How inflation is affecting UK interest rates in 2025

Published: 24 September
Reading time: Four minutes

Interest rate movements regularly make the headlines and there’s a good reason for that. When inflation starts heating up, increasing interest rates is a key way central banks can manage the economy. But in the past year, the Bank of England has been cutting rates as inflation doubled. Our UK Economist Daniel Mahoney explains the link between inflation and interest rates.

The general idea is for the Bank of England to set interest rates so that demand matches supply and at a level that promotes low and stable inflation in the medium term. When inflation is at the 2% target it’s reached its aim. 

A useful way of thinking about how the economy looks from a central banker’s perspective is to imagine driving a car on a motorway with a speed limit of 70mph. Let’s say 70mph is the optimum speed limit for the economy to grow without leading to high inflation (called the “productive potential of the economy”). 

If the car is over the speed limit, there’s too much demand for the supply available, i.e. an indication that higher interest rates may be necessary, requiring a central bank to apply the brakes on the economy. 

However, if the car is travelling below 70mph, there is spare capacity in the economy so a central bank needs to press the accelerator and encourage more demand by cutting interest rates.

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.

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.

Currently, financial markets think there will be two further UK interest rate cuts within the next year. Under these expectations, the Bank of England’s latest view is for the UK eventually to move back to 2% inflation. This view could of course change. 

Estimating the “neutral rate of interest” isn’t an exact science. Moreover, inflation risks lurk around the corner: the Bank of England now thinks inflation will be higher than previously expected for the rest of this calendar year, and the public is now more attentive to inflation compared to pre-pandemic times. 

Both factors increase the risk that interest rates may not continue to fall over the next twelve months (as of September 2025) . But, for now at least, the assumption remains that interest rates will fall a little further despite the current high levels of inflation. 

Key takeaways

• UK interest rates have fallen from 5.25% to 4% despite inflation doubling.
• The Bank of England is responding to one-off price shocks and delayed policy effects.
• Interest rates may fall further, but inflation risks remain.