The Reserve Bank of Australia on Tuesday cut the cash rate to a record low of 1.75 per cent in a bid to head off falling prices and an economic downturn.
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The cash rate is now easily at its lowest level under the current system of monetary policy setting.
The cut, the first in a year, came less than a week after a shock drop in core inflation to well below the central bank's 2 per cent to 3 per cent target band.
Tuesday's rates decision coincides with the federal government's third budget.
Tuesday's historic interest rate reduction coincides with the federal government's third budget, which is expected to be mildly stimulatory despite pressure to narrow the deficit.
Deflation in the headline consumer price index, due mainly to falling oil prices and aggressive retailer discounting, was the first such quarterly contraction in seven years.
The cash rate is now easily at its lowest level under the current system of monetary policy setting.
The latest cut puts Australia into the club of developed economies with ever-falling interest rates and bond yields. Japan, the European Union and parts of Scandinavia now have zero or even negative nominal rates. New Zealand, too, looks likely to keeping cutting from an already-low 2.25 per cent official cash rate.
RBA governor Glenn Stevens said the decision was based on last week's surprisingly weak inflation read-out.
"Inflation has been quite low for some time and recent data were unexpectedly low," he said in a statement.
"While the quarterly data contain some temporary factors, these results, together with ongoing very subdued growth in labour costs and very low cost pressures elsewhere in the world, point to a lower outlook for inflation than previously forecast," he said.
He also noted that softening conditions in what was an overheated housing market had allowed the bank to cut without fear of re-igniting unsustainable price growth.
The Australian dollar, which had risen solidly ahead of the decision, dropped like a stone. It was last trading around US75.72¢, down from just above US77¢.
National Australia Bank, the only one of Australia's "Big Four" lenders to forecast the reduction, immediately said it would pass on the cut to borrowers.
Jamieson Coote Bonds' Charlie Jamieson, who also predicted the cut, described it as "the path of least regret for the RBA".
"A failure today to address the shocking CPI numbers risked falling behind the curve and allowing that disinflationary force to build," he said.
"We fully expect a follow-up cut over next three months; the RBA rarely tweaks interest rate policy in isolation, so expect more to come."
