KINGSTON, Ontario - There remains a degree of untapped potential in the Canadian economy, particularly in the labour market, that means the country may be able to generate more growth without higher inflation, the head of the Bank of Canada said on Tuesday.

While interest rates are likely to move higher over time, the central bank cannot take a mechanical approach as policymakers cannot know in advance how far the capacity-building process can go but have an obligation to let it occur, Bank of Canada Governor Stephen Poloz said.

Although the labor market has become "a good deal" healthier over the past year, there is still some slack, Poloz said. Increased investment by existing and new companies and more turn-over in the labor market should create more supply in the economy through higher productivity and employment, he said.

As this process involves both upside and downside risks to inflation, the central bank will remain particularly data-dependent, Poloz said.

"If the economy builds more supply than usual, that will put downside risk on inflation; if less, that will create upside risk to inflation, and it is our job to balance those risks," Poloz said in prepared remarks of a speech.

The central bank has raised interest rates three times since last July and Poloz reiterated the bank will remain cautious in considering future moves.

Poloz said Canada is in the phase of the economic cycle where investment usually drives growth, calling it the "sweet spot" where companies will need to hire in order to boost sales.

Despite Canada's low unemployment rate, a wider range of indicators points to "a degree of untapped supply potential in the economy," Poloz said.

"This is important, for it means that Canada may be able to have more economic growth, a larger economy, and therefore more income per person, without generating higher inflation," he said.

Young people, women, recent immigrants and indigenous people are all sources of untapped potential that could increase the labor force by half a million workers and increase Canada's potential output by as much as 1.5 per cent a year, Poloz said.

Poloz noted that the bank is watching a number of other issues as well, including heightened uncertainty about future U.S. trade policies and the impact of higher interest rates on the economy.

But despite all the unknowns, "there is good reason to be optimistic about the Canadian economy," Poloz said.