Australia core inflation speeds up, lifts Aussie

A woman shops in a supermarket in Sydney, Australia.
Peter Parks | AFP | Getty Images

Australian consumer prices rose only modestly last quarter but a surprisingly high reading for a key gauge of underlying inflation was enough to dent market speculation of future rate cuts and lift the local dollar.

The main offender was the trimmed mean measure of prices which jumped 0.8 percent in the quarter and 2.9 percent for the year, above analysts forecasts of 2.7 percent.

That could pose a challenge to the Reserve Bank of Australia's (RBA) confidence that inflation would stay comfortably within its long-term target band of 2 to 3 percent.

Read MoreAustralia stocks:Good times to roll on

"The underlying numbers look a fraction higher - they're a warning sign that the inflation backdrop is not as benign as markets want to price in at the moment," said Michael Blythe, chief economist at Commonwealth Bank.

"The Reserve Bank is probably happy to leave rates where they are for quite a while yet, and market pricing for some chance of a rate cut looks misplaced."

Investors were quick to pare back expectations, with interbank futures falling out to year end. The December contract now shows a probability of a cut at less than one-in-three, compared to evens a week ago.

Read MoreAustralia jobless rate at decade high of 6 percent

That in turn sent the Australian dollar hopping almost half a U.S. cent to $0.9435.

Markets had recently moved to price in a greater chance of a rate cut, given signs the economy was struggling to cope with a slowdown in mining investment after years of growth.

On Tuesday, RBA Governor Glenn Stevens said the bank could consider cutting again should that be needed, but for now he was "content" with rates where they were.

The elevated reading in underlying inflation overshadowed a more muted 0.5 percent increase in the consumer price index (CPI). Annual inflation there was 3.0 percent, but is likely to decline in coming months in part due to the abolition of Australia's carbon tax.

Fortescue CEO: Repeal of carbon tax is good

The big price increases in the month were health care, especially private health insurance, the purchase costs of new homes and a tax-driven spike in tobacco.

Price falls were seen for holiday travel and hotels, gasoline and telecoms gear such as mobile phones.

Read MoreNo parity party for the Aussie this year

Helping restrain inflation is the strength of the local dollar which is suppressing import prices while also forcing domestic businesses to become more efficient to stay competitive.

That is one reason wage growth has slowed to just 2.6 percent a year, the lowest in more than a decade, while unit labor costs have gone flat as productivity improved markedly.