The worst appears to be over for Minnesota's sagging economy, but the deepest recession in decades has blown a multibillion-dollar hole in the budget that will take taxpayers and lawmakers years to repair.

An economic forecast Tuesday shows that the state budget deficit actually shrank modestly to $994 million, down from $1.2 billion projected late last year. But there's seriously bad news ahead: The deficit could swell to nearly $7 billion by mid-2013, with only modest inflation included.

Minnesota's economy remains "fragile," state officials said, and a higher rate of unemployment might be "the new normal" for years to come.

"We think we've turned the corner and we are on the recovery side," said Tom Stinson, state economist. "But it's going to be long, and it's going to be slow."

More than 160,000 Minnesotans have lost their jobs since 2008 and the diminished income and sales tax revenue will make budget gaps harder to fill. Tax revenues are "far below normal," state officials said. Right now, one out of seven Minnesotans lacks full-time work.

The forecast came on a day when the state saw one ray of hope on the job front. Minnesota employers added 15,600 jobs in January -- the largest one-month gain in state employment since April 2005.

Last year, economists saw only a bleak landscape, Stinson said.

Now, he's increasingly confident about the recovery and no longer fearful the state could slide back into recession -- the dreaded "double dip."

Yet, several factors could hobble the economic rebound.

Chiefly, forecasters warn that another round of home foreclosures and further declines in property values could wipe out the benefits of people returning to work. The forecast notes that as many as one in six Minnesota homeowners is underwater in their mortgages and that foreclosures and short sales still account for nearly half of all sales.

For now, state economists are looking for signs of improving credit markets and a boost in consumer confidence that gets people spending.

"We think that's going to happen, but there are no guarantees," Stinson said. "This isn't weather forecasting, it's economic forecasting."

Stimulus helped

The billions in federal stimulus dollars pouring into the state have helped resuscitate the economy, Stinson said.

Without the stimulus, "this recession probably would have been extended another year, at least," he said. "Looking at it as a whole, it was a necessary thing that had to be done to make sure the economy didn't stumble into an even deeper trough." According to the forecast, 45,000 jobs will have been saved or created by stimulus funds through 2010.

Even Gov. Tim Pawlenty, who has bashed the federal stimulus package and continued criticizing it Tuesday, admitted the windfall "temporarily ... helped Minnesota's budget numbers."

Pawlenty said the stimulus package had value but should have been constructed differently.

"I'm disputing not the value of it as a basic concept but in terms of the magnitude and the effects in terms of the government and the private sector and the like," he said.

At the Capitol, the forecast gives lawmakers a firm deficit number that will frame budget negotiations for the next couple of months. The short-term improvement comes mainly through $184 million in state budget cuts and increased federal aid. Only $25 million of the reduction came from an expected bump in existing tax collections. Sluggish revenues, accounting shifts that delayed payments to schools and higher state spending are to blame for the uptick in the deficit in coming years.

Pawlenty's budget, proposed earlier this year, would have wiped out the state's $1.2 billion deficit through a mix of cuts and $387 million in hoped-for increases in federal aid.

Now, with a slightly smaller deficit projection, Pawlenty said that rather than reduce his budget cuts, he would let them stand and use the resulting extra $200 million to reinflate the state's tapped-out cash flow account. Those reserves are so depleted the state must borrow heavily from public schools and universities just to pay bills this spring. As a precautionary measure, the state also is taking the unusual step of lining up a $600 million private loan in case more money is needed.

The updated revenue forecast is good news but, using one of his favorite lines, Pawlenty said the government must still live within its means.

"We will continue to push our efforts through the Legislature to restrain and reduce spending," Pawlenty said.

But DFLers pointed out that even under the most optimistic budget-slashing scenario, Pawlenty will leave the next governor a deficit of roughly $2.4 billion.

"We have a long-term problem that the governor has not been willing to address," said House Speaker Margaret Anderson Kelliher, a DFLer who is running to replace Pawlenty. "His legacy is a legacy of kick-the-can-down-the-road and ignore the underlying problems that the state faces."

Senate Majority Leader Larry Pogemiller said Pawlenty, given his fiscal philosophy, should deliver a balanced budget that does not rely on federal dollars not yet appropriated.

"Nobody can balance this budget without some new revenue," said Pogemiller, DFL-Minneapolis. Democrats in the Legislature have proposed tax increases in previous years and Pawlenty has vetoed them.

Pawlenty said that Democrats, who control the House and Senate, should propose their own budget by March 17. The March date, Pawlenty said, was "somewhat arbitrary, but sooner is better."

Rachel E. Stassen-Berger • 651-292-0164 Baird Helgeson • 651-222-1288