* April manufacturing growth much weaker than expected - PMI
* Output growth still above average; new orders well down
* Slowdown likely to fuel talk of BoE holding rates longer
(Adds analyst comment; market reaction, link to graphic)
By Peter Griffiths
LONDON, May 3 (Reuters) - British manufacturing grew at its weakest pace in 7 months in April and a sharp slowdown in new orders cast a cloud over what has been a rare bright spot in the UK economy.
The Markit/CIPS manufacturing PMI headline index fell to 54.6, well below even the most bearish analyst's forecast, suggesting the recent strong performance by British manufacturers is starting to weaken as domestic demand wanes.
The slowdown was likely to fuel speculation that the Bank of England will delay raising interest rates from the record 0.5 percent low even further as policymakers wait for the British economy to pick up after making a sluggish recovery at the beginning of the year.
"It does add further grist to the mill to the argument to keep interest rates on hold," said Philip Shaw, chief UK economist at Investec. Sterling tumbled and gilt futures hit a contract high on Tuesday after the PMI release.
Interest rate futures show a 50 percent chance of a first post-crisis rate hike in September and a full 25 basis point increase is not priced in until January 2012.
Manufacturers blamed the fall in new orders on weakening domestic demand, although the survey also noted that the Japanese earthquake and tsunami in March caused a "sharp lengthening" in supplier delivery times.
"It's unclear whether the drop in the index reflects a genuine slowdown in demand for manufactured goods or whether it reflects a degree of supply disruption arising from the tsunami in Japan in March," Shaw added.
The Markit/CIPS manufacturing PMI headline index fell to 54.6 in April, its lowest since September, from a downwardly revised 56.7 in March and well below the 56.9 consensus forecast in a Reuters poll. Figures above 50 show expansion.
Although the output prices index eased to 64.2 in April from a record 65.2 in March, the inflation rate was still the third highest since the data were first collected in 1999.
The figures underscore the central bank's plight as it struggles to tame inflation running at double its 2 percent target, while trying to protect Britain's fragile recovery.
Hetal Mehta, an economist at Daiwa Capital Markets, said the survey suggested manufacturing growth appeared to be easing back to more normal levels after a run of strong results.
"The good news from the survey is that employment in the manufacturing sector is still rising, and that inflationary pressures seem to be waning," she said.
Manufacturing has been one of the healthiest sectors of the UK economy since Britain emerged from a recession late in 2009. The PMI survey's headline activity rate has stayed above the 50.0 mark that separates contraction from growth for 21 months.
The sector, which accounts for about 13 percent of the British economy, grew 1.1 percent in the first quarter according to official data, helped by a weaker pound and strong export demand.
But Rob Dobson, senior economist at survey compilers Markit, doubted that this would last.
"The manufacturing growth spurt looks to be fading rapidly," he said. "The outlook has deteriorated sharply, with new orders growth having collapsed from a booming pace at the start of the year to only register a weak influx of new business in April.
A squeeze on consumer spending was partly to blame, he added.
"Manufacturers reported that the domestic market has weakened considerably in recent months, with consumer demand in particular shifting into reverse gear. The sector appears to now be completely reliant on export orders to sustain growth."
The survey suggested government spending cuts, tax rises and tighter household incomes are starting to erode domestic demand, hitting British manufacturers.
The new orders index eased to its lowest level in eight months in April, although new export orders picked up slightly from the previous month. (Editing by Ruth Pitchford)