The Bank of Canada raised its key interest rate by 25 basis points Tuesday and signalled that more rate hikes are coming.

The widely expected increase in the central bank’s overnight lending rate, now at 3%, was the second in as many months.

“Given that the Canadian economy now appears to be operating at capacity, some further reduction of monetary stimulus will be required,” the Bank of Canada said in a release. That likely means higher interest rates are on the way.

The Bank said high energy prices will cause inflation to average close to 3% until the second half of next year, when increases in the Consumer Price Index and core inflation, which excludes volatile items like energy, are expected to ease to 2%.

The Canadian economy, it said, “will continue to operate at about its production potential through 2007.”

News that further interest rate increases are likely gave an immediate boost to the Canadian dollar, which surged a fifth of a cent to US85.01¢.

Canadian banks quickly moved to raise their prime lending rates by a quarter of a percentage point to 4.75%.

The next interest rate announcement from the Bank of Canada comes on December 6.