The weakening U.S. economy contributed to Canada’s economic growth taking an unexpected drop in the first quarter of 2008.

The national growth rate is forecast to slow to 1.4% for 2008, according to the latest economic report from RBC. In 2009, Canada’s economy is expected to rise 2.5%.

“Going forward, Canada’s economy will continue to be hampered by flagging U.S. demand for exports, but domestic demand will more than offset the drag this year,” says Craig Wright, senior vp and chief economist, RBC. “The surprise economic contraction will be short-lived as growth prospects for the remainder of the year should brighten, with financial market pressures starting to ease, the U.S. economy getting a boost from the issuance of tax rebate cheques, and commodity prices remaining historically high.”

Canada’s strong terms of trade, boosted by rising export prices, will drive economic growth. Commodities continue to experience solid demand from emerging markets such as China. Over the past five years, Canada’s gross domestic income has outpaced gross domestic product by an average of 1.2 percentage points, also providing steady support for government revenues, corporate profits and the labour market.

Inflation has become the predominant worry for central banks given the elevated level of commodity prices, especially oil. However, the modest pace of growth and ease in labour markets are expected to be sufficient enough to offset these pressures, the report says.

The RBC report forecasts that Canada’s core inflation rate will likely trend higher this year though remain below the Bank of Canada’s 2% target. Mitigating factors that have pushed the inflation rate lower, such as the impact of the rising Canadian dollar in 2007 and the retail discounting that Canadian companies have had to offer to compete for market share, will start to dissipate through 2008. By 2009, RBC expects the inflation rate to average close to the 2% range.

Canada’s housing market is also poised to cool in the face of deteriorating affordability, the report says.

RBC forecasts U.S. economic growth to be modest this year rising 1.5%. However, the risks are largely on the downside as greater-than-expected restraint could emerge from still high energy prices, tight credit conditions and weakening labour markets. Growth is projected to strengthen to 2% in 2009. This modest growth outlook will help keep inflation pressures under control through the forecast.

“We believe that the U.S. economy will avoid a contraction this year and should start to see sustained upward growth momentum in 2009,” says Wright.

BMO Capital Markets said the Canadian economy will grow by 1% this year and 2.2% next year.

But both banks said central Canada, and particularly Ontario, will continue to face stiff headwinds as a result of the strong dollar, weak U.S. demand for exports, particularly autos, and high energy prices.

The forecasts come on the same day the Ontario Finance Ministry announced that the province’s economy shrank by 0.3% on an annualized basis during the first three months of 2008.