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Australia's Central Bank Keeps Foot off Rate Brake

Australia's central bank kept interest rates steady at 6.25% on Wednesday, as low inflation provided room for the economy to grow faster despite an already drum-tight labor market.

The Australian dollar held steady while bond futures were a shade softer after the Reserve Bank of Australia's (RBA) widely expected decision. The central bank provides no comment on its reasoning when leaving policy unchanged.

The RBA held its monthly policy meeting on Tuesday and financial markets had priced in almost no chance of a hike given inflation had slowed far more than expected in the past couple of quarters.

"Inflation is contained and the productive output of the economy seems finally to be matching demand, so what's not to like?" said Tony Meer, chief economist at Deutsche Bank. "I still think they'll probably have to tighten eventually, but that's on a 12-month horizon. For now, it's all good."

The announcement on rates came just a couple of hours before government figures on gross domestic product (GDP) are expected to show the economy fairly flew along in the first quarter.

The median forecast in a Reuters poll favored growth of 1.2% last quarter, a step-up on the previous quarter's already brisk 1.0% increase.

Compared to the first quarter of last year, the economy was expected to expand at a 3.1% pace, up from 2.8% the quarter before.

Broadbased Growth

Growth was also expected to be broadbased, with consumers, businesses and government all making a contribution. Even the drag from one of the country's worst ever droughts would do no more than take the froth off the top.

"Were it not for the drought, growth would be even stronger," said Michael Blythe, chief economist at Commonwealth Bank. "We estimate non-farm GDP increased by an annual 4.0%, a pace not seen since early 2003."

"The bottom line for policy makers is that the economy is in great shape," added Blythe. "But, as we have been saying for some time, that also means the risk is for higher interest rates." The central bank raised rates three times last year to restrain price pressures, and the tap on the brakes seemed to bear fruit as inflation slowed last quarter.

The annual pace of underlying inflation fell to 2.7% last quarter, from 3.0% the previous quarter, putting it well within the RBA's 2% to 3% target range.

Inflation was also likely to slow further in the current quarter as large rises from last year dropped out of the calculation. Yet the RBA itself has warned that price pressures were unlikely to remain so well contained as a revival in demand stretched an economy short of spare capacity after 16 years of ceaseless growth.

"The likelihood that headline and core inflation will rise back up into the top half of the RBA's target range in 2008 means the RBA is likely to move off the policy sidelines early next year," said Stephen Walters, chief economist at JPMorgan. "We now expect the RBA to raise the cash rate 25 basis points in February 2008."