Morgan Stanley is predicting that the Canadian economy will weaken this year, sparking rate cuts.

The anticipated recession in the U.S. is likely to be the main drag to growth, while domestic demand should moderate somewhat, the firm says. It expects that growth should slide to just 1.0% in the first half, rebounding to 2.0% in the second half of the year.

With growth slowing, Morgan Stanley also expects core inflation to decline, as a result of the currency’s appreciation and the slowing economy. It predicts core inflation to gradually drift lower throughout 2008, from 2.0% at the end of 2007 to reach 1.5% by mid-year and a low of 1.3% by the end of the year.

In response to moderating growth and inflation, the firm expects the Bank of Canada to cut interest rates by 100 basis points by mid-year, bringing the interest rate to 3.25%, and to remain on hold thereafter.

There is some risk that growth could surprise on the upside, it allows, noting that during the last five years, the links between the US and Canada have weakened somewhat and growth in Canada could be less dependent on exports than during the previous recession. “Therefore, Canada could be less negatively affected by a US recession than in the past,” it says. ”In addition, the solid gains in household income in 2007 could provide more momentum for consumer spending, while stronger demand from Asia and Europe could offset some of the negative impact from declining exports to the US.”

The main downside risk is that the US recession could be deeper and longer than it currently forecasts, dragging the Canadian economy lower for longer. However, it concludes that the risks of a recession in Canada are low.