Strong Growth In The First Quarter Masks A Much Weaker Economy

The U.K. economy expanded by 0.7% quarter on quarter in the first quarter of 2025

This was thanks to the front-loading of exports to the U.S. in anticipation of the new tariffs, with exports up 24% quarter on quarter in nominal terms. A 2.9% quarter-on-quarter rebound in investment also helped, driven by transport, equipment, and machinery (see chart 1).

Consumers increased their spending too, by 0.2% quarter on quarter, both on durable goods and food. However, the increase is not that great in the context of high savings and dynamic growth in real disposable income. The household savings rate, which stood at 11.6% at the end of 2024, close to its level in the global financial crisis, is likely to have increased further in the first quarter.

Chart 1

Soft data suggest that the underlying dynamism of the economy is much weaker than the first-quarter GDP numbers

According to S&P Global Purchasing Managers' Index surveys, the manufacturing sector has been contracting since October 2024 and services have edged down to the no-change mark of 50 since November 2024 (see chart 2).

In this environment, consumers have continued to lower their expectations for the economy. This is likely to be motivating higher savings than usual, preventing a stronger recovery in household spending. Retail sales dropped by 2.6% in May 2025, reversing earlier yearly gains.

GDP is likely to contract in the second quarter, reflecting the subdued trends and a drop-off in trade with the U.S., as the new tariffs have now kicked in. Exports to the U.S. were already 31% down month on month in April 2025, and the 0.3% month-on-month drop in GDP then reflects this.

Chart 2

Trade Uncertainty Persists In Spite Of New Trade Agreements

The U.K.'s new trade agreements with the U.S., EU, and India are not large enough to change the growth outlook

The agreement that the U.K. struck with the U.S. in May 2025 has not yet been implemented in full. When this will happen, and exactly what shape the agreement will take, are still uncertain. In addition, the agreement still leaves tariffs higher than they were before, at 10% for most products.

What's more, the exclusion of steel and aluminum from the proposed 50% tariff and cars from the proposed 25% tariff will only apply to a specific volume of goods. For cars, this volume is close to what manufacturers were already exporting before the tariffs went up.

Other industries like bioethanol and meat production are set to come under more pressure from lower tariffs for U.S. exporters. Therefore, even if the U.K. is slightly better off in terms of trade with the U.S. than other countries, U.K.-U.S. trade will still be lower than it would have been under the tariffs before April 2, 2025.

The implementation of the trade agreement with the U.S. would only bring the direct hit on trade down closer to 0.1 percentage point of GDP from 0.2 percentage points previously, according to our estimates. However, uncertainty will persist, and according to a survey by U.K. manufacturers' organization Make UK, manufacturers no longer view the U.S. as their second- or even third-largest export growth market.

The U.K.'s agreement with the EU is narrow in scope, even if it suggests that the U.K. may have put Brexit aside in favor of cooperation. The defense industry will benefit most, as it is now able to participate in the EU's €150 billion Security Action for Europe (SAFE) defense fund. The rest of the agreement mostly covers ease of travel between the two areas and removes barriers to agricultural trade.

Finally, the U.K.'s trade agreement with India will give U.K. exporters more options as they seek to diversify their trading partners. However, even if India is a fast-growing market, the U.K.-India trade deal is smaller in terms of economic significance than the U.K.'s narrow deal with the EU, according to HM Treasury estimates (that is, £4.8 billion versus £9.0 billion in the long run). India is a smaller trading partner, buying only around 2% of total U.K. goods exports in the past 12 months, compared with around 64% for the EU and U.S. combined.

Ease of access to more markets will help some U.K. exporters, but price pressures will continue to weigh on export performance for now

The British pound sterling was up 9% against the currencies of its main trading partners in March 2025 compared to the first quarter of 2023 (see chart 3). Economic fundamentals partly explain this, as other central banks, like the European Central Bank, have tamed inflation and cut rates more quickly than the BoE.

However, the rise in the pound's value also relates to more volatile geopolitical and economic conditions, particularly in the U.S. These have led to investors repositioning themselves away from U.S. assets in favor of other markets such as the U.K.

Chart 3

Procyclical Fiscal Policy, Volatile Data, And High Wage Gains Speak To Gradual Rate Cuts

Domestic inflationary pressures have persisted since last year, despite subdued economic growth

Coupled with a lack of improvement in productivity, persistent inflation suggests that the U.K.'s economic growth trend may be lower than before (see chart 4). Brexit, the COVID-19 pandemic, and the energy crisis seem to have hurt the U.K.'s supply side by weighing on workforce availability and investment.

Chart 4

At the same time, the U.K.'s pro-cyclical fiscal policy has added to demand pressures

The government's front-loading of spending and investment has had a little effect on growth so far. As spare supply capacity is limited, the announced spending and tax rises have mostly crowded out the private sector. The government's Spending Review of 2025 highlighted that it will direct investments to long-term goals in defense, health, and energy infrastructure. However, it will take time to add to supply capacity, and defense spending may not necessarily boost aggregate productivity as it diverts investment from the rest of the economy.

Weakening demand has brought the labor market to a turning point

The job vacancy-to-unemployment ratio of 0.46 is now close to its long-term average and back to where it was before the Brexit referendum in June 2016 (see chart 5). The Office for National Statistics' labor market survey data, which we deem to be somewhat unreliable, still points to job creation.

However, HM Treasury's pay-as-you-earn data suggests that employment has been declining for nine of the past 10 months, and more rapidly in the past three months (see chart 6). Some 280,000 jobs have been lost in the 12 months to May 2025. Employment expectations have stabilized but not yet reversed.

Chart 5

Chart 6

Recent trends in wage growth don't seem to align with a weakening labor market

This is worrying some Monetary Policy Committee members. Private-sector wages rose by 4.7% year on year in April 2025, compared with the 3.0%-3.5% needed to keep inflation close to 2.0%. The minimum wage increase in April 2025 is driving some of this rise. This is evident from faster pay growth, both at the median level and in the retail, accommodation, food, and public sectors, which have more workers earning minimum wage.

This disconnection between labor-market trends and wages also highlights that the noninflationary unemployment rate is higher than before the pandemic. We expect further increases in unemployment in the coming quarters, as low profit margins and uncertainty over the economic outlook prompt a normalization of pay growth to closer to 4% by the end of the year (see chart 7).

Chart 7

Lower pay rises should eventually reduce inflationary pressures

However, the effect may not be entirely visible until 2026 due to one-off changes. In April 2025, headline inflation climbed to 3.5% year on year and is likely to remain above 3.0% for the rest of the year. Increases in regulated and food prices have fueled inflation, but since the last quarter, imports have become cheaper thanks to the strength of the pound sterling. We expect less inflation this year than in our March 2025 forecasts, although energy prices may remain volatile as new geopolitical conflicts arise.

In sum, although demand is weakening, it is too high to keep prices in check

This is especially true as the U.K. has seen limited improvements in supply capacity. The issue will remain at the heart of the debate at the BoE's Monetary Policy Committee. It suggests that interest rates are likely to edge only slowly toward the neutral rate that keeps the economy in balance.

Volatile data and external shocks are compounding the uncertainty on where the economic equilibrium is. This will prompt the BoE to retain a gradual approach to rate cuts. We expect one rate cut per quarter until rates reach 3.5% in February 2026, with the next rate cut in August 2025.

Lower rates should incentivize more investment and less saving, which, in turn, should bolster demand and activity in the next two years. This assumes that there are no additional sources of risks until then.

Table 1