* 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
By Christina Fincher and David Milliken
LONDON, Jan 25 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
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
"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.
For Breakingviews column, click [ID:nLDE70O0T7]
For graphic on GDP and inflation: r.reuters.com/syp67r
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
(Additional reporting by Fiona Shaikh and Mohammed Abbas)
(Editing by Mike Peacock and Patrick Graham)