Market expectations of rate cuts seem to have boosted economic growth in the U.K. by 0.4 percentage points this year, by our estimates. Meanwhile, consumers have benefited from lower inflation, which stood at 2.2% in August compared to 7.3% in 2023.

Why it matters:   We expect disinflation and rate cuts will stimulate growth in the U.K. over the next 12 months as consumers reduce their savings and companies benefit from lower funding costs, and pursue investment opportunities.

What we think and why:  Despite tight monetary policy, the U.K. economy has done better than expected this year. Although we see no evidence of a structural shift in wage setting, the Bank of England's (BoE's) inflation target of 2.0% requires looser labor markets, in our view. We therefore expect a very gradual easing cycle, with rates reaching their terminal rate of 3% only in early 2026.

The U.K. Economy Made Up For Lost Ground In The First Half Of 2024

Actual quarter-over-quarter GDP outputs exceeded potential GDP growth, rising by 0.7% in the first quarter and 0.6% in the second quarter. Economic activity was most pronounced in the services sector, with consumers benefiting from wage rises and a decrease in inflation; inflation expectations one year ahead declined to 2.7% in August from 3.3% in November 2023, according to the BoE's latest survey.

Even though the latest GDP data showed no growth in June and July, the S&P Global Purchasing Managers' Index (PMI) remained positive in August about economic activity. We see some moderation of sequential growth, but now expect GDP will rise by 1.0% in full-year 2024, up from 0.6% in June 2024, and by 1.3% in full-year 2025.

Investments increased as financing conditions improved, with markets expecting rate cuts (see chart 1). Among other things, this translated into a 2.4% year-over-year increase in house prices as of August. Terms of trade are improving too, even though strong domestic activity means imports are set to outperform exports this year. Stocks and statistical discrepancies contributed most to the GDP increase in the second quarter, although this could be partly revised or reversed in the third quarter (see chart 2).

Chart 1

Chart 2

Consumption And Investments Are Fueling The Recovery

So far, the soft landing we forecast has unfolded as expected. Inflation is reducing and the labor market appears resilient. This means most consumers have seen their financial situation improve and their real incomes recover, with few households experiencing job losses.

That said, higher interest rates have constrained households' purchasing power by contributing to an increase in the cost of housing, particularly for renters. The annual consumer price inflation (CPI) rate, including housing costs, is currently 0.9 ppts higher than headline CPI. This is one way in which elevated interest rates have encouraged households to save more and hold back on purchasing durable goods. The household savings rate was 11.3% in first-quarter 2024, close to 3 ppts above the long-term average.

Now with lower inflation and expectations of interest rates coming down, confidence has improved. We therefore anticipate a gradual revival of major purchases, similar to what we observe in the housing market (see charts 3 and 4). This, in turn, would bode well for business investment in the rest of the economy, especially with financing costs set to decline well into next year. Using a SVAR (structural vector autoregression) approach, we estimate that the anticipation of rate cuts has already improved GDP by 0.4 ppts this year. This is equivalent to 20% of the total estimated impact of rate cuts we forecast, namely a total 1.9 ppts rise in GDP by the end of 2027.

Chart 3

Chart 4

Rates Will Decline Only Gradually, Given The Tight Labor Market

Despite a 25 basis-point rate cut in August, the BoE still faces a difficult task of managing growth and inflation. On the one hand, a resilient labor market is needed to keep the economy going and enable a return to potential. On the other hand, too strong a labor market risks increasing inflationary pressures.

So far, employment creation has accompanied further falls in wage growth. But with a vibrant economy at the start of the year, the U.K.'s labor market has been surprisingly buoyant and the unemployment rate fell to 4.1% in June. Wage demand has subsided but was still at about 4.9% annually in July, well above productivity and a level consistent with the central bank's 2.0% inflation target.

With these trade-offs in mind, BoE governor Andrew Bailey has outlined three scenarios: one where inflation continues to fall as the BoE cuts rate (his baseline); a second (intermediate) case, where more spare capacity is needed to reduce inflation; and a third (least benign) case, where inflation is so persistent that the labor market would need to slow down significantly to bring inflation back to target.

What might happen in coming quarters

Decomposing the U.K.'s wage and price inflation dynamics into its main drivers--using the Bernanke and Blanchard's 2023 model (see below)--can help us identify which scenario will likely prevail in the next few quarters. We find:

Supply shocks following the pandemic and the invasion of Ukraine are no longer fueling inflation.   The opposite is now true, with shortages, energy, and food prices representing a drag on inflation compared to before the start of the pandemic. We expect this will be the case for much of the rest of the year (see chart 6)

The period of real wage catch-up as price inflation led to higher wages, and companies raising prices and increasing profit margins in response to higher input costs, is over.   The model no longer underestimates wage and price dynamics as it did from second-quarter 2022 and throughout 2023. Profit margins are narrowing (see chart 5) and companies have had to grapple with higher financing costs and weak demand growth. Consequently, they are less willing to increase their workforce or employee salaries.

Chart 5

The labor market is now the main source of upward pressure on inflation and we expect it will be the BoE's focus when setting rates in the next few quarters.   The labor market still contributed to the 1.2 ppts of annual wage inflation in second-quarter 2024. Yet, this is already 0.6 ppt lower than in the third quarter of 2023, suggesting a further decrease in vacancies should help (see charts 6 and 7).

Chart 6

Chart 7

In short, there is no evidence of a structural shift in wage setting

But more slack is needed in the labor market for inflation to return to target. The Monetary Policy Council (MPC) is thus likely to display a mix of views around the baseline and intermediate scenarios until labor tightness diminishes further.

Running three alternative scenarios in our model for the labor market suggests the BoE may look to achieve a vacancy-unemployment ratio of about 0.5 by early 2026 (see chart 8). This would stabilize wage growth at 2.5%-3.0%, a pace roughly consistent with productivity gains that are noninflationary.

Chart 8

In terms of a tightening cycle, this would be consistent with the BoE reaching its terminal rate by the start of 2026. Current data suggests another cut will be on the cards in November, and even possibly in December, as the change in inflation persistence becomes more visible. Added to this, even if the September MPC consensus were to indicate a quarterly pace of easing, the aggressive start of the U.S. Federal Reserve's easing cycle may affect views within the BoE. Overall, we see rates coming down to about 3.0% in early 2026 from 4.5% at the end of 2024. The MPC is likely to continue emphasizing its dependence on data in its decisions, with a fairly gradual easing cycle, given the lags of monetary policy and uncertainty regarding the neutral rate.

Related Research

• U.K. Economic Outlook Q3 2024: A Cooling Labor Market Paves The Way For Rate Cuts, June 24, 2024