SYDNEY - Australia slashed interest rates by a shock 50 basis points Tuesday to 3.75 per cent due to weaker economic conditions and lower inflation, causing a drop in the Aussie dollar but a sharemarket boost.

It was the largest cut since the Reserve Bank of Australia reduced rates by 100 basis points in February 2009 in the wake of the global financial crisis, and came as a surprise to analysts who tipped a 25 basis point fall.

Bank chairman Glenn Stevens said the decision was "based on information received over the past few months that suggests that economic conditions have been somewhat weaker than expected, while inflation has moderated".

In particular, data showed underlying inflation had declined again, and was a little over 2.0 per cent over the latest four quarters, and would likely be lower than earlier forecast over the next few years.

"A reduction of 50 basis points in the cash rate was, in this instance, therefore judged to be necessary in order to deliver the appropriate level of borrowing rates," Stevens said.

The local currency, which has been at historic highs for the past 18 months, slumped from 104.10 US cents to 103.22 US cents after the announcement. Sydney stocks were up around 0.8 per cent.

Treasurer Wayne Swan welcomed the news, describing it as a move small businesses and householders had been "hanging out for", and urged the big commercial banks to pass the full cut onto their borrowers.

The RBA last slashed its rate in December, and Stevens said the board "judged it desirable that financial conditions now be easier than those which had prevailed" then.

He repeated his view that while growth in the global economy had slowed in late 2011, a deep downturn was not occurring.

"Market sentiment remains skittish, however, and the tasks of putting European banks and sovereigns onto a sound footing for the longer term, and of improving Europe's growth prospects, remain large," he said.

"Europe will remain a potential source of adverse shocks for some time yet." Australia was dubbed the "Wonder from Down Under" after its mining-fuelled economy dodged recession during the global financial crisis.

But despite its booming resources sector, other parts of the economy are struggling against higher labour and energy costs and the stronger Australian dollar.

Families are saving rather than spending, with retail in a slump and housing construction weak.

Chief economist at the Commonwealth Bank Michael Blythe said the rate cut could lift consumer confidence.

"I think it has provided a circuit breaker for the negative feedback loop of consumer confidence that has been coming through," he said.

Shane Oliver, chief economist at AMP Capital Investors, said the decision revealed "the RBA got it wrong, now it's trying to get it right".

"At last the RBA has moved to get back on track and reverse the de-facto monetary tightening we have seen so far this year thanks to higher bank lending rates, and address the fact that the non-mining economy in Australia is really struggling," he said.

Australia still has higher rates compared to other nations.

The US Federal Reserve is expected to keep rates near zero until late 2014, while Bank of England policymakers last month voted to keep them at a record low 0.50 per cent, where they have stood since March 2009.

With the European economy tipping towards recession, the European Central Bank's policy-setting governing council voted last month to leave its benchmark interest rate unchanged at the historic low of 1.0 per cent.