Meagre growth keeps deficit debate alive

A worker stands in the doorway of a train at the Bombardier plant in Derby, July 5, 2011.

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 Bank of England is seen holding interest rates at a record low for at least several more months given the weakness of the economy and Tuesday's number may keep debate about the need for further stimulus alive.

Britain's gross domestic product grew by 0.2 percent in the second quarter compared to the first, which 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.

Economists polled by Reuters expected growth of 0.2 percent 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 ONS said special factors such as an additional holiday for the royal wedding and the after-effects of the tsunami in Japan subtracted up to 0.5 percentage points of quarterly growth in the second quarter.

"GDP growth could have been as high as 0.7 percent if we discount the effects that we have seen in this quarter," it said.

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 as well as business lobby groups have called for emergency tax cuts to boost the economy.

The government has left little doubt that it would stick to its deficit reduction plan. Chancellor George Osborne said the economy was stable thanks to the government's commitment.

"Abandoning that now, as some argue we should, would only risk British jobs and growth," he said in a statement after the GDP data release.

Economists expect the government to keep up its austerity drive which it has made its centrepiece policy.

The government's figures are based on 1.7 percent growth this year which looks optimistic, meaning tax revenues fall short of expectations. That could leave Osborne with the unpalatable choice of cutting harder and faster, or missing his debt-cutting targets.

Bank of England policymaker Martin Weale told Germany's Handelsblatt newspaper there was a real danger that Britain's economy could contract again.

SPECIAL FACTORS

The ONS said industry output fell 1.4 percent on the quarter, while the service sector expanded by 0.5 percent, driven by growth in transport, storage and communication as well as business services.

The services sector rebounded strongly in May, growing 1.6 percent on the month after a 1.2 percent drop in April, caused by the extra holiday for the royal wedding.

"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 that manufacturers are facing a slowdown because the global economy is cooling and domestic demand remains sluggish.

Banks are keeping credit tight for small companies 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. So far, only BoE policymaker Adam Posen has voted for more quantitative easing.

"The fact the economy is growing more slowly than the Bank anticipated probably means they're going to be a little bit more cautious about raising rates," said Commerzbank economist Peter Dixon. "I would say that pretty much writes off any chance of a hike in 2011 unless we get a growth miracle towards the end of the year."

Most BoE watchers say further stimulus is unlikely as long as inflation runs at more than twice the Bank's 2 percent target and special factors made the assessment of the underlying economic trend difficult.