"Well basically, your guess is as good as mine." (The most honest Treasurer in Australian history, Mr John Kerin, August 1991, when asked for his economic outlook.)

Will the Australian economy follow the US into recession, putting a further dampener on local investment markets?

Unfortunately, economic forecasters don't just have to forecast what will happen to GDP growth, inflation and other key variables.

Their biggest nightmare is forecasting what the key market players might do in the face of a particular set of changed circumstances and totally unpredicted events, such as the recent US sub-prime mortgage crisis - which is still unfolding - are their worst nightmares of all.

However, the accompanying graph is instructive in helping us understand what is currently happening in our economy.

Note in particular that the Reserve Bank has raised the cash rate - which has an almost immediate impact on interest rates paid by business and consumers - because of the rise in the CPI to a level outside its 2-3 per cent annual percentage growth range.

The lowest unemployment rate for 33 years also means that it can raise rates without having a precipitous effect on the labour market and consumer spending.

Of special concern to the RBA is that the CPI rise has raised expectations about the future course of inflation.

Why is it so concerned about such expectations?

Central banks across the Western world have realised over the past twenty years that it is crucial to restrain these expectations, as if they are allowed to get out of control then restraining inflation requires much more drastic interest rate rises - and thus sharp contractions in the economy.

The big worry of the RBA is that its pre-emptive rises in the cash rate will either not be sufficient to slow the Australian economy enough or that they will be too punishing and produce a repeat of the early 1990s recession.

Over the rest of this year we will certainly see a re-adjustment in the growth process, in response to the RBA's recent hikes in interest rates and the negative "wealth effects" of the US sub-prime market-induced share market correction.

It is the timing and magnitude of this process which is quite unpredictable.

What does all the above mean for Aussie investors?

Once the economy is on a steadier keel, company profit expectations are likely to pick up again - as consumer spending recovers, under-pinned by low unemployment and continuing growth in wages and salaries.

This will put a floor under Aussie equities.

Property has a more complex outlook but unless the global economy goes into a tail-spin continuing reasonable Australian economic growth will prevent anything like an early 1990s crash.

It should also be remembered that too sharp an economic slowdown over the next year would see the RBA cutting rates again. This would also give a boost to equities by reducing the relative attractiveness of fixed interest investments to other forms of investment.

Uncertainty will thus continue to plague Australian markets until it is clear that the US sub-prime crisis is over and that the RBA has been successful in taking the heat out of the Australian economy without sending it into a serious downturn.

In short, what we very likely will see over the next few months is a re-adjustment to the Australian economy, rather than a recession.

Only a collapse in the Chinese economy and/or a global financial crisis could alter this relatively benign outlook.

Indeed, as the re-adjustment unfolds, canny advisers and investors will be waiting to take advantage of the very likely eventual recovery in the investment climate.

Dr David Clark taught Business Economics at the University of NSW for 35 years, was an AFR and Personal Investor columnist for over a decade, and is now an investor educator. The views expressed are those of David Clark's, not necessarily those of Vanguard's.