The UK economy is on course to shrink between July and September and could tip into recession, a closely-watched survey suggests.

The S&P Global/CIPS UK Purchasing Managers’ Index (PMI) found that rising interest rates and weaker household spending led to a sharp drop in demand for goods and services in August.

The index looks at key economic measures such as orders and employment.

It showed that activity shrank in August after six months of growth.

The index’s reading of 47.9 this month – anything below 50 marks a contraction – is the lowest level in two and half years.

On the upside, economists said that the PMI figures, which measure the health of an economy, showed that the Bank of England’s efforts to tame inflation were beginning to work.

Following the release of the PMI report, the pound fell against the dollar and City analysts lowered their expectations of where the interest rate would peak to 5.5% from 6%.

Interest rates currently stand at 5.25% following a succession of increases since late 2021 when it was close to zero.

However, Chris Williamson, chief business economist at S&P Global Market Intelligence, said the figures also suggested “the fight against inflation is carrying a heavy cost in terms of heightened recession risks”.

“A renewed contraction of the economy already looks inevitable, as an increasingly severe manufacturing downturn is accompanied by a further faltering of the service sector’s spring revival,” he said.

According to official figures, UK inflation was 6.8% in July which, although slower than the previous month, is still more than three times higher than the Bank of England’s 2% target.

The Bank’s Monetary Policy Committee has voted 14 times in a row to raise interest rates. The theory is that by making it more expensive to borrow money, consumer demand will cool and price rises will slow.

However, repeated interest rate rises tend to drag on economic growth as it becomes more expensive for consumers and businesses to borrow and spend. Companies may also cut back on investment and jobs.

Paul Dales, economist at Capital Economics, said the survey would encourage the Bank “that higher rates are working” but added that economic activity would soon contract and a “mild recession is on the way”.

According to the PMIs, UK activity fell in both the manufacturing and services sectors in August.

Rhys Herbert, a senior economist at Lloyds Bank, added that “the sharper-than-expected drop in retail sales in July” was also a warning of “further possible weakness as we enter autumn”.

“Some businesses continue to also experience challenges with recruitment, resulting in upward pressure on wages,” Mr Herbert added.

Pay has been rising at a record rate but the Bank of England has warned that wage increases will make it harder to get inflation down.