Governments must raise taxes or cut public spending after central banks kept interest rates too low for too long in the face of higher inflation, according to the Bank of International Settlements.

Closing the gap between government income and expenditure would “calm inflation”, according to the annual report from the Basel-based organisation, which advises 63 central banks covering 95% of global economic output.

Governments that embarked on spending cuts or tax rises would reduce business and consumer demand and be a critical part of the “last leg” in the battle to tame inflation, which despite an intense run of interest rate rises by central banks around the world is far from over, the institution warned in a press release alongside the annual report. This final drive would also be the “hardest” however, in the fight to cool the sharp rate of price growth.

Amid concerns that the UK economy is already heading into a recession after a succession of sharp interest rate rises, the BIS took a tough line, saying higher taxes and lower spending could “contain financial instability risks in several ways”.

“It would reduce the need for monetary policy to tighten further. It would mitigate the risk that the sovereign itself becomes a source of financial instability,” it added, saying it would also “create more headroom should public resources be called upon for crisis management in concert with central banks”.

Jeremy Hunt’s March budget loosened government purse strings slightly despite freezing personal income tax thresholds that will increase the number of higher rate taxpayers over the next five years.

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Conservative MPs are unlikely to support higher taxes when millions of working households already face higher mortgage bills and rising prices in the shops.

The Taxpayers’ Alliance has called for further spending cuts, but in opposition to the argument put forward by the BIS, said the funds generated should be used for tax cuts.

If efforts fail to drastically reduce the rate of inflation in the short term the impact for economies could be devastating, the bank said, warning that although inflation had come down from recent historic highs in many economies, there was still a serious risk posed by a prolonged crisis.

“The longer inflation is allowed to persist, the greater the likelihood that it becomes entrenched and the bigger the costs of quenching it,” the BIS said.

Both the government and the Bank of England, as in other economies, have faced criticism for failing to tame inflation effectively.

Still, while they have a key role to play in slowing price growth, there are limits to their roles going forward, the BIS said.

Recent calls for major government interventions in areas such as financial support for British mortgage holders affected by higher monthly payments came after “decades of reliance on monetary and fiscal policy as de facto engines of growth”, according to the report.

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This has created a false sense that so-called macroeconomic policy such as decisions made by central government or central banks can determine long-term economic growth.

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“Overcoming this ‘growth illusion’ fallacy and finding a coherent policy mix requires a change in mindsets, recognising the limitations of stabilisation policies,” said Claudio Borio, head of the monetary and economic department at the BIS in a press release.

The institution, informally called the central bank of central banks, often speaks out about the role of fiscal policy, which is set by governments, versus monetary policy, including key interest rates, set by central banks.

“The role of fiscal policy will be critical. To do its part, fiscal policy needs to consolidate. Consolidation would help tackle both the near-term and the longer-term challenges. In the near term, consolidation would calm inflation by reducing pressure on productive capacity,” the BIS report said.

It added that there must be a balance that must be maintained by tax and spend, and interest rates in order to retain public faith in economic management.

“The privileged powers of fiscal and monetary policy ultimately depend on an implicit social contract underpinned by trust in the state. People consent to paying taxes because they trust the government to use the proceeds for the public good. Similarly, people accept the use of money as a means of payment because they trust the central bank to preserve its value,” the bank said.


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