BASEL (Thomson Financial) - The downturn in the world economy could be deeper and more protracted than expected as a result of the ongoing turmoil in financial markets, the Bank for International Settlements said.

The BIS said in its annual report that the interaction of the market turmoil, slowing real growth and rising inflation points to a 'deeper and more protracted global downturn than the consensus view seems to expect'.

'The current market turmoil in the worlds main financial centres is without precedent in the postwar period. With a significant risk of recession in the United States, compounded by sharply rising inflation in many countries, fears are building that the global economy might be at some kind of tipping point. These fears are not groundless,' it said.

It will certainly be a long time before conditions return to normal after the credit crisis, the BIS said.

'We should not expect a quick and spontaneous return to normalcy,' it said.

Banks could cut back further on lending to financial sector borrowers, which therefore may be forced to sell assets.

In addition, it said households facing heavy debt burdens, and sometimes falling house prices, could cut consumption quite sharply.

'Given the possibility of such a worsening economic and financial environment, it would not be surprising if asset valuations also came under further pressure, with house prices still of prime concern in many countries,' it said.

Meanwhile, inflationary forces could prove unexpectedly strong and persistent, particularly in emerging market economies, the BIS said.

Central banks therefore should have a bias towards tighter monetary policy, it said.

'With inflation a clear and present threat, and with real policy rates in most countries very low by historical standards, a global bias towards monetary tightening would seem appropriate,' it said.

While the central banks have to strike a balance between inflation and the risk of a deep economic downturn, they should give more weight to inflation worries because inflation is actually rising now, while significantly slower growth remains only a possibility in many parts of the world, it said.

However, the BIS said the differing circumstances of individual countries rule out a 'one size fits all' response.

Within the advanced industrial economies, there is more need for tighter policy in continental Europe than in the United States, where the threat of recession seems greater, it said.

Emerging market economies would also benefit from tighter monetary policies, which would in turn require greater willingness to allow their exchange rates to appreciate. Exchange rate appreciation would further help fight inflation, as well as reducing global trade imbalances, it said.

Monetary policies could be relaxed if a sharp economic slowdown leads to an easing of inflation pressures, but this might take some time.

'Given the inertia in the inflation process ... this might still imply an uncomfortably long period of high inflation along with slower growth,' it said.

The BIS said currency movements could also have an impact on the inflation outlook.

While the decline of the U.S. dollar has been orderly so far, this is not necessarily a guide to the future, it said.

'Foreign investors in U.S. dollar assets have seen big losses measured in dollars, and still bigger ones measured in their own currency. While unlikely, indeed highly improbable for public sector investors, a sudden rush for the exits cannot be ruled out completely,' it said.

And if the dollar and sterling continue to depreciate, inflationary pressures in the United States and the United Kingdom would be expected to increase, it said.

Conversely, in countries whose currencies might appreciate, particularly in Asia and western Europe, this might help counter inflation pressures, it said.

But in Japan, an eventual rise in the yen would carry the risk of a return to deflation, it cautioned.

The BIS said governments may need to take actions to help clear up after the credit crisis, but losses should fall primarily on those who incurred them in the beginning -- firstly the borrowers themselves and then those who lent unwisely to them.

'Should governments feel it necessary to take direct actions to alleviate debt burdens, it is crucial that they understand one thing beforehand. If asset prices are unrealistically high, they must eventually fall. If saving rates are unrealistically low, they must rise. And if debts cannot be serviced, they must be written off. Trying to deny this through the use of gimmicks and palliatives will only make things worse in the end,' it said.

But it would have been better to avoid the build-up of credit excesses in the first place.

Securitisation clearly played a key part in this, the BIS said.

'Loans of increasingly poor quality have been made and then sold to the gullible and the greedy, the latter often relying on leverage and short-term funding to further increase their profits,' it said.

But a more traditional factor also had a major role in the crisis a surge in money and credit growth surged.

'The fundamental cause of today's emerging problems was excessive and imprudent credit growth over a long period,' it said.

The strong expansion of credit was largely the result of the fact that interest rates were kept low despite strong economic growth, because globalisation was bearing down on inflation.

'Instead of temporarily allowing inflation to drift lower, analogously to the past treatment of negative supply shocks, policymakers interpreted this quiescence of inflation differently. They took it to mean that there was no good reason to raise interest rates when growth accelerated, and no impediment to lowering them when growth faltered,' it said.

Excessive credit growth explains not only the current financial turbulence, but also imbalances in the real economy and the recent rise in inflation, the BIS said.

The main lesson from this is that policymakers should therefore seek to limit such uncontrolled credit growth during future economic expansions.

'Fewer excesses on the way up would probably imply less damage to clean up afterwards,' it said.

This would mean that monetary policy and regulatory policy would need to 'lean against the wind' of the credit cycle.

'Monetary policy might be tightened even with projected inflation under control, given a sufficiently worrisome combination of rapid credit growth, rising asset prices and distorted spending or production patterns,' it said.

Such a policy approach would not eliminate credit-driven economic cycles, but it would attenuate them, it said.

steve.whitehouse@thomsonreuters.com

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