this important area and do not want to lecture the federal and state governments on this issue, which i know is already absorbing a lot of their attention. this process of slowing demand and expanding capacity has been going on for several years, but it has not prevented some general upward pressure on producer and consumer prices. this was brought home to the public with the publication of the june quarter cpi. the increase of 4 per cent over the year to the june quarter made headlines, even though many observers were quick to point out that more than half of the june quarter increase was due to petrol and bananas, the latter influence giving the cartoonists of australia great opportunities for mirth. they were correct to downplay these two influences which, in all probability, will either reverse or revert to zero in the coming quarters. but there is also a danger in simply taking out the two fastest growing components and looking at the rest of the cpi basket. at the bank, we tackle the problem of lumpy, and possibly one - off, price movements by looking at various measures of underlying inflation. our preferred measures show that underlying inflation is running slightly below 3 per cent per annum. this has picked up moderately since the start of the year, after a period when it had been fairly stable at around 2½ per cent. the bank's mandate is to keep inflation averaging 2 to 3 per cent over the medium term. this does not mean that it is never to exceed 3 per cent or fall below 2 per cent – it clearly has done both during the inflation targeting period. we need to be confident, however, that it will return to the 2 to 3 per cent range. viewing all of the available evidence that has accrued over the six months since we last appeared before this committee, the board came to the view that inflation was likely to exceed earlier forecasts and that corrective action was therefore needed. as you know, the cash rate was raised by 25 basis points in may and again by the same amount earlier this month. in making these decisions, the board was conscious that the global economy remains very strong, with output expanding at an above - average pace for the fourth year in a row. it also noted that global inflationary pressures have been rising. this is in part the consequence of the very accommodative monetary policies that the major countries ran over 2003 and 2004. while the english - speaking countries have generally returned interest rates to more normal levels, the continuing low level of interest rates in asia

permanently below it. second, there is no sensible alternative monetary policy that would have prevented us from entering the zone of full capacity. the only way monetary policy could have prevented this is if it had kept the economy'semi - comatose '. that would have meant growing so slowly on average that, even with the passage of fifteen years, it did not use up the excess capacity. third, full capacity is not a brick wall that you suddenly hit – approaching it is something that happens in stages. it is a rather patchy process, with some sectors reaching it early and some not at all. that is why i called it the zone of full capacity. sometimes it is an industry that becomes a bottleneck, sometimes a type of capital equipment and often it is a type of skilled labour. the situation that attracts the most attention is when it is a piece of infrastructure such as a port or a railway. but normally when the bank talks about capacity, we are not talking about the specific pieces of infrastructure but about the economy's overall availability of labour and capital resources. it is also worth keeping in mind that it is normal for the capacity of the economy to grow over time. this is because the labour force grows and investment and economic reforms lift output per worker, or productivity. there are limits, however, to how quickly capacity can be raised, though increased investment, as is taking place at present, will boost the rate of increase. but it takes time. in the meantime, it is helpful if demand can slow sufficiently to allow capacity to'catch up'and perhaps get ahead a little. if this fails to happen, then there is a risk of a generalised pick - up in inflation. some rises in prices and wages in the areas where bottlenecks exist are unavoidable, but a generalised inflationary process is avoidable. this is why last year i started saying that we should get used to gdp growth with a 2 or a 3 in front of the decimal point, rather than a 3 or a 4 as we had become accustomed to throughout most of the expansion. in light of what i have just outlined, i would like to review our progress to date. the first thing to note is that over the past two years the economy has slowed from its earlier fast pace of growth. the last time we had gdp growth of over 4 per cent was in the year to june 2004. since then, the growth rates have had a 2 or a 3 in front of