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Australian Inflation Slows, Curbs Rate Risk

Underlying inflation in Australia was surprisingly subdued in the first quarter while consumer prices rose at their slowest pace in two years, radically lessening the risk of a rise in interest rates.

The Australian dollar dived half a U.S. cent while bonds surged after two key measures of underlying inflation rose just 0.5% last quarter, the same as in the fourth quarter.

That was below market expectations for increases of 0.6% and dragged the annual rate down to an average 2.7%, putting it back within the Reserve Bank of Australia's (RBA) 2% to 3% target band.

"Now we've had back-to-back benign readings on core inflation, the RBA is firmly on hold until at least July," said Rory Robertson, interest rates strategist at Macquarie Bank. "So far, Australia's drum-tight labor market has not led to greater inflation pressures. There's not much else to be said."

The central bank holds its monthly policy meeting next Tuesday and there had been speculation it could tighten policy for a fourth time in 11 months given the strength of demand in an economy already strapped for spare capacity.

But given the marked improvement in inflation, March interbank futures slashed the probability of a rate rise to just 4%, from 45% ahead of the numbers.

The government's consumer price index rose only 0.1% in the first quarter, well below market forecasts of a 0.6% rise. The annual pace of consumer price inflation ran at 2.4%, down from 3.3% in the fourth quarter and the slowest pace since the first quarter of 2005.

Seasonal gains in education, health, house purchases and rents were tempered by falls in fruit, furniture, overseas holiday travel and audio, visual and computing equipment.

Demand And The Drought

So subdued was the inflation outcome, that markets also slashed the chances of a hike at all this year. Having been been fully priced for a tightening to 6.5% at some point, bill futures were now implying almost no chance of a move right out to June next year.

However, analysts thought it too soon to declare the war on inflation won given the strength of recent economic indicators, notably on consumer demand, credit growth and the jobless rate which fell to a 31-year low of 4.5% in March.

There is also a risk that a worsening drought could push up food prices. Last week the government threatening to shut off irrigation water to farms in Australia's largest agricultural belt if it doesn't rain soon.

"The economy is gaining momentum, we have an election year budget coming up and the housing market looks like it is getting its second or third wind," said Josh Williamson, a senior strategist at TD Securities. "We don't see the RBA losing its tightening bias for a good six months."

The Liberal National government faces a tough election later this year and there has been talk it would opt for generous vote-winning policies in its annual budget on May 8.

Still, on Tuesday, a beaming Treasurer Peter Costello could only welcome the inflation news, telling reporters he expected the consumer price index to grow moderately in the period ahead.

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