Inflation is falling but alarm bells are ringing in the job market

The following column by Gerard Lyons appeared in The Telegraph on Sunday 21 December, 2025. It discusses the BoE bank rate cut. 

The Bank of England’s Monetary Policy Committee (MPC) cut the Bank Rate from 4pc to 3.75pc on Thursday. The rate cut was justified. Inflation is falling.
 
Policy has been restrictive and still appears so. I think it should be followed by another cut by the spring, to 3.5pc. Downside risks to the economy could even allow rates to fall below that over the next year to 3pc.
 
But even this economic outlook should not mean a return to cheap money, where interest rates fall to the very low level seen before the pandemic.
 
The vote was a close call of 5-4, reversing a 5-4 decision to leave rates at the prior meeting. Although the minutes imply that future decisions will be data dependent, they also make clear the committee is hardening into distinct camps.
 
The doves’ position is that disinflation is more established and slack is building in the economy. The hawks worry that inflation could stall above target because wages, expectations and service price inflation are too high.
 
Following the meeting the key issues are, was the cut justified and what happens next? To help answer these an important issue is what is the neutral level for Bank Rate? Neutral is the rate that would deliver the 2pc inflation target without either squeezing the economy or stimulating it. The minutes allude to neutral, without specifying where it is. 

Whereas we focus on the Bank Rate, before the pandemic, central banking circles became fixated on ‘r star’, the neutral rate in real terms, after taking account of inflation.

Then the view took hold that r star was around zero in the UK and a number of other western economies. If inflation was 2pc the Bank Rate could sit at 2pc.

This was based on longer-term thinking linked to demographics and the savings investment balance. It also reflected group thinking and treating a benign inflation era as proof that the framework itself had allowed inflation and rates to settle at permanently lower levels. That was not the case and as we saw in recent years inflation persisted, before now subsiding.

Neutral is a good guide, but it is not set in stone and reflects the moving parts of the economy. 

If growth in 2026 is around 1.5pc and inflation is 2pc then nominal GDP would be growing around 3.5pc, and this would be a useful gauge of a neutral rate in the current environment. It’s where rates should settle, with scope to dip temporarily below this in 2026 if economic prospects permit.

Last week’s release of the inflation data for November showed the first monthly fall since January. And over the last three months, inflation has risen by an annualised rate of just 1.4pc. 

The annual rate of inflation fell to 3.2pc versus 3.6pc in October. Goods price inflation fell to 2.1pc from 2.6pc, and while service sector is still sticky it fell, too, to 4.5pc from 4.6pc and has been trending down in recent months. 

Many firms may wish to pass on higher costs. So there is no room for complacency. Yet, intense global competition, modest UK growth and the legacy of Budget measures will see inflation head lower, possibly to the 2pc target by next spring.
 
Last week also saw the latest jobs data, which highlights a cause for economic concern. Economists have often referred to the jobs data as a lagging indicator, but such is the flexibility of the UK’s labour market it is better to think of it as a coincident measure. It thus provides a good reflection of what is currently happening. 
 
The unemployment rate, which was 4.1pc at the time of the 2024 general election has risen to 5.1pc and is set to rise further. Private sector payrolls are down 171,000 in the year to November.
 
As slack accumulates, the balance of risks shifts away from inflation sticking. That is precisely the environment in which the Bank can move even into accommodative territory. The MPC minutes explicitly link falling inflation to subdued growth and building slack, alongside continued easing in pay growth and services price inflation.
 
The labour market is likely to soften in 2026, with unemployment rising amid modest economic growth, continued uncertainty about the outlook and higher business costs driven by policy changes. 

High-employment, low-wage sectors are likely to shed staff and limit hiring as a direct consequence of measures announced in the 2024 and 2025 Budgets. Small and medium-sized enterprises will face a particularly challenging environment, with higher wage costs and the new Employment Rights Bill weighing on hiring decisions. 

For many people job security will largely be maintained. This group is also likely to see pre-tax real income gains, as earnings growth, although slower, should outpace inflation. However, post-tax income growth will be more limited due to fiscal drag. 

Higher minimum wages will provide a direct boost to those who receive them, but the aggregate impact will be offset to some extent by weaker employment prospects as firms absorb higher wage costs. 

AI will impact too. Graduates are likely to face particular pressure as AI reshapes entry-level roles. 

AI has the potential to be most transformative in the public sector, provided there is the political will to embrace it, though it is difficult to see such gains materialising as soon as 2026. 

The sequence of previous technological changes is that first comes the substitution effect, which displaces jobs; then the income effect followed by the creative effect, both of which create jobs. But job losses will come first from AI as roles have to change.

If 2026 is shaping up to be a year in which inflation falls back towards target while the labour market weakens then macro policy has to work together. While monetary policy delivers low inflation, fiscal and supply-side policy need to incentivise growth.

A Chancellor who wants growth but delivers measures that undermine hiring and investment, forces monetary policy to be the shock absorber. But there is only so much monetary policy and interest rates can do.

This article is for information purposes only and does not constitute financial advice.