Bank of Canada hikes rate to 2.5 percent amid energy cost surge

Canada's central bank increased its benchmark interest rate on Wednesday, marking the first hike in the country in more than three years. The move lifted the target rate by 0.25 percentage points to 2.5 percent, a shift that most market participants had predicted.

The bank had previously cut rates from a peak in 2024, but the decision to pause that easing cycle and reverse course was driven by persistent pressure from energy prices. This marks the first time since July 2023 that the Governing Council has chosen to raise costs for borrowers and lenders.

Governor Tiff Macklem stated that the stronger inflation outlook and a resilient economy necessitated the increase. He explained that the goal is to limit the risk that elevated energy prices spread into what he called "generalised inflation." While acknowledging that more tightening may be needed, Macklem added that the bank "will proceed carefully" given the current uncertainties.

The bank significantly revised its economic projections in the accompanying monetary policy report. It now projects inflation will reach 3.1 percent in 2027, up from the 2 percent forecast made in July. Annual inflation hit 3.2 percent in September, driven almost entirely by higher energy and transportation costs. Macklem expects inflation to end the current year at 3.5 percent and remain near 3 percent through most of 2027 before easing back toward the 2 percent target by mid-2028.

Not all economists supported the decision to hike rates. Critics noted that core inflation, which excludes volatile items like energy, remains steady at around 2 percent. They argued that higher borrowing costs could weaken a modest economic recovery that is already facing pressure from trade tensions with the United States and a soft job market.

Andrew Grantham, senior economist at CIBC Capital Markets, expressed doubt that core inflation will accelerate as aggressively as the bank fears. He does not expect the policy rate to rise above 2.75 percent if global energy prices stabilize. However, money markets suggest a steeper path, with traders pricing in the benchmark rate reaching 3.25 percent by December 2027.

The bank's growth forecast shows the economy slowing from a 3.3 percent annualized pace in the second quarter to 0.8 percent in the fourth quarter. Macklem attributed part of the fourth-quarter slowdown to new US tariffs. The next scheduled rate decision is set for December 9.