Energy Inflation Sparks Bank of Canada Rate Hike

The Bank of Canada increased its key interest rate to 2.5 percent on Wednesday. This marks the first adjustment to the policy rate since July 2023. The quarter-point move aligns with market expectations. Governor Tiff Macklem stated the hike aims to prevent high energy costs from driving general inflation. The bank warned that further increases might be necessary.

Macklem told reporters, "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 noted that the Governing Council agreed risks to inflation had increased. Consequently, there was less scope for monetary accommodation.

The decision follows a September annual inflation rate of 3.2 percent. This figure sits above the bank's 1 to 3 percent target range. Energy and energy-related transportation costs drove the majority of this increase. Macklem projected inflation would end the year at 3.5 percent. He expects rates to hover near 3 percent for most of 2027. The central bank forecasts inflation will return close to the 2 percent target by mid-2028.

The new monetary policy report raised the inflation forecast for 2027 to 3.1 percent. This is up from the 2 percent predicted in July. Growth projections for the current year also increased to 1 percent, compared to 0.7 percent in the previous report. The bank upgraded its gross domestic product forecasts for 2027 and 2028 to 2 percent, up from 1.8 percent in both years.

Economic growth slowed in the second half of 2026 after a strong start. The annualized growth rate was 3.3 percent in the second quarter. The bank projects a slowdown to 2 percent in the third quarter. Growth is expected to dip further to 0.8 percent in the fourth quarter. Macklem attributed the fourth-quarter slowdown to new US tariffs. He expressed confidence that consumer spending and exports would drive recovery in 2027.

Andrew Grantham, a senior economist at CIBC Capital Markets, offered a differing view on the necessity of further hikes. "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," Grantham said. He added that the policy rate likely will not exceed 2.75 percent.

Money markets price in an additional 25 basis point rate cut in January. Analysts see the benchmark rate reaching 3.25 percent by December 2027. Some economists opposed the recent hike, arguing core inflation remains near 2 percent. They contend that raising rates could impede the modest economic recovery amid US trade tensions and a weak job market.

Macklem acknowledged lingering uncertainties, including the trade rift with the United States and the conflict in the Middle East. He stated that higher energy prices and business cost pass-through increase inflation persistence. Businesses typically adjust product and service costs to match input costs over the following year. The Bank of Canada will announce its next rate decision on December 9.