UK economists predict more substantial interest rate cuts as inflation decreases.

• After key data releases showed inflationary pressures are easing, economists predict that the U.K. will see interest rates drop at a faster pace than previously expected.
• The Bank of England considers services inflation to be a crucial measure, but it fell below expectations in September due to a decrease in wage growth.
• Despite their anticipation, market-watchers are still waiting for the Labour government's first budget at the end of the month to determine its economic impact.

According to economists, the U.K. is likely to see interest rates drop at a faster pace than previously expected due to key data releases indicating that inflationary pressures are finally easing.

The upcoming debut budget of the Labour government will be critical for market participants to evaluate its economic impact.

The Bank of England's next meeting in November is expected to see a quarter-percentage-point rate cut, with a high probability of the same size cut occurring at the December meeting.

The central bank's key rate, which was at a 16-year-high of 5.25% at the beginning of the year, is expected to decrease to 4.5% by the end. According to pricing, it is predicted that the rate will further decline to 4% by the May 2025 meeting and to 3.5% by December 2025.

Goldman Sachs economists predict rate cuts "significantly below market expectations" due to their calculation of a neutral real rate of interest at 0.8% for Q2 2024, as well as the decline in U.K. inflation and BOE policymakers' dovish comments.

Consecutive 25 basis point cuts will bring the Bank Rate down to 3% by September 2025 and to 2.75% by November next year.

The BOE has consistently maintained a cautious tone on the path of inflation over the past three years of painful price rises. In its recent Monetary Policy Committee meeting, the BOE voted 8 to 1 to hold rates, stating that a "gradual approach" to easing policy was still appropriate, particularly as services inflation remained "elevated."

The services sector, which accounts for 81% of the U.K.'s economic output in the second quarter of 2024, continues to experience high price rises.

The Bank of England may face a significant challenge as services inflation fell from 5.6% to 4.9% in September, marking the first time it has been below 5% since May 2022, according to James Smith, developed markets economist at ING.

Smith stated in a note that services are "the most crucial factor in the BOE's decision-making process, as it assesses the degree of inflation 'persistence' in the economy."

Smith stated that the actual figure was a "sizable undershoot" of the BOE's forecasted rate of 5.5% in September.

The U.K.'s inflation rate decreased from 2.2% in August to 1.7% in September, lower than predicted by economists surveyed by Reuters and below the Bank of England's 2% target for the first time in three-and-a-half years.

Despite the energy market's impact on the price cap, inflation has remained close to its target for six consecutive months since its peak of 11.1% in November 2022.

The average earnings including bonuses for the period June to August have dropped to a more than two-year low of 3.8%, according to wage growth data.

Despite the intense conflict in the Middle East, oil prices have not increased significantly, as the International Energy Agency reports a "sizeable surplus" in the oil market next year. The global inflationary picture has improved enough for the U.S. Federal Reserve to cut interest rates by half a percentage point in September, and for the European Central Bank to declare that disinflation is "well on track" in its October meeting.

According to David Muir, senior economist at Moody's Analytics, recent data has solidified predictions of another interest rate reduction in November. Additionally, there is a possibility that the Bank of England may lower rates at a faster pace than anticipated if the positive inflation news continues.

Muir stated that the uncertainty around the economic outlook is high, and interest rate expectations will be affected by the government's Budget announcement.

Risks remain

The greatest risks for the U.K. are from within its borders, according to economists. The Labour government, which came to power in July, plans to revitalize the country's slowing economy with a major budget shake-up in October.

The budget will be "painful" for the nation as it needs to cover a £22 billion ($29 billion) financing shortfall left by the previous administration, which some of its members have disputed. Finance Minister Rachel Reeves previously stated that the country would not return to "austerity," but later said that hard decisions would need to be made before Labour can fully enact the changes it wishes to see.

The uncertainty surrounding major fiscal consolidation has increased due to Labour's messaging, as the government has ruled out increasing taxes on income, sales, and corporations. Additionally, it is unclear what spending cuts or sector stimulus may occur in the future.

AXA's group chief economist, Gilles Moëc, advised the BOE to consider a "front-loaded fiscal consolidation effort" and quicken the pace of monetary easing.

"The argument that Keir Starmer can blame the need for painful fiscal measures on the legacy of the Tory administration politically will fade soon, as Moëc stated in a note on Monday,".

The BOE may accelerate cuts if front-loading is economically feasible, as it will dampen demand and inflation immediately. The U.K.'s sensitivity to interest rates and the speed of monetary policy transmission mean that a lot of the negative impact of fiscal tightening can be mitigated by the monetary stance.

Sanjay Raja, an economist at Deutsche Bank, stated on Monday that there is a growing expectation for more relaxed fiscal policy in the budget compared to initial predictions.

Raja forecasted a new plan for the Bank Rate to gradually increase to 3.75% by May 2025, followed by quarterly cuts until it reaches 3%, but warned that looser fiscal policy could cause the BOE to pause at 3.75%.

Ruth Gregory, the deputy chief U.K. economist at Capital Economics, stated on Friday that she anticipates a net fiscal loosening of approximately £18 billion, or 0.6% of GDP, in 2029 to 2030 compared to previous plans. This is in an effort by Reeves to balance tax increases, increase investment spending, and ease cost of living pressures while avoiding austerity.

She stated that the outcome would be a more relaxed fiscal policy than initially intended, but higher interest rates than expected.