Rising oil prices and the appreciation of the Canadian dollar are likely to slow economic the Bank of Canada said in the October Monetary Policy Report released today.

The report notes that the Canadian economy has grown faster than was projected in both April’s Monetary Policy Report and the July Update, largely because of a surge in exports. “It is now operating near its production capacity and continues to adjust to global economic developments,” the Bank says.

Given the effects of higher oil prices and the past appreciation of the Canadian dollar, the Bank projects economic growth to be slightly less than 3% in 2005, and slightly more than 3% in 2006.

The Bank predicts that aggregate demand for Canadian goods and services will expand, on average, at about the same rate as potential output between now and the end of 2006.

With the economy expected to remain near its production capacity throughout this period, core inflation is projected to move back up to the 2% target by the end of 2005, the Bank says. Coupling strong growth with higher oil prices, the Bank expects headline consumer inflation will rise to the top of its 1% to 3% target range in the first half of 2005, before falling slightly below core inflation in early 2006.

With these expectations of economic growth and higher inflation, the Bank raised interest rates earlier this week and expects to continue to do so. “To keep the economy near its production potential and to achieve the inflation target, further reduction of monetary stimulus will be required over time,” it says, noting that the pace of rate hikes will depend, “on the Bank’s continuing assessment of the prospects for factors that affect pressures on capacity and, hence, inflation.”

The Bank allows that there are significant risks and uncertainties to its outlook, including, “changes in commodity prices and exchange rates. The risks surrounding global economic prospects relate primarily to the evolution of oil prices, the pace of expansion in China, the way in which current account imbalances in the United States and East Asia will be resolved, and geopolitical developments.”