Australia's economy unexpectedly shrank for the first time in eight years in the last quarter as firms ran down inventories at the fastest pace in more than two decades, reviving pressure for more monetary and fiscal stimulus.

The Australian dollar slid while bill futures surged as investors wagered the Reserve Bank of Australia (RBA) might come to regret not easing at its policy meeting on Tuesday and would now have to cut interest rates in April.

"A massively, massively weak number and this is the necessary condition for the first leg of a recession," said Joshua Williamson, a senior strategist at TD Securities.

The common definition of recession is two successive quarters of contraction in gross domestic product and the last time Australia suffered that was in 1991.

"Global weakness has now extended well and truly to Australia and should add to expectations for more aggressive rate easings in coming months, especially given the RBA's decision yesterday to keep rates on hold," said Williamson.

Investors rushed to price back in the prospect of a 50 basis point cut in the 3.25 percent cash rate when the RBA next meets on April 7, and suggested it could approach 2.0 percent by mid-year.

Wednesday's report showed GDP, essentially the value of all goods and services produced in Australia, fell 0.5 percent last quarter, from the third quarter when it rose 0.1 percent. The result was well below forecasts of 0.2 percent growth and the first drop since 1991, when the introduction of a sales tax caused a one-off slump in demand.

It was still better than much of the competition. Japan, Australia's biggest export market, saw GDP fall 3.3 percent last quarter, while Korea suffered a 5.6 percent drop, the euro area 1.5 percent and the United States 1.6 percent.

HARD TO STOMACH

But the weak result challenged the RBA's argument that Australia would ride out the global storm relatively well. The economy expanded by just 0.3 percent compared to the same period in 2007, down from 1.8 percent the previous quarter. That was tough to stomach for a country that has grown used to average growth north of 3 percent in the past 17 years.

"The Australian economy looks to be flirting with recession, despite obvious support and assistance from policy stimulus," said Su-Lin Ong, senior economist at RBC Capital Markets. "And you've got to think that there's a risk that the first half of this year is pretty weak as well."

The RBA cut rates by 400 basis points between September and February, while the government announced fiscal packages worth over A$52 billion ($33 billion). GDP for all of 2008 amounted to A$1.09 trillion in inflation adjusted dollars, or $50,925 for every man, woman and child in the country.

Household consumption surprised by barely growing in the quarter, even though government hand outs worth more than A$8 billion boosted retail sales sharply in December.

Instead, cautious consumers chose to save rather than spend with the household saving ratio surging to 8.5 percent, up from just 0.5 percent at the start of 2008 and the highest since 1990.

Firms were also bracing for bad times ahead by running down stocks at a furious pace. In all, inventories took a savage 1.7 percentage points from GDP in the quarter.

That more wiped out a much improved trade performance, with exports outstripping imports enough to add 1.5 percentage points to growth.

There were also signs of worse to come from an industry survey of the country's service sector on Wednesday. Firms from retailers to restaurants, banks and estate agents reported big falls in sales, new orders and employment.

The Australian Industry Group (AiG)-Commonwealth Bank Performance of Services Index (PSI) dived 8.8 points to 32.2 in February, with all sectors reporting weakness in demand.

"There is scope for further rate reductions," said Heather Ridout, chief executive of AiG. "Monetary policy will need to remain agile in the face of numbers such as these."