Australia's drought is considered to be the worst on record

Treasurer Peter Costello said in his mid-term review the economy was likely to grow 2.5% in the year to June 2007.

That is down from his estimate of 3.25% in the May budget.

The economy expanded by just 0.3% in the three months to September, compared with the previous quarter, the slowest growth rate in more than three years.

'Risks to economy'

"The Australian economy remains sound although it is buffetted by severe drought," Mr Costello said.

"The downturn in the farm sector and related industries since the budget has reduced forecast growth by three quarters of a percentage point.

"The risks to the economy are weighted to the downside, particularly if dry conditions persist."

Earlier this month it was revealed that Australia's key crop production fell by more than a third during the three months to September.

And in November the Reserve Bank of Australia warned that the national drought was likely to slow economic growth, as a result of a drop in farming output.

Inflation worries

On Wednesday Mr Costello raised the government's inflation forecast from 2.75% to 3.0%, at the top end of the Reserve Bank of Australia's 2% to 3% target band.

He said rising prices for fruit and fuel had boosted inflation, but it was expected to drop back into the middle of the 2008.

Australia's central bank has been pursuing a policy of interest rate rises in recent months, and increased base rates by a quarter of a percentage point to 6.25% in November in a bid to keep a lid on inflation.

However any further rises in inflation, outside the bank's target band, may be enough to provoke an interest rate rise in early 2007.