IMF Says U.S. Faces `Sharp Downturn' as Market Crisis Worsens

By Christopher Swann

Oct. 2 (Bloomberg) -- The U.S. may fall into a recession as the financial rout deepens, the International Monetary Fund said in its most pessimistic outlook for the world's largest economy since the credit crisis began last year.

``The financial turmoil that began in the summer of 2007 has mutated into a full-blown crisis,'' the fund said in a section of its semiannual World Economic Outlook released in Washington today. There is ``a substantial likelihood of a sharp downturn in the United States,'' the fund said.

By contrast, the IMF in July projected the U.S. would ``contract moderately'' in the second half of 2008 before recovering in 2009. Officials also said in a July update of economic forecasts that the global growth outlook was more ``balanced.''

``Strong actions by policy makers to deal with the stress and support the restoration of financial system capital seem particularly important,'' the lender said today. Next week, the IMF will release updated projections for gross domestic product for the U.S. and other economies.

The warning came as the U.S. Congress worked to pass a $700 billion bank rescue package to reassure financial markets. The Senate passed the legislation late yesterday, and the House of Representatives may vote tomorrow after rejecting a different version three days ago.

Euro Area

The 15 countries that use the euro may be able the weather financial shocks and slowing growth, the IMF said. ``In the euro zone, by contrast, the relatively strong position of households offers some protection against a sharp downturn,'' the report stated.

IMF Managing Director Dominique Strauss-Kahn said as recently as Sept. 17 that ``we may be seeing the end of the financial-sector crisis.''

Last week, IMF First Deputy Managing Director John Lipsky said the global economy may skirt a recession if policy makers respond with ``effective'' measures to ease financial stress. ``The latest challenges have not altered our core expectation of a gradual 2009 growth recovery'' and ``a global recession can be avoided,'' Lipsky said Sept. 24.

Since then, the Dow Jones Industrial Average suffered its biggest point decline, plunging 777 points to 10,365.45 on Sept. 29 after the House initially rejected the rescue plan.

Banking System

In today's report, the IMF warned that stress in the banking sector tends to deepen recessions, based on comparisons with previous periods of market instability. Slowdowns or contractions preceded by a banking crisis tended to double or triple the size of the downturn, the fund said.

The threat of a recession was increased by ``the extent to which house prices and aggregate credit have risen prior to the stress episode,'' the fund said.

Earlier this week the S&P/Case-Shiller index showed home prices in 20 U.S. cities declined in July by 16.3 percent from a year earlier -- the most on record.

``The current situation of the United States bears some resemblance to previous episodes of banking-related financial stress episodes that were followed by recessions,'' the fund said.

In a press briefing today, IMF Deputy Director of Research Charles Collyns called the financial crisis ``the most dangerous shock to the financial sector since the 1930s.''

``I cannot think of an example of a country that had a major banking system failure and not suffered serious economic consequences as a result,'' Collyns said. ``When the banking system suffers major damage -- as in the current episode -- the likelihood of a severe and protracted downturn in activity increases.''

To contact the reporters on this story: Christopher Swann in Washington at cswann1@bloomberg.net