By Stella Qiu and Wayne Cole
SYDNEY, Feb 3 (Reuters) - Australia's central bank on Tuesday raised its benchmark policy rate for the first time in two years, saying the economy was growing faster than expected and inflation was likely to remain above target for some time.
The Reserve Bank of Australia now joins the Bank of Japan in being the only other developed-world central bank tightening policy at the moment. Markets are still priced for rate cuts in the U.S., UK and Canada, while the European Central
Bank is widely expected to be on an extended pause.
Wrapping up the February policy meeting, the RBA raised interest rates by 25 basis points to 3.85%, delivering the first hike in two years, and coming just six months after its last cut in August.
Markets had wagered on a 78% probability of a hike on Tuesday given inflation surprised on the high side in the fourth quarter, while unemployment hit a seven-month low in December.
"While part of the pick-up in inflation is assessed to reflect temporary factors, it is evident that private demand is growing more quickly than expected, capacity pressures are greater than previously assessed and labour market conditions are a little tight," the RBA's board said in a statement.
"The board judged that inflation is likely to remain above target for some time and it was appropriate to increase the cash rate target."
The Australian dollar extended earlier gains to be up 1.1% to $0.7020 while three-year government bond futures tumbled 9 ticks to 95.65.
Investors ramped up bets for a follow-up hike in May, which is now priced at 75%. Markets expect an additional total tightening of 40 basis points this year.
INFLATION SURPRISE SET TO KEEP RBA ON TOES
The RBA did not raise interest rates as aggressively as its international peers when inflation was running hot due to its desire to preserve gains in the labour market.
That approach may yet test policymakers. The central bank's three rate cuts last year saw inflation rear its head again, forcing it to pivot towards a hawkish stance late in 2025 and prompting market bets of an earlier-than-expected start to the tightening cycle.
Consumer price growth has surprised on the upside for two straight quarters now, and is well above the RBA's target band of 2% to 3%. Underlying inflation, the central bank's preferred measure, ran at a quarterly pace of 0.9% in the fourth quarter, lifting the annual pace to the highest in over a year at 3.4%.
The recent flow of data has only served to reinforce the need for a quicker-than-expected turn in monetary policy levers, with a surprise fall in the unemployment rate to a seven-month low of 4.1% suggesting the labour market may have started to tighten again.
Robust consumer spending, record-high housing prices and easy credit availability for households and businesses added to the case that financial conditions might not be restrictive at all.
In its separate economic update, the RBA said it was uncertain that financial conditions were restrictive and some indicators suggested they may have been accommodative.
It saw the risk of persistently high inflation even on the technical assumption of more than two rate hikes this year.
(Reporting by Stella Qiu)
