Growth in the service sector is stalling and the number of companies shedding jobs has risen sharply as worries over the economic outlook lead their clients to cut spending, according to a survey closely watched by policymakers.

The Chartered Institute of Purchasing and Supply and NTC, the research group, yesterday said their index of service sector activity fell from 50.4 to 49.8 in May, the first time in five years it has dropped below the threshold of 50 that indicates stagnation.

The employment index fell from 51 to 46.5, the biggest drop in the survey's 12-year history, with a balance of 6 per cent of companies saying staff numbers had fallen in the past month. Cips said job losses were widespread, with the strongest decline among hotels and restaurants.

In the past, the Bank of England has cut interest rates in almost every month when the purchasing mangers' services index has fallen below 50.

However, there is little prospect of a rate cut at today's monetary policy committee meeting, with consumer price inflation already running a full percentage point above target.

"With no further rate cuts likely in the near term, growth is likely to suffer in a big way," said Alan Clarke, economist at BNP Paribas.

Falling orders suggest service sector output will weaken further.

But soft demand has not stopped companies putting up their selling prices to offset a fresh rise in cost inflation, now at a new high for the survey, which they attributed to soaring fuel costs and higher wages, food prices and charges from suppliers.

A further worry will be if, as suggested by Michael Saunders at Citi, the survey signals "that a major labour market shake-out is starting".

Although businesses have become steadily less confident since the credit crunch hit last summer, they have avoided large-scale redundancies, with unemployment up only slightly and employment remaining remarkably robust.

Malcolm Barr, economist at JPMorgan, describes this healthy labour market as "one of the UK's best defences against recession".

However, he said that, if the shift in services employment were sustained, it would be a "very clear" warning, noting there would be no boost from public sector hiring as in previous downturns.

The swing in the PMI employment index is not conclusive - the survey looks at the number of employers reducing headcount, not the scale of job losses, and has not proved a reliable guide to official employment data.

But Cips said falling workloads and the poor economic climate were now leading more companies to sack or not replace staff.