The Reserve Bank said there would be more scope in the future to cut interest rates after keeping rates steady for a fifth month.
The central bank held official rates at a 12-year peak of 7.25 per cent and said it expected inflation to remain relatively high in the short term.
But RBA governor Glenn Stevens said that with “demand slowing, the board’s view is that scope to move towards a less restrictive stance of monetary policy in the period ahead is increasing”.
The bank's dovish comments on an eventual move towards easing rates prompted an immediate reaction on the financial markets, as traders sold off the Australian dollar.
The currency moved from US92.81c ahead of the decision down to around US92.17c.
Interest rates markets are convinced the RBA will order a rate cut as soon as next month.
And the equities market interpreted the RBA statement as a positive, with the losses in the benchmark S&P/ASX 200 Index halving after the release of the policy outlook.
ANZ senior economist Katie Dean said there was now a strong chance the first rate cut could come as early as next September.
“This is vindication for the market, which had moved sharply in the last week to price in around three interest rate cuts before the end of the year,” Ms Dean said.
“The RBA has effectively signalled that if wages growth remains moderate and if the next round of growth data remains soft, they could start the process of reducing interest rates in the months ahead. In effect the RBA has shifted to an easing bias that looks like it could be acted upon at any time.”
Su-Lin Ong, the senior strategist at RBC Capital Markets, said the timing of the rate reduction would depend on the next set of economic data.
The unemployment rate for July is expected to tick up slightly from 4.2 per cent to 4.3 per cent when published on Thursday.
“Further downside surprises will support the case for rate cuts sooner rather than later,” Ms Ong said.
“We also think that today's short statement was quite strongly worded. In opening the doors to easing, we doubt if the RBA would choose to sit on the sidelines for many months.”
For the first time, the RBA acknowledged the moderation of the economy was occurring swiftly - an admission which will exacerbate calls for a cut.
“On balance, however, it is looking more likely that demand will remain subdued, and economic growth will be fairly slow, over the period ahead,” Mr Stevens said.
“Inflation is likely to remain relatively high in the short term, with the CPI affected by high global oil prices.”
The statement said the Reserve Bank was maintaining its projection that inflation would be back within the 2-3 per cent target band by the middle of 2010.
Mr Stevens surprised bank observers recently when he declared he could cut rates while inflation was outside the management bracket.
“Looking further ahead, inflation in both CPI and underlying terms is likely to decline over time, given the outlook for demand, provided wages growth remains moderate,” he said today.
Mr Stevens said the RBA realised financial conditions remained tight in Australia for most households, however, the terms of trade boom was still buoyant.
“The evidence is that the tightening in financial conditions, in conjunction with other factors including rising fuel costs, and lower asset values, has restrained demand,” he said.
“Indicators of household spending have continued to record subdued outcomes over recent months, and credit expansion to both households and businesses has slowed significantly.
“Surveys suggest a softening in business activity, and there have also been some early signs of an easing in labour market conditions.”
A rush of negative economic data recently, particularly weak retail sales numbers, has strengthened the case an interest rate reduction in the next few months.
Ahead of the interest rate decision, Treasurer Wayne Swan said he realised Australian households were under stress.
“I certainly think Australian homeowners would welcome some relief but that is entirely a matter for the independent Reserve Bank,” he said.
In its fight against inflation, the RBA has raised official rates twice this year – February and March – in a tightening cycle that began in May 2002.
Commercial banks this year have raised their rates independently of the RBA’s moves in response to higher wholesale funding costs due to the global credit crunch.
