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The Organization for Economic Cooperation and Development predicted a “modest” recovery for the world’s leading industrialized economies as it cut its estimate for their recession this year.

The combined economy of the Group of Seven nations will shrink 3.7 percent this year, less than the 4.1 percent projected in June, the OECD said in a report published today in Paris. That would still be the worst slump since World War II and the OECD warned that weakness in corporate profits, hiring, incomes and housing markets would slow the subsequent rebound.

“We clearly have a recovery at hand that seems to have materialized a little earlier than we expected,” Jorgen Elmeskov, the OECD’s acting chief economist, said in an interview. “There’s still a lot of caution about the recovery as there are some quite significant headwinds.”

The outlook illustrates the challenge facing finance ministers and central bankers from the Group of 20 rich and emerging countries as they meet in London tomorrow to discuss ways to strengthen the recovery without cutting off their support too early. “Substantial slack combined with the prospect for a weak recovery implies that strong policy stimulus will continue to be needed in the near term,” the OECD said.

The OECD didn’t include a projection for the G-7 in 2010 and will wait until November before revising its June forecast that the combined economy of its 30 members will contract 4.1 percent this year and grow 0.7 percent next year.

‘Slow Recovery’

“We’re still looking for a fairly slow recovery,” Elmeskov said today in Paris, adding that the risk of the world relapsing into recession had diminished.

Major central banks should delay raising interest rates well into next year at the earliest and communicate their intentions so as to restrain borrowing costs in markets, the report said. While governments don’t need to inject extra fiscal stimulus, they should deliver on their previous plans, it said.

“Preparing credible exit strategies and fiscal consolidation plans now, even if actual implementation will only commence later, is desirable,” said the OECD, which was founded in 1961 to coordinate international economic policies across its members.

Of the G-7 economies, the OECD said the U.S., Japan, Germany and France will each expand in the third quarter. It estimated Italy and Canada will shrink before growing in the subsequent three months. The U.K. will shrink this quarter and then be flat, when Japan will contract again, it said.

Japan’s Slide

It left unchanged its estimate of a 2.8 percent contraction in the U.S. this year, while calculating that the euro-area will shrink 3.9 percent rather than 4.8 percent. Japan will slide 5.6 instead of 6.8 percent, the worst slump in the G-7 in 2009.

Germany’s outlook improved the most as the OECD said it will shrink 4.8 percent, 1.3 percentage points less than it envisaged in June. Only the U.K.’s outlook deteriorated as the OECD predicted a contraction of 4.7 percent, worse than the 4.3 percent it previously anticipated.

Data this week suggested the global economy is improving with an index of U.S. manufacturing expanding for the first time in 19 months and a similar gauge in the euro-area rising to its highest in 14 months.

The recovery in emerging markets is “gaining momentum,” especially in China, which it estimated to have grown by more than 14 percent in the second quarter, the OECD said. The global rebound means the deterioration in labor markets will slow, trade will accelerate and the risk of deflation now appears small, the OECD said. Housing markets in the U.S. and U.K. are stabilizing and companies may soon begin to boost their investments by rebuilding inventories, it said.

Risks include lingering concerns over the health of banks, rising unemployment and the need for consumers and businesses to repair their balance sheets, it said.

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Filed under: money by Finance Boss