By James Glynn

SYDNEY--Inflation in Australia rose by less than expected in the fourth quarter, creating room for the central bank to lower interest rates again if the economy loses momentum.

Consumer prices rose by 0.5% in the fourth quarter and were up 1.5% from a year earlier, the Australian Bureau of Statistics said Wednesday.

Economists had expected consumer prices to rise by 0.7% in the quarter and by 1.6% from a year earlier. The Reserve Bank of Australia targets an annual inflation rate of between 2% and 3%.

Core inflation, which is more central to policy making at the RBA, rose by an average of 0.4% in the quarter, compared with 0.5% expected by economists.

Higher fuel prices, domestic vacations and the cost of buying a house contributed to the rise in consumer prices during the quarter. They were partly offset by weaker prices for international travel and the cost of soda drinks.

Weak inflation outcomes throughout 2016 led the RBA to cut interest rates twice, taking its cash rate target down to a record-low 1.50%.

Still, the RBA now appears reluctant to cut interest rates further, pointing to an overheated housing market, while fearing that lower mortgage costs will worsen the problem.

RBA Governor Philip Lowe has said inflation below the desired target in itself is not a reason to cut interest rates again. The first policy meeting of the RBA will be Feb 7, and it will announce new economic forecasts shortly after.

A trigger for an interest rate cut could emerge if the resource-rich economy fails to recover from a deep contraction in the third quarter. GDP growth fell by 0.5% in the third quarter of last year from thesecond, surprising most economists, and raising the potential for a first recession in 25 years.

Unemployment has also begun to nudge up over recent months in Australia, raising another red flag over the economy. If the jobless rate continues to lift, some economists argue the RBA will have no choice but to cut rates again at some point.

Still, few expect a recession. The GDP slump in the third quarter was due to a confluence of events that many economists believe weren't likely to be repeated in the fourth quarter, while other measures of economic activity are mostly upbeat.

All eyes are on the U.S. and policy changes by President Donald Trump. How these events play out in global markets, particularly currency markets could also have a big influence on the RBA's decisions around interest rates in the year ahead.

The Australian dollar has risen strongly so far in 2017. If that rally persists, it could attract the ire of the RBA. There are some signs already that the RBA is growing uneasy about the level of the Australian dollar.

For a small open economy like Australia's, a weaker exchange rate would also leave it "riding pretty," helping to raise growth and speed up the nation's transition from mining investment to a broader economy supported more by services and manufacturing industries, Ian Harper, economist and RBA board member, said in a recent interview.

"I'd like to see the (Australian-dollar) rate weaker than where we've seen it over the last 2-3 years, that's for sure," Mr. Harper said, though he added that he didn't see a sudden decline in the currency on the horizon.

-Write to James Glynn at james.glynn@wsj.com

(END) Dow Jones Newswires

January 24, 2017 19:53 ET (00:53 GMT)

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