The the official interest rate is now 6.25 percent, the highest level in six years.
The widely-anticipated move by the Reserve Bank of Australia came after the
annual rate of inflation surged to 3.9 percent last month, well above the bank's target range of between two and three percent.
It's the third hike in six months after rates were raised 0.25 percent in May and August.
The rise in the cost of borrowing to banks, if passed on fully to customers, will add around $40 per month to the average mortgage repayment.
Citigroup economist Shane Lee says strong quarterly inflation numbers published last month was the main reason for the move.
But he says other data released since then suggests the economy's been slowing fairly quickly since the May and August rate rises.
PM insists rates are low
Australian Prime Minister John Howard says the economy is strong enough to handle another rate rise.
Mr Howard says while any interest rate rise today is unwanted, it may be necessary to cool down the economy.
"I have to accept the economic reality that occasionally a central bank does find it necessary to lift interest rates in the name of keeping inflation in check and guaranteeing our longer-term prosperity," Mr Howard said.
However he told ABC Radio interest rates are still very low.
Opposition Leader Kim Beazley has rejected the Prime Minister's reasoning, accusing Mr Howard of breaching the trust of Australians.
The opposition leader says the government hasn't managed the economy well enough to keep interest rates down.
Labor has also launched a new nationwide advertising campaign attacking what it says is the government's broken election promise to keep interest rates low.
Housing industry hit hard
Australia's housing industry will be hit hard by the latest interest rate hike, which is expected to lead to a downturn in housing affordability and demand.
Real Estate Institute of Australia (REIA) president Tony Brasier said the decision was not good news for home buyers, renters or the economy.
"This third interest rate rise will hit the housing market hard with the likelihood that there will be further upward pressure on rents," he said.
Mr Brasier said the rise would also keep investors and first home buyers out of the market.
"First home buyers and young people in particular are going to be thinking long and hard before buying in an interest rate environment where there has been three upward movements in six months," he said.
Housing Industry Association (HIA) executive director of housing and economics, Simon Tennent, said that while there was no denying the inflationary risks to the economy, the RBA's decision would hurt the country's two-speed economy.
"The economic divide between the resource rich states and the rest of Australia has never been wider and sadly while the latest increase may cool the hyper inflated West, it will add further to the pain being felt among homeowners and renters in other states," Mr Tennent said.
"There are already worrying signs within the data, in particular the cooling in retail sales, new home sales, declining housing affordability and the potential effect of the drought.
"With weakness appearing in some key sets of data, it is imperative that the Reserve Bank hold off on any further interest rate rises throughout 2007 until the three increases have been fully absorbed into the economy."
Mr Tennent said the latest rate hike would put increasing pressure on home buyers, who would now need to find an extra $122 per month to meet minimum monthly payments on a mortgage of $250,000.