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The UK’s latest budget statement, unlike in October 2024, will only have a minor impact on the economy. It contained modest spending cuts but no tax measures to stay in line with fiscal spending rules
Constrained by an inflexible fiscal framework and the government’s election pledges, the UK’s outlook contrasts with recent German fiscal ambition, and leaves the UK limited room to respond to a rapidly changing global outlook
The Bank of England’s monetary policy remains cautious given above-target inflation: we expect more interest rate cuts given the high starting point and risks to UK growth
The UK remains hopeful that its services-oriented economy will be relatively less affected by US tariffs, but this is far from guaranteed.
The UK’s fragile fiscal state came under scrutiny last week when the government announced a set of spending cuts that leave it little margin to boost the economy. Following its October 2024 budget, Chancellor Rachel Reeves was forced to announce new measures as disappointing economic growth and higher government yields shrank her room for manoeuvre.
In contrast with October’s budget that projected GBP 41.5 billion in tax increases and spending on infrastructure and public services to boost growth, last week the Chancellor presented small-scale adjustments. The announcements leave limited “headway” against the government’s fiscal rules for unexpected spending. The margin that the government created came mostly through cuts to welfare spending, and were criticised by its own parliamentary party.
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The Office for Budget Responsibility (OBR), which independently costs UK public finances, estimated that the Labour government’s second budget announcement, officially a ‘Spring Statement,’ will leave the country with a surplus of GBP 9.9 billion. That is “a small margin” in the event of an interest rate shock, lower productivity or global trade disruptions, it said. The OBR also cut its forecast for gross domestic product (GDP) growth in half, from 2% to 1% for 2025, largely reflecting the slower-than-expected pace seen in recent months.
The UK government seems poorly-positioned to respond to new shocks
Slower growth and rising UK government bond yields in the six months since the previous budget forced the Chancellor to announce consolidation measures. While able to do this without breaking the government’s pledge not to raise key taxes, it is not at all certain that this risk won’t re-emerge by the time of the autumn budget in October. An ongoing debate around potentially higher taxes threatens to damage the economy by discouraging spending at a time of global uncertainties.
Crucially, considering the self-imposed constraints by the government’s fiscal rules and election pledge, as well the real-world constraints imposed by an elevated debt burden and a high cost of servicing it, the UK government seems poorly-positioned to respond to new shocks.
In Germany, much lower interest costs have allowed the government to make a “whatever-it-takes” investment pledge. It is extremely unlikely that the UK could make a similar commitment. In contrast with Germany, the UK government’s efforts to finance additional defence spending in March were financed through a cut in foreign aid worth about 0.1% of GDP.
Growth ticks up
Economic headwinds for the UK are a result of policy decisions, including a tax hike that starts in April, still-restrictive Bank of England (BoE) interest rates, as well as the risks of US trade tariffs. We should not overlook some potential offsetting factors, including fiscal expansion in Europe, and the potential for gas prices to fall if there is a workable ceasefire in Ukraine (wholesale gas prices are already down about 30% from their February peak after a cold European winter). There is also the possibility that the impact of US tariffs on the UK may be lower than elsewhere, thanks to the country’s heavily service-oriented economy, and relatively balanced trade relationship with the US.
Still, while still-high UK inflation remains a concern, strong wage growth has made for a healthier environment for UK consumers. The latest data from both the consumers and the corporate sector have been encouraging, with meaningful upward surprises in February retail sales and the Purchasing Managers’ Index. We have recently reduced our 2025 growth forecast for the UK from 1.8% to 1.3%, which while uninspiring, is still higher than consensus, and an improvement on 2024.
While uninspiring, the UK growth forecast is an improvement on 2024
The BoE left interest rates at 4.5% earlier in March, and we expect the central bank to cut rates when it next meets on 8 May, but keep the pace of easing gradual. Previously, we expected policymakers to begin making consecutive rate cuts as soon as May. We now we only expect consecutive cuts starting in the last three months of this year, given persistent inflation and the Bank’s cautious approach. Our growth expectations incorporate expectations that the BoE will make more cuts to interest rates than the market currently forecasts. We see 100 basis points (bps) of BoE cuts, taking the UK’s terminal rate to 3.5% in 2025, compared with the market consensus of 45 bps in cuts this year.
This supports our preference for UK Gilts with maturities in the 5- to 7-year range. We have raised our Bund yield forecasts to reflect Germany’s fiscal stimulus, and given broadly unfavourable public debt trends, we continue to prefer corporate over sovereign bonds, in both developed and emerging markets.
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