The UK economy unexpectedly contracted in the fourth quarter of 2010 as the harshest winter in a century hit retail and service sectors. GDP fell by 0.5% in Q4 after having increased for the last 4 quarters according to the Office for National Statistics this morning. The ONS said that growth would have been flattish in the fourth quarter without the impact of the weather and that weather-related disruptions accounted for most of the 0.5% decline.

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The pound was immediately lower against its major trading partners shedding 1% against the USD after the release. The pound had been softer through the latter half of the Asia/Pacific session and early in Europe as many expected growth in the UK to have slowed from the previous quarter. Few, however, expected such a disappointing outcome, resulting in the sharp sell-off in the pound.

The aforementioned comments from the ONS that growth would have been flattish without the severe cold weather are problematic too as there is now a fear that the UK recovery is losing momentum even before the government steps up its austerity measures. The measures are widely expected to cost the UK some 330,000 public sector jobs and are likely to slow consumer spending further as many fear for their jobs and save larger portions of their income. This is coupled with the fact that the government plans to raise the sales-tax rate in an effort to tackle the deficit.

All these factors combined make for a very uncertain outlook in the UK with growth worryingly low and slowing, with inflation uncomfortably high. The Bank of England faces an immense task in deciding how to reconcile these uncertainties and walk a course which will damp down inflationary pressures but will still support the recovery. The annual inflation rate hit 3.7% in December, the highest in 8 months.

Written by Jonathan Granby, DailyFX Research Team

If you wish to contact the author with comments or questions email jgranby@fxcm.com

DailyFX provides forex news on the economic reports and political events that influence the currency market.
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