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Reserve Bank of Australia cuts cash rate to fight deflation

The cut, the first in a year, came less than a week after a shock drop in core inflation to well below the central bank's 2 per cent to 3 per cent target band.

Most economists expect a second cut before the end of the year, although some say the June quarter inflation figure, out in August, will determine the RBA's next move.

Tuesday's historic interest rate reduction coincides with the federal government's third budget, which is expected to be mildly stimulatory despite pressure to narrow the deficit.

Deflation in the headline consumer price index, due mainly to falling oil prices and aggressive retailer discounting, was the first such quarterly contraction in seven years.

Moderate inflation, the result of demand for goods and services – including labour – just outstripping supply, is usually the mark of a healthy economy.

However, when prices and wages continue to fall, consumers often hold off on buying and companies on investing. Deflation also pushes up the relative burden of debt.

The cash rate is now easily at its lowest level under the current system of monetary policy setting.

The latest cut puts Australia into the club of developed economies with ever-falling interest rates and bond yields. Japan, the European Union and parts of Scandinavia now have zero or even negative nominal rates. New Zealand, too, looks likely to keeping cutting from an already-low 2.25 per cent official cash rate.

RBA governor Glenn Stevens said the decision was based on last week's surprisingly weak inflation read-out.

"Inflation has been quite low for some time and recent data were unexpectedly low," he said in a statement.

"While the quarterly data contain some temporary factors, these results, together with ongoing very subdued growth in labour costs and very low cost pressures elsewhere in the world, point to a lower outlook for inflation than previously forecast," he said.

He also noted that softening conditions in what was an overheated housing market had allowed the bank to cut without fear of re-igniting unsustainable price growth