By Leigh Thomas
PARIS (Reuters) - Global economic recovery is on track, helped by a stronger United States, but threats ranging from high oil prices to European sovereign debt crises could yet combine to create a bout of stagflation, the OECD said on Wednesday.
The Paris-based Organization for Economic Co-operation and Development said the U.S. and euro area economies were growing faster than expected in forecasts six months ago, although Japan's economy was set to contract after the March earthquake, tsunami and nuclear crisis.
As a result, it said the U.S. Federal Reserve should look to raise interest rates this year, while the European Central Bank could afford to pause its tightening cycle for a while and Japan faced no pressure to act.
In its twice-yearly Economic Outlook, the OECD forecast world growth would ease to 4.2 percent this year from 4.9 percent in 2010 before accelerating to 4.6 percent in 2012.
"This is a delicate moment for the global economy, and the crisis is not over until our economies are creating enough jobs again," OECD Secretary General Angel Gurria said.
"There is also some concern that if downside risks reinforce each other, their cumulative impact could weaken the recovery significantly, possibly triggering stagflation in some advanced economies," he said.
The OECD raised its outlook for the United States from its last report in November, forecasting growth this year of 2.6 percent, compared with an estimate of 2.2 percent in November.
It was also slightly more optimistic about the outlook for growth in the euro zone, forecasting the bloc's economy would expand 2.0 percent in 2011, up from 1.7 percent in November.
But it slashed Japan's forecasts after the country's triple disaster in March. It estimated the country's economy would contract 0.9 percent this year, having forecast growth of 1.7 percent in November.
The OECD also cited a slow recovery in Japan as a possible threat to its economic partners, especially if global supply chains remain disrupted as a result.
The effect would be all the more damaging if coupled with a bigger-than-expected slowdown in China, a spiraling sovereign debt crisis in Europe and/or persisting uncertainty over budget policies in the United States and Japan, the OECD warned.
If those risks coincided with a renewed surge in oil prices, then the major economies could see stagflation -- the pernicious combination of stagnant growth and high inflation.
The situation was made all the more fragile by high levels of debt, with the average level of debt across the OECD expected to top 100 percent of output this year.
OECD chief economist Pier Carlo Padoan said major economies were not only strong enough to withstand fiscal tightening, but needed to get debt down to keep it from becoming a brake on growth.
"While in the short term there is a cost in terms of fiscal consolidation, there are big benefits in the medium term, both in terms of market response and especially (because) higher debt means lower growth," he told Reuters Insider TV.
FED SHOULD ACT
With European countries making more of an effort to cut their deficits than the United States, the OECD said there was a stronger case for raising interest rates in the United States than in the euro zone.
In a bid to keep rising inflation in check, the European Central Bank raised interest rates in April, to 1.25 percent, for the first time since the 2008-2009 economic crisis.
With long-term inflation expectations on the rise in the United States, the OECD recommended in the report "an initial and visibly positive rise in the policy rate from mid-2011."
It said the U.S. Federal Reserve should then follow up with a series of rate hikes, lifting the Federal funds target rate by one percentage point by the end of the year.
After the ECB's April move, the OECD said it did not need further increases in the immediate future, although rates should be lifted gradually through the course of 2012 to stand at 2.25 percent by the end of 2012.
The OECD said there was no need for an interest rate increase in Japan in the absence of any signs that inflation is rising there toward 1 percent.
But China must stay focused on taming inflation and raise interest rates by another 50 basis points even though its economy is slowing, it said.
(Reporting by Leigh Thomas, editing by Mike Peacock)