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The Bank of England’s grim snapshot of the UK economy on Thursday raised fresh concerns about the government’s efforts to lift growth, as the central bank forecast weaker activity, higher inflation, rising unemployment and a sharp deterioration in Britain’s output potential.
The BoE’s Monetary Policy Committee cut interest rates by a quarter percentage point to 4.5 per cent against a backdrop of stagnant output and rising trade tensions, with two rate-setters favouring an even bigger cut to guard against the risks of a sharper downturn.
The weak outlook underlines the challenge facing chancellor Rachel Reeves after she pledged that growth was the government’s number one mission. It raised fresh questions about the fiscal outlook, analysts said, given the importance of stronger growth to bolster tax revenue.
If the Office for Budget Responsibility, the government’s fiscal watchdog, were to issue a similarly downbeat growth outlook, it would increase the risk that the chancellor would break her self-imposed fiscal rules, said Paul Dales of Capital Economics. Weaker growth prospects meant “the government will need to tighten its fiscal belt”.
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In another blow to the government’s attempts to send an upbeat message on the economy, the BoE’s short-term forecasts point to an acceleration of inflation to 3.7 per cent by the middle of 2025 — far above the BoE’s 2 per cent target.
Even if interest rates remain higher than recent market expectations — with only two more quarter-point cuts by the end of 2027 — the forecasts show inflation would only return to the BoE’s 2 per cent target in late 2027.
Meanwhile, GDP would grow just 0.75 per cent this year, before picking up in 2026 and 2027, and unemployment would rise to 4.75 per cent.
Andrew Bailey, BoE governor, sought to put a positive spin on the inflation forecast, saying the near-term jump was chiefly due to “temporary factors” that were “not directly linked to underlying cost and price pressures in the UK economy”.
A 20 per cent rise in wholesale gas prices across Europe was the biggest driver, he said, along with planned increases in regulated bus fares and household water bills. But Bailey also acknowledged there was “heightened uncertainty” that could push inflation in either direction.
The biggest worry is that the BoE has become more pessimistic about the rate at which the UK economy can grow without pushing up inflation.
In its annual stock take of the supply side of the economy, it said the UK’s potential growth rate — often described as a “speed limit” on sustainable GDP growth — had slowed to just 0.75 per cent by the start of 2025, down from 1.5 per cent a year earlier.
This meant that even with actual GDP growth at a standstill, there was only a small margin of slack in the UK economy — with rate-setters split on the extent to which the recent slowdown was due to weak demand or constrained supply.
The picture from the BoE is quite bleak, said Andrew Wishart, a UK economist at Berenberg Bank. “High inflation despite weak growth partly reflects the new judgment that the supply capacity of the economy has weakened, and partly higher energy price futures,” he said.
Bailey said the “challenges reading some of the data” had made it especially difficult for the MPC to judge what was going on.
Recent data revisions showed the UK population and workforce had grown faster than previously thought, he noted — and since “we haven’t had a change in GDP, we can only conclude mathematically that productivity has got much worse”.
Growth in employment has been fastest in parts of the public sector such as education and health, whose contribution to GDP is notoriously hard to measure.
All this meant “the speed limit [on growth] in the short term is lower”, said Dave Ramsden, BoE deputy governor. However, he added that there was “good reason to think productivity will pick up” in the longer term, as the government’s structural reforms began to pay off.
The BoE is forecasting an improvement in potential growth over the coming years as productivity rises, but the outlook for GDP remains murky.
Bailey said there was a risk that Budget tax increases could both boost prices and hit jobs more than the BoE initially thought, as employers in some sectors could not cut pay for staff already on the minimum wage.
Meanwhile, businesses were telling the BoE’s agents that they were holding off hiring and investment because of worries over trade tensions, high borrowing costs and a squeezed cash position, as well as the Budget.
Bailey said the MPC would “have to judge meeting by meeting” how far and how fast it could cut rates because of these uncertainties. Analysts said developments on the supply side would ultimately be critical.
“We do not want to see what the BoE thinks happened on supply in 2024 being repeated for the next five years,” said Rob Wood, at the consultancy Pantheon Macroeconomics. “If productivity growth remains that weak, both the outlook for living standards and also the fiscal outlook [are] going to be dire.”