Sterling Outlook Softens amid Sticky Inflation, Slowing Growth and Fiscal Strains

[Redator]

⦁ GBP outlook has turned bearish: Sticky inflation, slowing growth, and tight fiscal prospects tilt risks to the downside despite earlier stability versus G10.

⦁ BoE likely to cut once more, then pause: After a split August 25 bp cut, a single 25 bp cut in November is plausible, with futures sceptical about further easing.

⦁ Inflation is persistent and services-led: Core ~3.8% y/y; services ~5% y/y; broad pricing pressure and elevated expectations keep disinflation progress limited.

Recent performance and policy signals

For most of 2025 sterling was broadly stable against the G10 basket despite a marked weakening of the US dollar and a modest strengthening of the euro. The latest data and turbulence in monetary policy suggest the balance of risks for GBP has tilted to the downside, so earlier, more optimistic views on the currency may now lack sufficient support.

After an unexpectedly strong first quarter supported by above average exports to the United States, April and May weakened, which was offset by a strong June, leaving second quarter growth at 0.3 per cent quarter on quarter. In June the Bank of England signalled a more dovish stance, briefly lifting expectations for rate cuts. Higher inflation then cooled those assumptions.

In early August a 25 bp cut passed only on a second vote. In the first vote four members favoured no change, four supported a 25 bp cut and one argued for a 50 bp reduction. The economic picture is also harder to interpret because of quality issues in ONS data.

Inflation remains persistently high

Core inflation remains stubborn. For nearly two years its seasonally adjusted month on month pace has hovered around 0.28 per cent, clearly above target. After a brief episode of goods disinflation, goods prices have accelerated again, while services inflation has eased slightly.

Headline CPI and core CPI have been rising year on year for several months, with core at about 3.8 per cent year on year. Services inflation is around 5 per cent year on year and has oscillated near that level since last autumn. Overall, price pressure has not abated. The ONS has not published PPI since January. Import costs are likely falling, as suggested by declining container freight rates.

The Bank of England has comparatively few concerns about industrial goods excluding energy, where price growth is only moderate. Services generate the larger problem, with wages running above trend. Pricing pressure is broad based across many categories and both firms and households report elevated price expectations.

For now companies can accept lower margins to avoid choking demand, but that may change, with more costs passed through to customers, which would lift inflation over a longer horizon.

UK CPI and core CPI inflation, y/y, source: Bloomberg

Growth is unbalanced and increasingly reliant on services

The United Kingdom’s growth dynamics are not encouraging. Since the fourth quarter of 2022 almost all gains in GDP have come from the public sector. Without government spending the economy would have been in stagnation for more than two years.

In 2024 goods exports fell back to their 2019 level. Combined with a weak industrial sector this points to a growing dependence on services. If services were to weaken as well, the outlook would deteriorate quickly. Real wages are rising, but this is not feeding through to consumption because households are increasing savings.

UK GDP growth, q/q., source: Bloomberg

Labour market momentum is cooling

The labour market has been losing momentum for more than a year. The downtrend began well before the change of government and is consistent with the lagged impact of restrictive Bank of England policy. The vacancy to unemployment ratio, which is central to the Bank’s framework, has fallen below its 2019 average.

Public finances are tight and October could be pivotal

The public finances are stretched. Chancellor of the Exchequer Rachel Reeves faces a difficult balancing act. On the one hand she aims to show that current commitments will be funded from taxation. On the other she has pledged not to raise taxes. Changes due in October that increase employer contributions could bring additional revenue to the Exchequer, but they may also push up labour costs.

Meanwhile spending needs, for example on defence, are rising. The October Budget is likely to be pivotal and could generate higher volatility in GBP.

Policy outlook points to one cut and then wait and see

The Bank of England faces a classic dilemma. It must continue to tackle persistent inflation while also supporting a slowing economy. A single cut of 25 bp in November looks plausible, followed by a shift to a wait and see stance.

Futures pricing remains sceptical about further easing this year according to Overnight Index Swaps. The situation could change if forthcoming data disappoint, which would likely exert downward pressure on sterling.

UK Bank of England Official Bank Rate

Near term upside risks versus medium term headwinds

In the near term positive data surprises are possible given low expectations and the likelihood that recent prints understated the underlying trend. Over the medium and longer term structural growth constraints, a cooler labour market and tight fiscal conditions may dominate.

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