SHANGHAI (Reuters) - The euro zone economy is on track for a recovery later this year driven by the European Central Bank's loose monetary policy and demand from abroad, the bank's President Mario Draghi said.

The ECB cut interest rates to a new record low in May and said it would act again if necessary but its hand may in part be stayed this month and going forward by a rebound in inflation, which rose back to 1.4 percent in May from 1.2 percent in April.

That is still way below the bank's roughly 2 percent target and unemployment in the euro zone reached a fresh high in April at 12.2 percent, fuelling further calls for policymakers to do more to help the economy.

"The economic situation in the euro area remains challenging but there are a few signs of a possible stabilization, and our baseline scenario continues to be one of a very gradual recovery starting in the latter part of this year," Draghi said in the text of a speech prepared for the International Monetary Conference in Shanghai.

After the ECB's last policy meeting a month ago, the bank said economic activity should stabilize and recover gradually. The bank meets again on rates next Thursday.

Ahead of a court hearing in Germany later this month on complaints about the ECB's new government bond purchase program, dubbed Outright Monetary Transactions (OMT), Draghi spent much of the speech defending the initiative.

He said the threat of the ECB buying bonds had played a key role in calming financial markets, from which "virtually all economic agents, including corporations, banks and households" were benefiting.

"Nevertheless, vulnerabilities remain," Draghi said.

Calmer markets have given governments more breathing space to adjust and last week, the European Commission announced that several countries would have more time to meet deficit targets.

But Draghi urged governments to stick to their reform paths.

"To inspire confidence, policy-makers must follow-through with their fiscal reform agenda," Draghi said.

"In fact, little would be gained from a loosening of fiscal adjustment today if it creates market expectations that additional tightening will become necessary tomorrow."

In the medium term, he said, it had to be ensured that the adjustment was based on increasing productivity.

"Only through steadfast pursuit of such structural reforms can the competitiveness of euro area economies in the global marketplace be restored," Draghi said.

The ECB can only start buying a government's bonds once the country has signed up to strict reforms under a bailout program and even then, Draghi said, the OMT was "designed to keep government bond yields just below ‘panic' levels".

"Not to bring them down to levels that would somehow help government solvency," he said. "ECB intervention under OMTs would not address those parts of sovereign bond yield spreads that are fundamentally justified."

Draghi said it was important to recall that always and especially in the present situation, the need for governments and parliaments to reform did not stem so much from the bond market but from the dramatic conditions in the labor market.

(Reporting by Gabriel Wildau, writing by Eva Kuehnen)

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