We now have a complete picture for 2025 of the UK economy and it’s one of gradual, if unremarkable, improvement. Much like a bob sledder who runs full pelt only to mistime their landing, the UK economy’s strength in the first half of the year gave way to wobbles and near stagnation in the second. Even worse, the real economy, which is those firms that make, do and sell things, slipped into recession. That makes an interest rate cut in March even more likely.

The UK economy’s big picture

The headlines are, understandably, focusing on Q4’s weakness. But, taking the year as a whole shows a marked improvement in some key areas. Consumer spending grew by 1% after shrinking by 0.1% in 2024 and business investment growth accelerated to 3.5% from 2.5%. Admittedly, there was a big jump in imports, which offset some of this strength, but overall growth rose to 1.3% from 1.1%. Steady, if not exactly amazing, progress.

However, that relatively positive picture fizzles out when we zoom in on the latest data.

In the final quarter of the year, consumer spending growth slowed to just 0.2%. That was down from 0.4% in Q3. Business investment collapsed by 2.7% after growing by 1.6% the quarter before. These are pretty good signs that speculation in the run up to the Autumn Budget prompted consumers to hold back on spending and firms to delay investment.

Even more concerningly, strong government spending was the only reason the economy didn’t completely stagnate in the second half of the year. In fact, our proprietary Real Economy Barometer, which strips out volatile industries and public services, shows that the real economy entered a technical recession at the end of last year, with output falling by 0.1% for two consecutive quarters. That’s one reason why many businesses are struggling, despite the economy still growing.

As a result, the Bank of England is even more likely to cut interest rates in March to support growth. Markets are currently pricing in a 70%+ chance of a cut – good news for those of you with mortgages.

Of course, a key reason why the private sector has been faltering is because of higher taxes, increased cost burdens and more legislation. So, the increase in government spending is more a transfer of activity from the private sector to the public one, rather than a good old-fashioned Keynesian stimulus designed to boost the economy. This clearly is not a sustainable growth model: a recovery in the private sector is needed to keep growth at even these subdued levels as fiscal policy tightens.

Luckily, there are some signs of a recovery here.

Reasons to be hopeful for the UK economy

Aside from the fact that the sun will stay out beyond 5.30pm from next week, there are some reasons to be cautiously optimistic.

Hospitality services and retail sales rebounded in December, suggesting confidence is recovering rapidly after the Autumn Budget turned out to be much more benign than expected. This rebound should continue in 2026 as consumer confidence has continued to rise and business surveys have jumped. Indeed, much of the activity postponed before the Budget should now occur in Q1. For example, there are strong signals that the housing market is coming back to life now that there is certainty on property taxes.

Inflation should have slowed sharply to 3% in January (see preview below) and drop to around 2% in April, which will help to ease some of the cost pressures households and businesses have been facing. It will also lay the groundwork for a March rate cut and probably another in the summer. This, combined with last year’s rate cuts, should start to feed through into stronger consumer spending and business investment later in the year − as long as another bout of political uncertainty doesn’t put higher taxes back at the top of the worry list.

That said, we aren’t expecting growth this year to be any better than in 2025. However, lower inflation and interest rates should set the stage for more robust growth in 2027. Indeed, there are some early signs that the UK’s infamous productivity problem might be starting to improve, but more on that next week.

We expect this week’s labour market report to continue showing pay growth ticking down and payrolls weakening.

Private-sector pay excluding bonuses – the measure most relevant to the Monetary Policy Committee (MPC) as it’s more reflective of underlying inflationary pressures – should tick down to 3.4% y/y from 3.6% previously. Meanwhile, whole-economy pay growth will remain stickier at around 4.6% until the spring, which is when more favourable base effects will weigh on public sector pay growth.

Meanwhile, we expect the unemployment rate to hold at 5.1% in January. However, the Labour Force Survey, from which the unemployment rate is derived, remains questionable despite the ONS successfully boosting the sample size. This means the MPC will need to look at a broader range of indicators. But, we think payrolls will continue to fall.

Ultimately, further weakening in private-sector pay growth and payrolls will keep the MPC’s dovish tone in play heading into March’s meeting. Indeed, a March cut looks increasingly likely. If this week’s employment figures are disappointing, then that will probably seal the deal on the MPC cutting rates next month.

Inflation will take a step down to around 3% in January from 3.4% in December for a few reasons.

First, more favourable base effects will drag down on food inflation as last January’s big 0.9% m/m rise in food prices is unlikely to be repeated. Meanwhile, education inflation will fall as the government’s VAT hike on private school fees also drops out of the comparison.

Second, despite oil prices rising by about 10% in pound terms since the start of the year, weekly pump-price data shows prices falling in January. This will provide a short-term drag before reversing in the coming months as higher oil prices start to feed through to the pump.

Third, erratic factors such as surging airfares boosted inflation in December. Those factors are likely to have unwound in January, helping to drag inflation down further.

All told, inflation will likely fall to around 3% in January, before taking a further step down to only a little above 2% in April, which is when last year’s swathe of regulated-price hikes will drop out of the annual comparison. The Chancellor’s decision to freeze rail fares and electricity bills will also knock a further 0.5ppts off headline inflation.

Retail sales are likely to pick up in January after a disappointing Golden Quarter left many retailers ending 2025 on a low. Fortunately, we think the evidence points to a strong bounce in January.

First, consumer confidence rose again in January. It’s now the highest since August 2024, which should support spending. What’s more, consumers’ major purchasing intentions, which are a better indicator of willingness to spend, rose to the highest level in around four years.

Second, the BRC’s measure of retail sales and Barclay’s Consumer Spend Report both show sales picking up in January. Granted, the relationship with the official data can be noisy. However, we suspect falling Autumn Budget uncertainty and signs of growth picking up elsewhere suggest a solid gain for retail sales when the report is released on Friday.

However, there’s a risk that January’s wet and stormy weather kept consumers at home. The UK saw 117% of its long-term average January rainfall this year and multiple storms may have deterred consumers from heading out to the high street.

In any case, we’re expecting retail sales to rise by around 0.5% in January. This will further match the signal from private-sector surveys that show the economy managed to gain some momentum if January after a weak end to the year.

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