Rate cuts won’t save us: why Rachel Reeves must do more to fix the economy
6 February 2025, 14:17
As was widely expected, the Bank of England has cut its main interest rate from 4.75% to 4.5%.
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Two members of the Committee voted for a larger cut to 4.25%. The Bank also halved its forecast for growth in 2025 from 1.5% to just 0.75%.
Key indicators show that the UK economy is weakening: growth was zero in the third quarter of 2024 and the unemployment rate continues to rise from the post-pandemic low of mid-2022.
The situation with inflation is more complicated. The most recent official data shows inflation falling more than expected, driven by services inflation, an important indicator of domestic price pressure. However, rising global energy costs are expected to push inflation back up over the coming months while the prospect of a potential global trade war triggered by US President Donald Trump's tariffs raises the prospect of higher inflation and interest rates in the US. These global pressures could act as obstacles to further Bank of England rate cuts.
Nonetheless, many analysts expect at least two more rate cuts in 2025: Morgan Stanley is predicting a total of five cuts in this year. Falling rates are viewed as providing economic stimulus: households will move onto lower mortgage rates as their current fixed rate contracts expire, although for many there is a lag.
Lower rates also tend to increase share prices and house prices. At least on paper, this raises the wealth of asset holders. Lower mortgage costs and higher asset prices can lead to higher household spending, raising revenues for firms and stimulating economic activity.
But despite falling interest rates, most forecasts of growth – including the Bank's – are being revised down. Most significantly for chancellor Rachel Reeves, in March the Office for Budget Responsibility is likely to lower its growth forecast, making it unlikely that Reeves will meet her self-imposed fiscal rules without further tax increases or cuts to already at-the-bone public services.
The UK appears to be entering a period of so-called 'stagflation': a combination of economic stagnation and inflation. This is a challenge for policymakers because the conventional response to weak growth is to cut interest rates but the conventional response to inflation is to raise rates.
This illustrates the problems of relying on a single tool – the Bank of England's interest rate – to manage the UK economy. Given the complexity of the challenges facing policymakers, the case for increased coordination between the Bank of England and the Treasury is becoming stronger.
On the fiscal side, Reeves should abandon the caution that has defined her period as Chancellor and commit to unpopular but unavoidable tax rises and to the investment spending needed to secure a sustainable economy. She cannot rely on the Bank of England to deliver the growth that Labour has promised.
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Jo Michell is a professor of economics at the University of the West of England.
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