LONDON (Reuters) - The economy will stagnate until mid-2012 and could easily fall back into recession, the government said on Tuesday, a grim outlook that puts its debt reduction plans in jeopardy and will mean more austerity for longer.
Chancellor George Osborne, unveiling much lower growth and higher borrowing forecasts than outlined in March, said the coalition government's deficit plan was still broadly on track but he had lost a one-year cushion factored in to the strategy.
Ratings agency Fitch said Britain's ability to absorb further economic shocks while keeping its top triple-A credit rating was "largely exhausted" unless the government takes further steps to cut its deficit.
In one of his two major annual parliamentary setpieces, Osborne warned the economy risked getting dragged into recession if the euro zone debt crisis was not solved.
But he said he would not deviate from hefty spending cuts outlined last year in order to protect Britain's top-notch credit rating, despite calls from economists, unions and opposition politicians for more of a focus on boosting growth.
"If the rest of Europe heads into recession it may prove hard to avoid one here in the UK," he told parliament.
"Much of Europe appears to be heading into recession caused by a chronic lack of confidence in the ability of countries to deal with their debts."
Osborne said the euro zone crisis meant getting the public finances in order was the only way to build solid foundations for future growth but markets may now doubt whether Britain can deliver on its fiscal promises and the Labour party said his plans were in tatters.
The economy was now forecast to grow by only 0.7 percent next year, way below a March budget forecast of 2.5 percent, Osborne said, presenting figures from the independent Office for Budget Responsibility.
The OBR expects the economy to shrink by 0.1 percent in the last three months of this year and then grow by just 0.1 percent in the next two quarters.
Fitch, in a statement released after Osborne's speech, said the lower, more realistic, growth forecasts boosted the credibility of the government's deficit-cutting efforts but also warned further steps were needed.
Among a raft of measures announced alongside the forecasts, Osborne said pay rises for public sector workers would be capped at one percent once a two-year pay freeze ends in 2013. Public sector job losses will rise to 710,000 from an original estimate of around 400,000.
That will fuel anger among unions on the eve of a one-day strike by 2 million public sector workers over cuts by the Conservative-led coalition that will make them pay more and work longer for their pensions.
Growth was expected to recover to 2.1 percent in 2013, down from a previous forecast of 2.9 percent, before accelerating to 3.0 percent by 2015 - a rate which analysts said was optimistic.
"The growth forecast is still a little bit unrealistic and higher than the market believes," said Colin Mclean, a fund manager at SVM Asset Management. "You question whether they can see through the plan."
Public sector borrowing will hit 120 billion pounds in 2012/13, up from 100 billion pounds forecast in the March budget. Borrowing will come in at 79 billion pounds in 2014/15, up from a previous forecast of 46 billion pounds.
Osborne said he would still meet his target of eliminating the government's structural deficit - that part not affected by changes in the economic cycle - but it would be delivered in 2016/17, two years later than estimated in March.
The coalition has made erasing a deficit that peaked at 11 percent of national output its priority.
Labour Shadow Chancellor Ed Balls accused Osborne of a catastrophic error of judgement. Labour, ousted from power in May 2010, says the coalition is squeezing the life out of the economy by cutting too much and too quickly.
It is that argument which will go a long way to deciding the result of the next election in 2015.
"The country either needs a new Chancellor or a new plan ... The Chancellor needs to change course and he needs to do so now," Balls told parliament.
The new figures bring the government broadly into line with independent forecasters for next year at least.
The OECD rich nations' economic think-tank said on Monday that Britain will slip back into a modest recession early next year. It lowered its 2012 growth forecast to just 0.5 percent and urged the Bank of England to expand its money-printing programme.
Despite fears that the country is being pushed back into recession, the government will not fundamentally change tack.
Britain has enjoyed record-low borrowing costs thanks to its perceived status as a safe-haven from the euro zone debt crisis, which helps alleviate the pressure on public finances.
The yield on 10-year gilts has been trading at 2.3 percent, well below the 3.8 percent average rate projected by the OBR in March, resulting in a total debt interest saving of 22 billion pounds up to 2015/16, Osborne said.
What stimulus there is, is likely to come from monetary policy.
The Bank of England will pump an additional 75 billion pounds into the economy in coming months, a Reuters poll indicated on Tuesday, taking the total to 350 billion as it tries to revitalise growth.
"The UK is part way through a 'lost decade', and I expect that 2012 will be another difficult year," said Michael Saunders at Citi, who expects the total BoE spend to be at least 500 billion pounds -- the highest forecast in the poll.
Recognising that he has little scope to alter Britain's short-term economic prospects, Osborne focussed on measures that will boost growth in the longer term, such as promoting lending to small businesses and encouraging private sector investment in infrastructure.
He plans to tap pension funds to provide the bulk of up to 30 billion pounds of investment in building projects, while the government will underwrite up to 40 billion pounds of loans to smaller companies struggling or credit.