Canada's central bank surprised market watchers with a 100-basis-point increase in its benchmark rate to 2.5%, the largest hike since 1998.

The move, putting Canada at the top of G7 nations for interest rates, is expected to continue to strain prices in the housing market, which have been dropping since hitting a peak in February.

"Inflation in Canada is higher and more persistent than the Bank expected," the Bank of Canada said in a statement.

The bank is estimating an 8% inflation rate over the next few months.

"Surveys indicate more consumers and businesses are expecting inflation to be higher for longer, raising the risk that elevated inflation becomes entrenched in price- and wage-setting. If that occurs, the economic cost of restoring price stability will be higher," the statement said.

Many economists had been expecting an increase of 75 basis points or even 50 basis points, but the Bank of Canada said it wanted to front-load the path to higher interest rates while continuing with its policy of quantitative tightening.

"Global inflation is higher, reflecting the impact of the Russian invasion of Ukraine, ongoing supply constraints, and strong demand. Many central banks are tightening monetary policy to combat inflation, and the resulting tighter financial conditions are moderating economic growth," said the statement.

The Canadian Real Estate Association, which represents real estate boards across the country, said deals for homes of all property types in May were down 21.7% from a year ago, and local statistics for June indicate prices and activity continue to decline in major markets such as Vancouver and Toronto.

For May, the average existing home sold for $711,000 across the country, up 3.4% from a year ago but well below the peak of $816,720 in February.

Canada Mortgage and Housing Corp., which advises the federal government on policy, warned this week that rising rates would make homeownership more challenging. It predicts prices could drop from 3% to 5% by mid-2023, depending on how aggressive the central bank gets with rates.

Canadian Imperial Bank of Commerce economist Karyne Charbonneau noted the Bank of Canada's increase follows a move by the U.S. Federal Reserve to raise its rate in June.

"The Bank of Canada reclaimed its top gun status, with the highest policy rate among G7 countries and the biggest step in this tightening cycle, as it seeks to calm inflation fears," said Charbonneau in an economist note.

Benjamin Reitzes, managing director of Canadian rates and macro strategist with the Bank of Montreal, said the central bank shocked the market by going to 100 basis points.

"Surging inflation and rising inflation expectations prompted today's surprise 100 basis point rate hike from the Bank of Canada," Reitzes said in an investor note. Policy rates are poised to climb further, with Bank of Canada's Gov. Tiff Macklem suggesting that rates are headed to the "top end or slightly above the neutral range," said Reitzes.

Reitzes added that the Bank of Montreal anticipates the Bank of Canada will hike rates another 50 basis points in September, but a larger increase "could be in the cards given today's move."

Carl Gomez, chief economist and head of market analytics for Canada at CoStar, said the size of the rate hike was also a bit of a surprise.

"The Bank is under the gun right now as it needs to firmly demonstrate to the market that it will get ahead of the curve" on inflation, Gomez said. "But some perspective is needed. First, while rates are moving higher, they aren't high, at least from a historical perspective. Second and more importantly, there are reasons to believe that inflation has already peaked, while the economy, especially in Canada, has little capacity to withstand materially higher interest rates without slipping back into recession. My bet is that by the end of next year, we might be talking about rate cuts again."

The move may also continue to drive consumers into the surging rental market because they cannot finance housing, said Ben Myers, president of Bullpen Research and Consulting.

"It will likely further depress housing prices, too," said Myers in an interview. "People expect housing prices to continue to go down, and they will just like they did when they expected them to go up."

At the same time, the drop in purchaser demand is coming with rental demand surging and the average monthly rent up 9.5% year over year in June across the country for all property types to $1,885 per month. June rental rates are still 3.5% lower than the pre-pandemic rate of $1,953 per month in June of 2019.

"If you locked into a rental rate during the pandemic and are now covered by rent control, you are not going anywhere," said Myers, noting Ontario has capped most rental increases at 2.5%.