A shaken coalition government today lashed itself to the mast of multi-billion spending cuts and rejected calls for a change of economic course in the face of shocking figures that showed the economy contracted by 0.5% in the last quarter of 2010.

The figures, raising fears of stagflation – high unemployment and inflation with stagnant growth – mark the first serious challenge to the coalition's political and economic edifice.

In an attempt to reassure volatile markets, Mervyn King, the governor of the Bank of England, urged the cabinet to stand firm and warned of many shocks to the economy before it settled down to a consistent pattern of growth.

The markets had been expecting growth in the final quarter of 2010 in the region of 0.3% and 0.7%. Ministers blamed the coldest weather in a century or a survey error by the Office for National Statistics.

But even if the effect of the weather is stripped out, the economy was flat in the final quarter after a year of recovery. One cabinet minister privately called for calm: "It's a flash estimate based largely on two months' data. It is best to wait and see."

Meanwhile Vince Cable, the business secretary who is seen as the cabinet figure most concerned at the pace of the cuts, insisted there was no Plan B.

In cabinet, David Cameron urged colleagues to recognise that there was no alternative and said the programme to reduce the deficit was the prerequisite for a return to growth.

But even if the figures are revised upwards in a month's time, they put pressure on the chancellor, George Osborne, to find a more coherent growth plan or examine the speed of the deficit-reduction plans set out in the June spending review.

Backbench Tories are already calling for faster deregulation of the economy or lower taxes to unleash private enterprise and create growth.

The fact that the contraction has come before the economy has begun to feel the impact of the VAT rise or the start of the spending cuts, due to bite from April, has also worried ministers. Public spending was at a record high in December.

While calling for calm, King warned of further pain ahead. The public should expect further falls in incomes this year, he said, and would need to accept that inflation would remain a factor until next year as the economy coped with the cuts and the restrictions on bank lending.

He told an audience in Newcastle: "The UK economy is well-placed to return to sustained, balanced growth over the next few years as a result of a fall in the real exchange rate combined with a credible medium-term path of fiscal consolidation.

"Of course, there will be ups and downs as the squalls from the world economy blow us around. But the right course has been set, and it is important we maintain it."

However, King studiously avoided endorsing the speed and severity of the Tory-led coalition's strategy.

Government officials acknowledged that the 0.5% contraction means 2011 growth forecasts by the Office for Budget Responsibility, due to be published on the day of the budget in March, will have to be revised downwards, putting further pressure on the public finances.

Facing the first serious challenge of his chancellorship, Osborne insisted that the economy could withstand the contraction. He said: "These are obviously disappointing numbers, but the ONS has made it clear that the fall in GDP was driven by the weather.

"There is no question of changing a fiscal plan that has established international credibility on the back of one very cold month. That would plunge Britain back into a financial crisis. We will not be blown off course by bad weather.

"You wouldn't give up a fitness programme because it rained when you went for your first run. We have to keep focused on the big picture."

However, Osborne knows the entire political foundation of the coalition rests on its judgment that £81bn had to be cut from public spending – and taxes increased by £30bn – to restore confidence in the UK economy.

The shadow chancellor, Ed Balls, said the figures were a matter of "great concern" and due largely to the speed and scope of the coalition government's deficit-reduction programme.

"Simply slamming on the brakes will never work. It is not a strategy. Don't make up excuses when you need to make a change of policy. Do it quickly, Don't get dug in.

"We have inflation going up, unemployment rising, now the economy not growing. And all those boasts from George Osborne and David Cameron that the economy is out of the danger zone – it seems as though the opposite has happened."

Balls refused to predict a double-dip recession. Even some Labour-orientated economists thought the figures were too bad to be true.

But the numbers shook the Tory backbenches. Andrew Tyrie, chairman of the Treasury select committee, said: "What we need is some very, very careful thinking about this.

"What we don't want is a string of little initiatives all pointing in different directions. We want a clear coherent programme, starting with a reform of the tax system."

In the short-term the figures end speculation the Bank of England would raise interest rates in response to inflation. King, who has come under attack from some City economists for his refusal to raise rates, said prices would peak at about 5% in the next few months before falling back next year to the target of 2%.

He said pushing up base rates would simply depress the economy further. Most inflation was imported through higher oil prices and commodities, which higher domestic rates would do little to dampen, he said.

"The headlines will inevitably focus on the immediate effect of shocks on CPI inflation rather than the outlook ahead. Central banks, though, do not set policy or react according to headlines," he said.