LONDON (Reuters) - The economy barely grew between April and June and industrial output shrank, casting doubt over the government's ability to erase the budget deficit and raising pressure on the chancellor to boost growth.
The government pledged to stick to its drive to eliminate a budget deficit of some 10 percent, brushing off opposition calls for emergency tax cuts, and Business Secretary Vince Cable said the Bank of England may have to step up stimulus should the economy fail to gain traction.
Gross domestic product grew by 0.2 percent in the second quarter compared to the first. That took the annual growth rate to 0.7 percent, the lowest since the first quarter of 2010, the Office for National Statistics said on Tuesday.
Analysts polled by Reuters had expected such a reading after the economy flatlined over the six previous months.
The pound rose and gilt futures dropped after the data as some investors had braced for a worse figure, with some economists predicting an outright fall in GDP.
"If you consider that the bank holiday for the Royal Wedding probably subtracted a quarter percent or so from growth, the numbers aren't that far from being respectable," said Investec economist Philip Shaw. "However, looking forward there are a number of headwinds to growth and the policy outlook remains very uncertain."
The Bank of England is seen holding interest rates at a record low for at least several more months given the weakness of the economy, though a fresh round of asset buying by the central bank is unlikely with inflation running above 4 percent.
The sluggish economy is a serious headache for a government already under pressure over politicians' ties to Rupert Murdoch's media empire in the wake of a phone hacking scandal.
The Labour party and business lobby groups called for a cut of value-added tax to boost the economy.
"The cautious thing to do is to change course before it is too late, not to plough on with a reckless gamble which doesn't seem to be working," said shadow finance minister Ed Balls.
The government has left little doubt that it would stick to austerity measures, which include tax hikes and unprecedented cuts in public spending. Chancellor George Osborne said the economy was stable thanks to the government's commitment.
"There is no need for a Plan B. We have to stick to deficit reduction," Business secretary Cable said. "If we do need a new stimulus to demand, it's got to come through monetary policy."
Economists expect the government to keep up its austerity drive which it has made its centrepiece policy.
The government's borrowing plans for this year are based on 1.7 percent growth, which looks optimistic, meaning tax receipts may suffer. That could leave Osborne with the unpalatable choice of cutting harder, or missing his debt-cutting targets.
A Reuters poll of economists earlier this month showed the United States is seen growing 2.5 percent this year, Germany is expected to storm ahead by 3.4 percent while Britain will grow by just 1.3 percent.
Bank of England policymaker Martin Weale told Germany's Handelsblatt newspaper there was a real danger that Britain's economy could contract again, though he also repeated his call for a pre-emptive interest rate increase to fight inflation.
The ONS said special factors such as an additional holiday for the royal wedding and the after-effects of the tsunami in Japan weighed on growth, which could have been as high as 0.7 percent without them.
"There is likely to be some bounceback over the autumn, but it's clear that the underlying economic recovery remains fragile and difficult," said Ian McCafferty, chief economic adviser at the employers' organisation CBI.
Business surveys have indicated manufacturers are facing a slowdown, banks are keeping credit tight as they repair their balance sheets and consumers are suffering the worst squeeze in income for 30 years on the back of soaring food and fuel prices, higher taxes and slow wage increases.
Abroad, the euro zone crisis poses another risk for Britain with its large banking sector and close trade ties to the area.
The Bank of England has warned that Britain faces tough times ahead and discussions about a fresh round of asset purchases have intensified over the last couple of months among rate-setters, who have kept interest rates at a record low of 0.5 percent for nearly 2-1/2 years now.
"The fact the economy is growing more slowly than the Bank anticipated ... pretty much writes off any chance of a hike in 2011 unless we get a growth miracle towards the end of the year," said Commerzbank economist Peter Dixon.
Markets are only pricing in a first full quarter-point interest rate increase in October 2012 but most Bank watchers say further stimulus is unlikely as long as inflation runs at more than twice the Bank's 2 percent target..