(Adds details, comment, market reaction)
* NZ annual inflation drops back into target band
* Backs view rates will stay low for longer
* NZ dollar falls, debt futures rise
By Mantik Kusjanto
WELLINGTON, Jan 19 New Zealand's annual inflation unexpectedly fell in the December quarter as food prices dropped, giving the central bank plenty of leeway to keep interest rates at a record low as global risks threaten to derail a limp recovery in the domestic economy.
The consumer price index fell 0.3 percent in the three months to Dec 31, to be 1.8 percent higher than a year ago, data showed on Thursday. That was the first decline in two years.
Analysts polled by Reuters forecast a rise of 0.4 percent for the quarter and 2.6 percent from a year earlier, in line with the Reserve Bank of New Zealand's (RBNZ) forecasts.
New Zealand has seen soft price pressures over the past year, leaving aside the one-off impact of a rise in the government sales tax in October 2010.
"It means the RBNZ is probably on hold for the entire year. Policy is already more than accommodative, so we can't see them cutting any further," said RBC Capital Markets strategist Michael Turner.
The New Zealand dollar fell nearly half a cent after the data from $0.8070, but steadied around $0.8030. The currency has risen about 4.5 percent over the past 12 months, helping contain inflation.
Interest rate futures <0#NBB:> rose in a delayed reaction by up to 9 points as markets pushed out the timing of future rate increases.
The RBNZ cut its official cash rate by 50 basis points to a record low 2.5 percent in March last year to help the economy after a devastating earthquake the previous month.
The bank is expected to leave the cash rate there at next week's first interest rate review of the year, and reiterate that the uncertain global outlook and moderate domestic demand make it prudent to keep rates on hold for now.
Last month, the RBNZ projected rate hikes to start from the middle of this year.
In contrast, financial markets pricing implies a 6 percent chance of a rate cut this month, with a largely flat outlook over the next 12 months.
The majority of a Reuters poll of 18 analysts expect a rise in the second half or even next year, with no prospect seen of a rate move at the Jan 26 rate review.
The decline in December quarter inflation was driven by a 2.2 percent fall in food prices, largely volatile fresh fruit and vegetables, and also appliances and furniture.
The non-tradables component of the index, a key barometer of domestic inflation including electricity, house rental and property prices, rose 0.2 percent on the previous quarter for an annual rise of 2.5 percent.
Inflation for sectors like apparel and household contents facing competition or open to currency changes fell 0.9 percent on the previous quarter.
"The lingering impact of the strong New Zealand dollar and the economy's spare capacity is keeping retail price inflation down," said Westpac chief economist Dominick Stephens.
"At this stage there is little evidence of inflation pressures stemming from a tighter housing market."
Recent data has indicated some stability in the housing market, after a sluggish 2010.
The annual inflation rate hit a 10-year high in the second quarter last year as the sales tax increase added an estimated 2.2 percentage points.
With business and consumer confidence slipping and pricing intentions easing, inflation pressures are expected to remain subdued in the near term, and well anchored within the RBNZ's 1-3 percent target zone.
Economic growth is expected to pick up this year as the rebuilding of earthquake-hit Christchurch gains some momentum. (Reporting by Mantik Kusjanto; Editing by Lincoln Feast and Sanjeev Miglani)