In January’s Rate Wrap, we highlighted the dual prospective challenges of below-trend growth and above-target inflation for the UK economy over the course of 2025. Developments since then very much re-enforce this projection. As widely expected, the Monetary Policy Committee (MPC) cut rates by 0.25pp in February (although Catherine Mann, of course, surprised markets with her pivot from chief hawk to dove by being one of the two members that backed a 0.5pp fall in rates), but the real story from the Bank of England’s (BoE’s) latest Inflation Report is the updated forecasts for growth and inflation. 

Starting with the inflation challenge, the BoE’s new forecast in its February report now shows, on the face of it rather surprisingly, that inflation is expected to peak at 3.7% in Q3 of this year, although there is no need to panic just yet. The projection, based on market expectations for interest rates, continues to show that inflation will still return to 2% in the medium term (end of 2027). 

The key drivers of this upcoming spike in inflation will be higher energy prices as well as the growth in other regulated prices. MPC members are currently minded to “look through” this given it will be driven by one-off factors, in essence signalling that elevated headline inflation in the short term will in all likelihood not affect their decisions on interest rate policy. However, should any second-round effects emerge – such as a response in wage demands – this position could shift, especially since existing wage settlements and services inflation continue to be a source of concern.

While the increase in prices during 2025 will be far less severe than the those experienced in 2022, recent volatility in inflation means medium-term expectations of consumers may now be less “anchored” to the 2% inflation target than was the case in the two decades prior to the pandemic. Does this mean inflation persistence is more of a risk, especially if there is an additional supply shock this year from, say, escalatory tariffs? And, in general, are second-round effects now more likely to occur when one-off factors increase inflation? It is certainly plausible and something to keep an eye on (see our latest Macro Comment Opens in a new window). 

Turning to the growth challenge, the recent souring of consumer and business sentiment is now being reflected in the BoE’s growth forecasts. Its forecast for 2025, for example, have been slashed in half from 1.5% to just 0.75%. The Office for Budget Responsibility (OBR) will no doubt follow suit and downgrade its near-term forecasts for the UK economy while raising its projections for government borrowing costs. A recent leak from the OBR to Bloomberg has confirmed what many of us have suspected for some time, which is that Chancellor Rachel Reeves’ fiscal target of achieving a current surplus within five years is now at risk and will probably mean that further fiscal consolidation is set to be announced at the March statement. 

A key question with respect to the current weak growth that the UK is experiencing, is what exactly is driving it? Is it being driven by suppressed demand, which would allow for a reasonable loosening of monetary policy, or is it being prompted by constrained supply that requires interest rates to remain higher for longer? Minutes of the MPC meeting suggest that the seven members backing a 0.25pp cut to rates are split on this question. The reason why this is so important is that it highlights a large degree of uncertainty about the trajectory of base rate both this year and next year. However, while uncertainty about future interest rates is certainly material, our base case scenario remains for a gradual cutting cycle down to 3.5% in 2027 as the BoE balance indicators suggesting inflation persistence with weakness in growth that may suggest disinflationary forces are ahead. 

Daniel Mahoney, UK Economist

Feb BoE decision leaves more confusion than clarity for rates market

The February Bank of England decision was one for the history books, but more symbolic than anything impactful. It was the first time we have seen two dissenters vote for a larger cut to rates relative to the majority, where Swati Dhingra and to the surprise of most, Catherine Mann, voted for a 0.5% cut. The fact all nine voters opted for a cut is telling, but the market was expecting a cut to 4.5% anyway. The question is whether we need to read into Catherine Mann’s vote, given her previous uber-hawk stance – of which the answer for now is probably not.

The rates market was a little perplexed in the hour following the vote, the initial reaction as expected was a knee-jerk move lower in rates following news of the vote – but this retraced throughout the afternoon as the accompanying Monetary Policy Report was digested. After a brief dip below 3.8%, 5-yr SONIA swaps trade close to 4%, higher than pre-decision levels. 2 and 10-yr swaps trade slightly higher at 4.1%. Markets still only see two more 0.25% cuts this year taking base rate to 4.00%.

The message may seem confusing, but the market interpretation correctly seems to be a “hawkish cut”. The inflation forecasts support the continuous “gradual” approach. Catherine Mann’s vote is in tune with her more “activist” approach to monetary policy, and her vote to front-load rate cuts likely reflects what she views as an opportunity, rather than a complete U-turn on her previous hawkish stance. In an interview with the FT, she did note concerns about loosening in the labour market and firms’ ability to raise prices, but caveated her choice for a 50bp cut now with “continued restrictiveness in the future”. The concerns around the economy, and the fact markets were expecting some policy loosening, represents the opportunity that Ms Mann saw – but another vote for a larger cut is very unlikely to be repeated.

UK swap rates are not getting any support from developments in the US. The Federal Reserve appears content with rates at current levels, given the still relatively strong economic data – evidenced by the January payroll report with 143k jobs added alongside a net 100k positive revision to the previous two months. Markets are only fully pricing in one more quarter point cut from the Fed this year, and a 50% chance of another. Given the decoupling of growth prospects between Europe and the US, there is an argument that UK markets place more weight on domestic developments. We are seeing that in European bond markets this month as the region grapples with poor growth prospects and growing pressure to increase defence spending.

Natural Gas back in the spotlight – but perhaps some relief?

Another talking point in 2025 is the switch back to energy inflation rather than deflation in 2024. With favourable base effects now reversing, a more watchful eye has returned on European gas markets – where supply concerns remain. The focus comes as various short- and medium-term concerns plague the market, with prices trending higher since the middle of December.

Short-term variables such as weather are an inevitable risk that can drive heating demand, and it has been a cold February! Reduced inventories in Europe and subsequent need to refill them is leading concerns as of now, especially with prices for delivery in the summer currently sitting at a premium to winter deliveries (as per the futures market). Some European countries are exploring altering inventory targets set by the EU, whilst the German government is considering offering subsidies to rebuild inventories. But supply concerns extend beyond that, exacerbated by the official end of pipeline supply into the EU from Russia. Then add in additional uncertainty from President Trump’s trade policy. The outlook for European gas markets is important given the correlation between UK and European gas prices.

Reduced supply from Russia has been a known risk for a while, the end of pipeline gas only directly impacts around 5% of European demand. Sanctions on Russian LNG enacted by the Biden administration are not a surprise either, albeit their impact would be more significant. However optimism around a swift end to the war in Ukraine has opened up a potential path for Russian gas back into Europe and reduced risk of infrastructure damage, and therefore lower prices. This optimism has reversed all of the 2025 gains in nearest-to-deliver European gas futures, which are trading around the EUR 50 per megawatt hour (UK equivalent at 110 pence per therm). A peace agreement remains far from a done deal at this stage, it’s unclear how much the US is willing to commit, and the EU remains isolated from current negotiations. How any peace agreement is upheld also remains a contentious issue amongst European nations.

At least at the time of writing, another big unknown as of now is the implications of President Trump’s trade policy, and what that means for global trade in natural gas. The blanket 10% in tariffs on China, and subsequent retaliation which includes commodities, may reduce the pressure on European natural gas prices given reduced Chinese demand. But with increased tariffs also expected to hit the EU, the outlook remains uncertain, in particular around European reciprocal tariffs. Given President Trump’s desire for Europe to buy more LNG from the US, this may well be a key part of the trade negotiation alongside defence.

Cameron Willard, Capital Markets