By Matt Falloon
LONDON (Reuters UK) - The services sector contracted at a slower pace than expected in August, but a gloomy consumer mood failed to improve and analysts still expect the economy to shrink and interest rates to fall.
Wednesday's figures came hot on the heels of news that manufacturing has contracted for four straight months, construction has declined for six months and a warning from Chancellor Alistair Darling about the challenges ahead.
However, the closely-watched Chartered Institute of Purchasing and Supply/Markit purchasing managers' index for services companies also provided a glimmer of hope that a prolonged and deep slump could be avoided.
The index actually picked up to 49.2 last month from 47.4 in July, a surprise outcome suggesting the sector, which makes up about three-quarters of the economy, hardly shrank at all.
Even so, the index for the sector that makes up about three-quarters of the economy has held below the 50 level marking the divide between contraction and growth since May.
"While there is some encouragement that the surveys have not weakened further this month, we still think it likely that the economy will contract in the second half of this year before recording negative growth in 2009 overall," said Jonathan Loynes, an economist at Capital Economics.
Sterling rose immediately after the data against the dollar and euro as the better-than-expected figures gave investors an excuse to buy back the currency after it was driven to fresh multi-year lows earlier in the session.
The pound has been hit hard by intensifying concerns about the state of the economy. Sterling has slumped about 10 percent against the dollar in the last month and by a similar amount against the euro since the start of the year.
Investors are now convinced interest rates will fall, perhaps before Christmas, as the economy flirts with its first recession since the early 1990s.
The Organisation for Economic Cooperation and Development forecasts show the economy could enter that recession -- two consecutive quarters of negative growth -- this year.
CONSUMER GLOOM
A report from the Nationwide building society showing consumer confidence held at a series low last month, ending seven months of declines, but analysts expect retail spending to decline this year as unemployment picks up.
"We do now expect interest rates to be cut from 5 percent to 4.75 percent before the end of 2008, with a move most likely in November," said Howard Archer, an economist at Global Insight.
"Furthermore, we expect the Bank of England to cut interest rates aggressively thereafter as extended very weak economic activity contains and then increasingly dilutes underlying inflationary pressures."
However, there has been no decisive signal from the Bank of England yet that a cut is imminent because inflation is running at more than twice the official 2 percent target and is expected to spike higher in the coming months.
A weaker pound is seen adding to those inflationary pressures, as imported goods become more expensive.
No change is expected when the Bank announces its latest interest rate decision on Thursday and policymakers may also be concerned to see shops ramping up prices, with food prices in particular surging higher.
The British Retail Consortium said shop prices were 3.8 percent higher than a year ago in August, up from 3.2 percent in July and the highest since the series began in 2006. Food price inflation accelerated to an annual 10 percent.
However, there are signs that strong price pressures elsewhere are starting to come off the boil. The services PMI showed firms' cost inflation cooling, with the input price index falling to its lowest since March.
Services firms also raised their prices at a less aggressive rate last month, with the prices charged index slipping to its weakest since April.
(Editing by Stephen Nisbet)
