BRITAIN’s economy is out of the financial frying pan and into the fires of recession, according to a forecast from the Ernst & Young Item Club to be published tomorrow.

It comes ahead of official figures to be released on Friday which will be widely seen as confirmation that the economy has entered recession.

Gross domestic product is expected to have slipped by 0.2% in the July-September quarter after no growth in the second.

Economists expect a further fall in the final three months of the year. The Item Club says the economy will contract by 1% next year, making this a full-blown recession, and recover by a feeble 1% in 2010.

“We have to face up to the reality of an economy that has been seriously weakened by recent dramatic events,” said Peter Spencer, its economic adviser.

“The effects of the credit crisis are spreading out from the financial and housing sectors and impacting every part of our domestic economy,” he said.

He warned that the recession could be even more severe if the Bank of England fails to cut interest rates enough or that further action to stabilise the financial system, if needed, is not taken.

Item predicts a drop in Bank rate to 3% next year, its lowest for half a century. Inflation, it says, will “start tumbling” by the end of the year and will average 2.8% next year before dropping below the Bank’s 2% target in 2010.

“Even if the equity markets stabilise and we begin to see capital flowing around the international banking system again we are looking at a domestic and global economy that will be in recession for the next 12 months,” Spencer said.

“But with plunging interest rates, falling inflation, a fundamentally strong economy and some sort of stability in the banking system, it should be a relatively short and shallow downturn.”

Even so, there will be a sharp rise in unemployment. It predicts a doubling in the claimant-count unemployment rate from 2.5% to 5%, implying a jobless total of over 1.5m. On the wider Labour Force Survey measure of unemployment it predicts an increase in the rate from 5.7% to 7.8%, equivalent to nearly 2.5m.

Forecasters have become gloomier about economic prospects following grim survey evidence and figures last week showing the sharpest rise in the wider measure of unemployment since the early 1990s. Figures for the public finances, also to be published this week, will underline the impact of the downturn on the government’s books.

The Item Club predicts that public-sector net borrowing will total £60 billion this year, 2008-9, nearly 50% above the Treasury’s £43 billion forecast. Borrowing will surge to £92 billion, or 6% of gross domestic product, next year, it predicts. George Osborne will today urge the government to allow small and medium-sized firms to defer their Vat bills for up to six months to help businesses struggling with cash flow due to the credit crunch.

The shadow chancellor will say many small businesses have had overdrafts either withdrawn or interest rates raised above 15%. The next Vat bill could force many out of business, he warns.

Her Majesty’s Revenue & Customs (HMRC) is aggressive with businesses that are late with Vat payments, the Tories say, with the first late-payment triggering a warning and subsequent late payments incurring penalty charges of up to 15% of their tax bills.

Under the Conservative scheme, firms would be able to defer Vat bills for up to six months. Any deferred tax would be charged at the usual HMRC interest rate for late payments of other taxes, currently 7.5%.

“This is another example of the Conservatives offering practical help to save jobs and businesses during very difficult economic times,” Osborne said.

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