March 2025

• The backdrop for the UK economy remains challenging, with Monetary Policy Committee (MPC) members now appearing to be expressing more concerns about second-round effects from the upcoming spike in inflation. This leads to some upside risks associated with future rate pathway. 
• While the Spring Statement leads the OBR to predict the Chancellor will meet her fiscal targets, this is conditional on relatively optimistic growth forecasts being achieved from 2026 onwards.  

We’ve got both a Bank of England Rate decision and a Spring Statement to cover in this month’s Rate Wrap. Let’s start with March’s MPC meeting… In one sense, this was a non-event. Rates were held at 4.5%, as widely expected, and the vote was conclusive at 8 – 1. However, the minutes accompanying the decision suggest a hawkish pivot by the MPC, especially with respect to the upcoming spike in inflation. 

In February’s Rate Wrap we warned that, even though the spike in inflation was being driven by one-off factors, the post-pandemic era could mean we need to be vigilant with respect to second-round effects (e.g. wage demand responses). Evidence suggests that consumers may now be less “anchored” around the 2% inflation target in the medium term while supply shocks could be both more frequent and volatile over the next 20 years compared to the previous 20 years, potentially making it harder for central banks to “look through” supply shocks when setting interest rates (see Macro Comment: Are second-round effects a risk from the upcoming spike in inflation? Opens in a new window). 

It is notable that at the February meeting, the MPC judged that the upcoming inflation spike “would not lead to additional second-round effects” whereas the March minutes state that “second-round effects related to the near-term increase in CPI inflation…would warrant a relatively tighter monetary policy path”. So, what has made the MPC become more vigilant with respect to potential second round effects? Energy prices have seen a considerable fall between the February and March meetings yet the MPC maintains its prediction of inflation peaking at 3.7% in Q3. This suggests that proxies for domestically-generated inflation, such as wage rates and services inflation, will end up playing a bigger part in the upcoming inflation spike compared to what the BoE was initially envisaging. This change in potential make up of inflation certainly presents some upside risks to the potential future rate pathway. 

A week after the MPC decision, we had the Spring Statement. Chancellor Rachel Reeves was going into this statement with a very difficult backdrop, and it turned out that her fiscal headroom of +£9.9bn had fallen to -£4.1bn due to increased projections for government borrowing costs and the halving of the growth forecast in 2025. As a result Ms Reeves set out a series of civil service and welfare reforms along with supply-side policies, which allowed the Office for Budget Responsibility (OBR) to give £9.9bn of fiscal headroom back to the Chancellor.  

Does this mean job done? Absolutely not. The OBR has said there is around a 50:50 chance that the Chancellor will need to take further action to meet her fiscal target of a current surplus by 2029-30, and it is easy to see why. While the OBR has heavily downgraded 2025’s growth forecast, it is still expecting fairly punchy growth rates from 2026 onwards (2026: 1.9%; 2027: 1.8%; 2028: 1.7%; 2029: 1.8%). These forecasts exceed those published by the Bank of England, as they often do, and are based on some relatively optimistic assumptions. 

The OBR assumes an average 1% growth of productivity per annum over the forecast period. This sounds modest but it would be double the typical productivity growth seen in the UK following the Global Financial Crisis. I would, however, argue that this is a plausible assumption, especially since AI clearly has the potential to boost productivity once adoption is more widely spread. The UK remains relatively well-placed to take advantage of this. 

Other assumptions seem more uncertain. For example, no major further escalation in tariffs globally or between the UK and US is assumed. Moreover, the OBR projects that the government’s planning reforms will lead to a material improvement in the productive potential of the economy and achieve over 300,000 new homes per year by the end of the decade. You would have to go back to the 1960s/1970s to see that kind of level. Given the practical, political and environmental hurdles of ramping up building to these levels over a relatively short space of time, there must be a reasonable chance of housebuilding falling short of the OBR’s projections.

The backdrop for the UK economy remains challenging. Projections for this year continue to be for below-trend growth and above-target inflation, while developments both domestically and internationally have the potential to create further fiscal challenges for this government. While there remains a huge deal of uncertainty, we continue to predict that the rate cutting cycle will continue gradually down to 3.5% in 2027, as the BoE continues to balance weakness in growth with continued signs of inflation persistence.

Daniel Mahoney, UK Economist

• UK data supports forecasts for moderately rising inflation combined with low but stable economic growth, stabilising expectations for slow and steady interest rate cuts.
• Uncertainty around the impact of a trade war on the US economy sees Treasury yields soften.
• Meanwhile, plans for greatly increased defence spending cause longer-term German bund yields to spike up.

An unusual month of stability for UK interest rates markets

The discussion around interest rates seems to be diverging in major economies, with different countries now facing different risks and inflationary pressures.

For once the UK is the country with a (relatively) calm market outlook, particularly compared to the confusion in February. Whilst global steel, aluminium and car tariffs will hurt certain sectors in particular, the lower likelihood of  being dragged into a wider trade-war resulting in retaliatory tariffs on imports from America is good news from an inflation perspective. Economic growth is firmly expected to be slow but still to remain expansionary. Additionally, the UK had already committed to increasing defence spending so further pledges in light of the formation of the ‘Coalition of the Willing’ has had little impact.

March 20 brought no real surprised with the MPC voting to hold base rate at 4.50%, as Daniel has mentioned above, although notably Catherine Mann who voted for a 50bps cut at the previous meeting switched this time to vote for a hold, resulting in the slightly more hawkish 8-1 split. 

The latest CPI data for February, released on March 26, was better than expected in showing that headline inflation fell to 2.8% from 3.0% in January, however that was tempered by services inflation remaining steady at 5.0% meaning the MPC’s prediction of a CPI peak of 3.7% in Q3 could still happen. The data release did marginally improve market expectations of a base rate cut in May, given a probability of 76%, and then for one further cut to most likely come by the end of the year (84% likely). From there a third cut in 2026 to 3.75% is seen by markets as less than 1% likely! 

The relative calm has also been seen in the swaps markets, where rates across the board have risen by only a small degree. Shorter-dated tenors have seen the least movement, with 2-year SONIA swaps starting the month at 4.02% and now sitting at 4.08%, whilst 5-year swaps are marginally lower at 4.06%. This reflects the aforementioned market expectations for base rate to come down to 4% by the end of 2025 and then remain steady at that level for the longer term. Longer-term rates have seen more action, with 10-year swaps climbing 20bps throughout the month as traders price in a long-term neutral rate of 4.50%.

March 26 of course also saw Chancellor Rachel Reeves deliver her latest fiscal statement, which Daniel has already discussed in detail. Gilt yields did initially whipsaw during the speech after the Debt Management Office unveiled plans for £299bn of gilt sales in 2025-26, less than the £302bn estimated. Ultimately 10-year gilt yields have risen about 30bps since the start of the month although much of this increase occurred in the first week of March when bond yields in general rose as many governments announced increased plans for defence spending.

Trade tariffs continue to dominate discussion but the longer term impact is not yet clear

For the USA, the question is more what the long-term impact of a trade war will mean both for prices and for economic growth. Federal Reserve Chairman Jerome Powell said on Friday March 7 at an economic forum that it remains to be seen if President Donald Trump’s trade tariffs will prove to be inflationary. If they prove to be a “one-time thing” then “the textbook would say look through it” i.e. no need for the Federal Reserve to respond with tighter monetary policy, however “if it turns into a series of things… if the increases are larger, that would matter… how persistent are the inflationary effects?”. 

This lack of clear direction was seen in the Fed’s decision on March 19, keeping the target rate unchanged in the 4.25-4.50% range as expected, but with new language in the comments stating that “uncertainty around the economic outlook has increased. The initial market reaction saw 10-year Treasury yields sell off a further 11bps on the day, having already fallen 25bps since the prior Fed meeting in January, barely a week after President Donald Trump’s inauguration.  

Plans to increase defence spending rattle German bond markets

The Eurozone meanwhile faces an entirely different scenario again; that of already low inflation and a large increase in future government spending. Whilst the latest European Central Bank (ECB) rate-decision meeting on March 6 brought a further 25bps cut as expected, President Christine Lagarde refused to reaffirm her past message that the direction of travel towards lower rates is clear.

Early March of course also saw US President Donald Trump’s push for a settlement to the Russia-Ukraine war, one which seemingly involves Europe shouldering more of the burden for providing a credible military deterrent. Germany’s Chancellor-in-waiting Friedrich Merz wasted no time in committing, announcing that the constitution will be amended to reform the so-called ‘debt brake’ to allow for significantly higher defence spending and saying he will do “whatever it takes” to defend the country. 

Expectations are for as much as €500bn of further German government spending, most of which will have to be funded by further new borrowing, led by the long-end as 10-year German bund yields rose by  as much as 10bps on the day of the announcement and causing the spread between 2 and 10-year Bund yields to climb the most in two years.