Governments around the world should raise taxes or cut public spending to help central banks tame inflation and mitigate the risk of a financial crisis, the Bank for International Settlements has said.

The central bankers’ bank, which often operates as an informal mouthpiece for the institutions, said governments were “testing the boundaries of what might be called the region of stability” by leaving fiscal policy loose while inflation remains high and interest rates are rising rapidly.

“[Fiscal] consolidation would provide critical support in the inflation fight,” the BIS said in its annual report, published on Sunday. “It would also reduce the need for monetary policy to keep interest rates higher for longer, thereby reducing the risk of financial instability.”

Traditionally there has been a separation between fiscal policy, set by governments, and monetary policy, set by central banks and targeted to control inflation, while taking account of the levels of public spending and taxation.

Central bankers have insisted that they are confident in their abilities to separate monetary policy decisions from financial stability concerns, but the BIS’s concern contrasts with those assurances.

The chances of a financial crisis are significant given that interest rates are high and still rising, the BIS said. However, it added that these risks could be reduced if governments tightened fiscal policy, taking some pressure off interest rates as the primary policy tool and strengthening countries’ public finances.

High interest rates have already caused serious financial turmoil in the past year, the BIS said, citing the UK government bond and pension fund crisis last October and the failure of US regional banks and Credit Suisse this spring.

Agustín Carstens, head of the BIS, said inflation was falling in most countries but “the last mile is typically the hardest”.

“The burden is falling on many shoulders, but the risks from not acting promptly will be greater in the long term. Central banks are committed to staying the course to restore price stability and protect people’s purchasing power,” he said.

The BIS warned that, in the longer term, governments and central banks should avoid seeking to solve all of society’s problems with economic stimulus. This echoed recent advice from the OECD.

Central bankers kept rates too low for too long when inflation was below target because this encouraged the private sector to pile on debt, adding to eventual financial sector vulnerabilities, the BIS said.

“Once price stability is re‑established, monetary policy could be more tolerant of moderate, even if persistent, shortfalls of inflation from point targets,” the report said.

It added that instead of seeking to boost growth and offsetting crises with public spending surges, governments should recognise that weaker public finances ultimately limit their ability to react in a crisis.

“Policymakers need to have a keener recognition of the limitations of macroeconomic stabilisation policies,” the report said. “Monetary and fiscal policy can be a major force for good, but, if overly ambitious, can also cause great damage.”

Monica Defend, head of Amundi Institute, said: “We need by far more co-ordination between fiscal and monetary [policy], and we are not there yet. The fiscal stance should be dynamic, meaning really adapting to preserve social wellbeing, but at the same time being quite focused and targeted.”

This pressure will mount as the transition towards greener energy alternatives advances in the coming years, Defend warned. “The key issue is, who is going to finance it? How can we seriously go down that road without co-ordination between fiscal and monetary [policy]?”

James Knightley, chief international economist at ING, said: “You can’t really have macro stability without financial stability, and if you are focusing too much on one at the expense of the other, that is when risks do materialise.”

Additional reporting by Colby Smith in Washington

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