On the heels of its improved outlook for the U.S. economy, Merrill Lynch & Co. Inc. economists are also raising their forecast for the Canadian economy. However, they warn that the recovery may be short lived.

Merrill Lynch has revised its call for Canadian gross domestic product growth up to -2% for 2009 from its previous forecast of -2.7%. For 2010 it is also now expecting the economy to post a 2.7% increase vs its previous 2.3% forecast.

“Fiscal and monetary policy will start revving the Canadian economy by the end of the year, in our view, and the more optimistic outlook for the U.S. economy will provide some boost to 2010 as well,” it says. It also expects job losses to taper off by the end of the year and give way to some modest employment growth in the fourth quarter allowing the unemployment rate to top out at a 12-year high of 9% this autumn.

The upgrade to its Canadian outlook follows a similar revision last week to its U.S. forecast. The firm revised its quarter-over-quarter growth forecast for the second half of 2009 in the U.S. to 2.7% from its previous prediction of 1.4% growth. It also raised its annual growth outlook for 2009 to -2.1% from its previous -2.4% forecast, and it revised its 2010 outlook notably higher, calling for GDP growth of 2.6% next year, up from its previous forecast of 1.8%.

The rosier outlook reflects the fact that Merrill Lynch now also sees growth emerging from numerous sources, including the fact that various fiscal stimulus measures are likely to boost consumer spending, it sees a stabilizing housing market, stronger exports as growth revives in the rest of the world, and slower inventory reductions.

For Canada, Merrill Lynch also suggests that the stronger than expected growth “may well test the Bank of Canada’s commitment to leave rates at the effective lower bound until mid-2010.”

“We do not believe the Bank will go as far as raising administered rates any time soon, but any softening on the conditional commitment, or throttling back on term PRA transactions, will push long rates higher with the 10-year likely to top out at close to 4% by the end of the year,” it notes.

“Summing up our forecast in just one phrase, we are not going to fight the feds. Both fiscal policy and monetary policy are in easy mode and the magnitude of the policy response will produce growth,” Merrill Lynch explains.

However, it also cautions that it remains bearish longer term. “Restructuring and credit issues are going to be headwinds for the Canadian economy for the next couple of years, much like the Bank of Canada laid out in the last Monetary Policy Report,” it says, and it worries that the Bank may overreact to the growth resurgence. “All of which suggest, the upturn in the economy will be very short-lived indeed.”