US STOCKS-Wall Street slips on Fed caution, volatility rises

* CBOE Volatility index rises to highest level since mid-Oct (KOSDAQ: 039200.KQ - news) .

* U.S. budget deal clears crucial vote in Senate

* KFN shares rise after KKR (Frankfurt: A1C10P - news) plan to pay $2.6 billion for firm

* Indexes down: Dow 0.2 pct, S&P 0.4 pct, Nasdaq 0.2 pct

By Angela Moon

NEW YORK, Dec 17 (Reuters) - U.S. stocks edged lower on Tuesday, with investors reluctant to make new bets before the outcome the Federal Reserve's last policy-setting meeting of the year.

Major stock indexes briefly extended losses after a two-year U.S. budget deal cleared a Senate procedural vote that all but assured its passage by the Senate as early as Wednesday.

Although many in the market don't expect the Fed to begin to wind down its market-friendly purchases of $85 billion a month in bonds until March, some are betting the Fed will taper earlier after a series of stronger-than-expected economic data.

The policy-setting Federal Open Market Committee is expected to issue a statement on Wednesday at the meeting's conclusion.

The CBOE Volatility index VIX, Wall Street's so-called fear gauge, rose 2.3 percent to 16.39, its highest level since mid-October.

"There has been a lot of chatter recently about a December tapering, so the next two days could be quite volatile," said Tony Venosa, senior options strategist at Schaeffer's Investment Research.

Investors digested a batch of economic data, trying to assess the impact on the Fed's deliberations.

U.S. consumer prices were flat in November, but a bounce back in the annual inflation rate from a four-year low will probably give the Fed cover to start the taper. Separate data showed the U.S. current account deficit was the smallest in four years in the third quarter as exports increased and more income was earned abroad.

The Fed has said its current policy is data-dependant, and some market participants believe the U.S. central bank will upgrade its economic forecasts in the two-day meeting.

The Dow Jones industrial average fell 28.07 points or 0.18 percent, to 15,856.5, the S&P 500 lost 6.63 points or 0.37 percent, to 1,779.91 and the Nasdaq Composite dropped 9.115 points or 0.23 percent, to 4,020.403.

In corporate news, specialty finance company KKR Financial (NYSE: KFI - news) Holdings rose 27.5 percent to $12.05 a day after KKR & Co said it would acquire KFN in a $2.6 billion deal. KKR slipped 2.9 percent to $24.36.

Facebook (NasdaqGS: FB - news) shares rose 1.3 percent to $54.48 after the Wall Street Journal reported the social network will begin selling video ads later this week.

Shares of 3M rose 2.6 percent to $131.02 after the industrial conglomerate affirmed its outlook and raised its dividend.

Boeing (NYSE: BA - news) 's board raised the company dividend about 50 percent on Monday and approved $10 billion in new share buyback authority that the company said it would use in the next two to three years. Shares rose 1.8 percent to $137.12.

AT&T (NYSE: T - news) said it would sell its wireline operations in Connecticut to Frontier Communications for $2 billion in cash, partly to fund the expansion of its 4G network. Frontier (LSE: FDEV.L - news) shares jumped 8.5 percent to $4.77.