The International Monetary Fund (IMF) suggests that the global economy is facing the threat of stagflation, as growth slows, but inflation builds.

“The global economy is in a tough spot, caught between sharply slowing demand in many advanced economies and rising inflation everywhere, notably in emerging and developing economies,” the IMF says in an economic update.

Global growth is expected to decelerate significantly in the second half of 2008, before recovering gradually in 2009, the IMF forecasts. At the same time, it notes that rising energy and commodity prices have boosted inflationary pressure.

“Against this background, the top priority for policymakers is to head off rising inflationary pressure, while keeping sight of risks to growth. In many emerging economies, tighter monetary policy and greater fiscal restraint are required, combined in some cases with more flexible exchange rate management,” it counsels.

“In the major advanced economies, the case for monetary tightening is less compelling, given that inflation expectations and labor costs are projected to remain well anchored while growth weakens noticeably, but inflationary pressures need to be monitored carefully,” the IMF adds.

Global growth is projected to moderate from 5% in 2007 to 4.1% in 2008 and 3.9% in 2009. Risks to the global growth outlook are seen as balanced. “Financial risks remain elevated, as rising losses in the context of a global slowdown could add to strains on capital and exacerbate the squeeze on credit availability,” it says. And, inflation is a rising concern that will constrain the policy response to slower growth.

“On the positive side, demand in advanced and emerging economies might be more resilient than projected to recent commodity price and financial shocks, as was the case during the first quarter of 2008,” it suggests.

Risks related to global imbalances also remain a concern for the IMF. “The continuing decline in the U.S. dollar and slower growth of the U.S. economy relative to its trading partners have put the current account deficit on a more sustainable trajectory. However, the pattern of exchange rate adjustments has borne little relationship to the pattern of current account balances, as the euro and other flexible currencies have carried the brunt of U.S. dollar adjustment and there has been less movement in currencies of several emerging economies recording large external surpluses,” it notes. “Moreover, rising international oil prices have raised projected current account surpluses of oil exporting countries.”

Financial market conditions remain difficult, the IMF says. “Forceful policy responses to the financial turbulence and encouraging progress toward bank recapitalization seemed to have reduced concerns about a financial meltdown but, as events over the past week have underlined, markets remain fragile amid concerns about losses in the context of slowing economies,” it says. “At the same time, extension of new credit will be constrained by the need to repair balance sheets. Accordingly, credit conditions in advanced economies are expected to remain tight in the coming quarters and efforts aimed at advancing balance sheet repair in financial sectors need to continue.”