Canada’s economy will be affected by the U.S. slowdown, but not mirror it, reported TD Economics on Monday in its Quarterly Economic Forecast.

A mid-business cycle slowdown will see U.S. economic growth dip to a modest pace of 2% before recovering. This will have a direct impact on the overall performance of the Canadian economy, resulting in a four quarter period where economic growth hovers within a sub-par 2%-2.5% annualized range, states the report, entitled U.S. Slowdown Underway, Canada in for a Bumpy Ride.

However, Canada will fare better than the U.S., according to Don Drummond, chief economist of TD Bank Financial Group. It is estimated that the Canadian economy can grow at a sustained pace of roughly 2.8% without causing inflation to rise or fall.

In the coming quarters, the pace of expansion will float in a 2%-2.5% range, which is slightly below the potential rate. This means that a bit of slack will build in the economy, but labour markets will remain solid.

The U.S. economic growth numbers will be similar to those in Canada, but they will be well below the U.S. estimated potential pace of 3.3%. So, “while the absolute economic growth numbers will be similar, the accumulation of economic slack will be far less in Canada and this demonstrates the relative outperformance of the Canadian economy.”

The weaker U.S. economy will impact Canadian industries in different ways. Canadian exporters will be negatively affected. Still struggling to adjust to the higher value of the Canadian dollar, they will now have to cope with weakened demand from their largest market. Any decline in shipments will lead to a reduction in production, and this will take an economic toll, as U.S. exports represent almost 30% of Canadian real GDP. As a result, the export-oriented manufacturing sector will bear the brunt of the fallout.

However Canada’s domestic economy will likely grow at a strong pace despite a gradual cooling in Canadian housing markets. Drummond attributes the positive trend to several factors: Consumer spending will remain buoyed by solid income growth and continued low unemployment; business investment will also remain robust, with purchases of machinery and equipment lifted by high levels of retained earnings and the reduced cost for imported capital when priced in Canadian dollars. As well, non-residential investment (i.e construction and expansion of commercial offices and plants) will be bolstered by strong balance sheets, moderate borrowing costs and tight capacity usage in many industries, providing an offset to weaker residential construction as housing cools.

TD Economics cites several implications related to Canada’s economic performance. The Bank of Canada and the U.S. Federal Reserve are expected to cut interest rates in early 2007. However, Canada’s relative outperformance of the U.S. economy suggests the Bank of Canada will be less aggressive in lowering interest rates, which TD Economics expects will be cut by 50 basis points in Canada compared to 100 basis points in the U.S.

The Canadian dollar will face a headwind due to weakening U.S. demand, and its corresponding global impact that will likely spark a pullback in commodity prices. However, the currency will receive offsetting support from two factors. First, the U.S. dollar is likely to weaken under the weight of the large U.S. current account deficit. Second, the Bank of Canada will cut rates less than the Fed, which is a positive development for the Canadian dollar. Overall, the Canadian dollar is expected to trade in a tight range of US87¢-US90¢ in 2007.

Much attention has also been paid recently to the rapid cooling in U.S. housing markets, but an analysis in the report concludes that this is unlikely in Canada.

“Bubbles form when prices rise without being supported by supply and demand considerations. However, Canadian home prices are largely being driven by strong demand growth, which has reflected the lowest unemployment rate in 30 years, personal income gains in the past three years, and attractive borrowing costs,” said Drummond. “Moreover, supply has also been hard pressed to keep up with demand, with the result that the inventory of unsold homes has remained tight. The opposite is true in the U.S.”