By James Ramage 
 

The Australian dollar tumbled after muted inflation data scotched investors' expectations that the central bank would raise interest rates.

Investors had been buying the Australian dollar since late January. The wager was that Australia's economy could weather a slowdown in China, its biggest export market, and that the Reserve Bank of Australia would become the second major central bank-after New Zealand-to raise rates since the financial crisis. Higher interest rates would support the Aussie by boosting returns on assets denominated in the currency, attracting investors.

That support crumbled with the lower-than-expected inflation figures released Wednesday. Consumer prices rose 2.9% in the first quarter from a year earlier, compared with an average forecast for a 3.2% increase. The Reserve Bank of Australia is widely seen as unlikely to raise rates unless inflation is above its target range of 2% to 3%.

The Australian dollar hit a two-week low after the report, trading down 0.9% at $0.9285 late Wednesday in New York. The currency was trading near a five-month high against the U.S. dollar before the inflation data.

Some money managers and analysts say it will be hard for the Aussie to keep climbing now that a rate increase is likely off the table in the coming months. Many still harbor doubts about the health of Australia's economy, particularly the mining sector, which depends on demand from China. Without the incentive of higher yields, Australia's currency and bonds may have a tougher time attracting investors.

"We do think an important support was taken away from the Australian dollar by the CPI number," said Roger Hallam, who helps manages over $230 billion as currency chief investment officer of global fixed income at J.P. Morgan Asset Management.

Mr. Hallam bought the Aussie in early March, during a stretch of strong economic data, but exited those wagers earlier this month. He said he doesn't have any exposure to the Australian dollar currently, adding the currency could fall to $0.90 by the end of the year.

Before Wednesday, investors had been warming to the Australian dollar. Earlier this month they held a bullish position in Aussie futures for the first time in almost a year, according to the Commodity Futures Trading Commission.

The currency has been a popular bet off and on since the financial crisis. Australia's economy, supported by commodity exports, never entered recession during that period. The RBA was one of the few central banks in the developed world not to cut interest rates to near zero, making the Aussie attractive to investors hunting for higher returns. Australia's central bank sets its benchmark interest rate at 2.5%, compared with the U.S. Federal Reserve's range of between zero and 0.25%.

But over the last year, the Aussie has suffered as Australia's economy faced headwinds from slowing growth in China. Prices for iron ore and coal, the country's two biggest exports, have fallen amid fears of shrinking Chinese demand. The Australian dollar traded at a 3½-year low in January.

More recently, the outlook has brightened. Australia has posted a trade surplus for three straight months and the unemployment rate has backed down from recent highs.

Some investors and analysts say improvement in Australia's economy should continue to carry the Aussie higher, even without a rate increase.

The Australian dollar "still offers attractive yields compared with other currencies," said Kathy Lien, managing director of FX strategy at BK Asset Management. "The yield story is in play. And we're seeing improvements in Australia's economy."

Ms. Lien said she would consider buying the Australian dollar if it fell to $0.9150, and sees it rising to $0.97 in the next six months.

But a large number of bullish bets on the Aussie were centered on interest rate expectations and had to be hastily unwound on Wednesday, said Sebastien Galy, FX strategist at Société Générale.

"Some were wrong-footed hoping for more" gains for the Australian dollar, Mr. Galy said.

Write to James Ramage at james.ramage@wsj.com