By Wayne Cole
SYDNEY (Reuters) - Australia is suddenly at risk of succumbing to the bane of global deflation that could unmoor future price expectations and force reluctant policy makers to cut interest rates deeper into record territory.
The country's benign inflation outlook was upended on Wednesday when data showed consumer prices surprisingly fell in the first quarter, pulled by the tumbling cost of oil. Key measures of underlying inflation also slowed to their lowest since the series began in 2002.
The disturbingly weak report revived talk the Reserve Bank of Australia (RBA) could cut the already record-low 2 percent cash rate at its May policy meeting next week, and knocked the Australian dollar down over a U.S. cent to $0.7639 <AUD=D4>.
"It looks like the disinflationary trend intensified in the first quarter," said Su-Lin Ong, a senior economist at RBC Capital Markets.
"Inflation has never stood in the way of a rate cut, the question is whether a miss of its target range pushes the RBA more in the direction of easing."
Investors answered by ramping up the chance of a cut next week to 48 percent <0#YIB:>, from just 12 percent ahead of the data. That probability rises to 90 percent by August.
Yields on three-year government paper (AU3YT=RR) fell 12 basis points, the largest daily drop since June last year, in a sign the global curse of deflation could force the RBA's hand just as it has seen authorities in Europe and Asia take unprecedented easing steps to restore momentum.
The RBA has repeatedly said that low inflation would allow room for a further cut, but it has also sounded unconvinced ever-easier policy was the right prescription for the economy.
EXPECTATIONS UNANCHORED?
Australia enjoyed relatively rapid growth of 3 percent last year and recent news on business conditions and investment has been upbeat. Unemployment ticked down to 5.7 percent in March and further away from last year's highs of 6.2 percent.
The country had also been fortunate in that expectations of future inflation were not falling away as they had in Europe and Japan, a slippage that can become self-fulfilling.
Yet Wednesday's price numbers were so weak that it pointed to a danger expectations could become unanchored.
The Australian Bureau of Statistics reported its headline consumer price index (CPI) fell 0.2 percent last quarter, the first decline in seven years.
Annual inflation slowed to 1.3 percent, from 1.7 percent, led by falling petrol and food prices.
Key measures of underlying inflation rose by just 0.15 percent on average in the first quarter, easily the lowest outcome since the series first began in 2002.
The annual pace slowed to 1.6 percent, again the lowest on record and well under the RBA's long-term target band of 2 to 3 percent. That would be a shock to the central bank which had projected core inflation would bottom around 2 percent.
Even inflation in the services sector, which has been stubbornly high for years, slowed to under 2 percent.
"While this is not a problem for short periods, the risk is that thanks to a combination of deflationary pressures globally, soft demand domestically and very weak wages growth, inflation could remain well below target for an extended period," said Shane Oliver, chief economist at AMP Capital.
"This is a risk that the RBA cannot ignore and as a result we remain of the view that it will cut interest rates again in the months ahead."