The Canadian economy will gain momentum by the middle of this year, says the Bank of Canada. But further interest rate cuts will likely be needed to make this happen.

Growth will average a little more than 1% in the first half of the year, but will expand to more than 2% in midway through the year, at annualized rates. This will bring the yearly average to 1.8%, according to the Bank of Canada’s quarterly policy update, released today.

Looking ahead a little further, the bank expects the economy to grow by 2.8% in 2009.

“Against this scenario that we’ve set out, further rate cuts are to come,” said David Dodge, governor of the central bank, in a press conference this morning. He didn’t indicate whether markets should expect a 25 or 50 basis point cut. “Not only will I not be here in March, but we try to operate in a measured fashion.”

The economic slowdown in the U.S. will put downward pressure on Canadian export growth in the coming year, says the bank. But high commodity prices, expanding incomes and lower policy rates will all keep domestic demand strong. “The major change is much weaker net exports,” reads the report. “With the pickup in U.S. GDP growth in 2009, the drag on Canadian economic activity coming from net exports diminishes.”

Canada will manage to evade a recession, as will the U.S., although only by a hair, according to today’s report. The first half of this year is expected to be particularly weak south of the border, with real GDP growth averaging a 0.5%, and inching up slowly to eke out 1.5% growth for the year and rising to 2.5% for 2009.

“Our projection for the U.S. is for incredibly slow growth,” said Dodge. “We’ve said just above zero — but we can’t measure it that finely—in the first half, and some recovery going forward.” He said for this to happen, rate reductions beyond Tuesday’s surprise 0.75% slashing of rates would be required in the U.S.

When asked about the surprise Fed cut on Tuesday, Dodge noted that the economic conditions on either side of the border differ dramatically and central bank moves must reflect these differences.

“Credit conditions for households have tightened a lot more in the U.S. than they have here in Canada,” he noted. “Secondly, the Americans were not starting from a position of excess demand going in to 2008, whereas we are. And finally, if you look at the indicators right through our economy they are still at very high levels.”

The bank’s projection for core inflation is 2% by the end of 2009, lower than in its October report, due mainly to excess supply in the economy and pressures from lower-than-expected prices for some tradeable goods.

In general, the bank has cut its growth expectations since its last report n October, as financial conditions have deteriorated and the housing sector decline in the U.S. has proven longer and more pronounced, which will negatively affect Canadian exports.

Dodge’s remarks this morning in Ottawa will be his last as Governor of the Bank of Canada. His seven-year term ends next week, when incoming governor Mark Carney will replace him.