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Fed expected to raise rates this week, but outlook for 2018 still unclear

The Federal Reserve is widely anticipated to raise the federal funds rates for a third time in 2017, this time to a target range of 1.25% to 1.5%, but analysts say the outlook for 2018 is hazy.

Inflation numbers continue to underwhelm and some worry about a possible inversion in the yield curve. Participants at the Federal Open Market Committee, which meets Dec. 12 and 13, have signaled they think three increases in 2018 are appropriate. But although there are signs inflation has picked up, observers are split on whether prices will rise rapidly enough to warrant more than two rate hikes next year.

Some analysts are not very optimistic about inflation. Brian Rehling of the Wells Fargo Investment Institute said many have consistently hoped inflation would meet the Fed's 2% target but it has yet to do so. The Fed's preferred measure of inflation personal consumption expenditures minus food and energy was up roughly 1.4% in October compared to the previous year.

"There's just really not a need, I don't think, for the Fed to be raising rates three times a year," Rehling said. "At this point, it's likely to do more harm than good."

Others think a tightening labor market may finally push inflation up further, partly because employers will offer higher wages while competing for an increasingly small pool of workers. Robert Wescott, the founder and president of Keybridge Research, predicted 2018 may be a "turning point" for wage inflation.

"I suspect we're on the cusp of starting to see [that]," said Wescott, who was chief economist at the Council of Economic Advisers under the Clinton administration.

If that is the case, it will help the Fed battle a yield curve that is continuing to flatten. The Fed's gradual push to hike up the federal funds rate has caused yields for two-year Treasurys to rise to about 1.8%, as those shorter-term assets are more affected by Fed actions. Weak inflation expectations, meanwhile, have contributed to holding down yields for 10-year Treasurys, which are now at 2.38%.

The gap between the two, or 0.58%, is at its lowest point since October 2007. Some are increasingly worried that the two measures will invert in the coming months, a sign of a possible upcoming recession.

St. Louis Fed President James Bullard warned about that possibility this month, saying the Fed could bring about another recession by being overly aggressive in raising the federal funds rate. Fed Chair Janet Yellen has said inflation should hit the Fed's 2% target within the next two years, though she has also warned there may be "something more endemic" holding it down. Other Fed officials have been more upbeat in their inflation expectations.

Jim Paulsen, chief investment strategist at the Leuthold Group, predicted that "just like everything else in this recovery," inflation will continue its slow ascent.

Yellen's news conference after the Dec. 13 FOMC announcement is expected to be her last as Fed chair. She has said she will resign as a governor once President Donald Trump's pick to replace her as chair, current Fed Governor Jerome Powell, takes the helm.

The FOMC decision comes as Congress' approval of a tax reform package has become more likely. The conference committee is getting underway to resolve some key differences between the versions the Senate and House approved, though GOP agreement on a final package is far from a sure thing.

To what extent the bill boosts economic growth is a point of debate, though Fed officials would have to contend with at least a modest bump in GDP if it passes and may have to raise rates more quickly if that is the case, analysts say.

The Fed will also continue its early efforts to lower the roughly $4.5 trillion balance sheet it racked up to fight the financial crisis. In October, the agency began to gradually let some of the Treasurys and mortgage-backed securities it held mature rather than reinvesting them. The Fed capped the reductions to $10 billion in October, though the limit will rise to $20 billion next month. It will then continue to go up until hitting a $50 billion monthly cap in October 2018.

The initial steps in that process, which observers say the Fed communicated clearly, had little effects on the markets. And most think that will continue to be the case as the gradual effort moves forward.

"If it goes off as planned, I think it will be a non-event," said Michael Skordeles, of SunTrust Advisory Services.