President Obama giving a wide-ranging speech on health care reform to the American Medical Association in Chicago on Monday, June 15, 2009

A strong monetary and fiscal policy response is supporting the US economy, but the immediate outlook remains weak, with a solid recovery beginning in the middle of 2010, the IMF said after completing  its annual review of the world’s largest economy.

A final report will be issued once it has been discussed by the IMF’s 24-member executive board in late July.

The financial system has stabilized while the downward slide in labor and housing indicators have slowed, but the short-term outlook remains uncertain. Significant risks continue to linger, including more foreclosures and further drops in housing prices, rising unemployment, and higher interest rates, the IMF said after concluding consultations with  authorities.

Every year, the Fund conducts reviews of its member countries economies as part of its work in monitoring the health of the global economy.

“Recent data suggest that the sharp fall in economic activity has slowed notably, while financial conditions have improved noticeably. Correspondingly, we are revising our forecast upward, although its broad contours remain unchanged. We anticipate stagnation and economic activity in the coming quarters before a sustainable recovery takes hold next spring,” John Lipsky, First Deputy Managing Director of the IMF, told reporters.

Banks recovering, housing market still unsteady

The global economic crisis erupted in the  housing market and financial system in 2008 and quickly spread around the world. Governments reacted with fiscal and monetary policies to counter the downward turn in their economies.

The IMF found the  fiscal stimulus package “well targeted, timely, diversified and sizeable,” which will help soften the blow of declining growth. While GDP is expected to contract by 2.5 percent in 2009, followed by a modest expansion in 2010, this includes the effects of the fiscal stimulus package, which would boost annual GDP growth by 1 percent in 2009 and a quarter of a percent in 2010.

The Fund said the bank stress tests conducted by the Federal Reserve and the Treasury and the capital injections into the banking system have raised confidence in the stability of the major financial institutions. Close monitoring of the financial system should continue, according to the IMF, with regular stress tests to evaluate any potential weaknesses.

The statement also called for quick implementation of the proposed resolution framework for nonbank financial institutions, which would strengthen the process for unwinding large, troubled financial institutions.

Efforts to stabilize the housing market have helped bring down mortgage rates over recent months, though they have risen recently. The government’s latest efforts to encourage mortgage modifications for distressed homeowners should provide further help, although the extent to which it can stem the flood of foreclosures remains to be seen.

The IMF said the  faces three linked challenges:

• Completing economic and financial stabilization to set the stage for ongoing recovery.

• Developing strategies for unwinding massive public interventions, which should be coordinated with other countries.

• Addressing the long-term legacies of the crisis – a revamped financial system, fiscal imbalances and weakened household finances.

Exit strategy

As conditions normalise, implementing and communicating an exit strategy from the current extraordinary macroeconomic policies will be necessary, the IMF said.

There will be two main strategies needed once recovery is underway: unwinding monetary stimulus; and shrinking government support for the financial sector, by gradually tightening access to encourage institutions to access markets.

International coordination among countries in this latter area will be essential for a smooth exit, the IMF said.

Longer term legacies

The IMF noted that the crisis had brought to the fore several legacies of the crisis—a changed financial landscape, fiscal deficits, and the damage to household balance sheets.

The IMF welcomed the  proposal for a systemic risk regulator, which should be accompanied by measures to discourage institutions’ complexity, interconnectedness and size, to limit systemic risks and moral hazard.

Beginning later this year, the IMF will be working with the authorities to assess the  financial system and regulations more deeply in the Financial Sector Assessment Program, which is a detailed examination of a country’s financial sector.

According to the IMF analysis, the crisis has led to a deterioration in  public finances, and put upward pressures on long-run interest rates. The 2010 budget lays out appropriate objectives, including an early stabilisation of debt relative to GDP, but is based on relatively optimistic economic assumptions. IMF estimates suggest that significant additional measures will be needed to ensure its targets are met.

The Fund says tThere are looming challenges from entitlement spending, and the  authorities aim to undertake health-care reforms is especially welcome. It will be important that proposals for universal health care are accompanied by strong measures to achieve the goal of reducing cost growth by 1.5 percent annually.

Changing role

Finally, the IMF says the financial crisis also has important longer-run implications for the  role in the global economy.

The very large decline in  household wealth has already led to a strong pickup in household savings, which seems likely to continue, resulting in a sustained reduction in the  current account deficit. This also means that the  consumer will no longer be the global buyer of last resort, suggesting that other regions will need to play an increased role in supporting global growth and adjustment.