Australia Central Bank Raises Inflation Forecasts

Australia's central bank on Monday raised its forecasts for underlying inflation to above its 2 to 3 percent comfort zone, strongly suggesting that further increases in interest rates might be needed to restrain price pressures and cool the red-hot economy.

In its 69-page Statement on Monetary Policy, the Reserve Bank of Australia (RBA acknowledged that strains in global credit markets and a slowdown in the U.S. economy bore careful watching, but was upbeat on the domestic economic outlook, saying data pointed to considerable momentum in the third quarter.

The central bank lifted its forecast for annual underlying inflation to 3.25 percent for the current quarter and out to mid-2008, up from 3 percent in its previous statement in August.

The RBA aims to keep inflation in a 2 to 3 percent band over the medium term, so such a forecast implied a risk of a further rise in interest rates even after last week's hike to an 11-year high of 6.75 percent.

The RBA estimated underlying inflation would moderate to 3.0 percent by the end of 2008 and then stay in a 2.75 percent to 3.0 percent band for all of 2009.

"Taking into account the recent monetary policy decisions along with other factors such as the higher exchange rate and the expected moderation in global demand, the bank projects that inflation will settle at a rate a little below 3 percent over the next two years," the RBA said.

"But with demand growth still close to trend, and pressure on capacity only diminishing gradually, inflation is unlikely to decline far," it added.

Underlying inflation had already picked up to 3 percent by the third quarter of this year, driven by widespread increases in food, housing and service costs.

The central bank saw risks to inflation in both directions.

"Somewhat lower outcomes could eventuate if global economic conditions prove to be weaker than expected, which might occur if there were further significant disturbances in global financial markets," said the RBA.

"But it is also possible at this stage of a long economic expansion that inflation will be more difficult to contain, particularly if domestic demand does not moderate."

Australia is currently enjoying its 17th straight year of economic expansion, a run that has seen the jobless rate decline to a 33-year low of 4.2 percent and industry use up most of its spare capacity.

"Recent data have continued to indicate strong growth in the Australian economy, with demand and activity rising faster than trend, confidence high and labor market conditions tight," the central bank said.

The RBA noted that the non-farm economy had grown by a rapid 5.2 percent in the year to June, while overall gross domestic product (GDP) rose 4.3 percent. The central bank forecast non-farm GDP growth of 3.5 percent for both 2007/08 and 2008/09, unchanged from its August statement.

However, the impact of a lingering drought on farm output led the central bank to trim its forecast for overall GDP for 2007/08 to 3.75 percent, from 4.25 percent previously. Its forecast for 2008/09 GDP growth remained unchanged at 3.5 percent.

The RBA said global growth looked set to moderate, in part due to strains in credit markets, yet the central bank's board still expected growth to run at an above-average pace, led by strength in China.

Strong demand for resources was also keeping commodity prices high and delivering a big windfall to incomes in Australia -- a major exporter of commodities.

While the global credit squeeze had led to higher rates for some borrowers in Australia, overall the RBA considered the market tightening to be relatively contained and its impact on domestic growth modest.