FED FOCUS-Budget nearly as key as jobs in Fed's QE exit timing

NEW YORK/SAN FRANCISCO, April 3 (Reuters) - Investors trying to assess when the Federal Reserve will start to trim its economic stimulus via massive asset purchases would do well to track any progress Washington makes in reaching a budget deal.

While the Fed's public focus on the U.S. jobs market has drawn the most scrutiny, fear of fiscal austerity was a major reason the Fed embarked on the current round of bond buying that injects money into the economy and keeps longer-term interest rates low.

Should there be a deal in Congress that replaces the current across-the-board spending cuts with much more measured restraint, economic growth could accelerate, adding to the surprisingly robust retail sales and manufacturing activity so far this year.

Fiscal policy "is certainly top of their mind" as the Fed's monetary policymakers weigh their options, said Scott Anderson, chief economist at Bank of the West in San Francisco.

"The private sector really is chomping at the bit" to expand at the first sign of fiscal policies that encourage growth, or at least that don't hold it back, he said.

New York Fed President William Dudley, one of the central bank's most influential policymakers, betrayed his frustration at partisan gridlock last week, saying the fiscal consolidation underway in Washington is "nearly the opposite" of what the labor market and the broader economy need right now.

Warnings like Dudley's indicate that the end of the central bank's $85 billion in monthly purchases of Treasuries and mortgage debt could remain a long way off, even if the U.S. unemployment rate dips in coming months.

This would be especially true if lawmakers do nothing to blunt this year's automatic spending cuts, known as the sequester.

But if the fiscal mess gets cleared up sooner than expected, Fed policymakers could be a lot closer than is widely thought to slowing or ending the purchases.

The Fed's extremely easy monetary policy has helped boost U.S. stocks, now hitting record highs, while bond yields remain near historic lows. Any hint of fewer Fed asset purchases, however, could spark sharp reversals in these markets.

A Reuters poll published early last month found that economists expect the Fed to keep buying bonds until at least the first quarter of 2014. But those predictions could quickly change, one way or the other, if politics affect short-term economic growth.

LONG-SHOT

While sudden partisan agreement over the budget seems to be a long-shot, surprises do happen: lawmakers agreed sooner than expected to a stop-gap funding bill in late March, avoiding a government shutdown. And a last-minute deal was struck to avoid the worst of the year-end "fiscal cliff," allowing the economy to dodge big tax hikes.

However, little has happened since lawmakers agreed last month to fund the government for another six months.

As part of its unprecedented effort to break out of the pattern of stop-start economic growth since the Great Recession, the central bank has said it will buy bonds until the labor market outlook improves "substantially."

The Fed adopted its open-ended bond-buying program in September and expanded it in December, just before the fiscal cliff's tax rises and spending cuts were supposed to hit.

While the worst of the tax hikes were avoided, politicians allowed $85 billion in across-the-board spending cuts to take effect last month. The cuts are expected to take an increasing toll on the economy by the middle of this year, and the non-partisan Congressional Budget Office estimates the cuts will eliminate 750,000 jobs and shave 1.5 percentage points from GDP growth in 2013.

If Democrats and Republicans can strike a deal, they could replace the spending cuts with a longer-term deficit-reduction plan that wouldn't stall this year's rebound in economic growth.

Fed Chairman Ben Bernanke has advocated for just such an approach.

While the Democratic-controlled U.S. Senate narrowly passed a federal budget that aims to raise $1 trillion in new tax revenues, the Republican-controlled House of Representatives had already passed a cuts-heavy budget that would not raise new taxes.

"The bad news is there's still a great divide," said Ward McCarthy, chief financial economist at investment bank Jefferies. "The good news is there's still a lot of room for negotiation - if they're capable of doing that."

NOT HELPING

Dudley, a key ally of Bernanke and a good barometer of what the Fed is thinking, put the blame squarely on fiscal policies when he argued it was premature to expect substantial labor-market improvement any time soon.

We have "significant retrenchment in the near-term, but no credible action over the long-term, with partisan divisions and significant uncertainty about what will happen next," he said in a speech last week.

Among the majority of Fed policymakers who back the bond buying, there is divergence on what they would like to see in the labor market that would mark the end of the program.

Where employment-focused doves and inflation-focused hawks do agree, however, is that lawmakers are not helping the situation.

"Monetary policy is necessary but not sufficient to achieve full employment because it's also a function of fiscal policy," Dallas Fed President Richard Fisher, an outspoken hawk, told a conference in Abu Dhabi last week.

"And there lies the problem," he said. "In the United States we have a terrifically dysfunctional government."

With fiscal policy hard to predict and the Fed itself explicitly tying policy to the labor market outlook, investors are understandably focused on jobs for clues on how long the so-called quantitative easing program, or QE3, might last.

On Friday, a government report is expected show the U.S. economy added 200,000 jobs in March.

Chicago Fed President Charles Evans has said he wants to see at least 200,000 jobs created for six months running before he would support a cut in asset purchases.

Meanwhile, the White House will release its budget proposal on April 10 and a government shutdown looms this summer if lawmakers cannot agree to raise the government borrowing limit.

For the Fed and investors alike, all this means at least another few months of hoping lawmakers don't send the economy into the sort of downturn it experienced midway through each of the last couple of years.

(Reporting by Jonathan Spicer and Ann Saphir; Editing by Tim Dobbyn)