UPDATE 3-British economy suffers shock Q4 contraction

Tue Jan 25, 2011 10:34am EST

* Q4 GDP shrinks 0.5 pct, first quarterly drop since Q3 2009

* Growth probably flat excluding snow impact - stats office

* Government says won't turn back on austerity programme

* Markets back off early rate rise expectations

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By Christina Fincher and David Milliken

LONDON, Jan 25 (Reuters) - Britain's economy unexpectedly shrank in the last three months of last year, prompting warnings of a grim 2011 as the government embarks on the deepest spending cuts in a generation.

The figures also complicate life for the Bank of England, which has come under fire for failing to keep a grip on inflation but which will be reluctant to raise interest rates when the economy is so weak.

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.

Evidence that Britain's economy was in trouble even before the bulk of the budget austerity kicks in shocked financial markets, braced for growth of between 0.1 and 0.6 percent.

January's rise in value-added (sales) tax will only add to the economic headwinds, making a bounce back at the start of 2011 unlikely.

"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."

The sharp reversal from growth of 0.7 percent in the third quarter and 1.1 percent in the second sent the pound tumbling more than a cent against the dollar GBP=D4.

European shares and commodity prices also fell as the data disappointment reverberated beyond Britain, the first G7 country to report Q4 GDP numbers.

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For Breakingviews column, click [ID:nLDE70O0T7]

For graphic on GDP and inflation: r.reuters.com/syp67r

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STAGFLATION FEARS

The figures both challenge the viability of the government's austerity plan and leave ministers hoping the central bank will be able to keep monetary policy loose and help deliver growth.

"There is no question of changing a fiscal plan that has established international credibility on the back of one very cold month," Osborne said.

"One of the advantages of having a credible fiscal plan is it gives the Bank of England the freedom -- and it's independent in making these choices -- to keep interest rates lower for longer," he later told BBC radio.

Some economists, however, have warned of "stagflation" and Ed Balls, opposition Labour's finance spokesman, criticised the government's policy of "slamming on the brakes".

"We always need to keep this economy moving, keep it growing," he told the BBC. "There is a plan B, there's a better way to do this."

With UK inflation almost double the Bank of England's 2 percent target, the bank in turn is under growing pressure to raise interest rates to stop expectations of high price growth bedding down for years to come.

Stagflation, a term to describe a toxic combination of moribund growth and rising prices, was coined in the 1970s when inflation in Britain rose well into double-digits.

At 3.7 percent, UK inflation is far from historic peaks but well above U.S. levels of 1.5 percent and euro zone inflation which has only just ticked above the European Central Bank's 2 percent comfort ceiling.

NO EARLY RATE RISE

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.

Although the data is backward looking, economists said it highlighted how vulnerable growth was to negative shocks.

The June short sterling contract leapt 14 ticks -- its biggest one-day gain since last June's Budget as investors took their bets on a May rate hike off the table.

British interest rates have stood at a record low 0.5 percent since March 2009, when the BoE turned monetary stimulus up to full throttle to deal with the recession.

"I think the data really confirms the idea that, given the headwind the economy is facing, that this monetary stimulus is still required," said Stuart Green, economist at HSBC.

IMF forecasts released before the GDP data suggested Britain's economy would grow 2 percent in 2011, more slowly than both Germany and the United States. Analysts said even that now looked optimistic. (Additional reporting by Fiona Shaikh and Mohammed Abbas) (Editing by Mike Peacock and Patrick Graham)

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