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The Peace Tower is seen through the iron gates of Parliament Hill in Ottawa on March 19, 2015.Sean Kilpatrick/The Canadian Press

A new forecast warns that rising interest rates will ultimately produce larger deficits as the federal government faces higher borrowing costs on its $637-billion debt.

Canada's economy is now humming along, with new April GDP data showing a strong start to the second quarter. Several consecutive months of positive economic news have increased expectations that Bank of Canada Governor Stephen Poloz will start increasing interest rates in July, which is much sooner than most observers have been expecting.

But a new fiscal forecast from the University of Ottawa's Institute of Fiscal Studies and Democracy predicts higher-than-expected borrowing costs will throw off Finance Minister Bill Morneau's deficit projections over the coming years.

For the next three years, stronger-than-expected economic growth will be good news for Ottawa's bottom line. The report projects a deficit of $18.4-billion for 2017-18, which is an improvement over the $28.5-billion deficit forecast in the March, 2017, budget. But rather than continuing on a shrinking trend, as outlined in the budget, the institute says deficits will start getting bigger. By 2020-21, the institute estimates that deficits will be larger than current official forecasts.

"Federal government deficits are expected to rise quickly toward the end of the forecast after showing some improvement over the next few years," writes Randal Bartlett, the institute's chief economist. "The forecast for ever-increasing deficit over time suggests that the federal government would be wise to consider committing to a plan to return to more manageable budget balances."

The main reasons why the institute expects higher deficits are lower corporate profits due to moribund energy prices and rising debt service costs. Mr. Morneau's 2017 budget said the size of the federal debt would climb to $756.9-billion in 2021-22 from $616-billion in 2015-16. In spite of that increase, Ottawa expects the size of the federal debt as a percentage of GDP will decline slightly. The institute agreed with that claim.

The institute's report questions the federal government's approach to managing the federal debt, noting that Ottawa has recently shown a preference for short-term borrowing.

"The federal government has recently focused on issuing debt at relatively short-term maturities, thereby capitalizing on low borrowing costs when short-term interest rates were low," the institute's report states. "But given much of this debt is going to need to be rolled over in relatively short order and the Bank of Canada is expected to begin hiking rates as early as July, 2017, this strategy looks as though it may backfire."

The Liberal Party's 2015 platform promised to run three years of deficits – representing a combined total of $25.1-billion – before returning to balance in 2019-20.

Mr. Morneau's March budget laid out a plan to run six consecutive years of deficits between 2016-17 and 2021-22 worth a combined $142.8-billion in additional debt. Friday's forecast from the University of Ottawa estimates that total will be reduced to $131.1-billion over that period because of smaller deficits in the first three years.

At a news conference in Ottawa Tuesday, Mr. Trudeau was asked when he planned to erase the deficit. Mr. Trudeau did not answer the question.

"We're looking to grow the economy in ways that are going to benefit Canadians, and we're always going to be fiscally responsible in the decisions we make," he said.