World needs tough monetary policy to cool inflation

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.

Central bankers themselves, speaking on the sidelines of the event, also stressed their concern about global price rises driven by the increasing cost of oil and food.

"It is a very major concern for me, not just for me but all central bankers," Polish central bank chief Slawomir Skrzypek told reporters.

BIS General Manager Malcolm Knight said central banks faced their greatest challenge in years, as inflation argued for interest rate hikes that could further dampen economic growth.

"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.

This did not mean central banks should abandon their focus on fighting inflation with rate hikes. "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," the BIS said.

But it added: "That said, the circumstances of different countries, both actual and prospective, currently rule out a 'one-size-fits-all' approach. Moreover, should the global economy slow sharply and inflationary pressures recede, the bias to tightening would evidently also be reduced."

INFLATION PRESSURES

The difficulties facing central banks were highlighted by euro zone data released on Monday, showing inflation hitting a record 4 percent in June, double the European Central Bank's medium term target.

"I believe that inflation is a problem that can be controlled in the euro zone," Knight told a news conference, but added it was hard to tell whether an expected quarter-point ECB hike to 4.25 percent on Thursday would be enough.

Central bankers from emerging economies showed little appetite for one of the BIS's main calls: a revaluation of their currency rates, especially those pegged to a weakening dollar.

Sultan Nasser al-Suweidi, the United Arab Emirates' central bank chief, told Reuters the Gulf state was sticking firmly to its dollar peg, and the head of the Hong Kong Monetary Authority, Joseph Yam, said the Chinese dependency would not widen the trading band for the Hong Kong dollar.

MARKET TURMOIL

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 scope for 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."

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.

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.

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

(Editing by Ruth Pitchford)