U.S. trims '10 deficit forecast as economy faces headwinds

President Barack Obama walks off the stage after signing the Dodd-Frank Wall Street Reform and Consumer Protection Act in Washington, July 21, 2010.

WASHINGTON (Reuters) - The Obama administration warned on Friday the U.S. economy had encountered "strong headwinds" and the country's fiscal challenge remained grim, but it lowered an estimate for the budget deficit this year.

Outlining the country's fiscal path over the next decade, the White House said the numbers were moving in the right direction but the deficit and debt were too high.

"The economy is still struggling; too many Americans are still out of work; and the nation's long-term fiscal trajectory is unsustainable," the White House said in the annual midsession review of President Barack Obama's budget.

Polls show Americans are anxious about the economy and could punish Obama's Democrats in November 2 midterm congressional elections for perceptions of big government spending and high unemployment after a severe recession.

Investors are also focused on U.S. debt at a time when European governments are stressing fiscal consolidation. The White House said the country was on track to meet its June commitment in Toronto to the Group of 20 to halve the deficit by 2013.

The administration trimmed an expected funding gap in the current fiscal year by $84 billion, to $1.47 trillion, versus the estimate released in February. The gap was seen narrowing to $1.42 trillion in 2011.

Republicans jumped on the numbers as proof "Obamanomics" was not working.

"This report confirms that our national debt will double in five years and triple in 10 years. It confirms that our deficits are not sustainable," U.S. House of Representatives Republican Leader John Boehner said in a statement.

The review also tweaked White House assumptions about the economy, which have been criticized as overly optimistic in the past. The White House forecast growth at 3.2 percent this year, 3.6 percent in 2011 and 4.2 percent in 2012.

Unemployment will only decline slowly, to 8.1 percent in 2012, the year of next presidential election, and stay above 6 percent until 2015.

The forecasts were based on data available through May and finalized in early June.

"The most pressing danger we now face is unacceptably weak growth and persistent unemployment, rather than outright economic collapse, and that is a very substantial difference," White House Budget Director Peter Orszag told reporters.

Job creation is a vital goal for Obama and will loom large in the November poll, but unemployment has lagged growth and remains at a lofty 9.5 percent.

EUROPEAN RISKS

"The U.S. economy still faces strong headwinds," the White House said, citing a weak housing market and doubts about the recovery in Europe, which could sap demand for exports.

"The European recovery is at risk because of increased uncertainty while government stimulus is withdrawn, and a further slowdown in Europe would pose problems for the rest of the world whose exports to Europe may be reduced," it said.

Britain and Germany have announced austerity plans to reassure investors, contrasting with the U.S. preference of phasing in budget controls going forward.

European Central Bank President Jean-Claude Trichet, in an article in the Financial Times on Friday, urged countries using the common euro currency to "implement a credible medium-term fiscal consolidation strategy."

In contrast, Federal Reserve Chairman Ben Bernanke argued this week the economy still needed fiscal support and it did not make sense to try to rein in this year's deficit.

But he stressed the country needs to curb the deficit over the next 2 to 3 years.

Obama signed an $862 billion emergency stimulus last year, which the White House says helped restore U.S. growth. But his subsequent efforts to increase aid to cash-strapped states and small businesses have been thwarted in Congress, mainly by Republicans in the Senate objecting to more deficit spending.

U.S. government debt held by the public is projected to rise above 70 percent of gross domestic product in 2012 and reach 77 percent by 2020.

Critics warn adding to the deficit could sap investor faith in the administration's commitment to phase in budget controls, risking a sovereign debt crisis here that unnerved European markets earlier this year.

Long-term U.S. interest rates have stayed low despite the grim U.S. budget outlook, supporting the recovery by holding down borrowing costs on mortgages and auto loans. But that could quickly change if bond investors take fright.

Obama vows to halve the deficit by 2013, a promise the larger Group of 20 rich and emerging nations also adopted at a meeting in Toronto last month, and the president has appointed a bipartisan commission to suggest how to tackle the fiscal challenge.

Obama's 18-strong panel is expected to recommend a mixture of spending cuts and tax increases when it reports findings by the end of December, well after the congressional vote.

(Reporting by Alister Bull; Editing by Andrew Hay and Dan Grebler)