Canada’s domestic economy will continue to be strong enough to offset a struggling trade sector, with real growth expected to reach 2.7% in 2005 and 3.2% in 2006, according to the latest economic forecast from RBC Financial Group.

“While the Canadian dollar has fallen from its high, its past appreciation will continue to weigh on net trade and overall economic growth in 2005,” says Craig Wright, vp and chief economist, RBC. “Nonetheless, we expect growth in the Canadian economy to accelerate in 2006 as the drag from trade diminishes.”

According to the report, Canada’s domestic economy has been running at full speed, offsetting the drop in net exports. Pent-up demand accumulated in the 1990s, favourable interest rates, solid labour markets and rising corporate profits have pushed growth in consumer spending and business investment to near decade highs.

“The brief rise in core inflation in early 2005 was more of a smoke screen than a danger sign,” says Wright. “The rise was nothing more than a temporary blip, since the Canadian economy is operating with some excess capacity, and the past appreciation of the Canadian dollar relative to the U.S. dollar is keeping downward pressure on pipeline inflation. However, we do expect inflation to reach the Bank of Canada’s target of two% by the end of 2006.”

RBC notes that the growth outlook for the United States is consistent with a slowing global economy, with real growth expected to moderate from 4.4% last year to 3.7% this year and 3% in 2006.

Despite operating with excess capacity, RBC notes that the U.S. economy has experienced a lift in core consumer price inflation from a low of 1.1% at the end of 2003 to 2.2% in May of 2005. More upward pressure on core consumer price inflation is expected given the recent weakness in the U.S. dollar, rising unit labour costs, heightened inflation expectations and signs of increasing pricing power for businesses. Ultimately, it says rising inflation is expected to dominate monetary policy with the U.S. Federal Reserve expected to lift the Fed Funds rate to 4% by year-end.

RBC expects Canada’s inflation environment to remain benign. The Bank of Canada is only expected to raise the overnight rate by 50 basis points to 3% by the end of 2005.

With the U.S. dollar approaching the end of its correction and U.S. short-term interest rates expected to continue climbing, short-term gaps between higher U.S. and Canadian rates will widen. RBC expects the Canadian dollar to retreat to a trading range of US77.5¢ and US80¢ over the next 18 months.

RBC Economics sees slowing economic growth in most of the world’s major regions.

Eurozone growth is likely to stay sluggish, RBC says. “Recent indicators point to real growth of 1.4% this year and 2% in 2006,” it says. Adding that, “cooling retail sales, housing prices and manufacturing activity hint at easing growth in the United Kingdom”, too.

China’s economy is also showing signs of slowing, based on slower growth in investment spending, RBC observes. It says pressure by the international community to revalue the yuan is going largely ignored.

Notwithstanding the general trend to slower growth in the U.S., Europe and China, RBC suggests that Japan’s economy is showing signs of a sustainable comeback, as disposable income and retail sales move higher.