The Canadian economy will continue to grow as expected in 2006, based on its continued strength and the trade sector’s adaptation to a higher dollar, economists at Royal Bank forecast.

Real economic growth is projected to come in at 2.9% in 2005 and 3.4% in 2006, according to a forecast released Wednesday by RBC Financial Group.

However the Bank of Canada will have to keep going with its modest program of interest rate hikes to keep annual inflation around a targeted 2%, the RBC report said.

“The Canadian economy weathered the sharp appreciation of the Canadian dollar in 2003-04,” Craig Wright, RBC’s vice-president and chief economist, said in a news release.

“The emerging perception of the Canadian dollar as a petro currency has led it to be modestly overvalued. Consequently we forecast a slight decline to 82 U.S. cents in 2006.”

Net exports have improved in 2005 and are expected to support growth through 2006.

“Combined with continuing gains made by the trade sector, the Canadian economy is expected to move into excess demand and put upward pressure on core inflation,” Wright said.

“To hold core inflation from going beyond its 2% target, the Bank of Canada will likely keep hiking the overnight rate in a proactive manner to 4% by April 2006.”

RBC says Canada’s domestic economy will outperform the U.S. economy next year.

U.S. real growth is expected to moderate to an estimated 3.4% this year and 3.2% in 2006 as domestic spending slows due to higher short-term interest rates.

Despite a modest decline in growth, U.S. core inflation is expected to increase to 3%, the bank says, with the Federal Reserve funds rate expected to reach 4.25% by the end of 2005 and remain at that level in 2006 while it attempts to keep inflation under control.

RBC says it expects the price of crude oil to average US$58 per barrel in 2005 and US$57 in 2006.