Given wage pressures, UK inflation is likely to rise above the two per cent target throughout 2025. Despite unpredictability around the future policies of US President Elect Donald Trump and their inflationary impact, the economy’s weak momentum might confirm a scenario in which the Bank of England proceeds with faster interest rate cuts in 2025. Costas Milas analyses the monetary policy scenarios in the twelve months ahead.
Best selling author Dan Brown notes in “The Da Vinci Code” book the following: “Today is today. But there are many tomorrows”. In other words, what has happened today is far from certain to be repeated tomorrow. The same principle applies to the prospects of UK interest rates, output growth and inflation for 2025.
Noting rising uncertainty (or, “multiple tomorrows”, in Dan Brown’s terminology), the Bank of England’s (BoE) Monetary Policy Committee (MPC) decided to keep, in December 2024, interest rates on hold at 4.75 per cent. Six MPC members voted for no change in interest rates, whereas three MPC members voted in favour of an interest rate cut. This notable divergence in views is not surprising. November 2024 show in increase in UK inflation to 2.6 per cent (from 2.3 per cent in October 2024) which prompted many to declare that the economy is heading for a 1970s-style stagflation, not least because GDP growth is faltering.
So, how likely is that inflation will run out of control ,and at the same time the UK economy will be trapped in downward trajectory?
One main worry is rising wages. Back in the summer, Chancellor of the Exchequer Rachel Reeves authorised public-sector wage increases of around 5.5 per cent without securing any increase in public-sector productivity. At that time, I argued that the (big) increase in public-sector wages risks higher inflation. According to my quantitative analysis, public wage increases, well in excess the rate of inflation, trigger additional increases in private wages, and consequently higher inflation, a year later. Some of the impact of higher public-sector wages on inflation is already taking effect but the full effect will be felt all the way up to the summer of 2025.
All the above seem to imply that UK inflation will continue to rise much above the two per cent target throughout 2025. If this turns out to be the case, it makes sense for the BoE’s MPC to keep interest rates on hold for most of 2025. Yet, financial markets have pencilled in at least two interest rate cuts in 2025. This contradicts the inflationary impact of public-sector wages I mentioned above.
Let me elaborate by bringing back Dan Brown’s argument of the existence of “many tomorrows”. The inflationary impact of public-sector wages generates one possible “tomorrow”. Alternative “tomorrows” relate to additional variables affecting both UK inflation and GDP growth. In our recent research (jointly with Georgios Papapanagiotou), we flagged two powerful drivers of UK inflation, namely Divisia M4 growth, and global supply pressures. Divisia M4 growth, which measures the flow and strength of liquidity in the UK economy, forecasts inflation quite impressively in the year ahead and even further. We see this in Figure 1, which plots together UK CPI inflation and Divisia M4 growth from the first quarter of 1998 onwards.
Figure 1: CPI inflation and Divisia M4 growth
Divisia M4 growth reached a peak of close to 20 per cent in the first quarter of 2021, that is, six quarters prior to the peak of UK inflation in late 2022. Notice, however, that money recorded negative growth rates over the period between the first quarter of 2023 and the third quarter of 2024 and only turned positive in the fourth quarter of 2024.
Money affects inflation with “long and variable lags” as economist Milton Friedman famously noted. This suggests that, at least in the short run, weak money growth rates will “limit” the inflationary impact of public-sector wage increases. The bad news is that weak money will also suppress UK growth. Figure 2 makes this point by flagging a close relationship between Divisia M4 growth and UK GDP growth.
Figure 2: Divisia M4 growth and GDP growth
Apart from Divisia M4 growth, global supply pressures will also suppress UK inflation. Figure 3 elaborates. I note that global supply pressures reached a peak well before the spike in inflation at the end of 2022. Over the most recent period, however, global supply pressures have been very weak. This suggests a fairly low risk of higher UK inflation as we enter 2025.
Figure 3: Global supply pressures and UK inflation
But if weak Divisia M4 growth and subdued global supply pressures manage to keep a lid on UK inflation, why did the BoE’s MPC decide not to “press the button” for additional interest rate cuts in December 2024? The reason relates to the “predictably unpredictable” Donald Trump and his economic policies.
If, and this is a big if, Trump authorises additional tariffs on Chinese and world imports to the US, US inflation will surely rise. To the extent that other countries retaliate, in terms of higher tariffs on US imports, world inflation will also rise, at least in the short run. In the longer run, however, both US and world GDP will take a hit because of substantial frictions in world trade.
Higher inflation surely requires higher interest rates both in the US and elsewhere to “hedge” against the risk of going back to double-digit inflation figures last recorded in 2022. Bearing this in mind, the Monetary Policy Committee decided in December 2024 not to proceed with interest rate cuts that it might be forced to reverse in early 2025 because of Trump’s potential “trade wars”.
Notice, however, that Trump has a business-oriented mind and, therefore, a very “keen eye” on stock market developments. During his first term as president, Trump had favourable targets for the stock market, not least because big drops in stock indices predict future recessions (which every president wants to avoid). During Trump’s first term as president, the Dow Jones Industrial Average returned 56 per cent, an annualised gain of 11.8 per cent. This was the best performance for any Republican president since the 1920s.
One can only hope that Trump will prioritise again the stock market over substantial tariffs on imports, therefore reducing the risk of tariff-related spikes in inflation and interest rate hikes in 2025. In such scenario, the Trump-related risk of higher UK inflation will not materialise and, consequently, UK interest rate cuts should come as early as February 2025.
This cut in interest rates is not wishful thinking. Revised GDP data published on 23 December 2024 point to a possible contraction in the fourth quarter of 2024. The economy’s quarter-on-quarter GDP growth in 2024 has been revised down to 0.4 per cent (from 0.5 per cent previously) for the second quarter and to 0 per cent (from 0.1 per cent previously) for the third quarter.
This very loss of momentum over successive quarters suggests that the 0 per cent growth for the fourth quarter of 2024 predicted in mid-December by the BoE’s policymakers is our “best case scenario”. The 10-year UK government yield climbed in early 2025 to 4.6 per cent. This is approximately 40 basis points above its level one month earlier, which indicates even tighter monetary conditions than when the last interest rate decision was made.
Notice that the Monetary Policy Committee will decide again on interest rates in early February 2025, that is, before having the full picture of the economy’s performance for the fourth quarter. It makes sense to cut interest rates at that point rather than being overtaken fully by adverse economic events!
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