Published: Friday, 6 Nov 2009 | 12:03 AM ET

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Australia's central bank said on Friday that interest rates would likely have to rise gradually as it sharply upgraded forecasts of economic growth for next year and pointed to a dwindling pool of spare capacity.

Market reaction was restrained, since the central bank left open the question of whether it would tighten in December or not.

But for long-term investors, the Reserve Bank of Australia (RBA) laid out a tempting vista.

Its quarterly Statement on Monetary Policy essentially held out the prospect of an almost golden period of prosperity fuelled by rapid population growth, rising terms of trade and a boom in resource investment.

"The question of whether it might hike in December just completely misses the point," said Su-Lin Ong, a senior economist at RBC Capital Markets.

"The RBA here is foreshadowing years of expansion based on resources, population and Asian demand," she argued.

"It's big picture positive for Australia and the Australian dollar, and means rates are going nowhere but up. All we're doing is arguing about the timing."

Thus while interbank futures showed a roughly even chance of the RBA hiking to 3.75 percent in December, they were already fully priced for a tightening to 4.50 percent by June and at 5.0 percent or more by the end of 2010.

The central bank lifted its cash rate by 25 basis points to 3.5 percent this week, the second hike in as many months. That set it far apart from most other developed nations which still
have rates at emergency lows.   Central banks from the United States, eurozone and UK all kept policy super-loose at meetings this week.

That offered the Australian dollar an ever-widening rate premium which helped lift it to $0.9125 by Friday, from 89 cents at the start of the week and lows of 61 cents this time last year.

"The RBA's statement is a picture of optimism, diminished risks, upside growth surprises," said Annette Beacher, senior economist at TD Securities.

"This implies higher interest rates and an elevated exchange rate for some time," she added. "We remain with our target of a 4.5 percent cash rate by mid-2010 and the A$ reaching $0.95 at around the same time."

Investment Boom

Underlying the RBA's confidence on the economy was what it termed a "boom" in investment in Australia's coal, iron ore and natural gas sectors.

"The bank's liaison with mining companies suggests that further significant increases in mining investment and output are likely over the years ahead," the RBA said.

Output of coal and iron ore could expand by around one third over the next two years if capacity came on stream as expected, with further major increases possible over the remaining decade.

Liquefied natural gas production was only just coming on stream but investment in this sector could rise from around 0.5 percent of GDP now to about 2.5 percent in the next 4-5 years.

Ultimately, the value of LNG exports could match that of coal or iron ore, the country's biggest earners.

Strong demand for Australian resources from Asia, especially China and India, meant the country's terms of trade were expected to rise over the next year or two, a marked improvement from the previous monetary-policy statement in August.

Added to that was the rapid growth of Australia's population and stock of capital which seemed to foreshadow many years of expansion ahead, the RBA said.

It more than trebled its forecast for gross domestic product growth (GDP) for 2009 to 1.75 percent, while raising its estimate for 2010 to 3.25 percent, from 2.25 percent previously.

Growth was seen running at 3.25 percent right through 2011 before accelerating to 3.5 percent in 2012.

The RBA also nudged up its forecasts for underlying inflation, but only modestly, perhaps reflecting its internal expectation for where interest rates might be by then.

Underlying inflation was seen declining from an annual 3.5 percent last quarter to 2.25 percent by the end of 2010.

Inflation was then seen travelling at 2.5 percent through 2011 and into 2012, compared to 2 percent in the previous statement.

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