The International Monetary Fund (IMF) has said that the world economy will grow much more slowly in the next two years as a result of the credit crunch.

In its latest economic forecast, the IMF says that world economic growth will slow to 3.7% in 2008 and 2009, 1.25% lower than growth in 2007.

The downturn will be led by the US, which the IMF believes will go into a "mild recession" this year.

Growth in the UK will slow sharply to 1.6% in both 2008 and 2009.

It said that the UK economy would be affected by a weakening housing market, the contraction of the financial sector, and the impact on UK exports of weaker growth in the US and Europe.

Its UK forecast is substantially below the Treasury forecast of around 2% growth this year and 2.5% next year made at the time of the March Budget.

'Worst since Great Depression'

The IMF admits that the global downturn might be still more severe than it is currently predicting, and says that there is a one in four chance of a "global recession" when world growth falls below 3%.

"The financial market crisis that erupted in August 2007 has developed into the largest financial shock since the Great Depression," the report says.

The world downturn will be led by problems in the US housing market, but the IMF warns that excessive house price inflation in some European countries, including Spain, Ireland and the UK, has made them more vulnerable to a slowdown.

House prices have already fallen by around 10% in the US by some measures, and the IMF says that they may be over-valued by 10% to 20% in the UK.

It is forecasting further falls in US house prices of 14% to 20% this year.

US recession

The IMF forecasts that the US economy will grow by just 0.5% during 2008 and will actually contract in the first half of the year.

Its recovery will be slow, with growth of only 0.6% forecast in 2009.

"The US economy will tip into a mild recession in 2008 as a result of mutually reinforcing housing and financial market cycles, with only a gradualrecovery in 2009, reflecting the time needed to resolve underlying balance sheet strains," the report notes.

It says that, comparing the US economy year-on-year from the four quarter of 2007 to the fourth quarter of 2008. it will be 0.7% smaller, as the recession bites in the first half of this year.

And it warns that with the scale of the credit losses to the financial sector approaching $1 trillion (£500bn), there is a risk that the crisis could get worse.

"The greatest risk comes from the still-unfolding events in financial markets," it says, warning that the current credit squeeze could "mutate into a full-blown credit crunch".

The IMF says that losses are spreading from sub-prime mortgage assets to other sectors, such as commercial property, consumer credit, and company debt.

The IMF also says that given the potentialseverity of the problems, "additional initiatives to support the US housing market, including the use of the public balance sheet, could help reduce uncertainties about the evolution of the US financial system" although it warned that "care would be needed to avoid undue moral hazard".

The US Congress and the Bush administration are currently deadlocked over plans for further aid to the housing sector, with Democrats in both branches of Congress proposing an expansion of financial support for home owners facing foreclosure.

European impact

The biggest impact of the US slowdown is likely to felt in Europe, which is the biggest trading partner with the US.

"Activity in the other advanced economies will be sluggish in both 2008 and 2009 in the face of trade and financial spillovers," the IMF says.

It is predicting growth in the eurozone of just 1.4% in 2008 and 1.2% in 2009, with Europe's largest economy, Germany, growing by just 1% in 2009, a sharp revision of its forecast just three months ago.

And it says that in light of the slowdown, the European Central Bank - which has kept interest rates unchanged due to concern about inflation - "can afford some easing of its policy stance".

And it suggests that in future, central banks should take more account of rising house prices when setting interest rates, in effect "leaning against the wind" to prevent house prices moving out of "normal valuation ranges".

This is an implicit criticism of the US Federal Reserve which kept interest rates at 1% for several years under former chairman Alan Greenspan.

Worldwide impact

The IMF says that the big emerging market countries like China and India which are growing rapidly will be less affected by the slowdown, although they will be affected by a slowdown in trade among the rich countries.

The rate of growth of imports into rich countries is expected to slow sharply, leading to a cut in the rate of growth of exports by developing countries.

And it warns that the spillover will more severe in Latin America or in countries linked to the dollar, which has declined sharply on world currency markets.