May 4 (Bloomberg) -- The European Union cut its forecast for the euro-area economy to show a contraction twice as deep as it projected just three months ago, and said the region’s budget deficit will swell to more than double the EU limit.

The economy of the 16 countries sharing the euro will shrink 4 percent in 2009 and 0.1 percent in 2010, the European Commission, the EU executive in Brussels, said today, revising a January estimate for a contraction of 1.9 percent this year. The region’s average budget deficit will swell to 6.5 percent of output next year, when unemployment will rise to 11.5 percent, the commission said.

Companies across the continent are cutting production and firing workers to survive the worst recession since World War II, while governments’ efforts to support their banks and economies have pushed public deficits beyond the limit of 3 percent of output set out in European rules. The European Central Bank may this week announce new measures to combat the recession after cutting its benchmark rate to a record low.

“We are no longer in free fall, but even if some positive signals appear, we don’t have the critical mass of data to say we are out of the woods,” EU Monetary Affairs Commissioner Joaquin Almunia told a news conference in Brussels. “I hope this will be the last downward revision of our forecasts.”

New Forecasts

The euro traded at $1.3269 against the dollar at 12:40 p.m. in Brussels, compared with $1.3288 before the report.

The commission’s new forecasts are in line with numbers from the International Monetary Fund and the Organization for Economic Cooperation and Development. The IMF said on April 22 that the euro-area economy may shrink 4.2 percent this year and 0.4 percent in 2010, while the OECD forecast a contraction of 4.1 percent this year and 0.3 percent in 2010.

Infineon Technologies AG, Europe’s second-largest maker of semiconductors, and BASF SE, the world’s largest chemical company, are among companies cutting jobs. Infineon has reduced its workforce by 9 percent since September and BASF last week said it would cut 2,000 jobs.

As the global slump curbs orders and rising unemployment undermines consumer spending, companies are being forced to hold the line on prices. Paris-based Carrefour SA, Europe’s largest retailer, is launching a budget range covering 400 product lines to help reverse declining sales in its home market.

Inflation Easing

Euro-area inflation will slow to 0.4 percent this year before accelerating to 1.2 percent in 2010, the commission projected. That follows a report from the commission last week showing consumers expect prices to decline over the next 12 months, the first time the price-outlook gauge has been negative since at least 1990.

The commission doesn’t see a “serious risk for deflation in the EU or in the euro area,” Almunia said.

The EU sees the euro region’s unemployment rate increasing to 9.9 percent this year and 11.5 percent in 2010, with the highest rates expected in Spain and Ireland. The budget deficit will probably swell to 5.3 percent this year and 6.5 percent in 2010 from 1.9 percent in 2008, it said. The overall shortfall will break the EU limit of 3 percent of gross domestic product for the first time since 2003 and next year 13 euro members will breach the threshold.

This year, Ireland will contract 9 percent, Germany 5.4 percent and economic output in Italy will drop 4.4 percent. The economy of the 27 countries in the EU will also shrink 4 percent this year, according to the commission forecasts.

Gains in Confidence

Europe’s economy may be moving past the worst of the recession, data last week and today suggested. Confidence in the euro area increased for the first time in 11 months in April, the European Commission said, and an index of European manufacturing rose to a six-month high. European investor confidence also rose for a second month in May. Beyond Europe, U.S. consumer confidence jumped the most in more than two years and data showed today that China’s manufacturing expanded for the first time in nine months in April.

Still, German retail sales fell unexpectedly in March, the Federal Statistics Office said, as unemployment increased.

The economic slump has prompted the ECB to embark on the most aggressive series of interest-rate cuts in its 10-year history. The Frankfurt-based central bank has lowered its benchmark rate 3 percentage points to a record low of 1.25 percent and signaled another cut is likely at its next meeting on May 7. President Jean-Claude Trichet has said policy makers will decide on any additional measures at that meeting.

To contact the reporter on this story: Emma Ross-Thomas in Madrid at erossthomas@bloomberg.net

Last Updated: May 4, 2009 06:41 EDT