As expected, the Bank of Canada hiked its key interest rate by a quarter point to 4.5 per cent, the first rate hike since May 2006.

The bank also signalled that future rate increases will likely happen. Its next official interest rate announcement is on Sept. 5.

"Some modest further increase in the overnight rate may be required to bring inflation back to the target over the medium term," said the bank. 

Tuesday's increase will spark higher borrowing costs for financial products from car loans, to mortgage rates, to floating lines of credit.

Financial institutions are already reacting to the hike, with many increasing their prime lending rates 25 basis points to 6.25 per cent. Longer-term products, like five-year fixed mortgages, are unlikely to rise, with current posted rates at about 7.25 per cent.

"We remain comfortable with our view that another 25 basis-point hike will likely be necessary in September followed by another similar-sized move before the end of the year. One final rate increase is expected early in 2008, bringing the overnight rate to a near-term peak of 5.25%," said RBC Financial Group in a daily economic report.

The Bank of Canada said it upped rates Tuesday because the economy as well as inflation have been growing more than anticipated over the first half of the year.

"Both total [inflation] and core inflation have been higher than projected in April and are above the two per cent inflation target," said the bank in a statement.

The bank expects core inflation to drop to two per cent by early 2009.

It also projected that the Canadian economy will grow 2.5 per cent this year, a somewhat stronger performance than it forecast in April.

As well, the bank said that Canada's economy is set to grow more slowly in 2008 and 2009.

"Final domestic demand has remained the key driver of economic growth in Canada, bolstered by firm commodity prices," it added.  

The rate increase didn't bolster the Canadian dollar Tuesday. It closed the official trading day at 95.10 cents US, down 0.17 cents from Monday's close.

The bank also projected that the dollar would trade in a range of 93 to 95.5 cents US for 2008 and 2009.

Recently, the loonie has been flirting with 30-year highs. Many economists expect it to reach 96 cents by the fall, and perhaps even reach parity by the end of the year.

Looking ahead, market watchers are waiting for more clues about the direction of interest rates from the Bank of Canada's closely watched Monetary Policy Report Update, which comes out on Thursday.