High interest rates + low growth 'double whammy' puts the UK economy back on the brink of recession

According to Zhitong Finance APP, the UK economy is facing severe challenges, with a potential contraction in the fourth quarter that could push the country to the brink of recession. Economists estimate that the UK’s Gross Domestic Product (GDP) fell by 0.1% in the third quarter due to the tax-increasing budget proposed by Chancellor Rachel Reeves. Surveys indicate a slow start to 2025, with the Bank of England estimating a 40% chance that the UK has already entered a technical recession (two consecutive quarters of contraction), marking the second time in over a year that the UK would fall into a technical recession.

Figure 1

The re-emergence of stagnant economic growth and cost-of-living pressures further exacerbates the challenges Reeves faces ahead of the official release of new forecasts. The Office for Budget Responsibility is expected to follow the Bank of England in downgrading economic forecasts, increasing the likelihood that the Chancellor will have to cut public services or welfare spending to avoid breaching fiscal rules.

Currently, the UK is in a dilemma: government borrowing costs are similar to those of the rapidly expanding US economy, but growth rates are closer to those of the struggling Eurozone. The European Central Bank has lowered interest rates in the Eurozone to levels far below those in the UK, making the stabilization of public finances a unique challenge for Reeves. Investors are uneasy about the high levels of government debt, which have reached their highest proportion of the economy since the early 1960s.

Figure 2

According to calculations by EY's ITEM Club, the UK's borrowing costs relative to its nominal growth rate are higher than those of most developed economies.

Ruth Gregory, Deputy Chief UK Economist at Capital Economics, stated: "Unless the government manages to reduce the enormous primary deficit, concerns about the sustainability of public sector debt may intensify. This means there is little room for complacency." The primary deficit refers to the funds the government needs to borrow to finance its spending, excluding debt interest costs.

The UK’s Office for National Statistics will release fourth-quarter GDP data and the latest estimates for December on Thursday. Bloomberg Economics estimates that output stagnated that month, with the economy smaller than when the Labour Party took office seven months ago. Consumers and businesses continue to be troubled by the £40 billion (approximately $49.5 billion) tax increases announced in the budget and the threat to the global economy posed by tariffs imposed by US President Donald Trump.

Economists Dan Hanson and Ana Andrade expect a modest recovery in the Indian economy in the first quarter driven by government spending, but they do not rule out the possibility of a recession. They wrote: "The recent weakness has surprised us, and economic activity may continue to disappoint. This could push the economy into a technical recession this winter, giving the central bank reason to reconsider its gradual rate-cutting approach." It is worth mentioning that the Bank of England announced its third interest rate cut since August last week, setting a pessimistic tone for the market. The central bank predicts that the economy will shrink by 0.1% in the fourth quarter and has halved its economic growth forecast for 2025 to 0.7%, while also predicting that inflation will be higher than previously expected, mainly due to the rebound in energy prices. Bank Governor Andrew Bailey hinted at a "gradual and cautious" approach to further rate cuts, with the money market believing there will only be two to three more cuts this year.

If the Labour Party is to fulfill its campaign promises to repair public services and increase investment, economic growth is crucial. Last month, Reeves pledged to build new wind turbines, roads, airports, railways, and trade agreements to revive the sluggish economy, but economists warn that these projects will take time to materialize. The Chancellor of the Exchequer faces a reckoning, as the Office for Budget Responsibility will assess the economic situation in preparation for her spring statement on March 26.

According to reports on Tuesday, financial regulators have downgraded their growth forecasts, with early predictions released last week showing that Reeves will face a small deficit. Rating downgrades and volatility in the bond market have led to rising borrowing costs since October, erasing the slim £9.9 billion surplus she left after violating the rule that day-to-day spending must be funded by tax revenues.

Reeves now faces the prospect of being forced to cut spending, as she stated that she would not raise taxes temporarily after the budget proposal faced strong opposition from businesses.

Figure 3

The UK is facing a dual dilemma of high interest rates and low growth: the yield on UK ten-year bonds is about 4.5%, similar to that of the United States, but the growth rate difference is significant. Last year, driven by consumer spending willingness, the US economy grew by nearly 3% in real terms, while the Bank of England estimates that the UK economy will only grow by 0.7%, the same as the Eurozone, and will not recover until 2026.

Peder Beck-Friis, an economist at Pacific Investment Management Company (PIMCO), stated at a hearing on the UK's debt situation held by the House of Lords Economic Affairs Committee last week: "A prominent variable for the UK is R minus G (interest rate minus growth rate), and we have been talking about this variable. Only Italy has a higher borrowing rate compared to the UK's growth rate."