UK Stagflation-lite as policy headwinds increase turbulence

In our view, the UK economy remains exceptionally fragile; subdued growth and high inflation (mild stagflation), and a weak fiscal position are set to persist as a sustainable driver of UK growth has yet to emerge.

The Budget may contribute to the headwinds. Media speculation that the UK risks a 1970s-style fiscal crisis is overstated. But the fiscal situation is poor and, as recent weeks have shown, UK bond yields are particularly vulnerable to swings in market sentiment.

We think the government will need to tighten policy by around £30bn in November to stay compliant with its fiscal rules. We expect the freeze on tax thresholds and allowances to be extended beyond fiscal year 2027-2028, with more narrowly focused tax hikes biting sooner.

More interest rate cuts are likely, but given the Monetary Policy Committee’s concerns about the strength of underlying inflationary pressures and that rates are moving closer to neutral territory, we expect it to adopt a more cautious approach. We anticipate the MPC skipping a November rate cut and expect Bank Rate to end next year at 3.5%, 50bps higher than our previous forecast but still below current market pricing.

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