Extensive reconstruction after Australia's floods risks fuelling a wages blow-out, as flooded states and the booming resource sector bid for scarce workers, which will in turn push up inflation and add pressure for a tightening of interest rates.

The initial impact of flooding in four states is an expected 1 percentage point drop in gross domestic product growth for Australia's A$1.3 trillion economy, with reconstruction costs ranging from A$3 billion to A$20 billion. But most analysts see a short-term V shaped recovery when $24.5 billion annual coking coal exports fully resume to Asia.

The government has pledged to return the budget to surplus by 2012-13, as promised before the floods, but the pledge may be tested if the forecasts of more extreme weather in the next two months proves true and resource exports are again hit.

The more worrying long-term scenario facing the economy and government is that Australia does not have enough skilled labour for both its booming mining industry and flood reconstruction, particularly in Queensland state where an areas as big as South Africa has been hit by floods.

The government may have little option but to increase skilled migration, a sensitive issue with voters, if it is to avoid the greater political risk of a wages blow-out and rising inflation and interest rates which will hurt voters.

There is going to be a huge demand for skilled labour in Queensland over the next 12 to 18 months and that looks like competing with the resource sector, said Michael Turner, strategist at RBC Capital Markets.

Australia's unemployment rate is already at its lowest in two years at 5.0 percent. A rate under 5 percent is as near full employment as Australia can get without stoking inflationary pressure, say analysts.

The Reserve Bank of Australia (RBA) will be keen to avoid a repeat of 2007 to 2008 when the jobless rate fell steadily to a trough of 4 percent, sending annual underlying inflation racing to a peak of 4.7 percent, far above its 2 to 3 percent target.

FLOODS TO PRESSURE RATES

Australia's annual inflation rate rose to 3.8 percent in December and the floods will worsen it, the TD Securities-Melbourne Institute said in a report released on Monday.

With vast tracts of the Brisbane CBD (central business district) severely affected by the floods, the concentration of infrastructure to be repaired could exacerbate already stretched labour and building materials, hence the upside to inflation could last longer than the temporary food price spike, said Annette Beacher, head of Asia-Pacific research at TD Securities.

The Reserve Bank has led the developed world by pushing rates up 175 basis points since October 2009. The last increase in November to 4.75 percent was a pre-emptive strike against inflation, to make room in the economy to accommodate a boom in business investment, particularly in the resource sector.

If underlying inflationary pressures remain contained, then the Reserve Bank can stay on the sidelines until well into 2011, said CommSec economist Savanth Sebastian.

Many analysts believe the RBA will look past the initial inflationary impact of the floods, with the loss of activity in Queensland dampening growth in the first quarter and even into the second quarter of 2011. Queensland accounts for about a fifth of the national economy and some 90 percent of Australia's $24.5 billion coking coal exports.

But once the economy, which is on track to grow at a robust 3 percent this year, shows signs of regaining traction post-floods, the RBA will no doubt continue to tighten policy.

The risk to inflation is skewed to the upside as a result of these floods, Turner said, adding he had three rate increases penciled in for 2011.

FLOODS RAISE POLITICAL RISK

The floods present the government a dual risk: it challenges the target for achieving a budget surplus and could reopen a debate about immigration, experts said.

Prime Minister Julia Gillard and Treasurer Wayne Swan have both reassured markets the budget would return to surplus by 2012-13. The surplus is the political holy grail and trumpeted by successive governments as proof of good economic management to voters when they cast their ballots.

But it is early days in calculating the costs of flooding and reconstruction and both concede tough decisions will be needed to afford reconstruction that will take years.

This (floods) rewrites the budget outlook for the next several years and Wayne Swan's fairly ambitious target for getting the budget back into surplus, that's material for the shredder at the moment, Norman Abjorensen, political analyst at the Australian National University.

But others do not see a threat to state coffers.

I don't subscribe to the view that there is a serious threat to the Commonwealth not achieving surplus budget by 2013, said TD Securities' Beacher. We are more likely to see a switching of priorities as opposed to a run-away expense associated with the clean up of the floods.

Inflationary pressures from a labour shortage will also be a key challenge as it could force Gillard to increase immigration -- a sensitive issue with voters complaining of population pressures in big cities.

Job markets are already tight across the country, especially in the construction trades. It is almost certain that workers will need to be brought in from abroad, said Craig James, chief economist at CommSec.

But with predictions the population will rise from 22 million to nearly 36 million by 2050, the government is targeting a sustainable population with net immigration falling from about 300,000 in 2009 to about 145,000 by 2012.

The Australian Industry Group (AIG) has called on the government to increase immigration and funding for labour training in the May budget to ensure future economic growth.

If we don't do that we will pay a very heavy price through wage inflation and ultimately higher interest rates, said AIG chief executive Heather Ridout. (Additional Reporting by Rob Taylor in Canberra and Cecile LeFort in Sydney)

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