The Bank of England held interest rates at 4.75% in its final meeting of 2024. The move was widely expected, after experts warned that measures announced in the Autumn Budget could prove inflationary over the next couple of years.
Chancellor Rachel Reeves unveiled £70 billion in spending policies and £40 billion in tax hikes, with a portion of this being funded by an increase in employer National Insurance contributions.
More than half of British companies are planning price rises before April this year, according to 4,800 businesses polled by the British Chambers of Commerce. Shevaun Haviland, the group’s director general, said: “The worrying reverberations of the Budget are clear to see."
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Other economic indicators released just before December's rate decision also suggested inflationary pressures have not yet been fully squeezed out of the economy.
The Consumer Prices Index rose by 2.6% on an annual basis in November, up from 2.3% in October and 1.7% in September. Higher energy costs were largely to blame, as well as steeper fuel and clothing costs.
On 7 January, market researcher Kantar said annual grocery price inflation was 3.7% in the four-week December period – its highest level since March 2024, and a jump on the 2.6% posted the previous month.
The Monetary Policy Committee (MPC) was not unanimous in its decision to hold rates in December, with three members voting for another cut. However, rate cuts are now expected to be fewer and further between in 2025.
The market is currently pricing in two rate cuts in 2025. Some economists believe market pricing looks overly cautious.
Why have interest rate expectations been scaled back?
The Office for Budget Responsibility (OBR) says it expects policies announced in the Budget to push inflation up by 0.4 percentage points, once they hit peak effect. This might sound like a small number when you consider inflation hit 11.1% at its peak in October 2022, but it has been enough to prompt economists to scale back their interest rate forecasts.
Other risks on the global stage include an escalation in the Middle East, and the threat of tariffs from president-elect Donald Trump.
Sticky services inflation is another barrier to interest rate cuts. The Bank of England is watching this metric closely, as the services sector accounts for around 80% of the UK economy. Services inflation came in at 5% for the second month in a row in November.
Despite this, the economists at financial institution ING believe the market is being overly pessimistic in pricing in just two or three interest rate cuts in 2025.
ING has its own measure of services inflation which strips out measures the Bank of England cares less about – such as airfares. It calls this “core services inflation”. It expects this measure to fall close to 3% in the spring.
“A lot of the services basket is affected by one-off annual changes in index-linked prices – think of things like phone and internet bills,” said James Smith, ING’s UK economist.
He added: “If 'core services inflation' does look steadily better, then that would provide some ammunition for the Bank of England to move a little faster on rate cuts than markets are now pricing. Our base case is for back-to-back rate cuts from February onwards, with Bank Rate falling to 3.25% later in the year.”
How far will interest rates fall in 2025?
ING is not alone in its view that rates will fall more quickly than markets are expecting. The consultancy Capital Economics expects the base rate to fall to 3.5% by early 2026. This mirrors what the Organisation for Economic Cooperation and Development (OECD) said in its latest economic outlook. It is also forecasting 3.5% for just over a year’s time.
Meanwhile, economists polled by news agency Reuters in December said they expect four interest rate cuts in 2025. Governor Andrew Bailey indicated something similar in a conversation with the Financial Times at the start of December, but sounded a more cautious note in the aftermath of the latest rate decision.
“We think a gradual approach to future interest rate cuts remains right but with the heightened uncertainty in the economy we can't commit to when or by how much we will cut rates in the coming year,” he said.
Over in the US, policymakers have also tempered their tone in recent weeks. Despite cutting rates in December, the Fed’s closely-watched “dot plot” indicated only two further cuts are likely in 2025.
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 5.47% and 5.25%.
- Pre-pandemic rates: In 2019, both the two and five-year rates were below 3%.
Borrowers hoping for mortgage rates to fall further in 2025 will be “buoyed” by the fact that three MPC members voted for a rate cut in December, said David Hollingworth, associate director at L&C Mortgages. However, he added that “stubborn inflation may hold back the pace of those cuts”.
“With so much uncertainty around, it can be a good idea for anyone with a looming remortgage to secure a rate now,” said Sarah Coles, head of personal finance at Hargreaves Lansdown. “If rates rise in the interim, they’ll have locked in a cheaper deal, but if they fall, they can shop around for something cheaper.”
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.
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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