Banks are expected to pass on the rate rise, which brings the official interest rate to 5.75 percent, to borrowers, with at least three major banks confirming that their home loan rates are under review.
The Australian dollar soared after the announcement, rising as high as US76.78 cents, compared with about US76.07 cents just prior to the move.
The RBA said inflationary risks have increased enough to warrant the rise, with the headline annual inflation rate reaching three percent in the first quarter, taking many economists by surprise.
RBA governor Ian Macfarlane said in a statement signs of inflationary pressures had to be acted upon.
"In Australia, domestic spending has been growing at a solid pace recently and prevailing conditions suggest that this is likely to continue," he said.
"High profitability and rising share prices are indicative of a favourable business environment in which investment growth is likely to remain strong."
Banks can now lift their home loan rates from the current level of around 7.32 percent to about 7.57 percent.
The Housing Industry Association estimates that the rise will add about A$20 per fortnight to an average mortgage of around $250,000.
Australian Treasurer Peter Costello said there is no suggestion that inflation is outside the RBA's target band of two to three percent.
He said the economic cycle is probably at its peak, and this is consistent with inflation being at the top of the RBA's target range.
He said the move was not motivated by current inflationary pressures, but rather is a precautionary measure thanks to a strong international economy.
"That economy is bringing money into the country," said Mr Costello, adding that high prices for commodities such as iron ore and coal meant record profits are being earned by mining companies.
"You are seeing absolute record profits for mining companies -- the like of which you haven't seen -- and so you've got an extremely profitable corporate Australia with a lot of income coming into the country and the bank has taken that as a sign to cap consumption," he said.
Prime Minister John Howard said he expects economic growth to continue to be strong despite the rate rise and the challenge posed by high petrol prices.
"I believe that we will continue to grow at a very strong rate because we have the fundamentals right," he said.
"We have quite low levels of inflation and not withstanding the small adjustment to interest rates by the Reserve Bank today, we have historically low levels of interest in this country.
"We have our budget in surplus and we intend to keep it that way."
Rise justified
Mr McFarlane said domestic spending has been growing at a solid pace recently and he expects this to continue.
"Recent trends in credit growth indicate that households and businesses have continued to find it attractive to borrow at prevailing interest rates," he said.
"High profitability and rising share prices are indicative of a favourable business environment in which investment growth is likely to remain strong."
International developments are also providing stimulus to growth in Australia, he said, with the global economy growing at an above average pace for a fourth successive year.
"Commodity prices have been increasing strongly for some time and they have risen further in the year to date.
"This suggests a strengthening in the outlook for Australia's export earnings with consequent expansionary effects on incomes and spending.
"These domestic and international trends have added to inflationary pressures in an economy that has been operating for some time with rather limited spare capacity and low unemployment," he said.
Blow for families
The decision to lift interest rates is another blow to families already struggling with high petrol prices and workplace changes, said NSW Premier Morris Iemma.
"This will add further pressure on young couples trying to buy a home," said Mr Iemma.
His federal colleague, opposition treasury spokesman Wayne Swan, said Mr Costello is now under pressure to deliver real tax reform to boost productivity across the country.
"It is clear from the Reserve's statement that this country desperately needs an ambitious economic agenda to lift our productivity and to put downward pressure on inflation," he said.
"There's an urgent need to invest in an economic agenda which puts downward pressure on inflation through lifting productivity."