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OTTAWA — The Bank of Canada announced another hike to its key policy rate of half a percentage point, in an attempt to rein in decades-high inflation rates while facing stalled economic growth. 

Here's what to know about the connection between interest rates, inflation and recessions.

What is the key policy rate and what does it do?

The key policy rate, also known as the target for the overnight rate, is how much interest the Bank of Canada wants commercial banks to charge when lending each other money overnight to settle daily balances. Knowing how much it costs to lend money, or deposit it with the central bank, helps set the interest rates charged on things like loans and mortgages.

Lowering the key rate makes it cheaper to borrow and spend, usually during economic downturns when inflation rates are too low, with the goal of creating growth. When inflation rises above the Bank of Canada's comfort zone of two per cent, it raises the rate to cool spending. 

In a news conference Wednesday, Bank of Canada governor Tiff Macklem noted that home prices have dropped since it began raising interest rates, and the central bank is now seeing less spending on big-ticket items such as cars that people typically borrow money to pay for.

What is happening with inflation?

Inflation numbers have begun to stabilize after 10 consecutive months of hikes. In the last three months, customer price index (CPI) inflation has declined from 8.1 per cent to 6.9 per cent, primarily due to a fall in gasoline prices. Food prices, on the other hand, were up 11.4 per cent year over year, increasing at the fastest rate since August 1981.

Statistics Canada's latest CPI report said unfavourable weather conditions contributed to food price increases, along with higher prices for inputs such as fertilizer and natural gas, and global instability stemming from Russia's invasion of Ukraine.

The Bank of Canada said it expects the rate hikes to help rebalance supply and demand and ease inflation, as the bank predicts the inflation rate will decline to around three per cent by the end of 2023, and then return to the two per cent target by the end of 2024.

Will interest rates continue to rise?

Macklem said at the news conference that the bank expects its policy rate will need to rise further. Another "large increase" of a half-percentage point or more could be on the table, he said, and there are no "easy outs" in restoring price stability.

However, it is very unlikely Canada will see another full percentage hike as seen on July 13, as the 0.5 per cent rate hike was smaller than some economists predicted, signalling the bank is nearing the end of one of the fastest monetary policy tightening cycles in its history.

"How much further will depend on how monetary policy is working to slow demand, how supply challenges are resolving and how inflation and inflation expectations are responding to this tightening cycle," Macklem said.

Could Canada be heading toward a recession? 

While a technical recession is defined as two consecutive quarters of negative economic growth, the bank says it's projecting zero to 0.2 per cent economic growth towards the end of this year and into the beginning of 2023, signalling that the stall in growth could appear functionally the same whether it's slightly above zero or slightly below zero. 

The bank does see growth returning by the second half of next year, with expectations for one per cent growth for all of 2023. It's projected to pick up slightly in 2024, reaching a modest two per cent. 

— With files from Adena Ali

This report by The 91Ô­´´ Press was first published Oct. 26, 2022.

The 91Ô­´´ Press