OECD says interest rates should be lowered further

PARIS (Reuters) - Central banks need to pay close attention to the risk of deflation and are likely to keep cutting interest rates in coming months, the Organisation for Economic Cooperation and Development said on Tuesday.

"Headline inflation, while still high, is declining," the Paris-based organization said in its latest Economic Outlook, a report that said many countries faced "a protracted recession of a magnitude not experienced since the early 1980s."

"Indeed, though not part of the central projection, deflation would now appear to be a greater risk than an alternative where inflation expectations become unanchored, although neither eventuality has a very high probability."

Commenting on the report, which called for more fiscal stimulus measures, OECD Chief Economist Klaus Schmidt-Hebbel said central banks had so far reacted well to the deflation threat by moving quickly with deep interest rate cuts.

"Monetary authorities have to monitor this very, very carefully and react accordingly and I think by and large they are," he told Reuters.

He said central banks had even more room to move in conjunction with tax breaks and other measures and were likely to keep cutting rates in the weeks and months ahead.

"In our basic scenario we expect significant easing in monetary policy in reaction to these actual and expected developments and I think this monetary easing will be the most effective way to avoid protracted deflation," he said.

FED, ECB, BANK OF ENGLAND TO CUT RATES, JAPAN ON HOLD

The OECD saw room for more cuts by the U.S. Federal Reserve, which has lowered its main rate by 475 basis points since July 2007 to just 1.0 percent, as well as by the European Central Bank and the Bank of England.

"Falling inflation and confirmation of the adverse impact of financial stress on activity would justify additional cuts in the federal funds rate by around 50 basis points to bring it to 0.5 percent by early 2009," it said, referring to the benchmark U.S. rate.

It said that once there were clear signs that financial stress was abating, the Fed should rapidly move rates back up.

The ECB, which is widely expected to cut rates at a meeting next week, had even more room and the report said a reduction by a further 125 basis points by early 2009 was warranted.

In Britain, where a credit-fueled property bubble has burst and where the financial sector has been battered by the market crisis, the Bank of England should follow the deep cuts it has already made with further easing, the OECD said.

It said another 100 basis points should be cut, bringing the main repo rate to 2 percent.

Japan, which the OECD expects to fall into deflation from the third quarter of 2009, had already cut its main interest rate to 0.3 percent and has no room for further cuts.

But it should maintain rates at their current accommodative level "possibly even beyond 2010," the OECD said.

It said cuts of a further 100 basis points by the Bank of Canada would be justified, implying an overnight rate of 1.25 percent by early 2009.

Schmidt-Hebbel said lower oil prices had taken much of the sting out of inflation and he noted that exchange rate developments had tended to help economies adjust to the crisis, although he declined to comment on individual currencies.

"I don't see it as fundamentally out of balance," he said, referring to the broad relationship between currencies on foreign exchange markets.

(reporting by James Mackenzie, Editing by Brian Love)