The Federal Open Market Committee surprised no one by standing pat on U.S. interest rates Tuesday, but the shift to an easing bias did come as a shock to economists.

“As was widely expected, the Fed remained on the sidelines again today, refraining from cutting the fed funds rate from its 41-year low of 1.25%,” said BMO Nesbitt Burns. “But, in a more interesting development, they quashed the notion of a Phillips Curve tradeoff between inflation and unemployment by bisecting their so-called bias statement.”

BMO points out that the Fed suggests the risks are balanced, but Fed chairman Alan Greenspan is still concerned about a possible further decline in inflation. “This could occur even with a strengthening economy, hence the disconnect between inflation and unemployment,” it says. “This is an interesting twist on Fed pyrotechnic market guidance.”

“So the bond market is happy that the Fed might well ease when they meet again on June 24-25. But there is something here for the stock folks, as well, as Greenspan & Company continue to highlight that, though production and employment have been disappointing, much of the weakness might well reflect decisions made when the Iraqi War uncertainty was still a huge negative factor,” it notes.

TD Bank says that the continued focus on inflation suggests the Fed will be keeping its eye on the yawning U.S. output gap, which measures roughly 2% of GDP. “In short, the Fed appears to be concerned that, even if the U.S. economy does achieve “sustainable growth” over the foreseeable future, the output gap will remain open – limiting the risks of inflation.”

“That squares with our latest quarterly forecast, which shows a negative output gap at the end of 2004, in spite of six quarters of above-potential growth. We still do not believe this will translate into a rate cut, but it strengthens our view that rates are on hold at their current 41-year low until 2004. And, it is likely to spark renewed interest in the next U.S. CPI release – due out May 16 – as markets wait to see whether core inflation dips further below its own 37-year low of 1.7%,” TD says.

BMO says that the recent strength in corporate profitability in the U.S. should portend a further revival in business spending on capital equipment, especially technology excluding aircraft, as well as a rebound in employment growth. “Hopefully, we will begin to see that before the next FOMC meeting. If not, look for a rate cut in late June. With the U.S. dollar so weak, and likely to weaken further, import prices will continue to rise. Hard to imagine that deflation will be a meaningful problem with this backdrop,” it says.

“In this environment, the Bank of Canada should take a breather at their June 3 meeting. With the dampening effect of the SARS crisis on the Toronto economy, alongside the tightening effects of the surging Canadian dollar, the BOC has no need to tighten this next time around,” BMO concludes.

“From a Canadian standpoint, the introduction of a loosening bias should provide even more fuel to the Canadian dollar as it now looks more likely that spreads over the near-term could come to positively influence the Canadian dollar to an even greater extent than previously thought,” offers RBC Financial.