SYDNEY—Australia's annual inflation rate rose much less than expected in the second quarter, causing the currency to fall as it now likely means interest rates will be kept on hold for a number of months at least.

Central bank may be pleased with consumer prices for now, but there's risk of overheating in coming months. Dow Jones Newswires' Mark Cranfield reports.

The consumer price index rose 0.6% in the second quarter and rose 3.1% from a year earlier, the Australian Bureau of Statistics said Wednesday. Economists had expected the CPI to rise 1.0% from the previous quarter and to rise 3.4% from a year earlier.

The Australian dollar, fell sharply after the data was released. It was trading at US$0.8940, down from US$0.9003 just before the report. Government bond prices rallied

Core inflation rose a mild 0.5% in the second quarter and rose 2.7% from a year earlier, well within the tolerances of the Reserve Bank of Australia, which targets inflation between 2% and 3%.

A tobacco tax increase and a strong rise in health costs added to inflation through the quarter. Offsets came in the form of a fall in prices for food, communications and recreation, the ABS said.

Economists said the data confirms Australia may have temporarily won a victory over inflation pressures after aggressive interest rate increases over the last year.

"The RBA will remain on hold for at least the next three months and probably into 2011," said Rory Robertson, senior debt strategist at Macquarie Bank.

The surprising inflation outcome comes despite the fact that the economy is reporting strong economic growth, a commodity price surge that has pushed the current account surplus to 50-year highs and job growth suggests full employment isn't far off.

Having already hiked rates six times since October 2009, the RBA has been sidelined since May saying it has been waiting for the release of the inflation report and signs of improved confidence in global market confidence.

The 30-day interbank futures markets rose after the CPI data. The August contract now implies almost no chance of a hike a rate hike next week compared with around a 30% chance ahead of the report.

Australia Treasurer Wayne Swan told a conference in Sydney that he remained optimisitic for a strong Australian economy and for continued growth in the Asia Pacific region. Swan said Australia is "in the best possible position that could be", having avoided a recession, to maximise the opportunities that flow from growth in the region.

"The outlook for Australia is I believe quite bright," he said.

Write to James Glynn at james.glynn@dowjones.com