How inflation is affecting UK interest rates in 2025

Handelsbanken Insights Blog

By Daniel Mahoney, UK Economist

Why has the Bank of England cut interest rates despite rising inflation?

Earlier this decade, inflation initially took off due to two key shocks: disruption to supply chains from covid, and then Russia’s invasion of Ukraine. This was made worse by consequent high wage demands, which showed up in high earnings growth and services inflation.

The Bank of England put the brakes on this by hiking interest rates from 0.1% at the end of 2021 up to 5.25% in mid-2023 and then holding rates at this level for around a year.

That appears to have been somewhat successful in bringing down inflation, which fell from a peak of 11.1% in mid-2022 to around 2% in mid-2024, as energy prices dropped and interest rate rises reduced demand in the economy.

However, over the past year we’ve seen the Bank of England cut interest rates, as inflation has doubled from around 2% to nearly 4%. This, on the face of it, sounds counterintuitive given the motorway analogy: inflation rising suggests the car may be driving too quickly for the economy’s speed limit and requires the central bank to apply the brakes through higher interest rates.

Three reasons behind the Bank of England’s decision

So why, albeit very cautiously, has the Bank of England cut interest rates?

First, the increase in UK inflation is in part being driven by one-off price increases in regulated markets (for example, think about how much your water bills have gone up recently). It’s assumed that these price increases will wash through by next year (pardon the pun);
Second, the impact of changes to interest rates do not all occur immediately – the obvious example is the mortgage market as most UK mortgage holders are on fixed rates. The Bank of England must consider how previous interest rate policy is affecting the economy currently, and how interest rate decisions today will affect the economy in the future.
Third, most economists think that the current Bank of England base rate of 4% is above the “neutral rate” of interest. The neutral rate is effectively where interest rates should be to achieve 2% inflation in the medium term when the economy is steady. This means that despite interest rates falling from 5.25% to 4% over the past year or so, the Bank of England’s policy continues to bear down on UK economic growth. If we go back to the car analogy, that means while the driver is starting to lift their foot off the brake pedal, they continue to apply some pressure so that the car is still slowing down towards the economy’s speed limit.