Understanding central bank responses to geopolitical risks: Evidence from the Fed and ECB

Evangelos Salachas, Georgios P. Kouretas and Nikiforos T. Laopodis

Journal of Financial Stability, 2025, vol. 80, issue C

Abstract: Using VAR and Local Projections models, enhanced with macroeconomic factors and monetary policy shocks, we investigate the underlying mechanisms through which the Fed’s and ECB’s react to bank reactions of geopolitical risks between January 1994 and March 2024. Our findings reveal that central banks react to geopolitical risk events by tightening monetary policy to fend off potential inflationary pressures. However, the effect is often temporary, as policymakers typically adopt accommodative measures during economic expansions and shift to tighter policies during contractions. Analyzing reactions based on central bank presidents' tenures, we find that while earlier responses were limited, in recent years, both central banks have reacted more strongly and immediately, reflecting their growing concern over geopolitical risks. Furthermore, we document that the Fed adopted a more accommodative stance in response to bilateral geopolitical risk shocks between the US and China, driven by changes in capital flows and trade activities. In contrast, the ECB’s responses were more consistently contractionary, particularly in periods of heightened inflation concerns or when geopolitical tensions threatened price stability within the euro area.

Keywords: Monetary policy shocks; Geopolitical risk; Capital flows; Economic activity (search for similar items in EconPapers)
JEL-codes: E52 E58 G32 (search for similar items in EconPapers)
Date: 2025
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Persistent link: https://EconPapers.repec.org/RePEc:eee:finsta:v:80:y:2025:i:c:s1572308925000816

DOI: 10.1016/j.jfs.2025.101452

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