Corrected: Fed to stick to stimulus as Cyprus rekindles global risks

(Corrects economist's first name in paragraph 13)

By Pedro Nicolaci da Costa

WASHINGTON (Reuters) - The Federal Reserve looks set to sustain its $85 billion monthly bond-buying stimulus despite improving U.S. economic data as a new flare-up in the euro zone crisis reminds officials of a risky global environment.

As it wraps up a two-day meeting on Wednesday, the U.S. central bank's policy-setting Federal Open Market Committee will continue debating the potential costs of quantitative easing, including the possibility its easy money policies will inflate asset market bubbles.

But Fed Chairman Ben Bernanke has made clear he still firmly believes the benefits are palpable, and the risks worth taking.

"The only change in the Fed statement we expect is a nod to the economy being better than what the FOMC saw six weeks ago," said Steve Blitz, chief economist at ITG.

"This nod should only sharpen divisions within the FOMC about whether it's time to give a hint of the potential of a promise for the Fed to begin tailing off asset purchases sometime sooner rather than later," he said.

The Fed will release its policy statement, along with a new set of economic projections, at 2 p.m. (1800 GMT) and Bernanke will get a chance to answer reporters' questions at a quarterly news briefing a half hour later.

One key indicator that bolstered confidence in the U.S. recovery was a February employment report showing a lower jobless rate, down 0.2 percentage point at 7.7 percent, and the creation of 236,000 net new jobs.

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.

If anything, developments in Cyprus, where the announcement of a tax on bank deposits to help fund the country's bailout sent jitters through the global financial system, are likely to reinforce the resolve of Fed officials to bolster the U.S. economy.

"What this event assures is that the Fed underscores the importance of protecting against downside risk," said Quincy Krosby, market strategist at Prudential Financial. "It assures investors Mr. Bernanke is going to keep his accommodative stance."

The latest Reuters poll of economists showed they are looking for 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.

Global concerns aside, the Fed has plenty of reasons not to begin pulling back on stimulus yet. Its preferred measure of inflation continues to run below the Fed's 2 percent target and unemployment remains far above its pre-recession levels.

"I don't see any sign or reason for the policy to change," said Robert Shapiro, co-founder and chairman of Sonecon, a Washington-based economic advisory firm. "If anything, one might think an expansion of the current policy might be warranted."

The Fed cut benchmark overnight rates effectively to zero in 2008 as it battled the financial crisis. It has also bought more than $2.5 trillion in Treasury and mortgage bonds to keep long-term borrowing costs low to spur consumption and investment.

Since December, the central bank has said it will keep 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 - a commitment economists expect it to reiterate on Wednesday. The Fed has also vowed to keep policy loose even as the recovery picks up.

HAWKISH RUMBLINGS

Some of the Fed's more hawkish members have opposed the latest round of bond buys, citing various concerns ranging from worries about future inflation to the prospect of financial instability. In a recent speech, Fed Board Governor Jeremy Stein highlighted the possibility that a bubble might already be forming in certain parts of the corporate bond market.

That emphasis means policymakers will likely touch on potential changes to the Fed's strategy for eventually unwinding its stimulus during their discussion - and Bernanke may be asked about it at his news conference.

Officials had originally planned to sell some of the assets on the central bank's $3.15 trillion balance sheet sometime after they begin raising interest rates.

But recent comments from top Fed officials, including Bernanke, suggest they are strongly considering holding onto those assets, in part to minimize the potential for losses that would force them to halt regular remittances to the U.S. Treasury.

(Additional reporting by Rodrigo Campos; Editing by Tim Ahmann and Dan Grebler)