Geopolitical risks, financial stability and central bank responses

We live in a world where geopolitical risks and geoeconomics are increasingly significant. The first 25 years of the 2000s have been marked by continual disruptions: financial shocks, anti-globalisation trends, a pandemic and geopolitical conflicts ranging from trade wars and global sanctions to military invasions. The second Trump administration has altered the global economic order, causing shocks and breaking the 80-year neoliberal consensus and creating a “new economic geography” (Posen 2025). 

Geopolitical risks are defined as the “threats, realization, and escalation of adverse events associated with wars, terrorism, and any tensions among states and political actors that affect the peaceful course of international relations” (Caldara & Iacoviello 2022: 1195). These events are difficult to predict and can spread across financial markets and the broader economy, creating systemic effects (Beck et al. 2025). They deter foreign investment, fragment trade and supply chains and disrupt financial markets (Dieckelman et al. 2024). For households, the consequences are tangible, including rising prices of essential goods, higher borrowing costs and growing uncertainty about employment and income. 

How do geopolitical risks affect financial stability? 

A 2026 ECB/ESRB report categorises geopolitical risks into shocks and trends. Shocks are sudden events such as wars, cyberattacks, introductions of sanctions and disinformation campaigns, while trends are longer-term developments like external security deterioration, technological decoupling, trade and capital-market fragmentation and political polarisation. These risks span five areas – military conflict and war, infrastructure, trade, capital and finance, and politics and society – and raise uncertainty and financial market volatility.  

Transmission channels are multiple and sometimes unpredictable. Geopolitical shocks are commonly assumed to be inflationary as they drive up energy and commodity prices with supply disruptions (Pinchetti 2024; Ferrari Minesso et al. 2023). Russia’s invasion of Ukraine caused a major uncertainty shock and a severe supply-side contraction that pushed prices higher across the euro area. However, inflation effects vary case by case (Antonnen & Lehmnus 2024). The Israel-Hamas conflict functioned more like a deflationary shock. It reduced aggregate demand with little impact on supply (Idem). Most recently, the Iran war has already triggered a negative global supply shock and might lead to further inflation pressure. 

Central banks responses 

As guardians of financial stability, central banks cannot ignore geopolitical shocks. Recent research by Salachas et. al. (2025) analyses how the US Federal Reserve and the ECB have behaved. Both tend to tighten monetary policy in the immediate aftermath of geopolitical shocks to contain expectations of inflation, although this is typically a short-term reaction rather than a lasting shift. When the broader environment is expansionary, central banks ease policy to cushion growth. The Fed has responded more accommodatively to US-China tensions by prioritising trade and capital flows, while the ECB has leaned more consistently towards tightening, reflecting its price stability mandate (Idem.). 

Beyond interest rates, central banks can inject liquidity to prevent credit crunches, intervene in foreign exchange markets to stabilise currencies and activate macroprudential tools to shore up the banking sector (Idem). Clear communication is also important to prevent market panic from spiralling into systemic crises. 

As geopolitical uncertainty becomes a structural feature of the current global landscape, central banks will need sharper tools, better scenario planning and closer coordination with fiscal and regulatory authorities to navigate these challenges effectively.