Fed is set to raise rates this week despite political tumult

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For the second time this year, the USA central bank appears poised to raise interest rates despite fresh signs the world's largest economy is not in peak condition. They view weak first quarter growth as transitory and believe inflation will resume rising toward the central bank's 2% target.

A June rate hike has been widely expected since Fed commentary in recent weeks suggested there were more hawks than doves.

However, they implied traders have not fully priced in the Fed's target range on rates reaching 1.25-1.50 percent until late 2018.

"I think they are going to raise rates and stay on the current course", said Ryan Sweet, an economist at Moody's Analytics.

Economists are almost unanimous that the central bank will raise rates at the end of the two-day meeting on Wednesday.

Economists are more divided about what the central bank will say this week about its plans to shrink its balance sheet.

Economists stuck with their previous forecast that the fed funds rate would peak in this cycle at 3 per cent, but moved back by six months the expected timing of that peak to the fourth quarter of 2019.

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"These rate hikes are not costless", he added.

Another aspect of caution on policy normalisation is the central bank's slow moves to start to reduce the size of its massive balance sheet, with FOMC chair Janet Yellen set to face multiple questions on when and how it will unwind the massive stimulus still in place. "With the United Kingdom event risk successfully negotiated, it would appear the market is putting more emphasis on this week's FOMC (Federal Open Market Committee) rate hike", said Jeffrey Halley, a senior market analyst with OANDA, adding that markets had priced in an nearly 100 percent chance the Fed would lift rates.

Even with the growing doubts, as of Friday, futures markets still were forecasting a better-than-99-percent chance of an increase at this week's Fed meeting.

"Even though the soft inflation may give the Fed pause, the significant easing in financial conditions gives them more room to continue to "tighten" policy", Levy wrote in a research note.

"We do not expect capitulation on the rate path at this meeting", said Krishna Guha, vice chairman of Evercore ISI.

The Federal Reserve meeting is clearly the biggest event for the bond market this week, but there is a lot of important economic data due as well.

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