U.K. GDP expanded by 0.9% in 2024, reflecting strong momentum in the first half of the year, but stagnation in the second half. Against this weak economic backdrop, sustained wage growth of close to 6% in December 2024 is puzzling.

High prices and weak growth suggest that the economy has lost some capacity to grow following recent shocks, namely, the COVID-19 pandemic, Brexit, and the energy crisis. At the same time, businesses and households across the U.K. are adjusting to changes in public policy.

A loss of cost competitiveness and a challenging global environment have hit exporters and manufacturers hard in recent years, and this is set to continue. Further spikes in inflation as resilience in the labor market fades will delay a full recovery in consumption to next year. This will also make the central bank more cautious about cutting rates too quickly and thus slowing the rebound in investment.

On the upside, many of the constraints to growth in 2025 should ease in 2026, helping the U.K. economy bounce back, unless risks to growth materialize.

Past Crises Weigh On The U.K.'s Growth Potential

All three components of economic supply--labor, capital accumulation, and productivity--have performed poorly since the pandemic.

Labor supply has been rising slowly since 2019.   In 2024, the employment rate is still about 1 percentage point lower than it was in 2019 (see chart 1). If it had recovered to 2019 levels, the U.K. would have 450,000 more workers--half the amount of current job vacancies.

A higher share of inactive sick people--something the government is looking to address with cuts in welfare benefits--a drop in EU workers, and a high share of immigrant students explain part of this development. There is only scope for a modest reversal in the short term.

Chart 1

At the same time, investment has remained weak since the Brexit referendum.   However, the ongoing recovery in investment in transport, information and communications technology, and machinery, together with the easing of the building-permit process, could mark a turnaround (see chart 2). This is also visible in more dynamic lending to firms. Productivity could thus rebound over the next few years, particularly when demand picks up for real estate and financial and information services. Higher rates affect these sectors more than others.

Chart 2

Government Policy Is Rebalancing Public- and Private-Sector Activity

Government policy to increase the size of the public sector since October 2024 has crowded out the private sector.   Firms have scaled back their investment and employment plans in expectation of higher taxes. This is making households more cautious about spending their pay rises too quickly.

Reforms to boost economic efficiency will take time to bear fruit, even if they are brought forward.   Policymakers are pressing regulators to reduce barriers to growth and are looking for savings in public spending as borrowing costs have wiped out some fiscal space. Policymakers' commitment to implement reforms bodes well for the U.K.'s long-term growth prospects, but could weigh on consumption in the short term as households may fear further cuts to their benefits or higher tax bills.

Exporters Navigate A Challenging Environment

The energy price shock and its inflationary pressures have been particularly detrimental for industry and trade.   Weak demand in Europe and China, coupled with a strong rebound in imports, have weighed on the U.K.'s overall economic performance (see chart 3).

Chart 3

Chart 4

Cost-competitiveness issues have been even more salient since 2023.   This is because the pound has strengthened on the back of higher interest rates than in its key trading partners (see charts 5 and 6). The combination of currency strength, higher labor costs, energy prices that are still double what they were before the energy crisis, and the loss of EU market access since Brexit has made it hard for U.K. businesses to compete abroad, and in some cases, even domestically.

Chart 5

Chart 6

The impact of tariffs is not entirely clear cut.   We estimate that a 10% tariff on U.K. goods exports to the U.S. would cost around 0.2 percentage points of GDP. However, so far, the U.K. is likely to be exempt from tariffs outside the steel and aluminum industry. This means that tariffs on EU countries could bode well for U.K. exporters if U.S. trade demand diverts to the U.K. At the same time, more domestic competitive pressures could challenge domestic manufacturers as foreign firms seek to sell their products outside the U.S. Finally, external demand is set to slow due to tariffs and uncertainty.

Exports should recover next year as European demand accelerates.  This is on the back of higher defense spending (although the U.K. might be excluded from some of that) and a large fiscal stimulus in Germany--the U.K.'s second-largest export market. A push for greater Europe unity on the security front could help if it improves the U.K.-EU trade relationship.

A weaker exchange rate could dampen some trade headwinds in the short term, but volatility is set to prevail.   In the past month, the pound has strengthened against the dollar. This should reverse in the medium term, as we expect the Bank of England to cut rates more than the U.S. Federal Reserve this year. However, a repricing of U.S. assets could put more upward pressure on the pound and monetary policy expectations are more volatile in the U.S.

Higher Inflation And Uncertainty Will Slow The Recovery In Consumption In 2025

U.K. manufacturers also face a slowing recovery in consumption as inflation picks up and the labor market softens.   We expect inflation to average 3.3% in 2025 up from 2.5% in 2024 as energy, water and food prices rise. At the same time, surveys and the government pay-as-you earn data suggest that employment is now contracting slightly. Unemployment is expected to edge up to 4.7% by the start of 2026. This means that real disposable income growth will be much weaker, at around 1% this year, compared to 4% in 2024.

Chart 7

Households could save less to cope with rising bills.   Households' savings to income ratio is still close to 10%, 1.5 percentage points above the historical average. Yet, consumer confidence suggests cautiousness is likely. Over the past year, the recovery in spending has lagged income gains significantly, partly because workers are worried about the economic outlook and losing their jobs--something that is now becoming a reality.

Moreover, the recovery in income has been more pronounced at the lower end of the pay scale, where workers are more exposed to economic weakness (see chart 8). They may not have rebuilt their savings buffers following recent shocks, and at the same time, are coping with higher rents or mortgage repayments.

Chart 8

Monetary Policy Will Remain Restrictive To Avoid The Second-Round Effects Of Inflation

The spike in prices will be smaller than in 2022 as the labor market is close to balance.   The vacancy-to-unemployment ratio is slightly above 0.5, a level we estimate to be consistent with 3% wage growth. Companies also have less pricing power. However, consumers are now more alert to price changes. Inflation expectations already rose at the start of the year and risk becoming a bit more entrenched if monetary policy is eased too quickly. In this environment, the Bank of England is likely to remain cautious until inflation returns to 2% toward the second half of 2026.

The focus of the Bank of England's next policy meetings will be on the output gap and whether the slower pace of growth is down to demand- or supply-side factors.   Weak demand warrants more rate cuts and weaker supply a more restrictive stance. Due to the headwinds outlined above, we expect the economy to build some spare capacity in the first half of this year. Firms are now responding to higher cost pressures by shedding workers and scaling back investments.

A weaker demand outlook should enable the Bank of England to cut rates twice this year, in May and August.   This would bring the base rate to 4%, close to the upper range of the bank's neutral rate estimates. By mid-2026--when most of the renewed bout of inflation will have dissipated--and in the absence of significant second-round effects, we expect the Bank of England to make another two cuts to bring its policy rate to 3.5% by the end of 2026. This means that the full recovery in investment is shifting out to 2026, reflecting lower financing costs and improving demand.

Uncertainty Points To Potential Forecast Revisions

Global uncertainty is set to remain a defining feature of the outlook and raises the possibility of changes to our forecasts. Although tariffs and government policies abroad do not necessarily affect U.K. exporters directly, they are impinging on their competitiveness via trade diversions and the exchange rate. It's unclear which effects will dominate and if the U.K.'s exemption from tariffs will hold.

A large part of the U.K.'s economic slowdown in 2025 now rests on higher energy prices. These are volatile in the context of evolving geopolitical frictions and could take a different course to our current baseline. Finally, uncertainty about supply-capacity and inflation anchoring casts doubt on future monetary policy decisions. Potential changes in government policies compound this.

Related Research

• U.K. Economic Outlook 2025: Monetary Policy And Trade To Offset Fiscal Impetus, Nov. 26, 2024