Fed likely to reduce bond buying, pass policy milestone

* Fed expected to begin process of normalizing monetary policy

* Seen scaling back bond buys to $75 billion per month

* Likely to underscore commitment to hold rates near zero

* Statement at 1800 GMT on Wednesday, news conference at 1830 GMT

By Alister Bull

WASHINGTON, Sept 18 (Reuters) - The Federal Reserve is expected to begin its long retreat from ultra-easy monetary policy on Wednesday by announcing a small reduction in its bond buying, while stressing that benchmark U.S. interest rates will remain near zero for a long time.

Most economists think the Fed will opt to scale back its monthly purchases of Treasury and mortgage-backed securities by a modest $10 billion, a Reuters poll found.

That would take them to $75 billion and signal the beginning of the end to an unprecedented episode of monetary expansion that has been felt worldwide.

The baby step would begin to provide a bookend of sorts to the U.S. central bank's response to the global financial crisis that reached fever pitch five years ago this week with the collapse of investment bank Lehman Brothers.

"It is an important milestone ... juxtaposed against five years ago, when the Fed began the huge expansion of its balance sheet," said Carl Tannenbaum, chief economist at Northern Trust in Chicago. "This is going to be the first step, potentially, in a very, very long walk."

The Fed will announce its decision in a statement following a two-day meeting at 2 p.m. (1800 GMT), and Fed Chairman Ben Bernanke will hold a news conference a half hour later. It is also set to release fresh quarterly economic and interest rate projections.

In slashing overnight rates to zero in late 2008, the Fed launched an extraordinarily bold campaign to shelter the U.S. economy. The effort included three rounds of bond purchases that more than tripled its balance sheet to around $3.6 trillion.

The actions, unthinkable to many within the Fed prior to the crisis, sparked intense criticism from those who feared the measures would create an asset bubble or fuel inflation.

But the Fed's show of force was credited with saving the U.S. and world economies from a much worse fate.

With the U.S. economy now on a somewhat steady, if tepid, recovery path and unemployment falling, policymakers have said the time was drawing near to begin ratcheting back their bond buying with an eye toward ending the program around mid-2014.

Incoming (Other OTC: ICNN - news) economic data has been mixed, with a disappointing reading on Wednesday on housing starts potentially pointing at some slackening in the housing recovery after mortgage rates rose in anticipation of less Fed stimulus.

The nation's latest monthly employment report was also lukewarm. The jobless rate declined to 7.3 percent in August, but that was because more people left the workforce, rather than as a result of much stronger hiring.

While Treasury bond yields and mortgage rates have shot higher in recent months, the Fed will still be expanding its balance sheet for months to come as it tries to wean the economy and financial markets from its ever-expanding stimulus.

YELLEN AND FORWARD GUIDANCE

To temper any jitters the bond market may feel from a slowing in the Fed's purchases, Bernanke is expected to reinforce the bank's commitment to keep overnight rates near zero for a long time to come at what is likely his penultimate news conference before stepping down in January at the end of his term.

The guidance on rates is aimed at holding down longer-term borrowing costs, which encompass investors' views on the path of short-term rates.

That task may have gotten easier after former U.S. Treasury Secretary Lawrence Summers withdrew from the running to replace Bernanke when his term ends on Jan. 31, restoring current Fed Vice Chair Janet Yellen to the front-runner position.

"To the extent that there is an effective tool, it's forward guidance," Goldman Sachs Chief Executive Lloyd Blankfein told CNBC on Wednesday. "Forward guidance is more credible if it emanates from an institution that is going to have continuity."

The Fed has said it will not begin raising rates at least until the unemployment rate falls to 6.5 percent, provided inflation does not threaten to go above 2.5 percent.

Some analysts wonder if the Fed might try to hammer home the message that rates would stay lower for longer by reducing the unemployment threshold to 6.0 percent.

But it could prove hard for Bernanke to muster sufficient support from other members of the central bank's policy-setting committee for such a move.