UK interest rates will stay high unless service sector inflation falls, says IMF

The UK faces the prospect of interest rates being higher for longer unless there is more progress in reducing service sector inflation, the International Monetary Fund has warned.

While the Washington-based IMF nudged up its 2024 growth forecasts for the UK, it identified the stickiness of price growth in the service sector as a potential headache for the Bank of England.

The IMF’s economic counsellor, Pierre-Olivier Gourinchas, said the UK was similar to the US in having “somewhat persistent services inflation”. His comments chime with comments from Bank of England policymakers about the risks of service sector inflation becoming embedded.

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Since the start of the year the headline rate of UK inflation has halved to 2% while service sector inflation has fallen from 6.5% to 5.7%. The Office for National Statistics will release the latest cost of living figures on Wednesday.

The IMF said its forecasts for the global economy had not changed much since the release of its world economic outlook (WEO) in April. Its July WEO update left 2024 growth unchanged at 3.2%, while its estimate for 2025 was revised up from 3.2% to 3.3%.

A stronger than expected start to 2024 has resulted in the IMF raising its growth estimate for the UK from 0.5% to 0.7%, while the eurozone was upgraded from 0.8% to 0.9%.

The fund believes UK growth will continue to pick up and has pencilled in expansion of 1.5% in 2025. Elsewhere, the IMF said the growth gap between the US and the EU would narrow over the next 18 months.

Rachel Reeves, the chancellor, said: “While it’s welcome that the IMF is forecasting growth to pick up this time, I am under no illusion to the scale of the challenge facing the economy and the inheritance this new government faces. That is why we are already taking the tough decisions to fix the foundations of our economy, so we can rebuild Britain and make every part of our country better off.”

While the IMF believes the global economy is on course for a slowdown but not a recession it said the service sector cost pressures were holding up progress in the fight to bring inflation down sustainably.

“As in April, we project global inflation will slow to 5.9% this year from 6.7% last year, broadly on track for a soft landing,” Gourinchas said. “But in some advanced economies, especially the US, progress on disinflation has slowed, and risks are to the upside.”

Risks of persistent inflation in the services sector were tied to wage and price setting, given that labour accounted for a high share of the costs in that sector. The service sector accounts for about 80% of the UK economy’s output.

“Persistently elevated uncertainty around the inflation outlook has led central banks in major advanced economies to become somewhat more cautious about the pace of policy easing, compared with their positions at the end of the first quarter,” the IMF said.

The IMF also expressed concern about the potential for significant swings in economic policy as a result of elections this year, with knock-on effects to the rest of the world.

Without singling out any country, Gourinchas said he was worried about mounting protectionism.

“The gradual dismantling of our multilateral trading system is another key concern. More countries are now going their own way, imposing unilateral tariffs or industrial policy measures whose compliance with World Trade Organization rules is questionable at best,” Gourinchas said.

“Our imperfect trading system could be improved, but this surge in unilateral measures isn’t likely to deliver lasting and shared global prosperity. If anything, it will distort trade and resource allocation, spur retaliation, weaken growth, diminish living standards, and make it harder to coordinate policies that address global challenges, such as the climate transition.”