Australia's central bank on Friday cut its forecast for underlying inflation this year to 2.5%, right in the middle of its target band and suggesting a much-reduced risk of a rise in interest rates for the next few months.
However, the Reserve Bank of Australia (RBA) also cautioned that inflation was unlikely to remain so low and forecast a gradual rise back into the upper half of its 2% to 3% target range for 2008 and 2009.
"The decline (in inflation) appears to have been a little faster than originally expected, and it now seems likely that underlying inflation will be about 2.5% or possibly a little lower during 2007," the central bank said in its quarterly Statement on Monetary Policy.
That was a step down from the 2.75% forecast in its last Statement in February and an important distinction since RBA Governor Glenn Stevens has said that a forecast above 2.5% automatically implied a bias to tighten policy.
The reduction reflected recent figures showing underlying inflation slowed to an annual 2.7% in the first quarter, from 3.0% in the fourth quarter of last year. Still, the RBA sounded a warning on the longer-term outlook.
"Longer term, it seems unlikely that inflation will continue to decline. All available data suggest high capacity utilization, a tight labor market and strong demand growth. Based on these trends, inflation is forecast to return to the top half of the target during 2008," the RBA said in its 58-page assessment of the economy.
Indeed, the central bank forecast underlying inflation would run in a 2.5% to 3.0% range for all of 2008 and the first half of 2009, implying little chance of a cut in the 6.25% cash rate for a long time to come.
The RBA raised rates three times last year to curb inflation, in what has been a lengthy tightening cycle encompassing eight hikes in five years.
The central bank said its policy Board, which held its May meeting earlier this week, had focused on evidence of greater strength in domestic activity and on the risks to the global economy, as well as the inflation data.
"While uncertainties about the international situation remain, recent information has pointed to continued global expansion," the RBA said.
Domestic data suggested demand and activity at home had entered 2007 with much momentum, and the RBA said it now expected the non-farm economy to grow by between 3.25% and 3.5% in the year ahead, up from a forecast of 3.25% back in February.
The drought was expected to take around 0.75 percentage points from growth in the current 2006/07 fiscal year, but the RBA assumed the farm sector would add to growth thereafter should seasonal conditions return to normal.
The central bank said the strength of the Australian dollar should contribute to some modest downward pressure on prices, though past experience suggested the effects could be small and drawn out. The RBA did not expect the drought to have a significant impact on consumer prices inflation.
In weighing up all this information the Board considered that these forces, if they persisted, were likely to put upward pressure on prices over time, the Statement said.
"But an appreciable tightening of policy had already been implemented during 2006, and the more benign recent inflation outcomes also lowered the starting point from which any further pick-up in inflation would occur," the RBA said.
"Hence the Board judged, at its May meeting, that maintaining the current mildly restrictive stance of policy would leave adequate time to respond as needed to the possibility of higher medium-term inflation," the central bank concluded.