By Glenn Somerville
WASHINGTON, Jan 28 (Reuters) - The International Monetary Fund said on Wednesday the global economy most likely will avoid a punishing bout of deflation but warned policy-makers need to act fast to counter rising risks of it.
It said the world should learn from Japan's lengthy spell of deflation in the 1990s and act decisively to wring toxic assets out of the banking system in addition to injecting new capital into them so they can resume lending.
The last great deflation scare occurred in 2002-2003, when the bursting of the technology-stock bubble and the recession that followed the Sept. 2001 terror attacks on the United States chilled global economic activity. The IMF said the current situation is further complicated by weak housing markets and a global financial crisis.
"Considering this, risks for sustained deflation are appreciably greater than in 2002-2003, particularly in several G7 (Group of Seven) economies," the IMF said. "Nonetheless, the most likely outcome is that sustained deflation will be avoided, as was the case in 2002-2003."
The IMF included a 32-page analysis of the risks of deflation -- generally characterized as a prolonged period of falling prices and weak demand -- in a report that further cut estimates for global growth in 2009 and 2010.
It urged policy-makers to "err on the side of acting too soon rather than too late" to counter deflationary shocks because ingrained expectations of falling prices weaken central banks' ability to use interest-rate policy to spur growth.
Delay will make the economic downturn worse, it said.
"If financial sector problems are not remedied or further shocks add to current stresses, there is a significant probability of more negative deflationary outcomes, with a deeper and more prolonged recession," the IMF said.
The IMF said there were many useful lessons to be gained from Japan's experience with deflation during the 1990s -- a period popularly referred to as "the lost decade" -- before it embarked on "quantitative easing" to restore growth.
Such infusions of liquidity need to go hand-in-hand with efforts to restructure weakened financial institutions, the IMF said, if healthy lending activity is to be restored.
"Specifically, in addition to the recapitalization efforts that are currently under way, it will therefore be crucial for governments to promote the removal of toxic assets, with a view to fostering a transparent clean-up of bank balance sheets," the IMF said.
The week-old Obama administration is looking at the possibility of setting up a "bad bank" to take toxic assets off banks' balance sheets, a policy the former Bush administration first advocated but then abandoned in favor of pumping more capital into faltering banks.
So far, there is little evidence that banks are boosting their lending despite the infusions of taxpayer-provided capital, which has renewed interest in trying to get bad assets out of the system to see if that makes lenders more confident. (Reporting by Glenn Somerville; Editing by Andrea Ricci)