SYDNEY (Reuters) - Australia’s central bank on Friday raised its forecasts for inflation this year, but said a significant slowing in domestic demand was underway which would bring inflation back into its target band by the end of 2010.

In its quarterly Statement on Monetary Policy, the Reserve Bank of Australia (RBA) cautioned the outlook was uncertain, in part because of a coming 20 percent jump in the country’s terms of trade, and it might have to tighten again if the economy did not slow as expected.
Yet the central bank also slashed its forecasts for economic growth and felt that monetary policy was “sufficiently restrictive to reduce inflation over time.”
“The recent evidence is that a significant moderation in domestic demand is now occurring,” wrote RBA Governor Glenn Stevens in the introduction to the 68-page report.
“On balance the Board’s assessment is that a period of below-trend growth in the Australian economy is now in progress.”
If sustained, this would pull inflation back down into the RBA’s 2 to 3 percent target band, albeit not until late 2010.
Investors took the statement as a further indication that interest rates were on hold, likely for months to come. The local dollar dipped and bonds added to early gains as the market pared the risk of a further tightening.
“The RBA has dealt with a serious inflation problem, they have tightened policy aggressively, and now they are seeing a significant slowdown in spending,” said Rory Robertson, an interest rate strategist at Macquarie. “There are many reasons for the bank to wait and watch for an extended period.”
---------------------Higher inflation, lower growth
Core inflation accelerated to a 17-year high of 4.2 percent in the first quarter as the price of everything from fuel, to food, rents and health surged.
That in turn forced the central bank to revise up its forecasts for inflation this year. It now saw core inflation running at 4.25 percent by June, up from 3.75 percent previously, and slowing only slightly to 4 percent by year-end.
The consumer price index would likely rise even further to 4.5 percent by end-2008 due to the impact of record oil prices.
Core inflation, which strips out the most volatile price moves in any quarter, was then seen falling gradually to 3.25 percent by the end of 2009 and 2.75 percent by the end of 2010.
To get there, the economy would have to slow and the RBA duly cut forecasts for gross domestic product (GDP) growth.
It now saw GDP growth of just 2.25 percent by the end of 2008, a full percentage point below its previous forecast, rising only modestly to 2.5 percent by the end of 2009.
“Several factors including a slowdown in global growth, strains in world financial markets and tight domestic financial conditions, are working to dampen demand,” said Stevens.
The RBA has hiked its benchmark cash rate four times since August, taking it to a 12-year high of 7.25 percent, and commercial banks had lifted borrowing costs even further as the global credit squeeze drove up funding costs.
On the other hand, Stevens noted Australia would get a big boost this year from huge increases in contract prices for coal and iron ore, its two biggest export earners.
The RBA now expects these increases to boost Australia’s terms of trade -- what it gets for exports compared to what it pays for imports -- by 20 percent this year. That was up from a forecast of 15 percent made just a few weeks ago.
“That just points to the idea the slowing in demand we’re seeing at the moment is not going to persist for all that long,” warned Michael Blythe, chief economist at Commonwealth Bank.
“With inflation already above the top of the zone and expected to stay there for quite a while, I don’t think it will take too much to get another rate rise in place.”