Bank of Montreal has lowered its forecast for the Canadian economy and interest rates. In a new report, the bank suggests that strength in the Canadian dollar will slow the economy and limit further interest rate hikes.

“We have revised down our outlook for Canada’s economy this year as a result of the strong Canadian dollar. We now expect growth of 3.2% in 2006, on a fourth quarter-over-fourth quarter basis, down from 3.8% previously anticipated,” it says. “Earlier interest rate hikes will limit growth next year to 3.3%.”

“We now see just one final increase of 25 basis points in the overnight rate to 4.25% on May 24,” it adds.

BMO says the Canadian dollar is expected to appreciate from US90¢ currently towards US92¢ by early 2007 as a result of a weaken U.S. dollar and high commodity prices.

“The main risk to the Canadian outlook is that the loonie is pressured sharply higher in the face of a significant shift out of the greenback,” BMO warns. “Such a rise in the Canadian currency would imply even greater restraint from net exports than what we are currently assuming. In the case of pronounced economic weakness, the Bank of Canada may be compelled to start unwinding some of its earlier interest rate hikes.”

As for the U.S. economy, it predicts its growth will moderate in response to rising interest rates and high energy costs. “The U.S. economy currently remains strong despite rising interest rates and high gasoline prices, with real GDP expanding at an annual rate of 4.8% in the first quarter. However, growth is expected to slow to 3.5% in Q2 and 3.1% over the second half of this year in response to past monetary tightening and a cooling housing market,” it says. “The economy is expected to expand by 3.1% in 2007.”

The bank adds that it believes U.S. rates have peaked, and that a slowing in growth will compel the U.S. Federal Reserve Board to return rates to a more neutral level of 4.50% by the spring of 2007.

“The greenback has lost 5% of its value on a broad trade-weighted basis since the end of 2005, and we expect it to fall a further 12% by late 2007,” it notes.