Australia’s inflation rate has dropped sharply, raising fresh hopes the Reserve Bank will take its foot off the interest rate accelerator when it meets next week.

But despite a sharp fall in the consumer price index to 5.6 per cent in the year to May – down from 6.8 per cent in April – persistent growth in rents and services mean further interest hikes remain likely.

Wednesday’s result was well below market and most economists’ expectations, with a sharp turnaround in fuel prices feeding into the weak figures.

“This month’s annual increase of 5.6 per cent is the smallest increase since April last year,” Australian Bureau of Statistics head of prices statistics Michelle Marquardt said.

“While prices have kept rising for most goods and services, many increases were smaller than we have seen in recent months.”

A 6.7 per cent fall in automotive fuel prices in the month of May, to be down 8 per cent annually, weighed heavily on the headline figure.

Ms Marquardt said petrol price movements 12 months ago were now showing up as volatility in the annual consumer price index, and swinging the annual rate around.

Holiday travel and accommodation prices also fell 11.3 per cent in monthly terms and grew at a softer annual rate compared to April.

Housing was among the top contributors to the annual growth, lifting 8.4 per cent, but was down from 8.9 per cent in April.

Low vacancy rates fuelled another uptick in rents from 6.1 per cent in April to 6.3 per cent in May.

Other top contributors to the annual growth included a 7.9 per cent jump in food and non-alcoholic beverage prices, led by a rise in meals and takeaway food.

Treasurer Jim Chalmers, who also on Wednesday confirmed Australia’s first budget surplus in 15 years, welcomed the slowing inflation rate.

“I think it’s really important for us to understand and acknowledge that with all of the price pressures that Australians are feeling right now, petrol prices have come off substantially on average in the capital cities since this time last year,” he said.

“We finish the financial year with petrol cheaper, on average, than it was at the start of the financial year. Given all the other pressures people are facing that’s a good thing.”

Dr Chalmers said Australia’s budget surplus for 2022/23 would be bigger than the $4.2 billion projected in the May budget, but high inflation and global challenges would “significantly slow” the domestic economy.

It has come as strong jobs growth and bumper mining profits will swell government coffers, while spending curbs and $40 billion in savings have also boosted the budget bottom line.

The Reserve Bank’s next step

Ms Marquardt said the decline in inflation was more modest when volatile items such as automotive fuel, holiday travel and fruit and vegetables were stripped out.

The bureau’s measure of underlying inflation, calculated by removing volatile items, fell to 6.4 per cent in May which is slightly lower than the rise of 6.5 per cent recorded in April.

Barrenjoey chief economist Jo Masters said the headline number came in well below market expectations. But some concerning details are likely to weigh on the RBA when it meets to make its July cash rate decision next Tuesday.

For example, she said rents lifted by more than expected and services inflation accelerated by more than anticipated, across utilities, insurance and rents.

“These are items where prices almost never fall, so they take a very long time to come out of the inflation data,” Ms Masters said.

She said she was leaning towards another hike.

EY senior economist Paula Gadsby said inflation had slowed, but remained to far above the Reserve’s 2-3 per cent target.

“Persistent services inflation, along with subdued productivity growth driving a rapid rise in unit labour costs, will make the Reserve Bank very uncomfortable. This, combined with the strong labour market reading for May, strengthens the case for tighter monetary policy in coming months,” she said.

“Any stickiness in prices, upside surprises on rents or wages, and or further downside surprises in productivity growth present risks to inflation over coming quarters.

“This will make it harder for the Reserve Bank to achieve their forecast falls in inflation and keep interest rates higher for longer.”

The central bank has handed out four percentage points of rate increases since April last year in an attempt to pull inflation back within its target range. Since the RBA began its most recent round of increases, there has been only one month that it has paused hikes.

-with AAP