Sept. 24 (Bloomberg) -- Australia's inflation risks are ``on the upside'' and the Reserve Bank of Australia may have to increase interest rates, the International Monetary Fund said.

The IMF Article IV Consultation, released after talks with central bank Governor Glenn Stevens and Treasurer Wayne Swan in June and July, said the economy's capacity has become ``increasingly stretched'' and growth will slow.

``On inflation, the risks are clearly on the upside, reflecting capacity constraints, especially in the mining and housing sectors,'' the IMF said. ``Monetary policy should be tightened quickly if leading indicators suggest that domestic demand will not slow as expected or the outlook for inflation deteriorates.''

Australian central bank policy makers cut the benchmark borrowing cost to 7 percent this month for the first time in seven years because the risk of leaving the benchmark rate too high for too long outweighed the danger of stoking inflation, which climbed 4.5 percent in the second quarter.

Australia's commercial banks were sound, yet there are ``vulnerabilities'' in the financial system, the IMF said. Global financial turmoil swept Lehman Brothers Holdings Inc. into bankruptcy last week and prompted government takeovers of Fannie Mae, Freddie Mac and American International Group Inc. this month.

To contact the reporter on this story: Gemma Daley in Canberra at gdaley@bloomberg.net

Last Updated: September 23, 2008 17:50 EDT