* Euro holds just below two-year high against dollar
* Fed meeting that opens Tuesday could fuel dollar selling
* Dollar pares gains after weak U.S. data
* Dollar edges up against the yen
By Julie Haviv
NEW YORK, Oct 28 (Reuters) - The dollar notched moderate gains on Monday but held close to a nine-month low against a basket of currencies, with most investors convinced the Fed will maintain its ultra-loose monetary policy when it meets this week and in the months ahead.
The Federal Open Market Committee, the Fed’s policy-making arm, is unlikely to make any shift to policy at its two-day meeting that opens on Tuesday, as the Fed awaits more evidence of how great an impact Washington’s budget battle had on the U.S. economy.
Many economists believe the Fed could stand pat for the rest of the year, and most expect the U.S. central bank will not begin reducing its $85 billion per month bond-buying program until March 2014.
“It may turn out that a neutral FOMC is a green light to keep selling the dollar until November headline data begin appearing in early December, but ... there is already a lot of dovishness priced in,” Steven Englander, global head of foreign exchange strategy at CitiFX, a division of Citigroup in New York, said in a research note.
The government’s 16-day partial shutdown in October interrupted data gathering, muddying the picture for Fed policymakers seeking signs on the economy’s strength. Data released since the shutdown ended, some of which covered September, has been surprisingly weak.
“However, insofar as the Fed gives any hint that the market has swung too far in the direction of ‘QE forever,’ there will be risk for emerging market (currencies) and in particular for the high yielders that investors have bought back with a passion over the last month,” Englander said.
The dollar index, which tracks the greenback against a basket of six major currencies, rose for a second straight session. The index last traded 0.2 percent higher at 79.358 after earlier falling to 79.154, close to the near nine-month low of 78.998 touched on Friday.
The longer the Fed maintains a loose monetary policy, the more U.S. yields stay anchored, making the dollar less attractive to hold.
The Fed is to release its statement on its policy decision at 2 p.m. (1800 GMT) on Wednesday, at the end of its two-day meeting.
To spur growth, spending and hiring, the Fed has held overnight rates near zero since late 2008 and has quadrupled its balance sheet to around $3.7 trillion through three massive rounds of bond buying in a further effort to keep borrowing costs low.
The dollar slightly pared gains after private industry data showed U.S. pending home sales dropped by the most in more than three years in September.
Also on Monday, the Federal Reserve reported that U.S. manufacturing output rose by a scant 0.1 percent in September as the production of computer and electronic goods fell. The report suggested business spending ended the third quarter with less momentum.
The amount of industrial capacity in September, however, rose to the highest level since July 2008, the data showed.
“Amid softer payroll expansion, and with a still-uncertain outlook for fiscal resolution, we now expect the Fed to delay tapering until March 2014,” Barclays Capital economists said.
“An extension of QE would be welcome for the euro area and Japan, where export recovery has stalled and deflationary pressures linger,” they said.
The euro traded down 0.2 percent at $1.3784, having risen to $1.3832 on Friday, which marked its highest level since November 2011, according to Reuters data.
Investors are a bit wary of pushing the euro much higher, however, worried that policymakers at the European Central Bank may try to talk down the currency in coming days.
Speculation that ECB policymakers may talk down the euro has gained pace especially after recent economic data, including German business confidence and purchasing managers’ index surveys, highlighted the fragile economic recovery.
“Euro-zone policymaker concern is probably the biggest restraint for a euro/dollar that looks technically mobile toward the $1.3980/4000 area,” said Tom Levinson, currency strategist at ING. “The dollar index looks primed for a test of support in the 78.60/90 area in coming days.”
Against the yen, the dollar was supported by the view that yield differentials between Japanese government bonds and U.S. Treasuries will persist, as the Fed eventually moves toward tapering while the Bank of Japan keeps its ultra-easy stance.
The BOJ is widely expected to maintain its monetary policy stimulus at its policy review on Thursday to meet its target of 2 percent inflation in two years.
The dollar rose 0.3 percent to 97.74 yen, above a more than two-week low of 96.92 yen hit on Friday, according to Reuters data.