UPDATE 2-British economy suffers shock Q4 contraction
* Q4 GDP shrinks 0.5 pct, first quarterly drop since Q3 2009
* Growth likely flat without snow disruption - stats office
* Government says no question of changing austerity plan
* Markets back off early rate rise expectations
LONDON, Jan 25 (Reuters) - Britain's economy unexpectedly shrank in the last three months of 2010, causing a major headache for the government as it embarks on the deepest spending cuts in a generation.
Finance minister George Osborne said the shock 0.5 percent contraction would not derail his austerity plans, blaming the drop in output on the harshest December weather on record.
But even without the heavy snow, the economy would have struggled to register any growth, according to the Office for National Statistics, an assessment that spooked financial markets, sending the pound tumbling against the dollar GBP=.
"This is a horrendous figure. An absolute disaster," said Daiwa economist Hetal Mehta.
"It seems that the economy is incredibly vulnerable. And with the fiscal tightening yet to fully bite, we have to brace ourselves for a bumpy ride."
Sterling fell 1.5 percent to $1.5760 and UK shares dropped on the figures, which showed Britain's economy was in trouble even before the government starts to cut public spending in earnest in 2011.
January's rise in value-added tax will only add to the economic headwinds, making a strong bounce back at the start of 2011 unlikely.
The data, following growth of 0.7 percent in the third quarter, reverberated beyond Britain's shores, fanning worries about the health of the global recovery.
Britain is the first G7 country to report Q4 GDP data and its results can set the trend. Economists had predicted growth of around 0.5 percent, with forecasts ranged between 0.1 and 0.6 percent growth.
New IMF figures released on Tuesday forecast UK growth of 2.0 percent this year, lower than in Germany, the United States and others. That forecast now looks optimistic. [ID:nN21EO] <^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^ For graphic on GDP and inflation: r.reuters.com/syp67r ^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^>
With UK inflation at 3.7 percent almost double the Bank of England's target, Tuesday's shock figures raise the ugly spectre of stagflation and leave the central bank with an acute policy dilemma.
Investors took the view that the BoE would refrain from an early rate rise, despite coming under attack for failing to curb inflation, and interest rate futures <0#FSS:> soared.
The June short sterling FSSM1 contract leapt 14 ticks -- its biggest one-day gain since last June's Budget and almost completely reversing its losses since the start of this month, as investors took their bets on a May rate hike off the table.
"We have been of the opinion that the Bank of England should not raise interest rates until the first quarter of next year," said Stuart Green, economist at HSBC. "I think the data really confirms the idea that, given the headwind the economy is facing, that this monetary stimulus is still required."
Although inflation remains far from the double-digit rates of the 1970s, economists are dubbing the outlook "stagflation-lite" and predict it could be around for a while.
Stagflation is a term coined to describe a toxic combination of moribund growth and rising prices.
NO TURNING BACK
Tuesday's data is backward looking but economists said it highlighted how vulnerable growth was to negative shocks -- something that will worry the government as it steps up its five-year plan to slash Britain's budget deficit.
Construction and service sector output both posted big quarterly falls, the former dropping by 3.3 percent to record its biggest quarterly decline since the start of 2009 when Britain's economy was deep in recession.
Osborne insisted that the shrinking economy was no reason to deviate from his programme of public spending cuts.
"There is no question of changing a fiscal plan that has established international credibility on the back of one very cold month," he said.
Separate ONS figures showed Britain's public sector net borrowing rose from a year ago to its highest December reading on record, though it fell from the all-time record reached in November.
Public sector net borrowing came in at 15.3 billion pounds ($24.47 billion) in December, below the 18.1 billion pounds forecast but above December 2009's total of 14.3 billion pounds. (Editing by Mike Peacock)