Domestic demand in Australia is cooling in the face of higher interest rates but coming stimulus from a trade boom means a tight monetary policy remains essential, the country's top central banker said on Friday.
Speaking at the American Chamber of Commerce, Reserve Bank of Australia (RBA) Governor Glenn Stevens said surging prices for the country's major commodity exports would deliver the biggest boost to the economy in more than 50 years.
"This is why a tight monetary policy setting is essential," said Stevens, who has raised interest rates twice so far this year to a 12-year peak of 7.25 percent.
He also cited a stronger Australian dollar and the Australian government's record budget surplus as being useful in cushioning the expansionary shock from the trade boom.
"A higher exchange rate plays a very valuable role in dampening the expansionary impact, lowering prices for traded goods and services and spilling some demand abroad," said Stevens.
"It falls to monetary policy to play its proper restraining role as well, dampening private demand not only because inflation has already picked up, but seeking to head off further problems that could easily emerge given the expansionary effects of the terms of trade."
Core inflation in Australia accelerated to a 17-year peak of 4.2 percent in the first quarter driven by the rising cost of everything from fuel, to food, to health care.
Stevens reiterated that tighter financial conditions combined with the global credit squeeze had made Australian households more cautious in spending and borrowing while business appetite for credit had fallen significantly.
"In short, things are happening that suggest a moderation in growth in domestic demand is occurring," Stevens said. But he added: "At this stage, inevitably, the extent and likely duration of the moderation remains uncertain."
The greatest uncertainty was over the impact of the rise in the terms of trade -- what Australia gets for its exports compared to what it pays for imports.
Stevens said the terms of trade were likely to increase by around 20 percent in 2008, bringing the total gain since 2002 to between 65 and 70 percent. He estimated this increase would boost real gross domestic income by around 4 percent in 2008.
"The very large change in prices for mineral and energy resources is the most expansionary external shock to affect the economy for 50 years or more,"
Commodity prices looked like staying high for some time given continued strength in Asian and many emerging economies, he said. He noted that for many of these countries inflation was more of a danger than slower economic growth.
The trade boost was also driving a major increase in business investment as mines and the like expanded production to meet demand from China and India.
Stevens said it was necessary that domestic consumption and demand for housing make room, for some period of time, for the rise in other forms of investment that will sustain higher incomes and living standards in the future.
"The expansionary terms of trade shock occurring now obviously would have the potential, absent some other adjustment, to be seriously destabilising," said Stevens.
That was why the central bank had raised interest rates, he said.