Economic update: Interest rates cut to their lowest level for over two years

August began with a knife edge vote at the Bank of England, where the Monetary Policy Committee cut interest rates to their lowest level for over two years.

Financial markets were expecting further cuts to follow in 2025, but recent inflation and other economic data appear to have made the pace of cuts more uncertain.

Looking ahead, when MPs return to Parliament in September, we may get a date for the 2025 Autumn Budget.

Bank cuts interest rate by 0.25 percentage points

On 7 August, the Bank of England’s Monetary Policy Committee (MPC) reduced its benchmark interest rate by 0.25 percentage points to 4%. This can be seen in the chart below.

The benchmark interest rate began 2025 at 4.75% but the Bank has made cuts because inflation has subsided from its earlier peaks. Inflation rose to over 11% after the shocks of the pandemic and the energy crisis following Russia’s full-scale invasion of Ukraine in 2022. Despite now being much lower, inflation hasn’t yet returned to the Bank’s target rate of 2% (as we show below, it was 3.8% in July 2025).

The decision to cut the interest rate to 4% was only narrowly backed with a five to four vote by the MPC, which took two votes to reach the decision. Broadly speaking, the MPC’s tight vote reflects two conflicting concerns:

• that higher inflation could become persistent
• that the economy could downturn sharply

Markets appear to think that data released since the MPC’s vote point to interest rates being cut slower than previously expected.

Signs of persistent inflation in the July data

Prices, as measured by the Consumer Prices Index (CPI), rose by 3.8% in the 12 months to July 2025, the highest rate since January 2024. July’s inflation was driven by transport, with a sharp rise in air fares (probably influenced by the timing of school summer holidays) and a rise in petrol and diesel prices. Food and non-alcoholic drink prices also contributed, increasing by 4.9% in July 2025.

While July’s overall inflation rate of 3.8% was as the Bank expected, measures of inflation that reflect domestic price and wage pressures may concern members of the MPC. Inflation in services prices and core inflation (CPI, excluding energy, food, alcohol and tobacco) both increased in July 2025, which could give more weight to the argument that UK inflation is more persistent than hoped. These trends can be seen in the chart on the left below.

There are also signs that the UK is becoming an international outlier, with the highest rate of inflation in the G7 and a higher rate than the EU and Eurozone averages. This can be seen in the chart on the right below.

Signs of a gradual economic slowdown

The UK economy grew faster than most forecasters expected in the second quarter (Q2) of 2025. While the UK economy expanded by 0.3% in Q2 2025, this was somewhat slower than the 0.7% growth experienced in Q1 2025. Since 2022, the UK has grown fastest in the first quarter of the year and the data for the first half of 2025 is in keeping with this recent trend.

As we have discussed previously, labour market data is very uncertain at the moment. That said, employment appears to have continued falling in June and July 2025, but not as quickly as some on the MPC may have worried. Compared with May 2025, payrolled employment fell by around 26,000 in June 2025, rather than the 41,000 suggested in the early estimate for June 2025. Early estimates suggest that there were 8,000 fewer payrolled employees in July 2025 than in June 2025.

Budget speculation

MPs return to Parliament on 1 September for a little over two weeks, before conference recess begins on 16 September. During this sitting period, it’s likely that the Chancellor will announce the date of the 2025 Autumn Budget. The required timescales for the Office for Budget Responsibility (OBR) to complete its forecasts for the Budget suggest the Chancellor will present the Budget no earlier than the week beginning 10 November.

Commentators expect the Chancellor to raise taxes in the Budget to meet her self-imposed rules for the public finances (the fiscal rules). The fiscal rules were being met by a relatively small margin when last assessed by the OBR and many commentators expect the OBR’s forecast for the public finances to get worse, reducing or wiping out the small margin.

Greater government revenues but even greater spending

The big picture for the Chancellor is that while UK tax revenues are relatively high by historical standards, the government is still having to borrow over £100 billion a year (around 5% of gross domestic product (GDP)) to cover its spending.

In 2018/19, government borrowing was 2.1% of GDP, its lowest level in over 15 years. Since then, government spending has grown faster than government revenues, and borrowing was 5.1% of GDP in 2024/25.

As the chart below shows, government spending on debt interest and on goods and services (largely salaries and procurement) are significantly higher than six years ago. There are more government employees now, and inflation has put pressure on wages and costs. Debt interest costs have more than doubled because of high inflation and increases to interest rates.

A tough time to be Chancellor?

In the Budget, the Chancellor will face the immediate challenge of meeting the government’s “non-negotiable” fiscal rules while growing the economy. The public finances also face fundamental longer-term challenges, which we discussed in the economic update for July 2025.

The Chancellor’s (and the MPC’s) challenges are made more difficult by fears over the unreliability of the Office for National Statistics’ economic data. Making economic policy is particularly difficult when policymakers can’t be confident about the reliability of data in important areas such as the labour market and retail sales.

About the author: Matthew Keep is a senior researcher at the House of Commons Library, specialising in public finances.

Photo by: Sergei Mutovkin via Flickr