Bank of Canada interest rate hike to 2.5% raises inflation and growth concerns

The Bank of Canada increased its benchmark interest rate by 25 basis points to 2.5% on October 28, 2026, marking its first rate hike since July 2023. The decision follows a deterioration in the inflation outlook as elevated energy prices and uncertainty over trade relations with the United States threaten to push consumer prices higher.

The central bank’s October monetary policy decision identified persistent oil prices and the potential for businesses to pass higher operating costs on to consumers as the principal concerns. Canadian inflation reached 3.1% in September, remaining above the bank’s 2% target.

• The Bank of Canada raised its policy interest rate to 2.5%, its first increase since July 2023, citing persistent energy prices and the risk of broader inflation.
• Canadian inflation reached 3.1% in September, while economic growth slowed and unemployment remained around 6.5%, complicating the monetary policy outlook.
• Economists at the C.D. Howe Institute questioned the rate hike, pointing to subdued core inflation, job losses and uncertainty surrounding US tariffs and the Middle East conflict.

Governor Tiff Macklem said the inflation outlook had worsened considerably since July, making tighter monetary policy necessary despite continuing uncertainty about economic growth.

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.

Tiff Macklem, Governor

The decision has also drawn criticism from economists who argue that subdued underlying inflation, weakening employment and the effects of US tariffs warranted keeping interest rates unchanged.

Bank of Canada raises interest rates as oil prices fuel inflation

The central bank’s decision comes amid sustained pressure on global energy markets following eight months of conflict in the Middle East, which began when the United States and Israel launched military operations against Iran.

Brent crude oil averaged $124.96 per barrel in October, approximately $35 higher than in July. Macklem warned that the prolonged conflict would keep oil prices elevated, affecting Canadian motorists and increasing transportation and production expenses for businesses.

Although higher energy costs have yet to spread extensively across consumer prices, the Bank of Canada reported mounting evidence that companies intend to transfer more of those expenses to customers.

Among consumer-facing businesses surveyed by the central bank, 60% expected to pass increased costs on to customers over the following 12 months.

The bank considers that behavior a potential source of persistent inflation, particularly if businesses begin adjusting prices in anticipation of continued high energy costs.

The October Monetary Policy Report identified the conflict in the Middle East and Canada’s uncertain trading relationship with the United States as major risks to the inflation outlook.

The central bank expects inflationary pressures to persist as businesses respond to higher input costs, even though the immediate effects of energy prices have remained relatively concentrated.

Canadian economic growth remains resilient despite US tariffs

Stronger-than-expected economic activity provided further support for the Bank of Canada’s decision to raise interest rates.

Canada’s economy expanded by 3.3% in the second quarter of 2026, with growth estimated to moderate to approximately 2% in the third quarter. Both figures indicated greater resilience than the central bank had anticipated in July.

Macklem attributed the improvement partly to solid consumer spending despite weak population growth. Business investment also recovered, supported by oil and gas activity and increased expenditure on machinery and equipment.

Canadian exports strengthened despite continuing difficulties in industries exposed to US trade restrictions.

“Despite ongoing weakness in sectors affected by US tariffs, exports overall have strengthened, bolstered by robust US demand, higher energy production and increasing signs that businesses are adapting to the changing trade environment,” Macklem said.

Canada’s unemployment rate has stayed near 6.5% in recent months, indicating persistent difficulties for unemployed workers seeking new positions.

The central bank also expects economic activity to weaken in the fourth quarter as additional US tariffs affect Canadian businesses.

Growth is projected to recover in 2027 following a period of weaker activity, although the outlook remains sensitive to trade developments and energy prices.

Macklem acknowledged that the combination of stronger inflation and economic uncertainty had reduced the scope for maintaining accommodative monetary policy.

Economists question whether the Bank of Canada should have held rates

Jeremy Kronick, president and chief executive of the C.D. Howe Institute, and Steve Ambler, the institute’s David Dodge Chair in Monetary Policy and professor emeritus of economics at the University of Quebec at Montreal, questioned the timing of the increase. They argued that the central bank had understandable reasons for tightening policy but should have maintained its previous rate given the available economic data and considerable uncertainty.

The possibility of a rate increase had become substantially more likely following Macklem’s October 17 briefing at the International Monetary Fund meeting in Thailand.

Before his remarks, financial markets assigned a relatively low probability to an October increase. Bloomberg data indicated that the implied probability subsequently climbed to almost 90%.

Investors responded to Macklem’s warning that oil prices had remained higher than anticipated in the bank’s July projections.

Kronick and Ambler acknowledged the potential consequences of prolonged energy inflation but argued that the projections did not necessarily establish a sufficient case for higher interest rates.

Their assessment focused on whether rising energy costs would produce persistent inflation across the wider economy or remain concentrated in particular components of consumer prices.

Bank of Canada’s Prima model points to persistent energy inflation risks

The central bank’s updated forecasting framework, known as Prima, provides a more detailed assessment of how economic shocks affect different sectors and eventually influence consumer prices.

A recent Bank of Canada study of the Prima model examined the different consequences of temporary and prolonged increases in energy prices.

Under a short-lived energy shock, headline inflation rises temporarily before returning toward its previous level, with limited effects on other consumer prices.

A sustained increase produces a different outcome. Businesses anticipating continued cost increases may adjust prices, causing inflation to remain elevated for longer.

The current environment appears more consistent with the second scenario, according to Kronick and Ambler.

Producer prices increased 14.5% in the year to September, while raw material prices rose 27% over the same period. Such increases can precede higher consumer prices as businesses absorb or pass through their rising costs.

Consumer inflation expectations have also increased.

The Bank of Canada’s October 19 consumer expectations survey showed that five-year inflation expectations had approached 4%, nearly matching elevated expectations for the following 12 months.

According to the economists, this was the first time since the inflation surge associated with the pandemic that longer-term expectations had reached such levels.

They considered the findings concerning because persistently elevated expectations could make inflation more difficult to control. The central bank’s delayed response during the previous inflationary episode also strengthened the argument for preventive action.

Core inflation and weaker employment support a cautious approach

Despite those risks, Kronick and Ambler argued that several indicators supported leaving the policy rate unchanged. Headline inflation increased only marginally in September, rising from 3% in August to 3.1%.

More importantly, the central bank’s preferred measures of underlying inflation declined over the same period. CPI-trim decreased from 1.9% to 1.8%, while CPI-median fell from 2% to 1.9%.

Both indicators are widely used to assess underlying inflation pressures and help anticipate price developments over the short and medium term.

Their relatively subdued readings suggested that higher energy costs had not yet generated broad-based inflation across the Canadian economy.

On October 20, the Parliamentary Budget Office published its updated economic and fiscal outlook, reducing its forecast for Canadian GDP growth in 2026 to 0.9%, compared with 1.1% in June. October 2026

The central bank separately estimated that new US tariffs, including measures scheduled to take effect on October 30, could reduce fourth-quarter economic growth to less than 1% if they remained in place.

Canada lost more than 40,000 jobs in August and nearly 70,000 in September. Many of those positions were full-time jobs, with substantial losses among workers aged 25 to 54.

For Kronick and Ambler, these developments indicated that considerable unused capacity remained in the economy. They argued that weaker demand and labor market conditions could restrain future price increases even if businesses continued facing higher energy costs.

Increasing interest rates under those circumstances risked intensifying the economic slowdown without necessarily addressing the underlying source of energy inflation.

Bank of Canada signals further interest rate hikes remain possible

The October decision leaves the Bank of Canada balancing two competing risks: persistent inflation resulting from elevated energy prices and weaker economic activity associated with trade restrictions and deteriorating employment.

Macklem indicated that the central bank was prepared to increase borrowing costs again if inflation pressures persisted. “There could be a need to raise the policy rate further, but given the uncertainties we will proceed carefully,” he said.

The outlook depends heavily on developments in the Middle East, the duration of elevated oil prices and the outcome of trade negotiations between Canada and the United States.

Kronick and Ambler maintained that these uncertainties strengthened the case for delaying monetary tightening.

In their assessment, subdued core inflation, continuing economic slack and the prospect of weaker growth outweighed the immediate justification for higher rates.

The economists also warned that the conflict involving Iran and the unresolved trade dispute with the United States made the outlook exceptionally difficult to assess. Their conclusion was that the Bank of Canada should have waited for clearer evidence of broader inflation before increasing its policy rate.

The central bank, by contrast, determined that the combination of resilient economic activity, higher inflation expectations and growing pressure on business costs justified preventive action, even as it acknowledged the possibility of further economic weakness.