UK QUARTERLY ECONOMIC OUTLOOK | Q4 2024
Interest rates
One cut a quarter
The rebound in headline inflation won’t stop the BoE from reducing interest rates next year. However, the budget means the BoE will probably cut rates once a quarter rather than once a meeting. We expect interest rates to finish 2025 at 3.75%. Given the likely policies coming from the new Trump administration in the US, the risks are weighted towards fewer cuts.
There are three key reasons why the BoE will continue to cut interest rates next year despite the rise in headline inflation. First, most of the factors driving up inflation, such as the minimum wage increase and some of the measures included in the budget, will have a one-off impact on the price level, rather than permanently pushing up the rate of inflation. That makes the Monetary Policy Committee (MPC) more likely to look through them when setting policy for the next two years.
Second, a slowdown in wage growth will remove one of the big risks to the inflationary outlook. As wage growth slows, it becomes less likely that inflation in the medium term will increase.
Third, interest rates are still well into restrictive territory. Now that inflation has fallen into the 2%-3% range, there is no need for the BoE to keep pressing so hard on the brake pedal. Given that the neutral rate is around 3%-3.5%, the BoE can reduce interest rates to a little below 4% without being too concerned about stoking inflation.
That said, the MPC has made it clear that it intends to tread carefully when it comes to reducing interest rates over the next year. Indeed, in November, the MPC backed away from recent comments by BoE Governor Andrew Bailey that more “aggressive” rate cuts might be needed and kept its previous guidance that a “gradual approach to removing policy restraint remains appropriate”.
Slowing wage growth and disinflationary trends will allow further rate cuts in 2025.
Slowing wage growth and disinflationary trends will allow further rate cuts in 2025. We currently expect four cuts, which would leave interest rates at 3.75% by the end of 2025. However, the risks are firmly weighted towards fewer cuts. There is significant uncertainty around how much the budget will push up inflation and whether firms will try to pass on the increase in taxes by raising prices, which would be inflationary, or by cutting labour costs such as wages and employment, which could be disinflationary.
What’s more, the new Trump administration raises inflationary risks. The direct impact of tariffs on the UK should be relatively small, but higher inflation and an expansionary fiscal policy in the US would boost the dollar, which would mean higher inflation in the UK.