The threat of a double-dip recession intensified today after it emerged that Britain's powerhouse services sector saw its growth stall last month, jeopardising hopes of a sustained recovery.

As the Bank of England prepared to announce its latest decision on interest rates tomorrow, a survey of the sector that makes up the bulk of Britain's economic output showed that its growth slipped to its slowest since it emerged from recession a year ago.

Many of the companies surveyed said cancelled public-sector contracts were beginning to hurt their businesses, forcing them to cut jobs and dealing a blow to chancellor George Osborne's hopes of reviving the private sector by reducing public spending.

The gloom was compounded by warnings from leading retailers that consumer spending is cooling off after a strong start to the year amid uncertainty about the economic outlook.

Labour today continued to challenge the wisdom of cutting the deficit so hard so soon, in contrast with its own plans. Ed Balls, the shadow education secretary, said: "These warnings show why it is so risky for the government to be cutting public sector contracts now when the recovery in Britain is so fragile and people around the world are worried about a double-dip recession. David Cameron is misguided and wrong to say the most urgent priority for Britain is to slash the deficit. The most urgent priority should be to secure Britain's economic recovery by boosting jobs and growth."

The reports will be a powerful weapon for doves on the Bank's monetary policy committee, who will argue that raising interest rates from their current historic low – which more hawkish members believe is necessary to combat inflation – will risk strangling the recovery in the second half of the year.

The bank's governor, Mervyn King, met David Cameron today. He was likely to have emphasised to the prime minister his publicly expressed belief that rates will have to stay low because the recovery is still fragile. They also discussed the need to encourage more bank lending to help the recovery.

But casting a shadow over their meeting were the figures showing that growth in the service sector, which spans businesses from insurance to hotels and restaurants, fell more than expected to a 13-month low in July, according to the Markit/CIPS UK services purchasing managers' index. "This has hugely increased the risks of a double-dip recession, perhaps even by the end of the year," said Chris Williamson, chief economist at survey compiler Markit.

The companies surveyed – which account for about 40% of the economy – were only slightly more optimistic than in June, when Osborne's austerity budget hammered their hopes of a swift recovery. Reflecting dwindling confidence and a slowdown in order book growth, they cut staff, casting further doubt over the private sector's ability to provide jobs as government departments are shrunk.

"This survey is representative of the type of trends we are likely to see over the next couple of years – a long and slow grind towards recovery, with public sector cutbacks bearing down on demand," warned Andrew Goodwin, senior economic adviser to the Ernst & Young Item Club thinktank. "Given the impending squeeze on the public sector, the onus is on the private sector to create new jobs. The service sector has been central to job creation over the past decade, so these results highlight the risk of further increases in unemployment as the public-sector cuts begin to bite."

The darkening picture in the services sector follows similar reports this week on both manufacturing and construction and sent the pound lower as traders fretted over the fragile nature of the UK's economic recovery. Accompanying complaints from retailers such as high street chains Next and Carpetright that consumer spending is flagging bolstered economists' views that a surprise jump in second-quarter GDP was probably a blip and likely to be followed by subdued growth, especially once the government's autumn spending review spells out the full scale of the fiscal squeeze.

Ministers remain confident that the public is still with them on the need to cut the deficit and believe growth will continue through until 2011. Cameron will tomorrow reiterate the necessity of tackling what he regards as Britain's uniquely high deficit at another "PM direct" session.

Shadow ministers will not predict a double dip, but instead highlight the risk of it happening. Most forecast a long, slow recovery, such as in Japan, in which joblessness remains high.

Business groups seized on the news of mounting economic headwinds to urge the Bank to keep interest rates steady today and for many more months.

"Given the risks of an economic setback it is far too early to consider raising rates," said David Kern, chief economist at the British Chambers of Commerce. "Any serious consideration of raising interest rates should be off the table until the second quarter of 2011 at the earliest."

Even though inflation is above the Bank's government-set target, City economists unanimously expect rates to be held tomorrow. King has already flagged the balancing act policymakers face between price pressures and fragile growth at home and abroad, hinting rates will remain low for the rest of the year. He will have a chance to outline the Bank's latest thinking in next week's quarterly inflation report.