* RBA holds at 3.75 pct, wants to see impact of past rises
* Leaves door open for further moves as economy improves
* A$ slides, market scales back expectations for year ahead
SYDNEY, Feb 2 (Reuters) - Australia's central bank kept rates steady at 3.75 percent on Tuesday, confounding expectations of a hike and hammering the local currency as investors slashed estimates for how high rates might go this year.
The Reserve Bank of Australia (RBA) surprised almost everyone by saying it wanted to judge the impact of its past three moves before lifting the cash rate further. It had already raised rates by 75 basis points since October, putting it far ahead of most developed nations in removing exceptional stimulus.
Yet, RBA Governor Glenn Stevens also emphasised that, should the domestic economy continue to improve as expected, then further hikes would likely be needed over time. This is a pause, not a stop, said Peter Jolly, head of research at National Australia Bank. It's just that they paused earlier than most thought.
I don't think they have radically changed their view, he added. We still think they need to lift rates again and we see rates at 4.75 percent by the year end.
The market was badly caught out, however, having almost fully priced in a hike to 4.0 percent at Tuesday's policy meeting. As a result, the Australian dollar sank over a cent to $0.8800 AUD= and February interbank futures <0#YIB:> surged 0.17 points to 96.25.
Investors also doubted whether the RBA would move in March either, with futures pricing in around 35 percent chance of a rise to 4.0 percent. Expectations for the next 12 months were pared back to show around 80 basis points of tightening, compared to 105 basis points before Tuesday's announcement.
It implies that the RBA feels it has done enough for the time being, said Stephen Roberts, a senior economist at Nomura. You'd think there would be a pause for a few months before lifting to 4 percent by mid-year. It's going to be a slow process getting the cash rate higher.
ONE EYE OFFSHORE
The RBA's caution was warmly welcomed by the Labor government which faces a tough election fight later this year. Families will welcome this decision and businesses will welcome this decision, Treasurer Wayne Swan told parliament. Mortgage rates are a sensitive topic in Australia, where home ownership is a national obsession.
Analysts suspected recent events offshore may have added to the case for a pause. In a brief policy statement, RBA chief Stevens noted China had begun to rein back stimulus in its economy, global credit conditions were difficult and worries had grown over debt levels in some countries.
So maybe a little bit more of international concern stayed their hand and they want to see how that evolves, said Joshua Williamson, an economist at Citi.
But there is a risk given the underlying strength of the (domestic) economy that this was a missed opportunity and they're going to have to potentially go a little harder in the second half of the year if they don't make this up in the next few months.
Indeed, the RBA stated the economy had proved stronger than expected with unemployment peaking much lower than feared, resource investment strong and house prices up sharply. Yet it also noted that lending rates in the economy had risen faster than the cash rate as banks sought to cover increased funding costs caused by the global credit crisis.
It has estimated this effect meant effective rates across the economy were more than 100 basis points above the cash rate, far higher than before the credit squeeze.
This means that neutral rates, ones that neither stimulates nor retards economic growth, are lower than in the past. As governor Stevens often says when quized on where neutral is: We'll know when we get there.
(Editing by Kazunori Takada)