Fears for UK economy as Osborne sharpens axe

Further warning signals emerged yesterday over the parlous position of the UK's economic recovery, just three days before the Office of Budgetary Responsibility (OBR) publishes new projections for growth that could prompt even larger public spending cuts than currently expected.

The Office for National Statistics said the manufacturing sector, until now one of the biggest contributors to the recovery, had slipped back in April, with a 0.4 per cent fall in industrial production. Although production was still 2.1 per cent higher on an annual basis, the data will unnerve economists worried that problems in the eurozone, the key export market for British manufacturers, could damage the sector's prospects.

"The key question is whether manufacturers sustain healthy growth over the medium term, particularly as fiscal policy is tightened substantially," said Howard Archer, chief economist at Global Insight. "Manufacturers will be desperately hoping the eurozone debt crisis does not derail growth."

The Bank of England added to the concerns with its monthly survey of expectations of inflation, which showed that people think price rises will average 3.3 per cent over the next 12 months, the highest level for almost two years. That could add to pressure on the Bank's Monetary Policy Committee to raise interest rates sooner than expected, with the OECD having said last month that the cost of borrowing would have to be increased before the end of the year.

The National Institute of Economic and Social Research said yesterday it believed the economy had grown by 0.6 per cent over the three months to the end of May, an encouraging report given official first-quarter growth of 0.3 per cent. But Martin Weale, the director of Niesr, was cautious.

"We hope the rate of growth will improve further but there are a number of factors which will impede growth in the coming months," he said. "The euro area may be adversely affected by the spill-over from Greece's debt crisis, the UK has recently lost competitiveness against the euro area as sterling has risen, and there are risks of renewed weakness to domestic demand as the UK's fiscal deficit is corrected."

The OBR, appointed by George Osborne last month to provide the Chancellor with independent fiscal forecasts, is due to publish its assessment of the economy on Monday. While the existing Treasury forecast of growth for this year – 1 to 1.5 per cent – is likely to be maintained, the OBR is expected to cut the forecast for next year very sharply.

The Treasury has been working on the basis that the UK economy will grow by 3.25 per cent in 2011, but the OBR could cut that projection as low as 2.2 per cent, the consensus prediction amongst independent forecasters.

Roger Bootle, managing director of Capital Economics, said that if so, the government borrowing requirement would rise by £20bn by 2015, suggesting even more drastic spending cuts would be needed to address the shortfall. "The pain starts here," said Mr Bootle. "The next fortnight marks the start of an eye-watering squeeze that could hold back the UK recovery for several years."

Nervousness about the state of the UK economy was also heightened yesterday by warnings from other countries around the world, which suggest continued doubts about the sustainability of the global recovery.

In Japan, the new Prime Minister, Naoto Kan, warned that his country could face a European-style debt crisis unless it dealt with its borrowing quickly. In the US, stock market investors were shocked by the latest retail sales data from the Commerce Department, which revealed a decline in May, the first monthly fall since last September, and added to fears that the American recovery is stalling.

In China, which the West increasingly relies upon as a key engine of growth, official figures revealed inflation had moved above the Government's 3 per cent target, raising the prospect of interest rate rises that could slow the economy. Chinese growth is already falling back on some measures, with industrial production slipping sharply in May.