The economy is likely to shrink by at least another 1.5 per cent in the first quarter of the year, economists warned on Tuesday after official figures showed manufacturing output suffered the largest annual decline since 1981.

With the first indications for 2009 proving much worse than expected, the economy is on course to contract at least 3 per cent in 2009, compared with the Treasury’s central forecast last November that output would fall by only 1 per cent. Capital Economics, a consultancy, said the slump could reach 4 per cent this year.

But investors put aside the gloomy data and sent the stock market rallying as traders were cheered by an internal staff memo circulated by Vikram Pandit, Citigroup chief executive, claiming the bank had been profitable in the first two months of the year.

The FTSE 100 index closed 4.88 per cent higher at 3,715, while the S&P 500, which closed at a 12-year low on Monday, was up more than 6.4 per cent in New York, with similar rises in European markets.

The poor economic data will intensify pressure on Alistair Darling, the chancellor, who is aiming to introduce additional tax cuts in the Budget on 22 April even when the public finances are fast deteriorating. Most economists expect government borrowing to surge in 2009-10, hitting £150bn or about 10 per cent of national income. In the Budget a year ago, Mr Darling forecasted a deficit of only £38bn.

Such large borrowing on top of the eventual cost of taxpayer support for banks, estimated by the International Monetary Fund at 9.1 per cent of national income or £135bn, is likely to send the core level of public sector debt close to 80 per cent of national income, twice the limit the government said was inviolable until last autumn.

With industrial production falling 11.4 per cent in the year to January, the worst fall since January 1981, Neville Hill of Credit Suisse forecasted national income in the first quarter would drop back to “levels last seen in early 2006”.

The National Institute of Economic and Social Research estimated gross domestic product fell 1.8 per cent in the three months ending February, suggesting a similarly gloomy outturn for the first quarter. “The economy is experiencing a combination of a sharp reduction in stock levels and very weak demand for manufactured goods,” the institute said.

But Britain is far from alone in suffering industrial fallout from the recession. French industrial output declined by more – 3.1 per cent in January – and German exports are 20 per cent lower in January than a year earlier.

The silver lining in all these figures is that a substantial part of the pain in industry comes from temporary factory closures as manufacturers sell accumulated stock. A rebound can be expected once companies’ unsold stocks fall and production lines are restarted.

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