In its quarterly statement on monetary policy, the Reserve Bank of Australia (RBA) said risks to inflation, including high oil and labour prices, were being offset by domestic demand growth easing to a more sustainable pace.
This would lead to "the rise in inflation (being) relatively modest, with underlying inflation levelling out at around three percent in the second half of 2006," the RBA said.
The consumer price index (CPI) grew by 0.9 percent in the September quarter and by three percent over the year - the largest annual increase since March 2003.
Annual inflation is now at the top end of the central bank's two to three percent target band for inflation over the medium term.
The bank left its key interest rate on hold at 5.50 percent for the eighth straight month last week.
It said the economic situation reviewed by the RBA board at its recent meetings had been one in which international conditions appeared likely to remain favourable to growth in Australia. The bank said that over the last three years Australia had experienced its largest cumulative increase in terms of trade since the early 1970s.
"World prices of coal, iron ore and a range of other resources have risen sharply as a result of strong growth in global demand, with the rapidly expanding Chinese economy playing an important part," the RBA said.
"These trends are to Australia's advantage, providing a substantial boost to the country's terms of trade and hence having an expansionary influence on domestic incomes and spending."
It said the stronger world climate was helping support growth at a time when domestic factors were exerting a modest dampening effect on household spending.
"The net result is that growth of the economy overall has remained quite solid, while there has been a significant shift in the composition of demand and output," the RBA said.