* Upside in gold capped by strong U.S. economic data -Macquarie
* Trade war fears simmer, underpinning dollar
* Palladium hits highest since late January (Updates prices, headline; adds comment, NEW YORK to dateline, byline)
By Renita D. Young and Maytaal Angel
NEW YORK/LONDON, Sept 25 (Reuters) - Gold edged higher on Tuesday as the dollar drifted ahead of a U.S. Federal Reserve monetary policy meeting, but bullion's upside remained capped by strong U.S. economic data that continues to underpin the greenback.
The U.S. dollar fell against a basket of currencies .DXY , with an expected Federal Reserve rate rise mostly priced in by traders, who will be looking for clues on the future pace of rate hikes from the central bank. scenarios (for gold are if) the Fed sounds a bit more dovish, but there's not a lot of room for that at the moment. U.S. data hasn't weakened and market positioning for rate hikes is not excessively hawkish compared to the Fed," said Macquarie commodity strategist Matthew Turner.
"In general, market dynamics are quite weak for gold."
A strong dollar makes dollar-priced gold costlier for non-U.S. investors, while rising U.S. interest rates typically deter investors from buying a non-yielding asset such as gold.
Spot gold XAU= gained 0.2 percent at $1,200.60 per ounce by 1:39 p.m. EDT (1739 GMT). U.S. gold futures GCcv1 for December delivery settled up 70 cents, or 0.1 percent, at $1,205.10 per ounce.
The Fed is scheduled to complete its two-day policy meeting on Wednesday.
"The key will be in the language. There's also a question of if they will keep doing three (rate hikes) next year," said Rob Haworth, senior investment strategist at U.S. Bank Wealth Management.
Gold has fallen around 12 percent since April, hit by rising U.S. interest rates and a global trade war that threatens growth and has led investors to chose the dollar as a safe haven rather than gold.
A senior Chinese official said it was difficult to proceed with trade talks with the United States while Washington was putting "a knife to China's neck", a day after both sides heaped fresh tariffs on each other's goods. lingering trade war fears or renewed emerging market jitters sour sentiment, the U.S. dollar may reclaim a haven bid, making gold vulnerable," said Ilya Spivak, a currency strategist for Dailyfx.
In wider markets, European shares and Wall Street got a lift as oil's rise boosted energy equities. Oil's rise will fan inflation and growth concerns in many countries, and could in the long run benefit gold. palladium XPD= increased 0.3 percent at $1,062.20 per ounce after hitting $1,068.50, its highest since late January.
Platinum XPT= lost 0.2 percent at $822.80 per ounce.
Silver XAG= gained 1.6 percent at $14.45 an ounce, earlier reaching $14.56, its highest since Aug. 31.