IMF World Economic Outlook Update: The global economy is beginning to pull out of a recession unprecedented in the post–World War II era, but stabilization is uneven and the recovery is expected to be sluggish, according to the latest forecast from the International Monetary Fund.

Economic growth during 2009-10 is now projected to be about ½ percentage points higher than forecast by the IMF in April, reaching 2.5 percent in 2010, according to the World Economic Outlook Update, published today, Wednesday July 8th. Among the major economies, growth rates have been marked up mainly for the United States and Japan.

“The good news is that the forces pulling the economy down are decreasing in intensity,” IMF Chief Economist Olivier Blanchard told a July 8 press briefing. “The bad news is that the forces pulling the economy up are still weak. The balance is slowly shifting, and this leads us to predict that, while the world economy is still in recession, the recovery is coming. But it is likely to be a weak recovery,” Blanchard said.

The IMF also released  a separate update to its Global Financial Stability Report (GFSR). Financial conditions have improved, as forceful policy intervention has reduced the risk of systemic collapse and expectations of economic recovery have risen. “The unprecedented policy response in both the financial and macroeconomic domains has reduced the risk of systemic collapse and begun to restore market confidence,” José Vinãls, Director of the IMF’s Monetary and Capital Markets Department told the briefing. But many vulnerabilities remain and complacency must be avoided.

Recovery likely to be sluggish

Financial conditions have improved more than expected, owing mainly to public intervention, and recent data suggest that the rate of decline in economic activity is moderating, although to varying degrees among regions.

Despite these positive signs, the global recession is not over, and the recovery is still expected to be slow as financial institutions remain weak and credit intermediation impaired, support from public policies will gradually diminish, and households in countries that suffered asset price busts will rebuild savings.

The IMF says the main policy priority remains restoring financial sector health. Macroeconomic policies need to stay supportive, while preparing the ground for an orderly unwinding of extraordinary levels of public intervention. At the same time, given weak internal demand prospects in a number of current account deficit countries, including the United States, policies need to sustain stronger demand in key surplus countries.

Overall contraction in 2009

While the world economy is stabilizing, the report said that advanced economies as a group are still projected not to show a sustained pickup in activity until the second half of 2010.

Accordingly, global activity is forecast to contract by 1.4 percent in 2009 and to expand by 2.5 percent in 2010. The IMF is projecting that GDP in the advanced economies will decline by 3.8 percent in 2009 before growing by 0.6 percent in 2010.

Although the projections are 0.6 percentage points higher than in the April World Economic Outlook forecast, the IMF says growth in 2010 would still fall short of potential until late in the year, implying continuing increases in unemployment.

Stabilization uneven, challenges remain

In the United States, high-frequency indicators point to a diminishing rate of deterioration, including in the labor and housing markets. Industrial production may be close to bottoming out, the inventory cycle is turning, and business and consumer confidence has improved. These developments are consistent with stabilization of output during the second half of 2009, with a gradual recovery emerging in 2010.

In Japan, following a dismal first quarter, there are signs that output is stabilizing. Improved consumer confidence, progress in inventory adjustment, aggressive fiscal policies, and strong performance by some other Asian economies are expected to lift growth in the coming quarters.

In the Eurozone, consumer and business survey indicators have been recovering, but data on real activity show few signs of stabilization and thus activity is projected to strengthen more slowly than elsewhere. Macroeconomic policies are providing support, but much of the adjustment in the labor market still lies ahead. Rising unemployment will weigh on consumption and activity, as will the economy’s heavy dependence on a still-ailing banking sector.

Emerging and developing economiesare projected to regain growth momentum during the second half of 2009, albeit with notable regional differences. Low-income countries are facing important challenges because official aid has fallen and these economies are particularly vulnerable to swings in commodity prices.

More work needed to fix banks, markets

In the GFSR Update, the IMF noted that risks to the global financial system have moderated from the extreme levels seen just a few months ago. Unprecedented policy actions undertaken by central banks and governments worldwide have succeeded in stabilizing the financial condition of banks. These interventions have reduced the tail risk of another systemic failure similar to the collapse of Lehman Brothers. Nevertheless, risks remain and complacency must be avoided. Policymakers should continue to push ahead with reforms to strengthen the financial sector to mitigate risks.

The financial sector continues to be dependent on significant public support, resulting in an unparalleled transfer of risk from the private to the public sector. Securitization remains impaired, except where there is official support. Bank credit growth is still slowing and deleveraging continues, which is likely to place a drag on economic recovery. As a result, more public intervention may be needed in the near term.

On the positive side, the easing of macroeconomic risks has helped spur some return of risk appetite and a decline in volatilities, with investors moving into riskier assets and out of safe havens. This has benefited some emerging markets, but not all—vulnerabilities in some countries in emerging Europe persist. And even though perceived credit risk has diminished, as evidenced by narrower spreads and lower projected default rates, it remains high.

To minimize market uncertainty, the IMF says work should begin on designing strategies to exit from financial, monetary and fiscal support policies. These strategies should be consistent across countries to avoid opportunities for financial and regulatory arbitrage. Medium-term policies should help establish a lasting framework of sound financial regulation, sustainable fiscal balances, and price stability.

“We are at a critical stage in emerging from the crisis. We need to guard against slipping backwards, and be ready to do whatever is needed to address any remaining problems in the financial system. This is an indispensable condition for ensuring a sustained economic recovery,” Vinãls said.