Australia's RBA: trade boom requires tight policy

Reserve Bank of Australia (RBA) Governor Glenn Stevens told a business lunch that 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 as he tries to dampen the economy and rein in inflation.

He said in response to a question after the speech that high commodity prices were likely to become "a permanent enough feature of the landscape", and therefore likely to provide a long-term lift to the economy.

Stevens said the terms of trade -- what Australia gets for its exports compared to what it pays for imports -- were likely to increase by around 20 percent in 2008, bringing the total gain since 2002 to between 65 and 70 percent.

"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," said Stevens.

Stevens said there was no doubt economic growth needed to slow and he reiterated that tighter financial conditions combined with the global credit squeeze had made Australian households more cautious.

But, despite flat retail sales and a sharp drop in borrowing for housing and by business, the extent of the current slowdown remained uncertain.

"It is clear that slowing demand to reduce inflation over time remains (the RBA's) key objective," said RBC senior economist Su-Lin Ong.

AUSSIE DOLLAR HELPS

Stevens cited a stronger Australian dollar and the 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. He said monetary policy had to dampen demand not only because inflation has already picked up, but to head off further problems that could easily emerge given the expansionary effects of the trade boost.

Without policy adjustments, the expansionary shock could be seriously destabilising, he said.

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.

Inflation is not forecast to return to the central bank's 2-3 percent target band until late 2010, even with below trend growth.

After a six-year campaign of rate rises, Stevens also said that there was no evidence that the lag between rate moves and their impact on the economy was any longer or shorter than in the past.

Analysts say it takes six to 12 months for the full impact of rate changes to be felt, suggesting the full impact of the hikes in February and March are yet to be felt. (Additional reporting by Wayne Cole; editing by Jonathan Standing)