"Staff has advised the authorities to be mindful of the limits to implementation capacity and potential inflationary pressures as reconstruction efforts proceed," the IMF said in a country report released Wednesday.
Inflation measured by the Colombo Consumers' Price Index is forecast to hit 12% by the end of this year, based on a 12-month moving average, up sharply from 7.6% at the end of last year.
The Asian tsunami in December left a trail of destruction along the island's coast, and the government has estimated reconstruction spending at more than $ 500 million this year.
Spending on reconstruction may further drive up inflation, which had picked up before the tsunami because of high international oil prices and government spending, the IMF said.
The fund said action to curb inflation may require a hike in interest rates.
"In this context, it is likely that the authorities will need to be prepared to increase interest rates in the course of 2005 to meet monetary policy and inflation objectives," it said.
The Central Bank of Sri Lanka has held key interest rates unchanged since November despite indications that money supply grew at a faster-than-targeted 20% last year.
This month, the IMF approved $157.5 million in emergency assistance to Sri Lanka at an annual rate of interest of 0.5% to help the country meet "immediate balance-of-payments financing needs, and maintain or restore macroeconomic stability."
The loan carries a low rate of interest, as it comes after a natural disaster - it has to be repaid in eight quarterly installments over 3 1/4 to 5 years from the disbursement date.
The IMF said the tsunami will drive up government spending and additional revenue measures might be needed if the government is to stick to its budget deficit target, which has risen to 9.6% of gross domestic product, from 7.5% before the tsunami.
"Staff's view is that additional measures equivalent to about 1.25% of GDP would still be required to meet budget targets," the report said, though debt relief by creditor countries would provide some support to the budget.
Last year, the government raised $250 million in dollar-denominated bonds from domestic commercial banks to bridge the budget deficit, but the IMF said the government hadn't announced any plans to issue further bonds this year.
-By Chamath Ariyadasa, Dow Jones Newswires; 9411-2304-942; chamath.ariyadasa@ dowjones.com
-Edited by Hilary Mc Cully
Dow Jones Newswires