One day ahead a highly anticipated decision on U.S. interests rates, National Bank Financial is calling for rates to climb gradually to 2.25%.

Most economists agree the Federal Open Market Committee, or FOMC, will vote Wednesday in favour of a quarter-point increase in the U.S. federal funds rate. The rate is now at a 46-year low of 1%.

In a new report from Paul-André Pinsonnault, senior fixed income economist, NBF says that it expects the Fed to push the fed funds target rate up to 2.25% by year-end. NBF also now expects the Bank of Canada to start raising Canadian rates in September.

NBF is expecting pretty strong U.S. GDP growth in the second quarter, up roughly 5.2% compared to last year’s second quarter, But it expects GDP growth to slow to 3.2 % in 2005. “However, like the Fed, we have been somewhat surprised by the acceleration in the core U.S. CPI figure since the beginning of the year,” it says, noting that there is anecdotal evidence of pricing power. It now expects core CPI to be roughly 2.5 % on average for 2005.

“Our own reading of the current situation argues for a Fed that is proactive in the second half of 2004, raising rates while GDP growth remains strong and inflation surprises on the high side. Under this scenario, the Fed should raise its rate to 2.25 % by year-end. Then in 2005, modest GDP growth compared to potential and stubborn inflation will push the Fed toward higher rates, but at a slower pace,” it says, noting that under this scenario, the fed funds target rate will reach 3.5 % in 2005.

In Canada, NBF observes that low rates are boosting domestic demand, and the worldwide recovery is providing more stimulus to the Canadian economy than the Bank of Canada had been hoping. “The consequence of all this is that it becomes quite likely the economy will reach its potential capacity much faster than anybody though possible only few months ago. With the output gap closing faster, the Bank will have to readjust its policy stance,” says NBF. It predicts that the Bank will follow the Fed with a series of three 25-basis-point hikes starting in September.

Although NBF says that the Bank should get some help from a strong loonie. “A stronger Canadian dollar will limit inflationary pressures via the import-prices channel. Secondly, it will also limit the Bank of Canada’s need to raise rates. Thus, while we expect the Fed to raise rates by 125 basis points in 2005, we expect 75 basis points of tightening in Canada over the same time period. By year-end 2005, both Fed funds and the overnight rate should be set at 3.5%.”