WRAPUP 6-Fed holds firm to stimulus plan despite brighter economy
* Central bank continues buying $85 bln in bonds per month
* Fed says weighing economic progress against QE3 risks
* Fed cites tighter fiscal policy, nods to euro zone strains
WASHINGTON, March 20 (Reuters) - The Federal Reserve on Wednesday pressed forward with its aggressive policy stimulus despite improvements in the U.S. economy, pointing to still-high unemployment, fiscal headwinds out of Washington and risks from abroad.
Meeting as turmoil in Europe took another turn for the worse, the U.S. central bank appeared unfazed by concerns that its $85 billion in monthly bond purchases could disrupt financial markets or inflate asset bubbles.
The Fed's policy-setting committee nodded to brighter economic signs in the United States. But Chairman Ben Bernanke said he had not yet seen meaningful changes to the troubled labor market, and noted that tighter fiscal policy is one reason the central bank has been so aggressive.
Most Fed policymakers believe the purchases of Treasury and mortgage bonds are lowering longer-term borrowing costs and providing "meaningful support to economic growth and job creation," Bernanke told a news conference after the central bank announced its decision.
"However, most also agree that this monetary tool will likely not be able on its own to fully offset major economic headwinds such as those that might arise from significant near-term fiscal restraint, or from a sharp increase in global financial stresses," he said.
The Fed cut overnight interest rates to near zero in 2008 and has bought more than $2.5 trillion in bonds to spur consumption, investment and hiring.
Its efforts appear to be paying off, with a rash of recent data showing the economy gathering strength. Retail sales have been stronger than expected, manufacturing output has picked up and employment growth has quickened, with the jobless rate dropping to 7.7 percent last month from 7.9 percent in January.
Bernanke said the central bank might slow the pace of its bond buying as the economy strengthened, but that it would only do so after the labor market showed sustained improvement over a number of months.
Some Fed officials have expressed concern that the purchases could fuel asset price bubbles, spark future inflation or lead to balance sheet losses later this decade. But Bernanke gave no indication those risks might soon become a binding constraint.
"These costs remain manageable but will continue to be monitored, and we will take them into appropriate account as we determine the size, pace and composition of our asset purchases," he said.
The vote to continue with the purchases was 11-1, with Kansas City Federal Reserve Bank President Esther George dissenting for a second straight time.
The decision helped calm investors who had been worried about a flare-up in the euro zone's debt crisis. U.S. stocks closed higher, the dollar rallied against the yen and prices for U.S. Treasury debt dropped.
"The Fed still is in a very dovish mode and I do not expect to see them remove policy accommodation anytime soon," said Eric Stein, co-director of global income at Eaton Vance Management in Boston.
THE GOOD AND THE BAD
In a statement, Fed officials took note of the economy's brighter signs but also nodded to the headwinds from a tighter fiscal policy in Washington. They also dropped a reference from their last policy statement that had said global financial strains were easing.
"The committee continues to see downside risks to the economic outlook," the Fed said.
Developments in Cyprus, where the prospect of a tax on bank deposits to help fund the country's bailout sent jitters through the global financial system earlier this week, likely reinforced the Fed's resolve to bolster the U.S. economy. The levy was rejected in the Cypriot parliament, leaving the financial rescue in disarray.
Bernanke called the situation in Cyprus "difficult" because the country faces fiscal and bank-capitalization issues, as well as political stress.
"It does have some consequence," he said. "But having said that, the vote failed and the markets are up today, and I don't think the impact has been enormous."
FOOT ON THE GAS PEDAL
In its statement, the Fed reiterated that it planned to keep interest rates near zero until the jobless rate falls to 6.5 percent as long as inflation did not threaten to pierce 2.5 percent over a one- to two-year horizon.
Quarterly forecasts released along with statement showed that 13 of the 19 policymakers still think it will be appropriate to keep rates steady until sometime in 2015.
The forecasts showed only minor changes in expectations for economic growth, but were a bit more upbeat on unemployment.
Fed officials now see growth in a range of 2.3-2.8 percent in 2013, down from 2.3-3.0 percent in December.
However, they now expect the jobless rate, which registered 7.7 percent in February, to average 7.3-7.5 percent in the fourth quarter of this year. Previously, that range had been 7.4-7.7 percent. However, the unemployment rate will not fall to 6.5 percent until 2015, the estimates indicate.
One key indicator that bolstered confidence in the U.S. recovery was a report earlier this month that showed the creation of 236,000 net new jobs in February.
If that pace of job growth can be sustained for a few months, the Fed might be able to claim substantial progress has been made toward an improved employment outlook - its own stated prerequisite for the cessation of bond buys.
A Reuters poll published a week ago found economists expect the Fed's current bond purchase plan eventually to total $1 trillion, though many see the central bank easing off on the pace of buying toward the end of the year. Analysts also see a large gap, potentially one or two years, between the time the Fed stops buying bonds and when it begins raising rates.
"The Fed's pledge to keep its foot on the gas pedal of monetary easing ... should help shore-up America's economic recovery and ensure that the U.S. continues to outpace its major rivals in recovery," said Omer Esiner, chief market analyst at Commonwealth Foreign Exchange in Washington.
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