Despite the war in Iran and a change of administration, the standout economic story of this year has been the UK economy’s resilience. The economy will probably grow by about 1.4% this year, much faster than both the Bank of England and the OBR expect. However, that resilience will be stress-tested this winter as inflation rises above 4%, the Bank of England starts to raise interest rates and we face yet another tax-raising Budget.

UK economic growth exceeds expectations

The UK economy grew by 1.1% in the first six months of this year, more than the total growth recorded in 2024. That puts the economy on course for its best year since 2022, when it was still recovering from the pandemic, despite the sharp rise in energy costs.

Reassuringly, that momentum has been driven by private-sector activity rather than large increases in government spending. Business investment surged by 4.8% in the first half of the year, while consumer spending grew by 1%, despite real incomes doing little more than stagnating over the past year. That is because households have reduced the amount they save, from a peak of 10.6% of their incomes in Q4 2024 to 8.8% in Q2 2026.

What’s more, that momentum appears to have continued throughout Q3. The economy grew by a whopping 0.4% in July, and business surveys suggest that solid momentum continued into September. Consumer confidence hit a two-year high that month, while more timely credit data show that households are smoothing the impact of the energy shock by reducing cash savings and taking on a little more credit.

UK inflation, interest rates and tax rises: the outlook for winter

However, three factors will put that resilience to the test this winter.

First, energy prices continue to rise. Natural gas prices have doubled since June, while fuel prices are near record levels. As a result, household energy bills are likely to rise by 15% to 20% in January. Add in a super El Niño, which would push crop prices up further, and inflation is likely to breach 4% early next year, and could approach 5% if energy prices rise again.

That would have several consequences, none of them good. Real wage growth would probably turn negative next year, it already has for private-sector workers, weighing on spending. What’s more, when inflation rises above 4%, consumers and businesses become more attentive to it, increasing the risk of a drop in confidence and a dangerous feedback loop in which higher inflation expectations feed into actual decisions. Finally, it would make interest-rate rises more likely.

That brings us neatly to the second headwind. So far, the Bank of England has kept Bank Rate at 3.75%, but that has not stopped mortgage rates from jumping by a full percentage point, mainly because gilt yields have risen sharply. Inflation above 4% is probably too high for the Bank to ignore, so our base case is now for two interest-rate rises, with the first in November. That would push up the cost of shorter-dated mortgages and corporate debt, further weighing on consumer spending.

The third headwind is more of a wild card. The last two Budgets prompted intense speculation about potential tax rises, sapping confidence and causing a clear slump in economic activity around them. The new administration has been careful not to leak much ahead of this Budget, in an effort to avoid a repeat of that self-defeating pattern. However, with tax rises seemingly inevitable, we expect the Budget to weigh on growth in Q4. If handled badly, it could easily trigger a sharp drop in consumer confidence and business sentiment, or push gilt yields higher. There is, of course, a chance that the Budget offsets some of the rise in energy prices without unsettling bond markets, which would support growth. But, given recent Budgets, the risks are clearly tilted to the downside.

UK GDP growth is set to slow, but resilience remains

The big economic story has therefore been one of resilience, something that has probably been underappreciated in the press. However, past performance is no guarantee of future results, and there are good reasons to expect the economy to slow sharply over the next six months. The Bloomberg consensus forecast is for growth to fall from 0.5% in Q2 to 0.2% in Q4. Even so, that would not be a bad performance given the headwinds now arrayed against growth. Here’s hoping the economy pleasantly surprises us again.

Last week, we highlighted that annual business investment growth had been revised sharply higher, from 0.8% to 5.2%. The Bank of England’s Agents’ survey also suggested that investment intentions improved in August to their highest level since the end of 2024. That raises an obvious question: what is driving this sharp acceleration, especially given the steep rise in financing costs since the start of the year?

The main driver has been investment in buildings and other structures, which is up 15.3% over the past year. Over the same period, investment in IT and other machinery rose by 4.1%, while investment in intellectual property increased by 3.2%.

Breaking business investment down by industry shows that almost three-quarters of its rise over the past year came from the utilities sector. Sharp increases in utility bills, together with public funding designed to crowd in private investment, are supporting improvements to the electricity grid and water infrastructure, as well as the build-out of renewable energy. Elsewhere, the other major driver has been the IT sector, possibly reflecting the construction of data centres, given the sharp rise in building investment.

More broadly, business investment has picked up sharply over the past couple of years, averaging 1.0% per quarter since the start of 2024. That compares with little more than stagnation in the years following the Brexit vote and the pandemic.

All told, UK business investment is recovering strongly after years of weak growth, adding to the positive story around the economy. Given the sharp rise in financing costs and the persistent uncertainty of recent years, that recovery is even more impressive.

The UK economy probably contracted by 0.1% in August as some of the strong growth recorded in June and July unwound. However, one weak month should not obscure the broader trend of resilience. Growth has averaged 0.5% per quarter this year, and the economy remains on course to expand by around 0.4% to 0.5% in Q3.

Looking at the detail, industrial production probably did little more than stagnate in August. Another decline in mining activity, based on the signal from North Sea loadings, is likely to offset a 0.1% rise in manufacturing output.

Elsewhere, there is little reason to think the construction sector’s malaise eased in August. The dismal construction PMI remains consistent with contraction, so we expect output to fall by 0.2%. Admittedly, brick deliveries surged by 12.6% in August, but deliveries feed through with a lag and remain 13% below their May level. This suggests that builders endured a poor summer, despite the scorching weather that would usually support activity.

Turning to the all-important services sector, where activity jumped by 0.4% in each of the previous two months, we expect a 0.1% fall. This is likely to be driven by lower output in administrative activities, professional services and IT. The risks around this forecast are greater than usual. Our modelling points to stronger gains than we have pencilled in for August, but these sectors have grown rapidly in recent months, so some modest payback seems likely. In any case, robust business surveys and anecdotal evidence that AI adoption is supporting IT output suggest that solid growth in the powerhouse sectors of the UK economy can continue for a while longer.

Ultimately, we think some of the economy’s strong gains in June and July unwound in August, leaving GDP down by 0.1%. Even so, the economy remains on track to grow by 0.4% to 0.5% in Q3. Further ahead, firms will have to contend with a softer demand backdrop. Rising inflation, higher interest rates and a weak labour market will all drag on activity, leaving growth at little more than a crawl in Q4 and into the new year.

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