The International Monetary Fund has slashed its forecast for world economic growth to just 0.5% this year down from a 2.2% forecast in November.

The group says that world growth is now projected to fall to its lowest rate since World War II. “Despite wide-ranging policy actions, financial strains remain acute, pulling down the real economy,” it says. It also lowered its forecast for 2010 to 3% growth, a reduction of 80 basis points from its previous call.

For Canada, it sees a 1.2% output contraction this year, a reduction from its previous forecast of 150 bps. It also predicts a more modest recovery with just 1.6% growth in 2010, down from a 3% forecast.

“A sustained economic recovery will not be possible until the financial sector’s functionality is restored and credit markets are unclogged. For this purpose, new policy initiatives are needed to produce credible loan loss recognition; sort financial companies according to their medium-run viability; and provide public support to viable institutions by injecting capital and carving out bad assets,” the IMF says.

“Monetary and fiscal policies need to become even more supportive of aggregate demand and sustain this stance over the foreseeable future, while developing strategies to ensure long-term fiscal sustainability. Moreover, international cooperation will be critical in designing and implementing these policies,” the IMF adds.

Financial markets are expected to remain strained during 2009, the IMF says. “In the advanced economies, market conditions will likely continue to be difficult until forceful policy actions are implemented to restructure the financial sector, resolve the uncertainty about losses, and break the adverse feedback loop with the slowing real economy. In emerging economies, financing conditions will likely remain acute for some time—especially for corporate sectors that have very high rollover requirements,” it adds.

And, it says that a pernicious feedback loop between the real and financial sectors is taking its toll, observing that global output and trade plummeted in the final months of 2008. “The continuation of the financial crisis, as policies failed to dispel uncertainty, has caused asset values to fall sharply across advanced and emerging economies, decreasing household wealth and thereby putting downward pressure on consumer demand. In addition, the associated high level of uncertainty has prompted households and businesses to postpone expenditures, reducing demand for consumer and capital goods. At the same time, widespread disruptions in credit are constraining household spending and curtailing production and trade,” it notes.

Advanced economies are suffering their deepest recession since World War II, the IMF observes. Output in the advanced economies is now expected to contract by 2% in 2009, amounting to the first annual contraction during the postwar period.

“Nevertheless, assuming more comprehensive and coordinated financial policy actions that support a gradual normalization of financial market conditions, as well as sizable fiscal stimulus and large interest rate cuts in many advanced economies, output is expected to start recovering in late 2009 and rise by about 1% in 2010,” it says. “Stabilization in the U.S. housing market should help underpin recovery during this period.”

The slump in global demand has led to a collapse in commodity prices, the IMF says, and its baseline petroleum price projection has been revised down to $50 a barrel for 2009 and $60 a barrel for 2010 (from $68 and $78, respectively, in November), and risks to this projection are on the downside, it says.

The uncertainty surrounding the outlook is unusually large, the IMF says. “Downside risks continue to dominate, as the scale and scope of the current financial crisis have taken the global economy into uncharted waters,” it adds. “The main risk is that unless stronger financial strains and uncertainties are forcefully addressed, the pernicious feedback loop between real activity and financial markets will intensify, leading to even more toxic effects on global growth. In addition, the risks of deflation are rising in a number of advanced economies, while emerging economies’ corporate sectors could be badly damaged by continued limited access to external financing. Furthermore, while fiscal policy is providing important short-term support, the sharp increase in the issuance of public debt could prompt an adverse market reaction, unless governments clarify their strategy to ensure long-term sustainability.”

However, there are also upside risks, it adds. “In particular, global financial conditions could improve faster than expected due to stronger policy actions. This could boost consumer and business confidence and alleviate the credit crunch, thereby lifting global growth,” it maintains.

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