The odds have shortened on a third interest rate rise after the Government's top economic official said parts of the economy must be constrained to avoid a 1970s-style inflation surge. The Treasury secretary, Ken Henry, a member of the Reserve Bank board, is often regarded as a "dove" for his preference of lower interest rates. But influenced by the inflation associated with the resources boom, Dr Henry showed his focus had shifted from averting a recession to stopping the economy from overheating. "The economy is as close to fully employed as I've ever experienced in my professional life," he told an Australian Industry Group conference in Canberra. "We're going to see much stronger demand." The terms of trade boom has seen prices for non-rural commodity exports jump 84 per cent from the 1990s average, flooding the economy with extra income and raising consumer prices amid higher petrol costs. Dr Henry said the boom would boost consumption without lifting output because the economy was already running close to full capacity - and had been for years. "That means that other sectors must expand at a slower rate - some may even have to contract," he said. If they did not, the economy would overheat and the result "would not be pretty". "Recall the inflationary surge in the aftermath of the 1970s terms-of-trade boom, and the dark shadow it cast over the economy for many years after." The chief economist at Deutsche Bank, Tony Meer, who predicts higher interest rates, said: "It's a pretty tough story if you're in manufacturing, or if you're in Sydney for that matter." Dr Henry did not spell out whether further rate rises would be required after increases this month and in May. But he suggested the boom in China had some way to run and said the Reserve Bank had only a single "blunt instrument" to manage a "two-speed" economy. "I've got substantial confidence that monetary policy will continue to be operated - I was going to say sensitively but that's not quite the right word - carefully." Inflation rose to 4 per cent in the three months to June. Figures released on Wendesday 16 August will show whether wages growth has picked up or remains contained. In the 1970s, wages growth hit 30 per cent while inflation rose to 18 per cent and remained high for 20 years. The Treasurer, Peter Costello, conceded that high petrol prices and inflation had become challenges requiring careful management. Craig James, chief economist at Commsec, said the average household was paying more than $192 a month for petrol - an increase of $31 a month since the beginning of the year. The Housing Industry Association-Commonwealth Bank index showed housing affordability worsened by 5.3 per cent in the three months to June as higher interest rates bit. Its chief economist, Simon Tennant, said: "The first of two rate hikes earlier this year did little more than push home ownership further out of reach for many families locked into the tightening rental market." While Dr Henry has allowed for a decline in resources, his central prediction is that prices will remain high. The terms of trade would stay high while China's demand for materials continued to "outstrip the rate of growth of productive capacity". Dr Henry predicted a "movement of labour" from south-eastern Australia to mining-rich Western Australia and Queensland, once these states exhausted their supplies of local labour. Source: SMH