Britain will slip into a modest recession early next year, the OECD said, slashing its 2012 growth forecast and urging the Bank of England to expand its asset purchase programme.
On the eve of Chancellor George Osborne's latest budget and growth announcements, the Organisation for Economic Co-operation and Development said the government may have to temporarily relax its deep austerity drive if conditions turn even worse.
The Paris-based agency said Britain's output will fall by 0.1 per cent in the fourth quarter of 2011 and by 0.6 per cent in the first three months of next year, before picking up during the rest of the year.
Economists define a recession as two consecutive quarters of contraction.
The OECD predicted Britain's economy would grow by 0.5 per cent next year, down from the 1.8 per cent it forecast in May. Its forecast is just half the one per cent average for 2012 growth seen in a Reuters poll of 42 economists conducted earlier this month.
Public spending cuts, falling household consumption and weak exports have weakened the UK economy, and more support is urgently needed to help it through strong headwinds, the Organisation for Economic Co-operation and Development said in a report.
The Bank's decision to keep interest rates at a record low of 0.5 percent since March 2009 and to pump 275 billion pounds into the economy through the purchase of UK government bonds has been helpful, but it should go further, the OECD said.
Growth will be even weaker than forecast unless the central bank expands the scheme to £400bn by early 2012, a far higher figure than most economists expect by that time.
That would leave the Bank with almost 40 per cent of the total stock of outstanding government bonds.
"More support is needed urgently as headwinds are strong," the OECD report said.
Britain's independent fiscal watchdog is also expected to cut its forecasts on Tuesday, forcing Osborne to borrow more to balance the books.
Britain is one year into a programme of tax rises and spending cuts to eliminate a budget deficit that peaked at 11 percent of GDP. The Conservative-led coalition government has rejected opposition calls to ease up on its cuts.
The OECD said Britain should stick to its fiscal plans because they have bolstered credibility and helped maintain low yields on government bonds.
However, if the economy deteriorates more than expected, the government should consider short-term fiscal measures to boost output, for example by softening planned public investment cuts.
"Credibility will demand that the medium-term fiscal targets be retained and achieved, implying greater tightening later on," the OECD report said.
If things turn out to be worse than feared, banks may need to be recapitalised, preferably with private money. However, governments must be prepared to step in, the OECD said.
The report forecast that the UK unemployment rate will rise to 9.1 per cent by 2013. That will exacerbate social problems and lead to a rise in homelessness, the OECD said.
City A.M. Reporter