Geopolitical Risk and Inflation: The Role of Energy Markets

Geopolitical shocks are not all alike -- different classes of geopolitical shocks can have different macroeconomic implications, particularly on inflation. This paper exploits the comovement between the Geopolitical Risk Index (GPR) developed by Caldara and Iacoviello (2022) and oil prices across major geopolitical events to disentangle two types of geopolitical shocks within a structural VAR model for the US economy. The VAR estimates suggest that geopolitical shocks associated with disruptions in energy markets are on average inflationary and contractionary. In contrast, geopolitical shocks associated with macroeconomic developments that are unrelated to energy markets are on average deflationary and contractionary. To validate this interpretation, the paper exploits the heterogeneity across sectoral output and prices of the US economy to show that a sector’s response to a geopolitical shock depends on its energy intensity. Sectors characterized by higher energy intensity are subject to larger output losses and price increases in response to geopolitical energy shocks.