Bank of Canada raises interest rates for the first time in three years

The Bank of Canada (BoC) has raised its key interest rate for the first time in more than three years and warned that further increases might be needed to prevent soaring energy costs from fueling broader inflation.

Wednesday’s quarter-point hike to 2.5 percent was widely expected, while the bank also ramped up its inflation forecast for 2027 to 3.1 percent from the 2 percent it had predicted in July. Growth this year is set to be 1 percent, higher than the 0.7 percent seen in July.

“With the outlook for inflation substantially higher and the economy showing resilience, an increase in the policy rate is needed to reduce the risk that elevated energy prices could spill over and become generalised inflation,” BoC governor Tiff Macklem said.

“There could be a need to increase the policy rate further, but given uncertainties, we will proceed carefully,” he added.

The annual inflation rate hit 3.2 percent in September, above the bank’s 1 to 3 percent target range, and was driven almost solely by higher energy and energy-related transportation costs.

Macklem said inflation was expected to end the year at 3.5 percent and stay at around 3 percent for most of 2027, before returning close to the 2 percent target by the middle of 2028.

“Governing Council agreed that risks to inflation had increased and there was less scope for monetary accommodation,” Macklem said.

The rate hike was the first since July 2023.

“We don’t expect that core measures of inflation will accelerate as much as the bank fears, particularly if global energy prices ease a little, and as a result we don’t think that the policy rate will need to move above 2.75 percent,” said Andrew Grantham, senior economist at CIBC Capital Markets.

Money markets are pricing in another 25 basis point rate cut in January and see the benchmark rate going up to 3.25 percent by December next year.

Past experience suggests that businesses will increase the cost of products and services in line with changing costs over the next year, increasing overall inflation, Macklem said.

“The combination of higher energy prices and pass-through increases the persistence of inflation,” he said, although he added that there are lingering uncertainties such as the trade rift with the United States and a faster resolution of the conflict in the Middle East.

Economists who opposed a rise said core inflation, which strips out the cost of volatile items, is still hovering at about 2 percent. They also say a rate hike could impede modest economic recovery, given US trade tensions and a weak job market.

Macklem said new US tariffs would slow the economy in the fourth quarter, but expressed confidence that growth should pick up again in 2027 as consumer spending continues, exports pick up and business investment strengthens.

After a robust annualised growth of 3.3 percent in the second quarter, the economy is likely to slow to 2 percent in the third quarter and further down to 0.8 percent in the fourth quarter, the BoC’s new monetary policy report projected.

The report, however, upgraded its gross domestic product (GDP) forecast for next year and the year after to 2 percent from 1.8 percent for both 2027 and 2028, as predicted in July.

Macklem said this additional growth would help absorb the slack, or its unused capacity, in the economy.

The BoC’s next rate decision is on December 9.