UK QUARTERLY ECONOMIC OUTLOOK | Q4 2025
Interest rates
MPC ‘one and done’ in 2026
We think the Monetary Policy Committee (MPC) will cut once in 2026. Inflation will fall back below 3% in April, but underlying price pressures will remain elevated and the labour market should stabilise throughout the year. This would leave interest rates at 3.5%, which is around our estimate of neutral. For rates to go lower, the MPC would need to see a material slowdown in the economy or signs that the labour market is loosening more sharply than expected.
MPC will leave interest rates at 3.5% in 2026
After delivering its fourth cut of 2025 in the final weeks of last year to bring interest rates down to 3.75%, we think the MPC has limited room to go further and will cut just once this year for three key reasons.
First, the government’s Autumn Budget policy decisions trim 0.3ppts off inflation across the year. This may be a marginal factor in any further interest rate cuts if conditions take a turn from the expected.
Second, the labour market has weakened markedly over the past year, which has helped to bring down pay growth. But, the unemployment rate should trend down this year. This will prevent a faster fall in pay growth. Another big rise in the National Minimum Wage (NMW) will help keep wage growth elevated. That said, if the labour market continues to loosen at pace − a genuine possibility − then that may be enough to convince the MPC rates need to come down further.
Third, our best estimate of the neutral rate – the level where interest rates are neither stimulating nor restricting activity – is around 3.5%. As the MPC gets closer to this level, it’ll be far more reluctant to cut interest rates. It’d take some very weak labour market or growth figures to convince the MPC that interest rates heading below neutral is necessary.
Borrowing costs to remain elevated for firms
Another cut to the base rate should help to reduce firms’ funding costs, which the RSM UK Financial Conditions Index tracks. However, several factors will keep long-term borrowing costs broadly unchanged. The Bank of England (BoE) will continue quantitative tightening (QT) − reducing its balance sheet − albeit at a slower pace. Private sector defined benefit pension schemes will continue to wind down, reducing demand for gilts. What’s more, the Budget didn’t address any of the long-term concerns around the public finances, so the UK will continue to face a risk premium on borrowing costs. Ultimately, an elevated yield curve, from which private sector debt is priced, will keep funding costs elevated.
All told, we think the MPC will be one and done in 2026, leaving interest rates at 3.5% at the end of the easing cycle. The MPC will be reticent to bring rates below neutral as inflation struggles to return to 2% and the labour market stabilises. However, if the labour market does take a turn for the worse or growth slows markedly, then the MPC may be tempted into further rate cuts.
