World needs tough monetary policy to tackle inflation

By David Milliken Reuters

BASEL (Reuters) - The world needs higher interest rates to tackle a clear inflation threat, even though economic growth is likely to be hit harder than most observers expect, the Bank for International Settlements said on Monday.

The Swiss-based BIS -- a meeting place and think tank for the world's central banks -- gave a gloomy outlook for both inflation and growth in its annual report, published after a three-day meeting of central bankers from over 100 countries.

BIS General Manager Malcolm Knight said central banks faced their greatest challenge in years, with growth slowing even as inflation pressures intensified.

"Clearly, the downside risks for future growth complicate the task of monetary policy," he said in a speech to the BIS annual meeting. "But there must in the end be a forceful response to confront the danger that inflation expectations could rise appreciably, with all the attendant problems that would bring."

The tone of the annual report was darker than last year after what the BIS described as the worst financial market turmoil since World War Two, and the bank saw a "significant risk" of recession in the United States, the world's biggest economy.

But this did not mean central banks should abandon their focus on fighting inflation, even if the BIS was concerned to point out that there was no single solution for all banks.

"With inflation a clear and present threat, and with real policy rates in most countries low by historical standards, a global bias towards monetary tightening would seem appropriate. That said, the circumstances of different countries, both actual and prospective, currently rule out a 'one-size-fits-all' approach," the BIS said.

"Moreover, should the global economy slow sharply and inflationary pressures recede, the bias to tightening would evidently also be reduced," it added.

The BIS said the financial market turmoil which spread from the U.S. subprime mortgage market in the middle of last year was the consequence of a classic unsustainable credit boom, and that disruption to the banking system limited the potential of interest rate cuts to boost demand.

Tax cuts and more government spending might have some merit, but the countries whose government finances were solid enough to afford that tended to be those less affected by the turmoil, the BIS added.

"In the aftermath of a long credit-driven boom, it would not be surprising to see turmoil in financial markets, slowing real growth and temporarily rising inflation," it said.

"Their interaction does appear to point to a deeper and more protracted global downturn than the consensus view seems to expect. At the same time, inflationary forces, particularly in emerging market economies, could also prove unexpectedly strong and persistent."

Knight, who leaves the BIS in September, said forecasts that current high inflation in industrialized countries was a temporary blip could not be fully trusted because of a significant rise in consumers' inflation expectations and past failures in accurately predicting rising commodity prices.

"It would seem imprudent from an inflationary perspective to rely heavily at this stage on such an outcome," he said.

U.S., EURO ZONE, JAPAN

The BIS was most pessimistic about the U.S. economy, saying that as well as the housing downturn there was a danger that consumption would take a further hit from people trying to rebuild savings depleted by past over-borrowing.

A bright spot for the United States was exports, helped by a weak dollar and the fact that other economies seemed to be less affected by its slowdown than in previous downturns -- though Britain appeared to be suffering a similar property-led malaise.

Strong business investment and falling unemployment meant prospects for domestic demand were good in the euro zone, especially Germany, though France, Spain and Ireland would have to cope with the end of house price booms.

Prospects were not so good in Japan, where weak wage growth and narrow profit margins in small firms meant demand from consumers and many businesses was vulnerable to rising prices.

Then there was the general fallout from the credit squeeze and rising oil and commodity prices, the BIS added.

"Fears are building that the global economy might be at some kind of tipping point. These fears are not groundless," the BIS said.

CENTRAL BANK REACTION

Analyzing how central banks had reacted to the crisis, the BIS said that most -- including the European Central Bank, Bank of Japan and Bank of England -- appeared to have set rates on the same criteria as before the crisis.

But the U.S. Fed had cut rates more rapidly, and the Reserve Bank of Australia raised rates faster than past behavior would have suggested.

"For these central banks, it appears that something not present in the equations, perhaps a shift in the economic outlook not present or reflected in the contemporaneous output gaps and rates of inflation, must have influenced policy in a decisive way," the BIS said.

The BIS repeated its call that central banks and regulators should do more to curtail future credit booms.

"It would have been better to avoid the build-up of credit excesses in the first place. In future, this could be done through the establishment of a new macrofinancial stability framework which would call for both monetary and macroprudential policies to 'lean against the wind' of the credit cycle."

* For a copy of the report and Knight's speech, go to www.bis.org