As expected, the Bank of Canada raised its overnight target rate from 3.25% to 3.5% today. The puzzle for economists is divining how many more rate hikes the central bank has in store.

Bank of Montreal notes that the Bank’s accompanying policy statement said that the economy is “evolving essentially in line with the Bank’s expectations,” and that it is “operating at its production capacity and will grow roughly in line with production potential through 2007.” The statement also noted that the risks to the outlook “remain balanced for 2006 and tilted to the downside through 2007 and beyond.”

BMO says that another tightening move at the March 7 fixed announcement date is indicated by the comment, “some modest further increase in the policy interest rate would be required to keep aggregate supply and demand in balance and inflation on target over the medium term.” However, it notes that a key difference from the last time is that today’s statement included the word “modest,” suggesting that the Bank thinks it is very close to the end of the tightening cycle.

“The Bank’s comments today suggest that it believes the overnight rate will climb one or two more times to 4% or less. However, based on our view of improved economic growth of 3.5% in 2006 compared with the Bank’s outlook of near 3%, we see rates peaking at a higher 4.5% by the fall,” BMO predicts.

“Much like the Fed, the Bank is pulling in its hawkish talons. Still, with the economy effectively operating at full capacity, the Bank views current interest rates as inappropriate, and will tighten slightly further. We continue to expect rate hikes at the next two decision dates (March 7 and April 25). However, it also seems that the Bank will be comfortable stopping at that point,” concludes BMO Nesbitt Burns.

TD Bank cautions against reading too much into the addition of the word ‘modest”. It says, “We believe the word was merely used by the Bank to defuse any expectations that it might be trying to get rates up to some perceived “neutral level” by aggressively hiking. To that end, we continue to believe that the Bank of Canada has two more 25 basis point hikes up its sleeve. That will take the overnight rate up to 4.0% by the end of April.”

Economists from RBC point out that a significant wild card is the post-election aftermath. “Here are three things to expect from a market standpoint. First, most polls were already indicating a conservative minority government, so this has already been largely priced into the Canadian dollar and bond yields. Second, look for fiscal policy to be significantly stimulative which may put heightened pressure upon the Bank of Canada to neutralize the effects through higher interest rates. Third, even with stimulative fiscal policy, it is likely that respect for fiscal policy prudence will remain in terms of targeting overall budgetary balance and a steadily declining debt-to-GDP ratio, which are what matter most to financial markets,” it says.