The U.S. Federal Reserve Board left rates unchanged today, and its policy statement leaves economists disagreeing over where it’s going next.

The Fed clearly shifted its rate ‘bias’ toward loosening, noting the risk of a weaker economy. BMO Nesbitt Burns says this means that the next move by the Fed could well be to ease monetary policy, cutting interest rates by 50 basis points. “With rates at a 41-year low of 1.75%, the Fed won’t waste its time on 25-bp baby steps,” it says.

BMO says that the market thought there was only a 50-50 chance that the Fed would shift the bias, and the fact that it did, “Is a strong indication for coming rate cuts, even a move before the next scheduled meeting on September 24th, depending on the incoming economic data and the financial markets, is now a possibility.”

Economists are torn over how much attention the Fed is giving financial markets. BMO insists that, “Alan Greenspan is watching the stock market. Odds are we will see a 50 basis point rate reduction (or more) by yearend.”

CIBC World Markets says that the statement makes it “evident that there will have to be even deeper pain in stocks or corporate bond spreads to bring the Fed off the sidelines as long as other indicators still show a demand recovery.” And, TD Bank predicts that there will be no rate move unless the financial markets really suffer. It sees the Fed on sidelines until spring, when it will start hiking rates.

Bank of Montreal economists agree with TD, saying, “Our view is that the current stance of policy will be sufficient to keep the economy from weakening further. In fact, we expect growth to strengthen sharply by late this year and through 2003. Such a scenario would leave the Fed on the sidelines this year before moving it to start tightening next year.”

BMO Nesbitt strongly disagrees. “While, in the minds of many, there may be little risk of [deflation] in the U.S., the Fed doesn’t see it that way. They will err on the side of ease rather than tightening. Count on it.”

“This isn;t great news for stocks,” CIBC concludes. “The Fed is saying, in effect, that the Dow may be at 8,600, but it’s got to be even worse before we’ll throw it a rate-cut lifeline. As for fixed income markets, they remain convinced that things will deteriorate enough in either the economy or financial markets to bring the Fed in with a rate reduction.”

CIBC says that the Fed’s willingness to rethink the risks to its economy should have the Bank of Canada reviewing its own rosy forecast. “At a minimum, the more cautious assessment by the Fed should see the Bank of Canada pull away from any plans for a rate hike in early September. If the U.S. downside risks materialize as we expect, we will have already seen the last Canadian rate hike for several quarters to come.”