Canadian economic growth is expected to slow to 2.7% in 2005, down from last year’s 2.8%, but will turn up the throttle to 3.2% in 2006, according to the latest economic forecast from RBC Financial Group.

A 30% rise in the Canadian dollar over the past two years leaves the Canadian economy facing some economic challenges, said Craig Wright, the bank’s vice-president and chief economist.

“However, resilient consumer and business spending will lead growth this year while international trade is expected to become less of a drag on growth as 2005 progresses,” he said.

Low inflation and low interest rates combined with rising net household wealth and solid labour markets are expected to keep consumer spending on an upward path, says RBC’s report.

Business spending is expected to increase in 2005, as corporate profitability remains solid, allowing firms in search of higher productivity to ramp up their investments in machinery, equipment and technology.

The stronger Canadian dollar should also prove supportive of business investment since 70 to 80% of the machinery and equipment purchased by Canadian companies is imported from the United States.

Canada’s trade sector took a beating in the second half of 2004 alongside a soaring Canadian dollar, triggering strong growth of imports while pushing exports sharply lower, but this drag on trade will diminish through 2005, said Wright.

U.S. economic growth is expected to fall to 3.7% in 2005, compared to 4.4% last year, says the report, which forecasts the U.S. dollar will stabilize against non-Asian major exchange rates in 2005 and 2006. The U.S. dollar will next depreciate against Asian currencies, which for the most part have not appreciated as much against the U.S. dollar as other major currencies, predicts RBC.

U.S. inflation will gradually rise to 3% by the end of 2005 and in its wake lead the Fed funds rate to 4%, says RBC. With a stronger Canadian currency, some excess capacity and a low inflation environment, the Bank of Canada is expected to wait until the last quarter of 2005 before lifting the overnight rate to 3%, notes RBC.