The Reserve Bank of Australia (RBA) surprised the banking community on Tuesday by announcing an overnight cash rate cut of 25 basis points. With the decision, the country's key lending rate is down to 3.25 per cent, the lowest in three years.

The RBA said the unexpected cut was in response to the worsening outlook for the global economy and amid indicators that the local labour market continues to weaken.

"The outlook for growth in the world economy has softened over recent months, with estimates for global GDP being edged down, and risks to the outlook still seen to be on the downside," RBA Governor Glenn Stevens said in a statement.

"Economic activity in Europe is contracting, while growth in the United States remains modest," he added.

He pointed out that growth in China also slowed but uncertainty over near-term prospects is greater compared to a few months ago. Mr Stevens also noted that key commodity prices for Australia continue to be significantly lower compared to the early part of 2012, although he observed some rebound in the past weeks.

"The peak in resource investment is likely to occur next year, and may be at a lower level than earlier expected . . . As this peak approaches it will be important that the forecast strengthening in some other components of demand starts to occur," Mr Stevens said.

The governor stressed that there were indicators that the low interest rates was starting to be felt by the Australian economy.

"However, credit growth has softened of late and the exchange rate has remained higher than might have been expected, given the observed decline in export prices and the weaker global outlook," he added.

It is the third interest rate cut made by RBA in 2012 and brings to 150 basis points that the central bank had cut since November 2011. It is the lowest interest rates since October 2009 after Australia emerged from the global financial crisis when rates fell to a 49-year record-low of 3 per cent.

With the RBA announcement, all eyes are now on the big four if they will pass in full the rate cut or pocket some of it. On Monday, Michael Chaney of the National Australia Bank insisted that Australian banks are not super profitable even if the bank's yearly profit reached $6 billion. He said the banks' return on equity is only average and only half of the returns enjoyed by large mining companies.

On news of the RBA rate cut, Australia's S&P/ASX 200 closed up 1 per cent while the Australian dollar also fell to US$1.0307 from US$1.0360 on Monday.

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