The Reserve Bank has raised the official cash rate 50 basis points, a larger than expected hike aimed at countering soaring inflation.
The cash rate is now 0.85 per cent following the decision of the central bank board on Tuesday afternoon.
Treasurer Jim Chalmers said the sharp rise would be "very difficult news" for households already under the strain of cost of living pressure.
In a blunt message, Dr Chalmers said there was now consensus among economists, the government and central bank that the inflation challenge would "get harder before it gets easier".
Dr Chalmers said inflation would be running higher than the 5.1 per cent recorded in the year to March, which was 21-year high.
The Reserve Bank's decision on Tuesday marks the second rate rise in as many months, after it made a mid-election campaign call to lift the cash rate from a historic low of 0.10 to 0.35.
Economists were predicting a rate hike of up to 40 basis points at Tuesday's meeting.
But the board went further as Reserve Bank Governor Phillip Lowe conceded inflation was outstripping its expectations.
In a statement following the decision, Dr Lowe said higher gas and electricity prices and recent increases in petrol prices meant that inflation is "likely to be higher than was expected a month ago".
He said global factors including COVID-related disruptions to supply chains and the war in Ukraine accounted for much of the increase.
But he said there were domestic factors pushing up prices, including capacity constraints in some sectors and a tight labour market.
Inflation was expected to fall back to the 2-3 per cent range next year.
Fronting reporters in Brisbane after the decision, Dr Chalmers said the rate rise would put pressure on family budgets and make it more expensive for the Commonwealth to service debt.
"The Albanese Labor government does not underestimate the serious combination of challenges that we have inherited," he said.
Ahead of the announcement, Dr Chalmers warned homeowners to brace for a rate raise.
"We don't preempt decisions of the independent reserve bank, but it is universally expected today that it will be a difficult day for a lot of homeowners who are already facing rising costs of living elsewhere in the household budget," Dr Chalmers told ABC's News Breakfast.
"They'll have to find a little bit more for this to service their mortgage."
Dr Chalmers has listed rising interest rates as one part of the "cost-of-living crisis" which Labor had inherited from the former Morrison government, alongside rising inflation and falling real wages.
After being kept at a record low during the pandemic, market analysts are predicting interests rates will continue to rise over the coming months.
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Dr Chalmers recommitted to using his October budget to start addressing the cost of living pressures on Australian households with measures to cut the cost of childcare and medicines.
"Our responsibility as the new government surveying this inheritance, this cost of living crisis that we have inherited from our predecessors, is to do what we responsibly can in the context of a budget which is heaving with a trillion dollars in Liberal Party debt," he said.
New shadow treasurer Angus Taylor acknowledged the looming rate rise was a "big deal for mortgage holders".
Mr Taylor said while the Reserve Bank made its decisions independent of government, the new Labor regime could avoid fuelling inflation by managing spending "very, very carefully".
Dan Jervis-Bardy
Dan covers federal politics from Parliament House, with a special focus on climate policy and the NDIS. He has previously reported on ACT politics and urban affairs since joining the Canberra Times in 2018.
Dan covers federal politics from Parliament House, with a special focus on climate policy and the NDIS. He has previously reported on ACT politics and urban affairs since joining the Canberra Times in 2018.
