By Andy Bruce and John Geddie
LONDON (Reuters) - Inflation gnawed away at British pay growth in the three months to January, an unpromising sign for the economy ahead of its divorce from the European Union even as the unemployment rate fell to its lowest level since 2005.
The official data painted a familiar picture of solid job growth but weak increases in income that have put a strain on many households since the financial crisis.
Pay growth, adjusted for inflation, halved to just 0.7 percent, the lowest since October 2014, which was shortly before inflation plunged to just below zero and made it easier for households to cope with slow pay growth.
But inflation is now rising again quickly, pushed up by the post-Brexit vote slump in the value of the pound. In January alone inflation-adjusted pay growth contracted by 0.2 percent, the first shrinkage since August 2014, the Office for National Statistics said.
The outlook for consumer spending is critical for Britain's economy as it begins the process of leaving the EU. Consumers kept up their spending after June's Brexit referendum shock but there have been signs that they are turning more wary.
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The weakness in pay growth is likely to reassure the Bank of England that it should keep borrowing costs at their record low for longer, despite the pick-up in headline inflation.
The BoE, which is due to announce its interest rate decision for March on Thursday, is watching closely for any signs that rising inflation is feeding through into pay pressure.
Wednesday's data showed growth in pay including bonuses slipped to 2.2 percent in the three months to January, the weakest since the three months to April last year and worse than forecast in a Reuters poll of economists.
"All told, the combination of meager wage growth despite very low unemployment supports the Monetary Policy Committee's view that enough slack remains in the labor market to warrant keeping rates on hold during the imminent period of high inflation," said Samuel Tombs, an economist at Pantheon Macroeconomics.
Sterling fell back below $1.22, halving the day's gains, and government bond prices rose as investors homed in on the implications of the weak wage growth figures for the BoE.
While the pay outlook is weak, Britain's labor market remains strong despite the shock of last year's Brexit vote.
The jobless rate fell to 4.7 percent from 4.8 percent, marking its lowest level since the summer of 2005, the ONS said.
The ONS said the unemployment rate was last lower in 1975. Economists polled by Reuters had expected no change in the rate.
The BoE has said it expects unemployment could fall as low as 4.5 percent before it starts to push up inflation.
The employment rate hit a record high.
Economists have said they largely expect unemployment to rise this year as companies hold off from hiring while they wait for more clarity on the country's future ties to the EU.
The BoE said last month it expected a jobless rate of 5.0 percent in a year's time, although that was lower than its previous forecast of 5.5 percent.
While rising employment has been one of Britain's economic success stories over the last few years, new figures from the ONS showed almost a million people in work were on zero-hours contracts - jobs with no guarantee of work.
The number of workers on these contracts rose to 905,000 in the three months to December, up by 101,000 in the space of a year and representing almost 3 percent of people in employment.
(Editing by Alison Williams)