RBA Sees Growth Slowdown Restraining Inflation

Australia's central bank on Friday  raised its forecasts for inflation this year further above its  comfort zone, but said a significant slowing in domestic demand  was underway which would bring inflation back into the band by  the end of 2010.

In its quarterly Statement on Monetary Policy, the Reserve Bank of Australia (RBA) cautioned that the outlook was  particularly uncertain, in part because of a coming 20 percent  jump in the country's terms of trade, and it might have to  consider tightening again if the economy did not slow as  expected.

However, the central bank also slashed its forecasts for  economic growth and felt that monetary policy was "sufficiently  restrictive to reduce inflation over time."

"The recent evidence is that a significant moderation in  domestic demand is now occurring," wrote RBA Governor Glenn Stevens in the introduction to the 68-page report. "On balance the Board's assessment is that a period of below-trend growth in  the Australian economy is now in progress."

If sustained, this would pull inflation back down into the RBA's 2 to 3 percent target band, albeit not until late 2010.

"This assessment would need to be reviewed if the expected moderation in domestic demand does not occur, or if expectations  of high ongoing inflation begin to affect wage and price  settings," Stevens warned.

Indeed, the central bank had to revise up its forecasts for underlying inflation this year given figures for the first  quarter had shown an acceleration to a 17-year high of 4.2  percent, above previous expectations.

It now saw core inflation running at 4.25 percent by June, up from 3.75 percent previously, and slowing only slightly to 4 percent by year-end. The headline consumer price index would  likely rise even further to 4.5 percent by end-2008 due to the impact of record oil prices.

Core inflation, which strips out the most volatile price moves in any quarter, was then seen falling gradually to 3.25  percent by the end of 2009 and 2.75 percent by the end of 2010.

To get there, the economy would have to slow and the RBA  duly cut forecasts for gross domestic product (GDP) growth. It now saw GDP growth of just 2.25 percent by the end of 2008, a full percentage point below its previous forecast, rising only  modestly to 2.5 percent by the end of 2009 and 2.75 percent by end-2010.

Non-farm GDP was seen at just 1.75 percent over 2008, 2.5 percent over 2009 and 2.75 percent in 2010. That would represent a sharp slowdown from 4 percent in the fourth quarter of last  year.

"Several factors including a slowdown in global growth, continuing strains in world financial markets and tight domestic financial conditions, are working to dampen demand," said Stevens.

The RBA has hiked its benchmark cash rate four times since  August, taking it to a 12-year high of 7.25 percent, and  commercial banks had lifted borrowing costs even further as the  global credit squeeze drove up funding costs.

"The evidence to date is that a noticeable restraining impact is being exerted in household and business borrowing and on overall domestic demand," said Stevens.

On the other hand, Australia would get a big boost this year from huge increases in contract prices for coal and iron ore, its two biggest export earners.

The RBA now expects these increases to boost Australia's terms of trade - what it gets for exports compared to what it  pays for imports - by 20 percent this year. That was up from a  forecast of 15 percent made just a few weeks ago.

"The projected increase in Australia's terms of trade represents a substantial boost to national incomes," said  Stevens.

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