The Bank for International Settlements warns that central banks should avoid premature rate cuts as this could trigger a new round of inflation.

The international financial institution known as the "central bank of central banks" said in its annual report that with inflation cooling and economic growth remaining strong, the global economy is expected to achieve a "soft landing".

However, the institution still urges rate-setters to set a "high bar" for policy easing and warns of the risk of a rebound in things like service prices and wage growth that could indicate a resurgence of demand-led inflation and the need to keep some space for rate cuts in the event of an unexpected downturn.

It also warns that the financial system remains vulnerable, especially with high public debt levels and falling commercial property prices.

Inflation could come back with a vengeance.

The Bank for International Settlements said, "Premature policy easing could reignite inflationary pressures and lead to costly policy reversals, with potentially higher costs because of damage to central bank credibility."

In 2021 and 2022, the biggest inflation surge in decades was fueled by supply-chain disruptions and soaring energy prices caused by the COVID-19 pandemic, with the US Federal Reserve and the European Central Bank criticized for reacting too slowly.

Agustín Carstens, the general manager of the Bank for International Settlements, praised the "forceful tightening measures" ultimately taken by central banks, saying they enhanced the central banks' credibility and deterred a shift toward a "high-inflation regime."

However, the Bank for International Settlements warns senior officials to remain vigilant against the resurgence of inflationary pressures despite some central banks already loosening policy. The European Central Bank already opened up rate cuts in June, while the US Federal Reserve is expected to lower borrowing costs as early as September.

While global inflation rates are steadily declining, most regions (including the US and Eurozone) still have inflation rates higher than central bank targets.

Carstens compared central bank governors' fight against inflation with doctors administering antibiotics to infected patients and said, "You have to go the full course, otherwise inflation may come back with a vengeance."

The former governor of the Bank of Mexico enumerated some "important pressure points" that could undermine the prospect of a soft landing, including weak public finances, slow productivity growth, and "persistent inflationary pressures."

Of critical importance, the Bank for International Settlements found that in many countries and regions, service prices relative to core commodity prices remain far below pre-pandemic trends. Similarly, real wages have fallen during high inflation periods relative to both goods and service costs.

Carstens said, "Either one or both of these relative prices rebounding too quickly could put significant inflationary pressure on."

For example, the Bank for International Settlements estimates that compensating workers for lost purchasing power due to surging inflation could increase the inflation rate by 0.75 percentage points for large euro-area economies in 2025 and by 1.5 percentage points in 2026. Faster-rising wages could boost their inflation rates by 1.5 percentage points in 2025 and by over 2.5 percentage points in 2026.

The Bank for International Settlements adds that fiscal policy should also remain tight to avoid exacerbating persistent inflationary pressures.

Financial stability also faces challenges.

On the other hand, rising public debt is seen as the biggest threat to monetary and financial stability by the Bank for International Settlements, and it says there is a risk of a sharp loss of confidence in markets for governments deemed to have unsustainable debt levels.

Claudio Borio, head of the Monetary and Economic Department at the Bank for International Settlements, says countries where the fiscal situation worsens further due to rising interest rates should prioritize repairing their fiscal condition. He said, "Experience tells us that things look sustainable until they suddenly don't - that's the way markets work."

The Bank for International Settlements says that historically, financial stress often emerges within two to three years after the beginning of a tightening cycle, which means it is still possible for it to happen within the next year.

While the necessity of repairing public finance has always been a theme repeatedly emphasized by the Bank for International Settlements, these remarks coincide with the strict scrutiny of indebted economies in recent times. Concerns over France this month prompted the French-German bond yield spread to reach its highest level since 2012.

Bank for International Settlements officials did not specify which country, but they did provide a chart showing the debt and market pricing of some of the world's largest borrowing nations, including Japan, Italy, the United States, France, Spain and the United Kingdom.

To stabilize finances, developed economies are required to limit their deficits to 1% of their GDP this year, down from 1.6% in the previous year. And this is only a small part of the current US deficit, which the International Monetary Fund said last week is "too big".

"Despite financial market pricing suggesting low probabilities of fiscal pressure, a weakening in economic growth momentum and sharp and/or urgent public expenditure needs both on a cyclical and a structural basis could result in a rapid loss of market confidence," the institution said. "Government bond markets would be first affected, but pressures could spread more broadly."

The report also noted that commercial real estate is a high-risk area because it "faces both cyclical and structural obstacles". The report said huge declines in real estate prices could drag down loans in many developed economies, with GDP falling 4 percentage points, like in the 1990s.

According to the Bank for International Settlements, commercial real estate owners may artificially maintain their valuation. The institution said that as banks continue to lend in order to avoid realizing losses, and with the hope that interest rates will fall to enable their recovery, commercial real estate owners may adopt an "extend and pretend" strategy.