A trader in inflation swaps works at BGC Partner's offices in Canary Wharf in London
A trader in inflation swaps works at BGC Partner's offices in the Canary Wharf financial district, in London January 20, 2009 file photo. REUTERS

The Bank for International Settlements, a global bank that acts as intermediary between central banks, has announced today that Governments face an increasingly difficult task to combat 'inflationary pressures', which it says could 'reappear earlier than anticipated'.

According to their annual report, high public debts combined with a fragile banking system could make it harder to sustain growth and keep inflation low.

"Despite the improvement to banks' balance sheets, several factors raise doubts about the sustainability of bank profits," the BIS said.

"Losses on European bank balance sheets are expected to mount over the next few years, anecdotal evidence suggests that some banks have taken to rolling over existing loans rather than inducing foreclosures, thus delaying loss recognition."

"To put it bluntly, the combination of remaining vulnerabilities in the financial system and the side effects of such a long period of intensive care threaten to send the patient into relapse," the BIS added.

The news came as the G-20 summit made efforts to tackle the looming public sector debts - a move which the BIS welcomed as 'deflationary':

"So far, there is no evidence that inflation expectations have become unanchored, however, a failure by governments to make headway in restoring fiscal sustainability increases the risk that inflation expectations may abruptly and unexpectedly change."

The BIS, which is also responsible for Basel III - a new set of rules for governing banks, also warned that Europe was overlay reliant on US dollar swaps with an $7 trillion in dollar-denominated assets on their books.

Such measures - including the UK's Quanititate Easing, and the ECB's bond purchasing markets - may keep markets stable, but add to inflation - and hence interest rates.

"Such powerful measures have strong side effects, and their dangers are beginning to become apparent," it said, adding that it "runs the risk of creating zombie financial and non-financial firms" and delaying the inevitable.

"We cannot ignore the fact that the culminating side effects themselves pose a danger that, at the very least, implies exiting sooner than may be comfortable for many," the BIS concluded.

The BIS said that whilst interest rates are currently low, a long-term rate increase is still required:

"A prolonged period of exceptionally low real interest rates alters investment decisions, postpones the recognition of losses, increases risk-taking in the ensuing search for yield and encourages high levels of borrowing," it warned.

The so-called 'central banks' central bank, believes that with rates so low, investors will take bigger gambles on lower returns ultimately leading to a dangerous level of borrowing.

The report also looks at fiscal deficits in several countries that appear to be spiralling out of control, and in particular, those associated with age-related spending and notes that where economies are shifted towards an older demographic, it would be harder to sustain a financial model.