By David Milliken and Daniel Bases
LONDON/NEW YORK (Reuters) - Britain suffered its first ever sovereign ratings downgrade from a major agency on Friday when Moody's stripped the country of its coveted top-notch triple-A rating, dealing a major blow to finance minister George Osborne.
Moody's said weak prospects for British economic growth, which have thrown the government's deficit reduction strategy off course, lay behind its decision to cut the rating by one notch to Aa1 from Aaa.
Austerity has been the watchword for Osborne's fiscal policy since his Conservative-led coalition came to power in 2010 after an election in which he vowed to defend Britain's triple-A rating, which can help keep down borrowing costs.
But a very slow recovery from the financial crisis has pushed back by at least two years the government's goal of largely eliminating the budget deficit by 2015's election.
The opposition Labour Party blames the deficit on too much austerity.
Nonetheless, Osborne insisted now was not the time to change course. His annual budget due on March 20 is expected to show a further deterioration in the country's fiscal outlook.
"Tonight we have a stark reminder of the debt problems facing our country and the clearest possible warning to anyone who thinks we can run away from dealing with those problems," he said in a statement. "Far from weakening our resolve to deliver our economic recovery plan, this decision redoubles it."
However, the downgrade may fuel unease amongst members of his own party and his Liberal Democrat coalition partners that Osborne's gamble that he could slash the deficit and ensure a return to growth by the May 2015 election is failing to pay off.
Sterling fell by almost a cent to around $1.5160 after the downgrade, just off Thursday's fresh 2-1/2-year low, and analysts expected it to weaken further on Monday, even if many had seen a downgrade coming sooner or later.
"It's a pretty big deal," said Kathy Lien, managing director at BK Asset Management in New York. "We didn't see a huge reaction in the pound because it's late in the New York session. But you'll see some more aggressive selling when the markets open (in Asia) on Sunday."
Moody's said the outlook on its rating on Britain was now stable, meaning any further change is unlikely for the next year or so.
Britain joins the United States and France in having lost its triple-A rating from at least one major agency, after holding a top-notch rating from Moody's and Standard & Poor's since 1978, and from Fitch Ratings since 1994.
Moody's said that despite considerable economic strengths, Britain's growth was likely to be sluggish due to a mix of weaker global economic activity - especially in the euro zone - and a drag "from the ongoing domestic public and private-sector de-leveraging process."
"This period of sluggish growth poses challenges to the government's fiscal consolidation program, which we now assume will extend well into the next parliament," Moody's analyst Sarah Carlson said in a telephone interview with Reuters.
But Ed Balls, the Labour Party's main spokesman on finance issues, said the Moody's decision should be a wake-up call for Osborne ahead of his annual budget statement as Chancellor of the Exchequer.
"This credit rating downgrade is a humiliating blow to a Prime Minister and Chancellor who said keeping our AAA rating was the test of their economic and political credibility."
"The issue is no longer whether this Chancellor can admit his mistakes but whether the Prime Minister can now see that, with UK economic policy so badly downgraded in every sense, things have got to change."
Howard Archer, chief UK economist at IHS Global Insight, said a new approach from Osborne was improbable.
"The strong likelihood is though that it will not materially lead to a change in his plans."
Changes are more likely from the Bank of England, which surprised markets earlier this week after it revealed that Governor Mervyn King and two other policymakers favored restarting bond purchases to boost the economy.
They remained in the minority among their fellow policymakers but economists increasingly expect more stimulus eventually by the central bank.
This - and the central bank's tolerance of above-target inflation - have combined to put pressure on sterling while leaving British government debt relatively shielded.
Charles Diebel, a fixed income strategist at British bank Lloyds, was sanguine about the impact of the downgrade on gilts, as U.S. and French debt was not badly affected when these countries lost their triple-A ratings.
"This has been speculated as inevitable and is most likely largely in the market. I would expect only very limited damage to the gilt curve and to sterling. Historically, losing your AAA is actually a bond bullish event," he said.
(Additional reporting by Steven C. Johnson in New York and Michael Holden in London; Editing by James Dalgleish, Jon Hemming and Eric Walsh)