June 18 (Bloomberg) -- U.K. retail sales unexpectedly dropped in May for the first time in three months and Bank of England Governor Mervyn King said the economic recovery may be sluggish as banks ration credit.

Sales declined 0.6 percent from April, the Office for National Statistics said today in London. Economists predicted a 0.3 percent increase, the median of 28 forecasts in a Bloomberg News survey shows. Sales dropped 1.6 percent from a year earlier. The pound fell.

Recent reports have indicated that Britain’s recovery from the worst recession since 1979 will be uneven. While surveys of manufacturing and services have improved, the central bank said today the flow of loans to companies stayed near a nine-year low in June. King said yesterday the rebound may be “protracted.”

“Today’s retail sales have muddied the waters,” said David Tinsley, an economist at National Australia Bank in London who used to work at the Bank of England. “We’d agree the growth outlook has improved. But analysis of past recessions suggests extreme caution on the pace of recovery.”

The pound dropped 1 percent against the dollar today, trading at $1.6237 as of 10:17 a.m. in London. It fell by about the same amount against the euro to 85.66 pence.

On the year, the value of sales dropped 1.1 percent, the most since records began in 1988. The annual data are affected by “unusually large” estimates of retail sales a year earlier in May 2008, officials said.

Britain’s recovery may be restrained by bank’s continued unwillingness to lend. New loans remained “very weak” amid “subdued demand” last month, the central bank said today. Gross mortgage lending fell 2 percent in May from the previous month, the Council of Mortgage Lenders said.

Impaired

“Banks’ ability to finance a sustained recovery remains impaired by low levels of equity capital,” said King.

Clothing, textiles and footwear retailers and department stores led the monthly sales decline in May, the statistics office said. Sales at non-food stores dropped 1.4 percent, outweighing a 0.3 percent increase at food stores.

“This is what you’d expect consumers to do as joblessness rises,” said Joost Beaumont, an economist at Fortis Bank NV in Amsterdam. “Consumers are being squeezed by tighter lending conditions and are seeing their wealth drop with falling house prices. Spending will still be negative this quarter.”

Chancellor of the Exchequer Alistair Darling said yesterday that he’s “confident there will be a sustained recovery.” Britain’s recession and rising unemployment have harmed the prospects of Prime Minister Gordon Brown, who this month fought off a crisis in his government after the ruling Labour party had its worst-ever result in local elections.

Profit Slump

Marks & Spencer Group Plc, the Britain’s largest clothing retailer, announced a 38 percent slump in annual profit on May 19. Home Retail Group Plc, the owner of Argos stores in the U.K., on June 11 cut its profitability forecast for Homebase and said sales at the home-improvement chain fell in May.

Joblessness rose to the highest level since 1996 in the three months through April, the statistics office said yesterday. The Confederation of British Industry predicts the unemployment rate may rise to 9.6 percent next year, when Brown must call an election, from the current 7.2 percent.

“Unemployment will keep rising,” said Amit Kara, an economist at UBS AG in London, and a former central bank official. “The economy will shrink in the second quarter.”

The retail price deflator, a measure of cost changes in shops, showed a 0.7 percent increase on the year, today’s data showed. Inflation was 2.2 percent in May, faster than economists had forecast and above the central bank’s 2 percent target.

To contact the reporter on this story: Brian Swint in London at bswint@bloomberg.net.

Last Updated: June 18, 2009 05:25 EDT