Fed's monetary stimulus meets 'fiscal cliff'

The contrast could not be sharper: Economists are all but certain the U.S. Federal Reserve will expand its monetary stimulus this week, but they have no clue how the fiscal battle in Congress will shake out.

U.S. central bankers look set to extend their monetary stimulus, known as Quantitative Easing, into the new year at a meeting on Tuesday and Wednesday. Analysts expect the Fed to continue buying $85 billion worth of securities per month.

"The Fed would not have emphasized the number ���$85 billion' in securities purchases in its statement if it wasn't prepared to continue at that pace well beyond the end of the year," said Roberto Perli, a senior managing director at investment research firm ISI.

No matter what it does, Fed Chairman Ben Bernanke has made it clear the central bank lacks the firepower to counter the possible drag from the looming $600 billion combination of expiring tax cuts and automatic spending reductions popularly known as the "fiscal cliff."

Alarm over an immediate, looming deadline may be overstated. Some analysts say the cliff is better described as a slope, since not all provisions will kick in at once. But Congress' budget watchdog and the Fed both think it spells recession.

The world is watching with bated breath, particularly given the fragile state of other major economies.

EURO ZONE HURTING

The euro zone remains mired in recession and, while Greece's latest debt deal has calmed nerves for now, few believe it will take long before troubles in Spain and Italy flare up again.

Euro zone industrial output numbers on Wednesday are forecast to show an uptick of 0.2 percent following a steep 2.5 percent plunge in the prior month, according to a Reuters poll. Still, few believe the euro zone's wounds will heal any time soon.

A European Central Bank policymaker said the bank had a "very serious" debate last week about cutting interest rates, which are already at a record low of 0.75 percent, and added that a cut was possible next year if the euro zone economy does not pick up. The German and Austrian central banks separately suggested such a turnaround is unlikely, forecasting scant growth in their economies for 2013.

With the continent still in crisis, European Union leaders will hold their last summit of the year. Ahead of that gathering, EU finance ministers will meet on Wednesday to try to hash out an agreement on cross-border banking supervision, having failed to do so last week.

Heads of state, for their part, will focus on the long-term direction and structure of the bloc, for which banking union is a key part.

The final Spanish bond auction of the year on Wednesday will provide a good opportunity to look back at how they have fared this year and, more importantly, a possible signal of how they will do in 2013 with investors still waiting for Madrid to request outside help, which would allow the ECB to intervene in the bond market.

'FISCAL CLIFF' OR BUST

Stateside, budget negotiations will remain center stage, even if expectations for a deal are based more on faith than fact.

"The decision is completely being driven by politics, not by what's good for the economy," said Eric Leeper, an economics professor at Indiana University. "That's what happens when you have no clear objectives for fiscal policy."

Republican House Speaker John Boehner accused President Barack Obama of pushing the country toward the "fiscal cliff" on Friday and of wasting another week without making progress in talks. Obama has argued it is Republicans and their desire to protect the Bush tax cuts for the wealthiest Americans that are preventing an agreement.

"Last week brought very little substantive progress," said Stephen Stanley, chief economist at Pierpont Securities, calling the discussions "a slow-motion train wreck."

U.S. employment picked up in November, according to a Labor Department report on Friday, but the drop in the jobless rate to 7.7 percent was due to discouraged workers bailing out of the labor force. This should keep the Fed, which has committed to buying assets for as long as it takes to improve the outlook for jobs, easing monetary policy for the foreseeable future.

Indeed, economists at JPMorgan said that the third round of quantitative easing could range as high as $3 trillion if recent progress in bringing down unemployment grinds to a halt.

At $2.8 trillion, the Fed's balance sheet is already more than triple its pre-crisis size.

(Editing by Tim Ahmann and Dan Grebler)