The global economic recovery is gaining strength, with world growth projected at about 4½ percent in both 2011 and 2012, but unemployment remains high, and risks of overheating are building in emerging market economies, the IMF said in its latest forecast.

High commodity prices present new policy challenges, while old challenges––fiscal and financial repair and reform and the rebalancing of global demand–remain work in progress.

“Given the improvement in financial markets, buoyant activity in many emerging and developing economies, and growing confidence in advanced economies, economic prospects for 2011–12 are good,” the IMF said in its April 2011 World Economic Outlook (WEO). However, disruptions to oil supply pose new risks to the recovery.

“Fears have turned to commodity prices,” said Olivier Blanchard, Chief Economist at the IMF. “Commodity prices have increased more than expected, reflecting a combination of strong demand growth and a number of supply shocks. These increases conjure the specter of 1970s-style stagflation, but they appear unlikely to derail the recovery,” he told a press conference in Washington.

Financial conditions fragile

Real GDP in advanced economies and emerging and developing economies is expected to expand by about 2½ percent and 6½ percent, respectively (see table below).

In the report released on April 11, it said financial conditions continue to improve after the global crisis, although they remain unusually fragile.

In many emerging market economies, demand is robust and overheating is a growing policy concern. Developing economies, particularly in sub-Saharan Africa, have also resumed fast and sustainable growth. But the IMF said new risks have emerged:

• Rising food and commodity prices pose a threat to poor households, adding to social and economic tensions, notably in the Middle East and North Africa.

• Oil prices have shot up because of unrest in the Middle East. The WEO said disruptions so far would have only mild effects on economic activity but, given falling spare oil production capacity, risks are on the downside.

• The IMF said that the earthquake and tsunami in Japan had exacted a terrible human toll but that its global macroeconomic impact would be limited.

Many old challenges unaddressed

The IMF said many old policy challenges remain unaddressed even as new ones arise. In advanced economies, weak sovereign balance sheets and still-moribund real estate markets continue to present major concerns, especially in certain euro area economies.

Strengthening the recovery in advanced economies will require keeping interest rates low as long as wage pressures are subdued, inflation expectations are well anchored, and bank credit is sluggish. At the same time, public spending needs to be placed on a sustainable medium-term path by implementing fiscal consolidation plans and entitlement reforms, supported by stronger fiscal rules and institutions.

The WEO said this is particularly urgent in the United States to stem the risk of globally destabilizing changes in bond markets. “To make a sizable dent in the projected medium-term deficits, broader measures such as Social Security and tax reforms will be essential. “

It said that in Japan, the immediate budgetary priority was to support reconstruction. Once reconstruction efforts are under way and the size of the damage is better understood, attention should turn to linking reconstruction spending to a clear fiscal strategy for bringing down the public debt ratio over the medium term.

In the euro area, despite significant progress, markets remain apprehensive about the prospects of countries under market pressure. For them what is needed at the euro area level is sufficient, low-cost, and flexible funding to support strong fiscal adjustment, bank restructuring, and reforms to promote competitiveness and growth. More generally, greater trust needs to be reestablished in euro area banks through ambitious stress tests and restructuring and recapitalization programs.

Overheating concerns

The challenge for many emerging and some developing economies is to ensure that present boom-like conditions do not develop into overheating over the coming year. Inflation pressure is likely to build further as growing production comes up against capacity constraints, with large food and energy price increases raising pressure for higher wages. The WEO published a chart showing countries in the Group of Twenty (G-20) with signs of overheating (see chart).

Real interest rates are still low and fiscal policies appreciably more accommodative than before the crisis. Appropriate action differs across economies, depending on their cyclical and external conditions. However, a tightening of macroeconomic policies is needed in many emerging markets. Many emerging and developing economies will need to provide well-targeted support for poor households that struggle with high food prices, the IMF said.

Over the medium term, greater progress in advancing global demand rebalancing is essential to put the recovery on a stronger footing. This is will require action by many countries, notably fiscal adjustment in key economies with external deficits, and greater exchange rate flexibility and structural reforms that eliminate distortions and boost savings in key surplus economies.