Quantifying the macroeconomic impact of geopolitical risk – Bank Underground

Julian Reynolds

Policymakers and market contributors persistently cite geopolitical developments as a key danger to the worldwide financial system and monetary system. However how can one quantify the potential macroeconomic results of those developments? Making use of native projections to a well-liked metric of geopolitical danger, I present that geopolitical danger weighs on GDP within the central case and will increase the severity of opposed outcomes. This impression seems a lot bigger in rising market economies (EMEs) than superior economies (AEs). Geopolitical danger additionally pushes up inflation in each central case and opposed outcomes, implying that macroeconomic policymakers should trade-off stabilising output versus inflation. Lastly, I present that geopolitical danger might transmit to output and inflation through commerce and uncertainty channels.

How has the worldwide geopolitical outlook advanced?

Dangers from geopolitical tensions have turn into of accelerating concern to policymakers and market participants this decade.

A well-liked metric to observe these dangers is the Geopolitical Risk (GPR) Index constructed by Caldara and Iacoviello (2022). The authors assemble their index utilizing automated text-search outcomes from newspaper articles. Specifically, they seek for phrases related to their definition of geopolitical danger, resembling ‘disaster’, ‘terrorism’ or ‘struggle’. Additionally they assemble GPR indices at a disaggregated country-specific stage, based mostly on joint occurrences of key phrases and particular nations.

Chart 1 plots the evolution of the geopolitical dangers over time. Most notably, the World GPR Index (black line) spikes following the 11 September assaults. Extra just lately, this index reveals a pointy improve following Russia’s invasion of Ukraine in February 2022.

Nation-specific indices usually co-move considerably with the World index however might deviate when country-specific dangers come up. For example, the UK-specific (aqua line) and France-specific indices (orange line) present extra pronounced spikes following terrorist assaults in London and Paris respectively, whereas the Germany-specific index (purple line) rises significantly strongly following the invasion of Ukraine.

Chart 1: World and country-specific Geopolitical Danger Indices

The GPR index is just like the Financial Coverage Uncertainty (EPU) index, produced by Baker, Bloom and Davis. The EPU index can also be constructed based mostly on a textual content search from newspaper articles, and out there at each a world and country-specific stage. However it measures extra generic uncertainty associated to financial policymaking, moreover uncertainty stemming from geopolitical developments.

Methods to quantify the macroeconomic impression of those developments?

In mild of accelerating issues about geopolitical rigidity, a rising physique of literature goals to quantify the macro-financial impression of those developments. For example, Aiyar et al (2023) study a number of transmission channels of ‘geoeconomic fragmentation’ – a policy-driven reversal of world financial integration – together with commerce, capital flows and expertise diffusion. Additionally Caldara and Iacoviello (2022) make use of a spread of empirical methods to look at how shocks to their GPR have an effect on macroeconomic variables.

These research unambiguously present that geopolitical rigidity has opposed results on macroeconomic exercise and contributes to better draw back dangers. However empirical estimates are inclined to differ considerably, relying on the character and severity of situations by means of which geopolitical tensions might play out.

My method focusses on the impression of geopolitical dangers on a spread of macroeconomic variables. Specifically, I take advantage of native projections (Jordà (2005)), an econometric method which examines how a given variable responds sooner or later to modifications in geopolitical danger as we speak. I make use of a panel knowledge set of AEs and EMEs (listed in Desk A), with quarterly knowledge from 1985 onwards.

Desk A: Checklist of economies

Notes: International locations divided into Superior and Rising Market Economies as per IMF classification. Nation-level EPU indices out there for starred economies.

Following Caldara and Iacoviello (2022), I regress a given variable on the country-level GPR index, controlling for: country-level fastened results; the worldwide GPR index; the primary lag of my variable of curiosity; and the primary lags of (four-quarter) GDP progress, shopper value inflation, oil value inflation, and modifications in central financial institution coverage charges.

I take advantage of unusual least squares estimation to estimate the imply response over time of a given macroeconomic variable to geopolitical danger. However to evaluate the impression of geopolitical danger on the tail of the distribution, I observe Lloyd et al (2021) and Garofalo et al (2023) through the use of local-projection quantile regression. This latter method makes use of an outlook-at-risk framework for example how extreme the impression of geopolitical danger might be beneath excessive circumstances.

How does geopolitical danger have an effect on GDP progress and inflation?

Chart 2 present the impression of geopolitical danger on common annual GDP progress throughout my panel of economies. Within the imply outcomes (aqua line), a one customary deviation improve in geopolitical dangers is anticipated to cut back GDP progress by 0.2 share factors (pp) at peak. However on the fifth percentile – a one-in-twenty opposed consequence – GDP progress falls by nearly 0.5pp. In different phrases, which means that geopolitical danger each weighs on GDP progress but additionally will increase the severity of tail-risk outcomes, including to the worldwide danger surroundings.

The magnitude of those results is considerably smaller than Caldara and Iacoviello (2022), although they use an extended time pattern (1900 onwards), which incorporates each World Wars.

Chart 2: Dynamic impression of geopolitical danger on GDP progress

Notes: Shaded areas denote 68% confidence interval round Imply and fifth percentile estimates.

The impression of geopolitical dangers on GDP progress is heterogeneous throughout AEs and EMEs. Chart 3 plots the impression of geopolitical danger on the one-year horizon for each teams of economies, on the imply and fifth percentile. For AEs, the imply impression of geopolitical danger on GDP progress seems to be negligible, although the fifth percentile impression is extra noticeable. For EMEs, nonetheless, each the imply and fifth percentile impression of geopolitical danger are materials. This result’s according to Aiyar et al (2023), who present that EMEs are additionally extra delicate to geoeconomic fragmentation within the medium time period.

Chart 3: Impacts of geopolitical danger on GDP progress at one-year horizon, by nation group

Notes: Shaded areas denote 68% confidence interval round Imply and fifth percentile estimates.

I additionally discover that geopolitical danger tends to lift shopper value inflation, according to Caldara et al (2024) and Pinchetti and Smith (2024). This might pose a difficult trade-off for a macroeconomic policymaker, between stabilising output versus inflation.

Chart 4 reveals that on the imply, common annual inflation rises by 0.5pp at peak, following a geopolitical danger shock. However on the ninety fifth percentile (one-in-twenty excessive inflation consequence), inflation rises by 1.4pp. As with GDP, the inflationary impression of geopolitical danger shocks seems to be bigger for EMEs, although the imply impression on AE inflation can also be statistically vital (Chart 5).

Chart 4: Dynamic impression of geopolitical danger on shopper value inflation

Notes: Shaded areas denote 68% confidence interval round Imply and ninety fifth percentile estimates.

Chart 5: Affect of geopolitical danger on shopper value inflation at one-year horizon, by nation group

Notes: Shaded areas denote 68% confidence interval round Imply and fifth percentile estimates.

What are the potential transmission channels?

One key channel by means of which geopolitical danger might transmit to GDP and inflation could also be disruption to international commodity markets, significantly power. Pinchetti and Smith (2024) spotlight power provide as a key transmission channel of geopolitical danger, which pushes up on inflation. Power value shocks might even have vital results on GDP and inflation in opposed situations (Garofalo et al (2023)).

The inflationary impulse following Russia’s invasion of Ukraine marks an excessive occasion of commodity market disruption (Martin and Reynolds (2023)). Sensitivity evaluation means that even excluding this era, geopolitical danger nonetheless has trade-off inducing implications for inflation and GDP.

I additionally discover that geopolitical danger results in vital disruption in world commerce, a channel additionally highlighted by Aiyar et al (2023). Chart 6 plots the estimated impacts on commerce volumes progress (measured by imports), whereas Chart 7 plots the impression on commerce value inflation (measured by export deflators). These outcomes suggest that each commerce volumes and costs are extremely delicate to international geopolitical danger. The height response of commerce volumes progress to geopolitical danger is round thrice better than GDP, on the imply and fifth percentile. And the height response of export value inflation – representing the basket of tradeable items and providers – is considerably better than that of shopper costs, on the imply and ninety fifth percentile.

This means that nations are prone to be uncovered to international geopolitical danger through the impact on buying and selling companions: falling import volumes for Nation A signifies that Nation B’s exports fall, weighing on GDP; larger export costs for County A signifies that Nation B imports larger inflation from Nation A.

Chart 6: Dynamic impression of geopolitical danger on commerce volumes progress

Notes: Shaded areas denote 68% confidence interval round Imply and fifth percentile estimates.

Chart 7: Dynamic impression of geopolitical danger on commerce value inflation

Notes: Shaded areas denote 68% confidence interval round Imply and ninety fifth percentile estimates.

Lastly, I discover that better geopolitical danger is related to considerably better financial uncertainty. Chart 8 reveals the response of country-specific EPU indices (compiled by Baker, Bloom and Davis) to a rise in geopolitical danger. This means a imply cumulative improve in uncertainty of round 0.1 customary deviations; the height impression on the ninety fifth percentile is twice as nice.

This impression, whereas statistically vital, seems comparatively small in an absolute sense. For context, the US-specific EPU index rose by two customary deviations between 2017 and 2019, after the onset of the US-China commerce struggle. Nonetheless, it’s believable that uncertainty could also be a key transmission channel for geopolitical tensions within the medium time period, which can significantly weigh on enterprise funding (Manuel et al (2021)).

Chart 8: Dynamic impression of geopolitical danger on financial coverage uncertainty

Notes: Shaded areas denote 68% confidence interval round Imply and ninety fifth percentile estimates.

Conclusion

This publish presents empirical proof which quantifies the potential macroeconomic results of geopolitical developments. Geopolitical danger weighs on GDP progress, in each the central case and tail-risk situations, and can also be prone to increase inflation through a variety of channels.

Additional research might look to refine the identification of geopolitical danger shocks, to purge the underlying sequence of endogenous relationships with macroeconomic variables. Additional evaluation may be useful to substantiate why EMEs seem extra delicate to geopolitical danger than AEs, significantly transmission through monetary situations and capital flows. Given the heightening geopolitical tensions that policymakers have highlighted, additional analysis into the macro-financial implications of those tensions is extremely necessary at this juncture.

Julian Reynolds works within the Financial institution’s Stress Testing and Resilience Group.

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