LONDON (Reuters) - Britain's government should rein in its flagship austerity programme and cut taxes or increase infrastructure spending if the economy has not regained momentum by early next year, the International Monetary Fund said on Thursday.
The IMF said Britain faces "significant challenges" from a stalling recovery, high unemployment and threats from the euro zone, and that the Bank of England may be losing its ability to support demand while the government cuts spending.
Britain's economy has struggled to recover from the 2008/2009 slump and official data shows it is in its second recession in four years, with little sign of a swift turnaround.
However, any change on austerity risks proving embarrassing to Britain's Conservative-Liberal Democrat government, which set itself the goal of largely eliminating the country's budget deficit over the next five years when it came to power in 2010.
Weak growth since then has meant this deadline has slipped, and in a newspaper interview published on Thursday, Prime Minister David Cameron said spending cuts could last until 2020. A national election is due in 2015, and the opposition Labour Party backs a slower pace of spending cuts.
The IMF's final conclusions after its annual assessment of Britain's economy echoed the recommendations given right after the meetings with Britain's officials in May, when IMF chief Christine Lagarde said policymakers should bolster demand before low growth becomes entrenched.
The IMF stopped short of calling for an immediate change to policy, saying recent Bank stimulus and measures to boost bank lending should be given time to bear fruit.
But it warned that a long period of stagnant growth and "alarming" youth unemployment could do lasting damage.
"Scaling back fiscal tightening plans should be the main policy lever if growth does not build momentum by early-2013 even after further monetary stimulus and strong credit easing measures," the IMF's staff said.
Fiscal tightening may need to ease earlier if the outlook deteriorates sharply before then, they said. "Temporary easing measures in such a scenario should focus on infrastructure spending and targeted tax cuts," they added.
The IMF said on Monday that Britain's growth prospects for the next two years had worsened more than those of any other big advanced economy over the past three months, a downgrade that chimes with other economists' darkening assessments.
In the quarterly update to its World Economic Outlook, the IMF cut its British growth forecasts for 2012 and 2013 by 0.6 percentage points each, to just 0.2 percent and 1.4 percent respectively -- well below what Britain's official forecaster, the Office for Budget Responsibility, predicted in March.
By contrast, the IMF's 2012 growth forecast for advanced economies as a whole is unchanged at 1.4 percent and for 2013 it has been cut by just 0.2 percent to 1.9 percent.
In recent weeks, authorities have undertaken a number of measures to improve businesses' and households' ability to borrow -- many of which are in line with the IMF's proposals.
The Bank has restarted its asset-buying quantitative easing programme, which will take total gilt purchases 375 billion pounds over the next four months, and the Bank and government have also announced an 80 billion pound scheme to lower funding costs for banks that lend to businesses and home-buyers.
The government also announced nearly 10 billion pounds of rail investment and further investment guarantees.
The IMF said it welcomed these steps, but it was cautious about their likely effectiveness and warned that the government should be sure that offering loan guarantees was more cost-effective than borrowing itself to fund investment.
It also said more action might be needed by the Bank -- even if its success was uncertain. "Most directors believed that further easing may be needed, including consideration of a cut in the policy rate," it said.
To date, the Bank has resisted buying large quantities of assets other than gilts or cutting interest rates below their record low 0.5 percent, though in policy minutes on Wednesday it said it may in future reconsider its stance on rates.
Reporting by David Milliken. Editing by Jeremy Gaunt.