Canada’s economy is expected to grow by 2.1% in 2008, down from 2.6% in 2007, as a result of greater strain from the trade sector, according to the latest economic forecast from RBC.

The weakness in trade is a reflection of the high value of the Canadian dollar and projected weak growth in the U.S., particularly in the first half of 2008. Recent credit tightening will weigh on growth of both economies in the near term, according to the report.

“The improvement in Canada’s terms of trade has been an important factor in supporting the domestic economy,” says Craig Wright, senior vp and chief economist, RBC. “However, import volumes have been growing at a faster rate than exports, resulting in the overall trade sector weighing down real GDP growth.”

RBC expects the drag from the trade sector in 2008 to be partially offset by a combination of the boost in terms of trade, the strong labour market, rising wages, the one percentage-point cut in the GST and unemployment near a 33-year low. These factors are also expected to support consumer spending through 2008.

In sharp contrast to the precipitous declines in the U.S. housing market, Canada’s housing sector is expanding at a strong pace with home prices continuing to rise. However, the strong Canadian housing market is beginning to weaken affordability, and will contribute to a slowing in residential purchases.

At the same time, the recent credit market tightening poses a clear downside risk to near-term growth. It is anticipated that the Bank of Canada will lower its overnight rate by 75 basis points early this year. Recent below-target core inflation will facilitate this near-term easing. However, as the U.S. economy rebounds in the second half of 2008 and more stable financial markets prevail, it is anticipated the central bank will start to reverse the easing in the final quarter of 2008 with the overnight rate moving up from a low of 3.5% to 3.75% at year-end.

Growth in the U.S. economy is expected to slow to the 1.5% range in early 2008 and rebound over the second half of the year to an annual average 2.5% pace as the credit market tightening eases.

The U.S. Federal Reserve is expected to further lower its funds rate by 100 basis points in the first half of 2008, which, alongside efforts by the U.S. government to limit future mortgage defaults, should prove sufficient to stave off a recession and support stronger growth in the second half of 2008, noted Wright.