Key Takeaways
- After a slower second half this year, the U.K. economy looks set to gather steam on looser fiscal policy, with GDP rising by 1.5% in 2025 versus our September forecast of 1.2%, and maintaining a similar pace through 2027.
- But we now expect the Bank of England (BOE) to cut its rate only four times over the next quarters to 3.75% by the end of 2025, as a result of stronger jobs growth and inflation stemming from higher government spending.
- These factors will likely dilute the economic impulse of the policy stimulus at a time when geopolitical risks and the potential for trade frictions have increased following the U.S. elections, though the impact on the U.K. is minimal at this stage.
At the end of October, the U.K. government announced in its budget a raft of measures that will see public-sector spending increase by slightly more than 2% of GDP over the next five years.
Why it matters: The U.K. economy lost some momentum toward the start of the fourth quarter (Q4) after a surprisingly strong first half. S&P Global Ratings projects that public spending on consumption and investment could add 0.9 percentage points (pps) to GDP growth next year and 0.5 pps in 2026. We anticipate 1.5% GDP growth in 1.5% in 2025, 1.6% in 2026, and 1.5% in 2027, versus our previous forecast of 1.3%, 1.6%, 1.7%, respectively.
What we think and why: The fiscal multiplier is at its lowest in the cycle because the U.K. economy is close to full capacity. This means most of the government stimulus will be offset not just by tax increases, but also by higher imports and a more restrictive monetary policy.
At the same time, the changing global environment suggests there could be some spillover from U.S. trade policy and financing conditions to the U.K. At this stage, these appear limited.
The U.K. Economy Slows At The End Of 2024
Revisions to U.K. growth statistics since September are the main reason we lowered our growth forecast to 0.9% for 2024 from 1% previously. As expected, the economy shifted down a gear in the second half of this year, with the latest GDP outturn showing just a 0.1% increase in Q3.
Weaker imports led to a positive contribution of net trade. At the same time, consumer spending and investment gained some dynamism, but statistical discrepancies pointed to weaker underlying growth. For Q4, soft data suggests budget uncertainty. And higher financing costs, driven by expectations of higher rates in the U.K. and U.S., have likely delayed some investment decisions for firms and households.
The Public Sector's Contribution To GDP Will Stay Close To Pandemic Highs
Fiscal loosening will boost GDP growth in the short term, but most of that growth will be offset by higher rates and imports. Overall, the public sector will take on a bigger share of U.K. economic activity, crowding out the private sector more than would otherwise have been the case. We expect public spending to stay elevated by historical standards, and at levels only seen during the peak of the pandemic (see chart 1).
Chart 1
The long-term impact of increased public spending is unclear at this stage
Investments in infrastructure, health, and education, are typical public goods that are not delivered in sufficient quantities by the private sector. Public spending in those areas should thus have positive implications for the rest of the economy and add to potential output, particularly if data suggests current levels are insufficient. As such, recent evidence points to a decline in the performance of public services. For example, long waiting lists at the NHS (National Health Service) are likely behind an increase in inactivity linked to sickness (see chart 2).
Chart 2
More investments in education could help make U.K. workers more competitive and bridge part of the skills gap in the country in the long term. According to the OECD, 26% of U.K. workers are underqualified for their occupation. In addition, infrastructure represents a smaller share of GDP (at 47% of GDP in 2016) in the U.K. than in some of its European peers (52% in Italy and 54% in France). This could be one reason for weak productivity in recent years.
That said, the total impact of government investments will depend on how this new spending and associated reforms (such as the planning reform) can unlock efficiency gains and spark business investment, which is unclear from the quick implementation envisaged in the budget.
Monetary Policy Will Counteract The Pro-Cyclical Fiscal Stance
The BOE confirmed at its last meeting that it expects more inflationary pressures to emerge, even though inflation has been moving back toward the 2% target quicker than expected.
Following the November cut to 4.75%, we now expect only another four rate cuts next year (one per quarter). We anticipate the rate will reach 3.75% by the end of 2025 (see chart 3). The BOE could be in a position to cut again in 2027 as inflation eases to 2%, if no new shocks materialize by then.
Chart 3
Since the summer, the BOE has also shifted to a slightly more hawkish view, expressing a need to see increased spare capacity before it can hit its 2% inflation target. The last headline figure pointed to 2.2% annual inflation in October, but services prices remained elevated at 5% (see chart 4). This signals remaining underlying domestic prices that the BOE wants to squeeze out of the system. Adding to this, the recent cooling of economic activity will reverse on the back of the fiscal expansion. We therefore expect job creation to push down the unemployment rate next year, while a higher minimum wage and employers' national insurance contributions add to price pressures. Higher interest rates may be needed to help offset some of these impacts, mainly by slowing the investment recovery. We estimate that 50 basis-point higher rates will subtract around 0.4 pps of growth over the next few years compared to our previous baseline.
Chart 4
A Delayed Consumption Recovery?
The U.K. household savings ratio suggests consumers have been relatively cautious and spent less than they could afford over the past year. The households savings rate reached 9.8% in Q2 2024, 1.5 pps above the long-term average, despite a robust recovery of real disposable income (see chart 5).
Chart 5
Why higher disposable income may not increase consumption
The following factors might explain what we see as a time lag between the recovery of income and increased consumption.
Consumption is less influenced by wages than by employment growth, which has slowed.
- Households benefiting from new jobs are more likely to increase their consumption than those with more income because of a pay rise. Yet, most of the recent increase in real disposable income has come from wages, while job creation has been muted. Real disposable income was up 4.5% from Q4 2019 in Q2 2024, but new jobs added only 0.7% to the total in the same period.
Higher interest rates encourage more savings, which some homeowners have invested in relatively illiquid assets.
- There is evidence that homeowners with mortgage loans have put money aside to pay off some of their debt and avoid paying higher remortgaging costs. The volume of refinanced mortgages is still well below the historical average. At the same time, renters have also faced steeper price increases overall, with rents up 8.4% year on year in September. With rate expectations shifting, this incentive seems to be fading, and the latest data on household savings highlights a shift from fixed term deposits to sight and individual savings accounts.
The inflation perception is coming down more slowly than the headline figure.
- The last BOE inflation attitudes survey showed respondents thought inflation was at about 5.2% annually in August, 3 pps higher than the actual inflation rate. It was much closer to services inflation however, which was 5.6%. This suggests that services prices may have been shaping perception more than energy in recent months.
General uncertainty about the U.K.'s economic prospects could have contributed to consumption reticence.
- This is visible in the difference between consumers' confidence regarding their personal situation and their confidence in the wider economy over the past year. Brexit, the pandemic, the cost-of-living crisis, and geopolitical developments are making households more worried about their job prospects.
Chart 6
Looking ahead, we expect three of these factors to normalize. Employment creation is set to accelerate, interest rates will decrease, and inflation perception will slowly move back to the headline number. The geopolitical situation suggests some uncertainty will remain, but it is unlikely to have been the main driver of weak consumption, in our view. In short, household, and not just public, consumption will be an important driver of economic activity next year.
Emerging External Risks Could Cloud The U.K.'s Economic Outlook
Geopolitical risks have returned to the fore with the U.S. election results bringing more uncertainty for trade in the coming years. At this stage, the potential impacts remain uncertain because policies are still unknown, but could affect countries with regards to tariffs, growth, and trade balances among other things. For the U.K. so far, there has been relatively little impact. The main transmission channels we will monitor are trade and financing conditions.
Although trade in goods could slow if the U.S. imposes tariffs on European exports, this could be counterbalanced by more demand for services, for example if tax cuts lead to faster growth in the U.S. The U.S. is the U.K.'s largest trading partner, representing 17.6% of total trade in Q2 2024. This is mostly down to services, which account for more than two-thirds of exports to the U.S. Services are less likely than goods to be subject to an increase in trade barriers and could even benefit from improved economic activity in the U.S.
In terms of financing conditions, current U.S. spillovers appear to be synchronized with the U.K.'s policy outlook. The latter has changed in a similar way to that for the U.S.: a more expansionary fiscal policy and expectations of higher interest rates. That said, some tightening could still happen. U.K. gilts are highly correlated with U.S. treasury bills. So, all other things being equal, a 100 basis-point increase in U.S. treasury bills leads to an 80 basis-point increase in U.K. gilt yields. This was apparent before the U.S. elections, since gilt yields increased despite the expectation of rate cuts in the U.K. remaining unchanged.
Overall, however, uncertainty has increased regarding the global trade and economic environment. Although it is difficult to foresee what will happen at this stage, market jitters could lead some businesses to rethink their investments. Consumers, likewise, may remain a bit more cautious than usual in their spending.
| S&P Global Ratings U.K. economic forecasts - September 2024 | ||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| (%) | 2022 | 2023 | 2024 | 2025 | 2026 | 2027 | ||||||||
| GDP | 4.9 | 0.4 | 0.9 | 1.5 | 1.6 | 1.5 | ||||||||
| Household consumption | 7.4 | 0.7 | 0.8 | 1.6 | 1.8 | 1.7 | ||||||||
| Government consumption | 0.7 | 0.6 | 2.4 | 3.9 | 1.7 | 1.5 | ||||||||
| Fixed investment | 5.1 | (0.1) | 0.8 | 0.8 | 2.7 | 2.5 | ||||||||
| Exports | 12.6 | (2.2) | (2.0) | 1.8 | 2.4 | 2.4 | ||||||||
| Imports | 13.0 | (3.4) | 2.6 | 3.4 | 3.3 | 3.1 | ||||||||
| CPI inflation | 9.1 | 7.3 | 2.5 | 2.5 | 2.3 | 2.1 | ||||||||
| CPI inflation (EOP) | 10.8 | 4.2 | 2.4 | 2.6 | 2.2 | 2.1 | ||||||||
| Unemployment rate | 4.7 | 4.5 | 4.3 | 4.1 | 4.1 | 4.2 | ||||||||
| 10-year government bond yield | 2.3 | 3.9 | 4.0 | 4.1 | 3.9 | 3.8 | ||||||||
| Bank rate (EOP) | 1.7 | 4.8 | 5.1 | 4.1 | 3.8 | 3.5 | ||||||||
| Exchange rate (US$ to £) | 1.2 | 1.2 | 1.3 | 1.3 | 1.3 | 1.3 | ||||||||
| EOP--End of period. CPI--Consumer price index. Sources: ONS, Bank of England, S&P Global Market Intelligence, and S&P Global Ratings (forecast). | ||||||||||||||
This report does not constitute a rating action.
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| Senior Economist: | Marion Amiot, London + 44(0)2071760128; marion.amiot@spglobal.com |
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