The economy remains at risk of recession despite a surprise pick-up in activity among services firms in December, as the spill-over from the euro zone crisis looms large and banks look set to tighten credit.
The unexpected jump in the Markit/CIPS Purchasing Managers' Index (PMI) for the service sector to 54.0 in December from 52.1 the month before provides some hope that the country may just skirt a recession for now.
But the Bank of England's quarterly credit conditions survey -- also released on Thursday -- showed that banks expected to apply stricter credit criteria and saw credit demand dwindling across the board.
With the euro zone debt crisis unresolved, and consumer spending under pressure from tough government spending cuts and soaring prices, the central bank is still expected to add more stimulus in the form of asset purchases soon.
The services PMI's rise to the highest level since July confounded expectations for a fall. The unexpected bounce comes after the construction PMI showed a slight pick-up in growth in December and the contraction in manufacturing slowed.
The PMIs have all surprised on the upside and offer some hope that there is still life in the UK economy, said ING economist James Knightley.
Nonetheless, the UK is still very vulnerable to the euro zone sovereign debt crisis given trade, financial and confidence linkages, he said. We doubt the UK will be able to avoid a return to recession, albeit a mild one.
Gilt futures fell slightly after the PMI data, though the improvement did little to change markets' views that the central bank will pump an extra 50 billion pounds of quantitative easing funds into the economy in February.
Services were likely to have expanded by around 0.3-0.4 percent in the final quarter, said Markit chief economist Chris Williamson. However, the combined PMIs posted their weakest quarter since the second quarter of 2009, when Britain was still in deep recession, he said, adding that the economy had probably stagnated in final quarter of 2011.
The BoE predicts a stagnation until mid-2012, though some policymakers have warned the economy may shrink for one or two quarters. A slump in industrial and services output in October had indicated a weak start to the fourth quarter.
Retailers have been suffering from consumers' restraint, painting a bleak picture for the coming months as Britons look set to cut back further after some indulgence for Christmas.
Consumers will increasingly look for value in these difficult times, said the chief executive of McBride, Europe's biggest maker of retailer own-brand cleaning products, after it reported a rise in revenue in the six months to December.
Banks warned in the Bank's credit conditions survey that the euro crisis could drive up their funding costs and hit credit supply.
The lenders already expect to toughen lending conditions and predict falling credit demand across the board after recording a sharp slump in demand from small firms in the fourth quarter.
Chancellor George Osborne announced a scheme of credit easing in November, aimed at boosting lending to small and medium-sized firms, hoping to boost the economy while sticking to his plan of spending cuts to erase the budget deficit.
The jump in Britain's services PMI follows more positive news from Britain's key export markets such as the euro zone.
But, the expectations index of the British services PMI fell back to the 2-1/2 year low of 67.4 recorded in September.
Companies grew increasingly worried about the coming year, suggesting that the upturn may prove short-lived as we move into 2012, Markit's Williamson said.
(Additional reporting by David Milliken and Olesya Dmitracova; Editing by Catherine Evans and Toby Chopra)