US markets react to oil shocks: AI index quantifies impact
A new ECB analysis, based on an AI-powered index, examines how US financial markets react to geopolitical shocks disrupting global oil supply. Such shocks reduce economic activity, increase prices, and raise risk premia.
AI refines geopolitical risk measurement
A new index, developed by Iacoviello and Tong (2026) using artificial intelligence, identifies geopolitical events specifically linked to global energy markets.
This AI-powered method analyzes over five million US newspaper articles, improving on traditional keyword-based approaches by distinguishing events that directly disrupt energy supply, such as the Gulf War or the current Middle East conflict, from those without such an impact.
The index clearly shows a sharp spike during the current Middle East war, standing out historically.
By focusing on days when the index is two standard deviations above its average, the study uses monthly sums of oil price changes as instruments for oil-related geopolitical shocks in a Bayesian vector autoregression (BVAR) model of US financial markets, augmented with key macroeconomic indicators.
This approach allows for a more precise identification of the impact of oil-related geopolitical tensions.
Oil prices amplify market turmoil
Geopolitical shocks that disrupt oil supply significantly impact US financial markets and economic activity.
Following such a shock, oil prices rise substantially and remain elevated for two quarters, leading to a modest increase in US consumer prices.
Industrial production contracts with a lag.
Financial markets react strongly: stock prices decline significantly for two quarters, and the dollar continuously appreciates.
Risk indicators like the VIX index and corporate bond spreads increase, while risk-free rates decline.
In contrast, when shocks do not affect global oil supply, financial market reactions are much milder.
Oil prices fall slightly, cushioning the blow to activity and resulting in a less pronounced decline in stock prices and faster industrial production recovery.
This highlights oil prices as a key amplifying channel for geopolitical shocks.
Muted response, striking disconnect
Market reactions to the current Middle East war remain contained, despite a substantial oil supply shock.
While oil prices temporarily rose, other financial variables showed muted responses, a striking disconnect from historical patterns.
This limited repricing could expose financial assets to sudden sell-offs if the conflict persists or monetary policy reacts aggressively.