inflationary
energy
supply
channel.
Policymakers
should
be
aware
of
these
distinct
channels:
GPR
shocks
may
propagate
in
different
manners
and
require
different
responses.

---

Samuel
Smith
works
in
the
Bank’s
International
Surveillance
Division
and

Marco
Pinchetti
works
in
the
Bank’s
Global
Analysis
Division.

If
you
want
to
get
in
touch,
please
email
us
at [email protected] or
leave
a
comment
below.

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