The Bank of Canada unexpectedly slowed its pace of interest-rate hikes as the nation’s economy flirts with recession, although sustained inflation meant it still expects to raise borrowing costs again.

Policymakers led by Governor Tiff Macklem hiked the benchmark overnight lending rate by 50 basis points to 3.75 per cent on Wednesday, less than the 75-basis-point move expected by markets and most economists. The central bank increased rates by three-quarters of a percentage point last month, and by a full percentage point in July.

While officials retained relatively hawkish language around combating inflation, the surprise move will raise questions about the central bank’s appetite to impose further damage on Canada’s economy. Other central banks may also look to their Canadian peer as they too try to work out how aggressively they need to keep tightening monetary policy. 

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The U.S. 10-year yield briefly dipped below 4 per cent after the Bank of Canada decision, which fueled speculation the Federal Reserve will pare back as well.

“This tightening phase will draw to a close. We are getting closer, but we aren’t there yet,” Macklem told reporters during a press conference after the decision.

Reaction from economists, however, was critical over a perceived communications misstep.

“The Bank of Canada is growing confident that its actions so far will be enough to vanquish inflation although, by doing less than markets were pricing in, the bank risks sending too dovish a message that it will eventually have to reverse,” Stephen Brown, senior Canada economist at Capital Economics, said in a report to investors.

The bank revised down its growth forecasts, predicting the economic expansion will stall and possibly even contract in coming months. The Bank of Canada also expects inflation will fall sharply to below 3 per cent by the end of next year -- within its target range for the first time since early 2021 -- as higher borrowing costs curb spending.

“Future rate increases will be influenced by our assessments of how tighter monetary policy is working to slow demand, how supply challenges are resolving, and how inflation and inflationary expectations are responding,” the bank said in the rate statement.

In a less dovish note, officials said inflation remains broad based, with data showing no “meaningful evidence” that underlying price pressures are easing. They again flagged risks of elevated inflation expectations becoming entrenched -- perhaps a signal they may be slowing the pace of hikes, but not the destination. And they cited the strength of the U.S. dollar as adding to global inflation.

The Bank of Canada reiterated that it estimates the nominal “neutral rate” for the economy to be about 2.5 per cent, suggesting rates are well into restrictive territory.

“We are resolute in our commitment to restore price stability for Canadians and will continue to take action as required to achieve the 2 per cent inflation target,” the bank said.

WHAT BLOOMBERG ECONOMICS SAYS

“The Bank of Canada’s smaller-than-expected 50-basis-point hike is difficult to square with pre-meeting communications, but better aligned with growing signs the economy is decelerating.”

-- Andrew Husby, economist

Still, the half-point increase means the Bank of Canada may be moving out of step with the U.S. Fed, which is expected to hike by 75 basis points next week. It’s a risky attempt at divergence that could weaken Canada’s currency, loosen financial conditions, drive up prices for imported goods and fuel inflation further.

The Bank of Canada also joins Australia’s central bank in easing off the brakes -- with officials in both countries sharing worries about the impact of higher rates on highly indebted households. The Reserve Bank of Australia ended its streak of half-percentage-point hikes on Oct. 4, opting instead to raise the cash rate by 25 basis points to 2.6 per cent.

Canadian policymakers have hiked interest rates by 3.5 percentage points since March, one of the most forceful tightening cycles in the central bank’s history. Traders in overnight swaps markets are still anticipating two more increases in the months to come, but with Wednesday’s smaller move they’re now expecting a terminal rate of 4.25 per cent, compared with 4.5 per cent before the decision.

In the rate statement, Macklem and his officials said tighter monetary policies globally are beginning to weigh on activity around the world. The Bank of Canada is now forecasting hardly any economic growth in the U.S. next year.

While the Canadian economy continues to operate in excess demand, the effects of higher borrowing costs “are becoming evident in interest-sensitive areas,” the bank said. “Economic growth is expected to stall through the end of this year and the first half of next year as the effects of higher interest rates spread.”

The central bank cut its gross domestic product forecast for 2023 by half to 0.9 per cent. It predicted economic growth will decelerate to an annualized 0.5 per cent pace in the fourth quarter of this year.

Separately, in detailed quarterly forecasts accompanying the decision, Macklem and his officials raised the prospect of a technical recession. “A couple of quarters with growth slightly below zero is just as likely as a couple of quarters with small positive growth,” the bank said in the Monetary Policy Report.

Wednesday’s smaller-than-expected rate hike comes amid an increasingly pitched political debate over monetary policy in North America. Macklem is taking fire both sides of the political spectrum in Canada. And the head of the U.S. Senate banking committee is calling on Chairman Jerome Powell to stay focused on employment as the Fed attempts to stabilize prices.

Officials in Canada may also be increasingly worried about growing financial stability risks associated with higher interest rates. In the MPR, the bank highlighted how “financial stresses” have increased globally.