UK economy shrinks and pound plunges

An unexpected contraction in the British economy shocked investors on Tuesday, prompting a sharp drop in the pound and reigniting debate about the government's plans to slash spending and raise taxes to reduce public debt.

The figures showing a 0.5 percent GDP drop in the last three months of 2010 reined in expectations that the Bank of England would start raising interest rates soon in response to stubbornly high inflation levels. Bank of England governor Mervyn King planned to deliver an eagerly awaited speech later in the day.

The Office for National Statistics blamed the dire figure mostly on heavy snow that gripped the country during December, snarling roads, crippling Heathrow and other airports and keeping people away from shops before Christmas.

But statisticians said the economy would have flatlined even without the snow, stunning markets that had been expecting a 0.5 percent increase in GDP. Stocks suffered too, with the FTSE 100 index of leading British shares underperforming its peers, closing down 0.4 percent at 5,917.71.

Britain plans sharper spending cuts than any of the other major global economies and how it fares is being closely monitored around the world, particularly in Europe.

Within a minute or two of the data's release, the pound had dropped over a cent against the U.S. dollar. By late afternoon London time, it was down 1.2 percent on the day at $1.58, above its earlier low of $1.5753.

"The fragility highlighted by today's data underlines our view that it is too early for the Bank of England to be thinking about interest rate rises despite inflation remaining above target," said Charles Davis, managing economist at the Centre for Economic and Business Research.

Recent data for December showed that consumer price inflation stood at 3.7 percent, way ahead of the Bank's target of 2 percent.

Anything Bank of England governor King says later in a scheduled speech in Newcastle on the inflation and interest rate outlook could have a huge bearing on how the pound performs over the coming days and weeks — after all, one of the main reasons behind its recent spike higher, particularly against the dollar, has been this growing view in the markets that the central bank will have to raise its main interest rate from the current record low of 0.5 percent way sooner than anticipated.

Analysts said the grim economic figures will make it difficult for the Bank of England to hike especially as the government is at the beginning of a sharp fiscal retrenchment. The raft of spending cuts and tax increases the government announced last autumn have not yet even come into force during the fourth quarter.

George Osborne, Britain's finance minister, conceded that the figures were disappointing but said the government would not be "blown off course" by the bad weather as it tries to get a grip on the public finances. Separate figures indicated that borrowing in December was much lower than anticipated, which could mean the deficit in 2010/11 come in below forecast.

"We have had the coldest weather since records began in 1910 and this has clearly had a much bigger impact on the economy than anyone expected," Osborne said.

Ed Balls, the new economic spokesman of the opposition Labour Party, urged a rethink in government policy,

"The fact is cuts which go too far and too fast will damage our economy," Ball said. "And shrinking growth and rising unemployment is not only bad news for families but will actually make it more difficult to get the deficit down."

The figures are preliminary, leaving them open to revision, and followed four quarters of growth — including 0.7 percent in the third quarter — as Britain climbed out of a deep recession.

They also come a day after a senior business leader accused Prime Minister David Cameron's government of neglecting growth while it hacked at spending.

"It's not enough just to slam on the spending brakes. Measures that cut spending but killed demand would actually make matters worse," said Sir Richard Lambert, outgoing director-general of the Confederation of British Industry.

Unlike countries like Greece and Portugal that use the euro, Britain's free-floating currency allows it more flexibility in generating growth because a falling currency boosts exports.

Without that option available, Europe's more indebted countries have to do more domestically to reduce costs to boost competitiveness. Invariably that leads to even more drastic declines in living standards.

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Robert Barr contributed to this story.