Australia's central bank shocked markets by skipping an interest rate rise this week, citing the impact of higher mortgage rates at home while noting tighter policy in China and concerns over sovereign debt abroad.

The Reserve Bank of Australia's (RBA) decision to keep its key cash rate at 3.75 percent confounded expectations of a rise to four percent and hammered the local currency as investors slashed estimates for how high rates might go this year.

Yet, RBA Governor Glenn Stevens also emphasised that, should the domestic economy continue to improve as expected, then further hikes would likely be needed over time.

“This is a pause, not a stop,” said Peter Jolly, head of research at National Australia Bank. “It's just that they paused earlier than most thought.”

“I don't think they have radically changed their view,” he added. “We still think they need to lift rates again and we see rates at 4.75 percent by the year end.”

The market was badly caught out, however, having almost fully priced in a hike at the policy meeting.

Investors now doubted if the RBA would move in March either, with futures pricing in around 35 percent chance of a rise. Expectations for the next 12 months were pared back to show around 80 basis points of tightening, compared to 105 basis points before the announcement.

“It implies that the RBA feels it has done enough for the time being,” said Stephen Roberts, a senior economist at Nomura. “You'd think there would be a pause for a few months before lifting to four percent by mid-year. It's going to be a slow process getting the cash rate higher.”

One eye offshore
The RBA's caution was warmly welcomed by the Labor government which faces a tough election fight later this year.

“Families will welcome this decision and businesses will welcome this decision,” Treasurer Wayne Swan told parliament. Mortgage rates are a sensitive topic in Australia, where home ownership is a national obsession.

Analysts suspected recent events offshore may have added to the case for a pause. In a brief policy statement, RBA chief Stevens noted China had begun to rein back stimulus in its economy, global credit conditions were difficult and worries had grown over debt levels in some countries.

China's tightening have rattled investors globally as they worried demand from the world's major growth engine could falter. South Korea's finance minister told reporters last week that the government needed to prepare to offset the impact of any policy moves in its biggest export market.

“So maybe a little bit more of international concern stayed their hand and they want to see how that evolves,” said Joshua Williamson, an economist at Citi.

“But there is a risk given the underlying strength of the (domestic) economy that this was a missed opportunity and they're going to have to potentially go a little harder in the second half of the year if they don't make this up in the next few months.”

Indeed, the RBA was resoundingly upbeat on the domestic outlook saying the economy had proved stronger than expected with unemployment peaking much lower than feared, resource investment strong and house prices up sharply.

The source of doubt seemed to be that lending rates in the economy had risen faster than the cash rate, as banks sought to cover increased funding costs caused by the global credit crisis.

The RBA has estimated that effective rates across the economy were now more than 100 basis points above the cash rate, far higher than before the credit squeeze.

This means that a neutral rate, one that neither stimulates nor retards economic growth, is also lower than in the past.

As governor Stevens often says when quized on where neutral is: “We'll know when we get there.”