The Bank of Canada warned today that interest rates must go up to keep inflation under control as the economy continues to grow.

In its latest update on the state of the Canadian economy, the central bank said growth is still expected to be 2.75% for this year. That figure is unchanged from the bank’s previous outlook released in April.

But growth for 2005 is predicted to hit 3.5%, down slightly from the 3.75% the bank forecast back in April.

The bank said the economy will hit its production capacity by mid-2005, prompting Bank of Canada governor David Dodge to caution that interest rates will have to go up in the future.

“As economies approach their production capacity, monetary stimulus must be removed to avoid a buildup of inflation pressures,” Dodge said.

Higher-than-expected world oil prices mean that total consumer inflation is likely to remain above 2% through the rest of this year, before falling slightly below core inflation in the second half of 2005, the bank said.

Core inflation – which excludes several volatile factors such as energy and food – is projected to remain just above 1.5% for the rest of 2004, before gradually moving back up to the 2% target by the end of 2005.

On Tuesday, the Bank of Canada left its key overnight rate at 2%. Economists generally expect the central bank to raise the overnight rate in September.