AAP

Australia's central bank says the current level of interest rates is appropriate but it still expects inflation to be high in the short term.

In its quarterly statement on monetary policy the Reserve Bank of Australia (RBA) jacked up its consumer price index forecast for 2008 by a full percentage point to 4.5 per cent from its February prediction.

March quarter inflation - released last month - showed the annual consumer price index jump to 4.2 per cent.

At the same time it slashed its economic growth forecast for 2008 by a full percentage point to 2.25 per cent for this year.

The central bank said it expects a period of below-trend economic growth.

"If sustained, this will mean a gradual easing in capacity pressures which, in turn, can be expected to have a restraining influence on inflation over time," it said.

In its latest forecasts, it predicts the consumer price index will remain above or at the top end of its two-to-three per cent target band until mid-2010 before easing to 2.75 per cent by end-2010.

"This assessment would need to be reviewed if the expected moderation in domestic demand does not occur, or if expectations of high ongoing inflation begin to affect wage and price setting."

Lehman Brothers Australia chief economist said the statement indicates the RBA will have a low tolerance to any second-round effects from high inflation.

"The Reserve Bank is saying it expects inflation to fall back inside target on current policy settings, but it will be a relatively long haul getting there," Mr Roberts said.

"With the above-target inflation forecasts extending over the next two years, the Reserve Bank's tolerance will be low for any second-round inflation pressure in any build-up of inflationary expectations or excessive wages growth.

The bank also said it expects a "substantial boost" in national income through the country's terms of trade - the net income from trade.

"Based on the latest contract negotiations for coal and iron ore, it is likely that the terms of trade will rise by around 20 per cent this year as the new contracts come into effect.

"This is well above the average increase over the past four years, and higher than appeared likely a few months ago."

The bank left its key cash rate unchanged for a second month in a row after this week's monthly board meeting but had raised it four times since last August.

"On balance, the board judged that the setting of monetary policy was appropriate for the time being," it said.

"The board will continue to monitor developments and will make adjustments to policy as needed to ensure that inflation returns over time to the medium-term target."