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Federal Reserve poised to hike rates amid uncertain economic outlook

In this June 19, 2015, file photo, people walk past the Marriner S. Eccles Federal Reserve Board Building in Washington. The Fed will announce an interest rate hike this week despite economic uncertainty moving forward.

Andrew Harnik/AP

The U.S. Federal Reserve is set to raise its key interest rate this week for the third time in seven months, but the outlook for the rest of the year has become clouded by economic uncertainty.

Markets are currently pricing in a quarter-percentage-point increase when the Fed announces its decision on Wednesday, which will lift the rate to a range between 1 per cent and 1.25 per cent.

Fed chair Janet Yellen will add to the importance of the event by holding a news conference after the release of the policy statement and updated economic projections.

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The central bank last raised its key rate in March, following through on heavy hints from Fed officials that the year could bring a series of hikes in response to upbeat readings on U.S. inflation and labour-market conditions.

As a result of this tilt toward monetary tightening, bonds were down and financial stocks explored nine-year highs.

Since then, though, the U.S. economy has been underdelivering on its promise. Gross domestic product rose just 1.2 per cent in the first quarter, according to the latest revisions – making longer-term monetary policy, and the direction of financial markets, less than clear cut.

"With most indicators pointing to a rebound in GDP growth in the second quarter, financial conditions still loose and the global backdrop remaining favourable, we think the Fed will be comfortable continuing its gradual tightening cycle," Michael Pearce, an economist at Capital Economics, said in a note.

He added: "That said, the last few months of data have made the Fed's job over the rest of the year a lot harder and pose a challenge to its forecasts."

Mr. Pearce's reservations are not unusual in the economics community and among investors. Some observers even argue that a rate hike this week might not be on the table if the Fed hadn't already committed itself.

"I think a rate hike now is a mistake. How big of a mistake is still to be determined," said Eddy Elfenbein, a U.S. financial blogger and portfolio manager.

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In May, the U.S. economy added just 138,000 jobs, far less than the 185,000 new jobs that economists had been expecting. A measure of inflation that excludes volatile food and energy items declined to 1.5 per cent in April, which is below the Fed's 2-per-cent target, and the latest ISM non-manufacturing survey suggests it could fall further.

Wage inflation, which had been picking up earlier in the year with the tighter jobs market, turned flat in April and missed economists' expectations.

"In all, it's likely that the Fed shifts to the sidelines after this meeting in order to evaluate growth and inflation data," Derek Holt, head of capital markets economics at Bank of Nova Scotia, said in a note.

Financial markets appear to agree. The futures market, which in March had been implying a federal funds rate of 1.8 per cent by the end of next year, is now implying a lower rate of just 1.5 per cent.

The bond market, sensitive to Fed policy, is also reflecting a less aggressive approach to rate hikes: The yield on the 10-year U.S. Treasury bond retreated below 2.2 per cent earlier this month after rising above 2.6 per cent as recently as March.

This is good news for bond investors. As yields fall, bond prices rise, boosting unit prices for popular exchange-traded funds that track the U.S. bond market.

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The iShares 7-10 Year Treasury Bond ETF, for example, has rallied nearly 4 per cent since March, not long after a number of observers pronounced the decades-long bull market in bonds dead.

However, the news isn't as welcome to investors in financial stocks. These stocks rallied after U.S. President Donald Trump won the U.S. presidential election in November with a pro-growth agenda that appeared to make rate hikes more likely.

Financial stocks, along with Canadian banks and insurers, have since handed back some of their earlier gains. On Wednesday, investors will have a clearer idea of what comes next.

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