Canada’s economy is expected to grow by 3.1% in 2004 and 3.6% in 2005, according to the latest economic forecast from RBC Financial Group.

According to the RBC report, real GDP growth rates have peaked in several major economic regions around the world, and over the remainder of 2004 and into 2005, rising interest rates will dampen growth levels across the G7.

RBC notes Canadian consumers will outspend Americans as household net worth and incomes continue to rise in 2005, a situation that will offset weakness on the trade front. However, a strong Canadian dollar — which is expected to rise to approximately US80¢ by the end of this year — combined with sub-par consumption growth in the U.S., will squeeze net exports. The trade sector is expected to be a drag on growth until the end of 2005.

On Tuesday, the Canadian dollar closed at an 11-year high, rising 0.70 of a cent to US79.27¢.

“Household debt levels have been growing quickly but have yet to put a dent into spending because assets have been rising faster and the debt-service- burden has been falling,” said Craig Wright, vice-president and chief economist, RBC, in a release. “Business profit growth is expected to slow, but it will remain strong enough to foster double-digit gains in machinery and equipment investment in 2005.”

RBC notes core inflation is expected to remain better contained than in the United States. This is because the pressures driving up consumer price index inflation in the U.S. do not exist here. “We expect the gap between Canadian and U.S. rates to close as U.S. rates move higher in response to a more threatening inflation environment,” added Wright.

Growing inflationary pressures at various stages of production, a return of corporate pricing power and further U.S. dollar depreciation suggest that U.S. core consumer price index inflation will rise again by year-end and finish next year at 2.7%. This is in contrast to Canada where the strong Canadian dollar has kept price increases at various stages of production more muted.

The report notes the Bank of Canada is expected to continue with a series of rate hikes culminating with a 4% overnight rate by the end of 2005 as it brings monetary policy towards a neutral setting.

As steady expansion takes over from recovery, RBC forecasts U.S. growth to converge to Canadian levels in a range 3% to 3.5% for the remainder of 2004 and 2005.