Economic Overview
The IMF's July assessment of the UK's macroeconomic position contained some relatively stormy warnings. With 'stagflation' once again being whispered and the fiscal headroom she created herself last October now wiped out, Rachel Reeves would be forgiven for viewing the rest of her tenure at Number 11 with trepidation.
Government borrowing for the last financial year reached £151.9Bn, exceeding official forecasts. The tax burden is now projected to rise to 37.7% of GDP by 2028/29, representing the highest level since 1948. The debt-to-GDP ratio remains elevated at 95.8%, whilst the Chancellor's £25Bn national insurance hike has clearly begun to impact business operations and employment decisions, as well as having an upward effect on inflation.
"Difficult decisions will likely be needed beyond the medium term to address new expenditure pressures and rebuild fiscal buffers…The UK has limited space to accommodate these pressures through borrowing, given that public debt is relatively high, the interest bill is larger than in other Advanced Economies, and additional buffers would be beneficial to reduce vulnerability to market pressures. Tough fiscal choices will therefore be needed."
(IMF UK 2025 Article IV Consultation)
Inflation Trends
The inflation landscape has evolved since our last update, with the Consumer Price Index (CPI) inflation rising to 3.6% in June from 3.4% in May – 100 basis points (bps) higher than the relatively encouraging 2.6% recorded in March. This increase was largely driven by regulated prices and previous energy cost increases.
Core CPI inflation reached 3.7% in June, up from 3.5% in May, reflecting broadening price pressures. Underlying services price inflation has remained elevated across a broad range of measures, with little change since late 2024. Food and non-alcoholic beverages inflation increased to 4.5% in June, driven by higher wholesale prices for beef, cocoa beans, and coffee, alongside labour and packaging regulation costs. Goods inflation reached 2.4% in June (largely due to new trade tariffs), while services inflation eased to 5.2%.
Monetary Policy Response
The June Monetary Policy Committee (MPC) meeting minutes indicated that the Bank expects inflation to remain broadly at current levels throughout 2025 before falling back towards the 2% target next year. This revised trajectory reflects what the Bank still refers to as "temporary inflationary pressures" – yet the longer the UK's data diverges from EU and US paths, the more such pressures appear permanent.
At its June meeting, MPC members voted by a majority of 6-3 to maintain Bank Rate at 4.25%. Market expectations for Bank Rate cuts have moderated, with markets still expecting 50 bps of cuts this year. Optimism is growing for a close vote in favour of a cut when the MPC meets in early August.
Labour Market Conditions
The labour market continues to loosen with clearer signs of slack emerging, though pay growth remains elevated above what economic fundamentals would suggest. While the UK has historically maintained strong employment rates compared to OECD and EU peers, this apparent success has masked deeper structural issues, including regional disparities, skills shortages, and rising economic inactivity post-pandemic.
The employment picture points to a labour market actively rebalancing and adapting to new economic realities. The ONS figures show payrolled employment has fallen by 143,000 since October 2024, with a further 75,000 reduction in the three months to May, and an initial estimate suggesting another 41,000 fall in June. The 16-64 employment rate has fallen to 75.0% in May 2025, down from its peak of 76.4% in April 2023.
Job vacancies have declined significantly, falling below pre-pandemic levels across most industry sectors. The estimated number of vacancies fell by 56,000 (7.2%) on the quarter to 727,000 in April-June 2025, marking the 36th consecutive period of decline. The unemployment rate has risen from 4.1% late last year to 4.6% in April, with forecasts suggesting it could reach 5.0% in coming quarters.
Wage Growth and Productivity
Nominal average regular earnings growth was 5.0% in the three months to May, down from 5.3% in the previous period. Private sector nominal pay growth has shown a significant fall - annualised quarter-on-quarter growth was 3.7% in the three months to May, down from 4.3% in the previous period. Both public and private sectors have experienced considerable nominal earnings increases, though the pace is expected to decelerate as firms continue absorbing higher labour costs following the 2024 Budget.
Perhaps the most concerning area is productivity, which remains significantly below that of comparable economies such as France, Germany, and the United States. This productivity gap has widened since the 2008 financial crisis, with UK productivity growth particularly sluggish over the past fifteen years. This failure to maximise productive capacity – or employee ennui – is potentially responsible for the ongoing wage inflation strength.
The IEA has identified several contributing factors to this stagnation, including over-regulation of employment practices, occupational licensing requirements, and complex dismissal laws. Labour mobility is currently hampered by high housing costs in growth areas and dysfunctional planning rules – an issue that Angela Rayner's drive to deliver 1.5M more homes may help address long-term.
Consumer Confidence and Spending
Recent data indicates a notable dip in overall consumer confidence, marking the first significant decline since late 2022. This downturn was largely attributed to weakening job security outlook and ongoing personal debt concerns. Card spending recorded a marginal year-on-year decline in June, though furniture stores saw their highest growth in activity in over two years, potentially linked to recent increases in mortgage completions following the SDLT cliff in April.
Debt Markets and Fiscal Challenges
UK debt markets have entered a period of renewed volatility through Q2 and into Q3 2025, primarily driven by increased public sector borrowing. July's figures revealed government borrowing exceeded forecasts by £4.2bn, intensifying concerns over fiscal sustainability and prompting a marked repricing of UK sovereign risk.
The Office for Budget Responsibility's latest projections indicate the government is on course to breach its self-imposed borrowing limits, fuelling market uncertainty and upward pressure on debt costs. Investors, already wary of the UK's elevated debt-to-GDP ratio, are demanding higher yields, particularly at the long end of the curve.
The Bank of England's quantitative tightening programme continues to drain liquidity from the gilt market, amplifying the impact of increased government issuance. This has translated into higher gilt yields, with 10-year yields reaching a 16-month high of 4.85%, and a notable uptick in swap rates—5-year SONIA swaps have risen by over 40 bps since late May. The widening gap between 5-year and 30-year gilts signals growing concern over long-term fiscal sustainability, with the 5-year/30-year spread reaching 100 bps this year for the first time since 2021.
International Trade Impacts
On a positive note, the expected price pressures from Trump Trade tariffs have yet to fully impact either the US or UK economies, due partly to deep pre-tariff stock inventories and larger firms absorbing part of the costs. The 'Brexit Bonus' conferred on the UK via a more favourable US trade deal than that secured by the EU, alongside the new India-UK trade deal, could help direct investment towards Britain.
Tariffs have significantly impacted FX markets. While theoretically the US$ could strengthen against other currencies, with nations like China potentially devaluing their currencies to offset tariff impacts, recent months have seen the opposite. Uncertainty and wider federal debt concerns have repriced dollar risk downwards, with the US$ weakening against both Sterling and the Euro. Goldman Sachs expects the euro to reach $1.20 and the pound $1.39 by mid-2026. As the values of major currencies continue to fluctuate in the coming months, more opportunities for value will likely emerge.
Real Estate Market Implications
These broader economic conditions and uncertainties may be triggering a 'real estate retreat' – a movement of capital into tangible, relatively low-risk and inflation-proof investments. Growing evidence in prime and upper-tier secondary markets suggests UK commercial real estate markets have bottomed out and are now on an upward curve. London office leasing voids appear to be shortening as occupier demand picks up, and transactions in the office sector, particularly from owner-occupiers, have also increased.
New housing delivery remains critically low, particularly in London, creating a supply/demand imbalance in the residential market. Until the first rung of the housing ladder becomes more accessible, the rental market will continue to see above-inflation growth. The government's drive towards professionalisation of the private rented sector is now reaching its final phases through the Renter's Rights Bill, Decent PRS Homes Standard, and the attrition of non-compliant Buy-to-Let stock.
Conclusion
The Chancellor and Bank of England are now trying to steer a safe course between their respective Scylla and Charybdis: the Government facing a difficult balancing act between further spending restraint and the risk of breaching its own borrowing limits if it does not somehow increase tax revenues; the Bank of England grappling with rising prices and inflation plateauing well above target, while growth and employment judder to a halt.
The next few months look set to be quite the Odyssey.
