Interest Rates in the UK: A Faster Pace of Cuts on the Horizon?
The UK is likely to see interest rates drop at a faster pace than previously expected, according to economists who point to key data releases indicating easing inflationary pressures. However, the Labour government’s debut budget at the end of the month will prove crucial in determining the economic impact.
Inflationary Pressures Ease
Recent data has shown a drop in services inflation, a key input into the Bank of England’s (BOE) decision-making process. The headline rate of UK inflation has also dropped, coming in under the BOE’s 2% target for the first time in three-and-a-half years. Wage growth data is also cooling, with average earnings including bonuses at a more than two-year low.
Market Expectations
Money markets have fully priced in a quarter-percentage-point rate cut for the BOE’s next meeting in November, with a high probability of a cut of the same size at its December meeting. This would take the central bank’s key rate from its 16-year-high of 5.25% at the start of the year to 4.5% by the end of the year.
Economists’ Forecasts
Economists at Goldman Sachs forecast rate cuts “notably below market pricing,” attributing this to their calculation of the neutral real rate of interest and the rapid fall in UK inflation. They see consecutive 25 basis point cuts taking the Bank Rate to 3% as early as September 2025.
Labour Government’s Budget
The Labour government’s debut budget will be a major shake-up targeted at rebooting the country’s sluggish economic growth. Prime Minister Keir Starmer has warned that the budget will be “painful” for the nation, with a £22 billion financing shortfall to cover. Finance Minister Rachel Reeves has said that hard decisions will need to be taken before Labour can fully enact the changes it wishes to see.
Uncertainty Over Fiscal Consolidation
There is considerable uncertainty over how major fiscal consolidation could be achieved, particularly as the government has ruled out hikes to major taxes on income, sales, and corporations. Economists say that the BOE should account for a coming “front-loaded fiscal consolidation effort” and accelerate the pace of monetary easing.
Monetary Policy Transmission
The UK’s strong sensitivity to interest rates and the speed of monetary policy transmission mean that a lot of the adverse effect of the fiscal tightening could be offset by the monetary stance. However, Deutsche Bank Economist Sanjay Raja says that expectations are growing for looser fiscal policy in the budget than previously thought, which could lead the BOE to pause at 3.75%.
Conclusion
The UK is likely to see interest rates drop at a faster pace than previously expected, driven by easing inflationary pressures and the Labour government’s debut budget. However, uncertainty over fiscal consolidation and the monetary policy transmission mechanism means that the outcome is far from certain.
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