SYDNEY, Feb 17 (Reuters) - Australia's central bank on Thursday said economic output would be around 1 percent lower this quarter because of weather damage while inflation would rise to 3 percent by mid-year, in a major revision to forecasts made just two weeks ago.
In a speech, Reserve Bank of Australia (RBA) Assistant Governor Philip Lowe also said global commodity prices were likely to remain strong for some time, given supply constraints.
That could add to inflationary pressure across Asia and might risk a sharp slowdown in growth if central banks have to respond by tightening aggressively.
Lowe said damage from recent flooding and Cyclone Yasi meant total output in the current quarter would be around 1 percent lower than it otherwise would have been.
"Given this mainly arises from a disruption to production, the decline in spending is likely to be somewhat smaller than 1 percent," he added.
He expected growth to rebound strongly from then on and reiterated the bank's forecast of gross domestic product (GDP) growth of 4.25 percent for all of 2011.
Consumer price inflation (CPI) was now expected to rise to an annual 3 percent by June, up from a forecast of 2.5 percent the RBA made just two weeks ago.
"The bank now expects CPI inflation to be around 3 percent over the year to June 2011, with the combined effect of floods and the cyclone likely to contribute around half a percentage point to this outcome," said Lowe, who heads the bank's economics division.
Headline inflation ran at 2.7 percent in 2010, within the RBA's long term target band of 2 to 3 percent.
Much of the increase would be due to a sharp rise in the price of bananas as Cyclone Yasi destroyed much of the crop.
But Lowe said banana prices were expected to fall back to more normal levels later in the year, and that there would be a period during 2012 when year-ended inflation outcomes could be expected to be lower than previously forecast.
"Looking through these weather-related effects, inflation is expected to gradually increase over the next couple of years to around 3 percent in late 2012," he said.
Lowe added that restrained consumer spending seemed to be putting downward pressure on prices for many retail goods, forcing retailers to pass on falls in import prices faster than they would have otherwise.
How persistent this consumer restraint proved to be would be crucial to the outlook for the economy, and monetary policy.
"On the one hand, it was plausible that consumption growth will strengthen considerably over the period ahead, supported by strong income growth and an unemployment rate that is trending down," said Lowe.
"On the other hand, this more cautious approach to spending could be quite long lasting, with households using the strong income growth to further improve their balance sheets."
Last week, RBA Governor Glenn Stevens said interest rates were likely on hold for some time in large part because the moderation in consumer spending was providing scope for the mining sector to boom without adding to inflation.
Australia's huge resource sector is riding a wave of high prices, fuelled by demand from the urbanisation and industrialisation of China and India.
"For many commodities, global inventories are now quite low and it would appear that we are currently operating on a relatively steep part of the global commodity supply curve," said Lowe. While increased investment would add to supply over time, it was a slow process, he added.
"It would appear that the ability of the world to produce commodities is becoming a key constraint on non-inflationary growth for the global economy," said Lowe.
"The world economy is going through a change in relative prices, and that this change is likely to be quite persistent."
This need not be inflationary for the world, he said, if monetary policy was set appropriately and inflation expectations were contained.
The RBA has been one of the most pre-emptive central banks in the developed world, lifting interest rates by 175 basis points since late 2009.
But Lowe noted that, at the moment, monetary policy was stimulatory in much of the world, including Asia.
High food prices across Asia had lifted headline inflation rates and inflation expectations, he added.
"If these inflationary pressures were to intensify, a stronger policy response than seen to date would be likely, increasing the risk of a subsequent sharp slowdown in the region."
(Reporting by Wayne Cole; Editing by Mark Bendeich)