Speaking at a panel of economists during the International Monetary Fund spring meetings in Washington DC, Reserve Bank of Australia chief economist Sarah Hunter said managing inflation expectations had to be the bank's "North Star" as it responds to the Iran war shock.
The RBA had managed to get inflation down post-COVID while keeping unemployment low only because inflation expectations remained anchored.
Even though inflation was spiking in the short term, households had faith the bank would get them back under control eventually.
"If we lose that, we go back to a world of the 1970s and 1980s, where it's much more costly," she said early on Friday morning, Australian time.
Headline inflation was at 3.7 per cent in February.
That's higher than the Reserve Bank's 2.5 per cent target but still far lower than the 17.7 per cent peak in 1975 or the 1982-83 recession, when inflation exceeded 12 per cent.
However, consumers were still recovering from the post-COVID inflation spike, when price growth peaked at 7.8 per cent - the highest level since the RBA began targeting inflation in 1993.
Adding to the bank's dilemma was the income shock households were facing as a result of the energy crisis, which will slow growth and put more people out of work.
Stagflation is a "central banker's nightmare", as RBA deputy governor Andrew Hauser said in a separate speaking event in Washington this week.
"We do have to balance these two things, but at the end of the day, that credibility is absolutely vital," Ms Hunter said.Â
Credibility was especially at risk in a world where economic shocks were increasingly frequent and inflation was a constant challenge, she said.
The RBA would have to act drastically if there was no resolution to the Iran war soon, Harry Murphy Cruise, head of economic research at Oxford Economics, said.
If the Middle East crisis lingers into the third quarter, crude oil prices could hit $US150 to $US160 a barrel, from just under $US100 currently, he warned.
"That would push underlying inflation much closer to six per cent, broadly in line with where it was at the peak of the pandemic," Mr Murphy Cruise said.
Annualised underlying inflation, which strips out volatile items, is currently at 3.3 per cent.
A further jump would force the Reserve Bank of Australia to hike the cash rate from 4.10 per cent to five and a half per cent through this year, Mr Murphy Cruise said.
"All that is very bad news for households," he said.
"Businesses are scared. They don't know what the outlook looks like, and they've got higher input costs."
A survey of 828 company directors conducted by Roy Morgan found 41 per cent believed current interest rate levels would cause a major uptick in insolvencies, while almost nine in 10 expected business costs to rise.
"While productivity concerns still dominate, the fuel and energy crisis unfolding as a consequence of the Middle East conflict will only intensify the challenges being felt in the economy," Australian Institute of Company Directors chief economist Mark Thirlwell said.
Treasurer Jim Chalmers also warned the effects of the Iran war would linger.
"Lasting damage has been done and the recovery will be longer and harder than any of us would like," he said in a speech overnight at a meeting of G20 finance ministers in Washington.
"We won't see everything go back to normal straight away. There is no normal anymore, and the fallout from this conflict will be felt for some time even if the ceasefire sticks and the Strait reopens soon."
HSBC chief economist Paul Bloxham expects the central bank to hike the cash rate again at its May meeting.
But beyond then, the stalling economy might do the bank's disinflationary work for it, he said.
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