The OECD slashed its global growth forecasts on Tuesday, warning that the debt crisis in the recession-hit euro zone is the greatest threat to the world economy.
In light of the dire economic outlook, the Organisation for Economic Cooperation and Development urged central banks to prepare for more exceptional monetary easing if politicians fail to come up with credible answers to the debt crisis.
The Paris-based think-tank forecast in its twice-yearly Economic Outlook that the global economy would grow 2.9 percent this year before expanding 3.4 percent in 2013. The estimate marked a sharp downgrade since the OECD last estimated a rate in May of 3.4 percent for this year and 4.2 percent in 2013.
The euro zone is facing two years of economic contraction, while the United States risks a recession if lawmakers there fail to agree a deal to avoid a combination of tax hikes and budget cuts that will otherwise go into effect next year.
Providing the deadlock in Washington is overcome, the world's biggest economy will grow 2.0 percent next year, the OECD estimated, cutting its forecast from 2.6 percent in May.
"The U.S. fiscal cliff is a very important source of concern, but the greatest downside risk remains the euro zone," OECD chief economist Pier Carlo Padoan told Reuters in an interview.
"The reason for that is not only recession, but also the fact that different negative policy (feedback) loops between sovereign debt, the banking situation and exit risks remain. So the overall zone remains in a state of fragility."
Cutting its estimates, the OECD forecast that the euro zone economy would contract 0.4 percent this year and another 0.1 percent next year, only returning to growth in 2014 with a rate of 1.3 percent.
The OECD warned that diverging financing conditions within the European monetary union threaten to pull it apart if policymakers fail to get a grip on the debt crisis.
"The euro area, which is witnessing significant fragmentation pressures, could be in danger," Padoan wrote in a foreword to the outlook, urging politicians to overcome deadlock over a single European Central Bank-led bank supervisor.
Given the weakness of the global economic outlook, the OECD warned governments against being too zealous in their belt-tightening efforts and recommended that Germany and China even pursue temporary stimulus spending to revive growth.
CENTRAL BANK SUPPORT
With many major economies in the mire, Padoan said it would be premature for central banks to take any exceptional monetary easing measures off the table at this point.
"They should be prepared to do more in the immediate term if things were to deteriorate," Padoan told Reuters.
He singled out the European Central Bank as the prime candidate for further action, saying it had room to cut its main interest rate by 25 basis points from its current record low of 0.75 percent.
The ECB should also consider setting a negative deposit rate and send a strong signal to markets on its long-term interest rate intentions, the OECD said.
The German central bank has been a vocal opponent of the ECB taking further exceptional actions to get the debt crisis under control, in part because of concerns that additional liquidity could boost inflation.
"We think fears that excessive liquidity could fuel inflation in the short term are misplaced," Padoan said.
Not only are all measures of inflation expectations currently subdued, he added, but there is also a risk that economists are underestimating the slack in major economies and therefore overestimating inflationary pressures.
The OECD said the U.S. Federal Reserve's monetary easing programme was appropriate, although it called on the U.S. central bank to do more if the economic situation worsens.
In particular, the OECD said further purchases of government bonds and asset-backed securities would be warranted while the Fed might also need to consider buying other types of assets.
The OECD urged the Bank of Japan not only to maintain its zero-interest rate policy until inflation emerges convincingly, but also to step up the pace of its asset purchases.
The OECD said the Bank of England's interest rates were appropriate for the British economic outlook and said China had scope to ease monetary conditions.