Scotia Economics forecasts modest slowing in growth on both sides of the border in 2006 and 2007, following higher interest rates.

In its debut financial forecast for 2007 released today, Scotia says that U.S. output growth is expected to decelerate below trend in 2006 and 2007, with real GDP estimated at around 3.2% and 2.7% respectively. “Consumer spending and residential construction will contribute less to growth, while business investment and government spending will contribute more,” it predicts.

“The drag from external trade will lessen through 2006 as imports slow and exports remain relatively firm. Discretionary household purchases are expected to weaken through 2006 and into the first half of 2007,” it says. “This reflects the loss of purchasing power associated with higher borrowing costs, elevated energy prices, increased ‘core’ price pressures for many products, the lack of new tax stimulus, a weaker pace of job creation, in addition to deteriorating consumer financials (too much debt, too little savings, and reduced wealth as real estate markets soften).”

Canadian real GDP will largely mirror U.S. trends, Scotia says, “with manufacturing output and shipments continuing to be constrained by the softening in U.S. growth, ongoing competitive pressures from lower-cost international producers, a persistently strong Canadian dollar, and chronically weak productivity.” Real GDP is expected to increase 2.8% in 2006 and match the U.S. gain of 2.7% in 2007.

“While the overall pace of personal consumption is still expected to slow, the growth trajectory will be better than in the United States because of stronger domestic job gains, a personal balance sheet that is less leveraged, personal tax cuts from Ottawa, and the increased economic strength in the commodity-driven regions in the West and the East,” it adds.

The sub-3% growth performance masks areas and regions that will outperform the national average, Scotia adds. “Housing activity will slow, but the strength in the West and a smaller demand/supply imbalance relative to the United States will reduce the chance of a significant market correction.”

“Slower U.S. demand will have a tangible slowing effect on global trade, though the pace of activity in the outsourcing powerhouses internationally will remain very buoyant,” it predicts. “Growth in the euro zone will remain at subpar levels, while the pickup in Japan is still constrained by the slow pace of consumer spending. Latin American prospects are set to improve gradually.”

Interest rates are expected to move even higher. Scotia says that the Fed funds rate is now forecast to increase to 4.75% by the spring of 2006, with the Bank of Canada’s overnight rate set to climb to 4%. “While commodity prices, and energy prices in particular, are expected to decline modestly from current levels in 2006 and 2007, underlying inflation pressures should still move higher in 2006 on both sides of the border, keeping the central banks in a tightening mode,” it says. “The ECB is expected to raise its benchmark lending rate another 25 bps in 2006 to 2.50%.”