UK QUARTERLY ECONOMIC OUTLOOK | Q2 2025
Interest rates
MPC can cut only gradually
Despite April’s jump in inflation, we still expect the Monetary Policy Committee (MPC) to keep lowering interest rates this year. Adding to the two cuts already made in February and May, we anticipate the MPC will opt for a further two 25bps reductions in the second half of 2025 to bring interest rates in at 3.75%. However, inflation will be well above target during this time, which will keep the MPC on its “gradual and careful” path, despite weak growth.
Gradual cuts and above-target inflation
Continuing to cut interest rates when inflation is close to double the 2% target may raise some eyebrows and feel counterintuitive. Yet, the MPC is far more concerned about inflation in the medium-term than it is with inflation right now. We think there are three key reasons why the MPC will continue to cut interest rates.
First, April’s rise in inflation was mostly driven by one-off increases, such as higher regulated prices and tax rises. The MPC can’t do much about these and will want to look through them as much as possible. What’s more, services inflation, which is more reflective of domestically generated inflation, should remain stable before easing in the first half of next year. This suggests the MPC is still on target to return inflation to 2% at the two-year horizon.
Second, interest rates are still comfortably in restrictive territory. We estimate the neutral rate to be around 3.5%, which means the MPC has a few cuts to go until it must worry about monetary policy stimulating the economy. The next couple of cuts will still be the MPC taking its foot off the brake as opposed to indicating a shift into the fast lane.
Third, while wage growth is still strong, the labour market has materially weakened. Pay growth should slow over the next year and allow the MPC to keep cutting interest rates without too much fear this will stoke domestic inflation. Workers will find it much harder to demand big pay rises against a backdrop of weak labour demand.
For now, the MPC is at a crossroads. Both inflation and wage growth are too high to justify an aggressive pace of cuts, but growth is also looking lacklustre. Given that the Bank of England (BoE) will rightly be much more concerned with inflation returning to target in the medium-term, we think the MPC’s “gradual and careful” guidance continues to be the right path.
Long-term borrowing costs for middle market firms to remain high
One cut more likely than three
However, there is no shortage of risks to the outlook. For example, firms could be more aggressive in passing on the increase in employment costs than we anticipate, which would push inflation up further. What’s more, wage growth could continue to be stickier than expected, as workers seek to protect their real incomes from the period of elevated inflation this year. This could feed through into stronger spending and higher inflation.
Indeed, inflation has been above target consistently since 2021. It has prompted both firms and employees to be far more aggressive in trying to maintain their real incomes through price hikes and wage bargaining. The clear risk is that what should be a one-off shock to the price level spirals, with both firms and workers trying to protect their margins and incomes in response to another prolonged period of higher inflation at a time when inflation expectations have already been rising. This could force the MPC to slow the pace of easing.
Ultimately, we expect the MPC to continue to cut interest rates at a quarterly pace, which would leave interest rates at 3.75% at the end of the year. However, the impact of a lower base rate on the economy won’t be as large as normal. Despite the expectation for interest rates to come down this year, long-term gilt yields have been rising across the globe. This is primarily due to US policy. Tariffs raise expectations of higher inflation and slow growth, which has made investors nervous about holding long-term debt over fears budget deficits may start to spiral. We doubt that yields will come back down any time soon given policy in the US. This will keep long-term borrowing costs high for middle market firms and make financing decisions more complex.
In the long run, we expect the base rate will settle around 3-3.5%
