Underwhelming gross domestic product and inflation figures prompted financial markets to temper their expectations of interest rate rises by the Reserve Bank ahead of a further slowdown in activity.

Economic growth advanced 0.5 per cent in the December quarter, missing forecasts of 0.8 per cent, as inflation and higher interest rates cooled demand. The annual rate of gross domestic product growth slowed to 2.7 per cent, from 5.9 per cent.

The Australian dollar initially dropped to its lowest in two months but rebounded 0.3 per cent to US67.48¢ after China posted it’s highest monthly gain in manufacturing activity in February in more than a decade.

The $A is often used as a proxy for Chinese growth because of the countries’ strong trade links.

China’s manufacturing purchasing managers index rose to 52.6 last month from 50.1 in January, according to the data, after COVID-19 restrictions were lifted late last year. It was the highest reading since April 2012 and beat forecasts of 50.6.

The non-manufacturing gauge, which measures activity in the services and construction sectors, rose to 56.3 from 54.4, better than a projected rise to 54.9. A reading above 50 indicates expansion from the previous month, while below indicates contraction.

In Australia, the weaker-than-expected GDP and inflation result prompted interbank futures to pare back the scale of interest rate increases. They indicate the Reserve Bank of Australia will lift the cash rate to 4.2 per cent, down from expectations of 4.3 per cent before the report’s release. This would mean at least three more rate increases. On Monday, bond traders had wagered the terminal would hit 4.4 per cent.

Financial markets indicate a 96 per cent chance the RBA will lift the cash rate by 0.25 of a percentage point to 3.6 per cent at its next policy meeting on March 7.

Three-year government bond yields, which reflect interest rate expectations, dropped 13 basis points to 3.5 per cent. They had jumped a whopping 44 basis points in February, the largest monthly gain since August.

Economists said the softer data was unlikely to derail the RBA rate outlook. ‘‘We expect the RBA to remain focused on accelerating labour costs,’’ said Andrew Boak, chief economist for Australia at Goldman Sachs.

He noted nominal unit labour costs had accelerated to an annual rate of 7.1 per cent, far above the pre-COVID-19 decade average of 1.6 per cent, and that would keep upward pressure on CPI.

‘‘We believe the RBA has more work to do to mitigate the risks to broader inflation as global peer central banks continue to lift interest rates,’’ he said.

Goldman Sachs maintained its forecasts of a 0.25 percentage point increase at each of the next three RBA meetings to a 4.1 per cent terminal rate by May.

Other reports released yesterday showed the monthly indicator of consumer prices rose 7.4 per cent in the year to January. The household savings ratio recoiled to a five-year low of 4.5 per cent, from 7.1 per cent in the September quarter.

‘‘The reduction in the savings rate to close to below its pre-pandemic average means the outlook for spending from here is more aligned with growth in household disposable income rather than savings accumulated during the pandemic,’’ said Gareth Aird, head of Australian economics at CBA.

‘‘The very pessimistic levels of consumer sentiment imply the tailwind on the economy from pent-up savings does not have much further to run.’’

CBA expects GDP growth will slow by more than the RBA anticipates over 2023 and the jobless rate will rise above the central bank’s forecast. It also anticipates inflation to recede more quickly than the RBA projects.

Mr Aird forecasts two quarter-point increases to the cash rate before easing policy later this year.

A separate report showed a slight improvement in manufacturing health, which may suggest the economy remains on track for a soft landing in 2023. The seasonally adjusted S&P Global Australia Manufacturing Purchasing Manager’s Index edged up to 50.5 in February, from the neutral level of 50 last month.

‘‘None of the forward-looking indicators are pointing to a recession,’’ said Warren Hogan, an economic adviser at Judo Bank. ‘‘The results support the notion that economic activity is holding up in early 2023.’’

He expects the cash rate to rise to between 4 per cent and 4.5 per cent.