Summary
- After experiencing solid growth during the first half of last year, the U.K. economy essentially came to a standstill in the second half of 2024, including just a 0.1% quarter-over-quarter gain in Q4 GDP. Subdued sentiment suggests a continued slow pace of economic growth in the near term, and we would also argue fiscal policy dynamics are turning less supportive of the growth outlook as well. We have lowered our 2025 U.K. GDP growth forecast to 0.8%, from 1.5% previously.
- The news on the inflation front is mixed. While inflation slowed more than expected in December, the Bank of England (BoE) still expects a further rebound of inflation on the back of higher energy prices and regulated price increases, and attributed the slowing in services inflation to some volatile price categories. Wage growth has picked up recently and remains elevated, especially given the U.K.’s recent underwhelming productivity performance.
- Against this backdrop of slowing growth and mixed inflation trends, the BoE lowered its policy rate 25 bps to 4.50% last week. We view the BoE announcement as decidedly mixed, with the central bank forecasting slower growth but faster inflation. The BoE said there has been substantial progress on disinflation, but also that a “gradual and careful” approach to easing remains appropriate, and that monetary policy will need to remain restrictive for sufficiently long.
- We view these mixed BoE comments as very much consistent with a once-per-quarter rate cut pace. Our view remains for 25 bps rate cuts in May, August, November and February, with the policy rate expected to reach a low of 3.50% by early 2026. We also view steady rate cuts and weak U.K. economic growth as consistent with moderate weakness in the pound versus the U.S. dollar over the medium term.
U.K. Economic Growth Shifts To A Lower Gear, Inflation Signals Remain Mixed
After enjoying solid growth through the first half of 2024, the United Kingdom’s economic performance softened though the second half of last year. The latest U.K. GDP report confirmed an economy that was essentially at a standstill through the second half of 2024, as Q4 GDP edged up by just 0.1% quarter-over-quarter, following a flat Q3 GDP outcome. The details of the report were also underwhelming, as consumer spending was unchanged in the quarter and business investment fell 3.2%, contributing to an overall decline in final private domestic demand of 0.4%, while exports also fell 2.5%. Instead, U.K. growth was driven by an increase in government consumption and public investment spending. December GDP figures offered perhaps a modest bright spot, as GDP rose 0.4% month-over-month, with gains in both services activity and industrial output.
That said, signs of economic softness are apparent across different sectors of the economy. The labor market, for example, appears to be losing some momentum. Payroll employment fell by an average of 16,000 per month during the fourth quarter although, admittedly, this series can be subject to large revisions. The unemployment rate has trended moderately higher during the past several quarters, reaching 4.4% in the three-months-to November. Meanwhile, corporate profitability still appears to be under some pressure. U.K. gross entrepreneurial income for non-financial corporates, as reported by the OECD, fell by 2.9% year-over-year in Q3-2024, a fourth straight quarter of decline. The sluggish corporate environment combined with still restrictive monetary policy could remain a restraining influence on investment spending in the period ahead.
Looking ahead, sentiment surveys are consistent with a continued slow pace of economic growth in the near term. The U.K. manufacturing PMI rose in January but, at 48.3, remained in contraction territory for the fourth consecutive month. Perhaps more importantly, the services PMI softened to 50.8 in January, a level historically consistent with only moderately positive growth. And finally, another area which seems to be turning less supportive of the U.K. economic outlook is fiscal policy. After an expansionary fiscal policy approach in the U.K. Autumn Government Budget delivered last year, Chancellor of the Exchequer Reeves now has only a limited £9.9B of headroom to stick within the government’s self-imposed fiscal rules. With U.K. yields having risen moderately since, and economic activity (and thus likely tax revenues) slowing, that headroom may have narrowed further. Media reports suggest the U.K. Treasury is telling several government departments to prepare for a budget freeze, which given inflation trends would imply significant spending cuts in real terms. The government’s next Economic and Fiscal Outlook is scheduled for late March. At this stage, we doubt fiscal dynamics will be as supportive of the economic outlook as they were late last year and, if anything, they could even be a mild headwind. Assessing recent developments, including softer economic activity, subdued sentiment, and less supportive fiscal dynamics, we have made a significant downward adjustment to our U.K. growth outlook. We now forecast U.K. GDP growth of 0.8% in 2025 (compared to 1.5% previously), while our GDP growth outlook for 2026 is unchanged at 1.7%.
While economic activity growth is clearly decelerating, the news on the inflation front is more mixed. To be sure, the latest CPI report (for December) was encouraging. Headline inflation eased to 2.5% year-over-year while, more notably, core CPI inflation slowed to 3.2% and services inflation slowed to 4.4%. Despite that good news, the Bank of England still expects a further rebound of inflation on the back of higher energy prices and regulated prices increases, while it also attributed the slowing in services inflation to some volatile price categories. Moreover, and despite some softening in the labor market, pay growth remains elevated, especially given the U.K.’s recent underwhelming productivity performance. Wage growth for the three-months-to November picked up, with average weekly earnings rising 5.6% year-over-year, and average weekly earnings excluding bonuses also rising 5.6%. Average weekly earnings excluding bonuses for the private sector, a measure monitored by BoE policymakers, also quickened to 6.0%.
Bank Of England Continues With Gradual, Careful Approach to Monetary Easing
It is against this backdrop of slowing growth and mixed inflation trends that the Bank of England (BoE) delivered its latest monetary policy decision last week. The BoE voted 7-2 to lower its policy rate another 25 bps to 4.50%, with two policymakers dissenting in favor of a larger 50 bps reduction. In its accompanying announcement, the BoE said:
- There has been substantial progress on disinflation over the past two years. That progress has allowed the central bank to gradually withdraw some degree of policy restraint, while maintaining the policy rate in restrictive territory so as to continue to squeeze out persistent inflationary pressures.
- Higher global energy costs and regulated price changes are expected to push up headline inflation to 3.7% in Q3-2025, even as underlying domestic inflationary pressures are expected to wane further. Inflation is expected to fall back thereafter.
- GDP growth and productivity growth have both been weaker than previously estimated, and thus the recent slowdown in demand is judged to have led to only a small margin of economic slack opening up.
- A gradual and careful approach to the further withdrawal of monetary policy restraint is appropriate. Monetary policy will need to continue to remain restrictive for sufficiently long until the risks to inflation returning sustainably to the 2% target in the medium term have dissipated further.
The BoE also published updated economic forecasts. Those forecasts envisage slower GDP growth than previously projected, at 0.75% in 2025 (down from 1.5%), while 2026 growth is forecast at 1.5% (previously 1.25%). Moreover, in addition to the near-term jump of inflation forecast by the BoE, the central bank’s medium-term inflation forecasts were also revised moderately higher. The BoE projects CPI inflation at 2.4% in Q4-2026, with inflation not reaching the 2.0% inflation target until Q4-2027. Keep in mind also these forecasts are based off market implied interest rates that anticipated only a modest further reduction in the policy rate, to a low of around 4%.
Overall, we view the Bank of England’s commentary and projections as decidedly mixed. On the one hand, the BoE acknowledged progress on disinflation and the weak economic growth environment, while the dissents in favor of a more aggressive rate cut also attracted some attention from market participants. At the same time, the central bank raised its medium-term inflation forecasts, indicative of lingering inflation risks. We view these mixed comments from Bank of England policymakers as very much consistent with a “gradual and careful” approach to monetary easing. Given the slower U.K. growth momentum and being cognizant of downside risks to growth, even with a mixed inflation picture our view remains the BoE will continue with a 25 bps per quarter rate cut pace. We expect 25 bps policy rate reductions in May, August, November and February, with the policy rate expected to reach a low of 3.50% by early 2026. Our outlook for Bank of England rate cuts is only moderately more aggressive than currently expected by market participants. However, combined with weak U.K. economic growth, we still view that as consistent with moderate weakness in the British pound versus the U.S. dollar over the medium term.
