Why Lower Interest Rates Won’t Rescue the UK Economy

At its most recent meeting, the Bank of England narrowly voted—by a margin of five to four—to cut interest rates by a modest 0.25%. The decision reflects a difficult balancing act. On one side, there are clear signs of an economic slowdown: unemployment is edging higher, and spare capacity in the economy is increasing. On the other, inflation remains stubbornly above target, defying forecasts that it would have cooled by now.

This makes the UK something of an international outlier. In the eurozone, inflation has been successfully brought down to around 2%. Even the United States, which has inflation above 2%, is dealing with a partly self-inflicted situation. For much of the 2010s, the UK operated with negative real interest rates—where the base rate sat below the rate of inflation—penalising savers while trying to stimulate spending. Over the past year, however, Britain saw its largest gap between nominal interest rates and inflation since 2007.

The recent rise in inflation now threatens to push the UK towards negative real interest rates once again. This is one reason the Bank has issued grim warnings about the limited scope for future rate cuts. The UK currently has higher interest rates than most other advanced economies, and if Donald Trump were to return to the US presidency and push through his promised aggressive rate cuts, Britain’s divergence would become even more stark.

The persistent question is why inflation has stayed so elevated in the UK compared to countries such as France and Germany. The Bank of England has repeatedly forecast that inflationary spikes would be temporary, but reality has proved otherwise. As one of its deputy governors recently admitted, the endurance of price pressures has been surprising. Normally, a slowing economy would help to dampen inflation. Instead, Britain is facing a combination of cyclical and structural factors keeping prices high.

What’s Driving UK Inflation?

Food inflation has been a particularly notable culprit. While global prices of commodities like coffee and chocolate have surged, in the UK the biggest driver has been the price of meat. Deadweight beef prices have risen by around 40%, a jump exacerbated by declining cattle numbers. Post-Brexit trade arrangements have also added to costs, particularly for imported food.

Energy and utility bills have played an even bigger role, accounting for nearly half of the UK’s excess inflation compared to other economies. Households have faced large increases in energy and water costs, both of which feed into broader consumer prices.

The Bank also worries about a self-reinforcing cycle: if people expect inflation to stay high, they demand higher wages, which in turn raises costs for businesses. Strong wage growth has already contributed to service sector inflation. Government fiscal policy has compounded the problem. Increases in National Insurance contributions for employers have largely been passed on to consumers, especially in labour-intensive industries such as hospitality and retail.

Even the official consumer price index including housing (CPIH) does not capture the full inflationary impact on households. While CPIH stands at 4.1%, rents have risen faster than inflation in recent years, adding to cost-of-living pressures.

The Limits of Monetary Policy

This raises an important question: in the face of both inflation and sluggish growth, what can interest rate policy realistically achieve? Higher interest rates help reduce inflation by cooling demand. They make borrowing more expensive, discourage investment, and leave households with mortgages less disposable income. As demand falls, the economy develops slack, creating downward pressure on wages and prices.

However, when the economy already has unused capacity and a weakening labour market, this approach has diminishing returns. Prolonged high rates risk worsening the slowdown, increasing unemployment, and further depressing investment.

If the problem is primarily on the supply side—meaning the economy’s ability to produce goods and services is constrained—then reducing demand will not fix it. Conversely, abandoning the inflation target and slashing rates to, say, eurozone levels of around 2% could boost some households’ spending power, particularly those with mortgages. Higher consumer spending might encourage investment and homebuilding, potentially spurring productivity growth.

But there are limitations. In the 1990s, around 40% of homeowners had a mortgage, mostly on variable rates. Changes to the base rate quickly flowed through to the economy. Today, fewer households have mortgages, and most are on fixed rates. This means a rate cut would have a smaller and slower impact, benefiting only a minority of borrowers in the short term.

Lower rates would also hurt savers, particularly older households who own their homes outright and rely on interest income. The UK’s savings ratio has risen in recent years, driven partly by an ageing population and partly by pessimism about the economy—people saving now in anticipation of higher taxes later. Rate cuts could therefore shift income away from savers without meaningfully boosting consumption.

A Structural Problem

The bigger issue is that the UK’s economic weakness is not simply a matter of weak demand. Growth has averaged just over 1% in recent years, yet the Office for Budget Responsibility estimates the output gap—the difference between actual and potential GDP—at a mere 0.5%. This means there is very little excess capacity to fill before supply constraints kick in, at which point stronger demand risks driving prices higher rather than increasing real output.

Productivity growth has been particularly poor, averaging just 0.5% annually and slowing further since the pandemic. Without productivity gains, sustained increases in real wages or GDP will inevitably create inflationary pressures. This leaves the Bank of England with an increasingly unattractive trade-off: higher rates to curb inflation at the cost of growth, or lower rates to boost growth at the cost of higher inflation.

Low productivity also contributes to the government’s persistent fiscal shortfalls. The latest forecast predicts a £50 billion gap in the autumn budget. Weak growth means lower tax revenues and higher demand for public spending, trapping the government in a cycle of higher taxes, weaker growth, and more inflationary pressure.

Labour Market Strains

A key factor is the shrinking labour force. The UK has seen a marked rise in economic inactivity over the past five years, driven largely by long-term sickness and disability. This trend is unusual among advanced economies and represents a direct loss of productive capacity, as well as higher welfare costs.

Reversing it is not a matter of tweaking interest rates. It requires coordinated policies—healthcare interventions, skills training, and incentives to rejoin the workforce. Without this, even if demand were stimulated, the supply side would remain constrained.

Fiscal Policy Dilemmas

The deterioration in public finances adds another layer of difficulty. The government faces three basic options: raise taxes, cut spending, or borrow more. All carry significant downsides. Higher taxes risk choking off growth, spending cuts can reduce public services and investment, and higher borrowing can spook markets or fuel inflation.

A long-standing issue is the UK’s low level of investment. Among G7 countries, Britain has consistently recorded the lowest investment rates. Low confidence among businesses and policy instability have discouraged long-term commitments. In theory, lower interest rates and faster growth could stimulate investment, but persistent inflation can have the opposite effect, raising uncertainty and reducing the incentive to commit capital.

Breaking the Cycle

The fundamental challenge is how to escape this loop of low growth and persistent inflation. Structural reforms could help: improving labour market participation, overhauling planning laws to encourage housing development, and reducing trade barriers with Europe to boost exports. These measures could raise productivity and growth without requiring significant new public spending.

The difficulty is that such reforms take time and may face political resistance. In the meantime, policymakers are left managing symptoms rather than addressing causes.

Lessons from the Past—and Limits of the Present

Comparisons with past downturns offer little comfort. In 1992, Britain was in deep recession, with unemployment at three million and house prices falling sharply. The government’s decision to leave the Exchange Rate Mechanism, devalue the pound, and cut interest rates led to a rapid recovery and a prolonged period of growth.

But in 2025, similar tools would not work as effectively. A sharp devaluation would raise import prices, adding to inflation, while rate cuts would have a smaller impact due to the prevalence of fixed-rate mortgages and the structural weaknesses in labour supply.

The UK finds itself on what economists sometimes call a “tricky wicket”—a situation where neither monetary nor fiscal policy offers an easy route to recovery. Without tackling the underlying productivity and supply-side constraints, changes to interest rates—whether up or down—are unlikely to deliver the economic revival policymakers and households are hoping for.

In the short term, the Bank of England must navigate a narrowing path, trying to contain inflation without crushing growth altogether. In the longer term, only sustained reforms aimed at boosting productivity, improving labour force participation, and encouraging investment can put the UK economy on a stronger footing. Until then, interest rate moves will remain a blunt instrument in a much more complex economic battle.