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The Bank of Canada has raised its benchmark interest rate by half a percentage point, the first oversized rate hike in decades and an aggressive step forward in its campaign to tackle runaway inflation.

The bank’s governing council agreed on Wednesday to increase the policy rate to 1 per cent from 0.5 per cent, and said that more rate hikes will be needed to prevent inflation expectations from spiraling upwards. It typically moves in quarter-point increments, and has not announced a half-point hike since May, 2000.

This puts the central bank on track for the quickest monetary policy tightening cycle in decades, which could push borrowing costs for Canadian households and businesses above prepandemic levels by the end of the year.

The bank also said it would stop buying federal government bonds and begin shrinking its balance sheet. This process, known as quantitative tightening (QT), is effectively the reverse of the bank’s massive bond-buying spree during the COVID-19 pandemic, which sopped up more than $300-billion worth of government debt in an effort to keep interest rates low.

The supersized rate hike – the bank’s second move in two months – combined with the start of QT marks a shift in policy. After holding interest rates at record lows and taking a gradual approach to unwinding pandemic-era supports, Governor Tiff Macklem and his team appear to have woken up to the danger of rising inflation expectations and have moved forcefully to defend their credibility.

“We are acutely aware that already-high inflation has risen further above our target,” Mr. Macklem said on Wednesday. “The invasion of Ukraine has driven up the prices of energy and other commodities, and the war is further disrupting global supply chains. We are also concerned about the broadening of price pressures in Canada.”

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He said that the bank was “prepared to move as forcefully as needed to get inflation back to target,” and suggested that the policy rate likely needs to return rapidly to the so-called “neutral rate.” The central bank estimates this to be somewhere between 2 and 3 per cent.

Most financial analysts expect the bank to raise the policy rate at each of its remaining five rate decisions this year.

Higher rates will show up most immediately in variable rate mortgages, while also pushing fixed-rate mortgage costs higher when people renew. Canada’s five large banks all increased their prime lending rate by half a percentage point, to 3.2 per cent, after the central bank announcement.

Inflation has run above the Bank of Canada’s target range of 1 per cent to 3 per cent since last April, hitting a three-decade high of 5.7 per cent in February. The bank said on Wednesday that it expects annual consumer price growth to average 5.3 per cent this year, up from its 4.2 per cent projection in January. It does not see inflation returning to 2 per cent until 2024.

Much of the upward revision to the inflation projection is due to higher commodity prices. But inflation is increasingly being driven by domestic forces as well, as demand exceeds supply and the Canadian economy begins to overheat.

This can be seen in exceptionally tight labour markets – unemployment fell to a 50-year low of 5.3 per cent in March – as well as in rising prices for some services, higher rents and rocketing homeowner replacement costs, which capture some of the rise in real estate prices.

“By making borrowing more expensive and increasing the return on saving, a higher policy interest rate dampens spending, reducing overall demand in the economy,” Mr. Macklem said. “And with demand starting to run ahead of the economy’s supply capacity, we need that to happen to bring the economy into balance and cool domestic inflation.”

A sense is growing among private sector economists that the Bank of Canada, like many of its counterparts around the world, waited too long to begin normalizing monetary policy and is now racing to catch up.

Not only is inflation far above target, but Canadians have begun to expect that it will remain high – a worrying development for central bankers, whose job is much easier when people trust them to keep the growth of prices low and stable.

“Whether you consider the Bank of Canada is behind the curve or not is somewhat inconsequential to the reality that inflation expectations have become unmoored, and Tiff kind of recognized that today,” Bank of Nova Scotia chief economist Jean-François Perrault said in an interview.

“You’re a central banker, you’re losing the plot ... you’ve got to react. And had they not moved by 50 basis points today, I think it would have been a big problem for them,” he said.

The challenge will be to engineer a soft landing: to normalize credit conditions and cool price growth without tipping the economy into recession.

Canadians are particularly exposed to higher borrowing costs owing to high levels of household debt. At the same time, household finances actually have improved on average through the pandemic, according to central bank research, and interest rate increases will happen against the backdrop of brisk economic growth.

The bank now expects gross domestic product will grow by 4.2 per cent this year, up from the January projection of 4 per cent, and 3.2 per cent next year. It also increased its projection for potential growth, thanks to rising immigration levels, growing business investment and the expected resolution of some of the supply chain problems associated with the pandemic.

The bank will rely mainly on rate hikes to increase borrowing costs and tamp down demand, although this will be complemented by QT. Since November, the bank had been in what it called the “reinvestment phase,” where it was no longer expanding its balance sheet like it did in the first 18 months of the pandemic, but was still buying between $4-billion and $5-billion worth of government bonds a month to replace maturing assets.

Starting on April 25, the bank will stop buying Government of Canada bonds on both the primary and secondary market – that is from the government itself and from investors. The bank does not intend to sell the bonds that it owns, but it will let them mature without replacing them. Around 40 per cent of these assets mature within the next two years, which means the bank’s balance sheet could shrink relatively quickly.

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