Bank of Canada: Rate rises to 2.5% as energy costs spike

The Bank of Canada raised its benchmark interest rate to 2.5 percent on Wednesday, marking its first increase in more than three years. The quarter-point move was widely anticipated by markets as the central bank sought to contain rising energy costs.

Governor Tiff Macklem stated that the decision was necessary to reduce the risk of elevated energy prices becoming generalized inflation. He noted that the outlook for inflation has shifted substantially higher while the economy demonstrates resilience. The bank increased its inflation forecast for 2027 to 3.1 percent, up from the 2 percent projection made in July.

Annual inflation reached 3.2 percent in September, exceeding the bank's target range of 1 to 3 percent. This surge was driven almost exclusively by higher energy and energy-related transportation costs. Macklem projected that inflation would end the current year at 3.5 percent and hover around 3 percent for most of 2027 before returning close to the 2 percent target by mid-2028.

The Governing Council agreed that risks to inflation had increased, leaving less room for monetary accommodation. While Macklem indicated that further rate increases might be required, he emphasized that the bank would proceed carefully given current uncertainties. These uncertainties include the ongoing trade rift with the United States and the potential for a faster resolution to the conflict in the Middle East.

Economic growth is expected to slow from 2 percent in the third quarter to 0.8 percent in the fourth quarter. The bank upgraded its gross domestic product forecast for 2027 and 2028 to 2 percent, up from 1.8 percent in its July report. Macklem said this additional growth would help absorb unused capacity in the economy, although new US tariffs would likely slow growth in the final quarter of this year.

Andrew Grantham, a senior economist at CIBC Capital Markets, argued that core inflation would not accelerate as much as the bank fears. He suggested the policy rate would not need to move above 2.75 percent if global energy prices ease. Other economists opposed the hike, noting that core inflation remains near 2 percent and that rate increases could impede a modest economic recovery amid a weak job market.

Money markets are currently pricing in another 25 basis point rate cut in January and see the benchmark rate reaching 3.25 percent by December of next year. The Bank of Canada will announce its next rate decision on December 9.