The Bank of England lowered the base rate twice last year, bringing it down from a 16-year high of 5.25% to 4.75%. Currently, the market is only pricing in two further cuts in 2025 thanks to new inflationary risks on the horizon.
Investors are concerned that tax changes announced in the Autumn Budget could push prices higher. If US president Donald Trump follows through with tariff threats, this could also stoke inflation on a global scale.
Despite this, most economists believe the Monetary Policy Committee (MPC) will act more aggressively than markets are currently expecting. Analysts at Goldman Sachs are forecasting quarterly cuts of 25 basis points, which would bring the base rate to 3.25% by the second quarter of 2026.
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In a report, Goldman Sachs said: “While it is possible that the Bank of England will slow the pace of cuts if underlying inflation fails to make progress, we believe that a step-up to a sequential pace of cuts in response to weaker demand is actually more likely.”
The economists at European bank ING are forecasting something similar. “We expect 25 basis point cuts per quarter, including in February,” they wrote earlier this week.
Market pricing vs economists: what’s causing this difference of opinion on interest rates?
Markets are partly nervous about what upcoming tax changes could mean for inflation. Employers’ National Insurance contributions will go up in April and 67% of retailers have said they are planning to pass these costs on to consumers by hiking prices.
As well as announcing £40 billion in tax hikes in the Autumn Budget, chancellor Rachel Reeves unveiled £70 billion in spending policies. Overall, the Office for Budget Responsibility (OBR) expects policies announced in the Budget to push inflation up by 0.4 percentage points once they hit peak effect.
Meanwhile, energy costs are also expected to rise further this spring, potentially by as much as 2.7%. As Alice Haine, personal finance analyst at Bestinvest, points out, this is likely to have a knock-on effect on other household bills like fuel and food too.
Further afield, Trump has threatened to impose wide-ranging tariffs on the likes of China, Mexico and Canada. Tariffs have the potential to disrupt global supply chains and make it more expensive for businesses to operate and provide goods and services.
Despite this, the picture is not as bleak as it might sound. According to the economists at ING, the argument that inflation is worse in the UK than elsewhere is becoming less and less convincing.
They write: “Services inflation, the Bank of England’s central focus, is no longer an outlier at 4.4%. It’s now similar to both the US and Germany.
“Last month’s drop was helped by airfares, which failed to properly account for Christmas price hikes. But that’s noise, and our favoured measure of ‘core services inflation’, which strips out volatile and less relevant services, has been showing consistent progress. This gauge is at 4.5% and looks set to fall to 4.2% at the next reading.”
ING believes services inflation will fall even further this April when index-linked contracts like broadband and phone deals come up for renewal. “Owing to lower headline inflation, these should be less aggressive than at the same point last year,” its economists write.
The labour market is also cooling and growth is slowing, which could give the Bank of England pause for thought. Alan Taylor, a recent addition to the MPC, recently warned that a weakening economy called for a “more accelerated pace of rate cuts”. Taylor was one of the three committee members who voted for a rate cut in November.
Speaking at the Leeds Business School on 15 January, he said: “We are in the last half mile on inflation, but with the economy weakening, it’s time to get interest rates back towards normal to sustain a soft landing.”
Odds of an interest rate cut at the next MPC meeting
The outcome of the next MPC meeting will be announced on 6 February and an interest rate cut looks fairly likely. In the latest survey from news agency Reuters, all 65 economists polled said they expect the Bank of England to trim the base rate by 25 basis points.
The Reuters survey was conducted between 10 and 15 January, just before latest inflation and growth reports were released (15 and 16 January respectively). Both of these should help the case for a cut.
December’s inflation report showed a surprise drop in the annual rate of price increases. The headline figure came in at 2.5%, down from 2.6% in November. Most analysts were expecting it to either hold steady at 2.6% or rise to 2.7%.
Meanwhile, the latest growth figures showed the economy only grew by 0.1% on a monthly basis in November. On a three-month basis, it did not grow at all.
How do interest rates control inflation?
Interest rates are the main tool the Bank of England uses to control inflation. In theory, when the MPC increases interest rates, it reduces the flow of money around the economy. Meanwhile, when it cuts rates, households have more money left over in their pocket to spend.
This works because higher interest rates make it more expensive for households to pay their mortgages and service any debts, which means they have less disposable income left over after paying for the essentials. When spending slows, prices rise more slowly too. Sometimes, they even start to plateau or fall if demand drops sufficiently.
It’s not just consumers that are impacted, though. Higher interest rates can also slow economic growth. They make it more expensive for businesses to borrow money, which ultimately hits their bottom line.
If interest rates are kept high for long enough, the risk is that the economy slips into recession, which invariably results in an increase in the unemployment rate as businesses are forced to make cutbacks.
What do falling interest rates mean for mortgages?
Mortgage rates have fallen from their peak, but remain significantly higher than the levels enjoyed for much of the past decade.
- Peak rates: In August 2023, both the average two and five-year fixed rates were above 6% at 6.85% and 6.37% respectively, according to Moneyfacts.
- Today’s rates: Today, average rates have fallen to 5.51% and 5.30%.
- Pre-pandemic rates: In 2019, both the two and five-year rates were below 3%.
“The surprise dip in inflation in December is some positive news for borrowers who will have been unsettled by the recent unrest in the gilt markets and what it may mean for mortgage rates,” says David Hollingworth, associate director at L&C Mortgages.
Gilt yields surged to their highest level since the global financial crisis earlier this month, largely driven by inflation fears.
“Although there may still be increases to come in the months ahead, the fall in inflation will firm up the hopes that the Monetary Policy Committee will cut the base rate in February,” he adds.
What do falling interest rates mean for savings?
Several providers have pulled their top savings deals over the past few months as interest rates have fallen. With this in mind, it could make sense to fix your savings if you have a pot of money you are willing to put away for a period of time. This should allow you to lock in higher rates for longer – but you will need to act quickly.
Despite this, it is also worth keeping an eye out for any new deals that emerge. Until recently, 5% savings deals had pretty much disappeared from the market, but challenger bank Chase launched a new boosted rate on its easy-access savings account in December, making it the top rate on the market.
See our round-up of the best easy-access rates, one-year savings accounts, regular saver accounts and cash ISAs for the latest deals on cash savings.
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