The Bank of Canada has raised interest rates for the first time in more than three years, lifting its key rate by a quarter point to 2.5% as higher energy costs drive inflation above target.
The increase, the first since July 2023, was widely expected. But the central bank also warned that further rises could be needed to prevent the impact of energy prices from spreading across the wider economy.
Annual inflation reached 3.2% in September, outside the Bank of Canada’s target range of 1% to 3%. The rise was driven almost entirely by energy and energy-related transport costs.
Tiff Macklem, the bank’s governor, said the inflation outlook had deteriorated while the economy had proved resilient.
“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,” he said.
“There could be a need to increase the policy rate further, but given uncertainties, we will proceed carefully,” Mr Macklem added.
Bank of Canada raises inflation forecast
The bank has raised its forecast for inflation in 2027 to 3.1%, from the 2% predicted in July. It expects inflation to end this year at 3.5%, remain close to 3% for most of next year and return to around the 2% target by the middle of 2028.
Mr Macklem said businesses were likely to pass higher costs on to customers over the coming year, adding to overall inflation.
“The combination of higher energy prices and pass-through increases the persistence of inflation,” he said.
He also pointed to uncertainty surrounding the trade rift with the United States and the possibility of a faster resolution to the conflict in the Middle East.
Some economists opposed the rate increase, arguing that core inflation, which excludes volatile items, remained at about 2%. They warned that higher borrowing costs could hinder a modest recovery while trade tensions with the US persist and the jobs market remains weak.
The Bank of Canada said new US tariffs would slow the economy in the final quarter of this year. It expects growth to strengthen in 2027, supported by consumer spending, increased exports and stronger business investment.
Economic growth is forecast to slow from an annualised 3.3% in the second quarter to 2% in the third quarter and 0.8% in the fourth, according to the bank’s latest monetary policy report.
However, the bank upgraded its growth forecasts for 2027 and 2028 to 2%, from 1.8% for both years previously. Mr Macklem said the additional growth would help absorb unused capacity in the economy.
Andrew Grantham, senior economist at CIBC Capital Markets, said he did not expect the policy rate to rise above 2.75%, particularly if global energy prices eased.
Money markets are pricing in another quarter-point rate cut in January, while also expecting the benchmark rate to reach 3.25% by December next year. The Bank of Canada’s next rate decision is due on December 9.
