The economies of Canada and the United States will deliver a lacklustre performance in the near term, but growth will revive once war fears dissipate, say TD economists.

“The uncertainty over a conflict in Iraq and the war against terrorism has roiled equity markets, dramatically increased energy prices, reduced consumer confidence and made businesses reluctant to invest — dampening the pace of economic growth in the United States and Canada,” said Don Drummond, senior vice president and chief economist at TD Bank Financial Group. Drummond was commenting on the latest edition of the TD Quarterly Economic Forecast released Monday.

“However, this soft patch will pass once the cloud of uncertainty lifts, with economic growth in the United States and Canada likely to rebound in the second half of this year,” he added.

According to TD, the key factor weighing on the U.S. economy is the uncertain fallout from a potential conflict in Iraq. If a war occurs, crude oil prices could spike temporarily into a range of US$40-50, further reducing discretionary spending and potentially curtailing investment. Military action could also further undermine consumer and business confidence. “However, barring a worst-case scenario, the negative fallout from a conflict is likely to prove limited and is unlikely to push the U.S. economy back into recession,” said Drummond.

Once the war-related uncertainty diminishes, the U.S. economy will snap back predicts TD. The U.S. manufacturing sector is no longer contracting, business investment is slowly gaining traction and consumers are keeping their wallets open. TD says the U.S. economy will also get a boost from the Bush administration’s economic stimulus package, which is expected to be passed by the end of the summer. “With the U.S. Federal Reserve likely to keep interest rates unchanged until it sees signs of a firming economy, the monetary and fiscal kick together will help to lift U.S. economic growth north of 4% in the second half of this year,” said Drummond.

The Canadian economy is holding up well according to TD, although the weak state of the U.S. economy is dampening Canadian exports.

With household spending running at a healthy clip, fuelled by low interest rates and previously strong job growth, and business investment on the rise, supported by a strong recovery in corporate profits, TD forecasts that Canadian economic growth will head north of 3% again once conditions in the U.S. economy improve. As a result, Canadian real GDP is expected to return to above its long-term potential rate in the second half of this year.

TD says the Bank of Canada and is likely to deliver further interest rate hikes this year. Although a conflict in the Middle East and weaker domestic economic conditions in the near term could lead the Bank to pause in its policy tightening cycle, perhaps leaving rates unchanged at the April and June policy announcement dates, there is little doubt that interest rates are headed higher. “Look for the Bank’s overnight rate to hit 4% by the end of this year — a full percentage point higher than today. That will significantly reduce the amount of monetary stimulus, both through higher interest rates and a stronger Canadian dollar, but it will not forcibly apply the brakes to the economy,” said Drummond.

As for the Canadian dollar, TD says the loonie is expected to benefit from widening interest rate spreads relative to the United States, a rising trend in commodity prices, a large Canadian current account surplus and a weakening in the U.S. dollar. “Although some profit-taking on the loonie is possible in the near-term, the Canadian dollar is conservatively expected to reach 69 U.S. cents by the end of the year,” said Drummond.