* Interest rates cut 100 basis points to record low 3.25 pct
* Government launches $26 bln stimulus package
* Prime Minister promises further action if needed
* Budget deficit to swell on spending, falling tax revenue (Adds market reaction, rate cut expectations for Europe)
By Wayne Cole and Rob Taylor
SYDNEY/CANBERRA, Feb 3 (Reuters) - Australia's ailing economy got a double dose of desperately needed stimulus on Tuesday as the government pledged billions in new spending to avoid recession and the central bank cut interest rates to record lows.
The news lifted the Australian dollar off 10-week lows against the dollar and bill futures, which had factored in the possibility of a bigger rate cut, fell.
"Australia is facing an unfolding national and international economic emergency," Prime Minister Kevin Rudd said in announcing A$42 billion ($26.5 billion) in stimulus spending to protect the Australian economy from the global financial crisis.
The plan includes A$28.8 billion for infrastructure, schools and housing, as well as A$12.7 billion cash payments for low and mid-income earners to be paid in March.
"It is a strategy to which we will add in the future as is necessary," Rudd told reporters.
Hours after the government announced its spending plan, the Reserve Bank of Australia (RBA) cut its key cash rate by a bold 1 percentage point to a record low 3.25 percent, citing the grimmest global outlook in many years.
The cut was in line with market expectations and brought the easing since September to a massive 4 percentage points. Investors are counting on further cuts to take the cash rate to 2.0 percent or less by May.
"Policy settings in Australia are now very stimulative," said Michael Blythe, chief economist at Commonwealth Bank.
"The RBA may want to judge what impact these cuts and the stimulus package has on the economy before moving further, but still, it would rather cut too much than not cut enough," he said.
The Australian dollar rose as high as $0.6421 from $0.6350 before the rate decision, well above $0.6248 -- a 10-week low -- traded in offshore markets in anticipation of the rate cut.
Bill futures for March fell 0.13 point to 97.23. The market is pricing further rate cuts to 2.75 percent next month.
Australian shares closed up 0.3 percent, well off earlier highs, finding most support from an upbeat earnings forecast.
Other central banks are expected to follow the RBA's lead this week as policy makers scramble to deal with the deepest economic downturn in decades.
The Bank of England is seen cutting its key rate to a record low of 1.0 percent from 1.5 percent and Norway's central bank is seen reducing its rate to 2.50 percent from 3.00 percent.
The European Central Bank meets on Thursday, but isn't expected to cut its key rate, now at 2.00 percent, until March.
WARD OFF RECESSION
The latest package takes Australia's total stimulus spending announced since last September to A$78 billion, or nearly 8 percent of gross domestic product, and adds to a raft of similar plans from major economies, including one for $819 billion in the United States.
The extra spending and deteriorating global financial conditions meant the government budget would fall into a deficit of 1.9 percent of GDP in the 2008/09 fiscal year ending this June and 2.9 percent the following year.
Rudd said his stimulus moves would stave off recession in the A$1 trillion export-driven economy, but not everyone agreed.
"It's not enough to ward off a recession. Nothing Australia will do will stop recession here because it is recession everywhere," said Chris Richardson from Access Economics.
Six of Australia's top 10 trading partners are already in recession. Japan's exports fell by a third in December, and South Korea this week reported a similar drop for January, reflecting the slump in global demand.
The government more than halved its earlier growth forecasts on Tuesday to predict the economy will expand by 1 percent in 2008/09 and by 0.75 percent the following year.
But Rudd will be hoping he's right as the government faces an election in late 2010 and may need to avoid recession and save jobs to win a second term.
The plan reinforces Rudd's political focus on families, education, the environment and homelessness.
The government will spend A$28.8 billion from late 2009 and through 2010 on building and infrastructure, including 20,000 new houses for the poor, free ceiling insulation for homes, new buildings for 9,500 schools, and money for local roads.
Rudd said insulating homes would reduce greenhouse gas emissions by 49.4 million tonnes by 2020, the equivalent of taking one million cars off the road.
"This is a plan of unprecedented scope. That is because the challenge we have been delivered by this global recession is also virtually unprecedented." he said.
But it looks like being a tight call because, even after all this stimulus, the government still expects unemployment to rise to 7 percent by mid-2010, from just 4.5 percent currently.
Yet employers, welfare groups and green groups all welcomed the latest stimulus package.
"The nation building and jobs plan announced by the federal government today is simple and substantial, and will provide a big stimulus to help keep the economy moving," said Heather Ridout, chief executive of the Australian Industry Group. (Editing by Michael Perry and Tomasz Janowski)