Quick take

The Bank of Canada Raises Interest Rates by 75 Basis Points But is Not Done Yet

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  • The Bank of Canada increased its target for the overnight rate by 75 basis points to 3.25 per cent, with the Bank rate at 3.5 per cent and the deposit rate at 3.25 per cent.
  • The Bank is continuing its policy of quantitative tightening, which started in late April. This means that maturing Government of Canada bonds on the Bank’s balance sheet will no longer be replaced, resulting in the size of the balance sheet to decline over time. By August 31st, the Bank’s holdings of Government of Canada bonds had declined from around $418 billion in late April to $381 billion.
  • Even though CPI inflation eased in July to 7.6 per cent, the Bank’s core measures of inflation continue to move up (ranging from 5 per cent to 5.5 per cent in July). The Governing Council judges that the policy interest rate will need to rise further to bring inflation down to the 2 per cent target level.
  • Although GDP growth of 3.3 per cent in the second quarter was weaker than the Bank had projected, the Bank believes that the Canadian economy continues to operate in excess demand. The Bank also expects the economy to moderate in the second half of this year due to weakening global demand and tightening monetary conditions.

Key Insights

Interest rates are close to peaking after today’s 75 basis point increase. After several rounds of relatively heavy rate hikes by the Bank, the overnight rate is now 3.25 per cent, which is above the upper range of the Bank’s neutral range (2 to 3 per cent). This means that interest rates above 3 per cent will have a restrictive effect on the economy. The impact of these rate hikes is beginning to manifest through the economy, whether in real output, the housing market, business investment, or inflation expectations. Still, interest rates will take around 18 to 24 months to fully manifest themselves.

Going forward, the Bank will take a wait-and-see approach. Given the lag with which the effect of monetary policy plays out on the broader economy, as well as the cooling off of inflation and worse than expected second quarter GDP numbers, the Bank may take a break from rate hikes. It will take this time to re-evaluate the economy. It would be counterintuitive for the Bank to continue raising rates, especially above the neutral rate, if inflation shows continuous signs of easing and the Canadian economy faces a potential slowdown.

The economic slowdown in Canada’s largest trading partner could also force the Bank to ease its hawkish stance. The U.S. economy shrank in the second quarter by an annual pace of 0.6 per cent after declining by 1.6 per cent in the first quarter. Given how closely the two economies are tied together, it would be difficult to imagine a scenario where the U.S. economy continues contracting while Canada escapes one. In an economic downturn and even a possible recession, inflationary pressures will tend to ease as consumers reduce their consumption and businesses look for ways to save costs.

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Sasan Fouladirad

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