Influential hedge fund adviser Medley Global Advisors issued a report on Wednesday saying there is a growing divide among Federal Reserve policy makers on how quickly they should begin raising interest rates, causing U.S. government bonds to briefly sell off.

The report, titled Fed: The Journey Begins, comes one week before the Federal Open Market Committee (FOMC), the U.S. central bank's policy-setting group, is set to meet in Washington to discuss where benchmark interest rates should be set.

According to a source who read directly from the Medley report, at issue is how quickly policy-makers should begin raising interest rates to head off inflation once the economy shows sustainable signs of growth.

While there are at least two senior officials who would support raising rates next week they will instead lean on communications to safeguard long-term inflation expectations, the report said, according to the source. The two FOMC members were not identified.

The report sparked selling of U.S. Treasuries on the notion that the Fed might be closer to raising interest rates earlier than previously thought. The central bank has said it would keep rates low for an extended period in order to foster economic growth.

The majority needs to see solid evidence a sustainable recovery is under way before seriously discussing a policy tightening in any context other than the ongoing strategic debate over an exit, the source said, citing the report verbatim.

The source added: A minority nonetheless will soon launch a campaign in favor of ending the emergency policy stance.

The report exacerbated an already weak market, sending the benchmark 10-year U.S. Treasury yield toward session highs. The peak on Wednesday was almost 3.50 percent, but last traded down to 3.44 percent.

It moved the market but I think it has worn off, said the source. The market got spooked a little because there was a reference to two members of the FOMC and there's talk about raising rates sooner than expected.

Benchmark U.S. interest rates have been set in a range of zero to 0.25 percent since December.

There is some agreement a sustainable recovery scenario implies fed funds somewhere around 2 percent; that is still accommodative but closer to neutral, the source said, reading from the report verbatim.

For now, at least, the idea of kicking off the cycle with 25 basis point increments seems to be in the comfort zone of most members although they will be at pains to convey that subsequent moves of the same size will not be automatic, the report said.

(Editing by Leslie Adler)

Inflation