Oct. 6 (Bloomberg) -- U.K. factory output in August had its biggest drop in almost two years, led by transport equipment and machinery, damping expectations of an interest-rate increase before the end of the year.

Manufacturing, which accounts for about 17 percent of Europe's second-largest economy, unexpectedly fell 0.8 percent following a revised 0.4 percent drop in July, the government's National Statistics office said in London. Output has dropped for three months, the longest sequence of declines since January 2002.

The decline in manufacturing adds to evidence that five interest rate increases since November and record energy prices are damping growth in Europe's second-biggest economy. The Bank of England will leave its key interest rate on hold this week, after boosting it to 4.75 percent in August, according to all 41 economists surveyed by Bloomberg on Friday.

``If you look at the official data we're not really seeing much of a recovery -- they point to quite a weak picture,'' said Nick Kounis, an economist at Fortis Bank, before the report. Rising oil prices have ``added to the risks'' of a slowdown, as has a ``moderation in world output.''

In the year, manufacturing production rose 0.4 percent. Industrial output, which includes mining and utilities, fell 0.8 percent in August from the month before, following a revised 0.5 percent drop in the previous month.

Economists surveyed by Bloomberg on Friday predicted a 0.3 percent monthly gain in manufacturing and industrial production. They expected 1.6 percent annual growth in manufacturing.

Weaker Demand

A resurgence in factory output had helped fuel second-quarter economic growth of 3.6 percent -- the fastest in almost four years. Manufacturing gained 1.2 percent in the second quarter following a 0.2 percent decline in the first three months of the year.

More recently, there have been signs that higher interest rates, record oil prices and weaker demand from abroad are beginning to damp the rebound in industrial output.

The recovery in manufacturing ``has definitely slowed,'' said Andrew Walton, a statistician at a press conference in the ONS. The statistics office's estimate for the underlying trend in manufacturing slid to a decline of 0.5 percent from an increase of 1.5 percent the previous month.

Manufacturing growth weakened to the slowest pace in 14 months in September, according to a survey of purchasing managers compiled by NTC Research Ltd. for the Chartered Institute of Purchasing & Supply and Reuters Group Plc. An index of factory export orders from the Confederation of British Industry dropped in September to -14, the lowest since February.

Declines in manufacturing were led by transport equipment, with a drop of 3.8 percent from a record high in July, and machinery and equipment, which fell 3.3 percent. Electrical and optical equipment slid 2.7 percent, after reaching the highest since December 2002 the previous month, the statistics office said.

Long-Term Decline

Employment figures point to a picture of long-term decline in British industry. Manufacturers shed 93,000 workers in the three months through July from a year ago, leaving employment at 3.36 million, government figures show.

Industry has lost more than 750,000 jobs since Prime Minister Tony Blair's Labour Party took office in 1997, according to the Trades Union Congress, an umbrella group representing 7 million union members.

Growth worldwide may be set to slow, in part because of the 65 percent increase in oil prices over the past year. The International Monetary Fund last week predicted high oil prices and trade imbalances would slow global expansion to 4.3 percent in 2005 from an estimated 5 percent this year.

Over the weekend finance ministers and central bankers from the U.S., Japan, Germany, France, the U.K., Italy, and Canada called on oil-producing states to provide ``adequate supplies'' of oil to help sustain the global economy. Still, ``global economic growth is strong and the outlook for 2005 remains favorable,'' they said in a statement.

Some manufacturers have been struggling to boost earnings. Pilkington Plc, the world's largest maker of car windshields, said last month that fiscal first-half pretax profit will be little changed from last year as a stronger pound curbs overseas earnings and a higher oil price lifts costs.

To contact the reporter on this story: Sam Fleming in London at sfleming5@bloomberg.net.

Last Updated: October 6, 2004 04:30 EDT