U.K. Economy Shrinks Unexpectedly as December Freeze Precedes Budget Cuts

Britain’s economy unexpectedly shrank the most in more than a year in the fourth quarter as construction slumped and the coldest December in a century hampered services and retailing.

Gross domestic product fell 0.5 percent after increasing 0.7 percent in the previous quarter, the Office for National Statistics said in London today. Growth would have been “flattish” without the impact of the weather, it said. The median forecast in a Bloomberg News survey of 33 economists was for an increase of 0.5 percent.

The pound dropped after the report, which shows the U.K. recovery faded even before Prime Minister David Cameron’s government increased sales tax to 20 percent this month, which may damp consumer demand this year. The data may reinforce calls for the Bank of England to hold off increasing its key interest rate to curb inflation. Governor Mervyn King, who leads the bank’s divided policy committee, delivers his first public speech of the year later today.

“The economy is underheating, not overheating,” Neil Mackinnon, an economist at VTB Capital Inc. in London and a former Treasury official, said in a phone interview. “An interest-rate increase would easily push the economy back into recession and would be a major policy error.”

Photographer: Chris Ratcliffe/Bloomberg

Construction slumped 3.3 percent in the fourth quarter from the previous three months. Close

Construction slumped 3.3 percent in the fourth quarter from the previous three months.

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Photographer: Chris Ratcliffe/Bloomberg

Construction slumped 3.3 percent in the fourth quarter from the previous three months.

The pound fell as much as 0.9 percent against the dollar after the data and was at $1.5790 as of 11:12 a.m. in London. It was down 1.2 percent since yesterday, the most since Dec. 15. U.K. 10-year gilts rose, with the yield falling to 3.58 percent.

‘Disappointing’

The GDP drop is the biggest since the second quarter of 2009, when it fell 0.8 percent. The statistics office said the data is “more liable to revision than usual.” None of the economists in the survey forecast stagnation or contraction. From a year earlier, the economy expanded 1.7 percent.

While these are “obviously disappointing numbers, there is “no question of changing” the fiscal plan, U.K. Chancellor of the Exchequer George Osborne said. “We will not be blown off course by bad weather.”

His opposition counterpart Ed Balls said in a statement that the figures were a “matter of great concern.”

“George Osborne and the Treasury must urgently re-think their reckless plan to cut the deficit too far and too fast and start putting growth and jobs first,” Balls said.

King’s Speech

Britain is the first member of the Group of Seven nations to report official growth data for the fourth quarter. The depth and breadth of the global recovery will be a focus for 2,500 political, business and academic leaders meeting at the World Economic forum in Davos, Switzerland from tomorrow.

Services, which make up 76 percent of the economy, shrank 0.5 percent in the fourth quarter from the previous three months, the statistics office said. Industrial production rose 0.9 percent, including a 1.4 percent gain in manufacturing. Construction slumped 3.3 percent. The economy grew 1.4 percent in 2010, the first full year of expansion since 2007.

King is due to deliver his speech in Newcastle, England at 7:40 p.m. local time. The Bank of England left its key rate on hold this month, and the outlook for growth and inflation has divided U.K. policy makers. Consumer-price increases accelerated to an annual 3.7 percent in December, the 13th month it’s been above the central bank’s 2 percent target.

‘Mistake’

While policy maker Adam Posen has described recent price gains as temporary, his colleague Andrew Sentance said late yesterday it’s a “mistake” to label “global factors affecting inflation as one-off short-term disturbances.”

“Emerging market and developing economies which appear to have shaped global price developments over the past decade, and this pattern looks set to continue into the future,” he said.

Investors have pared bets in the past week on interest-rate increases this year. The implied yield on 90-day short-sterling futures expiring in December, which rose to as high as 1.62 percent on Jan. 18 when the inflation report was published, was at 1.37 percent today.

“Any notion that interest rates were going to be put up earlier than the fourth quarter this year, this is the final nail in the coffin for that sort of talk,” said Hetal Mehta, an economist at Daiwa Capital Markets Europe Ltd. in London. “The government will have to rely on the Bank of England to keep interest rates very low for a very long time in order to allow them to continue with their fiscal tightening.”

Snow last month kept Britons away from shops, creating the biggest-ever drop in retail sales for a December. Surveys by the Chartered Institute of Purchasing and Supply and Markit Economics Inc. showed services and construction also shrank.

‘Uncertain’

The CIPS gauge of manufacturing nevertheless showed the recovery in factory production continued, bolstered by a drop in sterling. The U.K. currency has fallen 20 percent on a trade- weighted basis since the start of 2007.

The recovery faces further headwinds from government cuts to tackle a deficit that widened to 15.3 billion pounds ($24.4 billion) in December from 14.3 billion pounds a year earlier. The shortfall is projected to hit 10 percent of GDP this year.

The U.K. “is a very uncertain market because of the VAT increase and the overall economic environment,” Thierry Falque- Pierrotin, chief executive officer of Kesa Electricals Plc, Europe’s third-largest electronics retailer, said on Jan. 19. The company that day said same-store sales fell 4 percent in the 11 weeks to Jan. 18.

The GDP number “makes for some pretty nasty reading, but it does not reflect the underlying the condition of the economy,” said Philip Shaw, an economist at Investec Securities in London. Still, “it may be an reality check for markets to think about where interest rates will go for the rest of the year.”

To contact the reporter on this story: Jennifer Ryan in London at jryan13@bloomberg.net

To contact the editor responsible for this story: Craig Stirling at cstirling1@bloomberg.net

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