By Promit Mukherjee

OTTAWA (Reuters) -Canada’s annual inflation rate showed a surprise jump to 2.6% in February, surpassing expectations as a sales tax break that ended in the middle of last month pushed prices higher amid an already broad-based increase, data showed on Tuesday.

Higher-than-expected inflation highlights the difficult position Canada’s economy is in as U.S. tariffs take effect. The central bank had cut interest rates last week amid economic uncertainty.

This is the first time in seven months that the rate of increase of consumer prices has crossed the 2% mark, the mid-point of the Bank of Canada’s target range of 1% to 3%. In January, inflation was at 1.9%. The February inflation figure was the highest in eight months, Statistics Canada said.

Without the tax break, inflation in February would have been 3%, it said.

The inflation number expanded currency market bets for a pause in the interest-rate-cutting cycle next month to over 62% from 58% before the numbers were released.

The Canadian dollar firmed after the data and was trading up 0.06% at 1.4283 to the U.S. dollar, or 70.01 U.S. cents. Yields on the two-year government bond surged by 5.7 basis points to 2.596%.

On a month-on-month basis, prices rose by 1.1% in February from 0.1% the prior month, Statscan said.

Analysts polled by Reuters had forecast the yearly inflation at 2.2% and 0.6% on a monthly basis in February. The BoC had said last week that it expected inflation to reach 2.5% in March amid price pressures due to tariff-related uncertainty.

Economists, analysts and businesses expect prices to keep rising further due to U.S. tariffs and retaliation from Canada, making the Bank of Canada’s job difficult.

“The unexpected pickup in core measures isn’t good news as this doesn’t yet reflect the impact of tariffs,” Katherine Judge, economist at CIBC Capital Markets wrote in a note.

In an interview with Reuters after announcing a seventh consecutive cut in interest rate to 2.75%, BoC Governor Tiff Macklem said that the BoC cannot let the “tariff problem become an inflation problem,” underscoring the need to tread carefully with interest rates.

Royce Mendes, Managing Director and Head of Macro Strategy said in a note that the BoC should take a pause in interest rate cuts “driving home the point that containing inflation remains the central bank’s number one job.”

While prices increased across almost the entire CPI basket, the major jump was in food purchased at restaurants, some clothing items and alcohol after the tax reprieve was lifted.

“Restaurant food prices contributed the most to the acceleration in the all-items CPI in February,” Statscan said.

Food prices increased 1.3% year over year while clothing and footwear increased by 1.4% on a yearly basis. Other items that added to price pressures in the CPI basket were transportation, which jumped by 3%, and shelter costs, which were up 4.2%.

Economists have said that the sales tax break had distorted overall inflation numbers, and that core inflation was a more accurate gauge of consumer price trends.

The BoC has two preferred measures of core inflation: CPI-median and CPI-trim.

CPI-median, or the centermost component of the CPI basket when arranged in an order of increasing prices, rose to 2.9% in February. CPI-trim, which excludes the most extreme price changes, was also up to 2.9%. Both were at 2.7% in January.

(Reporting by Promit Mukherjee; Editing by Dale Smith and Mark Porter)

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