Tighter fiscal policy in the United States should be implemented gradually, the Organization for Economic Cooperation and Development said on Tuesday as it predicted moderate economic growth next year.
Automatic government spending cuts and tax increases, known as the "fiscal cliff", are set to begin in early 2013, draining about $600 billion from the economy unless the U.S. Congress and Obama administration agree on a plan to soften the blow.
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In its latest economic outlook, the OECD said while cutting the large budget deficit was necessary to put the nation on a sustainable fiscal path, this should be done gradually and in the context of a well identified medium-term consolidation plan.
"The pace of consolidation should be gradual so as not to derail the already weak recovery," the OECD said. "If unresolved, the fiscal cliff would generate a significant drop in activity in 2013."
The United States has run budget deficits topping $1 trillion for three straight years, and it is on course to do so for a fourth.
The Paris-based OECD forecast growth in the world's largest economy averaging 2.2 percent in 2013, up from a projected 1.8 percent this year. Output is seen expanding at an average of 3.2 percent next year.
Annual gross domestic product expanded by an average of 2.1 percent over the last two years. The OECD forecasts assume the reduction in the U.S. budget deficit is limited to 1.5 percent of GDP in both 2013 and 2014.
But it said economic headwinds will continue to blow from the debt crisis in Europe and slowing global demand.
"The potential credit market disruptions associated with the ongoing crisis in the euro area remain a major concern," the OECD said. "Growth in disposable income will continue to be restrained significantly by the withdrawal of fiscal support."
OUTPUT GAP TO NARROW
But with U.S. economic growth expected to accelerate next year, the output gap -- the difference between the actual output and output at full capacity -- should narrow to 2.5 percent by the end of that year, the OECD predicted.
The output gap is currently 5.9 percent. Underpinning growth this year and in 2014 will be increased household spending, reflecting a turnaround in the housing market, which until recently was the economy's Achilles heel.
"Household balance sheets continue to improve, with equity values recently returning to near cyclical highs and home prices showing a sharp and sustained upturn," the OECD said.
"The gains in net wealth, coupled with low interest rates and a continued easing in lending conditions, should contribute to a pick-up in aggregate demand going forward."
It forecast a gradual improvement in the labor market and projected the unemployment rate falling to 7.5 percent over the course of 2014 from a projected 7.8 percent average in 2013.
The jobless rate was at 7.9 percent in October and almost all the decline from a peak of 10 percent in October 2009 was because of frustrated people giving up the search for work.
Given the still considerable slack in the economy, inflation pressures are likely to remain contained, even though wages could see rapid growth as the labor market improves, the OECD said.
This should help the Federal Reserve to honor its pledge to keep interest rates near record low levels through at least mid-2015.
The OECD forecast the consumer price index rising 1.8 percent over the course of next year and picking up to 2 percent over 2014.
The U.S. central bank, which has held overnight lending rates near zero since December 2008 and pumped about $2.3 trillion into the economy through bond purchases, aims for a 2 percent inflation rate.
"With significant slack in resource utilization and inflation expectations appearing well anchored, this highly accommodative stance of monetary policy is warranted," the OECD said.
(Reporting by Lucia Mutikani)