* UK Budget raises risk of sluggish growth
* VAT rise likely to keep CPI above target for another year
* Inflation pressure limits chance of more QE
By David Milliken
LONDON, June 22 (Reuters) - Britain's economic recovery could grind to a halt early next year when it bears the brunt of hefty tax rises and unspecified spending cuts set out earlier on Tuesday in finance minister George Osborne's first Budget.
Moreover the Bank of England will face a dilemma as higher value-added tax looks set to cause inflation to spend another year above target at a time when extreme fiscal pressure might otherwise argue for more quantitative easing.
Nonetheless, most economists think Britain's new coalition of Conservatives and Liberal Democrats had little option but to deliver the toughest Budget in a generation to tackle Britain's worst-ever peacetime budget deficit.
"They didn't have the luxury of not taking action, and on balance the scale of deficit reduction is marginally less than what we expected," said Ross Walker, economist at Royal Bank of Scotland.
Ratings agency Standard & Poor's put Britain's triple-A government debt rating on negative watch a year ago due to the fiscal hit from Britain's deepest recession since World War Two, and Osborne has made stopping a downgrade a key policy goal.
But political will alone is not enough for the coalition to balance Britain's budget before the next election in 2015.
However much effort Osborne puts into driving down government spending, the exports that will be needed to fuel growth and tax revenue hinge on buoyant demand from Britain's equally stricken European trading partners -- a sharp contrast to when Canada and Sweden cut huge deficits in the 1990s.
"Can you have coordinated cuts in public spending across the world and not go back into a period of very slow growth or even recession," asked Peter Hemington, partner at accountants BDO.
The answer according to Britain's newly created Office for Budget Responsibility is yes. In forecasts after the Budget, it predicted that the economy would grow by 2.3 percent next year and by around 2.8 percent a year for the four years after that -- only fractionally less than it forecast before the Budget.
Given that over the period the coalition plans to raise taxes and cut spending by a combined 135 billion pounds to all but erase a budget deficit of 11 percent of GDP, this modest impact on growth looks far too optimistic, argues BNP Paribas economist Alan Clarke.
Assuming every pound less of government spending reduced GDP by a pound in the short-run, that would imply growth of just 1 percent in 2011 -- with quarterly growth close to zero in the first six months of the year, Clarke said.
"This is supposed to be the most aggressive fiscal tightening in a generation and (the OBR) merely knocks 0.1 percentage points off growth in a single quarter," said Clarke.
"Needless to say we suspect the government's growth projections will be disappointed."
Other economists are more optimistic. Walker sees downside risks from weak export demand, but otherwise thinks the new OBR estimates are in the right ballpark, and the National Institute of Economic and Social Research takes a similar view.
BOE DILEMMA
The BoE will also face a dilemma, as the budget will exacerbate inflation in the short term while putting pressure on growth in the medium term. Interest rates are already at a record low of 0.5 percent, and it suspended is quantitative easing policy of buying government bonds in February.
Inflation has been above the BoE's 2 percent target since the start of the year due to a rise in VAT on Jan. 1, and economists expect another year of above-target inflation is on the cards due to the increase in VAT sales tax to 20 percent pencilled in for Jan. 4, 2011.
In theory the BoE, with its medium-term view of growth in inflation, should look past these one-off upward shocks to inflation and focus instead on longer-term growth weakness.
"On a bald reading ... the case could be made for further policy loosening, ie more QE," said Simon Hayes, economist at Barclays Capital.
"However, taking the VAT increase into account we think it highly unlikely that QE would be extended ... as this would be likely to have an adverse impact on monetary credibility and inflation expectations," Hayes continued.
But Clarke was less sure, saying the fiscal tightening due for 2011/12 and 2012/13 would push the central bank's inflation forecast down to 1 percent or lower at the two-year horizon that is key for BoE policy decisions.
"If this is not enough to trigger additional unconventional monetary policy easing, we don't know what is," he said.
(Editing by Ron Askew)