BASEL, June 30: 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 II, 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.