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updated 4/22/2004 10:48:50 AM ET 2004-04-22T14:48:50

The U.S. Federal Reserve must prepare the world economy for higher interest rates to "avoid financial market disruption both domestically and abroad", the International Monetary Fund will warn this week. 

But the IMF repeats its advice that the European Central Bank should consider cutting rates owing to the eurozone's poor economic performance. 

Japan's recovery, the IMF says, has continued to "substantially exceed expectations". However, "a key question is whether Japan's recovery can be sustained or whether, as with earlier recoveries in the post-bubble period, it will prove to be another false dawn". 

Surging growth in China has helped to boost regional growth, it adds, but "signs of incipient overheating" call for tighter macroeconomic policy. This risk means "it remains in China' s interest to move gradually to greater exchange rate flexibility". 

The IMF's World Economic Outlook, to be published on Wednesday, will coincide with eagerly awaited testimony by Alan Greenspan, the Fed chairman, on the U.S. economy. 

While noting that the Fed has "leeway to maintain a very accommodative monetary stance", the IMF warns that "the ground should continue to be prepared for future monetary tightening", given the "buoyant short-term outlook and the need to avoid financial market disruption both domestically and abroad". 

A draft of the main chapter of the report has been obtained by Expansion, the Financial Times's Spanish sister paper. It was prepared before data released for March showed strong employment growth and a jump in U.S. consumer price inflation. 

Following these reports, investors are pricing in a quarter-point rise in the Federal funds rates by the time of the Fed's August meeting. The funds rate currently stands at 1 percent.

Fed-watchers say attention may focus on whether Mr. Greenspan's testimony continues to stress that the central bank will remain "patient" in raising rates, and on any guidance as to how quickly the Fed will want to return to a more neutral footing once it starts to tighten. 

The IMF says: "A key challenge for central banks will be to communicate their intentions as clearly as possible to the markets, thereby reducing the risk of abrupt changes in expectations later on." Rising U.S. rates could trigger severe difficulties in emerging markets, it warns. 

In March, the IMF forecast global growth of 4.6 percent in 2004 and 4.4 percent in 2005. 
Global growth this year has been revised upward by half a point compared with the IMF's forecast in September last year. 

Stronger data over the past month may encourage the IMF to increase some country growth forecasts. 

The IMF's growth forecasts for the U.S. and Japan have been revised upwards since September. The U.S. is forecast to grow by 4.6 percent this year and by 3.9 percent in 2005. Japan is forecast to grow by 3.2 percent this year and by 1.7 percent in 2005. 

There is little change for the eurozone, which is forecast to grow by 1.9 percent this year and 2.5 percent in 2005. 

As well as tighter monetary policy in the U.S. and possibly lower interest rates in Europe, the IMF calls for fiscal consolidation in the U.S., structural reforms in Japan and Europe to promote growth and "a gradual shift toward more exchange rate flexibility in most of emerging Asia" to aid the adjustment of global current account imbalances.

© The Financial Times Ltd 2010. "FT" and "Financial Times" are trademarks of the Financial Times.

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