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

The CBO forecast the US budget deficit will hit $1.34 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 US government's bailout of financial institutions in 2009.

But the figures show that without significant changes in US 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 painted a picture of a tough recovery from recession, although the CBO predicted a 3 percent economic growth rate 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 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 heading into recession and unemployment was on the rise.

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

Republican Sen. Judd Gregg warned of fiscal calamity.

"Today's CBO outlook only underscores what we already know - the current pace of US 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.

As if to illustrate the severity of the economic challenge ahead, the CBO forecast was released as new data dealt another blow to the fragile US economy, driving prices on US government debt higher and yields lower.

Concerns about the massive deficit, and the US triple-A credit rating, are not expected to lift Treasury debt yields from current low levels any time soon.

The budget and economic outlook are designed to give lawmakers the most up-to-date nonpartisan assessment of U.S. economic health and provide the latest projections on deficits that began in 2002 under former President George W. Bush and then skyrocketed 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.

The CBO projected a 9.5 percent jobless rate for this year, falling only slightly to 9 percent in 2011 and averaging 6.7 percent in 2012-2014, significantly shy of the 4 percent target economists would consider a full employment level.

Last month, the White House said unemployment will decline slowly, to 8.1 percent in 2012, when the U.S. presidential election will be held.

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

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

Meanwhile, US employers appear to be laying off workers again as applications for unemployment insurance reached the half-million mark last week for the first time since November.

Initial claims for jobless benefits rose by 12,000 last week to 500,000, the Labor Department said Thursday. It was the fourth increase in the past five weeks and evidence that the economic recovery has weakened.

The four-week average, a less volatile measure, rose by 8,000 to 482,500, the highest since December.

The increase suggests the economy is creating even fewer jobs than in the first half of this year, when private employers added an average of about 100,000 jobs per month.

The number of Americans continuing to receive benefits fell by 13,000 to 4.5 million, the department said.

A private research group said its gauge of future US economic activity edged up in July, suggesting growth will be sluggish for the rest of the year.

The Conference Board said Thursday that its index of leading economic indicators rose 0.1 percent last month after dropping 0.3 percent in June. Economists polled by Thomson Reuters had expected a gain of 0.2 percent.