The central bank's decision signalled a more aggressive approach to bringing skyrocketing inflation, which hit a 39-year-high of 7.7% in May, back down to its target of 2%.
Bank of Canada governor Tiff Macklem said the oversized rate hiked reflected "very unusual economic circumstances."
"Inflation is too high, and more people are getting more worried that high inflation is here to stay," Macklem said.
"We cannot let that happen. Restoring price stability—low, stable and predictable inflation—is paramount."
Macklem said higher interest rates will add to the difficulties that Canadians are already facing with high inflation, but if inflation becomes entrenched it will be more painful for the economy—and for Canadians—to get it back down.
In its latest monetary policy report, the Bank of Canada said inflation in Canada is "largely the result of international factors," but that "domestic demand pressures are becoming more prominent."
Most economists had forecasted a rate hike of three-quarters of a percentage point.
Tu Nguyen, an economist with accounting and consulting firm RSM Canada, said that while the rate announcement may have come as a surprise, it isn't unreasonable given the rate of inflation, rising inflation expectations and the tight labour market.
"As unsettling as this news is for consumers and businesses alike, an economy-wide recession is still unlikely in 2022," said Nguyen, adding that economic indicators still point to a healthy economy.
After raising interest rates by half a percentage point in June, Macklem said the central bank "may need to move more quickly" to bring inflation down.
The rate hike Wednesday brings the Bank of Canada's target for the overnight rate to 2.5% and is expected to prompt the commercial banks to raise their prime rates which will increase the cost of loans linked to the benchmark such as variable rate mortgages and home equity lines of credit.
In a note, CIBC senior economist Karyne Charbonneau said the Bank of Canada raising its key rate to a peak of 3.25% is now more likely.
"With the Bank of Canada qualifying this larger step than anticipated as 'front-loading,' we still believe they could stop at three per cent, but the risks that the peak reaches 3.25% have increased,'' Charbonneau said.
The central bank said the largest drivers of global inflation are the Russian invasion of Ukraine and ongoing supply disruptions, leading to higher global energy and food prices.
Statistics Canada is expected to release Canada's inflation data for June on July 20.
The Bank of Canada said "further excess demand has built up," allowing businesses to pass more of their cost increases on to consumers.
The unemployment rate fell to a record-low of 4.9% in June as businesses continue to struggle with an ongoing labour shortage.
The central bank is also citing concerns about rising inflation expectations among consumers and businesses. Economists generally worry when people begin expecting high inflation, as those expectations then feed into future prices set by business and wage negotiations.
"The bank is guarding against the risk that high inflation becomes entrenched because if it does, restoring price stability will require even higher interest rates, leading to a weaker economy," said the central bank.
In its forecast, the Bank of Canada expects GDP growth to begin to slow this year, growing by 1.75% in 2023 and 2.5% in 2024.
It's also forecasting inflation will remain at 8% over the next few months and begin to decline toward the end of the year and reach its target rate in 2024.
The central bank's projections assume that globally, oil prices will gradually decrease, and supply chain disruptions will ease.
"The governing council continues to judge that interest rates will need to rise further," the Bank of Canada said in its decision, adding that the pace of these rate hikes will depend on the central bank's assessment of the economy and inflation.