U.S. must hike debt limit soon to avoid shock: IMF

The International Monetary Fund on Wednesday pressed U.S. lawmakers to quickly lift the government's borrowing limit to avoid a severe shock to global markets and a still-fragile economic recovery.

In an annual review of the U.S. economy, the IMF said the key challenge for the country is finding a way to stabilize its debts by mid-decade without derailing growth, which is likely to remain modest for some time.

And of course, the federal debt ceiling should be raised expeditiously to avoid a severe shock to the economy and world financial markets, the IMF said in a statement.

The U.S. Treasury already has hit the existing $14.3 trillion legal limit on the nation's debt and has warned the debt ceiling needs to be raised by August 2 to avoid a default on the nation's obligations.

The IMF said a failure to raise the ceiling in time could lead to a downgrade in the United States' coveted AAA debt rating and send interest rates soaring. These risks would also have significant global repercussions, given the central role of U.S. Treasury bonds in world financial markets, it said.

The administration, and Democratic and Republican lawmakers are locked in tense negotiations to try to reach a deal on budget cuts, which would give lawmakers political cover to raise the debt ceiling.

Republicans pressing for deep spending cuts want to take tax increases off the table, but the Obama administration and Democrats say some revenue increases must be in the deal.

The IMF said negotiators should aim for a broad pact to stabilize the nation's debt ratio -- which it said now was unsustainable -- by mid-decade and gradually ratchet it down after that.

We see early political agreement on a comprehensive medium-term consolidation plan based on realistic macroeconomic assumptions, it said.

DEBT WRANGLING

President Barack Obama said he believed a deal to raise the debt ceiling would be reached in time.

Nobody wants to see the United States default. So, we've got to seize this moment, and we have to seize it soon, he told reporters at the White House.

At a news conference, IMF First Deputy Managing Director John Lipsky said he was certain the administration and Congress were fully aware of the risks and would not let the talks drag on unnecessarily.

Some Republicans have argued the administration could stave off a debt default by deciding not to meet other obligations, such as Social Security payments.

Treasury Secretary Timothy Geithner on Wednesday dismissed that notion, saying investors would shun U.S. debt if any financial obligations were not met and not meeting some payments would only buy a short period of time.

Ultimately, the notion of 'prioritizing' payments is futile because the debt limit must be increased regardless of which spending path is adopted, Geithner wrote in a letter to congressional Republicans.

There is no credible budget plan under which a debt limit increase can be avoided.

SLUGGISH GROWTH AHEAD

The IMF said it expected U.S. growth to be subdued for some time, projecting the economy would expand 2.5 percent this year and only 2.75 percent in 2012, partly because consumers are trying to pay down debts and have limited job opportunities.

The U.S. Treasury, through a spokesperson, said it considered the IMF's judgment overly pessimistic.

The fund said the Federal Reserve's policy of keeping interest rates near zero likely will be appropriate for some time in view of modest U.S. growth prospects.

But the U.S. central bank must also be ready to respond decisively if inflation expectations appear likely to become unhinged.

The IMF said eventually the Fed will want to normalize monetary policy by ending its policy of reinvesting proceeds from maturing securities it holds, allowing greater sway for short-term interest rates as its key policy tool.

The Fed is bringing to a close, on Thursday, a second round of so-called quantitative easing during which it bought some $600-billion of Treasury securities to pump liquidity into the economy in a bid to pump up activity.

A clearly communicated and gradual path of asset sales would be an additional step in the exit process, the IMF said.

(Additional reporting by Lesley Wroughton, Doug Palmer, Lucia Mutikani, Lisa Lambert and David Lawder; editing by Neil Stempleman)