By David Milliken and Christina Fincher
LONDON (Reuters) - Britain ran a smaller-than-expected budget deficit in February and retail sales rebounded, data showed on Thursday, a fillip for Chancellor George Osborne a day after he released dismal economic forecasts.
The Confederation of British Industry also reported that manufacturers expect the strongest growth in output since last April over the next three months.
Deficit reduction is the key economic policy of Britain's Conservative-led coalition government, which came to power in May 2010 when Britain's budget deficit exceeded 11 percent of annual economic output - one of the highest for a major economy.
Weak growth has plagued the government's budget consolidation plans, but retail sales figures released at the same time as the borrowing figures suggested at least some temporary relief after a dismal January for retailers.
The government's preferred measure of Britain's public borrowing, which strips out some of the effects of its bank bailouts, showed a deficit of just 2.8 billion pounds in February, the Office for National Statistics said.
This is the lowest deficit for February in the last five years - albeit one flattered by one-off factors and signs that some payments may have been pushed into the next financial year - and is far below average market forecasts of an 8.45 billion pound deficit.
With just one month of the fiscal year to go, borrowing for the year to date now totals 94.9 billion pounds, excluding a boost from April's transfer of Royal Mail pension assets.
This puts Osborne on track to undershoot an upwardly revised forecast of 114.5 billion pounds for 2012/13 - equivalent to 7.4 percent of gross domestic product - released on Wednesday by government forecasters at the Office for Budget Responsibility.
Sterling rose to a two-week high against the dollar and a five-week high against the euro after the data.
"It's mildly encouraging and we can see why sterling rallied on the back of that news," said Tom Vosa, economist at National Australia Bank. "Public sector borrowing now looks to be in line with stronger employment growth."
However the economic outlook is still tough. Wednesday's upward revision to borrowing forecasts was accompanied by a downgrade to the 2013 growth forecast to just 0.6 percent - half December's prediction - and prospects for British export markets in the euro zone are even worse.
Many economists still believe the economy is at risk of tipping into its third recession in four years - even if Thursday's retail sales data make this less likely.
Retail sales volumes jumped by 2.1 percent in February - their biggest rise since March last year and much more than economists forecast - and are 2.6 percent higher on the year.
A bounce back from a snowy January and strong demand for tablet computers, sports goods and jewellery helped sales, the statistics office said.
Still, there were signs of weakness in the retail sector. Next, Britain's second-biggest clothing retailer, said trading in its new financial year had been slow.
February's strong public borrowing figures are explained by a mix of factors - many of which are not set to last.
A 2.6 billion pound transfer of cash from the Bank of England under a deal to return gilt interest to the government, and 2.3 billion pounds from the sale of next-generation mobile phone frequencies flattered the data.
Government departments' spending fell and tax receipts were up 9 percent on the year in February, outpacing a 2 percent rise seen over the tax year as a whole.
However, economists warned that the drop in government departments' spending was due in some cases to postponing payment of bills until the new financial year starting in April.
"It's likely that we'll see stronger spending next year and hopefully stronger receipts as well. But the upshot of it is we shouldn't expect the strength evident in these numbers to continue. I think next year will be a struggle," said Peter Dixon, an economist at Commerzbank.
With growth weak, the government only aims to reduce its budget deficit to 6.8 percent of GDP in the 2013/14 tax year. That compares with 3.7 percent for 2013 in neighbouring France, which has been criticised for missing its targets.
(Editing by Jeremy Gaunt.)