Global interest rates must rise to avoid high inflation becoming entrenched, the Bank for International Settlements said on Sunday.

It also warned that delaying deficit cuts could risk intensifying the sovereign debt crisis and have grave consequences were investors to lose confidence in a major economy such as the United States.

With the arrival of sharper price increases for food, energy and other commodities, inflation has become a global concern, the BIS said in its annual report.

Tighter global monetary policy is needed in order to contain inflation pressures and ward off financial stability risks.

Of the four major central banks, the European Central Bank is the only one which has raised rates since the intensification of the financial crisis in late 2008.

Central banks may have to raise rates at a faster pace than previously, BIS said, adding that as long as global growth is robust, food and commodity prices may remain high or even rise further.

The Group of 20 economic powers agreed in Paris on Thursday to tackle high food prices by boosting farm output, food market transparency and policy coordination, after world food prices hit a record high earlier this year.

The deal is another sign that global policymakers are reaching beyond traditional economic policy tools to sustain global growth, which has shown signs of slowdown in recent months.

BIS said inflation expectations suggest central banks' long-term credibility has so far survived the inflation surge, but added that rates have to rise to ensure this anchoring.

The great danger is that long-term inflation expectations will start to climb, and current price developments and policy stances are sending us in the wrong direction.

The annual report also said the Bank of England should think about tightening its policy in the face of high inflation.

In the United Kingdom, CPI inflation had exceeded the Bank of England's 2 percent target since December 2009, it said. As yet, there has been no move by the Monetary Policy Committee, but one wonders how long its current policy can be sustained.

FISCAL TIGHTENING

Turning to fiscal policies, the BIS said that a major economy being drawn into the debt crisis could have catastrophic consequences.

We should make no mistake here: the market turbulence surrounding the fiscal crises in Greece, Ireland and Portugal would pale beside the devastation that would follow a loss of investor confidence in the sovereign debt of a major economy, it said.

The time for public and private consolidation is now.

It added that markets might not continue to view U.S. public debt as favorably as now were it to continue carrying heavy deficits.

The current ability of the United States to easily finance its deficit cannot be taken for granted. Past examples of a number of smaller economies in deficit suggest that market confidence can evaporate quickly, forcing sudden and costly adjustment.

Emerging countries should do their part to reduce global imbalances by easing exchange rate pegs, the BIS said, adding that China should let the yuan appreciate against the dollar.

The large costs of monetary instability mean that adjustment should principally work through more flexible nominal exchange rates, the report said.

In the case of the United States and China, the costs of that adjustment would probably fall mostly on China.

The BIS also said that while extremely low interest rates help commercial banks, they can delay necessary action.

At the same time as ultra-low interest rates have given banks the breathing space to take the necessary actions, they have weakened incentives to pursue the clean-up, the report said.

When banks are not forced to write down loans, they are actually provided with incentives to evergreen, i.e.. to roll over non-performing loans to firms that should have been bankrupt.

(Reporting by Sakari Suoninen)

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