The International Monetary Fund believes Australian interest rates should be kept low while economic growth is soft and the exchange rate remains strong.

In its annual report on Australia released in Washington on Wednesday, it also says monetary policy should be the prime tool for managing economic demand in the near term while the federal government tries to reduce the budget deficit.

It says the government faces a challenge repairing the budget, which has deteriorated since the 2008-09 global financial crisis.

“To achieve the aim of returning to and maintaining a budget surplus, sizeable cuts in projected spending would be required,” the Washington-based institution said.

It said the recommendations of the government’s national commission of audit review of commonwealth spending will be important in reaching this aim.

“This message reinforces the government’s position that difficult decisions will need to be made in order to put the budget back on a sustainable path,” Treasurer Joe Hockey said in a statement on Thursday.

The commission of audit is due to hand over its interim report to Mr Hockey this week.

The IMF said with the nation’s terms of trade in decline, improving productivity will be a key challenge if living standards are to be maintained.

It sees addressing infrastructure bottlenecks as a priority.

It also believes housing construction could play a key role in supporting the Australian economy as it transitions from a fading mining investment boom.

The IMF has made a modest upgrade in its Australian economic forecasts, predicting 2.6 per cent growth in 2014 and 2.7 per cent in 2015, rather than the 2.5 per cent it had expected for both years in November.

It does not expect the economy to return to its long-term trend of three per cent until 2017.

However, the IMF staff report was largely compiled in late 2013 and finished in January and does not take into account more recent upbeat data.

Even so, it is slightly more optimistic about Australia’s employment outlook than the government, predicting jobless rate to peak at 6.1 per cent this year rather than the 6.25 per cent forecast in the mid-year budget review.

The IMF said a slowdown in China and further volatility in global financial markets remained key risks to the Australian outlook.

A floating exchange rate will also provide a cushion against such shocks, but at the time of writing the report, the IMF thought the Australian dollar, at 89 US cents, was still five to 10 per cent overvalued.