Are low interest rates damaging the recovery?

Central banks around the globe have been keeping interest rates too low and run the risk of letting inflation rise unchecked, according to the Bank for International Settlements' (BIS) annual report.

The Swiss-based bank, which acts as an organisation for central banks, said base rates had been held too low from a historical perspective and the gap between policy rates and inflation had been allowed to widen by a large number of individual countries.

It added that the current loose stance on monetary policy could lead to a renewed build-up of risks to financial stability and central banks should think more about the combined implications of their actions.

The damning report was published on Sunday and warned central banks could lose their inflation-fighting credibility.

This will come as a blow to governor of the Bank of England, Mervyn King, and his Monetary Policy Committee, which has insisted on keeping UK interest rates at a record low of 0.5% for 26 months now.

King has repeatedly cited the temporary nature of inflationary pressures in the form of higher food and oil prices as the Committee's reason for maintaining low rates.

But BIS discredited this argument and said since 2005, before the financial crisis, inflation in most advanced and emerging market economies had been much more volatile due to the volatility of energy and food prices.

This suggested the BIS thinks the volatility of commodity prices could continue for longer than many central banks have allowed.

BIS also shunned King's argument that until workers start to demand higher wage settlements inflation is in no danger of becoming systemic.

It said: "Given the globalised nature of many supply chains, underlying inflation pressures in the advanced economies are affected indirectly by a pickup in unit labour costs in the emerging market economies. Advanced economies may see core inflation pick up through the back door of global supply chains despite moderate wage pressures in their domestic labour markets."

Specifically of the Bank of England, the BIS said: "In the United Kingdom, CPI inflation has exceeded the Bank of England's 2% target since December 2009, reaching a peak of 4.5% in April 2011 (in part due to a VAT increase). As yet there has been no move by the MPC, but one wonders how long its current policy can be sustained."

Since the start of the year, analysts' and economists' expectations for a UK interest-rate hike have moved further and further back.

Following a slowdown in the economic recovery, shown by flat GDP growth across the final quarter of 2010 and the first quarter of 2011, the market has deferred interest rate expectations to next year.

Last week interest rate expectations received a further blow when the MPC minutes from June's meeting revealed a 7-2 breakdown in favour of holding rates.

In previous months, the vote was split 6-3, but with the departure of renowned hawk Andrew Sentance, the dovish majority gained another member in the form of newly appointed Ben Broadbent.