UK QUARTERLY ECONOMIC OUTLOOK | Q3 2025
Interest rates
Final cut of the year hangs in the balance
After three interest rate cuts this year, the latest one in August, the chances of a fourth in the final quarter now look slimmer than they did in our Q2 Outlook. With inflation set to peak at 4% in September and growth surprising to the upside, the case for more rate cuts has weakened. However, the labour market is clearly loosening, which should depress pay growth going forward and eventually translate into lower inflation. MPC final cut of 2025 will hinge on whether the labour market continues to weaken or starts to recover along with the usual inflation metrics. All things considered, we think the MPC will delay its next cut until December or even February. It’s a very close call and the data over the next few months could easily shift that view.
Labour market and inflation of equal concern
At its last meeting, the MPC revealed a hawkish set of forecasts. This included an upwards revision to its inflation outlook, an acknowledgement that “the restrictiveness of monetary policy has fallen” and even suggested it may need to “skip” a cut in November. This makes the path for interest rates even harder to assess.
Underpinning this challenge are two conflicting stories about the UK economy: one where underlying growth is weak, the labour market is easing far too quickly and the recent rise in inflation is a one-off that will drop out of the inflation figures next year. In this scenario, more interest rate cuts are needed to prevent an unnecessary rise in unemployment.
The second, equally convincing, story suggests that most of the recent weakness in the labour market is due to a one-off adjustment to tax increases. Growth is around the UK’s economic speed limit, disinflation is stalling and inflation expectations are becoming dangerously high, which could all lead to even stickier inflation. In this scenario, the MPC will need to keep rates higher for longer to ensure inflation returns to target.
Both stories are convincing and it’s hard to pick a side, especially because we cannot trust official labour market data. Even financial markets are pricing in an almost exactly 50% chance of a rate cut by the end of the year.
However, we think the nascent signs of a recovery in the labour market and inflation at almost double the government’s 2% target mean the MPC skips a cut in November and waits instead for December or February to cut interest rates, again depending on the contents of the next Autumn Budget.
Interest rates on downwards path, but how fast?
Despite the near-term uncertainty for interest rates, we think the Bank of England (BoE) will continue to cut over the next year. We see a few reasons for this.
First, pay growth will continue to ease during the rest of this year. Weaker labour demand will feed into slower pay growth. Firms trying to protect their profit margins from the big rise in employment costs will offer less generous pay rises. This would provide the MPC with enough cover for more rate cuts.
Second, while inflation will rise in the near-term, Q2’s price hikes and regulated price increases will drop out of the inflation picture in April. This will bring inflation below 3% next year. While still above the government’s target, this level will be far more comfortable for the MPC than the 4% we expect this September.
Third, at 4%, interest rates are still in restrictive territory, meaning they should continue to weigh on inflation and dampen demand in the economy. This gives some room for rates to fall further once the MPC is satisfied inflation is under control.
However, a recovery in the labour market may prevent a more material and quicker fall in the base rate to the 3% level that the MPC is comfortable with. What’s more, if inflation proves more persistent than the MPC currently expects, then that could prompt the committee to press pause on future rate cuts.
Ultimately, we expect interest rates to settle at around 3.5% next year as the BoE reaches the end of its easing cycle. How quickly we get there will depend on the next few inflation and jobs market reports.
