More tough economic times forecast by CBO

The United States Capitol building is seen in Washington in this March 19, 2010 file photo.

WASHINGTON (Reuters) - The U.S. economy faces difficult times ahead with chronic unemployment and slow manufacturing hurting the pace of recovery, the head of Congress' budget agency said on Thursday.

The warning from the non-partisan Congressional Budget Office came on top of more bad U.S. economic data that heightened concerns about a return to recession, roiling markets. The gloomy outlook could also spell trouble for Democrats facing November congressional elections.

The CBO forecast the U.S. budget deficit will hit $1.342 trillion this year, down slightly from its March projection of $1.368 trillion.

It attributed most of the $27 billion change in its fiscal 2010 deficit projection to an estimated $50 billion reduction in the cost of TARP, the U.S. government's bailout of financial institutions in 2009.

But the figures show that without significant changes in U.S. tax and spending laws, the government will struggle to dig its way out of a deep fiscal deficit hole.

Congressional Budget Office Director Douglas Elmendorf said the economy faces a tough recovery from recession, although the CBO predicted 3 percent economic growth this year.

"The considerable number of vacant houses and underused factories and offices will be a continuing drag on residential construction and business investment, and slow income growth as well as lost wealth will restrain consumer spending," he said.

The unemployment rate, currently at 9.5 percent, will not fall to around 5 percent until 2014, Elmendorf said. The last time the jobless rate was 5 percent was April 2008, just as the economy was entering recession. Economists generally view a 4 percent target jobless rate as a benchmark of full employment.

BAD FOR DEMOCRATS

Anxiety over the economy is likely to punish President Barack Obama's Democrats in November's midterm elections because of perceptions of big deficits caused by government spending and high unemployment.

Obama has been pushing to expand jobs by encouraging more lending to small businesses. Proposed legislation has stalled over Republican objections to more federal spending. "They need help. And if we want this economy to create more jobs more quickly, we need to help them," Obama said in a statement.

Republican Senator Judd Gregg warned of fiscal calamity.

"The current pace of U.S. spending is unaffordable and unsustainable and without a change in direction this country is headed for fiscal calamity," said Gregg, the senior Republican on the Senate Budget Committee.

The CBO forecast was released as reports showed new claims for unemployment benefits rising, raising fresh fears of a return to recession, and manufacturing activity in the U.S. mid-Atlantic region unexpectedly contracting. The data unnerved investors, driving stocks down and prices on U.S. government debt higher while yields fell.

U.S. stocks tumbled to their lowest close in nearly a month and the benchmark 10-year Treasury note yield fell to a 17-month low of 2.56 percent this week. In light of recent data, Wall Street economists are revising their outlooks.

"We think bond yields are going lower, mostly on revised growth expectations -- all the shops are revising down their forecasts for inflation and growth," said Sergey Bondarchuk, U.S. interest rate strategist with BNP Paribas in New York.

The Standard & Poor's 500 stock index fell 1.69 percent.

WHAT TO DO ABOUT EXPIRING TAX CUTS

The CBO outlook attempts to give Congress an up-to-date, nonpartisan assessment of the economy and deficits that began in 2002 under former President George W. Bush and soared in 2009 during recession and stimulus spending under Obama.

The CBO's deficit numbers are slightly lower than recent White House predictions for the fiscal gap, but the two use different measurements.

Members of Congress will rely on the CBO numbers as they decide how to tackle the yawning budget gap. One of the top questions facing Democrats, who hold majority control of Congress, will be the fate of the Bush administration's tax cuts, which are set to expire at the end of this year.

Democrats say tax cuts for the rich, coupled with heavy Iraq war spending, ignited the cycle of budget deficits.

"Republicans bear much of the responsibility for wiping out the surpluses they inherited in 2001 and creating these deficits," said Thomas Kahn, Democratic staff director of the House of Representatives' Budget Committee.

"And what's their solution now? Almost $4 trillion dollars in new tax cuts largely benefiting the most privileged. That would just dig the deficit hole even deeper," Kahn added, referring to Republican tax cut plans.

An independent, bipartisan commission is studying possible fixes to the budget and economic dilemma but is not due to report to Obama until December.

CBO also forecast a $1.066 trillion deficit for fiscal year 2011, which begins on October 1, up slightly from the March estimate of $996 billion.

The U.S. budget deficit last year was a record $1.413 trillion, 9.9 percent of gross domestic product.

(Additional reporting by Glenn Somerville and David Clarke in Washington and Chris Reese in New York; editing by Todd Eastham)