Interest rates are going up, again, as Canada’s red-hot economy continues to defy expectations.

After a summer of surprisingly good economic news, the Bank of Canada raised its benchmark interest rate a quarter of a percentage point to 1 per cent Wednesday – its second rate hike in less than two months and a prelude to higher borrowing costs for Canadians.

Major lenders, including Royal Bank of Canada, responded by raising their own prime lending rates by the same amount – moves that could squeeze the most heavily indebted Canadians and discourage others from buying homes.

The earlier-than-expected move caught investors and analysts off-guard, sending the Canadian dollar up to nearly 82 cents (U.S.) and raising expectations of more hikes this year. The dollar is now up about 14 per cent since hitting a low for the year of roughly 73 cents in April.

Bank of Canada Governor Stephen Poloz and his central bank colleagues acknowledged they have been taken aback at the strength of the economy, which surged ahead at an annual pace of 4.5 per cent in the second quarter to lead the Group of Seven countries. As recently as July, the central bank said GDP growth would reach just 2.5 per cent in the second quarter.

“Recent economic data have been stronger than expected, supporting the bank’s view that growth in Canada is becoming more broadly based and self-sustaining,” the bank said in a generally upbeat overview of economic conditions. “The level of GDP is now higher than the bank had expected.”

That’s because a lot is suddenly going right for the Canadian economy, which has often sputtered since the 2008-09 recession and the 2015 oil price collapse. Consumers are spending, employers are creating jobs at a healthy clip and businesses are cranking up investments and exports.

Wednesday’s rate decision reinforces the message that the era of easy money and low rates is coming to an end in Canada. The central bank’s overnight rate generally sets the pattern for mortgages, bonds and deposits.

The Bank of Canada may not be done. Economists are already bracing for further hikes if the economy continues to show strength through the rest of the year.

“Absent a significant shock, [Wednesday’s] rate increase will be part of a larger and longer march towards rate normalization,” Toronto-Dominion Bank economist Brian DePratto said in a research note.

Bank of Nova Scotia economist Derek Holt applauded the central bank for doing “the right thing” and said the door is “wide open to further rate hikes.”

But there are limits on how far and fast the Bank of Canada can get its benchmark rate back to a more normal level.

Rising interest rates will reverberate through the housing and consumer-lending markets, squeezing homeowners who have taken on record debt levels to buy homes and fuel spending.

Low interest rates have made it easier for consumers to repay their loans.

The delinquency rate for mortgages and other consumer debt has declined over the past year. Even in the country’s hottest real estate markets of Toronto and Vancouver, the delinquency rate on mortgages has dropped, according to a second-quarter report from TransUnion, which was conducted before the central bank’s first rate hike this year.

“It takes time for this to filter its way through,” said Paul Smetanin, president with the Canadian Centre for Economic Analysis. “Households have an incredible ability at delaying the inevitable. There is a time lag. This time next year, it would not surprise us to see delinquency rates higher. It will be consumer debt before mortgages.”

The Bank of Canada warned Wednesday that it is keeping a close eye on how higher lending rates will affect the behaviour of Canadians.

“Given elevated household indebtedness, close attention will be paid to the sensitivity of the economy to higher interest rates,” the bank said.

Central bank officials have fretted in recent years about risky borrowing by some Canadians, warning what might happen if borrowing costs rise sharply or house prices fall. The bank has repeatedly warned about overheating in housing markets in Southern Ontario and B.C.

Inflation also remains an enigma for the central bank. Prices are rising at significantly below the bank’s 2-per-cent target. The bank pointed out in its statement that wage and price pressures are more subdued than normal in all developed countries.

The higher Canadian dollar will also help cool the economy by making exports less competitive in key markets.

The bank isn’t tipping its hand on what it will do next, or when. Future rate hikes are not “predetermined and will be guided by incoming economic data and financial market developments,” the statement said.

The bank’s next scheduled rate-setting is Oct. 25, when the bank is also due to release its quarterly forecast.

Financial markets had priced in a roughly 50-50 chance of a rate hike this week. But the vast majority of economists surveyed by Bloomberg still believed the Bank of Canada would wait until October.

At 1 per cent, the bank’s key interest rate is now exactly where it was in January, 2015 – before the central bank made two emergency rate cuts to deal with the aftershocks of the oil price collapse. Back in July, the Bank of Canada increased its key interest rate for the first time in seven years, saying the economy was now strong enough for it to unwind that rate relief.​

BARRIE MCKENNA, National Business Correspondent
The Globe and Mail, September 6, 2017