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Bank of Canada Governor Tiff Macklem announced a 'conditional pause' to interest-rate increases earlier this year in the belief that borrowing costs were high enough to cool the economy and bring down inflation.Sean Kilpatrick/The Canadian Press

The Bank of Canada raised its benchmark interest rate by a quarter percentage point on Wednesday, restarting its campaign to tighten monetary policy in response to stubborn inflation and surprising resilience in the Canadian economy.

The decision increased the policy rate to 4.75 per cent, the highest level since 2001, pushing up Canadian mortgage rates and further squeezing household budgets. And it marked a U-turn for the bank, which was the first major central bank to halt monetary-policy tightening, back in January.

Governor Tiff Macklem announced a “conditional pause” to interest-rate increases earlier this year in the belief that borrowing costs were high enough to cool the economy and bring down inflation over time. This has not, however, unfolded as expected.

The Canadian economy outperformed expectations in the first quarter as consumers continued to spend and businesses kept hiring workers. Meanwhile, the housing market has begun to rebound and inflation ticked back up slightly in April.

“Overall, excess demand in the economy looks to be more persistent than anticipated,” the bank said in its interest-rate announcement, adding that “monetary policy was not sufficiently restrictive to bring supply and demand back into balance and return inflation sustainably to the 2-per-cent target.”

Inflation has dropped considerably since last summer, with annual consumer price index growth falling to 4.4 per cent in April from a high of 8.1 per cent last June. Central bank economists expect inflation to decline to around 3 per cent this summer. However, they remain concerned that it will get stuck “materially above” 2 per cent unless economic growth grinds to a halt for a period of time and unemployment rises.

Monetary-policy tightening aims to lower demand for goods and services to curb upward pressure on prices. In effect, the central bank is hurting the economy – and Canadians – in the short-term to achieve a longer-term goal of stabilizing the purchasing power of the Canadian dollar.

The bank gave no indication of whether this would be the final rate hike or the start of a new phase of monetary-policy tightening. It said only that it will continue to assess inflation dynamics, paying close attention to core inflation measures – which strip out more volatile prices – wage growth, corporate price-setting behaviour and Canadians’ expectations about inflation.

“The economic momentum that it cited as a reason to lift rates today does create risks that a few months from now, the deceleration in the economy might still be insufficient to bring inflation to the 2 per cent target next year,” Canadian Imperial Bank of Commerce chief economist Avery Shenfeld wrote in a note to clients.

“We now expect a follow-up 25 bp [basis point] hike as a final fine tuning, with September more likely than July due to the need to gather enough additional insights on the lagged impacts of all the rate hikes thus far,” he said. (A basis-point is 1/100th of a percentage point.)

Other analysts took a more aggressive view, suggesting the bank will move again at its meeting on July 12. Interest-rate swaps, which capture market expectations about monetary policy, are now pricing in a roughly 60-per-cent chance of another rate hike in July, and an 85-per-cent chance of a rate hike by September, according to Refinitiv data.

Wednesday’s rate hike will put additional pressure on mortgage holders, and could act as a brake on housing market activity, which has picked up this spring, especially in major markets like Vancouver and Toronto. Home sales jumped 11.3 per cent from March to April, and the national home price index climbed 1.6 per cent in April, according to the Canadian Real Estate Association

Along with increasing borrowing costs, the rate hike could change the psychology of would-be homebuyers, particularly housing-market investors, said Farah Omran, an economist with Bank of Nova Scotia.

“It’s signalling that the pause may be over, which would help thwart the speculative activity that is driven by this assumption that rates are stabilizing and declining sooner than what is now clearly the case,” Ms. Omran said in an interview.

The decision caught bond traders off guard, leading to a large, 20-basis-point jump in two-year Government of Canada bond yields immediately after the announcement. However, it was hardly a surprise, given central bank signalling over the past few months.

Mr. Macklem had said repeatedly in recent appearances that the bank was willing to raise interest rates again if it was surprised by strong economic growth, employment and inflation data. Those numbers have consistently surprised to the upside over the past month.

Real GDP grew at an annualized rate of 3.1 per cent in the first quarter, handily beating Bank of Canada and Bay Street forecasts. Canadian employers added another 41,000 jobs in April, keeping the unemployment rate near a record low.

Live updates: Bank of Canada raises key interest rate to 4.75%, restarting its hike campaign

Labour-market strength is a particular worry for the central bank. High demand for workers is increasing wages. That’s good for workers, but rapid wage growth can push up prices, particularly for services, making the central bank’s inflation-control job more difficult.

“The labour market remains tight: higher immigration and participation rates are expanding the supply of workers but new workers have been quickly hired, reflecting continued strong demand for labour,” the bank said in its rate announcement.

It’s unclear why rate hikes have not bitten as much as expected. Economists point to several possible explanations, including a buildup of savings over the COVID-19 pandemic, and the fact that many variable-rate mortgage holders have been allowed to extend their amortization periods, rather than paying more each month.

The rate hike drew condemnation from across the political spectrum. Conservative Party Leader Pierre Poilievre called it “a disaster for the many Canadians barely hanging on,” and blamed government spending and budget deficits for pushing up inflation. Bea Bruske, president of the Canadian Labour Congress, said the bank’s move was “deeply disappointing.”

The central bank has come under political attack over the past year and a half – first for failing to keep inflation under control, then for its aggressive campaign to raise interest rates to bring inflation back down.

In a news conference after the rate announcement, Finance Minister Chrystia Freeland emphasized the strength of the Canadian economy and the global nature of inflation.

“We are very close to the end of this difficult time,” she said. “There are a lot of Canadians who are anxious right now and who will be concerned when they see this step taken by the Bank of Canada. That is entirely understandable, and I absolutely understand that anxiety and that concern.”

The government sets the Bank of Canada’s target for inflation every five years, but the central bank makes decisions independently on a day-to-day basis.

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