Britain’s services sector, including hotels and banks, grew at a faster rate than expected last month, setting the economy on course for its strongest quarter in 2017 despite mounting fears over the challenges ahead from Brexit.

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Households defied the biggest squeeze on living standards in memory to help spur the growth in service sector activity in December, while optimism reached a seven-month high. Still, there were worrying signals for the months ahead as firms reported the slowest growth rate since August 2016.

The main reading on the Markit/CIPS UK Services PMI confounded economists’ expectations of a slowdown, increasing to 54.2 in December from 53.8 a month earlier. Economists had forecast 53.8 on a scale where anything above 50 indicates expansion.

Alongside solid readings from the smaller manufacturing and construction sectors, the report from Britain’s dominant services industry suggested economic growth of between 0.4% and 0.5% in the final three months of 2017, according to the IHS Markit chief economist, Chris Williamson. That would be the strongest quarter of growth in the UK economy last year.

The services sector encompasses transport, communications, finance, business and personal services, computing and IT, and hotels and restaurants.

Economists had expected the overall UK growth rate for 2017 to be about 1.5% – which is 0.3 percentage points lower than the level in 2016 because of the cost-of-living squeeze on households denting consumer spending. The rate of growth is then forecast to fall closer to 1% in 2018 as talks to leave the EU intensify.

Kallum Pickering, senior UK economist at the City bank Berenberg, said the economy could have grown at a rate of about 2.5% last year if there had not been a vote to leave the EU in 2016. “The uncertainty from Brexit prevented the UK from fully enjoying the tailwind from the synchronised global upswing [for economic growth],” he added.

Although the PMI figures give a broadly positive reading on the health of the economy at the end of 2017, there were some signs of underlying weakness. As well as growing at the slowest rate since August 2016, services firms said Brexit-related uncertainty was holding back the willingness of their clients to spend. The rate of employment growth also eased to a nine-month low.

Q&A What is inflation and why does it matter? Show Inflation is when prices rise. Deflation is the opposite – price decreases over time – but inflation is far more common. If inflation is 10%, then a £50 pair of shoes will cost £55 in a year's time and £60.50 a year after that. Inflation eats away at the value of wages and savings – if you earn 10% on your savings but inflation is 10%, the real rate of interest on your pot is actually 0%. A relatively new phenomenon, inflation has become a real worry for governments since the 1960s. As a rule of thumb, times of high inflation are good for borrowers and bad for investors. Mortgages are a good example of how borrowing can be advantageous – annual inflation of 10% over seven years halves the real value of a mortgage. On the other hand, pensioners, who depend on a fixed income, watch the value of their assets erode. The government's preferred measure of inflation, and the one the Bank of England takes into account when setting interest rates, is the consumer price index (CPI). The retail prices index (RPI) is often used in wage negotiations.

Businesses were paying more for food, fuel and higher salaries, as they try to keep hold of staff at a time when unemployment is at a record low. To balance the books, firms increased the prices they charge customers, which could intensify the squeeze on disposable income.

The signals will encourage the Bank of England, which is looking for signs of pay growth in order to justify raising interest rates again this year. Threadneedle Street increased the cost of borrowing from 0.25% to 0.5% in the first interest rate hike in a decade in November. It said it would need to raise the rate further to peg back inflation.

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