Expectations of an early cut in interest rates were fuelled after activity levels in the manufacturing sector eased last month.

The Chartered Institute of Purchasing and Supply said recent gains made by the sector were reversed in December as firms battled the effects of the credit crunch and higher costs.

The Cips purchasing managers' index fell to 52.9 last month, below the 53.6 forecast by analysts and down from the 54.3 recorded in November. A reading above 50 represents growth.

New orders also fell to a 21-month low in December, reflecting weaker domestic and foreign demand.

Economists said the weaker activity meant a further manufacturing slowdown was likely, increasing the chances that interest rates would be cut sooner rather than later.

Howard Archer, chief UK economist at Global Insight, said a 0.25 per cent reduction to 5.25 per cent could come at the forthcoming meeting of the Bank of England's Monetary Policy Committee.

He said: "The December manufacturing purchasing managers' survey indicates that the recently resilient manufacturing sector is now starting to flag in the face of serious headwinds.

"Going forward, we expect the manufacturing sector to lose further momentum as it is buffeted by the credit crunch, slowing domestic demand and elevated oil prices."

Mr Archer added: "The weaker manufacturing survey keeps open the possibility that the Bank of England could cut interest rates by a further 25 basis points to 5.25 per cent as early as next week."

The Cips prices charged index also fell from 57.5 to 55.6, being attributed to price hike delays imposed amid fewer-than-expected new orders for firms.

Manufacturing is vital to the health of the West Midlands economy, with the sector employing 338,000 people and responsible for 27 per cent of the region's economy.

Ronnie Bowker, Ernst & Young's senior partner in Birmingham, said: "The fall in the Purchasing Managers' Index in December is a sign that the robust performance of the manufacturing sector in recent months may be under threat. The full impact of the credit crunch, the weak dollar and high prices for oil and other raw materials will be making conditions increasingly challenging for businesses in the sector.

"These recent statistics will add fuel to the fire for a further rate cut in the early part of this year, which would be welcome news for the region's economy.

"A rate cut sooner rather than later would be preferable, but I am doubtful that it will come as early as next week when the MPC meet for the first time this year."

Charlotte Ritchie, head of policy at Birmingham Chamber of Commerce, said: "In some respects, this is no surprise because growth has slowed across all sectors of the economy.

"But the figures do highlight that the credit crunch, relatively high interest rates, the strong pound and high raw material and fuel costs are beginning to hit manufacturers.

"However, our Quarterly Economic Survey has shown that confidence among manufacturers for 2008 is still high with nearly three-quarters of them expecting turnover to increase and a similar amount predicting a rise in profitability."

The Cips manufacturing index remained above the 50 mark separating growth from contraction for the 29th successive month.

It rose during November compared to October, but that has been described as "probably a blip in the downward trend".

Cips director Roy Ayliffe said many companies were fighting against lower spending and paying higher prices for commodities like fuel, metals, paper products and plastics.

He said: "Although the past year has seen an increase in new orders, demand from both the domestic and foreign markets dropped in December as firms felt the effects of recent economic uncertainty and the weakening of the US dollar.

"Companies are also continuing to battle against inflationary pressures, especially for essentials such as fuel, metals and oil.

"Despite this, some firms postponed planned price rises as a result of the weakening growth in new orders.

"On a more positive note though, employment levels have continued to rise in 2007 and December was no exception as firms added to staffing levels to meet rising production requirements."