Bank of Canada Raises Policy Rate as Inflation Fears Mount

• The Bank of Canada (BoC) raised its policy rate by 25 basis points (bps) to 2.50%, in line with market expectations. This is the first interest rate increase since July 2023.
• The Bank acknowledged that exports, business and government investment continue to support economic recovery despite ongoing trade headwinds. At the same time, they note that “the outlook for inflation has deteriorated” and global oil prices “are expected to stay higher for longer”.
• The updated Monetary Policy Report expects modestly higher GDP growth compared to July’s forecast. It revised growth higher to 1% in 2026 supported by stronger business investment and government spending. Looking further ahead, the Bank projects that “growth is positive across major expenditure components over 2027 and 2028 and as a result, “slack in the economy is absorbed”.  At the same time, the MPR continued to emphasize elevated uncertainty surrounding the outlook.
• The Bank also noted that the near-term inflation remains elevated and is expected to rise to 3.5% y/y by year-end. In its outlook, the Bank assumes energy-related costs pressures are passed through to consumers alongside diminishing slack, which will keep inflation “at or above 3% through much of 2027 before returning close to the 2% target by the middle of 2028”. Importantly, the Bank stressed that significantly higher prices for refined products like gasoline and diesel are becoming more of a stressor for households and businesses.
• Finally, Governing Council agreed to take future policy decisions one meeting at a time, acknowledging that there may be a need to raise policy rates further.

Key Implications

• With today’s hike, the Bank of Canada is taking out some insurance. We felt the case for patience was strong based on the latest data, with underlying inflation relatively contained, the labour market still on the softer side, modest economic growth, and an uncertain trade backdrop. But the Bank has clearly opted for a risk-management approach in light of its concern that inflation will remain higher-for-longer and its resilient economic growth expectations.
• We think this hike buys the Bank a few months to assess whether higher energy and input costs are actually filtering through to consumer prices. Our expectation is that we will start to see some pass-through, enough to prompt one additional 25 basis-point hike in Q1-2027.  This will take the policy rate to 2.75% and roughly the middle of the Bank’s neutral range. However, the bar for hikes thereafter should rise significantly as it would place unnecessary restraint on an economy that’s still trying to find its footing. In the wake of the decision, 2-year yields moved high by only a couple basis points and the CAD remained relatively unchanged.