Canada’s economy is expected to grow 2.7% in 2004 and accelerate to 3% in 2005, according to the latest economic forecast from RBC Financial Group.

A report from Scotia Economic, also released today, forecast the Canadian economy to grow at only 2.5% in 2005, lagging U.S. performance by half a percentage point.

RBC’s forecast is more optimistic. “Canada’s economy weathered the rapid appreciation of the Canadian dollar in 2004 and the recent slowing in world economic growth with surprising resilience,” said Craig Wright, vp and chief economist, RBC, in a release. “Looking ahead, several key factors point to healthy economic growth for Canada in 2005, despite the continued challenges of a strong currency.”

According to the RBC report, growth is expected to come from the strength in consumer spending and business investment, with the Canadian consumer poised to keep on spending well into 2005 thanks to solid labour markets and rising incomes.

RBC says Canada’s government sector also appears to be in good shape to support overall economic activity given its solid fiscal position.

The strong Canadian dollar is expected to weigh on Canada’s trade sector in 2005. An ongoing low inflation environment also suggests the Bank of Canada will not lift rates again until the fourth quarter of 2005. RBC notes the Canadian dollar will likely move to a range around US$80¢ by the end of 2005.

As for the U.S. economy, RBC forecasts growth of 4.4% in 2004, with growth expected to ease to 3.7% in 2005. Most sectors of the U.S. economy are expected to slow down in 2005, with consumer spending leading the way lower.

Although U.S. business investment may slow down temporarily as government incentives come off in early 2005, it is expected to rebound alongside strengthening business confidence and provide a boost to the labour market by year-end. Furthermore, by the end of 2005, additional household income is expected to go towards increasing savings in response to rising import prices and falling export prices.

According to the RBC report, the U.S. government sector will also contribute to slower growth, as the unsustainably large U.S. fiscal deficit is put on a more stable footing.

Aside from another sustained rise in oil prices and a weaker trade sector in Canada, one of the most important risks to the outlook is a sharper rise in U.S. core consumer price index figures and sharply higher interest rates. This would come as a result of a more excessive response to rising commodity prices, a falling U.S. dollar, and a decade-high rise in pricing power by corporations.

“Should inflation expectations rise in 2005, higher prices in the goods sector could spread through the entire economy more quickly and push the Fed to lift rates at a more aggressive pace,” RBC says.

In the absence of these risks, RBC says it expects the Fed to lift U.S. rates at a measured pace to 3.25% by the end of 2005 and the Bank of Canada to lift the overnight rate to 3%.