June 15 (Bloomberg) -- The International Monetary Fund, which has rescued economies from Pakistan to Iceland in the past year, raised its outlook for the U.S. and called for steps to reduce concern about rising public debt and inflation.

The IMF forecasts the world’s largest economy will contract 2.5 percent this year before expanding 0.75 percent in 2010, according to a statement today after an annual staff analysis of the U.S. In the IMF’s World Economic Outlook report released in April, the U.S. was forecast to contract 2.8 percent this year before stalling in 2010.

The Washington-based lender said a “gradual” recovery is likely with risks “tilted to the downside.” The Federal Reserve could ease credit further if conditions worsen and additional fiscal stimulus “could also be considered” in the event the economy doesn’t bounce back, the IMF said.

“The combination of financial strains and ongoing adjustments in the housing and labor markets is expected to restrain growth for some time, with a solid recovery projected to emerge only in mid-2010,” the IMF staff review said.

Today’s statement projected unemployment would peak around 10 percent next year, keeping core inflation at “very low levels.”

The report praised the efforts of the Fed, the Obama administration and Congress, calling the economic stimulus package “well targeted” and saying monetary policy is relieving financial strains. It also warns that the extraordinary measures required to stabilize the economy and financial markets must be followed by a plan to unwind them as soon as possible to avoid a rise in inflation.

Inflation Concern

“Monetary and fiscal stimulus may stoke concerns about inflation and rising debt, exerting upward pressure on interest rates,” the statement said. “Unwinding interventions will pose major challenges, and -- given the high level of cross-border competition in the financial sector -- will need to be coordinated internationally to facilitate a smooth exit.”

The U.S. jobless rate climbed to 9.4 percent in May, the highest since 1983, according to Labor Department data. Falling home prices, coupled with near-record low mortgage rates and tax credits for first-time buyers, may help bring an end to the worst residential construction slump in seven decades. Reports this week are forecast to show builders began work on more houses as sales steadied and consumer prices rose.

The IMF projects the U.S. stimulus package will raise gross domestic product growth by 1 percent this year and 0.25 percent in 2010. The fund also said additional spending could also be considered.

Deficits Rising

The IMF staff projects federal deficits will average 9 percent of GDP from 2009 through 2011, and public debt will almost double to 75 percent of GDP.

The increased debt “may put significant pressure on Treasury bond rates,” the fund said in its report, which described the U.S. dollar as “modestly above” the medium-term fundamental level.

John Lipsky, first deputy managing director at the IMF, said during a briefing with reporters in Washington after the forecast was released that the fund anticipates the dollar will continue to be the world’s main reserve currency.

Chinese, Brazilian and Russian officials have expressed an interest in developing an alternative to the dollar.

“The dollar is the principal reserve currency in the global economy and will remain so as far as we can see,” Lipsky said, responding to a question.

Global Demand

U.S. growth in coming years will depend “to an unusual extent” on domestic demand in its trading partners, Lipsky also said. The U.S. has “largely avoided protectionist measures” during the global crisis, even as the “Buy American” provisions in the stimulus package drew objections from major trading partners, the fund’s report said.

Along with fiscal measures, the IMF staff mission offered its analysis of the American financial industry, saying that while steps taken by the Fed and Federal Deposit Insurance Corp. have “done much to stabilize financial conditions,” its unclear whether the administration’s Public-Private Investment Program will be used effectively.

The fund cautioned that the “ramping up” of the Term- Asset Backed Securities Loan Facility, known as TALF, and further purchases of Treasury debt and mortgage-backed securities could “substantially” inflate the Fed’s balance sheet.

To contact the reporter on this story: Timothy R. Homan in Washington at thoman1@bloomberg.net

Last Updated: June 15, 2009 10:53 EDT