TOKYO, May 11 (Reuters) - Countries must keep fiscal spending targeted and temporary as broad-based, persistent stimulus could increase inflationary risks and compel central banks to raise interest rates, the head of the Bank for International Settlements (BIS) said in an interview with Japan's Nikkei newspaper.
Prolonged disruptions in the Middle East could also pose risks to global financial stability with rising public debt in the last 15 years increasingly being intermediated by nonbank financial institutions,
including highly leveraged hedge funds, said Pablo Hernandez de Cos, general manager of the BIS.
"In recent weeks, market sentiment has been buoyant, driven by optimism regarding artificial intelligence (AI) developments and the expectations of a rapid resolution to the conflict in the Middle East. If these expectations prove wrong, I can easily see the potential for abrupt market corrections," he said in the interview published on Monday.
The Middle East war has heightened volatility in global markets and prodded some countries, including Japan, to ramp up spending to cushion the economic blow from surging oil prices.
But the energy shock has also heightened pressure on some central banks to raise interest rates to combat the risk of too-high inflation, even if that meant cooling economic growth.
Central banks should "look through" a temporary negative supply shock if it does not destabilise inflation expectations or trigger harmful second-round effects, de Cos said.
But if the shock persists, such a "look-through" approach would become less sustainable, he said, adding that the memory of the post-pandemic inflation spike may increase the risk of second-round effects.
"Central banks must carefully monitor these developments and be ready to act if needed," de Cos was quoted as saying.
"Fiscal support should be targeted and temporary. If it becomes broader and more persistent, inflationary risks increase considerably, possibly compelling central banks to raise interest rates, which would, in turn, dampen economic growth," he added, according to the Nikkei.
De Cos declined to comment, the report said, when asked about media reports that he was considered as among candidates to succeed European Central Bank President Christine Lagarde.
(Reporting by Leika Kihara; Editing by Muralikumar Anantharaman)
