The Bank of Canada has increased its outlook for economic growth this year to 3.1%.

That’s strong enough to require further interest rate hikes in the coming months.

Canada’s economy “is operating at its production capacity,” the Bank of Canada says. “Some modest further increase in the policy interest rate would be required.”

The consumer price index and core inflation should return to the 2% target by the first half of 2007.

Risks to the bank’s projection remain balanced for 2006 and tilted to the downside through 2007 and beyond.

Although better growth is expected this year – 3.1% compared with last October’s forecast of 2.9% for 2006 – slower U.S. demand next year plus higher interest rates will weigh on growth in 2007, the bank says.

That has led the central bank to trim its projections for 2007 growth to 2.9%, down a bit from last fall’s forecast of a 3% expansion next year.

In the U.S., Canada’s largest trading partner, economic growth should average 3.6% this year, but that will slow to 3.1% in 2007.

The Bank of Canada raised its key policy interest rate by 25 basis points at each of the last four fixed announcement dates, bringing the target for the overnight rate to 3.5%.

In line with the bank’s base-case projection and the current assessment of risks, “some modest further increase in the policy interest rate would be required to keep aggregate supply and demand in balance and inflation on target over the medium term.”