Deficit report highlights Obama's challenge

Obama, struggling in polls, is expected to propose a three-year freeze on domestic spending programs and outline other measures to tame record budget deficits in his State of the Union speech on Wednesday.

The nonpartisan Congressional Budget Office said the deficit for the current fiscal year will come in at $1.35 trillion, a slight improvement over the $1.38 trillion it predicted last August. But it warned that rapidly rising federal debt could strangle the economy if Obama and Congress do not raise revenue or cut spending.

The deficit is slightly lower than the record $1.4 trillion posted in the last fiscal year, which ended in September 2009, but at 9.2 percent of gross domestic product, it still hovers at levels not been seen since World War Two.

On the margin, it should make you feel better (about the deficit). It's a mild positive, said Mark Pawlak, market strategist at Keefe Bruyette & Woods in New York.

That will be little comfort to Obama's Democrats, who face relentless criticism over spending from Republicans and rising voter unease ahead of the November congressional elections.

It appears that the sky is the limit for this tax-spend-and-borrow Democratic majority, said Senator Judd Gregg, the top Republican on the Budget Committee.

The CBO projected that deficits will come down to below 3 percent of GDP by the middle of the decade, a level many experts view as sustainable.

That projection assumes that Congress will leave in place several soon-to-expire tax cuts rather than renew them, which is not likely to happen. Steny Hoyer, the No. 2 Democrat in the House of Representatives, said on Tuesday that Democrats would seek to preserve middle-class tax cuts.

Budget-cutting measures could also conflict with Democrats' other top priority of bringing down the 10 percent unemployment rate. A jobs bill that passed the House in December carries a price tag of $155 billion, and the Senate is preparing a similar measure.

(Additional reporting by Donna Smith, editing by Vicki Allen)