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Headline UK inflation will rise over the rest of this year, but it’s unlikely to go over 3%. More importantly, services inflation should continue to slow gradually as wage pressures ease. The big risk is a spike in energy prices driven by geopolitical risks.

At the same time, however, services inflation will continue to ease. It’s likely to drop to a little under 5% by the end of the year. For policy makers, services inflation is a better measure of price conditions in the domestic economy, which is why we’re likely to see further interest rate cuts from the BoE.

There are three big risks to settling inflation. First, fighting in Russia and Ukraine further disrupts natural gas supplies. Second, an escalation of the conflict in the Middle East to involve Iran would risk a surge in oil prices. Third, shipping rates have rebounded strongly this year due to higher demand and attacks on shipping in the Red Sea, driving rates higher. Although, rates aren’t high enough yet to significantly alter the inflation picture in the UK, a bigger rise could lead to price increases for goods or delays to shipping.

Wage growth is expected to continue slowing next year due to lower inflation and better labour availability. Questions persist about the accuracy of volatile labour market data, but there is broader evidence that the market is stabilising. UK economic growth should lead to more stable hiring, and higher real wages may encourage more people to return to work. Overall, unemployment is projected to rise gradually from 4.2% to 4.5% by the end of the year. Wage growth is expected to slow to around 4% by late next year. However, the increase in the number of people too sick to work since the pandemic continues to pressure the labour market. Without efforts to address this issue, the labour market may remain tight, keeping wage growth, interest rates and fiscal pressure higher than necessary.

The BoE is expected to cut interest rates by at least 25 basis points this year, with the possibility of two. Four more drops are anticipated in 2025, though this will partly depend on the outcome of the Autumn Budget. Despite a rebound in headline inflation, the BoE will be looking more closely at services inflation and wage growth, which offer a better indication of domestic price pressures. As both are expected to slow, the Monetary Policy Committee (MPC) will likely proceed with rate reductions. However, it has signalled caution, indicating a preference to avoid cutting rates too quickly. The MPC will seek more evidence of a continued disinflationary trend before further drops, with the next possible cut in November. Another in December is possible if wage growth weakens significantly. Bringing rates down further in 2025 is anticipated, with the pace influenced by fiscal policy choices in the upcoming budget. Longer term, we expect interest rates to stabilise around 3%. 

Economic growth is expected to slow slightly in the second half of the year, transitioning from being driven by government spending to consumer spending and business investment, as real incomes and confidence rise and interest rates fall. While initial growth this year was largely government-led, with significant increases in government spending, the drivers of growth are set to shift. Rising real incomes, tax cuts, and falling interest rates are boosting household disposable income, which is expected to increase consumer spending later this year and into 2025. Real incomes are now back to pre-cost-of-living crisis levels and wage growth is outpacing inflation, reducing the impact of interest costs on spending.

Business investment is also expected to pick up, supported by high business confidence and increased net external financing. These factors should sustain private sector momentum, offsetting reduced government spending and contributing to economic growth into 2025. GDP is forecasted to grow by around 0.3% per quarter over the next two years, a notable improvement from recent years. However, a challenging budget in October with significant tax increases could dampen the economic recovery by reducing household disposable income and consumer confidence, and potentially discouraging business investment. If higher taxes fund increased government spending, the net impact might be limited, but the expected recovery in consumer spending could be weaker than anticipated.

Inflation in major economic regions, including the US, UK and eurozone, is now around 2% and expected to remain at this level through 2025. Consequently, interest rates are anticipated to fall across these regions. The US economy has significantly outperformed both the UK and eurozone in recovering from the pandemic, growing by about 12% since early 2019, compared to around 4% in the UK and eurozone. This trend is expected to continue, albeit with a smaller gap, as growth in the UK and eurozone improves. With inflation under control, the European Central Bank and the BoE have begun cutting interest rates, and the US Federal Reserve is expected to follow suit soon, with all three central banks likely to continue reducing rates over the next year.