The Reserve Bank of Australia raised its cash rate to 3.25 percent from a 49-year low of 3 percent. Between September 2008 and April this year, the rate was slashed a total of four and a quarter percentage points as the financial crisis morphed into a global recession.
The rate hike, which comes after recent data showed the economy was improving, sent the Australian dollar soaring to a 14-month high against the U.S. dollar.
The central bank's governor Glenn Stevens said it was "prudent" to begin gradually reducing the stimulus provided by low interest rates. He said the risk of "serious economic contraction" in Australia had passed.
At a Group of 20 summit in the U.S. last month, leaders of major developing and industrialized nations agreed to keep their stimulus efforts _ which include increased government spending and low interest rates _ largely in place for now to avoid derailing still-fragile recoveries.
But Australia, a G-20 member, has weathered the worst global downturn in decades better than other developed countries. It avoided slipping into recession _ helped by stable banks, demand from China for iron ore and other minerals, and the government's 42 billion Australian dollars ($37 billion) of stimulus spending.
Asia, a crucial market for Australia's mineral exports, is rebounding from the downturn faster than the West and could face asset bubbles and a spike in inflation if governments wait too long to withdraw stimulus measures. Rising food prices are already becoming a problem in India. HBSC economists said in a report Tuesday that South Korea, Indonesia and the Philippines are also on the radar as countries particularly vulnerable to an inflation blowout.
Australia's gross domestic product grew 0.6 percent in the second quarter, accelerating from 0.4 percent growth in the previous quarter. In September, consumer confidence surged to its highest level since July 2007. Since March, Australian shares are up 50 percent.
Stevens said the global economy was growing and its recovery was likely to continue during 2010. The prospects for Australia's Asian trading partners appeared to be "noticeably better," he said.
"Growth in China has been very strong, which is having a significant impact on other economies in the region and on commodity markets," Stevens said.
Most economists had expected the central bank to leave the interest rate unchanged until November.
Federal Treasurer Wayne Swan said the global economic outlook was still fragile, and growth was below its long-term average levels. This meant stimulus measures, including low interest rates, could not be fully withdrawn yet, he said.
"We must still keep in place expansionary monetary and fiscal policy," Swan told a news conference.
Economists were split on whether the move came too soon.
National Australia Bank senior economist Spiros Papadopoulos said the central bank clearly had more confidence about the outlook for the economy to take the action it did.
"We felt that the Reserve Bank would have waited another month to get further information that the recovery would be sustained but they are feeling confident that it will be," he said.
Papadopoulos said a 3.25 percent cash rate was still providing stimulus for the economy.
"It is still a very low interest rate," he said.
The opposition treasury spokesman Joe Hockey said the decision was a direct result of the federal government's reckless spending. He called on Prime Minister Kevin Rudd to pull back on its stimulus spending, saying it would put further pressure on the central bank to raise rates again.
The Australian dollar jumped from $US0.8671 just before the RBA's annoucement to $US0.8844 less than 10 minutes later.