BOGOTÁ--Colombia's central bank surprised financial markets Friday and increased interest rates after 12 months on hold, saying higher inflation and an improving economy means borrowing costs no longer need to be so low.

The bank's seven-member board said after its monthly meeting that it voted to lift its key interest rate 25 basis points to 3.5%. Economists widely expected the board to keep the rate steady at a near-record low of 3.25%, as low inflation and less-than-stellar growth rates forced the bank to keep monetary policy loose.

Many felt rate increases wouldn't be seen until around July or August.

In explaining its decision, which it noted wasn't unanimous, the bank said it no longer needs as expansive of a monetary policy as its had for the past year. As for critics who might say it has started raising rates too soon, when the economic recovery is still in its early stages, the bank said Friday's rate increase "will reduce the need for harsh adjustments in the future and will ensure macroeconomic stability."

"The macroeconomic outlook points to a continued increase in domestic demand at a good pace, and the economy will get near to its full productive capacity in 2014," bank President Jose Dario Uribe told reporters. Inflation, meanwhile, "has converged toward its target of 3%, " Mr. Uribe said.

Colombia's annual inflation last year was 1.9%, its lowest rate in decades, which is why the central bank maintained it was able to keep borrowing costs low throughout 2013 to try and spur economic growth. Economic activity fell below potential during the first two quarters of last year, to growth rates of around 4% on-year.

But economic activity began to rebound in the second half of last year, and full-year 2013 growth ended at 4.3%. The production of oil, Colombia's main export, remained strong at around one million barrels a day, and investment in public spending--mainly on much-need infrastructure projects--began to surge, helping to lift the economy.

Along with stronger growth late last year and so far in 2014, inflation is also picking up. Through March, annual consumer inflation was 2.5% compared with 2.3% at the end of February and 1.9% at the end of March 2013.

Colombia President Juan Manuel Santos said in an interview this week that the economy could grow at around 5% this year as investment spending remains robust. The bank's 2014 forecast is less optimistic, putting growth at around 4.3%, the same as last year.