The Reserve Bank of Australia (RBA) could cut the official cash rate as early as next week after the consumer price index (CPI) surprisingly fell by 0.2% for the first quarter of 2016.

Economists had forecast (guessed) that CPI would rise by 0.2%, following on from the previous quarter’s 0.4% rise. The core inflation number – the key number watched by the RBA – dropped to 0.2% for the quarter and up by 1.3% for the past 12 months – well below the central bank’s target range of between 2% and 3%.

In a sign that the market expects the RBA to cut rates, the Australian dollar plunged more than one US cent to around US 76.50 cents immediately after the announcement.

The odds of a rate cut as early as next week have soared to more than 50% according to several sources, including Citigroup.

It’s the first time in seven years that Australia has seen deflation, as falling petrol (down 10%) and food prices (fruit down 11%), holiday travel and accommodation both international and domestic also fell. Six out of the eleven CPI groups fell, indicating a broad-based decline in prices.

The RBA will now have to decide whether low global oil prices and the impact they are having on inflation is a good enough reason to cut the cash rate, or whether other domestic factors are likely to offset that.

The other problem the RBA faces is that despite the current record low cash rate of 2% since April 2015, Australia faces a similar problem to other countries and regions around the world including Japan and Europe that low interest rates and even negative interest rates are not triggering the expected growth. Would a 0.25% rate cut make much of a difference in Australia?

And even if the central bank does cut the official cash rate, will the banks including the dominant big four of Australia and New Zealand Banking Group (ASX: ANZ), Commonwealth Bank of Australia (ASX: CBA), National Australia Bank Ltd (ASX: NAB) and Westpac Banking Corp (ASX: WBC) pass on all or most of the cut to their customers?

They could easily hang on to some of the cut and pass on a token amount to customers, which would leave the RBA in a pickle.

Foolish takeaway

The RBA could, of course, go big and cut the cash rate by 0.5%, but if that doesn’t work, it leaves the bank with very little room to manoeuvre.

But if you consider the RBA’s main task of keeping inflation between 2% and 3%, there’s absolutely no reason why the RBA won’t cut rates on Tuesday next week.

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Motley Fool writer/analyst Mike King doesn't own shares in any companies mentioned. You can follow Mike on Twitter @TMFKinga

The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.