UPDATE 1-Weak UK services suggests bumpy economic recovery

LONDON, Nov 5 (Reuters) - Business in Britain's dominant service sector grew at the slowest pace in almost two years in October and optimism about the outlook waned, raising the risk that fragile recovery will falter.

Combined with a deeper contraction in manufacturing, Monday's data raises the chances that the economy could shrink again between October and December after surprisingly strong expansion in the third quarter.

In turn, this may prompt the Bank of England to announce more stimulus, although probably not on Thursday.

The main Markit/CIPS Purchasing Managers' Index (PMI) for the service sector, measuring the change in business activity including income and chargeable hours worked, eased to 50.6 last month from 52.2 in September, holding just above the 50 line that separates growth from contraction.

It was the lowest reading since December 2010 and fell short of analysts' forecasts for a smaller dip to 52.0.

``A return to contraction for the UK is on the cards in Q4,'' said Rob Wood, economist at Berenberg Bank who worked at the central bank until recently.

He said the BoE was still unlikely to launch a new round of quantitative easing asset purchases this week, as its Monetary Policy Committee had expected a weak fourth quarter anyway.

``I think they will either do more asset purchases or an alternative stimulus, along the lines of the Funding for Lending Scheme, sometime next year,'' he added, referring to the scheme that provides cheap funding to banks if they keep up lending to households and businesses.

British government bonds gradually extended gains in the wake of the data, showing that investors were pricing in a higher chance of more BoE gilt purchases again.


Several central bankers have indicated their reluctance to extend the bond purchases beyond the currently approved 375 billion pounds because the worry about the inflation outlook, while others said the policy had become less effective.

A PMI survey last week showed that the construction sector, which has been the main drag on the economy this year, eked out growth in October, but new work and employment shrank and builders remained cautious about future business.

Markit's composite index, which brings together all three business sectors, fell to the weakest level since July - when Britain had just exited recession - suggesting that the economy was broadly flat at the start of the fourth quarter.

``The expectation among (service) firms is for activity to improve over the coming year, but the road to full economic recovery still looks to be a long one,'' said Andrew Harker, economist at Markit, which compiles the surveys.

Business sentiment remained solid, albeit at its weakest since June, with 42 percent of respondents forecasting a rise in activity compared to the 11 percent that predicted a decline.

Similarly, a poll from business lobby CBI released on Monday showed that Britain's small and medium-sized manufacturers expected their output to rise slightly in the coming three months after a modest fall in the three months to October.

After news last month that the economy grew by 1 percent from July to September, many economists revised their forecasts for the central bank's announcement on Thursday, expecting no extension of its government bond purchases for now.

Much of that growth was based on the Olympics.

According to Markit, many service providers in the latest survey said improvements in demand and their clients' confidence were only tentative, and growth in new business slowed slightly.

There was also evidence of pressure on firms' profit margins as their costs rose more than the prices they charged, with increases in energy, food and fuel costs as well as wages.

Firms reduced their headcount for the second month running in October, although less than in September.