July 7 (Bloomberg) -- U.K. manufacturing unexpectedly contracted in May to the weakest in eight months, choked by record commodity prices and slowing economic growth.

Factory output fell 0.5 percent, compared with no change in April, the Office for National Statistics said today in London. Economists forecast stagnation, the median of 25 estimates in a Bloomberg News survey shows. The index of manufacturing production fell to 102.7, the lowest level since September.

Bank of England policy makers, who meet this week, have considered raising interest rates to keep inflation under control, threatening to exacerbate the economic slowdown as it spreads to manufacturing. Service industries are contracting at the fastest pace since 2001 and banks will curb lending further this quarter, surveys last week showed.

``The outlook for the economy is clearly deteriorating and the risks of a recession are rising,'' said Nick Kounis, an economist at Fortis Bank NV in Amsterdam and a former U.K. Treasury official. ``The bank is still facing huge inflationary pressures. Rates will be on hold this week.''

The pound fell after the report, declining to 79.45 pence per euro. Against the dollar, it slipped to $1.9683.

Overall industrial production, including manufacturing, utilities, mining and oil and gas output, fell 0.8 percent on the month and 1.6 percent on the year, today's report showed.

Recession Risk

Britain's economy is at risk of falling into a recession as house prices slump and surging oil prices squeeze purchasing power. The benchmark FTSE-100 Index last week dropped to the lowest level since 2005 as reports showed that manufacturing and services contracted in June by the most in seven years.

RPC Group Plc, the U.K. maker of plastic containers for Nivea sun cream, said June 18 that its full-year profit dropped 66 percent as rising oil prices lifted its operating costs. Marks & Spencer Group Plc lost a quarter of its value on June 2 after saying trading conditions won't improve for two years.

Manufacturing accounts for 15 percent of the economy, compared with about 75 percent for service industries. Ten out of 13 categories of factory production declined on the month, led by machinery and equipment, the statistics office said. Brent crude oil rose above $146 a barrel for the first time last week, while prices for corn, wheat, soybeans and rice have reached records this year.

`Overreact'

Inflation reached 3.3 percent in May, the highest in at least 11 years. The rate may exceed 4 percent by the end of 2008, central bank Governor Mervyn King told lawmakers on June 26. He said that to ``overreact'' to inflation risks pushing it below the government's 1 percent lower limit as economic growth slows.

A central bank survey last week showed U.K. financial institutions will curb lending to consumers and companies in the third quarter. Bank losses from the collapse of the U.S. subprime mortgage market climbed above $400 billion last week.

With growth slowing, the weaker pound has helped manufacturers by making British goods cheaper overseas. The pound has fallen 7 percent against a basket of currencies of the U.K.'s main trading partners this year.

Still, Lehman Brothers Holdings Inc. economist Peter Newland predicted on July 3 that the economy will fall into a recession this year.

Policy makers will probably leave the key rate at 5 percent this week after three reductions since December, according to 45 of 46 economists in a Bloomberg News survey. Four members of the rate-setting committee have said they considered voting for an increase last month.

``You are dealing with a very, very significant overshoot from the Bank of England's target for the CPI of 2 percent,'' Julian Callow, chief European economist at Barclays Capital, said in an interview on Bloomberg Television. ``It's well and truly boxed in, it seems, in the current environment.''

To contact the reporter on this story: Jennifer Ryan in London at Jryan13@bloomberg.net

Last Updated: July 7, 2008 05:19 EDT