Why economists see the UK cutting interest rates more substantially

LONDON — The U.K. is likely to see interest rates drop at a faster pace than previously expected, according to economists who flagged key data releases that indicated inflationary pressures are finally easing.

However, the Labour government’s debut budget due at the end of the month will prove crucial, as market participants wait to assess the economic impact.

As of Tuesday, money markets had fully priced in a quarter-percentage-point rate cut for the Bank of England’s next meeting in November, and put a high probability on a cut of the same size at its December meeting.

That 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. Pricing then suggests a further decline to 4% by the May 2025 meeting, and to 3.5% by December 2025.

However, economists at Goldman Sachs in a Monday note forecast rate cuts “notably below market pricing.” They attribute this to their calculation of the neutral real rate of interest (which sees the economy at 2% inflation with full employment) at 0.8% for the second quarter of 2024, along with the rapid fall in U.K. inflation and dovish comments from BOE policymakers.

As a result, they see consecutive 25 basis point cuts taking the Bank Rate to 3% as early as September 2025, and to 2.75% in November next year.

The BOE has consistently maintained a cautious tone on the path of inflation over the last three years of painful price rises. When its Monetary Policy Committee voted 8 to 1 to hold rates at its Sept. 19 meeting, it said a “gradual approach” to easing policy continued to be appropriate, particularly as services inflation remained “elevated.”

Price rises are still high in the services sector, which contributed 81% to the U.K.’s economic output in the second quarter of 2024.

But figures published last week showed services inflation dropped from 5.6% to 4.9% in September, coming in below 5% for the first time since May 2022 — and that is “potentially big news for the Bank of England,” according to James Smith, developed markets economist at ING.

Services is “by some distance, the most important input into the BOE’s decision-making process, as it tries to gauge the level of inflation ‘persistence’ in the economy,” Smith said in a note.

The BOE had forecast the rate would be 5.5% in September, Smith added, meaning the actual figure was a “sizable undershoot.”

The headline rate of U.K. inflation meanwhile dropped from 2.2% in August to 1.7% in September, lower than the forecast of economists polled by Reuters and under the BOE’s 2% target for the first time in three-and-a-half years.

From its peak of 11.1% in November 2022, inflation has now been close to target for six straight months, even if more fluctuations are expected to follow due to effects from the energy market after a regulator-set price cap was raised.

Wage growth data is also coming in cooler, with average earnings including bonuses at a more than two-year low of 3.8% across June to August.

More broadly, the intense conflict in the Middle East has not driven a spike in oil prices, with the International Energy Agency instead flagging that the oil market faces a “sizeable surplus” next year. The global inflationary picture has calmed sufficiently for the U.S. Federal Reserve to opt for a half-percentage point rate cut in September; and for the European Central Bank to declare in its October meeting that the process of disinflation is “well on track.”

“Recent data have cemented expectations of another cut in interest rates in November. And it’s possible that the Bank of England could even lower rates at a slightly brisker pace than we currently expect, should the positive news around inflation be sustained,” David Muir, senior economist at Moody’s Analytics, said in a note last week.

“That said, uncertainty around the economic outlook is high, and interest rate expectations will be sensitive to what the government announces in the Budget,” Muir added.

Instead, economists say the U.K.’s greatest risks come from the home front. The Labour government, which was voted into office in July, has said its October budget will be a major shake-up targeted at rebooting the country’s sluggish economic growth.

Prime Minister Keir Starmer has warned the budget will be “painful” for the nation as it needs to cover what the government claims is a £22 billion ($29 billion) financing shortfall left by the previous administration — a figure some of its members have disputed. Finance Minister Rachel Reeves said last month that the country would not return to “austerity,” but again said hard decisions would need to be taken before Labour can fully enact the changes it wishes to see.

Labour’s messaging has led to 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. It is also unclear exactly what could lie ahead in terms of spending cuts or sector stimulus.

Gilles Moëc, group chief economist at AXA, said the BOE should account for a coming “front-loaded fiscal consolidation effort” and accelerate the pace of monetary easing.

“Politically, Keir Starmer can still blame the need for painful fiscal measures on the legacy of the Tory administration — this argument will fade soon,” Moëc said in a note Monday.

“Economically, front-loading can convince the BOE to accelerate the cuts, given the immediate dampening on demand and hence inflation. Given the U.K.’s strong sensitivity to interest rates — and the speed of monetary policy transmission there — a lot of the adverse effect of the fiscal tightening could be offset by the monetary stance,” he said.

However, Deutsche Bank Economist Sanjay Raja said Monday that expectations are growing for looser fiscal policy in the budget than previously thought.

Raja issued a fresh projection for the Bank Rate to move sequentially over the coming months to hit 3.75% by May 2025, before moving to a quarterly pace of cuts until it reaches 3% — but said looser fiscal policy could lead the BOE to pause at 3.75%.

Ruth Gregory, deputy chief U.K. economist at Capital Economics, said Friday she expected a net fiscal loosening of about £18 billion – or 0.6% of GDP – in 2029 to 2030 relative to previous plans, as Reeves attempts to balance tax rises, ramping up investment spending and easing cost of living pressures while avoiding austerity.

“The consequence would be looser fiscal policy than previously planned, but higher interest rates than otherwise,” she said.