* Fed set to keep buying $85 billion per month in assets
* Balance sheet expansion seen replacing “Operation Twist”
* Labor market improvement short of Fed’s goals
* Fiscal cliff prospects may inform decision
By Pedro Nicolaci da Costa
WASHINGTON, Dec 12 (Reuters) - The U.S. Federal Reserve is expected to announce a fresh round of bond buying on Wednesday as part of its efforts to support a fragile economic recovery threatened by political wrangling over the government’s budget.
The central bank looks certain both to extend its purchases of mortgage-backed debt and replace another expiring stimulus program with a new bout of money creation.
Policymakers are also likely to repeat a pledge to keep buying bonds until the labor market outlook improves substantially. A drop in the jobless rate to 7.7 percent in November from 7.9 percent in October was driven by workers exiting the labor force, a fact certain to disappoint the Fed.
“The economic environment seems ripe for those at the Fed who support continued accommodation,” said Victor Li, professor at the Villanova School of Business and a former St. Louis Fed economist.
As its last program of Treasury purchases, known as Operation Twist, draws to a close, officials look set to replace it with a fresh $45 billion per month in buying. Unlike those in Twist, which were funded by sales and redemptions of short-term debt, the new Treasury purchases will further expand the Fed’s $2.8 trillion balance sheet.
Economists also expect the central bank to continue buying $40 billion per month in mortgage-backed securities as announced in September, keeping the monthly pace of total asset purchases at $85 billion -- a figure the Fed highlighted in its last policy statement.
“We want to see continued improvement in labor markets in the near term, and monetary policy should encourage faster economic growth to achieve that objective,” Eric Rosengren, the dovish president of the Boston Federal Reserve Bank, said last week.
The central bank will announce its decision around 12:30 p.m. (1730 GMT), and Fed Chairman Ben Bernanke will discuss it at a news conference at 2:15 p.m. (1915 GMT).
The Fed cut overnight interest rates to near zero in December 2008 and has bought about $2.4 trillion in securities in a further effort to push borrowing costs lower and spur a stronger recovery.
Despite the unconventional and aggressive efforts, U.S. economic growth remains tepid. GDP grew at a 2.7 percent annual rate in the third quarter, but it now appears to be slowing sharply.
Businesses have hunkered down, fearful of a tightening of fiscal policy as politicians in Washington wrangle over ways to avoid a $600 billion mix of spending reductions and expiring tax cuts set to take hold at the start of 2013.
Bernanke has warned that running over this “fiscal cliff” would lead the economy into a new recession.
In addition to their bond-buying plans, Fed officials appear likely to reiterate their expectation that overnight rates will stay near rock-bottom lows until at least mid-2015.
The Fed is working on an alternative framework to this calendar guidance that would instead use particular economic indicators as guideposts for policy. However, they do not appear ready to seal a deal.
Officials will also release a set of quarterly economic and interest rate projections that could show yet another round of downward revisions to future growth prospects.
Back in September, the Fed predicted the U.S. economy would expand 2.5 percent to 3 percent in 2013, but even that modest rate is looking potentially rosy.