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The Bank of Canada in Ottawa on July 12.Sean Kilpatrick/The Canadian Press

The Bank of Canada gave the economy a surprise jolt on Wednesday, raising its benchmark rate by a full percentage point in a sign that it is growing increasingly worried about inflation and is willing to slow economic growth to get consumer prices back under control.

In its most aggressive increase in interest rates since 1998, the central bank’s governing council raised the policy rate to 2.5 per cent from 1.5 per cent – four times the size of a typical rate increase – and signalled that more are coming.

The decision caught investors and economists off guard. Most private-sector forecasters were expecting 0.75 percentage points. Governor Tiff Macklem and his team opted instead to “front-load” rate increases, pushing borrowing costs higher now rather than in increments, citing signs that the Canadian economy is overheating and risks that high inflation could become dangerously self-reinforcing.

The supersized move highlights the urgency central bank officials are feeling in the face of the first inflation crisis in a generation. It also shows their willingness to squeeze Canadians’ finances, and even risk a recession, to slow the pace of consumer price growth. That’s a major shift from the first two years of the COVID-19 pandemic, when unprecedented monetary policy stimulus helped fuel inflation and spur a run-up in the price of homes and assets.

“We understand that higher interest rates are adding higher borrowing costs to Canadians at a time when they are already facing higher costs for groceries, higher costs for gasoline, and higher costs for many everyday items,” Mr. Macklem said during a news conference after the announcement.

“By front-loading, what we’re really trying to do is to avoid even higher interest rates further down the road,” he said.

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This is the fourth consecutive increase since March, and brings the policy rate to a level not seen since the 2008 financial crisis. It puts the Bank of Canada ahead of its peers when it comes to tightening monetary policy.

Central banks around the world were slow to start raising interest rates as inflationary pressures began to mount last year and early this year. Now they are scrambling to contain consumer prices, which are being pushed higher by a complex stew of supply chain disruptions, soaring commodity prices and growing demand for services as the last pandemic restrictions are lifted.

Canada’s annual rate of inflation hit 7.7 per cent in May, the highest since 1983. Rising prices, particularly for food, energy and shelter, are aggravating many Canadians’ concerns about the cost of living, and testing the central bank’s credibility.

Higher interest rates make borrowing money more expensive for households and businesses. This won’t do much to tamp down global inflationary pressures, such as transportation bottlenecks and a surge in commodity prices since Russia’s invasion of Ukraine. But it could help cool demand in Canada.

“The Canadian economy is overheated,” Mr. Macklem said. “There are shortages of workers and of many goods and services. Demand needs to slow so supply can catch up and price pressures ease.”

The challenge is to strike the right balance. If the central bank pushes interest rates too high too fast, it could tip the economy into a recession.

The Bank of Canada is not forecasting a recession in the next two years, but it does expect economic growth to fall significantly in the second half of the year and into next year, as a combination of high inflation and higher borrowing costs erodes household spending and business investment.

Mr. Macklem said he believes a so-called soft landing is possible: that is, a situation where inflation comes down without a sharp rise in unemployment. But the longer inflation remains high, the bigger the risk that it becomes baked into consumer and business psychology, requiring a more forceful response from the central bank.

“The path to this soft landing has narrowed because elevated inflation is proving more persistent,” Mr. Macklem said.

Higher interest rates are already affecting key segments of the economy, notably the housing market. In the Toronto region, the largest real estate market in the country, the number of home resales dropped 41 per cent in June compared with last year. The typical Toronto home price is down nearly 10 per cent from the March peak to June.

Last week, economists at the Royal Bank of Canada predicted that the Canadian economy will fall into a “moderate and short-lived” recession in 2023.

“We think the BoC’s forecasts are optimistic, with growth likely needing to slow more materially next year if domestic inflationary pressure is to be brought under control in any reasonable timeframe,” Royal Bank of Canada economist Josh Nye wrote in a note to clients after the rate decision.

The big wild card is inflation expectations among Canadian businesses and consumers. The longer inflation remains high, the more it becomes entrenched in people’s psychology – something that happened during the “stagflation” years in the 1970s.

The Bank of Canada’s biggest fear is that a wage-price spiral could develop, where business and consumers expect higher prices, and so set higher prices and demand higher wages in a self-reinforcing cycle.

“The lesson from history is if that happens, it’s going to take a much sharper slowing of the economy to get inflation back to our target,” Mr. Macklem said. “By raising rates proactively, by front-loading our response, we are really doing everything we can to avoid that risk materializing.”

The Bank of Canada updated its inflation forecast on Wednesday. It now expects the rate of inflation to average 7.2 per cent in 2022 and 4.6 per cent in 2023 – considerably higher than it forecast in April. It does not expect inflation to return to its 2 per cent target until the end of 2024.

Wednesday’s move puts the policy rate back in the so-called neutral range, where it neither stimulates nor restricts the economy. Mr. Macklem said that the rate will need to keep rising, likely to 3 per cent or slightly above. He said future interest rate decisions will be driven by incoming economic data.

Derek Holt, head of capital market economics at Bank of Nova Scotia, said interest rates will likely need to keep moving higher.

“The inflation picture clearly needs restrictive policy in order to meaningfully reassert control and 3 per cent or a little higher offers no such guarantees. Restrictive policy means significantly overshooting the neutral rate range. Inflation is already out of the BoC’s control,” Mr. Holt wrote in a note to clients.

The bank’s next interest rate decision is on Sept. 7.

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