The UK Economy - Cooling Inflation, Labour Jitters

The UK economy enters the final stretch of 2025 grappling with same issues we have seen all year: a sticky, though improving, inflation outlook; a faltering labour market; and fiscal unease. Recent data have eased some nerves - if only for now - as we head towards a key moment for the British economy: the autumn budget. Here we look at what has changed since last assessed the UK, and how interest rates and FX markets are set up to react as we move towards year-end.

MPC: Waiting for a Green Light

The latest inflation print showed headline CPI holding at 3.8% year-on-year in September, a touch below expectations the 4% consensus and a modest relief after months of stubborn readings. Services inflation also moved in the right direction, easing to 4.7%, below the BoE’s own 4.9% forecast.

This followed the Monetary Policy Committee’s (MPC) narrow vote to cut at its September meeting. While there has been no BoE meeting this month, the governor has appeared before MPs on the Treasury Committee, striking a cautious tone. Governor Bailey emphasised the need for “firm evidence” that underlying inflation pressures are easing before committing to a deeper cutting cycle. The statement struck a delicate balance — acknowledging cooling wage growth and softer headline inflation, while warning that services inflation remains uncomfortably high.

Market pricing mirrors the indecision: investors see roughly a 60% chance of another 25bps rate cut by December, with about 50bps of easing priced by mid-2026. Short-end gilt yields fell modestly on the softer inflation data, but the move was capped by fiscal concerns and lingering uncertainty over how much above-target inflation the BoE will tolerate through 2026.

Labour Market Cracks to Reveal Clarity

Employment data continue to show stress and be a source of frustration for the BoE. The economy continued to shed jobs in the latest quarter, and the unemployment rate edged up to 4.8%. Analysts note that the rise in unemployment has so far been cushioned by a sharp fall in vacancies rather than widespread layoffs — a pattern that could change rapidly if activity fails to rebound before year-end.

Earlier in the year, wage growth made the BoE’s job trickier: stubbornly above target inflation, it was difficult for the bank to cut with confidence. Recent data, however, showed signs that this problem may be coming to an end. Private-sector pay growth fell to 4.4% in the three months to August, from 4.7% in July, and below expectations of 4.5%. While still higher than ideal, a continuation of this trend would help deliver the “firm evidence” the MPC wants before cutting more freely.

Sterling’s Rate Support on the Wobble

As noted in our recent piece (Sterling’s Squeeze), there are few reasons to be overtly bullish on the pound, and some of the developments above may worsen its outlook. Much of sterling’s support against the dollar - and what has helped prevent even larger losses against the euro - has been the UK’s relatively elevated rates. Those rates have, in turn, been held up by sticky inflation, both core and wages. If these indicators keep turning the corner, the BoE will be more than happy to lower rates and support the wider economy. By the end of Q3 2026, markets expect a considerable 108bps of cuts from the Fed and a relatively muted 57bps from the BoE. From our vantage point, that skews the risk towards a relative tightening in interest rate spreads going forward, and with it, a weaker pound.

Meaningful developments have been scarce this year, but recent data have begun to clear the path. Key risks remain on the horizon, with the Chancellor’s budget chief among them and maybe the most important. On 26 November, Rachel Reeves will deliver her second budget and attempt to tread the fine line between increasing spending and maintaining market confidence.

For markets, her decisions will be digested within the wider context of the economy – if corners are seemingly being turned in the fight against inflation, will Reeves aid or hinder this progress? The UK’s balancing act — between credibility, inflation, and growth — will define both sterling’s direction and rate dynamics well into 2026.