Growth in the economy will put pressure on inflation and interest rates, according to ecnomists at Toronto Dominion Bank.

In its quarterly economic review, the bank said Canada’s economy will expand at average annual rate of 3.5% over the rest of this year and next, before cooling to slightly more than 3% in 2006.

As the Canadian economy uses up its unused capacity, the Bank of Canada is expected to raise it key overnight interest rate from the current 2.25% to 2.75% by the end of this year. Rates are forecast to rise to 4% in 2005 and 4.75% the following year, TD said.

“The good news is that the moderate pace of growth means that the risks of monetary authorities falling behind the curve are relatively low and that monetary policy can be tightened in a gradual fashion,” said TD Bank chief economist Don Drummond.

TD said it sees the consumer price index touching 1.9% in 2005 and 1.8% in 2006.

The U.S. dollar, meanwhile, will continue to come under pressure due to the big current account deficit south of the border, TD said. With the U.S. dollar under fire, the Canadian dollar expected to appreciate to US83¢ in 2006.

The bank cautioned that there are several factors that could affect its forecast, including continued high oil prices, the cost on consumer finances of rising interest rates, a softening housing market and a big drop in the U.S. dollar due to that country’s current account deficit.

The Bank of Canada will announce its next decision on interest rates on October 19, two days before it releases its latest outlook for the Canadian economy.