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Australia Central Bank Raises Rates to Decade High

Australia's central bank raised interest rates to a decade-high of 6.5% on Wednesday, as expected, saying higher borrowing costs were needed to check inflation.

The Australian dollar edged higher while bond futures remained soft after the Reserve Bank of Australia (RBA) raised its key cash rate a quarter of a percentage point to 6.5% following its monthly policy meeting on Tuesday.

This was the ninth tightening in a cycle that began in mid-2002, and took rates to their highest since December 1996.

The central bank cited a pick up in demand, tight labor markets, strong demand for credit, a lack of spare capacity and an unexpected acceleration in inflation as reasons for the move.

"Based on these considerations, the board judged that a somewhat more restrictive monetary policy setting was required in order to keep inflation consistent with the target in the medium term," the RBA said in a brief statement.

Underlying inflation jumped 0.9% in the second quarter, well above expectations and threatening to push the annual pace of 2.75% toward the ceiling of the central bank's 2% to 3% target range.

"It's the expected rise for the expected reasons," said John Edwards, chief economist at HSBC. "Growth indicators have strengthened and inflation at this point is rather higher than RBA expected it to be."

Interest rate futures had been pricing in a better than 80% chance of a hike, so the initial reaction in financial markets was muted, particularly as the RBA offered few clues on the outlook for further rate moves.

Insurance

"It is very much an insurance against medium term inflation pressures," said Su-Lin Ong, a senior economist at RBC Capital. "The RBA will remain in tightening mode, but like many other central banks will also adopt a wait and watch mode given the global developments."

The central bank did note that it had carefully considered the recent turmoil in financial markets, but judged that the outlook for global economic growth was still bright.

Interest rate futures still showed a real chance that a further tightening to 6.75% would be needed, though likely not until early next year.

"On most of the traditional measures monetary policy has now entered the restrictive zone, and that's occurring at a time when we know the household sector is particularly exposed to higher interest rates or negative income shocks," said Michael Blythe, chief economist at Commonwealth Bank. "I think the test for a further rate rise will be quite high," he added.

In some senses Australia is a victim of its own success in that, after 17 years of ceaseless expansion, there is little spare capacity in the economy. In particular, the unemployment rate has fallen to 4.3%, near three-decade lows, and firms constantly complain of a lack of skilled labour.

A strong Australian dollar and fierce global competition has helped somewhat by keeping import prices down, but the costs of domestic services from education to healthcare continue to climb.

"As a result we see the RBA retaining a tightening bias for the foreseeable future and do not see a peak in the domestic cash rate cycle unless and until the global economy slows markedly," said Deutsche Bank's chief economist, Tony Meer.

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