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Blow for Osborne as economy shrinks by 0.5 per cent

Fears of a double-dip recession return after economy unexpectedly contracts.

Most forecasters predicted economic growth of 0.4 per cent in the fourth quarter of 2010 but, as is often the case, the consensus was badly wrong. The economy actually shrank by 0.5 per cent, according to the first estimate by the Office for National Statistics.

George Osborne has inevitably cited the poor weather in the government's defence but even without the snow, the ONS says, growth would have been flat at 0 per cent. After strong growth of 0.7 per cent in the third quarter and 1.1 per cent in the second quarter (largely thanks to the last government's stimulus package and the Bank of England's ultra-loose monetary policy), the economy is running on empty again. Overall growth for the year was 1.4 per cent, significantly below the Office for Budget Responsibility's prediction of 1.8 per cent.

With the effects of the VAT rise yet to be felt and the spending cuts still to come in April, there is now a real risk of a double-dip recession – two successive quarters of negative growth. It's a good day for Labour to have Ed Balls, who has frequently warned of a double dip, leading the attack. But he should be careful this morning to strike a tone of concern, rather than one of vindication.

Meanwhile, as the graph I've put together shows, the spectre of stagflation – rising prices combined with falling growth – has returned.

GDP

The biggest difficulty for the government is that Osborne has few monetary weapons at his disposal. Interest rates are already at record lows and the exchange rate has fallen sharply since the crisis began in 2008. By contrast, as Robert Skidelsky noted in an essay last year for the NS, after the savage cuts of the 1981 Budget, Geoffrey Howe was able to loosen the money supply by cutting interest rates by 2 per cent.

Insofar as the government has a plan B, it is for further quantitative easing (QE). But with the cost of unsecured loans significantly higher than before the crisis, it is far from certain that another monetary injection will have the desired effect. Osborne is also under growing pressure from the inflation hawks to raise interest rates and avoid another round of QE.

For now, the government is sticking to its Thatcher-like insistence that there is no alternative. But if the next set of growth figures (published in April) show little improvement, Osborne will begin to come under significant pressure to postpone the cuts. The Chancellor's decision to declare hubristically last November that "the plan is working" now looks like a very poor judgement indeed.