Reserve Bank of Australia (RBA) governor Glenn Stevens says inflation could be rekindled to double-digit figures if the central bank's inflation target was not obeyed and that the United States was close to recession.
Mr Stevens defended the central bank's long-standing two to three per cent inflation target, saying inflation could rise to 1970s-type levels if a target band was not fulfilled.
"It's easy to say why not raise the target," Mr Stevens told a University of Sydney alumni dinner.
"That was the previous thinking of the 1970s. That's how we got 10 per cent (inflation), it's too big a liability."
The RBA adopted the two to three per cent inflation target in 1993 and it became official government policy in 1996.
Mr Stevens also said that Australia needed to adapt to the once-in-a-century rise of China.
"It's certainly a once-in-a-century economic event," he said.
"China will, unless something terribly destabilising occurs ... within a generation it's going to rival the large economies of the world.
"What we've got to do as a country is be able to adapt."
Mr Stevens said China's economic rise posed some environmental challenges.
"Its demand for energy grows very quickly and its environmental problems are growing very quickly.
"China is at this point over-heating and needs to slow down. Nothing short of a cataclysmic event will stop it growing quickly."
Mr Stevens said the United States was likely to be close to recession.
"We're a long way from out of the woods, the US economy looks like it's having a slight recession," he said.
Mr Stevens said there were moral hazards in central banks bailing out struggling financial institutions in the wake of the global credit crunch.
"It's an intervention without precedence," Mr Stevens said in relation to the US bank JPMorgan and the US Federal Reserve bailing out Bear Stearns.
"There's a more hazard issue. I think there's going to be an interesting discussion in several years about the (US regulatory system."
In his prepared speech Mr Stevens said Australia's strong fiscal position was the envy of most of the world and had given the federal government the capacity to respond to future uncertainty.
"But there would be very few countries, if any, which would not envy Australia's fiscal position," Mr Stevens said.
"The capacity to respond, if need be, to developments in the future is virtually without peer.
"This seems light years from the situation in the late 1970s."
The federal government this week forecast a $21.7 billion underlying cash budget surplus for 2008/09, building on an expected $16.8 billion surplus for this financial year.
The surplus will equate to 1.8 per cent of gross domestic product, the highest in almost a decade.
However, the RBA governor declined to comment on the Rudd government's budget.
"Two days after the budget, the Treasurer (Wayne Swan) has very visibly explained and defended it," Mr Stevens said.
"It won't help for me to chip in from the sideline."
In his speech Mr Stevens said Australia had shifted from a run of mostly budget deficits until the mid-1990s, to surpluses.
Mr Stevens said inflation targeting was the best system yet to keep prices down.
"Inflation targeting is not perfect and, on occasion, still leaves policy makers with some quite difficult decisions to make," he said.
"It is, however, the best system that has been devised as yet."
Mr Stevens said Australia's price pressure problems now were not as bad as in the 1970s.
"Even with the recent surge in consumer prices taking the inflation rate to a bit over four per cent, things are not like there were in the 1970s," Mr Stevens said.
