Service sector gloom raises case for Bank holding fire on interest rates

The case for caution over raising interest rates gained traction yesterday as it emerged that Britain's crucial services sector had come off the boil last month.

Bank of England policymakers are torn between pushing up borrowing costs to curb inflation and leaving interest rates at their historic low of 0.5 per cent amid fears of a double-dip recession.

Those worries intensified as the latest purchasing managers' index (PMI) report for the services sector, which accounts for almost three-quarters of the UK economy, pointed to a marked slowdown in growth.

The findings were described by one economist as a "game changer", coming after the recent revelation of a 0.6 per cent slide in GDP during the final quarter of 2010.

That surprise contraction has made the central bank wary of raising interest rates too rapidly, despite consumer price inflation running at double its 2 per cent target.

Bank of England deputy governor Charlie Bean yesterday admitted that inflation was a concern but suggested that faster rate hikes may not be needed.

In a speech to UK insurers, he said: "My own judgment is that, if anything, inflation may prove a little more persistent next year than presently embodied in our projections.

"On its own, that might appear to imply that (the bank rate] needs to rise faster than implied by the market yield curve that underpins our projections. But the risk of inflation staying above target into the medium term needs to be weighed against the downside risk to growth."

Markets are still pricing in two or three rate rises in 2011, starting in the middle of the year, and Bean's comments - which highlight the fragility of Britain's economic recovery - suggest he would not support any faster rate of tightening.

This makes him unlikely to imminently join his three colleagues on the Bank's monetary policy committee who voted for a rise in interest rates last month.

The service sector survey's headline activity index fell to 52.6 in February from January's eight-month high of 54.5, a peak that followed a contractionary reading in December blamed on the pre-Christmas big freeze. Any reading above 50 denotes growth.

Analysts had expected the index, which is produced by the Chartered Institute of Purchasing & Supply and information services specialist Markit, to dip to 53.5.

Alan Clarke, economist at BNP Paribas, said: "This could be a game changer. It could push the first rate hike back some way.

"The services sector looks like it is growing, but only moderately and probably not enough to meet the Bank of England's expectations.A rate hike in the next few months is not the done deal that the market had priced in."

Howard Archer, chief UK economist at IHS Global Insight, took a similar view, saying: "The marked slowdown in services activity in February to a relatively modest level bolsters the case for the Bank of England to hold off from raising interest rates in the immediate future at least."

Some analysts warned that it may be hard to get an accurate picture of recent activity in the sector due to the impact of the severe winter weather.

Vicky Redwood at Capital Economics said: "It won't be until March's survey that we get a completely weather distortion-free picture."

The report did contain some positive signals, with businesses more upbeat about the coming year's prospects than at any time since June and - excluding January's spike - the new business reading for February was the strongest in nine months.

Meanwhile, the rate of input price inflation eased slightly from January's near two-and-a-half year high.