Interest rates could rise to 3% from 2.25% by the middle of next year.
Bank of Canada governor Tiff Macklem held the overnight interest rate at 2.25 per cent on Wednesday, but made it clear the central bank is prepared to act if inflation continues to be a problem. The Bank remains focused on bringing inflation back to its two per cent target.
“Inflation is running at three per cent. That’s too high. Our commitment over time is to deliver two per cent inflation,” Macklem said.
He also pointed to the ongoing conflict in the Middle East as another concern.
“The conflict in the Middle East is ongoing, it’s dragging on, there’s no clear resolution in sight,” he said. “The longer it goes on ... the greater the risk that higher energy prices start to spill into the prices of other goods and services. Then you get more generalized inflation.”
Wednesday’s decision was the Bank of Canada’s seventh consecutive rate pause, and it wasn’t a surprise to most economists.
What has changed, however, is the outlook for where rates could go from here. Some investors are now expecting rate hikes to begin sooner than previously thought, with interest rates potentially reaching three per cent.
The renewed trade tensions with the U.S. are also part of the picture. Macklem said that while tariffs will “hit targeted sectors hard,” the Bank does not expect them to have a major direct impact on the economy as a whole.
The odds of a 25-basis-point hike in December jumped to nearly 90 per cent on Wednesday through the overnight swaps market used by investors and financial institutions to manage short-term interest rate risks. That was up from about 60 per cent the day before the announcement.
Expectations for rate hikes in 2027 have also increased. Investors are now fully pricing in one 25-basis-point hike in January, with some betting on as many as three hikes by mid-year.
But not everyone thinks that outlook is realistic.
Royce Mendes, managing director and head of macro strategy at Desjardins Group, said the market may be getting ahead of itself.
“That seems excessive to me,” Mendes said. “There is a necessary amount of tightening that will eventually be justified by the data, but I would say the level implied by market pricing seems excessive.”
That doesn’t mean Mendes believes investors are completely wrong.
He expects 50 basis points of rate hikes during the first half of next year. His view is based on the Bank of Canada becoming more concerned that inflation could spread into other parts of the economy following the U.S. war on Iran, which recently entered its seventh month.
When the U.S. started its war on Iran in late February, investors quickly increased their expectations for rate hikes, believing Canada could face another round of inflation.
Mendes felt those predictions were too early at the time. Now, however, inflation concerns are once again building.
Investors are also watching the U.S. Federal Reserve closely. The odds of the Fed raising rates by 25 basis points at its next meeting on Sept. 16 have risen to 65 per cent, up from about 35 per cent.
Derek Holt, vice-president and head of capital markets economics at the Bank of Nova Scotia, also believes the market may not be as far off as some economists suggest. In fact, he thinks investors could actually be behind the curve.
A rate hike could be on the table at the Bank of Canada’s Oct. 28 meeting, when the central bank is also scheduled to release its latest Monetary Policy Report.
Macklem indicated during Wednesday’s press conference that the Bank’s next decision will be heavily influenced by the forecasts contained in that report.
For homeowners and buyers, the big question is whether these expectations become reality or whether inflation starts to ease and gives the Bank of Canada more room to hold rates where they are.