Four days after it retained the overnight cash rate at 4.25 per cent, the Reserve Bank of Australia (RBA) lowered on Friday its inflation and growth forecast for the first six months of 2012.

The Australian central bank reduced inflation outlook to 2.25 per cent from 2.5 per cent three months ago and gross domestic product (GDP) growth rate to 3.5 per cent from 4 per cent.

The RBA explained the cuts to uncertainty over Europe's debt crisis which is expected to impact domestic household and business confidence.

"The major uncertainty regarding these forecasts stems from developments in Europe, where there is still some possibility of an intensification of the sovereign debt problems. While the likelihood of such an outcome seems to have lessened a little recently, if it did occur, Europe would be likely to experience a severe recession with spillover effects to the rest of the world through trade, financial and confidence linkages," the RBA said in its quarterly report.

"Australia is better placed than many other countries to deal with the downside risk, given the scope to adjust macroeconomic policy, the flexible exchange rate and the strong banking system. Nevertheless, if this downside risk did eventuate, growth in Australia would be weaker than in the bank's central scenario," the RBA explained.

The central bank pointed out that despite the strong growth in Australia's mining sector, other parts of the economy will be affected by the strong currency and would continue to struggle. Among the sectors mentioned by the RBA to be affected by the high dollar are construction, manufacturing, tourism and education.

At the same time, the RBA defended its Tuesday decision to retain the key lending rate. The bank cited two cash rate cuts made in November and December 2011 which were driven by the improved inflation outlook. It said the underlying inflation would provide scope for the central bank to ease monetary policy if demand conditions would weaken materially.

RBA said it would continue to monitor information on economic and financial conditions in the coming months and adjust the overnight cash rate "as necessary to foster sustainable growth and low inflation."

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