* CPI +0.5 pct q/q; +1.8 y/y - beating f'casts
* Core inflation averaged at 0.4 pct y/y
* Core measure undershoots RBA target for a third year
* A$ rises on headline inflation beat (Adds details, economist comments, A$ level)
By Wayne Cole and Swati Pandey
SYDNEY, Jan 30 (Reuters) - Australian consumer prices stayed soft last quarter as core inflation ended a third full year below the central bank's target band, providing the room for a cut in interest rates in the event economic growth slows sharply.
However, there was no trigger for any near term easing in policy as the headline consumer price index (CPI) rose 0.5 percent in the December quarter, surpassing forecasts for a 0.4 percent increase and sending the local dollar AUD=D3 rallying.
The Aussie touched a day's high of $0.7187 from $0.7150 before the data.
Annual CPI inflation ran at 1.8 percent, again beating estimates, the official data released on Wednesday showed. The biggest price increases in the quarter came from tobacco, food and recreation while clothing and footwear, health services and transport all fell. Taxes on tobacco alone accounted for half the rise in the CPI.
Importantly, key measures of underlying inflation favoured by the Reserve Bank of Australia (RBA) averaged around 1.75 percent for the year, in-line with forecast.
Core inflation has now undershot the RBA's long-term target band of 2 percent to 3 percent for 12 straight quarters, the longest stretch since the series began.
Economists expect the trend to persist in the current quarter pressured by a sharp decline in petrol prices.
"That means that further falls in headline inflation are on the way," said Ben Udy, Singapore-based economist for Capital Economics.
"We suspect that our expectations for a softening domestic economy mean that underlying inflation will struggle to pick up steam any time soon and the RBA will be forced to cut rates to stimulate the economy."
For the past couple of years, policy makers have argued that it would be counter productive to further reduce the policy rate from the record-low 1.50 percent in the hope of lifting inflation.
Lower rates would only encourage more borrowing, the RBA has said, inflating a housing bubble at a time when Australians were already saddled with massive amounts of debt.
That argument seems less tenable given house prices have suffered the steepest falls in two decades while banks have aggressively tightened lending standards and independently lifted rates on their mortgage books.
Investors have reacted by pricing in a realistic chance the RBA will eventually be forced to ease again, even if reluctantly. Futures 0#YIB: now imply a 52 percent probability of a quarter-point cut in the 1.5 percent cash rate by the end of this year.
The speculation intensified on Tuesday when a closely-watched survey of Australian business showed the sharpest decline in conditions since the global financial crisis. posed a challenge to the RBA which has long touted the strength of business sentiment as a reason for optimism on the economy.
"If the December update is accurately describing conditions across the Australian economy then this is a watershed moment," warned Westpac senior economist Andrew Hanlan.
The RBA will release its latest forecasts for the economy on Feb. 8 and will be under pressure to cut its previous call of growth a bit above 3 percent for both 2018 and 2019.
Such a downgrade means policymakers might soon have to temper their long-held view that the next move in rates will be up.