UPDATE 1-Australia inflation spikes, limits scope for rate cut

* CPI rises 0.8 pct in Q4, 2.7 pct for year vs 2.5 pct forecast

* Underlying inflation up 0.9 pct q/q, biggest rise since mid-2011

* Surprisingly high outcome lessens scope for further rate cuts

By Wayne Cole

SYDNEY, Jan 22 (Reuters) - Australian inflation rose by far more than expected last quarter as the cost of food, holiday travel and tobacco all rose, dealing a major blow to the prospects of another cut in interest rates and sending the local dollar higher.

Wednesday's figures from the Australian Bureau of Statistics showed consumer prices (CPI) rose 0.8 percent in the fourth quarter of 2013, taking annual inflation to 2.7 percent.

Key measures of underlying inflation both climbed by 0.9 percent in the fourth quarter, well above forecasts of 0.6 percent and the largest rise since mid-2011.

The annual pace on inflation accelerated to 2.6 percent, still within the Reserve Bank of Australia (RBA) long-term target of 2 to 3 percent, but a challenge to expectations it would stay contained for the next year or more.

" A disappointing set of numbers, which are a reminder that inflation is still a two-way story in Australia," said Michael Blythe, chief economist at Commonwealth Bank of Australia.

"The key part is we're starting to see some import price pressures coming through from the currency, but we're not seeing that offsetting slowdown from domestic inflation that the Reserve Bank has in its forecasts, an indication of some upside risks to be moved through 2014."

The Australian currency hit a three-and-a-half year low on the U.S. dollar this week having been on the decline for much of the past nine months. That was boosting prices for imported goods, a reversal of a trend that lasted from 2010 to 2012 when the currency held at historically high levels.

The market reaction was immediate, with investors sharply widening the odds of another cut in rates. Interbank futures

0#YIB: now show only a 20 percent of a cut by July, compared to just over 50 percent before the data were released.

Yields on three-year government paper AU3YT=RR shot up 12 basis points to 2.99 percent, wiping out gains made in the wake of a soft employment report released last week.

That in turn lifted the Australian dollar three quarters of a U.S. cent to $0.8864 and away from the week's trough of $0.8756.

"There's no doubt the figures were disappointingly high," said Shane Oliver, head of investment strategy at AMP Capital Markets. "It does substantially reduce the chances of another rate cut."

Equally, though, he did not see much risk of the RBA reversing course and tightening.

"I don't think it's enough given the volatility you can see in the quarter-to-quarter inflation numbers in Australia, I don't think it would be enough to shock the Reserve Bank to hike."

The Reserve Bank of Australia will hold its first 2014 monetary meeting on Feb 4.

(Editing by Eric Meijer)

((Wayne.Cole@thomsonreuters.com)(612 9373 1813)(Reuters Messaging: wayne.cole.thomsonreuters.com@reuters.net))

Keywords: AUSTRALIA ECONOMY/INFLATION