2025 Outlook: UK – Grappling With Stagflation-lite

The combination facing the UK economy at present is a rather grim one. On inflation, though progress has been made in headline CPI returning towards the 2% target, underlying inflation metrics continue to show persistent price pressures remaining intense, under the surface. The fall in headline inflation has, largely, been driven by energy, as well as by deflation in goods, with little by way of substantial disinflationary process having been made in the all-important services sector.  

In turn, with underlying price pressures still intense, the Bank of England are likely to continue with the current “gradual” approach to removing policy restriction.

Having delivered two 25bp Bank Rate cuts in 2024, the MPC are set to stick with the current quarterly cadence of rate cuts throughout the next 12 months, lowering Bank Rate at meetings in conjunction with the release of a Monetary Policy Report – i.e., cuts in February, May, August, and November. A quicker pace of policy easing is likely to require much faster, and more convincing, disinflationary progress than has been seen to date, with the MPC’s hawks likely to be particularly difficult to convince as to the need for a more rapid pace of easing.

While such an outlook is considerably more hawkish than the outlook for most of the BoE’s G10 peers, it can be argued that this hawkishness is for the ‘wrong’ reasons. As opposed to the ‘Old Lady’ remaining in restrictive territory due to inherent economic strength and solid growth momentum, such a stance will be maintained due to the inability to eradicate persistent price pressures from within the economy.

Speaking of economic growth, the outlook appears rather dour heading into 2025. While the beginning of 2024 saw the economy recovering at a solid pace from the shallow late-2023 recession, momentum has waned rapidly since the summer. Initially, this waning momentum was due to the uncertainty seen in the run up to Chancellor Reeves’ first Budget, which severely dented overall economic confidence. The significant tax hikes announced in said Budget, principally a lowering of the national insurance salary threshold, and increase in employer contributions, have only further dented said confidence.

It seems highly unlikely that confidence, business investment, or consumer spending will make a rebound in the short-term. The aforementioned national insurance changes have had the effect of raising the cost of employment, while a reform of so-called ‘Workers’ Rights’ is set to result in a much less pro-business stance, likely further deterring businesses from hiring afresh. On net, the Budget measures will result in one of three things – increased layoffs; slower earnings growth; or, increased costs being passed on to consumers at the end of the value chain.

Consumers, meanwhile, will likely remain pessimistic, not only due to the continued perils posed by persistent inflation, but also as the spectre of further tax hikes continues to loom large.

Despite the October Budget having been the biggest revenue raising Budget ever, in nominal terms, the fiscal backdrop remains perilous. Even when measured against the new-fangled Public Sector Net Financial Liabilities (PSNFL) metric, headroom against the current fiscal rules stands at a meagre £16bln.

Consequently, if the Budget measures fail to raise the – rather ambitious – amounts that the OBR forecast, or if a relatively minor macroeconomic shock were to occur, Reeves will be forced back to the despatch box to raise taxes further, or to increase borrowing. Either way, the lingering uncertainty that will persist should see international investors continuing to shy away from UK assets, and see a risk premium remain priced in to gilts, and the curve steepen.

While the Budget is likely to have a significant detrimental impact on the labour market, the precise impact will remain difficult to measure, given the ongoing difficulties that the ONS are experiencing in collating accurate data, which may not be available until 2027. Nevertheless, alternative labour market metrics point to a continued loosening in employment conditions, which is likely to continue into 2025. The BoE, however, will continue to place little weight on labour developments, given the aforementioned data quality issues, with inflation remaining the primary determinant of future policy shifts.

In isolation, one could assume that a hawkish central bank, and steeper FI curve, would be positive catalysts for the currency in question. It is, however, difficult to argue that that relationship applies to the GBP as we look ahead to next year. In fact, the BoE are set to stick with a relatively hawkish policy stance in an attempt to use a relatively blunt policy instrument – Bank Rate adjustments – to control what is set to become a stagflation-esque UK economy in 2025.

Consequently, it is more likely that the toxic mix of stubbornly high inflation, anaemic economic growth, substantial fiscal risks, and a loosening labour market, becomes a headwind for the GBP, particularly considering the continued economic outperformance likely to occur across the Atlantic, with further downside on the cards for cable, likely below the 1.25 figure.