Last week’s interest rate cut to 4% marks the fifth since this time last year, when it stood at 5.25%. Yet, this time around the Monetary Policy Committee (MPC) dropped some hints that this might be the last of 2025 – and maybe even of this rate-cutting cycle. Given financial markets are still pricing in interest rates falling to 3.5% by mid-2026, stopping at 4% would be yet another headache for Rachel Reeves.

Why can’t the BoE cut interest rates quicker?

The reality the Bank of England (BoE) has been grappling with over the last year is that economic growth has been pretty poor. The labour market has also been weakening, while inflation has consistently been well-above the 2% target. At the same time, wage growth – a good indicator of inflationary pressures in the economy – has been running too hot.

These problems have become even starker recently. The economy contracted for two consecutive months in April and May, although may have rebounded in June. The labour market has clearly weakened sharply since the Autumn Budget last October and the implementation of its tax hikes in April. Inflation has also jumped back up to 3.6% and will probably reach 4% by the end of the summer.

This is a particularly tricky combination of factors for the MPC to deal with, especially because there is a significant lag of one to two years between the MPC changing interest rates and it fully impacting the economy. It can’t simultaneously bear down on inflation and support growth. Usually, the BoE would raise interest rates – or at least not cut them – to suck demand out of the economy and dampen inflation.

However, with the economy and labour market already weak, keeping interest rates high risks pushing the economy into stagnation or even recession, as one MPC member warned last Thursday.

Are we at the start of a new interest rate-setting cycle?

The BoE has dealt with this dilemma by opting for a “careful and gradual” approach to rate cuts, which in practice has meant one 25bps reduction in rates per quarter. However, there were some signs last Thursday that we might be at the end of this path.

First, the vote was much closer than expected, with four of the nine committee members voting to keep rates on hold. The consensus had expected only two MPC members to vote to hold. In theory, this split raises the bar for any future rate cut because it means even more members will need to be convinced to change their positions.

Second, the emphasis in the latest MPC meeting minutes changed from worries about the weakening labour market to concerns about sticky inflation. More concern about inflation means less chance of rate cuts in the future. Take this quote for example: "the upside risks around medium-term inflationary pressures have moved slightly higher since May".

Third, the forecasts were revised to be slightly more hawkish. The highlight was that the MPC now expects inflation to peak at 4% rather than 3.7%. It will be tricky for the MPC to justify cutting interest rates when inflation has just hit 4%.

At the very least, these changes mean we can’t take a quarterly rate-cutting path for granted anymore. At most, it means we’ve already had the last rate cut for this year and maybe in this rate-cutting cycle.

Uncertainty is therefore much higher than normal. Indeed, Governor Bailey stated there is now “genuine uncertainty” about the future path of interest rates. However, our base case is still that the labour market will remain weak enough over the rest of this year as firms continue to adjust to higher costs to provide enough cover for one more rate cut. Indeed, financial markets are still pricing in one more rate cut this year and one more next year.

Interest rate outlook: key factors the BoE is watching

The big question for the MPC is whether or not the recent weakness in the labour market is mainly because of a one-off adjustment to higher labour costs. In this case, the employment picture should start to recover over the rest of the year. However, if the weakness is more down to chronically weak demand or interest rates that are too restrictive, then a labour market recovery would almost certainly mean no more rate cuts.

The path of inflation seems like an obvious factor that could also change the BoE’s approach. But the MPC is probably less concerned with the headline rate than it is about measures of underlying inflation. Crucially, inflation expectations that measure where households and businesses expect inflation to be in the future have risen sharply recently, which might present a problem. If everyone expects inflation to be 4% rather than 2%, then firms are more likely to put up prices and employers to give bigger pay awards.

Finally, the upcoming Autumn Budget may play the biggest role. It seems very likely that taxes will have to rise, but which ones do is important from the MPC’s perspective. A raise in something like income tax sucks demand out of the economy and is disinflationary. This would give the MPC cover to continue cutting rates. However, if we get another round of duty and payroll tax increases, then that would push up inflation and may prevent the MPC from cutting rates, especially if inflation expectations are rising.

Ultimately, financial markets don’t seem to think much has changed following last week’s announcement. Market pricing has barely moved. But the chances of a rate cut in Q4 are still much lower than they were this time last week.

Will GDP recover in June and keep the UK out of recession?

We expect GDP to rebound in June, growing by 0.2% after shrinking in April and May, when the official figures are released on Thursday.

Starting with the production side of the economy, we think industrial production climbed 0.6% m/m, largely thanks to a jump in mining output, which tends to be erratic. Our estimates also suggest North Sea Oil loadings surged 23% in June on a seasonally adjusted basis. This means we can add a solid 3% jump in mining output to our calculations.

Crucially, manufacturing output should gain 0.2% in June. The sector is now broadly in line with where it was before tariff front-running caused output in February and March to surge, with activity normalising. Early indicators of car production improved in June and the output balance of the manufacturing PMI has gained an impressive average of one point per month since it bottomed out in April.

Elsewhere, construction output fell in May by its largest amount since July 2024. However, the sector looks ripe for a rebound as the UK had, according to the Met Office, the second hottest June on record and good weather usually boosts construction output.

Rounding off with the services sectors, we’re looking for a modest 0.2% gain here. That will be driven by consumer-facing services. Retail sales gained 0.9% m/m after collapsing in May. Add in the rebound in motor trades we anticipate, then the retail sector should grow 0.7% in June. Good weather will likely also boost hospitality output. Our CGA-RSM Hospitality Tracker might show inflation outstripping sales growth, but total sales in June improved on May. We’re looking for a 0.3% gain there.

As we detailed in last week’s article, rising mortgage approvals and a 13% monthly gain in housing transactions suggested June was a good month for estate agents and professional services. Yet while housing transactions surged in May, real estate output fell. This is peculiar and suggests there could be an upside risk to our view that real estate output grew by just 0.1% in June.

All in all, we think the economy came back to life in June. Admittedly, there’s a risk that some of April and May’s fall in output was reflective of genuine weakness instead of just tariff and tax front-running unwinding. Ultimately, improving business surveys, retail sales and housing market activity all point in one direction. That should be just enough for the economy to grow 0.2% in Q2.

Labour market continues to loosen

June’s jobs data will likely show a continued weakening in the labour market when they are released on Tuesday. We expect the unemployment rate to remain unchanged at 4.7%, but other indicators will suggest the labour market is still easing.

Early indicators point to a continued decline in both vacancies and headcounts in June, with vacancies now well below pre-pandemic levels. Granted, chances are the first estimate for June’s payrolls will be revised up, but it’s still likely to point to a weak jobs market as firms continue to adjust to a big rise in employment costs.

This recent weakness is clearly starting to feed through into lower pay growth. We expect private sector pay growth (excluding bonuses) to ease to 4.8% in June from 4.9%. Additionally, the average weekly earnings for the whole economy should fall to 4.7% from 5%.

As we note above, a recovery in the labour market could close the door to another interest rate cut this year. However, we think weakening pay growth should give the Monetary Policy Committee (MPC) the balance it needs to cut interest rates in November, despite inflation heading towards 4%.

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