Fed to hold steady despite oil price and ravaged Japan

By Pedro Nicolaci da Costa

WASHINGTON (Reuters) - The U.S. Federal Reserve looks set to hold monetary policy on a steady course Tuesday, even as lofty oil prices and increased uncertainty following a devastating earthquake in Japan raise doubts about the economy's path.

The worst earthquake on record in Japan, the world's third largest economy, could have substantial ripple effects on the global recovery. But with the impact unclear as of yet, economists say the best thing for Fed officials to do at the moment may be nothing at all.

Even before the tragedy, U.S. central bankers faced plenty of confusing signals. For one thing, higher energy costs appear to be nudging U.S. inflation expectations higher, the first inklings of an inflationary psychology that the Fed would be loathe to see take hold.

"It's very tricky because calling out an increase (in expectations) would be a meaningful move in a hawkish direction," said Andrew Tilton, economist at Goldman Sachs.

At the same time, not acknowledging the recent pick-up seen in both market indicators and consumer surveys might make the Fed appear out of touch, eroding its inflation-fighting credentials.

In a statement due around 2:15 p.m. ET, policymakers are likely to nod to recent improvement in the economy while seeking to avoid any suggestion that they intend to cut short a $600 billion bond-buying program announced in November.

Fed officials will likely do so by beefing up their assessment of economic conditions while emphasizing just how far the central bank remains from its targets for both inflation and employment.

PROMISING SIGNS AND WORRY

Since the Fed's last meeting in January, the U.S. economy has continued to show signs of promise. The U.S. unemployment rate has fallen rapidly, down to 8.9 percent in February from 9.8 percent in November.

Still, the pace of hiring suggests further progress will be painfully slow for the 8 million-plus Americans who lost their jobs during the economic slump of 2007-2009.

At the same time, higher gasoline costs have injected a new note of worry among consumers, with a big hit to confidence this month raising concerns about whether a recent spurt in consumer spending can be sustained.

The U.S. economy expanded at an annualized rate of 2.8 percent in the fourth quarter, a respectable performance but one not seen fast enough to restore the job market to full health anytime soon.

Some economists thought growth could near 4 percent this quarter, but have pared back projections, in part because of an unexpected widening in the U.S. trade deficit.

The Fed chopped overnight interest rates down to effectively zero in December 2008 and since then has committed to buying a total of some $2.3 trillion in mortgage and Treasury securities to keep long-term borrowing costs down and support the recovery.

Those plans have proven controversial, with domestic critics arguing the Fed is courting future inflation while officials in emerging markets have accused the central bank of trying to boost U.S. exports by devaluing the dollar.

With the economy strengthening, officials are likely to have a vigorous debate on how best to eventually tighten policy, but analysts expect only minor changes to the Fed's statement.

Analysts will have to wait until minutes of the meeting are released in early April to get a fuller flavor of the discussions.