The UK economy shrank for the second consecutive month, with GDP unexpectedly declining by 0.1% in May, increasing pressure on the central bank to cut interest rates

The UK economy unexpectedly contracted by 0.1% in May, marking a decline for the second consecutive month, indicating that the strong growth momentum earlier this year has dissipated. This figure is well below economists' expectations of a 0.1% growth, with declines in production and construction being the main factors dragging down the economy.

Data released by the UK Office for National Statistics on Friday showed that the further contraction of the UK's GDP in May, following a 0.3% decline in April, suggests a significant slowdown in economic activity in the second quarter. If output falls by 0.4% or more in June, the UK economy will contract overall in the second quarter, in stark contrast to the 0.7% growth in the first quarter.

Following the data release, the British pound fell 0.2% against the US dollar, dropping to $1.35. Traders' bets on the Bank of England cutting interest rates by 25 basis points next month remained largely unchanged, with the money market expecting the Bank of England to cut rates once in August and again before the end of the year.

Chancellor of the Exchequer Rachel Reeves acknowledged that the May GDP data was "disappointing," stating a "determination to kickstart economic growth." The Labour government is counting on stronger growth to fund its spending plans, but the fiscal situation has tightened further following a shift in welfare payments and winter fuel subsidy policies for pensions.

Production and Construction Drag on Economic Performance

Liz McKeown, head of economic statistics at the UK Office for National Statistics, stated that the economic contraction in May was primarily driven by "a significant decline in production and construction, only partially offset by growth in the services sector."

The decline in production was concentrated in "oil and gas extraction, automotive manufacturing, and the often volatile pharmaceutical industry." This performance stands in stark contrast to the first quarter, when a surge in exports and strong performance in the services sector positioned the UK among the best-performing countries in the G7.

Economist Paul Dales from consultancy Capital Economics calculated that even if GDP improves to flat levels in June, overall growth in the second quarter will still slow to just 0.1%. He stated:

"The hangover from the surge in activity in the first quarter persisted into May, growth will be quite sluggish this year."

Expectations for Interest Rate Cuts Rise

After the data release, investors slightly increased their bets on a 25 basis point rate cut by the Bank of England in August. The market anticipates two rate cuts before the end of the year.

Suren Thiru, economic director at the Association of Chartered Certified Accountants, stated that these disappointing data "undoubtedly raise concerns about the health of the UK economy," and believes that a rate cut by the Bank of England in August "currently seems inevitable." The Bank of England maintained borrowing costs at 4.25% last month The Bank of England previously warned that potential growth remains weak and noted that economic activity in the first quarter was boosted by one-off factors, such as pre-activity before U.S. tariffs and changes in stamp duty.

Fiscal Pressure Intensifies Government Challenges

Professor Joe Nellis, an economic advisor at accounting consultancy MHA, stated that this data is "far from" the first quarter, and "growth in the first half of this year is now expected to be modest." He said:

"This poses a challenge for the Chancellor—Reeves's fiscal space is still constrained by high levels of public borrowing and debt, her spending plans heavily rely on reviving the economy."

The disappointing growth data will cast a shadow over the Cabinet "away day" convened by Prime Minister Keir Starmer on Friday, as ministers will attempt to chart a path for the autumn budget amid worsening fiscal prospects. Ministers will assess the damage to public finances caused by welfare reform and winter fuel subsidy concessions, which have created a gap of over £6 billion in the government's financial plans.

Shadow Chancellor Mel Stride stated:

"Due to the reckless choices of the Labour Party, the economy actually contracted in May. This will further increase the pressure for tax hikes in the autumn."