Fed keeps stimulus in place as U.S. economy "paused"

A view shows an eagle sculpture on Federal Reserve building, on the day it will release minutes of Federal Open Market Committee from August 1, 2012, in Washington August 22, 2012.

WASHINGTON (Reuters) - The Federal Reserve on Wednesday left in place its monthly $85 billion bond-buying stimulus plan, arguing the support was needed to lower unemployment even as it indicated a recent stall in U.S. economic growth was likely temporary.

The U.S. central bank predicted that the nation's job market would continue to improve at a modest pace, and repeated a pledge to keep purchasing securities until the outlook for employment "improves substantially."

"Growth in economic activity paused in recent months, in large part because of weather-related disruptions and other transitory factors," the Fed said after a two-day meeting.

A report on Wednesday showed the U.S. economy unexpectedly contracted in the fourth quarter as inventory investment slowed and government spending plunged. Analysts said superstorm Sandy, which slammed into a large swath of the U.S. East Coast in late October, also disrupted the recovery.

The Fed has kept overnight interest rates near zero since late 2008 and it has tripled its balance sheet to about $3 trillion through its purchases of securities, which are aimed at pushing longer-term borrowing costs lower.

While the recovery from the 2007-2009 recession has been stubbornly tepid, the Fed's policy panel voiced confidence it would remain on track with continued help from monetary policy.

"The committee expects that, with appropriate policy accommodation, economic growth will proceed at a moderate pace and the unemployment rate will gradually decline toward levels the committee judges consistent with its dual mandate," it said.

That was cautiously more optimistic than the Fed had sounded in December, when it emphasized it was "concerned" the economy would not deliver stronger hiring without policy support.

"The changes to the policy rationale were tilted to sound more affirmative in nature," JPMorgan economist Michael Feroli wrote in a note to clients.

A report on Friday is expected to show the U.S. jobless rate remained stuck at 7.8 percent for a third straight month in January. The Fed repeated that it would keep overnight rates near zero until the unemployment rate hits 6.5 percent, as long as inflation does not threaten to exceed 2.5 percent.

"It's a message that policy is steady as she goes," said Julia Coronado, an economist at BNP Paribas in New York.

By and large, the statement was widely as anticipated, and U.S. stocks .SPX, government bonds and the dollar .DXY were little changed after the news.

STILL LOOKING FOR LABOR MARKET IMPROVEMENT

The Fed noted that consumer spending and business investment had picked up and the housing sector had shown further improvement. It also acknowledged calmer financial conditions in Europe, omitting a December warning that these posed a significant threat, although it said downside risks remained.

Kansas City Federal Reserve Bank President Esther George, in her first policy vote, dissented against continued Fed stimulus, picking up the mantle left behind by Richmond Fed chief Jeffrey Lacker, who dissented at every policy meeting last year.

The Fed's bond-buying program, under which it currently purchases $40 billion of mortgage-backed bonds and $45 billion of longer-dated Treasuries a month, is part of the central bank's unprecedented effort to spark a stronger recovery and drive down unemployment.

Most analysts do not expect the outlook for the labor market to show the substantial improvement the Fed wants to see this year, keeping it on track for further bond buying.

Even so, minutes of the Fed's last meeting in December, released early this month, showed that a few policymakers thought the program should be halted by the middle of 2013.

Some Fed officials have voiced concern that any benefit from the bond purchases could be offset by mounting costs.

Two potential threats policymakers see are the risk of fueling an asset price bubble and the possibility of harming the functioning of Treasury and mortgage-backed bond markets. Some also worry that the Fed could suffer a loss when it eventually sells bonds to shrink its balance sheet, which might have serious political consequences for its independence.

(Writing by Alister Bull and Pedro Nicolaci da Costa; Editing by Andrea Ricci, Tim Ahmann and James Dalgleish)