McKinsey: Worst-case scenario of Ukraine war includes US recession

23 March 2022 3 min. read
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A recent McKinsey & Company report that examines the global economic impact of the Russian invasion of Ukraine says the worst-case scenario could result in a recession for the eurozone and United States.

Ukraine and Russia are already facing dire economic situations. The IMF expects Ukraine’s economy to shrink by a third this year. The Russian economy, which is facing heavy sanctions, could fall into recession by next month.

The war in Ukraine is putting more upward pressure on commodity prices and inflation. Brent crude is trading near $120 per barrel and prices for key agricultural and metal commodities rose 10-15% in the first week of the invasion.

Russia is a key producer of oil and gas, especially for end-markets in Europe. Ukraine and Russia together make up 30% of global wheat production, 23% of class 1 nickel, and 38% of palladium extraction.

The scale of the refugee crisis, which already includes 10 million displaced Ukrainians, will put additional economic strain on Europe.

McKinsey’s economic scenarios hinge on the severity and duration of the Russo-Ukrainian conflict, as well as the impact of global government policy, consumer, and business responses. The New York consulting firm chose not to model the escalation of conflict beyond Russia’s borders, which means that even the worst-case scenario has an optimistic bent.

The Eurozone is highly exposed to the conflict in Ukraine

The analysis puts forth three levels of disruption (contained, extended, and severe) and three potential policy responses  (restrained, moderate, and robust).

A contained disruption would entail a quickly negotiated cease-fire, some refugees being able to return home, energy and commodity markets stabilizing, and prices normalizing. A severe disruption would mean an escalated and lengthy war, the refugee crisis growing more desperate, and energy, food and commodity markets spiraling higher over an extended period.

A restrained policy response would entail central banks accelerating monetary tightening to limit inflation, as well as other headwinds persisting to limit growth, including labor market tensions and challenges stemming from Covid-19 shocks. A robust response would include monetary stimulus winding down and successfully curbing inflation, the launch of fiscal programs to blunt energy and food price gains, and sufficient consumer confidence to keep spending up.

McKinsey’s 3B scenario would involve a severe disruption and a moderate policy response – and would result in a recession for the eurozone and US. In this scenario, a protracted conflict would intensify the refugee crisis in Central Europe and sanction would be further extended on Russia, leading to a shutdown of oil and gas exports from Russia to Europe. European gas prices would rocket to $70 per MMBtu in 2022 and Brent crude would jump to $150 per barrel. Meanwhile, eurozone headline inflation would spike to more than 7% on the year.

Energy prices and inflation are likely to vary across scenarios

Combined with the collapse in consumer and business confidence already being felt, the eurozone would tip into recession in 2022 and 2023, according to McKinsey. Growth would drop to -0.5% in both years, with GDP growth resuming in 2024 as consumer spending and business investment rebound even as low-intensity conflict continues in Ukraine.

For the US, the central issue is how the Fed reacts to spiking oil, food, and metals prices. The Fed raised its short-term rate by 25 basis points on March 16 and said it would be the first of several increases. With already uncomfortably high inflation, McKinsey anticipates that the Ukraine war will only slow the pace of interest rate hikes instead of changing the course of US monetary policy.

The 3B scenario’s price hikes would shake confidence and reduce spending by consumers and businesses, and a recession would follow.

According to the report, only a contained disruption could be absorbed by Europe and the global economy, from a macroeconomic perspective. That window is, however, closing rapidly.