The UK’s economic recovery will accelerate over the next year, forcing the Bank of England to keep interest rates higher for longer, according to the National Institute of Economic and Social Research (Niesr).
Signalling that bets on further interest rate cuts before the end of the year could be misplaced, the thinktank said a modest economic recovery and the threat from persistent inflationary trends should make the central bank more cautious about reducing the cost of borrowing.
Niesr said its forecasts show interest rates will edge down slowly over the next year from 5% to 4.6% in 2025 and to only 4.1% in 2026 before reaching 3.1% in 2028 – well above the 0.75% set by the Bank in 2019 before the Covid-19 pandemic.
Mortgages and business loans will carry a higher cost, forcing many homeowners to pay higher monthly interest bills and companies to go bankrupt, leading to a rise in unemployment, it forecast.
Niesr said a lack of business investment and expected productivity growth will mean the UK’s growth falls to 1.2% for the rest of the forecast period from 2026 until 2029.
Officials at the Bank cut interest rates from 5.25% to 5% earlier this month. They expect the UK’s growth rate to be lower than the forecast by Niesr, putting the central bank on course to cut rates at least once more this year and steadily through 2025.
The chancellor, Rachel Reeves, has pledged to increase the UK’s growth rate to 2.5%.
Jagjit Chadha, the Niesr director, said Reeves needed to raise the UK’s growth rate without adding to inflation, which meant increasing long-term public investment in education, health, transport and energy.
He said the “dogma” of budget rules was preventing the Treasury from sanctioning long-term investments that cost billions of pounds in upfront costs but improve national income, or gross domestic product (GDP), over the longer term.
Referring to the recent riots across the UK, Chadha said that addressing productivity and raising incomes for those paid the least in society was the “best way” to raise GDP. He said that would require increased public sector spending, improved productivity and “a great deal of patience on behalf of an increasingly fractious population”.
Adding to the growing calls from economic thinktanks for the chancellor to increase investment spending in her budget, Niesr said Reeves should be “brave” and rewrite budget rules that tie day-to-day spending with longer-term public investments.
Reeves has pledged to maintain two rules before a budget on 30 October. The first forces the government to reduce debt as a proportion of national income in the fifth year of a five-year forecast.
The UK’s debt to GDP ratio is 97%. A second rule forces the Treasury to limit its spending deficit to 3% in the final year of the forecast.
The Institute for Fiscal Studies, a tax and spending thinktank, said changing the way debt is measured would allow the government to borrow billions more but would not change the “fiscal reality”.
The IFS senior research economist Ben Zaranko said a change to the debt rules could be an “attractive” option for Reeves, who has accused the previous government of leaving £22bn of unfunded commitments.
Reeves has said public sector pay awards costing almost £10bn and a £6.4bn bill for housing asylum seekers were among costs she inherited when taking office.
However, the thinktank said technical changes to definitions would not change the “fiscal reality”, and Zaranko warned the government not to get “bogged down in technical debt definitions”.
Global factors could also prove to be decisive in determining how quickly the UK grows. Niesr said there were risks from a US recession and conflict in the Middle East to the outlook for global growth, although most countries were expected to continue a recovery from the Covid-19 pandemic and cost of living crisis.
The global economy is expected to slow from 4% to 3% over the next year, the thinktank said.
• This article was amended on 7 August 2024. The Labour government’s first budget is to be announced on 30 October, not “1 October” as an earlier version said.
