Recovery feeble as service sector drags

City workers cross London Bridge during the morning rush hour, in London April 11, 2011.

LONDON (Reuters) - Economic recovery looks set to remain sluggish during the current quarter, after official data showed the biggest slump in services output for more than a year in April as well as weak bank lending in May.

Consumers have reduced spending sharply due to rising prices, higher taxes and fears of government cuts, and the Bank of England has warned of more tough years ahead.

The central bank is seen keeping interest rates at a record-low 0.5 percent until well into next year despite inflation at more than twice its target, as it tries to support a recovery that is struggling to gain traction.

However, the Bank's dilemma seems to be deepening as surveys showed that more consumers expect high inflation to persist while their morale took another hit in June.

Services output contracted by 1.2 percent in April after a 0.8 percent increase in March, driven by a sharp fall in wholesale activity, the Office for National Statistics said on Wednesday. The fall was the biggest since January 2010, when heavy snow caused disruption.

"It should be noted that April 2011 was an unusual month for a number of reasons," the ONS said, citing the effect of the royal wedding and the extra public holiday to mark it.

The services sector slump adds to a 1.7 percent drop in industrial output in April, and further doused hopes of faster growth in the second quarter after the economy stagnated over the six months following September 2010.

Markit economist Chris Williamson said surveys such as the Purchasing Managers' Indices (PMI) which his company compiles showed that services providers expect growth to slow in the wake of softening domestic demand.

"Consumers and households remain deeply concerned about falling incomes and job security at the same time asthe public sector continues to tighten its purse strings," he said, adding that Q2 GDP growth would struggle to exceed 0.3 percent.

Separate data from the Bank of England showed mortgage approvals ticked up only slightly to 45,940 in May, falling short of analysts' forecast of 46,100.

Consumer credit was up only 173 million pounds, with credit card borrowing rising by just 34 million pounds, the smallest amount since April 2010.

CONSUMER WOES

Bank Governor Mervyn King and some of his fellow policymakers repeated their dire outlook for consumer spending at a parliamentary hearing on Tuesday, though they remain split over the need for extra stimulus for the economy.

A Reuters poll showed on Wednesday that economists still see the first interest rate increase in the fourth quarter, though the conviction that rates will rise this year is dwindling and markets don't price in the first move until mid-2012.

The EU's consumer sentiment survey showed that consumer morale dropped in June after a brief rebound in May.

At the same time, however, the Citi/YouGov survey showed Britons' near term inflation expectations jumped in June to 3.9 percent, the highest in over 2-1/2 years. Long-term views hit the highest level since the survey's launch in late 2005.

"The speed of the rise indicates a risk that inflation expectations are becoming destabilised," Citi economist Michael Saunders said. "The MPC's strategy is helping to rebalance the economy, but this may come at the price of a marked loss in its anti-inflation credibility."

PRODUCTIVITY WEAKNESS

Economists said the services figures would depress second-quarter GDP data at a time when the country is still recovering from its deepest recession since World War Two.

"Even assuming a bounce in May and a moderate gain in June, the average of the quarterly data implies a significant drag on Q2 GDP," said Alan Clarke, economist at Scotia Capital.

The service sector, which makes up three quarters of the economy, grew at its fastest pace since early 2007 in the first three months of 2011, and was the main factor keeping the economy out of recession.

First-quarter GDP data released on Tuesday showed the biggest annual fall in households' real disposable income since 1977, due to rising prices, slow wage growth and higher taxes. Well-known retailers such as chocolate maker Thorntons and floor-covering chain Carpetright have said they plan to close stores due to weak consumer demand.

The ONS said workers' overall productivity had improved in the first three months, rising by 0.1 percent after dropping 0.3 percent at the end of 2010. Unit wage cost growth slowed to 0.5 percent from 1.2 percent, easing inflation pressures.

Some policymakers have cited slow productivity growth as a reason why rates need to rise despite weak growth, as lasting inflation may be triggered by slower growth than in the past.

(Reporting by David Milliken and Sven Egenter; Editing by Catherine Evans)