By Promit Mukherjee and David Ljunggren
OTTAWA, Oct 28 (Reuters) – The Bank of Canada on Wednesday hiked its key policy rate for the first time in more than three years and said further increases might be needed to prevent soaring energy costs from fueling broader inflation.
The bank lifted the rate by 25 basis points to 2.5%, as widely expected, and also ramped up its inflation forecast for 2027 to 3.1% from the 2.0% it had predicted in July. Growth this year is set to be 1.0%, higher than the 0.7% seen in July.
“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 generalized inflation,” Governor Tiff Macklem said in opening remarks to reporters.
“There could be a need to increase the policy rate further, but given uncertainties, we will proceed carefully.”
The annual inflation rate hit 3.2% in September, above the bank’s 1%-3% target range, almost solely led by higher energy and energy-related costs of transportation.
Macklem said inflation was expected to end the year at 3.5% and stay around 3% for most of next year before returning close to the 2% target by the middle of 2028.
“Governing Council agreed that risks to inflation had increased and there was less scope for monetary accommodation,” Macklem said.
The rate hike was the first since July 2023 and first move in a year.
Despite the increase, the rate is still below the mid-point of the neutral rate, a monetary policy level which is neither considered restrictive or accommodative. The BoC considers the mid-point at 2.75%.
“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, and as a result we don’t think that the policy rate will need to move above 2.75%,” said Andrew Grantham, senior economist at CIBC Capital Markets.
Money markets are pricing in another 25 basis point rate cut in January and see the benchmark rate going up to 3.25% by December next year.
Past experience and the BoC’s surveys suggest that cost pass-through will increase over the next year, increasing overall inflation, Macklem said.
“The combination of higher energy prices and pass-through increases the persistence of inflation,” he said, although he added that there are lingering uncertainties such as the trade rift with the United States and a faster resolution of the conflict in Middle East.
Economists who opposed a hike said core inflation, which strips out the cost of volatile items, is still hovering around 2%. They also say a rate hike could impede modest economic recovery, given US trade tensions and a weak job market.
Macklem said new US tariffs would slow the economy in the fourth quarter, but expressed confidence that growth should pick up again in 2027 as consumer spending continues, exports pick up and business investment strengthens.
After a robust annualized growth of 3.3% in the second quarter, the economy is likely to slow to 2% in the third quarter and further down to 0.8% in Q4, the BoC’s new monetary policy report projected.
The report, however, upgraded its GDP forecast for next year and year after to 2% from 1.8% for both 2027 and 2028 as predicted in July.
Macklem said this additional growth would help absorb the slack, or its unused capacity, in the economy.
The Canadian dollar firmed slightly and was trading at C$1.4050 to the US dollar, or 71.17 US cents.
The BoC’s next rate decision is on December 9.
(Reporting by Promit Mukherjee, Editing by Nick Zieminski)
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