Activity in Australia's services sector slowed further in January, with new orders, retail trade and employment all softening.

The Performance of Services Index (PSI) by the Australian Industry Group and the Commonwealth Bank fell 0.9 points to 45.5 last month, remaining below the 50 points levels separating expansion from contraction.

The weakness was evident in both the sales and employment sub-indices and particularly noticeable in the new orders sub-index which fell sharply to a disappointing level of 39.7.

Accommodation, cafes, & restaurants, transport & storage and health & community services were the only sub-sectors to expand in the month. Activity contracted most noticeably during January in the retail trade, wholesale trade, communication, finance & insurance and personal & recreational services sub-sectors.

Australian Industry Group chief executive Heather Ridout, said: "The services sector had a sluggish start to the year with interest rate sensitive households and businesses lacking confidence and remaining hesitant to spend. As well, the full impact of the flooding is yet to unfold.

"The very sharp fall in the new orders sub-index is of real concern. The poor outlook for new orders points to the possibility of the weakness in the sector that was evident for much of last year continuing over coming months," Mrs Ridout said.

Commonwealth Bank senior economist John Peters said: "The tepid January Australian PSI outcome showing services sector activity still losing momentum is not surprising given the negative economic headwinds buffeting services’ businesses at present. These headwinds include the high Australian dollar, rising interest rates over 2010, and the onset of the catastrophic Queensland and Victorian floods in January which further torpedoed business and consumer confidence and activity.

"Recent RBA credit data confirms that both consumers and businesses continue to deleverage (i.e. increasing their savings and paying down debt) in wake of the GFC, not a stimulating dynamic for service industries generally. In particular, this consumer caution is being accentuated by frequent and widespread reports in the media of more RBA rate hikes over the next year or so.

But looking ahead on the positive side of the ledger, a likely strengthening domestic economy in 2011, consequent further solid jobs’ growth and falling unemployment, and rising income levels and wages, are likely to cheer up consumers. In such a mood households are more likely to relax and spend more, despite likely rising mortgage rates," Mr Peters said.