World prospects have deteriorated sharply, with the US economy tipping into recession and a one-in-four chance of global recession, as the toll mounts from the “largest financial shock since the Great Depression”, the IMF said yesterday.

In a bleak assessment, the International Monetary Fund said the world was in the grip of a major financial crisis, fuelled by a US housing slump that continues full blast. It drastically cut its forecasts for the United States and other leading economies over this year and next in its latest World Economic Outlook.

Alistair Darling, the Chancellor, was again thrown on the defensive over his own forecasts for Britain as the IMF threw its weight behind City challenges to his projections as too rosy, particularly for 2009. Issuing stark warnings that growing dangers to world prospects could lead to a still more brutal slump, the Fund cut its forecast for expected global growth this year from 4.2 per cent to 3.7 per cent, and for 2009 from 4.4 per cent to 3.8 per cent.

Pointing to a series of dangers that could lead to an even worse outcome for the US and Europe, the Fund said there was now a 25 per cent chance of global recession, defined as world output growth falling to 3 per cent or less.

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Background

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• Bank predicts crisis will hit UK hard

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Multimedia

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Background

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After issuing startling estimates on Tuesday that losses to financial institutions from the credit crisis could mount to $1 trillion (£500 billion) or more, the IMF said the greatest uncertainties came from continuing market turmoil.

This was “inflicting heavy damage on markets and institutions at the core of the financial system” that could “further impair financial system capital and cause the current credit squeeze to mutate into a credit crunch”, it said.

The fund’s darkest prognosis was for the United States, where its projection for GDP growth was cut by two thirds, to a meagre 0.5 per cent for this year, and 0.6 per cent for 2009 — down from its previous projections that the world’s biggest economy would expand by 1.5 per cent this year and 1.8 per cent next.

The grim assessment of American prospects points to the weakest showing by the US economy, both this year and next, since the deep recession of 1991, when GDP fell by 0.2 per cent, and challenges the US Federal Reserve’s prediction that the US will rebound strongly next year.

“The US economy will tip into a mild recession in 2008 before starting a modest recovery in 2009,” the IMF concluded. Recovery next year was “likely to be slow, held back by continued household and financial balance sheet strains”.

The report raised the spectre that US prospects could be even more badly undermined if tightening financial and lending conditions and the housing slump now feed off each other.

“The restraint on demand from the housing cycle, as falling home prices prompt rising foreclosures and further price declines, is being reinforced by an interconnected financial market cycle: pressure on capital and credit forces asset sales, which lowers market values and further intensifies the downward swing of the credit cycle,” it said.

“As macroeconomic and financial weakness feed off each other, residential investment will continue to fall; consumption will decline as households retrench in the face of falling home prices, reduced employment and tighter credit, and business investment will also take a hit.”

For Britain, the IMF now sees economic growth of 1.6 per cent this year, down from its October projection of 1.8 per cent — and below the bottom end of Mr Darling’s 1.75 per cent to 2.25 per cent forecast.

But the bigger blow to Mr Darling was over his upbeat prognosis for next year, a likely election year, when he is counting on a recovery to see growth of 2.25 to 2.75 per cent. The IMF expects 2009 growth to remain stuck at only 1.6 per cent, however.

But Mr Darling defied his critics yesterday and insisted that he would stick by his Budget predictions.

The IMF renewed its recent warnings over Britain’s house prices, saying that a slowdown in mortgage lending could “accelerate the so-far gradual adjustment of housing prices”.

Amid intense pressure on the Bank of England to cut interest rates today, however, the fund said that despite inflation worries the Bank had scope to act. “The deterioration in the outlook for activity should alleviate inflation pressures and provide room for further monetary policy easing,” it argued. For the eurozone, the IMF cut expected growth this year to 1.4 per cent, from its October projection of 1.6 per cent. But the fund expects weakness in Europe to persist next year, with growth expected to drop to an even weaker 1.2 per cent.

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