GDP shrinks at worst time for govt, BoE

LONDON Wed Jan 26, 2011 11:50am GMT

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LONDON (Reuters) - A surprise contraction in the economy challenges the viability of the government's severe austerity plan and leaves ministers at the mercy of a central bank under mounting pressure to act against inflation.

What the Bank of England does next -- and when it does it -- could decide the future of both the economy and the Conservative-Liberal Democrat government, which is gambling on securing economic recovery by swiftly slashing a record budget deficit.

The coalition insists its austerity programme will not be derailed by one bad number, blaming Tuesday's data -- which showed GDP unexpectedly shrank by 0.5 percent in the last quarter of 2010 -- on freak winter weather, though even without the snow the economy would probably have stagnated.

While a policy reversal is highly unlikely for now, analysts say the government could use March's budget to offer some small support to vulnerable areas. But they warn that any sustained deterioration in the economy could prove a game-changer.

"If we had an actual recession -- two quarters of successive negative growth -- then you'd have a serious problem," said Wyn Grant, a politics professor at the University of Warwick.

"The problem is that if you start to backtrack then the risk is sterling falls. If you abandon the austerity plan you are in danger of losing your credit rating."

The pound fell as much as 1.4 percent against the dollar after the data was released.

Being forced to abandon their deficit plans to bolster the economy would inflict severe damage on the Conservatives -- an ideal scenario for Labour, who have warned that the government's fiscal policy is putting the recovery at risk.

The government has been criticised for its failure to come up with a "Plan B", a fall-back position were the economy to prove less resilient to public spending cuts than anticipated.

Any reverse would also add to tensions within the coalition, fuelling criticism of the Lib Dem junior coalition partners, who argued against severe cuts before the 2010 election but changed their minds during coalition talks.

ALL FOCUS ON BANK

Analysts expect deficit reduction to weigh heavily on the economy this year just as the Bank of England is considering when it should unleash an inflation-cooling interest rate rise.

Before Tuesday, investors thought an increase could come as soon as May but now it will have to be timed to perfection, with Britain's frail economic recovery faltering even before the big spending cuts bite.

"These numbers certainly seem to rule out the prospect of an early interest rate rise and could restart the debate on quantitative easing," said John Hawksworth, chief economist at PricewaterhouseCoopers.

"But the BoE is likely to want to bide its time and wait for more information to come in before making any changes in monetary policy."

Any delay to rate hikes would be welcome news for the government, which has pledged low borrowing costs as a trade-off for austerity.

But with price pressures seen strong throughout this year, households -- and policymakers -- look doomed to feel a squeeze on two fronts.

"In many ways, we have a bigger problem with inflation than anything else. The misery index is increasing. Inflation affects everyone -- people feel it in their everyday lives," said Grant.

Inflation, if left to run loose for too long, could prove just as damaging for the government as for the credibility of the independent central bank -- so both will be hoping Tuesday's shock GDP figure does not mark the start of a second downturn.

"Bad weather or not, these are truly awful figures, much worse than anyone expected. The government has a reverse Midas touch," said Brendan Barber, general secretary of the Trades Union Congress umbrella group.

"To implement drastic spending cuts when every sector bar production is in decline will hit business, send unemployment spiralling and make closing the deficit more difficult, not less."

(Editing by John Stonestreet)

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