Facing policy trade-offs

The UK economy has fared poorly over the past two years, hit by multiple issues ranging from elevated inflation, tight financial conditions, restrictive fiscal policy and deteriorating goods export competitiveness. Furthermore, policy announcements in 2024 have hit the private sector’s confidence owing to upcoming large tax hikes. Meanwhile, even though inflation has retreated significantly from its past peaks, it remains stubbornly above the Bank of England (BoE)’s 2% target. This means that the BoE has had to remain more hawkish than many of its central bank peers. Sticky inflation reflects a weak performance of the supply side of the UK economy, including a declining labor participation rate since the Covid-19 pandemic, persistent (though declining) labor shortages and lacklustre productivity growth.

We expect GDP growth to gradually pick up pace through 2025 after a dismal 2024. There are signs that persistently weak demand is starting to take its toll on inflationary pressures. Easing inflation should allow the BoE to step up its easing cycle later in the year. We expect the BoE Bank Rate to end 2025 at 3.25%. This will provide a welcome decline in funding costs for the private sector. Access to credit has started to loosen and should continue to do so as the BoE becomes more dovish. Fiscal policy should be less restrictive in 2025 than in 2024. Moreover, pro-investment government policies should provide tailwinds to the construction sector, including infrastructure, residential and the NHS.

Nevertheless, while the domestic environment should improve, upcoming US tariff hikes will provide a challenging external backdrop. The US is the first market for UK goods exports and we expect increased US tariffs on sectors such as automotive, chemicals and machinery & equipment. Finally, while the government’s pro-investment policies will be supportive to UK growth overall, the sharp planned rise in the National Insurance contributions will limit the growth benefits by weighing on both labor supply and labor demand.

Corporate risk in the UK will remain elevated. UK companies have showed resilience, but tight financing conditions and weak demand have put them under pressure over the past two years. We expect business insolvencies to remain at elevated levels in 2025 and 2026, though easing from 2024’s peak.

Under the current government, policy towards investment will become more favorable, especially on ambitious homebuilding plans and NHS, which are supportive of the economy’s potential growth.  The UK should also maintain an overall pro-business policy stance, as reflected by the Chancellor of the Exchequer’s push to incentivize domestic and foreign firms to increase investment in the UK.

However, taxation on corporates has increased in recent years (including sharply on oil and gas companies) and will continue from 2025 as NI contributions will be gradually raised. The UK’s overall tax take (35% GDP) will move from the middle of the pack advanced economies to the first quartile by 2029-30. Further increases in taxation on corporates and labor risk undermining growth by weighing on the private sector’s incentives to invest and save.

The UK continues to negotiate further trade agreements post-Brexit, seeking to strengthen its global trade network. The UK joined the CPTPP in 2024, a trade agreement representing over 15% of the global economy. We estimate it generate around USD1.3bn in export gains for British exporters, mainly in the machinery, automotive and pharmaceutical sectors.