WASHINGTON - The global economy is starting to pull out of its deepest recession since World War Two but recovery will be sluggish and policies need to remain supportive, the International Monetary Fund said on Wednesday.

In an update of its World Economic Outlook, the IMF said the global economy is likely to contract 1.4 percent this year, a touch steeper than the 1.3 percent decline it expected in April.

However, it now sees world economic growth of 2.5 percent in 2010, compared with an April projection of 1.9 percent.

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, the IMF said.

The IMF said while the world's advanced economies are expected to recover slightly next year, growth will remain below potential until later in 2010, suggesting unemployment will continue to rise.

It said the U.S. economy will contract 2.6 percent this year, slightly less than it thought in April, with growth resuming in 2010 albeit at a mere 0.8 percent.

It said the euro-area economy would shrink by 4.8 percent in 2009, a downward revision of 0.6 percentage point from its April forecast. Next year, the IMF said the euro-area would contract 0.3 percent, slightly less than it forecast in April.

Japan's economy is expected to contract by 6 percent this year, with growth resuming slightly to around 1.7 percent next year, the IMF said.

Emerging and developing countries are likely to regain growth momentum during the second half of 2009, it said.
The fund said policies should remain supportive until growth resumes and deflationary risks dissipate. Where there is room, central banks should explore cutting interest rates further and signal that they intend to keep them low until a durable recovery is under way.

In a separate updated report, the fund underscored the need for sustained economic stimulus.

Financial conditions have improved, as unprecedented policy intervention has reduced the risk of systemic collapse and expectations of economic recovery have risen, it said in an update to its global financial stability report.

Nonetheless, vulnerabilities remain and complacency must be avoided.

In the update to its economic outlook, it said the main priority for policy-makers should be repairing the battered financial sectors, with a focus on removing toxic debt from bank balance sheets and restructuring institutions.

It said concerns about rising government debt from efforts to shore up economies highlight the need to establish plans to tighten budgets over the medium-term.

Although fiscal policy should stay supportive through 2010, plans should be made for rebuilding fiscal balances and ensuring sustainable debt paths after growth is firmly re-established, the IMF said.

(Editing by Neil Stempleman)