Economists were quick to dissect the Federal Open Market Committee’s decision Wednesday to hike interest rates for the first time in four years. Some said there could be three more rate increases by yearend.

All 12 members of the committee voted in favour of the move and all Fed regional banks voted to hike the discount rate 25 bps as well to 2.25%.

Economists said that given the rate increase was widely expected, financial markets would be watching closely whether the committee would alter the text of its accompanying statement by dropping or modifying the reference to future rate hikes being delivered at a “measured pace”.

In the end, the FOMC retained the statement, but appended a caveat – specifically, that “the Committee will respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability.”

Gillian Manning, economist with TD Bank Financial Group, said the different phrasing in the communiqué reflects the important changes in the U.S. economic landscape since the Fed’s last meeting May 4.

“Eight weeks ago, in characterizing labour market conditions, Fed officials noted merely that ‘hiring appears to have picked up’,” Manning said in a report. “With the latest monthly employment report having since revealed that the U.S. economy has created 1.2 million new jobs so far this year, the Fed upgraded that assessment, remarking that ‘labour market conditions have improved’.

“But, the more profound shift over the last few months has been the acceleration in various measures of core inflation – prompting concern in some quarters that the Fed may have gotten ‘behind the curve’. Today, the FOMC sought to downplay those concerns, reiterating that it views the risks to inflation as balanced and suggesting that ‘a portion of the increase [in inflation] in recent months appears to have been due to transitory factors’.”

Sherry Cooper, chief economist at BMO Nesbitt Burns Inc., said her take on the “transitory factors” comment is that these factors are pushing up inflation expectations, which the Fed described as ‘well-contained’ last meeting. “The Fed appears to be downplaying the recent uptrend in expectations,” Cooper said in a report. “They must really, really mean measured.”

Economists said the Fed also decided that some additional flexibility on the rate front was warranted. Manning said rapid output and employment growth are eating up the slack in the U.S. economy, limiting the degree to which excess capacity will keep a lid on prices going forward. She noted that Wednesday’s statement contained no reference to ‘resource use [being] slack’ – a comment that has been made in every other statement so far this year.

“As a result, while inflation is still running at historically low levels, the Committee wants to keep its options open – which is exactly what a central bank should do,” Manning said. “If incoming data highlight the need for a more rapid tightening in monetary policy, the Fed stands ready to deliver. For now, however, the FOMC believes that it can continue to raise rates at a measured pace.

“We concur with that assessment, anticipating three more 25-basis-point rate hikes this year, which will take the Fed funds rate to 2.00% by yearend.

Cooper interpreted the committee’s need for flexibility as “mildly hawkish … leaving the smallest of cracks open for a more aggressive pace later on. They must really, really, really mean measured.”

Cooper said her “bottom line” is that a 50 bp move “is unlikely in August, and maybe for the rest of 2004.”

National Bank Financial said wages and productivity will be key factors in determining Fed actions in coming months. “With core inflation expected to be around 2%, Fed funds have to be closer to 3.25% by June 2005 (2.25% by year end 2004) to restore positive real rates and a more neutral monetary
policy.”

Looking further down the road, the Bank of Montreal said in a separate report that it continues to expect rates to increase in 25 bp increments at each of the next 13 policy meetings, eventually returning the fed funds rate to a more neutral level of 4.50% by early 2006.

“By reassuring markets that rates were likely to climb
slowly rather than quickly, the Fed has dampened speculation of a possible 50-basis points increase at the next policy meeting on Aug. 10,” the bank said.