Interest rates will likely continue to fall but at a slower rate than in the past, as the Reserve Bank of Australia (RBA) seeks to lower inflation gradually and ensure a soft landing for the economy.
RBA governor Glenn Stevens told a parliamentary committee the central bank was probably six months away from seeing clear evidence that price pressures in the economy were beginning to ease.
He said annualised inflation, currently around 4.3 per cent and forecast to peak at five cent this quarter, had to fall "some distance" before it came back within the RBA's preferred two to three per cent target band.
"A somewhat larger fall in inflation overall is required on this occasion than was the case in either 2001 or 1995," Mr Stevens said during testimony before the House of Representatives Economics Committee.
"Rather than trying to achieve that larger fall in inflation by pushing it down more quickly, the board's strategy is to seek a gradual fall, but over a longer period."
Mr Steven also told the committee, meeting in Melbourne, that the prospect for a moderation in inflation were evident in slowing domestic demand, particularly among households.
The RBA last week cut official interest rates for the first time in almost seven years, reducing the cash rate to seven per cent, from 7.25 per cent.
Mr Stevens noted that financial markets are already pricing in a potential rate cuts in the months ahead, with many economists expecting another cut next month.
But the RBA cautioned it would continue to assess the situation on a month-to-month basis.
"I think the near term question will be, do we hold here, or do we go down a bit more," he said during questioning by committee members.
Mr Stevens said the RBA was trying to reduce domestic demand and prices, without stalling the economy.
"We've got to try to navigate through some pretty tricky areas and accept some slowing in our economy for a while," he said.
"We're trying to achieve a path that slows the economy down, doesn't have a crash, gets inflation under control, doesn't just let it go, and leaves us in two or three years from now nicely set for the ongoing future of good expansion of steady, low inflation, interest rates back to normal levels - that's the path I'm trying to get us on
to."
CommSec chief economist Craig James said the RBA was likely to tread warily on future rate cuts, as it continues to weight the impact of slowing demand against strong business investment and Australia's strong terms of trade.
"The Reserve Bank governor has watered down
expectations on future rate cuts," Mr James said.
"The biggest complication for monetary policy is the contrast between strong business investment and weak consumer spending ... which of these forces wins out will have a major bearing on where monetary policy is headed."
RBC Capital Markets senior economist Su-Lin Ong said the RBA would cut rates in October, before waiting until early 2009 to ease again.
"In part, this reflects a degree of uncertainty over a multitude of factors - both domestic and international - and how they evolve over the coming months," she said.
Mr Stevens also rejected suggestions that the RBA's decision to raise official rates in February and March this year was wrong, given that inflation was still rising.
"I don't think the board had got it wrong," he told the committee.
"I doubt very much we could have credibly just sat there with what inflation was doing."
Mr Stevens also said that a recession in Australia was unlikely, noting that the RBA had maintained its forecasts for economic growth published in its August statement on monetary policy.
"Is there a zero risk of recession? No, it's not zero, but the most likely one is the one in the published outlook," Mr Stevens said.
In August, the RBA predicted gross domestic product growth to slow to two per cent by the end of December, before rising to 2.25 per cent at end June 2009 and to 2.5 per cent at end December 2009.
The RBA chief also expects the jobless rate to rise during the next 18 months, as the economy slows.
"We observe the unemployment rates goes up for a little while, while inflation stabilises for a little while - that was the story in 2001," Mr Stevens said.
Mr Stevens said he was not worried about wages pressures feeding inflation.
"I do think labour market conditions are easing but if the labour market didn't ease up and wages stayed steady that's great," he said.
"That doesn't preclude interest rates going down a bit, ultimately they are on the way down."