* RBA says interest rates back in normal range
* Market pares expectations for future tightening
* Aussie dollar slides on c.bank comment, sluggish GDP * GDP grows a slim 0.2 pct in Q3, outlook much brighter (Adds Treasurer's reaction, updates prices)
By Wayne Cole
SYDNEY, Dec 16 (Reuters) - Australia's central bank said on Wednesday that interest rates were back to normal, stunning financial markets and prompting investors to radically scale back expectations for rate increases next year.
The Reserve Bank of Australia (RBA) has lifted its cash rate by 75 basis points in just three months to 3.75 percent and investors had assumed it would keep going to 5 percent by the end of 2010.
But the Aussie dollar fell and bill futures soared after RBA Deputy Governor Ric Battellino said its current cash rate was equivalent to at least 4.75 percent because local lenders had been raising their rates on loans more aggressively than the central bank.
Battellino's dovish comments came as government data showed Australia's economy grew by a disappointing 0.2 percent last quarter as a huge drag from international trade swamped strength in household spending, housing and inventories. "The message is that rates won't have to rise as much as most people had thought," said Brian Redican, a senior economist at Macquarie. "We still think the RBA will hike in the first half of next year, but they may then rest around 4.5 percent."
One-month interbank futures for February climbed 0.070 point to 96.165, implying that the market believed there was less than a 50:50 chance of a hike to 4 percent at the RBA's next policy meeting in February.
The probability had been above 80 percent following strong jobs numbers released last week.
Three-month bill futures for December next year jumped 0.19 points, while the implied tightening for the next 12 months dropped 20 basis points to 4.75 percent
The Australian dollar fell 0.9 percent on the day to $0.8978, its weakest level for three weeks, as expectations of aggressive rate hikes receded. Battellino said funding costs for Australian banks had risen substantially because of the global credit crisis, estimating the extra cost at about 108 basis points.
This had led them to widen margins on business loans and, recently, on mortgages as well. When the RBA raised its cash rate by 25 basis points earlier this month, three of the four major commercial banks lifted their variable mortgage rates by more.
Battellino emphasised that the RBA had taken into account the higher level of lenders' market-determined rates when setting policy. These included the rates on housing and business loans and the rates on deposits and debt securities.
"Other things being equal, if interest rates in the economy are rising relative to the cash rate, there is less need for the cash rate to rise," said Battellino.
"Taking these considerations into account, it would be reasonable to conclude that the overall stance of monetary policy is now back in the normal range, though in the expansionary segment of that range," Battellino said.
In the past, the "normal" cash rate -- a level that neither stimulates nor restrains the economy -- was considered by market watchers to be between 5 and 6 percent.
"This is very important," said Bill Evans, chief economist at Westpac. "The RBA is likely to pause at around 4.5 percent, rather than the more usual view of 'neutral' of 5.5 percent."
WITHDRAWL SYMPTOMS
Battellino's comments were given an added edge by the release of gross domestic product (GDP) figures for the third quarter which showed the economy grew by a meagre 0.2 percent, half of what markets had expected.
In all, GDP totalled A$220.9 billion ($194 billion) in the quarter, up 0.5 percent on the same quarter of 2008.
Treasurer Wayne Swan said the modest result showed that government hand-outs early in the year had been necessary and planned spending on schools and infrasturcture was still needed.
"It suggests that the economy was essentially treading water in Q3," said Michael Blythe, chief economist at Commonwealth Bank. "But that was always likely as stimulus was withdrawn."
Data since September has been much more upbeat, with business and consumer confidence strong and employment rising. Insatiable Asian demand for Australia's commodity exports has also revived investment plans, particularly in mining and energy.
Major resource projects either committed or in construction are worth $A112.5 billion, or around 9.5 percent of GDP. The Gorgon liquefied natural gas (LNG) project alone could cost A$43 billion over its long construction life, and there are another nine LNG projects on the drawing board.
This is a key reason the RBA is much more bullish on the outlook for 2010 and beyond, predicting GDP growth of 3.25 percent next year, rising to 3.5 percent by 2012.
"The underlying drivers of growth, like employment, investment and housing, suggest the economy is on track to fulfill the RBA's hopes," said Blythe at CBA. (Graphic by Claire Morel; Editing by Kim Coghill)