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r981117a_BOC

canada

Opening Statement before the House of Commons Standing Committee on Finance

thiessen

Governor of the Bank of Canada before the House of Commons Mr. Chairman, my colleagues and I welcome these appearances before your committee following each edition of the Bank of Canada's . As you know, we published our latest report yesterday. It touches on a wide range of economic and monetary issues and provides an opportunity for us to account for our policy actions and the results of those actions. It is important to keep in mind that the objective of monetary policy is to help create and maintain a Canadian monetary climate favourable for improved economic performance over the long haul. The best way for monetary policy to make this contribution is to preserve low and stable inflation. As set out in the jointly agreed inflation-control target of the Bank of Canada and the government, our objective is to keep inflation within a range of 1 to 3 per cent. In our previous report in May, we highlighted the global economic uncertainties that shrouded the economic outlook. Since that time, economic uncertainties have further intensified. While some stability returned to Asia, instability spread to other regions during the summer, following further evidence of Japan's inability to deal with its problems and Russia's decision to declare a debt moratorium. Many emerging markets were faced with large capital outflows and widening interest rate spreads as investors looked for safe havens. More broadly, spreads between private sector and government bonds also increased, and market liquidity fell. Throughout this period the conduct of monetary policy has been influenced by these international factors. Problems in Asia and Russia have contributed to a sharp decline in the prices of the commodities we export. The difficulties this has caused in our primary industries were the source of ongoing downward pressure on the Canadian dollar during the summer. In August, financial markets became extremely nervous and uncertain. The Canadian dollar came under intense downward pressure and our medium- and longer-term interest rates began to rise sharply. To forestall a potential loss of confidence in our currency, the Bank of Canada raised its Bank Rate by one percentage point. Subsequently, the Canadian dollar stabilized and medium- and longer-term rates came back down. In response to the difficult and illiquid financial markets between August and October and some signs of a possible ''credit crunch'' the U.S. Federal Reserve lowered its interest rate twice by a total of 50 basis points. Because of the importance of the U.S. economy to Canada, and given our ongoing low inflation rate, the Bank of Canada followed these moves with similar reductions in our Bank Rate. Since then, international financial markets have been less volatile. Looking forward, the economic and financial upheavals in the international area have resulted in downward revisions to the estimates for global economic growth in 1998 and 1999. Nevertheless, economic activity in the major industrial countries, particularly in North America and Europe, is expected to be reasonably well sustained through to the end of 1999. The Canadian economy is expected to continue expanding over the next year on the basis of the projected sustained domestic demand in the United States and accommodative monetary conditions in Canada. However, the turbulent international developments have created greater-than-usual uncertainty around the economic outlook. Financial stability is particularly important to household and business confidence. Thus the extent to which growth in Canada's economy will take up slack over the next year will depend on how quickly international and domestic financial markets stabilize. Preserving confidence among investors in Canadian financial markets will therefore be an important consideration for the Bank over the near term. And I welcome the greater stability we have seen in financial markets in recent weeks. Let me reaffirm that the fundamental focus of monetary policy over the medium term continues to be on keeping inflation within the target range. Inflation is expected to remain in the lower half of the range of 1 to 3 per cent over the next year. I will conclude by underlining that the global situation continues to be uncertain and that this will have an effect on Canada. However, we are coping with these international difficulties on this occasion better than before. I believe that is because of the progress we have made in recent years in getting our fiscal house in order, achieving a low and more stable rate of inflation and restructuring our private sector to make it more productive and internationally competitive.

r981119a_BOC

canada

Opening Statement before the Standing Senate Committee on Banking, Trade and Commerce

thiessen

Governor of the Bank of Canada before the Standing Senate Committee on Mr. Chairman, my colleagues and I always welcome our appearances before your committee. We released our latest this past Monday. It covers a broad range of economic and monetary issues and provides an account of our policy actions and their results. The ultimate objective of Canadian monetary policy is to help create and maintain conditions that are conducive to improved overall economic performance over time. The best way for the Bank to make that contribution is through low and stable inflation. As jointly agreed with the government of Canada, the Bank aims to keep the rate of inflation within a target range of 1 to 3 per cent. In our previous report last May, we highlighted the uncertainties that clouded the global economic outlook. During the past six months, these uncertainties intensified. While some stability returned to Asia, other parts of the world came under pressure through the late summer and early fall, following Russia's unilateral declaration of a debt moratorium and Japan's apparent inability to deal with its problems. Many emerging-market economies suffered large capital outflows and widening interest rate spreads, as investors looked for safe havens and greater risk protection. Spreads between private sector and government bonds also increased more broadly, and market liquidity tightened. These international developments have had a significant influence on the conduct of monetary policy in Canada over the past six months. Problems in Asia and Russia have led to a decline in the prices of key primary commodities we export. And the difficulties that this has caused in our resource industries continued to put downward pressure on the Canadian dollar through the summer. With global markets becoming extremely nervous after the Russian crisis in August, and tending to exaggerate the importance of commodities for Canada, pressure on our currency intensified. And our medium- and long-term interest rates began to rise sharply at a time when comparable U.S. rates were falling. To forestall a loss of confidence in our currency, the Bank of Canada raised the Bank Rate by one percentage point in late August. This helped the Canadian dollar to stabilize and medium- and long-term rates came back down. When the U.S. Federal Reserve lowered its target rate three times between September and November, by a total of 75 basis points, in response to concerns about a credit crunch and a slowing in the U.S. economy, the Bank of Canada followed suit. Similar reductions in our Bank Rate were appropriate, given the importance of the U.S. economy to Canada, our continued low inflation rate, and the improving climate in international financial markets as a result of the U.S. actions. Let me now turn to the prospects for the Canadian economy. The international economic and financial turmoil has resulted in downward revisions to the estimates for global economic growth this year and next. Still, with the exception of Japan, economic activity in the major industrial countries is expected to remain reasonably well sustained through to the end of 1999, especially in North America and Europe. With sustained U.S. demand, and with employment gains and accommodative monetary conditions at home, we expect that the Canadian economy will continue to expand over the next year. I must stress, however, that the outlook is more conditional than usual because of lingering international uncertainty. I should also note that the extent to which growth in the economy will take up slack over the next year will depend on how quickly international and domestic financial markets stabilize. Because financial stability is particularly important to household and business confidence, helping to preserve confidence among investors in Canadian financial markets will be an important consideration for the Bank in the near term. But, over the medium term, the fundamental focus of monetary policy remains on keeping the trend of inflation inside the target range of 1 to 3 per cent. We expect inflation to stay in the lower half of that range over the next year. The main point I would like to underscore is that, even though Canada has been affected by the global situation, we are weathering the storm better than in the past. I believe that this is because of the remarkable progress we have made in getting our fiscal house in order, achieving a low and more stable rate of inflation, and restructuring our private sector to become more productive and internationally competitive. Mr. Chairman, I would also like to provide your committee with some comments on the implications of this past year's global upheavals for the Canadian dollar, and explain the Bank's response to all this. To understand what is going on, we need to correctly identify cause and effect in the decline of the Canadian dollar. Exchange rates will typically reflect developments at home and abroad. Thus, the downward movement in our currency is the consequence of developments since the summer of 1997. It is not the cause of the economic difficulties we are currently facing, as some commentators seem to suggest. The worldwide capital flight to the safe haven of U.S. assets and the 15 per cent decline over the past year in the prices of the primary commodities we export have been the main factors behind the marked depreciation of our currency against the U.S. dollar. In particular, the drop in commodity prices has meant lower incomes and wealth for Canadians -- a harsh reality that we must adjust to. Because we are on a floating exchange rate, this adjustment has taken place through a decline in the external value of the Canadian dollar. Had we been on a fixed exchange rate system, the adjustment would have been slower and more costly, as it would have to come entirely through lower output, employment, and wages. What can, and should, the Bank of Canada do about the exchange rate in times of international financial turbulence and major external shocks? First of all, let me repeat that the objective of monetary policy is domestic price stability -- that is, keeping inflation low and stable. In this policy approach, the exchange rate and interest rates are the channels through which monetary policy operates; and they must be allowed to adjust to help achieve the inflation targets. But when the momentum of currency movements pushes the exchange rate too far, beyond what is justified on economic grounds, the Bank needs to remind market participants of the positive trends in our economy. The Bank may do that by intervening in the foreign exchange market to buy Canadian dollars, as we did through the first half of last August. But, we can also respond with Bank Rate changes. This would be appropriate in the following two cases. First, when the magnitude of the decline in the currency leads to excessive monetary easing. Remember that a falling currency is a source of stimulus to the economy because it encourages exports and domestic production of import substitutes. Second, when there are signs that confidence in the currency is eroding. A loss of confidence can prove very costly for the economy if it leads to persistently higher medium- and long-term interest rates on loans for house purchases, construction, and business investment. It was because of such concerns that the Bank responded strongly to the decline in our currency during the Mexican crisis in early 1995. And, as I discussed earlier, it was again to head off a loss of market confidence that we raised the Bank Rate last August. I hope that this helps to clarify questions about the exchange rate and some of our recent related actions.

r981207a_BOC

canada

The Canadian economy and monetary policy in unsettled times

thiessen

Governor of the Bank of Canada The Canadian economy and monetary policy in unsettled times When the Asian crisis erupted in the summer of 1997, few observers anticipated that international financial markets would still be under its influence more than a year later. Most expected that the crisis would be contained and resolved relatively quickly. But then who could have foreseen a year ago that the Japanese situation would deteriorate as much as it has; or that Russia would declare a debt moratorium, jolting markets everywhere, and increasing financial pressure on parts of Latin America? All these unexpected developments have slowed world economic activity. Canada's very open economy has not been immune to these forces. The sharp decline over the past year in the demand for, and the prices of, the key primary commodities we produce has taken its toll. British Columbia has been particularly hard hit because it produces and exports a larger share of such goods than other Canadian provinces. These developments have been reflected in the value of our currency, which has declined substantially against the U.S. dollar. All this seems to have provided fertile ground for some pessimistic scenarios. Indeed, some commentaries have raised the spectre of global recession and deflation, implying a consequent downturn for Canada. Are such concerns justified, or are they an overreaction to I believe that the pessimistic commentary has been overdone. Given the global uncertainty and financial market volatility of the past year, Canada has been coping relatively well. It is normal for people to feel queasy and to fear the worst when caught in the kind of stormy seas we have encountered in the past year. But the important thing to remember is that these days Canada is better positioned to ride out the storm. And we will feel much better if we can keep our eyes on the horizon -- for there are signs that the sky is clearing. What I would like to do this morning is to put the recent changes in the global economic and financial environment in perspective. Next, I will look at the implications for the world economy and for Canada in particular. I will finish with a discussion of the Bank of Canada's response to the international turbulence. Global financial problems in perspective I will spare you the detailed chronology of the past year's events. You are probably already too familiar with it. Rather, I intend to focus on what has made this latest episode of global financial turbulence more troublesome than others in recent history. This should help us see recent developments in the Canadian economy and in monetary policy in a clearer light. It should also provide some insight on what needs fixing in the international financial system and what mistakes to avoid in the future. So, why has the 1997-98 financial turmoil been more widespread and long-lasting? The way I see it, there were two main reasons. First, with the benefit of hindsight, it is clear that too many incautious international portfolio investments were made in the wake of the growing globalization of capital markets. Second, it has taken Japan much longer than expected to deal with its serious economic and financial problems, problems that long predated the Asian crisis. Let me explain why I think these factors have had such an impact this time around. First, the matter of incautious international investment practices -- what was the problem here? With the opening up of financial markets and with the decline in interest rates in industrial countries, a growing number of investors were attracted to higher returns abroad. "Abroad" often meant the so-called emerging-market countries, particularly those in Asia. With their rapid rates of economic growth year after year, these countries seemed to have great investment potential. But foreign investments, especially in emerging markets, are far more complex than domestic ones. And assessing these investments can be very tricky. For one thing, investors are dealing with companies operating far away, in a very different economic and political environment. For another, financial regulatory and supervisory practices in some of these countries are less well-developed and transparent. In addition, investors may have felt rather well "protected" from risks -- for a couple of reasons. First, past assistance packages by the International Monetary Fund (IMF) and other international agencies may have led them to believe that the international community would always come to the rescue if worst came to worst. Second, many investment advisers evidently were not terribly fussed about the exchange rate risk because most Asian currencies were fixed to the U.S. dollar. It is all too easy to forget that having a fixed exchange rate is not in and of itself a guarantee that a currency will not decline in value -- which in fact is what many of these currencies have done. In the end, huge amounts were placed in emerging markets in the 1990s by mutual funds, pension funds, financial institutions, and their clients, evidently without full appreciation of the risks involved. Moreover, many banks in these emerging markets were also taking large risks. They were borrowing short term from foreign banks, in U.S. dollars, at relatively low rates, and lending out long term, in domestic currency, at high rates -- often to domestic real estate developers. When pegged exchange rate systems in Asia broke down under pressure, because they were fixed at levels that had become incompatible with changing economic fundamentals, both local and foreign investors rushed for the exits. And as exchange rates tumbled and interest rates soared, a host of other long-standing problems, especially related to weak banking systems, were unearthed. Investors that got burned in Southeast Asia tried to reduce their exposure to all emerging markets. Initially, emerging countries outside Asia managed to withstand the pressure -until the outbreak of the Russian crisis. That Russia was running into serious fiscal difficulties had been well known for some time. But its decision to declare a unilateral moratorium on its debt last August shook markets everywhere, and even the most sophisticated investors became very agitated. The resulting global reassessment of risk, and the greater weight placed by investors on security, led to a movement of funds out of emerging-market bonds and corporate bonds into more secure U.S. Treasury bonds. Interest rates rose in the markets for riskier securities, and liquidity tightened -- hence, the concerns through the autumn about a global "credit crunch" and recession. The second factor that has exacerbated the global financial turbulence this time is the surprising severity and intractability of Japan's long-standing economic and financial problems . Remember, Japan is the second largest economy in the world. Most of us expected that, once the Japanese recognized the seriousness of their problems, they would move quickly and decisively to fix them. A stronger Japanese economy would have made a significant difference to the outlook for the world economy. And it would have helped to speed up the turnaround in Southeast Asia -- much as a strong U.S. economy facilitated the adjustment in Mexico, following the 1994-95 crisis in that country. The deterioration of the Japanese economic and political climate in the spring and early summer of 1998 was an important factor in the intensified market pressures that precipitated the Russian crisis last August. What to do about the global turmoil? So what are we to conclude from all this? The last thing we should do is retreat behind national borders and start placing restrictions on the free flow of international capital. That would be very unfortunate. Even though capital flows may sometimes prove difficult to handle, especially for small countries, there is much to be gained from access to world savings -- provided those savings are used prudently and productively. What we must do is find ways to minimize the costs, without giving up the benefits. The Bank of Canada believes that a flexible exchange rate is very useful in this context. Under such a system, borrowers and lenders are constantly aware of the exchange rate risk, and the kind of pressures that built up behind the fixed exchange rates in Asia last year are much less likely to emerge. I should also note that a good deal of work has already been done by the international community to strengthen the global financial system and reduce the risk that these recent problems will recur. In their October communique, the Finance Ministers and Central Bank Governors of the G-7 countries outlined a series of initiatives. These are designed to: increase the transparency of the international financial system; promote international standards of good practice; strengthen incentives to meet such standards; provide assistance to developing countries to reform and reinforce their economic and financial systems; and put in place a process for crisis management that envisages the involvement of private lenders at an early stage. But all this, you may say, is to improve the international navigation and radar systems in the future. Meanwhile, we are still in difficult seas, wondering what's up ahead and worrying what may hit us next. How worried should we be about the world economy and the outlook for Canada? Keeping our eyes on the horizon I can tell you that there are positive factors in the picture as we look ahead. Let me elaborate, starting with the global environment. Perhaps the most reassuring element is that the economic expansion in the main industrialized countries, except Japan, is still well sustained. Remember that these countries account for more than half of world output. The U.S. economy, in particular, remains strong, growing much faster than anticipated in the third quarter. So even if it slows, that economy -- Canada's main export market -- will still be operating at relatively high levels. The major European economies, as a group, are also expanding moderately. And a number of industrial countries, including the United States, the United Kingdom, and many countries in continental Europe, have lowered their interest rates to help sustain domestic spending. Japan is still the main uncertainty at this point. But the recent legislation to rehabilitate its banking sector, which is at the core of Japan's problems, and other measures proposed to stimulate the economy are grounds for cautious optimism. If these are implemented in a sensible, systematic fashion, the world economic outlook will brighten considerably. Another factor that added to the pessimism through the early autumn was the concern about a "credit crunch" in the United States that could spread elsewhere, including here in Canada. However, the recent interest rate reductions by the U.S. Federal Reserve have eliminated the worst scenarios envisaged at the time. Some of the rise in interest rates on "lessthan-prime" debt, which occurred during the autumn because of concerns in global markets about risk and liquidity, has reversed. And the availability of credit is slowly improving. This is not to say that we are completely out of trouble yet; or that there is no longer considerable uncertainty out there. But, for the reasons I have discussed, I certainly do not believe that the scenarios of worldwide recession and deflation are very likely as we look ahead. As for Canada, it is true that we have been hit hard by the more than 15 per cent decline in commodity prices over the past year. It is also true that those lower prices, together with the slowing world economy, are affecting our export industries -- a fact that this audience probably knows only too well. It is also evident that the nervousness and volatility in financial markets have made some Canadian consumers and businesses less confident, affecting domestic spending plans. As a result, the Canadian economy has expanded much more moderately this year than in 1997, when it grew by more than 4 per cent (fourth quarter over fourth quarter). As we look ahead to 1999, the considerable degree of global uncertainty that is still lingering makes all economic forecasts more tentative than usual. Because financial stability is so important for household and business confidence, the expansion of our economy will be influenced by how quickly global financial markets stabilize. Still, with accommodative monetary conditions and recent solid employment gains, spending by Canadian households and businesses, while slowing, should continue to contribute to an expanding economy. And, based on the Bank's current assessment of the world economic outlook and Canada's improved competitiveness, our exports should continue to grow. The monetary policy response to the international turbulence Let me now turn to monetary policy. You will not be surprised to hear that throughout this period, the conduct of policy has been influenced by these exceptional international developments. The sharp drop in commodity prices has inevitably meant lower incomes and wealth for Canadians. And we have had no choice but to adjust. Because we are on a floating exchange rate, much of the adjustment has taken place through a decline in the external value of the Canadian dollar. Had we been on a fixed exchange rate, we would still have had to adjust. But the adjustment would have been more difficult, since it would have had to come mainly through downward pressure on output, employment, and wages. The depreciation of the Canadian dollar since the fall of 1997, while distressing, had for the most part been relatively orderly before the Russian crisis in August. At that point, pressure on our currency intensified because of a frantic worldwide capital flight to more secure U.S. assets and an exaggerated sense internationally of the importance of commodities for Canada. The move out of "commodity currencies" was intensified by fears that Russia would start dumping commodities on world markets. As the decline in the Canadian dollar accelerated through August, medium- and long-term interest rates, including mortgage rates, began to rise sharply at a time when comparable U.S. rates were falling. We took this as a signal of potential loss of confidence in Canadian-dollar investments that could prove very costly for the economy. To head that off, we raised the Bank Rate by one percentage point in late August. Our action, and the subsequent return of some stability to markets in the United States and elsewhere, helped to restore confidence in Canadian-dollar assets. And medium- and longer-term interest rates came back down. When the U.S. Federal Reserve lowered its target interest rate three times between September and November, because of concerns about a possible "credit crunch" and an expected slowing in their economy, we followed with similar reductions in our Bank Rate. These cuts were appropriate, given the importance of the U.S. economy to Canada, our continued low inflation rate, and the improving international financial climate. I know that the depreciation of the Canadian dollar has been a source of concern and dismay to many people. One concern is that a weak currency blunts the incentives to improve productivity in the export sector. I must say that this is more likely to be a problem if the weakness of the currency reflects an inflationary environment. But such is not the case in Canada today. Inflation is low and stable, and the Bank of Canada is formally committed to keeping it that way. At the same time, I most certainly agree that we should always be looking at our economic policies from the perspective of their likely impact on the growth of productivity. After all, productivity is what matters for a sound economic performance and for rising standards of living over time. Currently, the low Canadian dollar provides an opportunity for Canadian businesses to expand their presence in foreign markets. But they must also continue to work hard to increase productivity and to ensure that they stay competitive as our currency regains strength. What about monetary policy -- what is it doing to further productivity? The focus of Canadian monetary policy is on domestic price stability. This means keeping inflation low and stable over time -- currently within a target range of 1 to 3 per cent. The Bank aims to avoid both inflation and deflation. And if we are successful, we will have provided Canadians with greater predictability, fewer cyclical fluctuations, and sustained low interest rates. I believe that a monetary policy that seeks to provide this kind of environment is the most conducive to productivity growth over time. Concluding remarks To conclude, let me just say that Canada cannot escape the uncertainties that have clouded the global economic outlook. The pace of economic expansion in Canada is not as robust as it was a year ago. But our economy should continue to grow over the next year, supported by accommodative monetary conditions and sustained U.S. demand. Although it may be difficult to see while we are still battling the waves of global instability, the fact is that we are coping better this time around because our economy is in sounder shape. And this gives me reason to remain rather positive about our economic future.

r990120a_BOC

canada

The euro: Its economic implications and its lessons for Canada

thiessen

Governor of the Bank of Canada to the Canadian Club of Ottawa The euro: Its economic implications and its lessons for Canada We have just witnessed the dawn of a new era in Europe. Beginning this month, 11 of the 15 member countries of the European Union have joined in a currency union. And they are using the euro as their common currency. The currency union is yet another step on the road to greater economic, social, and political integration in Europe -- a vision some 50 years in the making. To be sure, this is a remarkable achievement. Especially when you think that not too long ago many observers were still very sceptical that these countries would be prepared to give up their national currencies. Or, indeed, that they would be able to meet the requirements for participation. The launching of the euro has naturally piqued public interest in Canada, leading some commentators to suggest that we should consider a similar type of monetary arrangement as Today, I would like to talk about some of the economic implications of the European currency union. I also intend to examine whether this common-currency model has any relevance for North America. Should Canada be thinking of a new monetary arrangement along similar lines? A common currency for Europe The introduction of the euro no doubt qualifies as an economic event of historic proportions. And some of the commitments required of the participating countries have, indeed, been momentous. This month, 11 European countries permanently locked in their exchange rates, adopted a common currency, and effectively ceded the conduct of their national monetary policy to a supranational institution -- the European Central Bank (ECB). To some degree, the national central banks of the participating countries are now like the regional federal reserve banks in the To understand how this major change in European monetary arrangements came to be, it is important to keep in mind that profound political forces started the process and have provided the impetus for action through the years. Indeed, one could argue that had this been a strictly economic initiative it might not have materialized. The impetus essentially stemmed from the belief that greater economic integration would foster permanent reconciliation, and thus peace and stability, among European nations. And with a shared currency, the economic integration would become much more difficult to reverse. The history leading up to the adoption of the euro is fascinating, with roots extending back to the years immediately following World War II. I will not go through the steps that led to the introduction of the euro. Suffice it to say that the process has been a major political, administrative, and technical feat. Imagine the logistics of transposing monetary values from national currencies -German marks, French francs, Italian lire, etc. -- into euros during the first weekend of 1999. And apparently this conversion was carried out without any major hitches. But the process of conversion is not yet complete. New euro notes and coins are not actually circulating yet, and will not be until January 2002. While financial market transactions must be carried out in euros, for all other transactions the use of the euro is optional over the next three years. The euro can now be used for purchases by credit or debit card, cheque, or traveller's cheque. Companies may do their accounting and pay their workers' salaries in euros. But, on the whole, most Europeans are unlikely to notice much change right away in their daily lives, other than that prices in stores may be quoted in both euros and the old domestic currency. What is crucial, however, is that the conversion rates of the national currencies in the monetary union are now irrevocably fixed against the euro and against each other. In this sense, the national currencies now exist only as price measures and as temporary subdivisions of the euro. Just as the Canadian dollar is composed of 100 cents, you can think of the euro as being What are the economic implications of the euro What does it mean for these 11 countries to be sharing a common currency? First, you may have noticed that, as much as the launching of a common currency across these countries (collectively referred to as Euroland) was a major event, it did not have a dramatic initial financial or economic impact. This is because of arrangements that have been in place for some time. For example, all currencies in the system had been effectively pegged to the German mark since May 1998; and some for much longer. With pegged exchange rates, interest rates in participating countries have tended to move together, in line with German interest rates. And over the past year, short-term official interest rates in all 11 countries gradually converged to the current single rate of 3 per cent. Moreover, with an effective common market already operating in Europe, a common trade policy and more integrated internal markets have been in place for some time. Just what does the arrival of the euro change, then? A shared currency undoubtedly brings a number of economic benefits to the eurozone countries. The main benefit comes from eliminating the costs of conversion from one currency to another in the 11 member countries. Thus, the flow of goods, services, and capital across national borders is no longer complicated by the use of different currencies. Comparisons of prices among suppliers throughout the euro zone are easier to make, which should spur greater competition and efficiency. And there is no need for hedging to protect buyers or sellers against the risk of currency movements. On the whole, there is greater certainty about the future when the risk of exchange rate fluctuations is eliminated among countries that have highly integrated trade and investment. The migration to the euro has required a major investment in time, resources, and technology by financial sector institutions to prepare for the conversion. But over time, Euroland is likely to end up with deeper and more liquid bond and stock markets. And that has the potential to enhance Europe's share of the global financial industry and the euro's attractiveness as a major international reserve currency. Of course, this will not happen overnight. It will take time. As for economic policy, the main change that comes with the euro is the shifting of responsibility for monetary policy from national central banks to the European Central Bank. Beginning this month, a single monetary policy applies across all Euroland countries -- just as here in Canada we have the same monetary policy right across the country. The responsibility for monetary policy decisions for the euro zone is now in the hands of the Governing Council of the ECB. The council consists of six members of an Executive Board plus the governors of the 11 national central banks. The ECB is an autonomous institution with a mandate to achieve price stability. Under these new arrangements, member countries give up that part of their national sovereignty which relates to monetary policy. In effect, individual countries no longer have the option to pursue an independent national monetary policy. What is the significance of Over the longer term, monetary policy has its effects only on the rate of inflation. So if all Euroland countries were already aiming at price stability, the loss of sovereignty involved in not being able to choose a national inflation target may not seem all that important. Nonetheless, there can be differences of opinion about the appropriate definition of price stability or how quickly to return to the target inflation rate when unanticipated events cause a deviation from the target. More importantly, with a common currency, individual countries can no longer benefit from having their national currency operate as a buffer in the event of an economic shock. Take the case of a sharp rise in world energy prices. In this instance, an energy-producing country would experience rising incomes, expansionary demand pressures, and perhaps increased capital inflows. Countries that are heavy users of energy would experience the opposite effects. Exchange rate movements can help smooth the economic adjustment to such a shock, through a rise in the currency of the energy-producing country and a decline in the currency of the energyimporting country. Where exchange rate movements are not an option, as within the current euro area, greater price and wage flexibility or greater worker and capital mobility between national economies will be needed in response to the shock. Otherwise, the adjustment will be more painful and costly, involving greater fluctuations in national output and employment. Europe is still characterized by significant wage and price rigidities and by low worker mobility, which could make the adjustment to shocks more difficult. Evidently, the hope is that participation in the currency union will act as a catalyst for action to reduce or eliminate these rigidities. The economic case for a common currency in Europe rests mainly on a judgment that buffering differential shocks in the partner countries will be a less important consideration than the benefits from lower transactions costs and from the greater economic certainty because of reduced currency risk. This presumes that the economic structures of these countries are sufficiently alike that any shocks will be felt by all of them at roughly the same time and to a similar degree. A good number of the euro countries probably fall into this category. Those that do not may find themselves having to adopt measures to increase price and wage flexibility, as well as encourage worker and capital mobility, to take the place of adjustments in the exchange rate. What are the implications and relevance of the European currency model for Canada? Canada's trade links with Europe are relatively modest. Only 4 per cent of our exports go to Euroland countries and about 7 per cent of our imports come from there. So the direct economic effects on Canada from any developments in Europe related to the move to a common currency are likely to be rather limited, at least in the short run. Of course, should the new monetary union lead to changes in world trade and finance over time, Canada would feel an impact, like any other country. But it is difficult to assess the likelihood and extent of any such changes. In the meantime, I hope that Canadian businesses trading with Europe have made the adjustment to the new currency and are seeking to benefit from the lower costs of operating in Europe that go with it. One thing that the launching of the euro has done in Canada is to generate discussion of the notion that we should be thinking of a North American monetary union with the United States (and perhaps Mexico). The decline in the external value of the Canadian dollar over the past year has, no doubt, heightened interest in the issue. Before I get into the arguments, let me remind you that we are talking about a currency union, not just a fixed exchange rate. Fixed rates that can be adjusted (that is, devalued or revalued) do not eliminate exchange rate uncertainty. Indeed, as we have seen recently in Asia, in Mexico in 1994, and in Europe in 1992, when adjustments are resisted, fixed exchange rates can become unsustainable. To obtain the economic benefits that I described earlier, a currency union, not just a fixed exchange rate, is required. But, as I have also noted, even with a currency union the economic benefits come at a price. And that price is the loss of a degree of political and economic autonomy and flexibility. Just how significant would that price be for Canada? It is important to remember that, in the case of Euroland, the monetary union is a considered, conscious choice that fits into the long-envisioned larger plan of greater economic, social, and political integration. But in North America, there are no parallels to these profound political forces. Nor does NAFTA entail the degree of economic integration involved in the Moreover, for Canada, any monetary union one might imagine with the United States would not only result in a loss of autonomy over monetary policy but would work very differently from the European monetary union. In Europe, there are three large partners of roughly comparable size and eight other medium- and smaller-size participants. Any North American monetary arrangement would most likely mean that Canada would have to adopt the For Canada, the other major problem with a single North American currency is that we would be giving up the buffer that a flexible exchange rate provides in dealing with shocks that affect us differently from the United States. An important contrast between Canada and the United States is the distinctly different impact that fluctuations in the world prices of primary commodities have on our two economies. To a significant degree, Canada is still an important producer of primary commodities. And we are major net exporters of such commodities, while the Americans are small net importers. Thus, Canadian and U.S. terms of trade (the ratio of export to import prices) move in opposite directions when there is a sharp movement in world commodity prices. Take the past two years or so: with a decline of over 25 per cent in such prices, our terms of trade deteriorated by about 6 per cent while the U.S. terms of trade improved by 5 per cent. When the terms of trade turn against us, it means that, on average, we receive less attractive prices for the goods we sell abroad compared with the prices we pay for the products we import. As a nation, we become less well off compared with our trading partners. That is reality, and we have to adjust to it, whether we are on a floating or a fixed exchange rate or even in a currency union. The value of the Canadian dollar reflected that reality by moving lower last year. This helped to smooth the process of adjustment. If the exchange rate is not allowed to move, then the adjustment would have to take place primarily through declines in prices and wages and the movement of labour and capital. And if those did not readily occur, the adjustment would take longer and cost more in terms of losses in output and employment. It is precisely for these reasons, and not by accident, that the Government of Canada has, for the better part of the past 50 years, operated a floating exchange rate. Concluding remarks The introduction of the euro ushers in an exciting new era for the Europeans, and we should all wish them well. But the euro is not a blueprint for a North American monetary union. The political objectives that motivated monetary union in Europe do not have a parallel in More importantly, Canada has a very useful economic safety valve in its floating exchange rate. Because movements in the Canadian dollar reflect external shocks as well as any domestic economic difficulties we may face, there is sometimes a tendency in Canada to blame such movements as the cause of our problems. In fact, these currency movements are a consequence, not a cause. Exchange rate flexibility has served us well over time. Why would we want to give it up?

r990311a_BOC

canada

Then and now: the change in views on the role of monetary policy since the Porter Commission

thiessen

Governor of the Bank of Canada Tony Hampson made a number of outstanding contributions to Canadian public life as well as having a successful business career. Many in this audience will be familiar with the fact that for a number of years he was Chairman of the C.D. Howe Institute's Policy Analysis Committee. Early in his career, he worked on the Royal Commission on Canada's Economic Prospects (the Gordon Commission) and, most prominently, served as secretary of the Royal His colleagues, on these Commissions as elsewhere, remember an engaging personality, an ambitious and demanding manager, a clear-headed analyst, and a thorough and helpful editor. He was also a superb communicator and writer. Let me quote the Secretary of the Commission. His intellect, organizing ability and energy proved invaluable in the planning of our work, the development of our views and the drafting of our entire report." The hearings and analysis undertaken in the early 1960s by the Porter Commission, together with its Report and the discussions it generated, were events of major importance for the Canadian financial system and for the Bank of Canada. Indeed, I will suggest in this lecture that the Porter Report contained the seeds of a major reorientation of thinking about financial structure and monetary policy. Its emphasis on competition, and on the use of market mechanisms in the implementation of monetary policy, clearly showed the way ahead. It also foresaw many of the subsequent changes in financial institutions and markets. Moreover, the The main revisions were to the Bank Act and the Bank of Canada Act. While the Commission had recommended a comprehensive definition of banking, the legislation did not go so far as to eliminate distinctions between different kinds of financial institutions. Moreover, the Commission was against government-backed deposit insurance, which was nevertheless enacted in 1967, following a run on a trust company. Commission underlined the necessity for inflation control at a time when the view that inflation could be traded off for lower unemployment was gaining in popularity. were people of experience and insight. They assembled an extraordinarily talented young research staff, and Tony Hampson proved to be an admirable team leader. The Commission believed in markets. This was not such a popular stance at the time. Extensive government controls, a legacy of the post-World War Two period, were still in place in many advanced economies, and they were widely thought to be necessary, if not desirable. In contrast, the Porter Commission felt that the somewhat more liberal financial regime in Canada was by and large working effectively. The financial system had played a central role in the post-war expansion, especially in the smooth financing of the tremendous wave of investment in the 1950s. Moreover, at the time it was undergoing considerable change, in response to the evolving demands in the financial markets of households, firms and governments. On the basis of this encouraging experience, the Porter Report came out strongly in favour of increased competition and deregulation. It was aware that this might entail some risks, but thought they were worth taking. This advice was followed in the revisions to federal financial legislation of 1967, notably in the following measures: removal of the 6% ceiling on bank loan rates; permission for banks to enter conventional (i.e., non-government-insured) mortgage lending; prohibition of interbank agreements on interest rates and of interlocking directorates; and the reduction of the burden of cash reserve requirements on chartered bank deposits. These measures have stood the test of time and have served Canada well. For example, the liberalization of interest rates allowed financial institutions to adapt appropriately to the requirements of the more volatile financial environment of the decades that followed. Canada was spared the systemic weaknesses caused elsewhere by ceilings on administered interest rates. In the United States, for example, such ceilings were a major factor encouraging the unbalanced portfolios of the thrift institutions, which in the 1980s would be revealed as a fatal flaw. In more philosophical terms, Porter's arguments on financial liberalization and competition were ahead of their time, and still read very well today. The Commission also dealt with the issue of central bank governance. It recommended formalizing the agreement on dual government-Bank of Canada responsibility that Louis Rasminsky had drawn up before accepting his appointment as Governor. In consequence, the Bank of Canada Act was amended in 1967 to provide the Minister of Finance with the right to issue a directive to the Bank if the government disapproved of the Bank's policy. Thus, the government is ultimately responsible for monetary policy, but if no directive is issued the Bank has full responsibility for designing and implementing monetary policy. These ideas were also to be found in similar inquiries of that time in the United Kingdom However, there were some differences in the argumentation of the three reports. For example, Radcliffe was most interventionist while Porter was the strongest advocate of market mechanisms. I cite all this to underline that the Porter Commission made an important difference to our financial landscape. But financial reform, important and topical though it may be, is not the central theme of my lecture. Instead, I will focus on the Commission's work on the conduct of monetary policy. First, I will set out a broad characterization of the view of monetary policy in the Porter Report. I have not tried to provide a thorough description of the Commission's analysis of monetary policy. Rather, I have focused on a few general policy issues that strike me as important. Next, I will present the general approach to policy that is taken today. Comparison of the two, you will see, reveals some striking differences, but also some common themes. These themes lead me to the view that the Porter Commission Report and the surrounding debate were a key step in the evolution towards the current monetary policy framework in Canada. The basic framework The Porter Report in most respects adopted a standard 1960s view of monetary policy. It was the heyday of Keynesianism, in official circles as well as in the universities. Although Milton Friedman and his collaborators had begun their restoration of the quantity theory with some impressive, if controversial, empirical work, theirs was very much a minority view in the early 1960s. There were four key tenets in the standard view of monetary policy at the time. First, monetary policy was seen as just one element of macroeconomic policy, which in its entirety has multiple objectives (high employment and output, low inflation, rapid economic growth, external balance, etc). And it was argued that monetary, fiscal and debt management policies should be coordinated in pursuit of these objectives. These propositions reflected a strong focus on the short run. While there is no doubt that monetary policy and fiscal policy both affect real variables in the short run, it was less clear at the time that the effects of monetary policy on the demand for goods and services did not extend into the longer run. Given its short time horizon, it was not surprising that macroeconomic analysis in the 1960s focused on stabilizing output and employment. Second, monetary policy on its own was viewed as not very effective. Large movements in credit conditions or interest rates might in theory have a large economic impact, but they had to be avoided because of harmful side effects (instrument instability, financial instability, balance of payments repercussions, etc.). The changes in credit conditions that were feasible had a comparatively limited effect. Third, the credit channel was thought to be the main source of impact of monetary policy on the economy. Conventional monetary policy instruments (open-market operations, bank reserve management, and Bank Rate changes) were said to affect credit flows by changing the liquidity positions of financial institutions. This credit channel embodied the effects of both the availability and the cost of borrowing. However, its overall influence was complex and typically slow; and the impact of an easing of credit was considered to be especially weak -- "you can't push on a string." Fourth, a need was seen for moral suasion or formal controls on lending in difficult short-run situations, such as balance of payments crises. The Commission recognized the defects of such measures: arbitrary discrimination, economic distortions, and eroding effectiveness over time. However, the general view at the time was that such controls were helpful when quick effects were urgently needed. The relationship between inflation and economic activity In 1958, A.W. Phillips published the analysis of the relationship between wage increases and unemployment in the United Kingdom that now bears his name, and researchers in the United States soon found a similar relationship. By the early 1960s macroeconomists were regarding the Phillips curve as a description of a policy trade-off between inflation and unemployment. By accepting more inflation, it seemed possible to reach a higher level of output. A seminal study of the policy implications of the Phillips curve was in a Royal Commission The Porter Commission accepted this line of reasoning and argued that a balance had to be struck between the goals of price stability and maximizing output, and that neither should be pursued to the exclusion of the other. At the same time, however, the Commission was aware that inflation could have very negative longer-run consequences for the economy. "The objective of stable prices..., while desirable for its own sake, is also important as a means to a wider end.... rising prices can weaken real economic growth by undermining the system of fixed value contracts on which efficient business is founded, by generating a fear of long-term saving and lending commitments, and by diverting real resources into unproductive and inefficient channels ...." In a similar vein, the Report rejected the argument for mild inflation to lubricate real wage adjustment, after noting that productivity was increasing at two per cent a year, so that a considerable degree of adjustment was possible without real wage declines, and that measures to increase market flexibility were a better solution. The Report also described inflation as acting "like a drug whose dose must be continually increased to get the same effect: if the authorities permitted the economy to become addicted, the inevitable return to reality would bring about very painful withdrawal adjustments." These passages were prescient in the light of what was to happen over the next 20 years. However, the Report struggled to reconcile its advocacy of multiple targets with its vivid warnings about inflation. The tension between the two, we can now see, stemmed largely from a lack of clarity about relevant time horizons. The multiple targets approach to monetary policy focused on the short-run trade-off between inflation and unemployment. It did not recognize that this trade-off disappears over time as inflation expectations adjust to changes in the rate of inflation. The idea of a vertical long-run Phillips curve, which was implied by the adjustment of inflation expectations, was developed only later in the decade. At the same time, the Report did recognize the likely damage that inflation could cause in the longer run to the productive capacity of the economy. The Submissions of the Bank of Canada also pointed to the importance of restraining inflation (II, paragraph 59): "Central banks feel a particular obligation for seeing that in the consideration given to the proper 'mix' of public policies adequate emphasis is at all times placed on price stability... being in a position to exercise an influence on the volume of money, they must inevitably be concerned with its value." In part these views stemmed from theories of inflation that emphasized non-monetary factors, e.g. cost push, union or seller power, demand shift, struggle for income, and so on. Exchange controls had been eliminated in the early 1950s. The Canadian dollar would remain fixed until June 1970. In the end, the Report did not recommend the firm guideline for monetary policy that its spirited advocacy of price stability would, in retrospect, seem to have justified. this ambivalence, the Commission was more far-sighted in its concerns about inflation than the consensus of economists of the day, which was that the Bank of Canada had been investing too much in fighting inflation. The scope for monetary policy under a fixed exchange rate Canada had been on a floating exchange rate regime when the Porter Commission was appointed in October 1961, but the government adopted a fixed exchange rate in May 1962. Given the degree of asset substitutability between Canada and the United States, Canadian interest rates were thereafter tightly constrained by the objective of maintaining the dollar at the With respect to longer-run policy objectives, as we know today, the fixed exchange rate implied that monetary policy in Canada would be mainly determined in the United States. However, the prevailing opinion among economists, reflected in the Porter Report, was that Canadian monetary policy could nevertheless serve a constructive short-run purpose with respect to the range of macro-economic policy objectives, as long as the currency was fixed at a reasonable value and the government had an adequate reserve of foreign exchange. At the time, most policy-oriented economists did not draw the sharp distinction we now do between fixed and floating exchange rate regimes. To understand this, we have to recognize three factors. First, under Canada's floating exchange rate regime of the 1950s -- which was the only post-war experience in the industrialized world to go by -- variations in the exchange rate had been quite modest, as had the movements in Canada-U.S. interest rate differentials. That is, in practice, the float did not appear to be very different from a fixed rate regime. Second, with their focus on short-run output and employment, policy-makers tended to neglect the possible inconsistency between the objective for domestic inflation and the fixed exchange rate. Third, the theory of monetary policy in an open economy was in a fairly Robert Mundell was at that very time making the contributions that would form the standard modern model for open-economy policy analysis. See Mundell (1961, 1962, and 1963). rudimentary state. The severe constraints that a fixed exchange rate imposes even on short-run monetary policy choices in a world of high asset substitutability were not fully appreciated at the time. In the case where a conflict might materialize between domestic objectives and the fixed exchange rate for the dollar, the Commission recommended that domestic considerations should prevail, and that the exchange rate parity be allowed to change. But it did not reopen the debate over the exchange rate, which had been a topic of heated political controversy earlier in the decade. By 1964, at the time the Report was published, the view of the Canadian authorities was very much that the fixed exchange rate system was appropriate, and that the existing parity was in the right range. Monetary policy instruments and the transmission mechanism Both the Porter Commission and the Bank in its submissions described the transmission of monetary policy actions in terms of their effects on credit conditions. By credit conditions they meant "the whole range of terms and conditions affecting borrowing and lending and the purchase and sale of financial assets." This would include, most importantly, interest rates, but also standards of creditworthiness, collateral, repayment periods, and other terms and conditions. In general, whereas the Bank of Canada stressed the importance of availability effects, the Porter Report was more inclined to give a central place to interest rates. One of the reasons why the Bank of Canada put so much emphasis on credit availability at that time was because, even apart from the 6 per cent bank loan rate ceiling, it believed that wide fluctuations in interest rates were not feasible. Indeed, historical experience was of a quite narrow range of interest rate movements. For example, the prime lending rate of the chartered banks, a key rate in the transmission mechanism, had never been lower than 4.5 per cent, while the maximum legal rate was 6 per cent -- a range of 150 basis points. There simply had not been much scope for borrowing costs to vary. As outlined by the Commission and the Bank, there were a number of possible reasons for this belief that wider movements in interest rates were not feasible: the possibility of instrument instability (with interest rates swinging abruptly), the potential effect of sharp changes in security prices on the stability of financial institutions, adverse public opinion, and the external constraint posed by the fixed exchange rate. While the Commission agreed with some of these concerns, it nonetheless argued that such considerations should not stand in the way of a vigorous monetary policy. The Porter Report accepted, however, the description put forward by the Bank of Canada of the way that monetary policy affected the operation of chartered banks. The provision of cash reserves by the Bank of Canada would bring about changes in chartered bank holdings of liquid assets, which over time would affect the banks' willingness to make loans. However, when quick results were deemed necessary, the Bank felt that resort to direct limits on bank lending would be justified. On the several occasions that moral suasion had been employed in the 1950s, it had seemed to work. The Commission showed little enthusiasm for such intervention. It argued that controls impaired market efficiency, were discriminatory, and were of diminishing effectiveness over time. There was also a concern about their clumsiness, especially the delays in making instructions effective in bank branches across the country, and possible misinterpretation of their eventual withdrawal. Despite all that was said and done about the credit conditions approach to monetary policy, empirically any significant effects seem to have been confined to a few brief periods of moral suasion and the impact on residential construction of the lags in changing the administered NHA mortgage rate and the interaction between this rate and the 6 per cent bank lending rate ceiling. The available empirical evidence did not indicate that changes in credit conditions systematically had much effect on aggregate demand. Econometric tests reported in the Commission's Working Papers show no significant effects on consumption and investment spending from interest rate or credit variables. This seems to have been because monetary policy actions had not been very aggressive. These results confirmed the conventional belief that ordinary monetary policy actions were not very effective. And this was a major reason for the insistence on policy packages with the right mix of fiscal and monetary policy, plus co-ordinated debt management policy, and on the possible need for moral suasion and/or some sort of direct controls on bank lending. The role of debt management I have noted that the package of macroeconomic policies advocated during the 1960s tended to include debt management policy along with fiscal and monetary policies. Certainly, central bankers of the day regarded debt management policy as an integral part of macroeconomic policy. The Porter Report had some sympathy with this notion. There were three discernible lines of thinking here. First, monetary policy is itself a kind of debt management with an open market operation switching one public sector liability (central bank deposits) for another (e.g., treasury bills). Second, changes in relative supplies of debt could affect the liquidity of the banks and hence their willingness to lend. Third, debt management might directly alter the term structure of interest rates. These notions may have had greater plausibility at the time, when there were some indications of segmented markets. But over time, market segmentation diminished in importance as both lenders and borrowers became increasingly willing to adjust the maturity of their commitments in response to interest rate differences across the term structure. Moreover, in the years following the publication of the Porter Report, evidence accumulated supporting the expectations theory of the term structure of interest rates. According to this theory, long-term rates are the average expected value of future short-term rates, plus a liquidity risk premium. Although in principle the latter could vary systematically as the composition of debt changes, in practice such effects, if they exist at all, are of too short duration to have any macroeconomic impact. The basic propositions Between the 1960s and the 1990s, informed opinion about the appropriate role of central banks shifted radically. The current mainstream view can be briefly summarized in the following four propositions. First, the main objective of monetary policy is to preserve the value of money, in other words to achieve a very low rate of inflation over the long run. Other economic objectives are not ignored, however, because price stability is the best contribution that monetary policy can make towards high employment and, more generally, towards a prosperous, growing economy. Second, an independent monetary policy or, more precisely, a domestically set objective for inflation, logically requires a floating exchange rate. Third, markets, and price mechanisms, work efficiently and thus provide effective channels for the transmission of monetary policy through short-term interest rates and the exchange rate. Fourth, short-term interest rates must be adjusted as much as required to meet the monetary policy objective. Most of the present policy framework is, I hope, reasonably familiar to you. So I will spare you further detail. Instead, I would like to underline the magnitude of the revision that has taken place in accepted thinking about monetary policy since the Porter Commission, and to speculate on the reasons for the shift. The Bank has long had a concern about restraining inflation. What was lacking in the past was the support from theory and experience to make that focus more precise and explicit. Public milestones in the evolution of the Bank's views were three lectures by my predecessors: the 1966 Per Jacobsson Lecture by Louis Rasminsky on the objectives of monetary policy and the mechanisms through which it operates; the 1982 Per Jacobsson Lecture by Gerald Bouey, which highlighted the need for a "place to stand" or, in other words, for a "nominal anchor"; and the Hanson Lecture of John Crow, which singled out price stability as the objective of monetary policy in Canada. Also, I would draw attention to Gerald Bouey's final Annual Report, for 1986, which emphasized the costs of inflation and the difficulty of reducing it once entrenched. For a fuller explanation of the relation between price stability and other economic Contrasts in views about policy objectives The sharpest apparent contrasts between the ideas and practices I have sketched for the two periods concern the objectives of monetary policy. Nowadays we focus the job of the central bank squarely on the single objective of price stability. In the 1960s, that would have been looked upon by most observers as an extreme and partial view of the role of monetary policy. What has been learned from the experience over the years is that high and variable inflation can be very costly for the economy and that aiming at low and stable inflation is the best contribution that monetary policy can make to achieving, over time, the multiple economic objectives espoused by Porter. Desirable economic outcomes can never be guaranteed, but chances of achieving them are best when inflation is low and stable. That is, low inflation is an indispensable asset for the achievement of the other economic goals. Consider, for example, the accepted view during the 1960s that there was an exploitable trade-off between inflation and unemployment. Along with the short-term perspective of policy-makers, this view led to excessively easy monetary and fiscal policies in most industrial countries. In Canada, we found ourselves confronted by an enormous and destructive inflation, with peaks in the mid-1970s and the beginning of the 1980s, and another bout of upward pressure in the late 1980s. Moreover, the high rates of inflation were accompanied by an economic slowdown in the 1970s (reflected in the coining of the term "stagflation") and were followed by unusually sharp economic recessions in the early 1980s and early 1990s. The idea of an exploitable long-run trade-off between inflation and unemployment was effectively demolished by this experience. And the lesson was reinforced by the success of the firm stance in favour of price stability taken by the German and Japanese central banks in the late 1970s. The inflation of the 1970s and early 1980s demonstrated just how costly inflation was and how difficult it was to eradicate once rooted in expectations. These experiences were key factors underlying the shift in views about monetary policy. They also were central to the acceptance of the expectations-augmented Phillips curve in place of the simple Phillips curve as part of the analytic framework underlying monetary policy. This is not just theory or central bank ideology. As we look around the world and over history, we see that countries that achieve high standards of living and sustained strong output growth have also maintained low rates of inflation. Understanding the role of the exchange rate in monetary policy As I explained earlier in this lecture, when the Commission was preparing its report, neither the then-current economic theory nor the Canadian experience of the 1950s provided strong evidence for the crucial role that exchange rate flexibility plays in the operation of monetary policy in an open economy like Canada's. When we floated our exchange rate in 1950 and again in 1970, it was because we were pushed off our pegged rate by the pressures of rising commodity prices and associated strong inflows of capital. The notion of a national monetary policy with an independent inflation target did not feature in these decisions. As we now see it, a floating exchange rate plays two key roles. In the first place, in the long run a floating currency allows the central bank to pursue a national inflation target, regardless of the behaviour of foreign inflation. In the second place, variations in the currency allow the real exchange rate, and hence the economy, to adjust more smoothly to international shocks to relative prices. It was only after currency and capital controls began to be removed (or were increasingly bypassed) in the post-war period, and domestic financial markets became more deregulated in a number of countries, that economists came to appreciate fully the interaction of domestic interest rates and exchange rates. In open economies with unhindered capital flows, it is only when the real exchange rate moves to levels where it is widely expected to appreciate or depreciate that domestic real interest rates can temporarily move away from their international counterparts. Furthermore, what we understand much more clearly these days is that movements in the real exchange rate are a major part of the process whereby an economy returns to a sustainable growth path after being hit by a shock. For example, it is well known that a drop in world commodity prices reduces the real equilibrium value of the Canadian dollar. If this is brought about by currency depreciation, the overall domestic price level need not deviate from its target path. In contrast, with a fixed exchange rate, domestic prices would have to fall below that path, and perhaps fall absolutely, to bring about the required decline in the real exchange rate. It is clear that real exchange rate adjustment works much more smoothly when the nominal exchange rate can adjust. However, for the benefits of exchange rate flexibility to be realized, expectations about nominal exchange rates must be anchored by a monetary policy that is focused on maintaining low and stable inflation over the medium term. Increased confidence in the resilience and efficiency of markets It would have been unthinkable in the 1960s to have suggested that the central bank's influence over interest rates was, in and of itself, enough to enable it to keep the rate of inflation low and stable. The view at the time was that there were narrow bounds on how far interest rates could be moved, and that these severely limited what the central bank could accomplish by varying them. As a result, moral suasion to affect bank lending policies or direct controls were seen as important additional instruments for central banks. A key reason for the change in attitude today is an increased confidence in markets. Certainly, at central banks, we are more confident than we were in the 1960s of the ability of financial markets to absorb changes in interest rates. At the same time, we have accumulated strong evidence to support the view that market mechanisms transmit monetary policy actions effectively. In the 1960s the Porter Commission was ahead of the Bank, and of conventional wisdom, in this. It envisaged a monetary system that in key respects would function much as it does today -- driven by market forces, flexible, and frequently undergoing rapid change. In its recommendations for reform, the Commission was looking forward to a world in which monetary policy would be increasingly reliant for its effectiveness on appropriate movements in financial market prices. In line with this view, the Porter Report maintained that institutions and markets were well able to withstand substantial shocks and warned against letting the conduct of monetary policy be excessively influenced by an undue concern for the stability of asset values. It saw that the aversion to significant interest rate movements expressed at the time by the Bank of Canada put at risk its ability to achieve its macroeconomic objectives. In one of its more colourful phrases, the Report warned that "the authorities must not be restrained by excessive However, the present confidence in markets is not just a question of philosophy. Since the 1960s, a variety of legislative and structural changes have made the financial sector still more resilient and flexible. This has made the transmission of monetary policy more efficient and has eliminated residual concerns about the inability of the markets to cope with the effects of central bank actions. Even though the Porter Commission had some remarkable insights, there is no doubt that there has been a major change in views since the 1960s with respect to the objective of monetary policy and the mechanisms through which policy works. Two factors stand out in trying to understand the change. The first is the simple accumulation of experience that has exposed some of the shortcomings in earlier thinking about macroeconomic policy. The second is the advances in the analytic framework available to policy-makers to help them analyze the workings of the economy and of monetary policy. These are not independent factors, of course, since economic analysis does change in response to experience. In this case, it was the inability of the previous framework to provide a satisfactory explanation of the developments in the second half of the 1960s and the 1970s that led to changes in the framework for analyzing the macroeconomy. Experience of good and bad outcomes has thus played a major role in the development of views about monetary policy. The theory dominating the views of Tony Hampson and his colleagues was developed in response to the Great Depression of the 1930s. However, the views of my generation of central bankers have been coloured by the great inflation that marked our professional years. This brought back to the fore the fundamental truth about inflation being a monetary phenomenon that had become temporarily obscured in the 1950s and I want to make sure, however, that I do not leave you with the impression that views on monetary policy are mere creatures of circumstance. Our belief in the objective of price stability has a more solid foundation than that. A vast range of historical evidence, as well as a large body of economic theory has long supported this objective as a necessary factor for good performance with respect to output, employment, and growth. I would like to end this lecture by drawing attention to the area in which central banking has probably changed most dramatically quite recently. This is the move, particularly during the 1990s, towards much greater transparency and public accountability in monetary policy 22 "Mystery leads to misinformation, and monetary policy needs informed public opinion to function effectively and acceptably. As the Governor pointed out, much of this information must be backward-looking, but we believe it need not all be." Porter Commission Report, p.555. For a detailed discussion of the movement to greater transparency, see Thiessen (1995). and in the operations of central banks generally. Here again, the Commission was insightful but did not make strong recommendations for greater transparency. Since 1991, the use of explicit low-inflation targets as the objective of monetary policy has been the most prominent aspect in Canada of this broader development. We now believe that our actions are likely to be more effective and more credible to the extent that they are more clearly understood and more predictable. Therefore, today we provide the public with large amounts of data and commentary on monetary policy, in our regular publications, on the internet, and in response to specific requests. We also try to give information on the outlook for the economy and monetary policy in our , in speeches by Bank of Canada officials, and in the extensive informal contacts of our regional offices across the country. In our Technical Reports and Working Papers and annual economics conferences, the Bank makes its latest research available in a timely fashion. This is a two-way street, by the way, since feedback and criticism is essential to good research. There has been a similar move to openness with respect to the process of policy implementation. Since 1994, the Bank has announced its operating band for the overnight interest rate, which is now tied to the Bank Rate. And since 1996, press releases providing an explanation of the Bank's actions have accompanied each change in the Bank Rate. Much of this is quite a break from the past, since traditionally central banks liked to retain a strong element of mystery about their conduct of policy and at times liked to have the capacity to surprise the market with shifts in the supply of reserves to move the overnight rate. Public opinion has been an underlying driving force in this movement towards transparency. People expect much more than they used to with respect to the accountability of public institutions. The great expansion in higher education over the past 40 years, and with it the rise in sophistication about financial and economic matters, means that the public is more apt to raise questions about economic policies. The amount and the quality of the information that we provide has had to keep in step. Also, the great inflation, which has had a lasting effect on perceptions about the value of money, has led to a heightened interest in the conduct of monetary policy. Expectations are not held as firmly as they were in the 1950s and early 1960s. People have had to be convinced in recent years that price stability is a credible objective. They still do not take the present low inflation completely for granted. Each action of the central bank is liable to be scrutinized for any sign of backsliding. For example, the volatility of bond and foreign exchange markets, which persists despite almost a decade of low inflation, can partly be attributed to lingering uncertainties with respect to future price movements. At the Bank of Canada, we have taken the position that these concerns are best confronted by making clear statements about the objective and strategy of monetary policy, by releasing our economic analysis to outside examination, and by publishing all relevant data. It is possible that some future governor of the Bank of Canada will want to give a lecture looking back at monetary policy in the 1990s. I believe that this future governor will be particularly impressed by the influence that demands for transparency and public accountability have had in shifting the culture of central banks and their approach to monetary policy in the Submissions by the Bank of Canada to the Royal Commission on ---------------. 1987. Annual report of the Governor to the Minister of Finance and statement of accounts for the year 1986. Studies in

r990322a_BOC

canada

Financial sector reform, the economy, and monetary policy

thiessen

Governor of the Bank of Canada Financial sector reform, the economy, and monetary policy I am delighted to be with you this evening to celebrate the 35th annual meeting of the Mennonite Savings and Credit Union. On this occasion, I propose to speak about the Canadian economy and monetary policy. But given this audience, I thought I might start with some remarks on the future of the Canadian financial sector -- a subject that has certainly grabbed its share of headlines over the past year! In December 1996, the Minister of Finance appointed a Task Force to assess the current situation and the future prospects of the Canadian financial services sector, and to make recommendations for change. In early 1998, while this inquiry was still on, four of Canada's six largest banks announced plans to merge. The Task Force submitted its report (the MacKay that report as well as assessments of the proposed mergers by the Office of the Superintendent of Financial Institutions and the Competition Bureau, decided not to allow the mergers. The Government is now examining the issues facing the financial services sector and, in the course of 1999, it intends to present its proposals for modifying the relevant regulatory framework. The Bank of Canada is one of several agencies in Ottawa that provide advice to the Minister of Finance on the appropriate legislative framework for the financial industry. Because of this, I am not in a position to comment on specific proposals for change. But what I can do is offer some general comments on the broad issues involved in ensuring an efficient and sound financial industry in Canada as we strive to adapt to ongoing worldwide changes in the provision of financial services. Potential reforms of the Canadian financial system Canadian financial institutions are among the best providers of financial services in the world. These days, they are operating in an intensely competitive global marketplace, teeming with change spawned by rapid advances in technology and innovative new financial products. These powerful forces have transformed the way financial institutions around the world operate and the way they market and deliver their services. Globalization creates both opportunities and challenges. We must make sure that Canadian financial institutions can compete effectively in both domestic and international markets, and that they can offer Canadians innovative, world-class financial services. The MacKay Task Force says this means we should enhance competition in the financial services industry. How? Primarily by reducing restrictions on existing providers of those services and by encouraging new players to enter the field. Members of this audience know that one of the proposals for strengthening the position of existing participants is to give credit unions the option to form co-operative banks. More generally, provided prudential concerns can be resolved, the Task Force suggests that the regulation of credit unions be re-examined to encourage them to become more active, dynamic competitors within the financial industry. We would all agree that consumers of financial services are best served when there is effective competition among financial institutions. A strongly competitive financial industry will provide customers with the best deals for loans, deposits, insurance, and so on. Such an industry would also be more innovative and should provide a wider range of services. But the appropriate legislative framework for financial services cannot be one that simply maximizes competition without regard for the safety and soundness of the industry. Why all this concern about safety? And why do we regulate this particular industry more closely than virtually all others? There are two main reasons. First, the financial industry is the repository for the wealth of a large number of small savers. For most of these savers, it is very difficult and costly to make a personal judgment of the risks involved in doing business with a particular bank, credit union, or insurance company. The second reason has to do with what we call systemic risk, or contagion. This refers to the risk that problems in one particular financial institution will be transmitted to others. Contagion can occur when depositor nervousness about one institution spreads to others. As well, since the payments system links financial institutions closely together, the failure of one institution can potentially lead to serious losses for others. Governments have addressed safety concerns by imposing capital requirements on financial institutions, restricting their ability to engage in risky activities, supervising their adherence to risk-reducing practices, and setting up deposit insurance. To limit contagion, central banks have the power to make liquidity loans to financial institutions in the payments system. And most central banks in industrial countries have been involved in initiatives to minimize the potential for systemic risk in their payments systems. When depositors feel "protected," however, they are less inclined to monitor the riskiness of financial institutions. Thus, governments feel a greater need to regulate to reduce the risks of institutional failure. This tends to have side effects which could potentially restrict competition. What then is the scope of increasing competition, by encouraging new players and by reducing restrictions on existing ones, without undermining the safety and stability of the system? Clearly, there can be a tension between the goals of fostering greater competition within the financial sector and of preserving safety and stability. To find a balance between the twin objectives of efficiency and safety has always been a challenge for governments when they examine proposals to change the regulatory framework for the financial system. I do not mean to make this sound like an impossible task. There are bound to be some changes that can help promote competition without adding substantial risk to the system. More generally, though, I believe that we need to examine ways that could ease the tension between efficiency and safety. For example, if we are to encourage the entry of new financial institutions as a means of promoting greater competition, perhaps we should also consider a more formal, explicit policy of "early exit" when an institution runs into trouble. One possible approach would be that when institutions reach some minimum level of capital, they would be required to recapitalize themselves or find a merger partner within a short period of time. Otherwise, and well before they became insolvent, they would be sold or wound up by the regulatory authorities. Such an approach might help to reduce risks to depositors, to the deposit insurance system, and to other creditors of financial institutions. This is not a new idea. The United States has already moved in that direction and so have we in Canada, to a certain extent. But there may be room to move further down this path and, in so doing, to provide managers of financial institutions with stronger incentives to avoid getting into financial difficulties. To summarize, I agree with the MacKay Task Force that encouraging new participants and reducing restrictions on existing players in the financial industry would benefit customers through improved service and lower costs. But this may have the potential to increase risks for the financial system. So we need to look at ways to avoid having these risks add to the costs of deposit insurance and to the costs for other users of financial services. One approach, as I mentioned, is to move further towards "early exit" arrangements for troubled financial institutions. Such arrangements might not be easy to implement. But if we could move in this direction, there might be more scope to benefit from enhanced competition without exposing users of financial services to unacceptable risks or compromising the stability of the system. I would now like to turn to our economic situation and monetary policy. The state of our economy The past year has been a trying one, both for the world economy and for Canada. Still, considering the seriousness of the global difficulties we have been facing, the Canadian economy has coped much better than expected, and certainly better than in the past. This is because it is in sounder shape now than it has been for many years. Canadian businesses have been investing in new technology to increase productivity and efficiency. Governments are no longer draining national savings to finance huge budget deficits. And with the Bank of Canada's commitment to inflation-control targets, inflation is low and stable. But what about our economic prospects as we look ahead? Let me start with the financial climate. Global financial markets have been calmer recently compared with the turbulence last autumn after Russia declared a debt moratorium. Cuts in official interest rates around the world since then and the success of some emerging-market economies in addressing their problems, have clearly helped. International investors' fears have abated, and markets seem to have regained a sense of their ability to assess risks and discriminate among borrowers. When it comes to the world economic environment, there is still uncertainty out there. But there are also positive elements in the picture. One area of uncertainty is the financial problems in Brazil and the extent of related economic weakness in Latin America more generally. If the Brazilians follow through on their fiscal-adjustment program and limit the inflationary fallout from the depreciation of their currency, financial market pressures should ease, and growth in Brazil should resume next year. But the foremost uncertainty in the outlook continues to centre on Japan, where the economy remains in a slump. Nevertheless, if present efforts at bank reform continue, and if stimulative macroeconomic initiatives are pursued systematically, the Japanese economy should begin a gradual recovery, perhaps by late 1999. The economic expansion in the other industrial countries, which together account for about half of world output, should remain relatively well sustained. In Europe, economic activity has softened, but interest rate cuts since the autumn and the easing of global financial strains should help support confidence and domestic spending in coming months. The most positive element, certainly from a Canadian perspective, has been the remarkable performance of the United States. That economy ended 1998 on a much stronger note than had been expected, growing at an annual rate of 6 per cent in the fourth quarter of 1998. Thus, its underlying momentum going into 1999 is much greater than most had supposed. This is confirmed by some of the advance data for early 1999. So even if growth slows, as expected, the U.S. economy should continue to operate at high levels. There are also signs that the sharp economic downturns in some of the Asian countries most affected by the financial crisis are bottoming out. The economy of South Korea has started to expand, and in Thailand economic activity seems to have stabilized. However, a broad-based recovery in the region has yet to take hold and will depend, to an important degree, on economic conditions in Japan. Here in Canada, the impact of the global turbulence since the summer of 1997 was felt mainly through the lower demand for the key primary commodities we produce and the 20 per cent decline in their prices between the middle of 1997 and the end of 1998. But consumer and business confidence were also affected, and that dampened domestic spending. Consequently, the Canadian economy expanded by just under 3 per cent through 1998 (fourth quarter-over-fourth quarter) compared with over 4 per cent in 1997. However, after some weakness through last summer and early autumn, our economy showed renewed strength recently. Helped by buoyant U.S. demand, easing global financial strains, and the rebound from major labour disruptions, economic activity grew at an annual rate of 4.6 per cent in the final quarter of 1998. And this was accompanied by robust, broad-based employment gains through the closing months of 1998 and into early 1999. With world economic and financial conditions still fragile and the timing of a firm recovery in primary commodity prices uncertain, projections for 1999 remain tentative. But with recent healthy employment growth, domestic spending should continue to contribute to an expanding economy. And sustained U.S. demand, coupled with our improved competitiveness, should continue to bolster our exports. Altogether, we are looking at a somewhat more positive scenario than seemed possible last autumn. The response of monetary policy to international turbulence Let me now say a few words about how the Bank responded to the exceptional global events of the past couple of years. As commodity prices tumbled, we became less well-off as a nation. Distressing as that is, it is a reality Canada had to face. And our currency moved downwards reflecting , not causing, the drop in our economic prosperity and the need to adjust. When shocks like this hit us from time to time, movements in the external value of the Canadian dollar help "buffer" the shock and smooth the process of adjustment. If the currency is not allowed to move, the adjustment will drag out and cost more in terms of losses in output and employment. However, the relatively orderly depreciation of our currency through to July 1998 accelerated following the Russian crisis last August. And Canadian longer-term interest rates rose sharply at a time when comparable U.S. rates were falling. To us at the Bank, this signalled a potential loss of confidence in Canadian dollar assets, which we moved to head off by raising the Bank Rate by 100 basis points. In so doing, we sought to limit the harmful effects of financial volatility on confidence by temporarily placing particular emphasis on calming markets. The situation has improved since then. Interest rates have been cut in all major industrial countries, and a measure of stability has returned to world financial markets. With this, concerns in Canadian markets have diminished, allowing us to unwind three-quarters of last August's increase in the Bank Rate. Calmer financial markets should now make it possible for the Bank to refocus attention on its medium-term policy objective of keeping the underlying trend of inflation inside the target range of 1 to 3 per cent. In conclusion, let me say that, given the financial market volatility and the global economic slowdown of the past couple of years, our economy has coped relatively well. And we begin 1999 on a positive note. This is testament to Canada's improved basic economic foundation these days. And it gives me reason to remain positive about our future despite lingering international uncertainties.

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Opening Statement before the Standing Senate Committee on Banking, Trade and Commerce

thiessen

Mr. Chairman, I am pleased to appear before your Committee to provide an update on the economy and monetary policy, as well as to discuss with you other economic policy questions. Since we have recently tabled the Bank of Canada's Annual Report in Parliament, I would also be happy to answer any questions you may have about our stewardship of the Bank. When we last met in November, a cloud of uncertainty hung over global financial markets and the world economy, although it appeared to be slowly lifting. At that time, I noted that the growth of the Canadian economy in 1999 would depend on how long the uncertainty lingered and how soon domestic financial markets stabilized. This was particularly important given that household and business confidence in Canada had been undermined by the heightened financial turbulence of last autumn. I also suggested to you then that Canada was weathering the international crisis better than in the past because of the progress we had made in restructuring our private sector to become more competitive, in getting our fiscal house in order, and in keeping inflation low and stable. Since November, the sky has become clearer, even though uncertainty persists in a number of areas. Interest rate reductions in the United States last autumn and in other industrial countries since then have helped to calm international markets and support economic activity. The most recent cuts occurred in early April -- 50 basis points by the European Central Bank and 25 basis points by the Bank of England. These latest interest rate reductions should help to support confidence and domestic spending throughout Europe, and are a positive element for the international economy more generally. As well, there has been some firming in commodity prices in the first quarter of this year. Perhaps the most important positive external development from a Canadian perspective has been the remarkable performance of the U.S. economy. That economy ended 1998 on a much stronger note than expected. And because of that, the level and momentum of U.S. economic activity in early 1999 is greater than most forecasters had predicted. The Canadian economy also regained vigour in the fourth quarter of 1998. Although this partly reflected the rebound from labour disruptions in the previous quarter, surging exports were the main factor behind the pickup in activity. And there was particularly strong employment growth in the closing months of 1998. With this and greater financial stability contributing to improved consumer confidence, all indications are that the Canadian economy has continued to expand at a healthy pace in the first part of 1999. Inflation in Canada has been fluctuating around the bottom of the Bank's target range of 1 to 3 per cent. This low rate of inflation and increased stability in financial markets prompted the Bank to reduce interest rates on four occasions between September and March. These reductions completely reverse the one percentage point increase in the Bank Rate that was needed to bolster investor confidence last August, in the wake of heightened global financial volatility. As we look forward, the ongoing strength of the U.S. economy and the low level of the Canadian dollar should continue to underpin growth in our exports. And more stable financial markets and accommodative monetary conditions should support increased spending by Canadian households and businesses. However, the economic stagnation in Japan and some lingering uncertainty in Latin America, associated with the financial problems Brazil is coping with, are constraining world economic activity and the recovery of those primary commodity markets that are important to Canada. Still, all in all, while uncertainties remain, the outlook for the world economy and for Canada is more positive than it was last November. Mr. Chairman, I know that with the recent successful launch of the euro as a common currency for the 11 countries participating in the European Economic and Monetary Union, your Committee has been discussing alternative exchange rate regimes. I will be happy to respond to your questions on this issue, but perhaps it would be useful if I briefly restated the views I have already expressed publicly. The smooth introduction of the euro has, no doubt, been a major political, administrative, and technical achievement. However, the euro does not provide a blueprint for a North American monetary union. There are no parallels here to the profound political forces that have been behind the move to greater integration in Europe over the past 50 years. Unlike the euro zone, which encompasses three large countries and eight other medium- and smaller-sized participants, any North American monetary arrangement would surely mean that Canada would have to adopt the U.S. currency. Moreover, our present flexible exchange rate regime plays an important role in helping us adjust to economic shocks that affect Canada differently than the United States. The most important shocks of this character have been fluctuations in primary commodity prices. The marked decline in commodity prices over the last two years has meant that Canada as a whole is relatively less well off. That is a reality we have to face, and adjust to, no matter what currency regime is in place. If the exchange rate for the Canadian dollar is allowed to move in response to this reality, the adjustment process is smoother and faster. Without exchange rate flexibility, the adjustment would have to take place primarily through declines in wages and prices, which would cost us more in terms of output and employment losses. There is a tendency in Canada to blame movements in the Canadian dollar as the cause of economic problems. The fact is that currency movements are a consequence of such problems, not a cause. In my assessment, Mr. Chairman, our flexible exchange rate regime is serving Canada well.

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Global financial turbulence and the Canadian economy

thiessen

Governor of the Bank of Canada to La Chambre de commerce de la region sherbrookoise Global financial turbulence and the Canadian economy The world economy and Canada have had to navigate some difficult straits in the past couple of years. But we have made it through. And considering the tide from the Asian financial crisis that washed around the world, the Canadian economy has coped better this time around than in the past. With the clouds of international uncertainty gradually lifting, Canada's solid economic foundations are providing good reason to remain positive about the outlook for our economy. Today, I would like to talk about recent economic developments and the prospects for Canada. But since much of what has been happening here recently has been heavily influenced by external events, I would also like to discuss some of the measures the international community is contemplating to prevent, or at least reduce the severity of, any future crises. Recent developments in the Canadian economy The financial crisis that began in Southeast Asia in mid-1997 turned out to be much more persistent and serious than anyone had expected. During 1998, the turmoil spread to Russia and Brazil, causing a great deal of nervousness and volatility in markets everywhere. This led to large outflows of capital from many emerging-market economies, rising interest rates, tighter credit conditions, and a marked slowdown in economic growth worldwide. Canada has not been insulated from these forces. Many of our industries, including those in Quebec, have been hard hit. The most immediate impact on our economy has been the lower foreign demand for the key primary commodities we produce and a 20 per cent drop in their prices between the middle of 1997 and the end of 1998. These developments were reflected in the value of our currency, which declined sharply against the U.S. dollar. As the turmoil in markets increased following the Russian debt moratorium last August, the Bank of Canada moved to head off signs of a potential loss of confidence in Canadian dollar investments, by raising the Bank Rate one full percentage point. The confidence of households and businesses in Canada was also affected by market nervousness and volatility, and this dampened domestic spending. Consequently, the Canadian economy expanded by just under 3 per cent through 1998 (fourth quarter over fourth quarter) compared with over 4 per cent in 1997. Considering the seriousness of the external disturbances, this is not a bad economic outcome. And for this, we can thank our sounder fiscal position and low and stable inflation, which have helped us weather the international instability better this time around. These same factors, coupled with calmer financial markets, have allowed the Bank to lower the Bank Rate four times since the autumn (fully reversing last August's increase), and to refocus attention on the medium-term objective of keeping inflation within the 1 to 3 per cent target range. Currently, inflation is just inside the bottom of the range. The economic outlook As I said before, the world economic horizon is now clearer. Interest rate reductions around the world -- most recently across the euro area -- have helped to rebuild investor confidence and to calm global financial markets. This includes markets in the troubled Southeast Asian economies, where progress is being made on structural reforms and the outlook for a turnaround this year and next has improved, especially in South Korea, but also in Thailand and Malaysia. There are also signs that the financial situation in Brazil, which looked precarious in late 1998, is now stabilizing with the adoption of measures to address imbalances in the country's fiscal and external accounts. What is less clear is the extent of short-term economic weakness one can expect in Latin America because of the difficulties in Brazil. There has also been a slowdown in the pace of economic expansion in Europe. But easier monetary conditions -- that is, lower interest rates and the lower value of the euro -- should help offset some of the economic weakness there. And these lower interest rates are a positive element for the international economy as a whole. The main question mark in the outlook continues to be the Japanese economy, which has been in recession since late 1997. Even if stimulative macroeconomic policies are pursued systematically, and progress continues on banking sector reform, it is rather unlikely that there will be much of a recovery there before the year is out. In contrast, the U.S. economy continues to flourish, consistently outperforming expectations and with no sign of inflationary pressures. That economy ended 1998 on a much stronger note than had been expected. And the momentum of U.S. economic activity in early 1999 is greater than most forecasters had predicted. From a Canadian perspective, this is the most positive element in the current external economic environment, as anyone who sells to U.S. markets can confirm. Strong U.S. demand for Canadian products and the rebound from major labour disruptions in Canada led to renewed vigour in our economy in the fourth quarter of 1998 which, by all indications, carried into early 1999. And this has been accompanied by healthy employment growth. As we look ahead, steadier financial markets, employment gains, and accommodative monetary conditions should bolster spending by Canadian households and businesses. All this, coupled with sustained U.S. demand and our improved competitiveness, should continue to contribute to an expanding Canadian economy. Since world economic and financial conditions are still fragile and since the timing of a firm recovery in primary commodity markets remains uncertain, I cannot be more specific about how strong our economy will be. But we are now looking at a somewhat more positive scenario than seemed possible last autumn -- both for the world economy and for Canada. What to do about future crises As much as we are all anxious to put this latest episode of global financial turbulence behind us, I hope that in one respect, at least, we won't soon forget it. The fact that things are getting better should not distract us from devising strategies to reduce the risks of similar crises in the future. And should there be any, we need to be better prepared to handle them and to minimize their economic fallout. So what are some of the issues, and what is being done about them? It would be all too easy to blame globalization and unhindered, large, cross-border capital flows for the recent financial problems, and to suggest that we retreat behind national borders and place restrictions on the flow of capital. But it would be unwise. For even though capital flows may sometimes be difficult to manage, especially for small countries, the benefits from access to a bigger pool of world savings are substantial -- when those savings are used prudently and productively. What we must do is find ways to minimize the risks, without surrendering the benefits. There are three main areas towards which international efforts are currently directed: strengthening financial systems; ensuring that countries follow responsible macroeconomic and financial policies; and developing effective processes for managing crises when they arise. Let's look at these three areas. First, there is the need to encourage sound financial systems -- nationally and internationally. Some of the things being addressed here are accounting and disclosure standards, supervisory and regulatory frameworks, and bankruptcy procedures. Why do we need to strengthen these practices? Widely accepted accounting standards are the key to communicating reliable information about a company's financial health and to making its operations more transparent. Disclosure of accurate and timely information strengthens confidence and helps markets to make more informed judgments about the riskiness of investments. Recall that one of the main problems behind the recent difficulties was the huge amounts of funds placed in some emerging markets in Asia by investment advisers from industrial countries and by their clients, evidently without adequate information or appreciation of the risks involved. History shows than when concerns arise, lack of information causes investors to expect the worst and run for cover. There is also a need to improve the effectiveness of regulation and supervision of banks and other financial institutions, especially in emerging-market economies. Banks are important intermediaries for moving funds around at home and abroad. But they will perform this role most effectively and soundly if they are properly supervised and if they have reason to control risk. In countries where banks have strong links to industry and/or to government, their ability to make objective credit judgments may suffer. And sometimes these relationships include provisions that protect banks from failure but do not encourage prudent behaviour. Plans to improve global financial rules also involve strengthening bankruptcy procedures. Well-defined bankruptcy codes are important. They can provide debtors and creditors with a clear understanding of the rules for resolving defaults. And they would enable the private business sector to continue to function even in the event of a financial crisis. So far, I have talked about institutional improvements that international bodies, like the International Monetary Fund, are helping to design and put in place through a code of "best practices". Let me now turn to economic policies and their role in promoting greater financial stability. One important lesson we have learned from experience -- including our own in Canada -- is that countries must, above all, follow sound and credible macroeconomic policies. This means a fiscal policy that avoids unsustainable public sector deficits and debts, and a monetary policy aimed at low and stable inflation. But the question of a country's exchange rate policy is also very relevant. Recent experience highlights the importance of ensuring that financial markets have the right incentives to make sound decisions and to avoid excessive exposure to risks. When a government pegs its exchange rate to another currency, pledging to do whatever it takes to ensure that the peg holds, domestic and foreign investors tend to minimize the exchange rate risk, as long as things are going well. The problem with a fixed, but adjustable, exchange rate is that it does not guarantee that a currency will not decline in value. Should it come under pressure, because it is fixed at a level that is inconsistent with changing fundamentals in the economy, and should markets begin to question the authorities' pledge to the peg, domestic and foreign investors would likely rush for the exits, triggering a crisis. When you think of recent crises in Southeast Asia and in Brazil, the first thing that strikes you is that they all occurred in countries with fixed exchange rates. I would argue that, in most of these cases, greater exchange rate flexibility would have helped to make borrowers and lenders more aware of exchange rate risks. And so I find it encouraging that some of the crisis-afflicted emerging countries have since moved towards more flexible exchange rates. Let me now say a word about the need to devise processes for the effective management and resolution of future crises, should they occur. Right now, the International Monetary Fund is the main provider of emergency assistance to a country that runs into financial difficulties, while its private creditors are not always involved. The main, and somewhat contentious, issue here is to ensure that private lenders have the incentive to participate in crisis prevention and that they bear their fair share of the financial burden of dealing with crises. Progress in this area has been slow, but a number of proposals are being examined that would encourage debtor countries and their creditors to work out financial problems in a cooperative manner. Let me conclude. Thanks to a stronger foundation these days, the Canadian economy has thus far weathered the financial volatility and the global economic slowdown of the past couple of years reasonably well. And having started 1999 on a strong note, we are looking for sustained economic expansion this year. The situation in world financial markets has improved. And the international community has been hard at work, seeking ways to strengthen the international financial architecture. There is no single, simple solution to prevent crises. Today, I have discussed some of the measures planned to provide a degree of comfort. None of them is dramatic, and much remains to be done. But I believe that these changes should help reduce future risks. Canada has a stake in building a stronger, more stable international financial system, and strongly supports global initiatives designed to achieve this.

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Release of the Monetary Policy Report

thiessen

This morning we released our ninth The economic and financial situation is much improved since our previous in November. Financial markets have steadied in Southeast Asia, and prospects are good for a gradual recovery there. In Brazil, the authorities have taken major steps to address their difficulties. Overall, global financial markets now seem better able to assess risk. Interest rate cuts by central banks in all major countries have helped restore investor confidence. Most economic forecasters have recently upgraded their projections for Canada's growth in 1999. We have also raised our forecast to a range of 2 3/4 to 3 3/4 per cent. Our forecast at the upper end of the range is above most private sector forecasters. That outcome is based on the possibility of stronger exports and weaker imports in response to the current levels of competitiveness than expected in most private sector forecasts. We expect the economy to expand in the year 2000 at a similar pace to this year. Recently, the driving force in the Canadian economy has been exports. Strong demand in the U.S. economy, the relatively weak Canadian dollar and increasingly competitive Canadian manufacturers are allowing us to sell into the United States very successfully. What we expect to see now, however, is an increase in consumer and business spending. We believe that the improvement in confidence that we have seen in the last few months, the better employment picture and recent reductions in interest rates will all help support domestic spending. Consistent with this economic outlook, we expect core inflation to rise gradually but to remain in the lower half of the inflation control target range. Finally, I believe it is important for me to stress the conditional nature of any projections for growth and inflation. Economic uncertainties remain. One of the main risks to the world economic outlook revolves around the divergent economic performances of the major industrial countries, particularly the United States and Japan. On the domestic side, there is the uncertainty regarding estimates of the economy's capacity to produce goods and services and the margin of unused capacity. As a result, the Bank will be placing increased weight on a range of indicators to assess the degree of pressure on the economy's production capacity. What we have in mind are such things as movements in inflation relative to expectations, growth of money and credit, wage pressures, evidence of supply bottlenecks and the information provided to our regional representatives from their business contacts.

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Opening Statement before the Standing Committee on Finance of the House of Commons

thiessen

It is always a pleasure to appear before your Committee following the publication of our . We released our ninth last Wednesday. The Bank of Canada began publishing these Reports on a semi-annual basis four years ago, as part of our effort to increase the transparency and accountability of the Bank's conduct of monetary policy. The main focus of every is how well Canada is doing in managing inflation. But controlling inflation is not an end in itself. The objective of monetary policy is to help create and maintain a monetary climate that favours good economic performance, an economy where growth and employment are strong and Canadians feel prosperous. The Bank feels very strongly that the best thing that monetary policy can do to help long-term growth in the economy is to preserve low and stable inflation. Indeed, I believe the low and stable inflation rate we have had in Canada in recent years has helped us through some difficult times. However, I am also happy to report that the global financial system is much more stable than it was at the time of my last appearance before you six months ago. The shock from the financial crisis in Southeast Asia, which began almost two years ago, was compounded last August by Russia's default on its external debt. The turbulence that followed has now largely subsided and investor confidence is being restored. As a result, the outlook for the world economy has become more positive than it was last November. Financial markets have steadied in Southeast Asia, and prospects are good for a gradual recovery there. In Brazil, the authorities have taken major steps to address their difficulties. Overall, global financial markets now seem better able to assess risk. Interest rate cuts by central banks in all major countries have helped restore investor confidence. Most importantly for Canada, the U.S. economy has continued to outperform expectations with strong growth and, as yet, no definitive sign of inflation pressure. Nonetheless, there is still a fair degree of uncertainty about the overall external environment, given the divergent performance of the major economies. Japan is still in recession and Europe has been slowing down. Because of this, we are expecting only a slow recovery in world commodity prices this year. In Canada, the recent driving force in our economy has been exports. The strong demand in the U.S. economy, the relatively weak Canadian dollar and increasingly competitive Canadian manufacturers are allowing us to sell into the United States very successfully. What we are expecting to see now, however, is an increase here at home in consumer and business spending. We believe that the improvement in business and consumer confidence that we have seen in the last few months, the better employment picture and recent reductions in interest rates will all help support domestic spending. To be more specific, compared with six months ago, we at the Bank have raised our projection for growth in the economy in 1999 to between 2 3/4 and 3 3/4 per cent. We have such a wide range because of the international uncertainties that I mentioned a moment ago. The high end of this range is well above the latest consensus among private sector forecasters. If the economy does grow at the higher end of this range, it is likely to be because of stronger exports and more substitutions of Canadian goods for imports due to Canada's good price and cost performance. Our economy should continue to expand next year at a broadly similar pace. On the basis of these growth forecasts, we would expect the trend of inflation to rise modestly over the next 18 months but remain in the lower half of the Bank's 1 to 3 per cent target range for inflation. There is an increasing level of confidence, both at home and abroad, that Canada's inflation will remain stable. Another source of uncertainty for the Bank at the present time is in estimating the margin of unused capacity in the economy. If economic activity expands as forecast, the traditional way of measuring these things tells us that the current margin of economic slack should be taken up in the second half of next year. However, the economy seems to have undergone some significant changes during the 1990s, and the traditional estimates of slack may no longer be accurate. As a result, the Bank will be placing increased weight on a range of indicators to assess the degree of pressure on the economy's production capacity. What we have in mind are such things as movements in inflation relative to expectations, growth of money and credit, wage pressures, evidence of supply bottlenecks and the information provided to our regional representatives from their business contacts. Mr. Chairman, we will not know just how much the Canadian economy has changed until its capacity limits come under more pressure. While the confidence of Canadians in ongoing low inflation allows monetary policy more room to accommodate demand pressures that test the limits of capacity, it will be very important for the Bank to be vigilant in following the array of indicators I have mentioned. We must not undermine the solid basis of low inflation and low interest rates that has been established in Canada.

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Canadian economic performance at the end of the twentieth century

thiessen

Governor of the Bank of Canada to the Canada Club Canadian economic performance at the end of the twentieth century As the curtain comes down on the twentieth century and we move on to the next millennium, it is difficult to resist the temptation to be both retrospective and prospective. Ask Canadians to think back and many will tell you that the economy and they, as individuals, have been through some difficult times. Those with longer memories, however, will recall the remarkably positive climate between the end of the Second World War and the early 1970s. Canada came out of the war with a relatively strong economy compared with the ravaged European countries. Moreover, there were sizable and sustained gains in productivity through the 1950s and 1960s. These reflected the revolution in agriculture and the forced modernization and expansion of Canadian industry during the war as well as the rapid changes in technology and industrial processes that followed. All this led to a substantial rise in Canadian standards of living instead of the postwar depression that many had feared. And despite the exodus of workers from agriculture, the overall unemployment rate remained low. At the same time, rapid economic growth generated rising tax revenues that governments could spend on an increasingly wider social safety net without taxpayers feeling much of a pinch. Compared with this post-war prosperity, our economic performance over the subsequent quarter century has been the source of some disappointment and concern. Various explanations have been advanced for this less-favourable record since the early 1970s. There are four trends in particular that I would highlight in this regard: high inflation in the 1970s and 1980s; large and rising fiscal deficits from the mid-1970s to the mid-1990s; a slowdown in productivity growth; and a decline in the prices of primary commodities. Tonight, I propose to comment on these four trends and their effect on the economy over the past 25 years. Much of the sense of economic disenchantment that Canadians have been feeling in the 1990s has been related to the difficult process of reversing these trends or adjusting to them. Fortunately, considerable progress has been made on several fronts. Hence, there are grounds for optimism regarding Canada's economic future. The harmful effects of high inflation The rate of inflation which, after getting through some of the post-war bottlenecks, averaged just over 2 per cent in the period to 1972, more than tripled over the next two decades. This pickup in inflation was not a uniquely Canadian phenomenon. In many countries, monetary policy had become too expansionary during the late 1960s. This partly reflected a misconception among policy-makers that, by fine-tuning the economy and taking advantage of a perceived trade-off between employment and inflation, overall economic wellbeing could be improved. One of the initial consequences of this accumulating worldwide monetary stimulus was a sharp rise in the prices of oil and other primary products in the early 1970s. Countries, like Canada, which are major producers of such commodities, experienced a surge in income and wealth. But they also faced strong demand pressures and rising inflation. In Canada, the surge in inflation was especially dramatic, reaching 12 per cent in 1974. Once inflation had risen to those levels, it was very difficult to reverse. With each passing year, expectations of ongoing high inflation became increasingly entrenched. High inflation exacts a heavy toll on an economy by making the future particularly uncertain. Long-term financing becomes less available and more costly as interest rates go up because of inflation and the higher risk premiums that lenders demand as compensation for the increased uncertainty. Inflation diverts resources away from productive investments into speculative ventures in real estate and other financial assets. And in its interaction with the tax system, high inflation encourages businesses to increase debt. These are the very types of excesses that lead to, and indeed aggravate, the economic busts that inevitably follow. During the 1970s and 1980s, Canadians had first-hand experience with such complications. The impact of persistent government deficits and rising debt High inflation was also partly responsible for the move towards larger government deficits in Canada that began in the mid-1970s. Initially, inflation tended to generate increased revenues for governments, and this encouraged additional spending. When the effects of inflation became more evident, however, public pressure led to the indexation of the personal income tax system and the growth in government revenues slowed. Unfortunately, this was not offset by a tighter grip on spending. For the government sector as a whole in Canada, on a national accounts basis, total program expenditures (not counting debt-servicing costs), rose from 37 per cent of gross domestic product (GDP) in 1975 to a peak of 43 per cent in 1992 (a year of recession). Over the same period, the budget deficit more than tripled to 8 per cent of GDP. And the ratio of outstanding net debt-to-GDP soared from less than 10 per cent to 60 per cent, and by the mid1990s it had climbed to 70 per cent. Increasingly, through the late 1980s and early 1990s, the growth in government spending raised concerns about whether this represented the most efficient use of the economy's resources. From a policy perspective, the greatest concern was that persistent large deficits were pushing Canada's debt-to-GDP ratio to unsustainable levels and driving up risk premiums in our interest rates. The economic costs of Canada's rising indebtedness became very clear after 1991, when our inflation rate came down quickly, but medium- and longer-term interest rates were slow to respond. One important reason for that was the persistence of high risk premiums because of fears that governments might be tempted to reduce the debt burden through inflation -- in effect, by printing more money. Canada's vulnerability to such concerns became particularly evident during the Mexican currency crisis. High interest rates meant that we had to pay more of our income to foreign holders of our public and private sector debt. This made us poorer as a nation. And these high rates discouraged investment which, to some extent, relates to the third 'disappointing' trend of the past quarter century -- the slowdown in productivity growth. The slowdown in productivity growth Productivity has been at the centre of many public discussions in Canada recently. For good reason, too, since productivity is critically important to growing incomes and rising standards of living over time. Unfortunately, such discussions are complicated by the fact that there is more than one measure of productivity, and there often seems to be some difficulty in distinguishing between the growth and the level of productivity. Things become even more complicated as one gets into cross-country comparisons. After a strong showing from the end of the Second World War to the early 1970s, our productivity growth became lacklustre. Output per worker slowed from an average rate of about 3 per cent in the 1950s and 1960s to 1 per cent in the 1980s and 1990s. Productivity growth also slowed in other industrial countries, including the United States, over this period. Indeed, average gains in labour productivity in the Canadian and U.S. business sectors have been roughly similar in the past 25 years. This means that the gap in productivity levels in favour of the United States has not really widened; but neither has it narrowed. Moreover, growth in U.S. productivity seems to have picked up strongly in the last year or so. I do not have a complete explanation for the productivity slowdown in Canada. But I am prepared to assert that high inflation and the large fiscal deficits through most of the past 25 years were not conducive to productivity growth. They led to high interest rates and considerable uncertainty about the future -- both of which discourage the investment in technology and new equipment that helps to advance productivity increases. Declining primary commodity prices The final factor on my list is the decline in the prices of the key primary commodities that Canada produces. Calculated from the early 1970s to the present, this decline amounts to some 45 per cent when the international prices of these commodities in U.S. dollars are adjusted for the increase in the general price level during this period. A drop of that magnitude in the prices of some of Canada's major exports is bound to have a significant effect on our standard of living. To look at the past 25 years in isolation, however, tends to magnify the extent of the decline and leaves one with an exaggerated sense of the associated economic consequences. This is because commodity prices jumped to historical peaks at the beginning of the period, in response to the worldwide monetary stimulus that I mentioned, and remained generally high for nearly a decade or so, before reversing. To put things in perspective, we need to focus on the longer-run behaviour of commodity prices. For only then does it become clear that these prices were exceptionally high through the first decade of this 25-year period, and that a good part of the subsequent downward movement represented a return to more "normal" levels. Indeed, between the late 1960s and the late 1980s, the level of inflation-adjusted commodity prices showed little change overall. We should also keep in mind that part of the decline in commodity prices has reflected new discoveries of raw materials, more efficient ways of extraction, and reduced production costs. Otherwise, we would have seen a much larger reduction in the importance of commodities, and in the profits and share prices of Canadian resource industries. When one allows for some of these factors, the downward movement in commodity prices in the past 25 years is not as dramatic as it appears at first. But I can certainly appreciate that the sharp drop in these prices in 1997-98, associated with the Asian financial crisis, has had an especially strong impact on many Canadians' sense of well-being. Adjusted for inflation, commodity prices hit a new post-war low during this period and led to a substantial depreciation of our currency. What does the future hold? So far, I have argued that high inflation, large government deficits, slower productivity growth, and lower commodity prices have tended to complicate Canada's economic situation over the past 25 years. But as I said at the beginning, much of the greater sense of difficulty and concern that Canadians have felt in the 1990s has to do with the after-effects of the strong medicine we have had to take to turn our economic performance around. The success we have had so far in this regard bodes well for our future. Canada's inflation rate has come down dramatically, averaging less than 2 per cent since 1992. And there are now agreed targets between the Bank of Canada and the Government of Canada to keep inflation low and stable in the future. More importantly, Canadians have come to expect continued low inflation and to build that expectation into their plans. The federal government and most provincial governments now have balanced budgets or are running surpluses. The total government debt-to-GDP ratio, which peaked at 70 per cent in 1996, has since fallen to 63 per cent. With present prudent fiscal policies, it should continue to decline steadily. Future gains in productivity are difficult to predict. Certainly, our improved inflation and fiscal situation, together with the low interest rates that they have made possible, provide the best climate for fostering productivity that we have had in a long time. Moreover, Canadian businesses have undergone major restructuring during the 1990s in response to increasingly competitive world markets. Business investment has been rising smartly recently and more firms have been adopting new production technologies. It is also interesting to note that, after eight years of economic expansion, productivity growth in the United States has picked up, rather than falling off as usually happens at this stage of the cycle. Tight labour markets seem to have encouraged a record level of investment in that country and more efficient use of technology than before. While the pickup in Canadian investment in machinery and equipment has lagged somewhat behind that in the United States, new technology is not the exclusive preserve of our U.S. neighbours. So I hope that in Canada, too, we will see a similar payoff from the adoption of new technology and a comparable improvement in productivity. As for commodity prices, there has already been some turnaround this year, but a firmer recovery requires a strengthening world economy -- in particular, a turnaround in Japan and the rest of Asia. The other point to note in this connection is that the relative importance of commodities in the Canadian economy has declined. The share of primary products in total Canadian exports has fallen from about 60 per cent in the 1970s and 1980s to about half as much presently. I should also add that our flexible exchange rate system has been playing the role that it should in helping us adjust to lower commodity prices. The decline in the value of the Canadian dollar in 1997-98 was mainly a response to the impact of the Asian crisis on commodity prices. A weaker currency has helped to cushion the negative effect on our resource sector. But, more importantly, it has helped to stimulate demand for other Canadian exports and import substitutes, particularly of manufactured goods. In turn, this is encouraging a shift in production from commodities towards other tradable goods. While I believe that this shift is exactly right for the Canadian economy, I do not agree with some recent suggestions that we should somehow force the pace of the movement out of primary products and into the so-called more modern, knowledge-based industries. If commodity prices do not recover from their current low levels and profits are squeezed as a result, this will happen naturally. But for now, primary products are still an important source of Canada's wealth and high standard of living, and they are likely to remain so for some time. To conclude, the past 25 years have not been easy. And they have been less prosperous overall than many Canadians had come to expect, based on the experience of the But, as we stand on the threshold of the next century, we can take comfort from the remarkable progress we have made recently in strengthening the foundations of our economy. This gives me reason to be positive about our capacity to improve our economic performance and to meet tomorrow's challenges with confidence.

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Canada's economy as the year 2000 approaches

thiessen

Governor of the Bank of Canada to the Chamber of Commerce Canada's economy as the year 2000 approaches It is always a pleasure to return and speak to people in my home province. This time, we are here for a meeting of the Bank of Canada's Board of Directors. Once a year, our Board meets outside Ottawa, in a different part of the country. This year, we are delighted to be in Regina. Today, I would like to give you an update on the Canadian economy -- its recent performance and its prospects. I would also like to brief you on the state of year-2000 readiness in the Canadian financial sector. The recent performance of the Canadian economy Here in Saskatchewan, you know only too well that the last couple of years have been difficult for the Canadian economy, especially for producers of primary commodities. But there is reason for optimism as we look ahead. To fully appreciate why, we need to understand the international shocks that have buffeted our economy since mid-1997 and how we have dealt with them. The global financial crisis, which started in Southeast Asia in mid-1997 and spread to other countries during 1998, led to a sharp decline in the world prices of primary commodities. By this time last year, the average price (in U.S. dollars) of key commodities produced in Canada had fallen by about 20 per cent over the course of the previous 18 months. And when Russia declared a standstill on the servicing of its debt in August 1998, the effects were felt far and wide. Conditions tightened in financial markets everywhere. Many highly rated corporate borrowers in the industrial countries were faced with a reduction in the availability of credit and with higher borrowing costs -the same conditions that faced governments from emergingmarket economies. Nevertheless, the Canadian economy has fared surprisingly well over the past year. Of course, we have not experienced booming conditions. Indeed, some of our primary sectors, such as farming, continue to struggle with low prices. Grain prices, in particular, have been plagued by ample global supplies and weak demand. But, on the whole, the economy has performed well. I expect that when the numbers for the third quarter of this year are out, they will show that output has grown by about 4 per cent since the third quarter of 1998. This compares with growth of only 2 1/2 per cent over the same period the year before. To be sure, the economic impact of the Asian crisis on Canada has been moderated by the strength of the U.S. economy and by the prompt response of major central banks, particularly the U.S. Federal Reserve, to the global financial difficulties. And the efforts made by emergingmarket economies in Asia to deal with their problems have helped to gradually repair confidence and improve world economic conditions. Although these positive developments are certainly important, it is also true that we have coped better with this crisis than in the past because our economy is now operating from a firmer base than it has for some time. This reflects a number of fundamental improvements in our economic structure. I would highlight three in particular: first, our low-inflation record and the Bank of Canada's commitment to keeping inflation low; second, the virtual elimination of government deficits and the beginning of a downward trend in the high level of public debt to the size of our economy (as measured by the ratio of public debt to GDP); third, the major restructuring of Canadian businesses during the 1990s in response to stronger global competition and to technological change. It has not, of course, all been smooth sailing. You will recall that throughout the summer of 1998 our currency kept losing ground in reaction to the sharp fall in commodity prices, which was made worse by the fallout from events in Russia. And with signs of a potential loss of confidence in Canadian dollar assets, the Bank of Canada moved to raise short-term interest rates significantly in But once we got through that period of unusual global turmoil, we were able to reverse that increase rather quickly. Consequently, Canadian interest rates for all maturities fell back to levels below those in the United States, consistent with Canada's lower inflation rate. The downward movement in the Canadian dollar, besides softening the impact on our resource sector, encouraged a rather prompt increase in exports of manufactured goods. This helped to compensate for the reduction in receipts from commodity exports. With this shift of economic activity out of the resource sector and into manufacturing, conditions in the labour market did not deteriorate as one might have expected. In fact, the unemployment rate has continued to decline over the past 12 months -- from 8.3 per cent to its current level of 7.8 per cent. And despite the loss of jobs in the resource sector, close to 350,000 net new jobs have been created across the economy over this period. The three factors I mentioned earlier -- low inflation, reduced budget deficits and debts, and business restructuring -- have provided a sound base for the Canadian economy during this turbulent time. They have also helped smooth the process of exchange rate and economic adjustment that I have been describing. Because of our good inflation record in recent years, achieved through the Bank's commitment to inflation targets, inflation remained subdued, even as our currency was falling and causing prices of imported goods to rise. Low inflation and a much improved fiscal position have helped to keep interest rates down. At the same time, because of restructuring, many more Canadian firms have been in a strong position to take advantage of the low Canadian dollar and increase their sales abroad. Low interest rates have also made it easier for businesses to finance investments so that they can expand production capacity and increase their foreign sales. The outlook for the Canadian economy The fundamental improvements in our economic foundation and the way that Canada has coped with these recent external financial difficulties give us good reason to be optimistic about the future. The export sector has been an important source of strength for the Canadian economy for some time now. Recently, the stimulus from spending by Canadian households and businesses has also been growing. Indeed, with the waning of last autumn's global strains, consumers have regained the confidence to go out and buy a new car, a house, or furnishings. And businesses have revived their plans for investment in machinery and equipment (including continued buoyant spending on computer upgrades, partly related to year-2000 readiness). With improved confidence, relatively low interest rates, and gains in employment, these trends should continue. Clearly, conditions outside Canada remain crucial to our economic outlook. In Europe, prospects for stronger growth now look better than they did a few months back. Even for the troubled Japanese economy, next year should be brighter. Forecasts for a number of emerging-market economies, particularly in Asia, have also been revised up. And with these improved global prospects, the prices of a number of our key commodities -- especially energy, base metals, and minerals -- have risen. Of course, for Canada the external influence that matters the most is the U.S. economy. That economy has turned in an amazing performance in the past seven years -robust output growth, low unemployment, and low inflation. But with U.S. consumers and businesses continuing to spend strongly, and labour markets tightening further, some signs of cost pressures have emerged recently. This has rekindled concerns about a pickup of inflation down the road. And it has prompted the U.S. Federal Reserve to reverse part of last autumn's easing, by raising interest rates twice this summer, in an effort to return the economy to a more sustainable, non-inflationary pace. The Fed's success in preventing the U.S. economy from overheating and bringing it down to a "soft landing" is critical for the world economy and especially for Canada. The worst case for us would have been for the Fed to have delayed action and risked another inflationary boom. Not only would this require more drastic tightening by the Fed down the road, but it could well lead to a recession -another episode of boom and bust. The Bank of Canada did not follow the two interest rate increases made by the Fed this summer. While there is no reason that changes in U.S. interest rates should automatically trigger similar movements here, neither is it the case that such developments are irrelevant for us. Canada is closely integrated into the world economy and international financial markets. Developments in the United States, the world's largest economy, will always have a major global impact. When it comes to Canada, the central bank must carefully assess the economic and financial circumstances in the United States that are behind any move by the Fed and their likely implications for our economy. Sometimes this will mean that the Bank of Canada will respond to a Fed move and sometimes it won't. The interest rate actions taken by the Fed this summer improve the odds of continued, non-inflationary economic expansion in the United States. This is good news for all concerned. But it also means that we cannot count on the U.S. economy to provide the same strong stimulus for Canadian exports in the future as it has in the recent past. Thus, the improved outlook for Europe and the firmer markets for primary commodities are particularly welcome developments for Canada. These external factors, along with the relatively low domestic interest rates and improved employment conditions that I mentioned, bode well for sustained economic expansion in Canada. Altogether, our economy should continue to grow at a healthy pace and take up slack in production capacity. Core inflation is expected to stay low over the next year, in the bottom half of the Bank's 1 to 3 per cent target range. But as the economy begins to produce at full capacity, monetary policy will have to be mindful of the potential for price pressures. However, there is a lot of uncertainty and imprecision in our estimates of the economy's capacity to produce. For example, we do not know to what extent large investments in new technology and in machinery and equipment during the 1990s may have raised production capacity. Consequently, the Bank will be putting more emphasis on, and carefully watching, a range of indicators to assess the degree of pressure on capacity and on inflation. The interpretation of developments on this front will be an important challenge for monetary policy in the period ahead, one that will require a great deal of careful analysis. The year-2000 changeover in the financial sector With the end of the millennium approaching, any review of near-term economic developments would be incomplete without a word on the efforts by financial sector participants and public sector agencies, including the Bank of Canada, to deal with the implications of the year-2000 date change. As part of its commitment to Canadians, the Bank seeks to promote the safety and soundness of our financial system. With this in mind, we have for some time now been working closely with various Canadian and international organizations to minimize any effects on our financial sector as we head into the year 2000. Today, I can tell you that the Canadian financial sector has done its homework. It has been passing its year2000 tests. And contingency plans have been made. So, at the dawn of the new year, the Bank expects that it will be "business as usual," but we will also be ready if anything unusual happens. Efforts to identify and fix potential year-2000 problems in the Canadian financial sector started early. And they have been exhaustive, with expenditures in the billions of dollars. Operators of systems shared by the financial sector have made the necessary changes and fully tested them. For example, last June, the Canadian Payments Association and its members participated in a Global Payments Systems test to verify the ability of financial institutions around the world to send and receive international payments. Domestic clearing and settlement systems have also been tested, as have all systems used by the markets for transactions involving Canadian debt and other securities. They are ready to operate in a year-2000 environment. At the same time, virtually all individual financial institutions have completed and tested changes to their critical systems, including those that support automated banking machines, credit and debit cards, and telephone banking. And major Canadian deposit-taking institutions have guaranteed the safety of their clients' accounts and records from any year-2000 computer-related disruptions. The Bank of Canada has given the same guarantee for Canada Savings Bonds records. Of course, the Bank of Canada's own critical computer systems have also been reviewed, upgraded as necessary, and tested. And they are year-2000 ready. An important issue for the financial sector is the state of preparedness of providers of infrastructure too, are reporting that they are year-2000 ready. With all the effort, time, and resources devoted to the task, it is not surprising that a number of knowledgeable year-2000 commentators have singled out the Canadian financial sector, especially the banking sector, as one of the world leaders in year-2000 preparedness. That is a strong vote of confidence, which should help reassure Still, we cannot afford to be complacent and relax our efforts. Computer systems will continue to be monitored and retested right up to the end of the year. There is also a need for ongoing clear, responsible communication to keep the public well-informed and confident in a smooth year-2000 transition. At the same time, increasing attention is rightly being paid to contingency plans. In this connection, the Bank of Canada has recently announced a number of arrangements to provide an additional measure of confidence to financial institutions and the general public. We are putting in place a special line of credit to assure these institutions and the users of financial services that if there is any unusual demand for liquidity around the turn of the year, it will be met. And the Bank is prepared to accept a wider-than-normal range of collateral to support any liquidity loans it provides. We have also made arrangements to counter any unusual pressures on money market interest rates during this period. All this should be enough to reassure the vast majority of Canadians that the safest place to keep their money is with their financial institutions. In fact, they should prepare for the century-changeover weekend much as they would for any other long weekend. Nevertheless, there will be some who still feel that they need to take further precautions. Those who prefer a little extra reassurance in the form of additional cash can rest easy -- it will be readily available. The Bank has increased considerably its inventory of bank notes. And it has been working with financial institutions to ensure that the system can meet an increase in demand for cash across Canada. But let me reiterate that there is no reason for Canadians to feel that cash is the only way they can pay for goods and services over the New Year's weekend. Overall, the Bank of Canada and other financial sector participants have every confidence that Canadians can plan on it being "business as usual" in the financial sector heading into the year 2000 and beyond.

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The Challenges for Canadian Monetary Policy in the Year 2000

thiessen

Governor of the Bank of Canada Monetary policy actions take a relatively long time to affect the economy and inflation -- anywhere between 12 to 24 months. Because of this, central banks must always look ahead and must put in place today the monetary conditions that are needed to help keep the economy on a sustainable path down the road. By 'sustainable' I mean a situation where economic growth and job creation are not at risk from rising inflation. It is in this forward-looking context that I would like to talk to you today about the challenges that may face Canadian monetary policy in the year 2000. First, of course, is the turn of the century itself. So let me start by saying a few words about year-2000 readiness in the Canadian financial sector. As I said in Regina a little over a month ago, the Canadian financial sector has done its year-2000 homework -- and, I might add, done it very thoroughly. The Bank of Canada and providers of financial services are confident that Canadians can expect "business as usual" in the financial sector as we head into the year 2000 and beyond. The critical systems of financial institutions, including those systems that support automated banking machines, credit and debit cards, and telephone banking, have been modified where necessary and tested. Providers of infrastructure services to the financial sector (for example, electricity and telecommunications) have also reported that they are year-2000 ready. And major Canadian deposit-taking institutions have guaranteed the safety of their clients' accounts and records from any year-2000 computer-related disruptions. The Bank of Canada has given the same guarantee to holders of Canada Even so, retesting of systems and contingency planning will continue right up to, and including, the New Year's weekend. Right now, the Canadian financial sector is so well prepared that the major issue is no longer one of potential technical problems. Rather, it is a matter of dealing with a possible overreaction to year-2000 fears that could be more disruptive than the year-2000 problem itself. With this in mind, the Bank of Canada has built up a large inventory of bank notes. This is not because we think that Canadians will actually experience widespread problems using means of payment other than cash, such as credit and debit cards, over the New Year's weekend. Not at all. Rather, this larger-than-normal inventory, together with the preparations made by the Bank and by private sector institutions that are responsible for distributing bank notes, is intended to reassure Canadians that, should some people decide to stock up on cash, the financial sector will be able to respond. By taking these actions, and by publicizing them, we hope to ease any public concerns in this area and so reduce the likelihood that we will actually need to use these extra bank notes. We have also made contingency arrangements to ease potential liquidity concerns in the business and financial sectors. Of course, the primary responsibility for contingency plans to meet possible liquidity needs rests with financial institutions. In addition to these private sector preparations, the Bank of Canada has set up a special liquidity facility to address any worries financial institutions may have about being hit with extraordinary demands for liquidity from their customers. And we are widening the range of collateral they can use to secure loans from the Bank. We have also announced arrangements to prevent any unusual liquidity demands from putting upward pressures on money market interest rates in Canada around the end of the year. So, there should be no reason for any material year-2000 risk premium in Canadian interest rates. In summary, the Canadian financial sector is well-prepared for the century changeover. All participants, including the Bank of Canada, have made contingency arrangements. Should unexpected glitches develop, these arrangements will provide a quick, effective response to minimize any disruptions. More importantly, they should bolster the confidence of Canadians in the financial sector's ability to operate normally. And this should ease year-2000 fears and reduce the likelihood of an overreaction. I would like to reiterate what I have said before: when it comes to financial matters, I see no reason why Canadians should prepare for this coming New Year's weekend any differently than for any other long weekend. I would now like to turn to the economy and monetary policy. The current economic situation The Canadian economy has bounced back from the global financial crisis of 1997-98 and its negative impact on the prices of the key commodities we export. Indeed, when the numbers for the third quarter of 1999 are out, I expect that they will show that output has expanded by over 4 per cent since the third quarter of 1998. And the unemployment rate has continued to fall over the past 12 months -- from 8.3 per cent to its current level of 7.5 per cent. A number of factors have contributed to this economic rebound. Commodity prices have turned around, responding to the ongoing strength in North American demand and improved economic prospects in Europe as well as in Japan and the other Asian countries most hurt by the financial crisis. While energy prices have shown the sharpest recovery so far, prices for base metals, potatoes, shellfish, and forest products, all of which are important in Atlantic Canada, have risen as well. Still, the prices for certain other key commodities, such as grains and oilseeds, remain soft, plagued by large global supplies and weak demand. Another factor that has been supporting economic activity in Canada is the amazing strength of the U.S. economy, our major export market. That economy has had a remarkable eight-year-long expansion, marked by vigorous growth in production, strong gains in employment, and low inflation. Inflation has been held down by improvements in productivity as well as special factors such as a strong U.S. dollar, low commodity prices, and intense global competition. Stronger domestic demand has also been instrumental in Canada's economic pickup. Indeed, the stimulus from spending by Canadian households and businesses has been growing recently in response to high levels of confidence, rising employment, and relatively low interest rates. Behind all this, of course, has been our environment of low and stable inflation, which has helped our economy perform well despite the global financial difficulties. But what about the outlook for the Canadian economy over the next year? How does it shape up? Let me begin with the U.S. economy. We currently expect that growth there will slow to a more sustainable pace next year. This will reduce the risk that U.S. inflation pressures will intensify. Although the U.S. market will no longer provide the same strong stimulus for our exports, we are now beginning to see stronger economic activity in Europe and Japan that should partly offset a slowing in U.S. demand. As for domestic spending in Canada, the recent momentum is likely to continue. With respect to inflation, the total consumer price index has risen recently. But that is mainly the result of the recent increases in world energy prices passing through to retail prices for gasoline and natural gas. Those increases now seem to be coming to an end. There has also been upward pressure on prices from the effects of the earlier depreciation of the Canadian dollar. The core rate of inflation (total CPI, excluding food, energy, and the effects of changes in indirect taxes) is currently near the middle of our 1 to 3 per cent target range. Overall, this is a positive economic picture as we go into 2000. But as I said earlier, monetary policy must be forward-looking. So central bankers are always peering into the future, looking for potential concerns. After all, it is our job to worry! And there are some rather significant risks to this positive economic scenario to worry about. Potential challenges for Canadian monetary policy There are a number of challenges that the Canadian economy and monetary policy may have to face in the coming year. Today, I would like to highlight two that are particularly important. The first challenge concerns the implications for Canada of the ongoing strength of the U.S. economy. The second relates more to our own domestic situation as the Canadian economy begins to operate at what is estimated to be full production capacity. Let me start with the issue of the prolonged vigorous expansion of the U.S. economy. This extraordinary performance presents the U.S. monetary authorities with the difficult task of ensuring that it does not lead to overheating and rising inflation. The Americans have already raised interest rates twice over the summer. What would be the implications for Canada if the U.S. economy does not start to slow and the U.S. central bank has to raise interest rates further? In these days of close global integration, developments in the United States -the world's largest economy -- are bound to have a major effect on national economies everywhere. This is especially true for Canada. Our proximity and strong economic ties with that country mean that the state of the U.S. economy and any associated monetary policy actions will certainly affect us. But there is no automatic rule as to how the Bank of Canada should respond if the U.S. Federal Reserve raised interest rates. We would have to examine carefully the strength of the economic expansion in the United States and the associated price pressures behind such a move by the Fed. The challenge for the Bank would be to assess the implications for our economy and for financial markets. If it looked as though these developments would have a significant effect on Canada and lead to upward pressures on prices here, our objective of keeping inflation within the target range might be jeopardized. In that case, the Bank of Canada would certainly respond. Let me be as clear as I can on this -- our current healthy economic expansion will continue only if we sustain a low and stable inflation environment. A more difficult scenario for Canadian monetary policy would be an actual outbreak of inflation in the United States next year. Let me hasten to add that I think this is rather unlikely, given the past success of the U.S. monetary authorities in keeping inflation under control and their resolve to continue to do so. Nonetheless, it is important that we be prepared for all contingencies. The first thing the Bank of Canada would have to do in such a case is to ensure that the U.S. inflation psychology did not cross our borders. That would mean making it absolutely clear that we would strongly resist movements in the underlying rate of inflation in Canada that risked taking it outside our target range. Once it became evident that the U.S. inflation rate was persistently rising relative to ours, the Canadian dollar should start to rise in value against its U.S. counterpart. Indeed, with such an adjustment in the Canadian dollar, our floating exchange rate would be playing its proper role in providing an important element of insulation for Canada from those rising U.S. prices. And monetary policy should be ready to encourage that process, if necessary, to prevent a spillover of inflation. You would be right to gather from what I have said so far that the best news we can all hope for is a "Goldilocks" U.S. economy -- not too hot, not too cold. This basically means an economy that slows down to a steady, sustainable pace of expansion that keeps it off the boom-and-bust roller-coaster. The second challenge I want to talk about today is how Canadian monetary policy should operate as our economy gets close to the full use of its production resources. Whether because of persistent U.S. demand for our exports or strong momentum in spending by Canadian households and businesses, we will very soon reach levels of economic activity that, based on typical measures of our production potential, appear to be at full capacity. Ideally, we want to see the economy operating at a level that is as close as possible to full potential. At this level, the economy can deliver a low and stable rate of inflation -- one that is neither rising nor falling persistently. And economic activity is expanding at as rapid a pace as is sustainable over time. Unfortunately, in practice, it is very difficult to estimate precisely where this ideal operating level is. And this gets to be even trickier after a period of business restructuring, rapid technological change, and strong business investment in plant and equipment. This is what happened in Canada during the 1990s. And it may have raised our economy's production capacity, although we cannot be sure by how much. Given the current momentum in our economy and the high levels of activity that we are seeing, and because of the uncertainty surrounding the conventional estimates of potential output, monetary policy-makers must be on guard. In other words, we are at the point in the economic cycle where the Bank of Canada will have to be very alert to early warning signs of accumulating price and cost pressures. And we will have to respond promptly and firmly if any such signs emerge. The Bank will deal with this risk by closely monitoring a wide range of indicators that can help it to assess the extent of present and future pressures on capacity and on inflation. These indicators include unanticipated movements in current inflation, changes in expectations of future inflation, the growth of money and credit, and information gathered from the Bank's regular contacts with businesses across Canada. In conclusion, let me say that you can be assured that the Bank is very sensitive to the increased risks of inflation that are coming from continued buoyant growth in the United States, improved economic prospects in Europe and Japan, and the increased momentum of domestic spending here in Canada. In facing the various challenges that may arise over the next year, it will be crucial to ensure that the Bank continues to deliver a trend of inflation that is inside our target range of 1 to 3 per cent. It is only when Canadians can count on inflation staying low and stable that our economy performs best.

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Release of the Monetary Policy Report

thiessen

Good morning. The Bank of Canada has just released its tenth . This morning, we also raised our target for the overnight interest rate by 1/4 of one percentage point to 4 3/4 per cent. This follows a similar increase yesterday in the The Canadian economy has steadily gathered strength since our previous in May. Exports have been growing strongly and domestic spending by consumers and businesses has increased. The increased momentum in the Canadian economy has been encouraged by continuing improvement in the international economic environment. Of most significance to Canada is that the U.S. economy has shown surprising strength. A number of the Asian economies that were hurt by the 1997-98 financial crisis have recovered more rapidly than expected. Japanese output has increased sharply following two years of recession, and growth in Europe has picked up. There has also been a significant turnaround in world commodity prices. Real GDP growth in the Canadian economy was about 4 per cent for the first nine months of 1999, and the economy is likely to register growth close to 3 3/4 per cent for the year as a whole. Inflation has been broadly in line with expectations over the past six months as it has moved towards the middle of the Bank's 1 to 3 per cent target range. For 2000, our projection in the Report is that the U.S. economy would slow to a more sustainable pace. On this basis, we projected economic growth in Canada to be in the range of 2 3/4 to 3 3/4 per cent. Given this growth projection, and with inflation expectations settling around the midpoint of the Bank's target range, we indicated that core inflation should remain close to 2 per cent through next year. However, as we pointed out in the Report, there are some important risks to this projection of economic growth and inflation. These risks relate to the possibility of a stronger momentum of demand from domestic as well as international sources and to potential inflation pressures in the United States. Yesterday's move by the Federal Reserve which suggests continued excess demand in the U.S. economy underlines these risks. In order to preserve the low trend of inflation in Canada, the Bank must be ready to adjust monetary conditions in a timely manner. And that is what we did this morning. However, the challenge for monetary policy remains, and we will be carefully monitoring all available indicators of future inflation pressures. Any resurgence of inflation in Canada would undermine our prospects for a durable expansion.

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canada

The Canadian economy, productivity, and our standard of living

thiessen

Governor of the Bank of Canada The Canadian economy, productivity, and our standard of living Over the past couple of years, there has been considerable debate about productivity and our standard of living in Canada. For the most part, the discussion of these issues has been useful, but at times it has been somewhat confusing. There are so many different facets to productivity and the standard of living that they cannot all be covered in one speech. My objective today is relatively modest--to try and clarify some of the basic ideas and measures and to explain where monetary policy fits in this debate. I will start by focusing on the relationship between the standard of living and productivity. Next, I will talk about some of the different measures of productivity. I will finish with a few words on how monetary policy can contribute to rising productivity and rising standards of living. The connection between the standard of living and productivity A country's standard of living and its productivity are not the same thing, although over the long run they are closely linked. This distinction has not always been made clear in some of the commentary I have seen. When we speak of a society's standard of living, we are typically referring to the individual well-being of its citizens. In principle, our standard of living should reflect both economic welfare and social ("quality of life") elements, such as a clean environment, a low crime rate, freedom of expression, etc. But because the social elements are difficult to assess and to weigh properly, the focus is usually on measures of our economic well-being. There are a number of different indicators of our economic welfare. The most common one measures how much output is produced in our economy, on average, for every man, woman, and child in Canada (real gross domestic product per capita). There are also various measures of real income per person, before and after taxes (such as gross national income per capita and personal disposable income per capita). If we look closely at any one of these measures, it is clear that productivity is a critical factor in the determination of our standard of living. But it is not the only factor. And when there are changes in any of the other elements that influence our economic welfare, our standard of living can, for periods of time, change in ways that appear to be disconnected from trends in the growth of productivity. As an example, let us look at the simplest yardstick of living standards--output per capita. Clearly, this is closely related to the output produced per worker--which is the most common measure of productivity. But it also depends on the number of people employed relative to the total population. Through the 1960s, 1970s, and 1980s, output per capita in Canada increased more rapidly than productivity. But over the past 10 years, it has fallen behind the growth in productivity. Canada's lacklustre standard-of-living performance in the 1990s, which we have heard so much about, has less to do with slower productivity growth than with the fact that the proportion of the population that is actually employed has not been increasing. This is in contrast to the rising trend of the previous three decades, when an increasing number of women and baby boomers were entering the labour market. During the 1990s, trends in employment rates in Canada also diverged significantly from those in the United States, contributing to an increased gap in living standards between the two countries. This weak employment growth in Canada partly reflects the extensive and difficult restructuring that our private and public sectors had to undergo in a relatively short time compared with the United States, where the process started earlier and was spread over a longer time period. If we measure our standard of living in terms of how much of the national income goes to each and every Canadian, then we are not just talking about the volume of goods and services we produce. We are also talking about the world prices we receive for what we sell abroad relative to the prices we pay for imports--that is, our terms of trade. During the 1970s, world prices for the primary commodities that Canada exports soared relative to prices in general. And they remained high through to the early 1980s. Since then, however, commodity prices have typically been on a downward trend. And, of course, they fell sharply in the wake of the Asian crisis in 1997-98, before partly recovering in 1999. We have to take this into account when we examine what happened to our standard of living in the 1990s compared with earlier decades. We also need to look at what has happened to personal income after taxes. From the mid-1970s to the early 1990s, tax revenues did not cover government spending and we were getting deeper and deeper into debt. In other words, we were living beyond our means. During the 1990s, taxes rose and government transfers and other expenditures were cut back relative to the size of our economy to reduce the burden of those large public debts that had accumulated during the previous two decades. Measures of after-tax income in the 1990s reflect that sobering reality. So these are some of the factors that have weakened the link between productivity and living standards in recent years. In the long run, however, productivity is, without a doubt, the key element contributing to our prosperity. Productivity growth is the foundation for real income growth -- it allows businesses to pay higher real wages and still keep costs down and remain profitable. There is one important difference between productivity and the other factors that influence our living standards. The difference is that there are no constraints on productivity and its ability to contribute to improvements in our welfare on a sustained basis. The other factors are constrained by physical, institutional, and legal limitations. For example, there is a limit to the proportion of the population that can, and will, engage in economic activity. Similarly, there are limits on the length of the work week. On the other hand, there does not seem to be an upper bound on capital accumulation over time or on the growth of human knowledge or on the degree to which both can result in higher productivity. But I have been talking about productivity without defining it properly or describing how we measure it. Measures of productivity tell us how much output we can produce from the effective use of various inputs--skilled workers, capital equipment, technological innovation, and managerial and entrepreneurial know-how. Increases in productivity trace improvements over time in our ability to boost output by finding new and more efficient ways to use these inputs. The most commonly used, and best-understood, measure of productivity is labour productivity. It tells us how much output is produced per worker or per hour worked. Of course, labour productivity is affected by experience and education as well as by the amount of capital equipment (notably machinery and equipment) that is available to workers. So, ideally, we would prefer to use the measure that combines labour with all these other inputs--what we economists call total factor productivity . In practice, however, it is very difficult to measure the amount of physical capital in the economy. Also, it is not clear how best to take account of improvements over time in the quality of the various inputs. And, of course, measurement problems are worse in the services sector, where output is also notoriously difficult to estimate. Because of these difficulties, analysts usually focus on the more straightforward measures of labour productivity. This has the added advantage of being closer to measures of standards of living and more directly comparable across countries. With that as background, let me now turn to the "facts" on productivity in Canada, as best we can measure them, and see how they compare with those for the United States. We should, of course, keep in mind that the relevant statistics for the two countries, while similar, are not always comparable. For example, there are differences in the way some prices are measured, particularly for high-tech equipment, as well as differences in adjusting for changes in the quality of inputs. Moreover, last month, the Americans revised their productivity figures upwards, following revisions to their national accounts going back to 1959. To a significant extent, these revisions reflect a definitional change that now treats computer software as an investment (instead of a business expense as before), and therefore as part of the country's gross domestic product. These definitional changes probably make the U.S. productivity figures less comparable with ours than before. So one should be careful not to draw strong conclusions from comparisons that focus too narrowly on these data. Nevertheless, we can still comment on the broad trends. Through the 1950s and 1960s and into the early 1970s, labour productivity in the overall business sector in Canada grew rapidly. It averaged close to 4 per cent per year--somewhat higher than in the United States. From the early 1970s to the mid-1990s, productivity growth slowed sharply in both countries--to less than half that rate. It has picked up in the latter half of the 1990s, especially in the United States, where an investment boom has given U.S. workers substantially greater amounts of capital equipment to work with. Some commentators have paid particular attention to productivity growth in the manufacturing sector, even though manufacturing accounts for less than 20 per cent of total economic activity in both countries. They believe that the measures for this particular sector are more reliable and more relevant for international competitiveness. Since the 1980s, labour productivity in the Canadian manufacturing sector has risen at a significantly slower pace than in the United States. To a large extent, this stronger showing by the U.S. manufacturing sector reflects the remarkable performance of two industries--electrical and electronic products and commercial and industrial machinery. These industries have benefited the most from dramatic advances in computer technology, and they have a much larger weight in the U.S. economy than here in Canada. As a last comment on the facts about our productivity performance, I would like to stress the need to distinguish clearly between the rate of growth and the level of productivity. While this may seem self-evident, there has been a certain confusion on this score in some of the recent public commentary. The rate of growth in our productivity has certainly slowed since the early 1970s, as it has in most industrial countries, for reasons that are still not fully understood. But the level of our productivity has been rising, not falling. And it cannot be blamed for the decline in some measures of our living standards during the 1990s. However, there is a significant gap in levels of productivity between Canada and the United States--ours is below theirs. Since access to ideas and technology is international, we would have expected that gap to narrow, as it did during the 1950s and 1960s. But it hasn't. For this to happen, productivity in Canada has to grow at a faster pace than in the United States. This is the challenge we Canadians face if we are to bring our standard of living closer to that of our southern neighbours. How can monetary policy support productivity growth? Economists have not been particularly successful in explaining differences in rates of productivity growth over time or across countries. As a result, there is no widespread agreement on what can be done to bring about faster productivity growth on a sustained basis. Nonetheless, I would like to make some comments on what would be helpful in this regard. And I would certainly emphasize that we should always scrutinize our economic policies for any potential impact on productivity. When it comes to monetary policy, there is an increasing international consensus that the contribution central banks can make to encourage growing productivity and higher standards of living is to provide a low-inflation environment. Low and stable inflation reduces uncertainty about future price movements, lowers the incidence of boom-and-bust cycles in the economy, and helps to keep interest rates down. All of this encourages investments in equipment and new technology that should lead to productivity gains. When I look at the impressive productivity record of the United States over the past couple of years, I am struck by the exceptionally large investments in machinery, equipment, and technology that have taken place there. I know that the depreciation of the Canadian dollar through late 1997 and 1998 has kindled some concerns that a weak currency blunts the incentives for export industries to improve productivity. And that has led to some suggestions that Canadian monetary policy, rather than targeting low inflation, should set targets for the Canadian dollar. Or that perhaps our currency should be pegged to the U.S. dollar. It is true that in a period of high, and potentially rising, inflation, a depreciating currency adds to the confusion about what is happening to relative prices and contributes to an attitude that any cost increases can be passed on. Thus, businesses may not be as concerned about improving productivity as a cost-cutting measure. But that is not the case in Canada today--inflation is low and stable, and the Bank is committed to keeping it that way. Businesses know that they will generally not be able to pass on cost increases, and so they focus on cost control. The argument that a depreciated currency tends to discourage productivity improvements also ignores today's powerful global competitive forces and the strong drive of businesses to increase their market share and their profits as well as raise the prices of their stock. In my judgment, our floating exchange rate works well. It absorbs the impact of, and facilitates the adjustment to, extraordinary shocks that hit our economy from time to time, such as the sharp drop in primary commodity prices in 1997-98. As part of that adjustment, the low Canadian dollar has encouraged businesses outside the primary industries to expand their presence in foreign markets. But they can maintain those gains only if they continue to work hard to increase productivity and to ensure that they stay competitive as our currency regains strength. Concluding thoughts To conclude, it is almost impossible to overemphasize the importance of rising productivity as the fundamental long-term factor contributing to healthy economic performance and prosperity. Over time, gains in productivity are the basis for growing incomes and rising standards of living. Compared with the strong performance of the 1950s and 1960s, Canada's productivity record since the early 1970s has been rather disappointing. Even though the level of our productivity has been rising, we have not made any headway in bringing it closer to that of the United States. Recent developments in Canada, however, offer some promise of improvement. Productivity growth has picked up in the past couple of years in response to the cyclical recovery and the structural changes in our economy. And investment in machinery, equipment, and technology has increased sharply in the past three years, much the same way as it did in the United States some years earlier. But there is no room for complacency. Increases in productivity do not just happen. These days, good productivity performance seems to be related to changing technology--an openness to adopting it and a flexibility in adapting to it. That is what we must strive for in Canada. We will also need to maintain a stable macroeconomic environment that combines low inflation and a prudent fiscal policy. This will help foster a climate conducive to initiatives in innovation, risk-taking, and investment that can contribute to sustained productivity gains. I can assure you that the Bank of Canada will continue to do its part, by keeping inflation low and stable.

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canada

Accountability and Transparency in Canada's Monetary Policy

thiessen

Governor of the Bank of Canada to the Metropolitan Halifax Accountability and transparency in Canada's monetary policy Public sector institutions have been undergoing significant changes over the past decade. One of the most important changes has been the move to greater accountability. Public institutions are now required to be more open and to provide more information about their operations. Or, to use the word currently in vogue, to be more "transparent." Nowhere has this move towards greater transparency been more dramatic than among central banks in the major industrial countries. Traditionally, central banks had been rather closed, almost mysterious, institutions. This reflected the view that financial markets needed to be "surprised" if monetary policy was to have a significant effect. In recent years, the philosophy behind monetary policy in Canada, and in most major countries, has been moving in the other direction. Not only does this reflect the need for accountability, but also the fact that central banks have come to appreciate that transparency can actually lead to better policy outcomes. Today, I would like to tell you about some of the steps we have taken to increase transparency in the conduct of Canadian monetary policy. In keeping with this theme, I will also take this opportunity to bring you up to date with the Bank's view of recent economic developments at home and abroad and tell you how the outlook shapes up. I will also discuss what monetary policy is doing to keep the current economic expansion in Canada on a sustainable course. Accountability and transparency in monetary policy I would suggest that what is absolutely crucial for the accountability and transparency of public institutions is clear objectives . This is certainly true for monetary policy. In Canada, a major step towards greater openness was the adoption in 1991 of specific targets for inflation reduction. Inflation was quickly brought down and, since 1994, the objective has been to keep it low and stable--within a range of 1 to 3 per cent. This explicit target is a precise yardstick for measuring the Bank's success or failure and, thus, provides the basis for our accountability to the public. But as I have said many times in the past, low inflation is not an end in itself. We focus on low inflation because it contributes to a more productive, stable, and prosperous economy. So ultimately, our accountability must be seen in terms of inflation control as a means to better overall economic performance. Interestingly, once a central bank has adopted an explicit inflation target, as we have, and is held to account for it, the move towards greater transparency is speeded up. For it quickly becomes apparent that monetary policy will be more successful in meeting the target if both the public and financial markets understand the factors affecting inflation as well as the central bank's assessment of those factors and its likely response. Here in Canada, we found that, as we consistently met our targets, public expectations about future inflation changed--the more credible the Bank's commitment to the targets became, the more Canadians formed their plans on the assumption that the future trend of inflation would stay inside the target range. Over time, a credible commitment to inflation control also sets other positive developments in motion. As credibility rises, uncertainty about future inflation diminishes. Interest rates are lower than otherwise and investment in machinery, equipment, and technology increases, leading to stronger economic growth in the longer run. But that is not all. As Canadians become more confident that inflation will be controlled, they are less quick to react to unexpected disturbances that could affect inflation. This contributes to greater economic stability and gives the Bank of Canada a bit more time to assess the extent and persistence of such disturbances. Greater public confidence thus gives the Bank more latitude to explore the limits of the economy's capacity to produce and to create jobs without setting off inflation pressures that undermine the sustainability of the economic expansion. Transparency and accountability in monetary policy require effective communication. At the Bank, we have undertaken a series of initiatives to improve our communications with the public. Five years ago, we redesigned our to make it a more reader-friendly yearly account of how we have managed the Bank and how effectively we have carried out our main responsibilities. At that time, we also introduced a , which is published every six months--in May and November. This describes our management of monetary policy and gives the Bank's assessment of recent economic information as well as our outlook for the economy and inflation. After the release of each , we meet with media as well as with business economists and financial analysts. In addition, I appear before a parliamentary committee to discuss the contents. Both of these initiatives are important parts of the accountability process. Six months, however, has been proven to be rather a long time between , especially for market participants and economists who follow monetary policy closely. That is why next month we will issue an appear in the Winter 1999-2000 issue of the . These will be published regularly, every February and August, between issues of the . Because Canada is such a large country with so many diverse economic regions, it is important that the Bank maintain contacts with the public that are country-wide and that involve two-way communication. We need to hear firsthand what is happening to the economy in every corner of Canada. That is why, in 1997, we set up five regional offices, including one here in Halifax for the Atlantic region. Our representatives are in frequent contact with various local associations, businesses, community groups, government officials, colleges, and universities to give and receive information and to exchange views on the economy and monetary policy. To supplement these contacts, my senior colleagues and I frequently travel across the country to talk to groups, like this, to respond to questions, and to listen to comments and concerns. That way, we ensure that we are heard and also that we hear what is going on from one end of this country to the other. For those of you who surf the Internet, I should mention that there is also a tremendous amount of information on the Bank of Canada's Web site. All of our recent publications, speeches, and press releases are there. You will also find short, straightforward notes explaining various aspects of monetary policy as well as information on interest rates and exchange rates. In addition, our site features a rather neat inflation calculator, which allows you to find out what inflation has done to the value of your money over any period during the past 85 years. This can really bring home just how inflation eats into the buying power of money over time. These are just some of the things we have done to become more open, understandable, and accountable to the Canadian public. I would now like to give you my reading of where the Canadian economy is, where we are headed, and what it all means in terms of the outlook for inflation and monetary policy. The Canadian economy--recent record and outlook 1999 turned out to be a very good year for Canada. Our economy rebounded strongly from the global financial crisis of 1997-98 and its negative effects on the prices of the key primary commodities we export. When the numbers for the final quarter of 1999 are out, I expect that they will show that the Canadian economy has expanded by close to 4 per cent since the fourth quarter of 1998. And employment has been growing strongly, taking the national unemployment rate down to an 18-year low of just under 7 per cent. Nova Scotia's economy has also done well this past year, both in terms of output and employment growth. Indeed, when it comes to job creation through the year (that is, December 1999 over December 1998), Nova Scotia has done better than the national average. A number of factors have supported the economic upswing in Canada. On the external side, we have greatly benefited from an amazingly strong U.S. market. A pickup in growth in Europe and a recovery in some of the Asian economies that were most hurt by the financial crisis have also helped. Another important factor has been the turnaround in primary commodity prices, in response to firmer world economic activity. Stronger domestic spending in Canada, reflecting growing confidence, rising employment, and relatively low interest rates, has also been instrumental in boosting the rate of economic expansion. When I talked about our economic prospects in Charlottetown in early November and again when our was released shortly after that, I indicated that the Bank expected a positive picture for 2000. This meant continued healthy growth and an underlying rate of inflation (as measured by the Consumer Price Index, excluding food, energy, and the effects of changes in indirect taxes) near the middle of our 1 to 3 per cent target range. Information received since then suggests that in the future there may be more upward momentum of demand in Canada than we thought because of greater strength both in the world economy, especially in the United States, and in global commodity markets. So we may be looking at a somewhat faster pace of economic expansion for this year--in the upper half of the 2 3/4 to 3 3/4 per cent range that we suggested in the autumn. I also pointed out last November that there were inflation risks in the outlook for Canada that the Bank was sensitive to, and should be ready to face, given that monetary policy must be forward-looking. I highlighted two risks in particular: a potential buildup of inflation pressures in the United States that could spill over to Canada; and the possibility of a much stronger momentum of demand in this country from both domestic and foreign sources. Economic developments since November continue to point to these risks. And they underline the need for the Bank to be vigilant and ready to act in a timely fashion to safeguard Canada's low trend of inflation. For let us make no mistake: a resurgence of inflation would undermine our chances of a durable economic expansion. Of course, the challenge for monetary policy is to assess carefully just when action is needed. Ideally, we would want our economy to operate at a level that is as close to full production capacity as possible. At this level, inflation will stay low and stable, and the economy can expand at as rapid a pace as is sustainable over time. It is when persistently strong demand pushes the economy to operate well above capacity over a period of time that inflation pressures develop. This is what monetary policy must seek to avoid. Unfortunately, in practice, it is very difficult to estimate exactly where that sustainable operating level for the economy is. And this is even harder after a period of major restructuring, such as we have experienced in Canada in the 1990s. conventional measures suggest that the economy may now be operating at capacity, it is quite likely that structural changes have raised the output potential of our economy. But we are not sure by how much. That is why the Bank closely monitors a wide range of indicators that can help it assess the extent of current and future pressures on capacity and inflation. Some of the elements going into this assessment are: unexpected movements in actual inflation; changes in expectations of future inflation; other measures of pressures in product and labour markets; the growth of money and credit; and information gathered by our regional representatives from business contacts across Canada. Because of the current strong momentum of demand and high levels of economic activity, and because of the uncertainty about Canada's production potential, the Bank must continue to be on guard. It must continue to watch for leading signs of future price and cost pressures and stand ready to respond promptly if such signs emerge. To conclude, the Bank of Canada has taken a number of steps to become more open, transparent, and accountable about the conduct of monetary policy. Through a regular flow of reports and speeches like this, we intend to continue telling you where the economy is and where we think it is going, what risks we see out there, and what monetary policy can do to reduce them. These days, the Bank is sensitive to the increased risks of inflation coming from a more synchronized expansion of the world's major economies. Not only does a buoyant U.S. economy continue to bolster the demand for Canadian products, but firmer commodity prices are boosting our national income and adding to the impetus of domestic spending in Canada. The Bank remains committed to delivering a trend of inflation that is inside the target range of 1 to 3 per cent. Because the long and the short of it is that low and stable inflation is a crucial ingredient for a durable, healthy economic expansion.

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canada

Release of the Monetary Policy Report Update

thiessen

Governor of the Bank of Canada on the release of This morning, we released our update to the November 1999 . It gives the Governing Council's latest outlook for the economy and for inflation. Information received since November confirms that our economy performed well last year - expanding by close to 4 per cent between the fourth quarter of 1998 and the fourth quarter of 1999. And nearly 430,000 new jobs were created during the year (December over December), taking the unemployment rate down to a 23-year low of 6.8 per cent. With respect to the outlook for this year, the presents our revised view that foreign and domestic demand for Canada's output is now stronger than had been anticipated in November. This is because of greater strength in the global economy, particularly in the United States, and in world commodity markets. We now expect real Gross Domestic Product growth in 2000 to be near the top of the 2 3/4 to 3 3/4 per cent range projected in November. Our core measure of inflation has been slightly lower than we expected, but it should still move up to the midpoint of the 1 to 3 per cent target range for inflation control in the next few months. Because of the recent sharp step-up in energy prices, however, the rate of increase in the total Consumer Price Index will likely rise to close to 3 per cent over the same period. Nonetheless, we continue to see the total CPI moving down towards the core rate during the course of the year, if energy prices moderate, as we expect. Monetary policy must always be forward-looking. And so the Bank must remain sensitive to, and be ready to respond to, any future inflation risks. We highlighted two such risks last November: the possibility of a much stronger momentum of demand in Canada from both domestic and foreign sources, and a potential buildup of inflation pressures in the United States that could spill over to Developments since then continue to point to these risks, reinforcing the need for the Bank to be vigilant and ready to act in a timely fashion to keep the trend of inflation well inside the target range. Our decision to raise the Bank Rate two weeks ago reflected these concerns. I would like to emphasize once again the importance of keeping the future trend of inflation in Canada low and stable. This is the way monetary policy can help to keep our economy expanding in a sustainable way.

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The Conduct of Monetary Policy When You Live Next Door to a Large Neighbour

thiessen

Both in Canada and elsewhere, much ink has been spilled over the past year on the pros and cons of different exchange rate regimes and the implications for monetary policy. Interest in the subject was piqued by the difficulties experienced in 1997-98 by a number of emerging-market economies in Asia--difficulties that had a lot to do with unsustainable exchange rate arrangements. As well, the formation of a large single currency area in Europe, just over a year ago, focused attention on monetary unions. Canada's floating exchange rate system has itself been the subject of debate, particularly while our economy was adjusting to the effects of falling world commodity prices. There have been a number of changes in exchange rate regimes recently. Several Asian countries have abandoned their fixed exchange rate arrangements for more flexible systems. Last year, Brazil also moved to a floating exchange rate. Conversely, Argentina was seriously debating giving up its currency board arrangement and adopting the U.S. dollar. And of course this past January, Ecuador embarked on the road to "dollarization" in an effort to restore political and economic stability there. In a world of increasingly open markets for goods and services, burgeoning international trade, and massive global capital flows, what can we say about the appropriate exchange rate arrangements and the scope for independent monetary policies in individual countries? I believe that Canada is well placed to offer some useful insights, living next to a much bigger neighbour, with whom we have forged very close economic and financial links over the years. And so today, I would like to talk about the conduct of monetary policy in Canada under a floating exchange rate system. I will end with a brief summary of the state of the Canadian economy. Economic and financial links between Canada and the United States No two other countries share as much as the United States and Canada--and I do not just mean hockey, baseball, or the longest undefended border in the world! Let us look at some basic economic facts. The value of goods and services that cross the Canada-U.S. border every year amounts to about US $ 370 billion--40 per cent of our gross domestic product. Canada accounts for nearly one-fifth of U.S. international trade in goods and services, while the United States accounts for close to four-fifths of ours. Canada and the United States have been eliminated on a large number of goods. Financial flows between our two countries have also generally been free of controls since shortly after the Second World War. Today, the United States accounts for two-thirds of our net international liability position and for approximately half of all Canadian gross international assets and liabilities. With this much economic and financial integration between our two nations, it is not surprising that there are people who believe that Canada should be in some type of monetary union with the United States (and perhaps Mexico) or that it should peg its currency to the U.S. dollar. Instead, the Canadian dollar has been floating against the U.S. dollar for all but eight of the last 50 years -- the longest time that any industrial country has been on a floating exchange rate system. Indeed, this coming September will be the 50 th anniversary of our first move to a floating rate. Canada's floating exchange rate regime The main reason for choosing to float is that economic shocks affect our two countries differently. Even when Canada and the United States are hit by the same shocks, the impact on our economies can vary. Movements in the world prices of primary commodities are a classic example. Although the share of primary products in total Canadian exports has fallen by nearly half since the 1970s--to about 30 per cent--primary-producing industries are still important to us. In the United States too, the primary sector is significant. But, unlike Canada, the United States is not a net exporter of commodities. Indeed, it is a net importer. So, when world commodity prices tumbled in 1997-98 in the wake of the Asian crisis, this actually helped a vigorously expanding U.S. economy, by reducing input costs and dampening upward pressure on the general level of prices. In Canada, however, lower commodity prices caused a deterioration of our terms of trade--the prices we receive for our exports relative to the prices we pay for imports. Between mid-1997 and the end of 1998, the U.S. terms of trade rose by about 3 per cent, while ours fell by close to 5 per cent. This had a negative effect on both our national income and the profitability of our primary sector. When something like this happens, our floating exchange rate helps us to absorb the consequences. This is not to say that it eliminates the effects of a decline in commodity prices. But it does cushion them, and it facilitates the necessary adjustments in the economy. In this instance, the external value of the Canadian dollar fell by about 12 per cent between mid-1997 and late 1998, reflecting a drop of some 20 per cent over the same period in the average world price (in U.S. dollars) of the key primary commodities we produce. Because of this movement in our currency, the price of these products in Canadian dollars fell by less than their world price in U.S. dollars, thus reducing the negative impact on our exporters of commodities. Even more important was the incentive that the lower exchange rate provided to Canadian producers and exporters of non-commodity goods and services to expand their sales abroad. With the exchange rate moving in response to the commodity-price shock, the negative effects were spread out more evenly across the economy and were less pronounced overall than they might otherwise have been. Yes, real GDP growth slowed from 4 per cent in 1997 to 3 per cent in 1998. But it picked up again to 4 1/4 per cent in 1999. Moreover, employment has been rising, and unemployment has continued to fall since 1997. And in response to the acceleration in economic activity and rising commodity prices, the Canadian dollar has strengthened over the past year. The other important characteristic of a floating exchange rate is that it allows us to have a monetary policy that is separate from that of the United States. Typically, economists express this independence as the ability to choose one's own national objective with respect to inflation. I do not find this to be a particularly useful way of looking at autonomy. And I most certainly would not want to suggest that there are serious shortcomings with the present objectives and approach of U.S. monetary policy that would justify pursuing a fundamentally different policy in Canada. In fact, the objectives of monetary policy in our two countries are very similar. Monetary policy affects the level of aggregate demand in the economy which, in turn, leads to an ultimate effect on prices and the inflation rate. The real essence of pursuing a separate monetary policy is having the option and the ability to respond to fluctuations in demand that are unique to our economy. Let me give you an example from recent Canadian history. It goes back to the sharp fiscal tightening that we had to implement in 1995 in order to turn around our large public sector deficits and mounting indebtedness. Of course, fiscal deficits also had to be reduced in the United States during the 1990s, but the relative tightening has been much less than in In any event, the dampening effect on aggregate demand of this dramatic change in Canadian fiscal policy called for easier monetary conditions. As progress was made in restoring fiscal credibility, the Bank of Canada was able to lower its policy rate during 1996-97, to levels well below the comparable U.S. Federal Reserve rate. Both market interest rates and the exchange rate moved down in response, helping to stimulate foreign and domestic demand and so moderate the effects of fiscal restraint on economic activity. For all these reasons, a flexible exchange rate has an important role to play in an open economy like Canada's. Let me now turn to the framework for monetary policy that the Bank of Canada has adopted. Inflation-control targets The objective of Canadian monetary policy is to keep inflation low and stable. The Bank of Canada pursues this objective by means of an explicit target for inflation control. This target has been the main feature of our monetary order since the beginning of 1991. The current goal is to hold inflation inside a range of 1 to 3 per cent. However, the Bank of Canada could not have targets for inflation control and be held accountable for achieving them without the flexibility provided by a floating exchange rate regime. But it is also true that a floating exchange rate system is more effective and reliable when there is a firm commitment to targets for inflation control. And our ability to have short-term interest rates for monetary policy purposes that are different from U.S. rates is greater in those circumstances. The Bank of Canada's success in meeting the targets over the past nine years has helped to increase public confidence that inflation will stay inside the target range. And this has been true even during periods of turbulence and relatively wide fluctuations in the external value of the Canadian dollar. Moreover, this increased confidence in the Bank's commitment to low inflation has, in turn, helped the operation of financial markets by providing a strong underpinning to the valuation of the Canadian dollar. This is a relatively new phenomenon for Canada. During the years of high inflation--the 1970s and 1980s--a depreciation of the exchange rate would, all too often, raise fears of still higher inflation, which would then lead to further depreciation and higher interest rates. Needless to say, it is only when expectations of inflation and of the future value of the Canadian dollar are well anchored that an independent monetary policy is possible. For only then will movements in the exchange rate permit adjustments in real (after-inflation) interest rates in Canada that are different from those in the United Put another way, monetary policy actions cannot bring about Canadian real interest rates that remain below U.S. rates for any significant length of time, unless markets have a fair amount of confidence in Canada's commitment to prudent macroeconomic policies, and unless there is a reasonable expectation of a real appreciation of our currency in the future. In this context, I strongly believe that, without our inflation-targeting framework, we could not have had interest rates in Canada generally below those in the United States, as we have in the past four years. But I should add that neither would this have been possible without the remarkable progress made by Canadian governments during the second half of the 1990s to reduce budget deficits and to bring down the amount of public sector debt relative to the size of our economy (debt-to-GDP Now, you may ask, How important can inflation-control targets really be if the United States has consistently turned in a strong economic performance and low inflation without their benefit? The key element here is monetary policy credibility. And credibility is not necessarily tied to inflation targets. As U.S. experience shows, a strong commitment to low inflation can do the job. But, where past price performance has not been particularly favourable, inflation targets can help to strengthen confidence in the central bank's commitment to low inflation. From the early 1970s to the early 1990s, on average, Canada had a somewhat higher inflation rate than the United States. Other factors that matter are the size and importance of the U.S. economy as well as the fact that the U.S. dollar is the pre-eminent international reserve currency. All this incites considerable investment interest and greater market confidence in the U.S. dollar compared with any other currency, especially during turbulent times. The Canadian economy, by contrast, is much smaller and more open. Because of these considerations, we in Canada have had to affirm our commitment to a more concrete monetary policy objective in the form of explicit inflation targets. The importance of credible macroeconomic policies In summary, I would suggest that our experience with a floating exchange rate system and a "made-in-Canada" monetary policy, despite high economic and financial integration with our much larger U.S. neighbour, provides an interesting example for those exploring the gamut of exchange rate and monetary policy options. As I look at Canada's exchange rate experience over the past few decades, however, one thing is very clear to me. And that is the importance of credible domestic macroeconomic policies. Without a sound fiscal policy and without a strong explicit commitment to inflation control, exchange markets will not have full confidence in the underlying value of the currency. And the ability of a flexible exchange rate to respond to shocks and to facilitate the interest rate movements needed for an independent monetary policy will be seriously compromised. This in the end says it all. No exchange rate system is going to bail you out of bad economic policies. And that is equally true of a floating exchange rate system, as it is of the alternatives--a fixed exchange rate or indeed a monetary union, even if that monetary union is with the world's largest, strongest economy. In today's rapidly changing, increasingly open world economy, there is an even greater need for flexibility than before. I believe that a flexible exchange rate regime continues to serve Canada well in dealing with the challenges of this new economic reality. The current economic situation in Canada Let me finally say a few words about the current economic situation in The Canadian economy had a good year in 1999. Our export industries benefited from the strong U.S. economy. And with global economic conditions generally improved, primary commodity prices rebounded. The resulting gains in incomes and employment in Canada led to higher levels of domestic spending. Recently revised statistics now show stronger economic growth in Canada during 1999 than previously estimated. And we continue to see strong momentum in our economy so far this year. Indeed, by some calculations, we could be operating at full capacity. However, as has been the case in the United States for some time, Canada has also recently experienced an increased level of investment in machinery, equipment, and technology. This should lead to improvements in productivity and in our economy's production capacity. But we cannot be sure by how much. In light of this uncertainty, the Bank of Canada has been concerned about our economy picking up too much speed. There is a risk that we could hit the capacity ceiling too hard, causing supply bottlenecks and shortages that could lead to an ongoing increase in inflation. To reduce this risk, the Bank of Canada increased its Bank Rate twice, in November and February, following similar rate hikes by the U.S. Federal Reserve. The latest data indicate that the external demand for Canadian output, especially from the United States, is stronger than previously expected. Under these conditions, it is essential for the central bank to be vigilant. Moreover, in view of the uncertainty about the production potential of our economy at this time of structural change, the Bank is now monitoring a wide range of indicators for early-warning signs of pressure on capacity and prices. Up to now, our inflation performance has been somewhat better than we had expected. While the increase in the total CPI over the past 12 months to January was 2.3 per cent, our core rate of inflation (excluding food, energy, and the effect of changes in indirect taxes), at 1.3 per cent, remains in the bottom half of the 1 to 3 per cent target range. This good inflation performance bodes well for the continued expansion of the Canadian economy. But what remains to be seen is whether this expansion will bring with it strong productivity gains for Canada similar to those witnessed in the One thing is clear. The job of the Bank of Canada must be to keep inflation in Canada low and stable. Without that, we will be risking both the economic expansion and the potential productivity gains.

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Opening Statement before the Standing Senate Committee on Banking, Trade and Commerce

thiessen

I very much appreciate the opportunity to appear regularly before your Committee. I would like to use this particular occasion to update you on economic and monetary developments as well as to discuss any issues that you may want to raise. Let me first give you an overview of the developments in the past year. When I appeared before you last April, there was still a high degree of uncertainty in the global economy related to the 1997-98 financial crisis in emerging markets and the associated fall in world commodity prices. And because of these difficulties, the pace of economic activity in Canada had slowed. But by mid-1999, our economy had regained its momentum, supported by buoyant U.S. demand, a rebound in commodity prices, and a pickup in domestic spending. Over the four quarters of 1999, output expanded by about 4 3/4 per cent and 425,000 new jobs were created, taking the national unemployment rate down to 6.8 per cent by this February--its lowest level in 23 years. At the same time, the underlying rate of inflation remained low. Why has Canada rebounded so quickly from the external shocks of 1997-98? I believe it is because Canada's economic policy foundation is stronger today than it has been in several decades. This foundation has two cornerstones. One is the improved fiscal positions of governments that have led to a declining ratio of public sector debt relative to the size of our economy. The second is an environment of low and stable inflation that is expected to persist because it is anchored by the Bank of Canada's target for inflation control. Since the early 1990s, Canadian monetary policy has been based on a commitment to explicit targets for inflation control. This commitment has helped to moderate fears of a resurgence of inflation, has assisted the Bank in taking timely action in response to changing economic and financial conditions, and has improved our public accountability. A crucial part of our monetary policy regime is our floating exchange rate. Without that, we could not have Canadian inflation targets. A good measure of the success of our monetary policy framework based on inflation targets and a flexible exchange rate is that Canadian interest rates have remained lower than comparable U.S. rates, apart from the period of turbulence in 1998. These lower rates reflect Canada's lower inflation rate, and the expectation that low inflation will continue. In the past, a depreciation of our currency has frequently fed fears of inflation and has led to interest rate increases. The difficulties of the past couple of years also illustrate the value of a flexible exchange rate as a shock absorber. The downward movement of the Canadian dollar from mid-1997 to the end of 1998 was largely a response to the sharp decline in world prices of the primary commodities that Canada exports. Our economy had to adjust to this reality; the exchange rate decline facilitated a shift in activity from the primary sector to manufacturing and other export sectors. It also provided an additional incentive for these sectors to take advantage of a strong U.S. economy. Because of these adjustments, the Canadian economy continued to expand during 1998 and recorded a substantial upswing in 1999. When I last appeared before this Committee, Mr. Chairman, there were a number of questions about Canada's rate of productivity and about the gap in productivity with the United States. I am happy to report that there have been some positive developments over the past year. Not only have we had better productivity gains through 1999, but purchases of machinery and equipment climbed 18 per cent during the course of the year. This continues the increase in investment in machinery, equipment, and technology that began in 1996 and that mirrors the increase in investment that began somewhat earlier in the United States. While we are certainly heartened by the better productivity outlook in Canada, we are not sure how large these gains are likely to be, how long they will last, or by how much they will eventually enhance our economy's production capacity. This uncertainty raises an important issue for monetary policy, especially since, by some measures, the Canadian economy is currently operating at or above full capacity. On the one hand, our low-inflation environment and the Bank of Canada's commitment to maintaining it give us more room than we have had for some time to explore the economy's full potential. However, because of the current strong momentum of the economy and the high levels of activity, the Bank must be careful to avoid approaching capacity limits too rapidly. We do not want to trigger bottlenecks and shortages that can put unnecessary pressure on inflation. Because of the time it takes for monetary policy to have its full impact on the economy, we can best achieve and maintain full potential if we approach capacity constraints gradually and carefully. We had these considerations in mind when we increased the Bank Rate in November, February, and March. These increases followed similar rate hikes by the U.S. Federal Reserve. The U.S. actions provided additional evidence of the likely further spillover of U.S. demand to our export sector. Altogether, this suggests an overall demand for Canadian output that is stronger than previously expected. Under these conditions, it has been essential for the Bank of Canada to be vigilant. As I said before, our inflation performance, up to now, has been good--in fact, somewhat better than we had expected. While the 12-month rate of increase in the total CPI moved up to 2.7 per cent in February because of sharply higher energy prices, when one looks through those developments at the underlying trend of inflation, our core CPI measure (which excludes food, energy, and the effect of changes in indirect taxes) was at 1.6 per cent in February. This is within the lower half of the 1 to 3 per cent inflation-control target range. When it comes to the surge in energy prices, let me just say that the Bank of Canada will be watching closely to ensure that the recent increase in energy prices does not show up in higher expectations of inflation. We expect that the recent decline in world energy prices will persist, bringing the rate of increase in the total CPI down, closer to the centre of our target range by late this year. I cannot stress enough the importance that we at the Bank of Canada place on keeping the future trend of inflation in Canada low and stable. This is the best contribution that monetary policy can make to the continued expansion of the Canadian economy and to further productivity gains.

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The Canadian Economy: Charting a Course for the Future

thiessen

Governor of the Bank of Canada to the Chambre de commerce The 1990s was a difficult period for Canada and the Canadian economy. From the beginning of the decade, it was clear that we had to grapple with the problems that had been hampering our economic performance through most of the 1970s and 1980s. Thus, the Bank of Canada set out to lower inflation. Canadian businesses began to restructure their operations to become more productive and internationally competitive. And governments started the process of cutting public deficits and lowering debt burdens. Dealing with these problems was certainly painful. And, in some cases, it took us a good part of the decade to overcome them. But we have now made some crucial improvements to our economic foundation. And as we step into the new century, we are beginning to see the benefits. The Canadian economy has been expanding solidly for some time now. In fact, if we look through some temporary monthly declines, we are in our nineteenth quarter of positive growth. This is the longest uninterrupted economic expansion in Canada since the mid-1960s. And throughout, inflation has remained low and stable. The advantages of this expansion are now showing up in gains in employment and incomes. This is all very heartening. To maximize these benefits, we must build on--not be complacent about--our new-found economic vitality. We must avoid the boom-bust cycles of the past. This is one issue I would like to discuss today-- how to minimize economic fluctuations . Not eliminate them altogether, that is just not possible. In today's globalized markets, there will still be times when Canada's very open economy will be hit by external shocks. And sometimes there will be surprises on the domestic side too. In the past, though, some of our economic ups and downs were aggravated by outbreaks of inflation. The question is, what can we do now to keep our economy moving along on a sustainable growth path? There is also the question of longer-term economic performance . For example, how low can our unemployment rate go on a sustainable basis? Will we succeed in narrowing the gap between our standard of living and that of our U.S. neighbours? What choices should we be making today that will improve our economic performance in the decade ahead? This sounds like a tall order! So before I raise expectations too much, let me say that I do not have answers for all these questions. There are, however, several important steps we can take that would increase our chances of preserving the current economic expansion and help improve our performance over the long run. Let me start at the beginning--with sound economic policies. ... keep inflation low and stable I see low and stable inflation as an essential building block of a strong economic structure. Is this just my bias as a central banker? Perhaps, but there are good reasons for it. Inflation carries with it costs that are more profound and widespread than is commonly recognized. Inflation magnifies uncertainty about the future: when prices are rising, the rate of inflation is rarely stable or predictable. Inflation distorts and confuses the information and incentives that consumers, entrepreneurs, savers, and investors rely on to make their economic decisions. And it causes households and businesses to spend time and money to try to shield themselves, or to benefit, from the effects of rising prices by turning to speculative assets (such as real estate) and away from productive investments. We saw a lot of this during the high-inflation days of the 1970s and 1980s. We also saw our interest rates rise higher and higher to compensate savers for expected higher inflation and for the risks caused by uncertainty about future inflation. And we saw economic booms turn into busts. So the focus of central banks on price stability these days is neither accidental nor whimsical. It is deliberate. And it has to do with reducing the toll that inflation takes on the economy and minimizing economic ups and downs. Put another way, if the goal of economic policies is a productive, well-functioning economy, capable of creating new jobs and delivering higher standards of living over time, then low and stable inflation is a crucial means to that end. That is why the Bank of Canada and the Government of Canada have agreed to an explicit target for inflation control, which currently aims to hold inflation inside a range of 1 to 3 per cent. There are already signs that this commitment is paying off in helping to reduce the fluctuations in our economy. In the nine years that the inflation targets have been in place, not only has the underlying rate of inflation been much lower than in the previous two decades, but the pace of economic activity has been less variable from one quarter to the next. ... keep public finances under tight control Fiscal prudence is the other crucial part of sound economic policies. Why does tight control over government budgetary positions matter so much? As I said before, governments have made remarkable progress in recent years in reducing deficits and bringing down the national debt relative to the size of our economy--the debt-to-GDP ratio. But this ratio is still high. Because of this, we remain vulnerable to unexpected developments, such as international financial crises, which can push up the risk premiums in our interest rates. There is no objective economic analysis that can tell us exactly what is the right debt-to-GDP ratio to aim for. But as long as our national debt ratio is higher than that of most other large industrial countries, we are at risk of being singled out by investors the next time there are international problems. I hesitate to make any comment on the current debate about tax rates. But it is important for a well-functioning economy to find the level of taxes and government services that would deliver the right balance of incentives and public support programs. Finding this balance is even more important these days. In today's environment of rapidly changing technology, there can be increased uncertainty and insecurity about the future; however, there can also be great rewards. Let me now turn to this issue of technological change and to some of the other challenges we must deal with if we are to prosper in the future. ... keep abreast of, and continue to invest in, new technology I do not believe that anyone would disagree with the importance of keeping up with the times. We are in the midst of a global technological and information revolution that is transcending national borders, pushing at new frontiers every day, and transforming our economies. This is the brave new world of microchips, fibre optics, and the Internet--a world more closely connected than ever before, where opportunities abound, competition is intense, and survival is synonymous with innovation. As a nation, Canada is probably better positioned than most to seize the opportunities presented by this new technological revolution. Canada is a large country that has been a pioneer in telecommunications, and we are well ahead of many countries in the use of personal computers and the Internet. Our colleges and universities turn out graduates that are highly skilled. And, in general, our population is well-educated. But to make the most of potential opportunities, we must ensure that we keep pace with the best in the global race to take full advantage of accelerating technological change. To appreciate the benefits of moving quickly to exploit the full potential of new technologies, we have only to look at the stellar performance of our next-door neighbour. The "strong growth-high productivity-low inflation" record of the United States over the past nine years has much to do with the systematic efforts of U.S. businesses since the 1980s to restructure their operations and invest heavily in machinery, equipment, and software that embody the latest technologies. Business spending on machinery and equipment as a percentage of that country's gross domestic product (GDP) rose from 6 per cent in 1992 to 11 per cent last year. Canadian businesses have also substantially increased their purchases of machinery, equipment, and techology--especially since 1996. As a percentage of GDP, such investment has risen from 6 per cent to 9 per cent in 1999--which leaves us where the United States was three or four years ago. There is no doubt that gains in productivity require more than just investments in technology. The entrepreneurial application of technology in new areas and employees skilled in the use of new practices and equipment are also key elements in this process. But because we are going through a period of major change in applied technology, the spotlight is naturally on investments in technology and on the need to intensify our efforts on this front. I believe that Canada has what it takes to make the most of this "new economy." ... the importance of being globally competitive More Canadian businesses also need to understand that globalization is irreversible--they must plan to operate on the basis that markets of all sorts will become increasingly globalized. Despite the problems that the World Trade Organization ran into in Seattle, the move towards freer trade is inevitable as more emerging-market economies recognize that opening up to international trade and investment is the best means of raising productivity and improving living standards. And while it may not always seem to be the case, this increased openness in world trade will be good for Canada too, especially if we are adept enough to take full advantage of it. A freer world trade environment opens up new vistas so that our companies can increase their global reach. Of course, it does the same for our competitors. And they will be out there, going after a bigger slice of the world market. The way to stay ahead of the game is by developing and maintaining a competitive edge. This means improving productivity and finding more efficient, less costly ways, of delivering the products that foreign customers want. And it goes beyond innovation and investment in new technologies. It also means strengthening our educational system and making sure that the workplace environment in Canada is ready to respond to the technological and market changes as they unfold. ... the importance of flexibility, training, and development Dealing with rapid change is always difficult. When people are not certain how their lives will be affected by it, they tend to be fearful and resistant. So what will be needed, to an even greater extent than ever before, is a sense of partnership between employers and employees in developing strategies to deal with the challenges of change. In my view, there are two important elements to such strategies: we need to foster a greater degree of flexibility in adapting to change and we need to increase training so that employees have the necessary tools to operate confidently with advanced technologies and to get the most out of them. Flexibility is important because job requirements will change more frequently, along with evolving technology. We must be prepared to accept and adjust to these changes as well as to the possible need for greater movement between jobs, employers, and even regions. When it comes to training, the main point I would like to make is that human skills are essential to innovation. What is the sense of spending heavily on state-of-the-art technology and equipment that ends up idle or inefficiently used because of a lack of trained personnel? The partnerships that are being formed between industries, on the one hand, and colleges and universities, on the other, are going to be even more important in the future. And I expect that all businesses, especially smaller ones, are going to have to devote more time and resources to training staff. ... the importance of an efficient and innovative financial sector The final item on my list today is the importance of an efficient and innovative financial sector. There is considerable evidence that the degree of financial development can have a marked impact on economic growth. A highly developed financial sector helps channel savings into investments and allocates that capital more efficiently. In these times of rapid technological change, many of the new and innovative applications of technology are going to take place in small, often new start-up, companies. Financing the growth of these companies presents a challenge for the financial sector because it requires an ability to assess the risk involved and then put the right price on that risk. And when concentrations of risk become too high for individual investors and lenders, the financial system must be flexible enough to allow them to shift their risks and rebalance their loan and investment portfolios. One of the factors behind the recent extraordinary performance of the United States has been the flexibility and innovation of its financial system. We will need to ensure that in Canada too, the financial sector responds to the challenges of today's changing financing needs. Concluding thoughts Let me summarize my main points today. Canada has made remarkable progress over the last decade in strengthening its economic foundation. Starting from that firmer base, we are now in a position to move forward and reap some of the potential gains in employment and incomes from the technological revolution that is now sweeping the world. Monetary policy can support this process by providing a low and stable inflation environment. This will minimize economic fluctuations and allow our economy to perform at its best. Fiscal policy can help by keeping public finances under control and continuing to reduce Canada's debt burden. The right balance of taxes and government services is also important. A stable, innovative financial sector can also help, by ensuring that financing flows efficiently to where it is needed the most. All this will go a long way towards providing an environment in which Canadian companies can go about their business confidently in a world of rapid change. It is the business community, however, that must take the innovative, and sometimes risky, decisions that are necessary to improve productivity and competitiveness, in order to meet the challenges and realize the gains of proliferating technologies and increasingly open world markets. There is no reason why we in Canada cannot meet these challenges and build a better economic future for ourselves.

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Release of the Monetary Policy Report

thiessen

This morning we released our latest . The outlook that we see for Canadian economic growth and inflation is very positive. The economy has outperformed expectations since our November and the underlying trend of inflation has been lower than expected. With the global economy gaining momentum and greater demand at home, we have raised our projection for economic growth in Canada to a range of 4 - 4 1/2 per cent this year. At this pace, pressures on capacity will likely intensify through the year, and we expect the core rate of inflation to rise gradually from 1 1/2 to 2 per cent--the middle of our target range. To keep core inflation steady near the middle of the 1 to 3 per cent target, some deceleration in economic expansion or a more rapid increase in productivity and production capacity will be required during 2001. The challenge for monetary policy will be to judge whether the trends of demand and supply are in balance. With the current momentum of demand in Canada, it appears that monetary policy will have to continue to lean against the wind. What is less certain, however, is the degree of monetary tightening that would be required. What is clear is the crucial need to preserve the low trend of inflation that has been contributing to the recent good performance of the Canadian economy.

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Opening Statement before the House of Commons Standing Committee on Finance

thiessen

Mr. Chairman, and members of the Committee: It is always a pleasure to appear before you. Since other Parliamentary business precluded my appearance before you last fall, I especially welcome this opportunity to discuss the economic situation in Canada and the prospects for inflation. Last week, we released our eleventh . Since our November , the Canadian economy has outperformed expectations. Bolstered by vigorous external and domestic demand, Canada's economic expansion strengthened in the second half of 1999 and into early 2000. The buoyant U.S. economic picture, combined with Canada's high levels of business investment and solid employment gains, augurs well for continued strong growth in Canada. Given the strong momentum of demand, the Bank of Canada has raised its projection for growth in 2000 to a range of 4 to 4.5 per cent. The trend of inflation in Canada over the past six months has been lower than expected and is among the lowest in the industrial countries. Nevertheless, pressures on capacity will likely intensify through the year. Consequently, we expect the trend of inflation, as measured by the consumer price index excluding food, energy, and indirect taxes, to rise gradually to close to the middle of our 1 to 3 per cent inflation-control target range. To keep this core rate of inflation steady near 2 per cent, some deceleration in economic expansion or a more rapid increase in productivity and production capacity will be required during 2001. When it comes to the production capacity of the economy, there is currently even more uncertainty than usual. The lower-than-expected rate of core inflation would suggest that conventional measures may be underestimating the economy's capacity to produce goods and services without adding to inflationary pressures. While the conditions that would permit an increase in productivity growth and in capacity have improved substantially in recent years, there has so far been no significant hard evidence of such an increase. This makes judging the balance between aggregate demand and supply in the economy an even greater challenge than usual for monetary policy. The other main risks to Canada's economic outlook include the possibility that the momentum of aggregate demand from the U.S. economy will continue to be stronger than expected and the likelihood of a buildup of inflationary pressures in the United States spilling over into Canada. The U.S. economy has continued to steam ahead. There is a clear need for the pace of expansion in the United States to slow as we progress through this year and into 2001. Prudent monetary management dictates that we in Canada not underestimate the upside risks for inflation, especially given the strong growth of aggregate demand in Canada, the United States, and elsewhere. Because of a lag of some 18 to 24 months in the effect of monetary policy on prices, the Bank is always trying to anticipate inflationary pressures one to two years ahead. Productivity growth is the only way to achieve long-term gains in incomes and living standards. The technological revolution that is currently sweeping the world provides Canada with a golden opportunity to improve its productivity. The best contribution monetary policy can make to enhancing productivity is to provide a low-inflation environment. Low and stable inflation reduces uncertainty about future price movements, lowers the incidence of boom-and-bust cycles in the economy, and helps keep interest rates down. All of this encourages investment in the equipment and software needed to take advantage of the new technology. Canada's inflation-control target and the Bank's commitment to maintaining that target, should ensure that monetary policy fosters a climate conducive to continued improvement in the performance of our economy.

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The Canadian Economy: Finding the Right Balance

thiessen

Governor of the Bank of Canada to the Kelowna Chamber of Commerce With the technological revolution that is currently sweeping the globe, dealing with change is a growing challenge for businesses these days. This revolution is erasing national frontiers, intensifying competition, and transforming economies everywhere. The rules of the game are constantly being rewritten, and the issues facing businesses are multiplying rapidly. To survive and prosper in today's world, businesses need to keep abreast of global technological trends, be ready to innovate and apply new technologies to both their production processes and the development of new products and services for their clients. From a broader perspective, in order to have a vibrant, dynamic economy, we count on the business community to take the initiatives that increase productivity and competitiveness so that we, as a nation, can benefit from rapidly changing technologies and increasingly open global markets. What business people need, in turn, in order to go confidently about their affairs and take the innovative, and sometimes risky, initiatives we expect of them, is a supportive economic policy environment. Today, I would like to talk about what monetary policy is doing to foster such an environment. Now, more than ever, businesses are operating in a changeable and uncertain world. The Bank of Canada has been doing what it can by removing one major cause of uncertainty--high and variable inflation. Low and stable inflation is good for business, good for the consumer, and good for the economy as a whole. This is not just a trendy central bank mantra. The emphasis that central banks are placing on price stability these days is neither fanciful nor unstudied. It is pragmatic. And it has to do with reducing uncertainty about the future, eliminating the inefficiencies caused by inflation, and minimizing economic ups and downs. The future is always uncertain. But it is even more so when inflation is rising because the pace at which prices rise is rarely stable or predictable. This uncertainty distorts and confuses the information that consumers, entrepreneurs, savers, and investors rely on to make their economic decisions. Not only that. Businesses and individuals end up spending more time and money either protecting themselves against inflation or trying to benefit from it. And interest rates rise to compensate savers and lenders for expected higher inflation and for the risks caused by uncertainty about future inflation. None of this encourages productive investment. In the highinflation days of the 1970s and 1980s, a lot of economic resources were instead devoted to hedging and speculative purchases. And inflationary booms--here and elsewhere--inevitably turned into busts. We must not let this happen again. That is why the Bank of Canada and the Government of Canada have agreed to an explicit target for inflation control. This target aims to hold inflation inside a range of 1 to 3 per cent. Inflation-control targets also ensure that monetary policy works to moderate fluctuations in output, employment, and incomes. In the nine years since the targets were first adopted, not only has underlying inflation been lower than in the previous two decades, but economic growth has strengthened and has shown less short-term variability. As we move ahead, we must ensure that this situation continues and that we avoid the boom-bust cycles of the past. Granted, we will not be able to wipe out fluctuations completely. External shocks will still buffet Canada's very open economy every now and then. And we will get economic surprises on the domestic front too. But in the past, our economic ups and downs were often amplified by outbreaks of inflation. So how is the Canadian economy performing these days and what is the Bank of Canada doing to help keep it on an even keel? Our economy has been expanding solidly for some time now--even through the Asian financial crisis of 1997-98--creating the conditions for the healthy gains in employment and incomes that we are now seeing. Since mid-1999, the economy has outperformed expectations--growing in excess of 5 per cent at annual rates and with an underlying rate of inflation that, excluding fluctuations in energy prices, has remained in the bottom half of our 1 to 3 per cent target range. The Bank has raised its projection for growth in 2000 to a range of 4 to 4.5 per cent because of stronger demand for Canadian products from both domestic and foreign sources. When it comes to foreign demand, this stronger momentum reflects faster-thanexpected growth in several parts of the world, including Europe and the emerging-market economies that were in the eye of the Asian storm. Even in Japan, where the outlook continues to be uncertain, economic conditions should improve this year. But by far the greatest source of this stronger external stimulus is the tremendous buoyancy of demand in the United States--a market that absorbs over 80 per cent of our exports. Demand in that country continues to steam ahead and to push hard against the limits of production capacity. And signs of price and wage pressures have become more visible. That is why the U.S. Federal Reserve has raised interest rates six times in the past 12 months to cool down the economy. The Bank of Canada has also been concerned that the greater-than-expected U.S. demand for our exports, along with the strong momentum of spending by Canadians, could lead to undue pressure on our production capacity and consequently on future inflation in Canada. With U.S. monetary actions reinforcing our view about the risks of a buildup of demand and inflation pressures in that country--a buildup which could spill over into Canada--we have raised interest rates four times since last November. In this connection, I would like to highlight a couple of important points that sometimes get lost in the public commentary. Monetary policy actions aim at future inflation First, monetary policy is concerned with future inflation pressures. Monetary policy works with relatively long lags. It takes between18 and 24 months for a change in interest rates to work through the economy and have an effect on inflation. For this reason, any actions taken by the Bank of Canada today must be based largely on considerations about the economy and inflation 18 to 24 months down the road-- not on what is happening now and not on the current rate of inflation (except to the extent that these factors colour our view of the future). So, even though the underlying rate of inflation has been in the lower half of the 1 to 3 per cent target range, the Bank has to consider what is likely to happen to prices in the future. Monetary policy actions are based on economic prospects here at home The next point I would like to stress is that Canadian monetary policy decisions focus, first and foremost, on the economic outlook here in Canada. So, the critical element is the Bank's assessment of the balance of forces at work in the Canadian economy, and what this means for future inflation. If domestic demand here in Canada was not particularly strong, greater-than-anticipated U.S. demand for our products would be a compensating element and hardly an issue. But if domestic demand was already rising rapidly, and the Canadian economy was operating at high levels, the spillover of strong U.S. demand would have the potential to strain our production capacity and lead to higher inflation in the future. The important judgment that your central bank must make--every step of the way--is how these domestic and external forces add up. When the Canadian economy is generally in sync with that of the United States, and interest rates in our two countries are moving in the same direction, I can appreciate that Canadian monetary policy may be difficult to interpret. Some people may be persuaded to think that the Bank of Canada never has any choice but to follow the U.S. Federal Reserve. Or, for that matter, that the Bank must have a target for the Canadian dollar that requires interest rates here to move in lock-step with U.S. rates. But that is just not so. When U.S. monetary authorities raise interest rates, the Bank of Canada has to look carefully at the reasons behind the move and decide what it means in terms of our ongoing assessment of the prospects for total demand and inflation in Canada. Developments in the U.S. economy will always be important to Canada. And moves in U.S. interest rates will always influence rates around the world, including ours. But that does not mean that we cannot have different interest rates in Canada and that the Bank always follows the Fed. Sometimes we do, and sometimes we don't. It all depends on what we think is necessary to keep the Canadian economy on a non-inflationary, and thus sustainable, growth path. As I have already noted, in the past 12 months, we raised our interest rates four times while the Americans have raised theirs six times. On those four occasions, including the most recent increase in May, the Bank, after careful consideration, decided that the implications of U.S. developments for our economy justified higher rates here as well. It is also important to remember that Canadian interest rates are still below comparable U.S. rates for all maturities--as they have been for the last few years. This basically reflects the fact that we have a lower rate of inflation than our U.S. neighbours and that our economy has not been pressing as hard against its capacity limits as theirs. We need to keep demand and supply in balance Through this discussion, I have talked mostly about total demand, but have not said much about our economy's ability to supply goods and services--except to suggest that a rapidly rising demand could lead to pressures on capacity and inflation. For the most part, we can be reasonably confident about assessing the various sources and strength of demand in the economy. But estimates of the production potential of our economy, are much more uncertain these days because of major ongoing structural changes. We know that in recent years, and especially since 1996, Canadian businesses have been investing heavily in machinery, equipment, and software, much of which embodies the latest technologies. This should raise productivity in Canada and allow our economy to grow faster than it otherwise would. But, at this point, it is difficult to tell by how much, whether some of the gains are already in, or whether most are still to come. So far, our statistics yield little direct evidence of a substantial pickup in productivity growth, although recent historical revisions to the National Accounts show somewhat larger gains than before. Because of this uncertainty, the Bank is taking a cautious approach to projecting a permanently higher rate of growth in our economy's capacity to produce. But we certainly do not want to dismiss this possibility either. That is why we are following closely a wider-than-usual range of indicators that could tell us what is happening on the supply side and give us earlywarning signs of pressure on capacity and prices. For example, we watch for unexpected movements in the underlying trend of inflation and for changes in expectations of future inflation. We also look at commodity prices, wage settlements, reports of shortages in product and labour markets, the growth of money and credit, and information from the Bank's business contacts across Canada. Take, for instance, our best estimate of the trend of inflation--what we call core inflation. This is a measure that takes out of the consumer price index the fluctuations caused by the very volatile energy and food components and the effects of changes in indirect taxes. By this measure, inflation has been somewhat lower than we had expected since late last year. This very favourable price performance suggests that our economy has not been pressing as hard against capacity as we had thought. It gives us some more room to explore where the limits of that capacity really are. And this should give businesses a greater opportunity to exploit their new equipment and technology to the fullest. Nonetheless, we must not be lulled into thinking that the threat of inflation has disappeared. Given the strong momentum and high levels of activity in our economy, and given the time that it takes for monetary policy actions to affect output and prices, the Bank must remain vigilant. Nothing will bring the present expansion to an abrupt halt more quickly than an outbreak of inflation. Assessing the balance between total demand and supply in the economy and the implications for inflation will be an ongoing challenge for monetary policy. I can assure you that the Bank is fully committed to the task--because keeping inflation low and stable will help to provide an environment in which the Canadian economy can enjoy solid growth and achieve its full potential.

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Release of the Monetary Policy Report Update

thiessen

This morning we released our update to the . Overall, the outlook for Canadian economic growth and inflation is positive. Economic activity in Canada has remained strong since our May Nonetheless, the underlying trend of inflation has been unexpectedly low - in the bottom half of our 1 to 3 per cent target range. We have raised our projection for economic growth to a range of 4.25 to 4.75 per cent for 2000. This reflects the upward revision to Canada's GDP in the second half of 1999 and the robust performance of the economy in the first half of this year. For the second half of this year, the Bank expects some slowing in the pace of activity, but to a rate that would remain above the economy's growth potential. As a result, we still expect the core rate of inflation to rise gradually to about 2 per cent by early 2001, reflecting emerging pressures in product and labour markets. Developments since our last reinforce the uncertainties surrounding this outlook that we have been highlighting for some time: the risk of a spillover of U.S. demand at a time of growing domestic spending in Canada; the possibility of rising inflation pressures in the United States; and the uncertain balance between demand and supply in the Canadian economy, given that production capacity has not been as tight as we previously thought. In light of these developments, and in order to preserve the low trend of inflation, we will continue to pay close attention to the strength of total demand in the Canadian economy and to any signs of pressure on capacity.

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The Outlook for the Canadian Economy and the Conduct of Monetary Policy

thiessen

Governor of the Bank of Canada to the Calgary Chamber of Commerce Today, I would like to bring you up to date on the Bank of Canada's views about the outlook for the Canadian economy. Prospects for the period ahead are generally very favourable. But, as is often the case, there are also uncertainties that the Bank will have to deal with as it pursues its objective of keeping the economy on a sustainable, non-inflationary track. Dealing with such uncertainties presents a constant challenge for the Bank in its job of conducting monetary policy. Another part of our job involves always looking at ways to enhance the effectiveness of policy--by reducing uncertainty about our actions, by increasing transparency and accountability, and by broadening public awareness of how monetary policy works. Today, I want to outline some new procedures for announcing changes in official interest rates that we plan to introduce later this autumn. We believe that these procedures should help improve the effectiveness of monetary policy in Canada. But first let me give you an update on the current economic situation. Economic update The Canadian economy has been expanding strongly for some time now, and particularly since mid-1999. Indeed, between mid-1999 and mid-2000, it grew by about 5 1/4 per cent. Through much of that 12-month period, economic growth outstripped expectations. In part, this can be attributed to the spillover of greater-than-anticipated demand from the United States. The rapid growth of the American economy has been confounding observers for quite some time now. And, as might be expected, buoyant U.S. demand has been pressing against that economy's capacity to produce. One safety valve that has helped to relieve the pressures on U.S. capacity has been the inflow of goods and services from abroad. Canada's export industries have benefited greatly from this spillover of excess demand from the United States. Not only have these exports contributed directly to the rapid economic expansion in Canada, they have been a source of encouragement that has added to the surge in purchases of machinery and equipment by Canadian businesses. And, of course, the recent gains in employment and incomes in the export sector have strengthened the momentum of spending by Canadian households. Together, buoyant exports, strong investment by domestic businesses, and robust household spending have led to a surprisingly strong demand for Canadian goods and services. What is remarkable under the circumstances is that pressures on the basic trend of inflation in Canada have been minimal. Now, I know that the 12-month rate of increase in the total consumer price index has risen to around 3 per cent because of the sharp rise in energy prices. Although these higher prices have boosted activity for Canada's energy producers, they are also raising living costs for most Canadians. The Bank remains fully committed to preserving an environment of low and stable inflation. But monetary policy can control only the future trend of inflation--not the temporary ups and downs caused by movements in the prices of very volatile items such as energy and food. Of course, if there was evidence that higher energy prices were beginning to feed into prices of other goods and services, or into expectations about the future trend of inflation, that would be different. But so far, this has not been the case. In order to get a better fix on the underlying trend of inflation, we should look at the Bank's core measure of inflation--the measure that excludes fluctuations in energy and food prices and the effects of changes in indirect taxes. This core measure has remained in the bottom half of the 1 to 3 per cent target range we have set for controlling inflation. This is somewhat lower than we had expected. It suggests that total demand, although stronger than anticipated, may not have been putting as much pressure on our economy's production capacity as we had thought at the beginning of the year. The economic outlook Let me now shift to the Bank's view on the outlook for the economy. When it comes to monetary policy, "looking ahead" is very important. Why? Because the actions that your central bank takes today will not have their full effect on the economy and on prices for another 18 to 24 months. That is why the Bank must always base its decisions on a judgment about future economic growth and future inflation. The Bank's latest projection for economic growth in 2000 (published in the higher than we had expected in the spring. This projection assumes a slowing through the balance of the year from the very rapid pace of the first half. But, even then, output will probably be growing faster than production capacity; and so pressures on capacity are likely to increase. Because of this, we are predicting that the core measure of inflation will move up to 2 per cent--the centre of the Bank's 1 to 3 per cent target range--by early next year. At the same time, if world crude oil prices stabilize, we expect that the rate of increase in the total CPI will gradually come down and eventually converge with our core measure of inflation. But, as I said before, there are a number of uncertainties attached to this projection. The most important uncertainties revolve around future developments in the U.S. economy. Will that economy slow to a more sustainable pace? Or will there be another surprising spillover of U.S. demand into our exports? Right now, it looks as if the growth of spending by U.S. households is moderating. What if the American economy does not slow fast enough to prevent a rise in U.S. inflation? Will that have a significant adverse effect on expectations of inflation in Canada? This is where the Bank's commitment to keeping the trend of inflation within the target range really comes into play. Our role is to reassure Canadians, by seeing to it that inflation here remains low and stable even if U.S. inflation rises. Another major area of uncertainty has to do with our economy's capacity to produce. As I said earlier, our remarkable inflation record to date suggests that there was probably still some excess capacity in the economy in the early part of this year. Although our projection assumes that pressures on capacity will contribute to an increase in the underlying trend of inflation--from around 1 1/2 per cent now to 2 per cent next year--there is, in fact, a significant margin of uncertainty around these numbers. It is possible that the investment boom we have witnessed in Canada since 1996 will increase productivity growth and capacity more quickly than we are allowing for. There is a good deal of anecdotal evidence that some of the American experience (burgeoning investments in technology leading to robust productivity gains) is being replicated in Canada. Until recently, there had been little evidence of this in our official, economy-wide productivity statistics. But there was a significant gain in productivity in the data for the second quarter of this year that were released recently. Of course, it remains to be seen whether this will continue. Monetary policy response How has monetary policy responded to all this? Because of the surprisingly strong momentum of demand in Canada since mid-1999, and because of the likelihood that this could lead to inflation pressures in the future, the Bank of Canada raised interest rates four times--by a These four interest rate increases followed similar actions by the U.S. central bank. The Federal Reserve's assessment that interest rate increases were necessary because the growth of demand in that country continued to outstrip the growth of supply, was an important factor in our decision to match those moves. The reason was that this implied a continued spillover of U.S. demand into Canada, which would add to the already buoyant growth in spending by Canadian households and businesses. This additional external demand for our products, at a time when domestic demand here was already brisk, essentially increased the risks that we would run into capacity constraints and pressures on inflation. Clearly, U.S. economic and financial developments will always be relevant for Canada. After all, we do over 80 per cent of our foreign trade with that country. And U.S. financial markets have an important influence on interest rates worldwide, including ours. But that does not mean that the Bank of Canada must always follow the Federal Reserve, or that interest rate levels here and in the United States must be the same. The job of Canadian monetary policy is to respond to trends in our own economy. Naturally, because of the close ties between Canada and the United States, economic trends in the two countries are often similar, and may require similar policy responses. But this is not always the case. Since mid-1999, the Americans have raised their interest rates on six occasions. We have raised ours four times. Moreover, Canadian interest rates continue to be below U.S. rates because inflation here has been lower and our economy has not been growing as quickly, or for as long, as theirs (so that the risks of pressures on capacity and inflation in Canada are not as Still, I can appreciate that, when our economies move together, people may find Canadian monetary policy difficult to interpret--particularly when the Bank has moved immediately to match increases in U.S. policy rates. On those occasions, there has been a tendency to conclude that either the Bank does not have much choice but to follow, or that it must have targets for the Canadian dollar that require interest rates here to move in lock-step with Neither of these assumptions is correct. When U.S. monetary authorities take a policy action, the Bank looks carefully at the reasons behind the move and at what it all means for our ongoing assessment of the outlook for total demand and inflation in Canada. Our job is to do what we think is necessary to keep our economy on a non-inflationary, and thus more sustainable, growth path. New procedures for announcing monetary policy actions I would now like to turn to another aspect of the way we conduct monetary policy in this country. As I said at the outset, the Bank is constantly searching for ways to enhance the effectiveness of monetary policy. Over the past couple of years, we have been looking at how other major central banks go about announcing changes in official interest rates, and we have been assessing whether our current arrangements could be improved. We have noted that most foreign central banks announce their decisions on interest rates only on certain dates that are set well in advance. In the United States, this has been the practice for some time. And now it is also the case in the other major economies (Japan, the euro zone, and the United Kingdom) as well as in a number of After carefully considering all the relevant issues, we have concluded that pre-set dates for announcing interest rate actions would improve the implementation and effectiveness of Canadian monetary policy. We have decided that eight specified dates per year would be appropriate in the Canadian context. The scheduling of these eight dates would be based on the timing of the flows of economic information that the Bank relies on to gauge the economic situation in Canada, to make projections, and to assess the need for monetary policy action. Each of these eight dates would be separated from U.S. policy action dates by a week or more. In preparing to move to this new system, we will be consulting interested parties on the most appropriate day of the week and time of day for announcing interest rate changes. The way we see it, this new approach has several advantages over the existing arrangements, advantages that should contribute to a more effective monetary policy. I would like to briefly highlight some of these benefits. To begin with, the new arrangements should reduce uncertainty in financial markets about the timing of policy actions. Under the current system, the Bank can move interest rates on any business day (Monday to Friday), at 9:00 a.m. Because market participants are not sure exactly which day a change in interest rates may be announced, trading can slow in the early morning, for several days, when there is an expectation that the Bank may move. Removing this uncertainty should improve market efficiency and liquidity. We also believe that the new system will help to focus public attention more closely on economic trends here in Canada , and on the appropriate monetary policy response based on those critical trends. Let me explain. On each of the eight pre-set dates for interest rate action, the Bank would issue a press release that would give a brief assessment of the economic situation in Canada and explain why we chose either to change interest rates or to leave them unchanged. This would also give us an opportunity to link the latest developments more directly to the underlying economic trends in the medium term--the 18 to 24 months over which the effects of monetary policy actions are spread. Integrating the information in these eight press releases with our other key monetary policy statements throughout the year would provide a more regular, frequent, and continuous account of our views on the Canadian economy. In the end, if the Bank does its job of keeping people well informed, we expect that economic analysts, market participants, and the public generally will be clearer about the factors that influence monetary policy and will be in a better position to anticipate the direction of policy. This has certainly proven to be the case in the United States, the euro zone, and the United There could, of course, be extreme cases that might call for an immediate policy response from the Bank rather than waiting for the next scheduled announcement date. The new arrangements would not preclude such an option. It would be used very infrequently, however, and only under extraordinary circumstances. Details of this new approach to announcing interest rate changes will be issued next Tuesday and will be posted on the Bank's Web site, along with an invitation for comments from the public. We plan to implement this system in the autumn, with the first date for interest rate action set for November 2000. Concluding remarks To conclude, let me return to my main points regarding our economic situation. The Canadian economy has been performing very well in recent years and the Bank expects that it will continue to do so. The task for monetary policy is to ensure that the economy stays on an expanding but non-inflationary path. Monetary policy faces some challenges in the period ahead--challenges arising from several uncertainties surrounding the economic outlook. The key uncertainty is the future performance of the U.S. economy and the implications for Canada. From this perspective, what matters most is that the U.S. monetary authorities succeed in bringing their high-flying economy onto a more sustainable track. Another important challenge for monetary policy will be to keep demand and supply here at home in balance at a time when the application of new technology may well be transforming Canada's economy and moving it onto a higher growth path. But we are not sure of that yet. While the recent productivity gains are encouraging, it is too early to tell if this is the beginning of a sustained improved performance on this front. Because of this, the Bank will be closely watching all indicators that could provide early signs of such an occurrence. But we must be careful not to let our hopes run ahead of reality and take risks with inflation. A flare-up in inflation and the higher interest rates that would go with it would discourage investments, especially those in high-tech equipment and software, that enhance productivity and are so crucial to improved economic performance in the future. The outlook for the Canadian economy is very promising. The best contribution the Bank can make to realizing this economic potential is to preserve the present environment of low and stable inflation. For this is what fosters sustained solid economic growth and improved standards of living over time. I can assure you that the Bank of Canada remains fully committed to the task.

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Can a Bank Change? The Evolution of Monetary Policy at the Bank of Canada 1935–2000

thiessen

Governor of the Bank of Canada to the Faculty of Social Science I would like to thank the Faculty of Social Science here at the University of Western Ontario for inviting me to deliver this lecture. The Department of Economics within the Faculty is known for its long-standing interest in monetary economics, as well as its appreciation of economic history. I thought that it would be appropriate, therefore, to combine these two elements and use this occasion to reflect upon the dramatic changes that have taken place in the theory and practice of monetary policy in Canada during the Bank of Canada's 65-year history. Over this period, there has been a fundamental transformation in the way monetary policy is conducted in Canada and in most other industrial countries. While globalization and technological change have played an important role in this area, as in so many others, they have not, to my mind, been the principal driving force behind this transformation. Far more important has been the interaction of experience and economic theory. The puzzling and, at times disappointing, performance of the economy has often served as the catalyst for major theoretical advances and policy innovations. Although the evolutionary process set in motion by these forces has not always been smooth or painless, it has, without question, deepened our understanding of how the economy works. It has also taught us valuable lessons about how monetary policy should be conducted. One of the most important lessons that monetary authorities have learned through this process of analysis and experimentation is that there is no virtue or advantage in vague policy objectives and complex operating procedures. Simpler and more straightforward approaches have generally turned out to be better. Monetary policy does not need to be cloaked in secrecy or artificial intricacies to be effective. What is needed to get the job done are one clear objective and one simple instrument. My career in central banking--of just over 37 years--covers more than half of the period since 1935 that I am going to review today. I do not intend, however, to describe every policy development since the early 1960s, when I first joined the Bank, nor all those from the preceding period. Instead, what follows is a selective overview of certain events that I believe were critical to the evolution of monetary policy in Canada. While the conduct of monetary policy will always involve a great deal of uncertainty and imprecision, the steps that we and other central banks have taken to make it simpler and more transparent have, in my opinion, improved its effectiveness and contribution to economic welfare. The Bank of Canada was established in 1935, confidence in the behaviour of markets, and the financial system in particular, had all but disappeared. Traditional remedies and the natural re-equilibrating forces of the capitalist system did not seem to be having much effect, and there was growing sympathy for more radical solutions. Still, many observers questioned whether the creation of a central bank would be the answer to Canada's problems. Other countries that had established central banks much earlier had suffered the same collapse in economic activity and were experiencing similar difficulties trying to extricate themselves from the situation. Keynes' would not be published for another year, but there was already widespread scepticism about the likely effectiveness of a more aggressive approach to monetary policy. Interest rates were at historically low levels, and the provision of extra reserves was seen as only adding to the surplus liquidity that already existed in most commercial banks. Nevertheless, excessive credit creation in the period immediately preceding the Depression, and the severe liquidity problems that many borrowers had experienced once it was underway, were generally viewed as important contributors to the collapse, if not the primary cause. Perhaps a central bank, learning from past experience, could reduce the likelihood of a similar occurrence in the future. Doubts about the usefulness of monetary policy in stabilizing output did not prevent the legislators who drafted the original Bank of Canada Act from giving the Bank a broad and ambitious mandate. According to the preamble of the Act, which is the only description that we have ever had of its basic functions, the Bank was expected to: . . . regulate credit and currency in the best interest of the economic life of the nation, to control and protect the external value of the national monetary unit and to mitigate by its influence fluctuations in the general level of production, trade, prices and employment, so far as may be possible within the scope of monetary action, and generally to promote the economic and financial welfare of the While the legislators seemed to appreciate that not all of these objectives were mutually consistent or even attainable with a single policy tool, they may have assumed that the Bank would have more than one instrument at its disposal. Indeed, moral suasion, interest rate ceilings, and various other means of directly influencing the volume and composition of credit had already been used extensively in Canada. The segmented nature of our financial system, in which banking, insurance, trust, and securities activities were all carefully segregated from one another, combined with the high levels of concentration that existed in most of these industries, contributed to the "success" of such an approach. In any event, according to the new Keynesian orthodoxy that was soon to take hold, most of the heavy lifting associated with economic stabilization would be performed by fiscal policy. To ensure that the new central bank would not be subject to undue influence from either the government or the financial sector, the architects of the Bank of Canada made it a privately owned corporation with widely distributed shares. Neither the shareholders nor senior officers of the Bank were allowed to work in the financial sector, and the only formal representation that the government was permitted was through the Deputy Minister of Finance, who was expected to serve as a non-voting member of the Board of Directors. The Bank's accountability and reporting requirements were limited to the publication of weekly financial statements and an annual report. Even though Parliament in 1935 was prepared to allow greater public regulation of the economic life of the nation, it realized that some separation of money creation from the government's spending activities was probably important. Subsequent legislation reversed some of this separation by eliminating private equity holdings and making the government the exclusive owner of the Bank's shares. Other restrictions, however, on the government's ability to participate in Board meetings and influence the daily conduct of monetary policy remained in place. The issue of whose will would prevail if there was ever a major disagreement between the Minister of Finance and the Governor of the Bank of Canada was not explicitly addressed until much later. The contrast between the policy environment in 1935 and that of today could not be more dramatic. Diffuse policy objectives, uncertain reporting lines, interventionist policy measures, and a distrust of financial markets have given way to clearly defined inflation targets, improved governance and accountability, simple operating procedures, and a more open approach to policy formulation and implementation. We now have a single long-run objective--price stability--and a single policy instrument--the overnight interest rate. The targets for our objective and our instrument are both publicly announced, and our actions are subject to constant scrutiny and review. The story of how this profound transformation was brought about is the subject of the rest of my lecture. The changes that I am about to describe did not happen overnight or in any continuous way. They were the result of a long, and sometimes painful, process of experience, experimentation, academic investigation, and market pressures. At times, Canada was able to trade on the experience of other countries, but on other occasions it had to find its own way. The challenges and problems that we encountered were often unique or unprecedented. Our proximity to the United States, coupled with our smaller size and openness, forced us to confront many of the issues associated with globalization long before the term became fashionable. We have always been the archetypal small open economy. The Great Depression may have been exacerbated or even caused by monetary policy errors in Canada and elsewhere, but the newly created Bank of Canada had limited means of dealing with it. Financial markets were not very well developed in the 1930s and the monetary policy instruments at the Bank's disposal did not appear likely to be effective. Interest rates, as noted earlier, had reached historically low levels and commercial banks, with few exceptions, had more than enough liquidity. No serious effort was made, therefore, to mount an aggressive countercyclical policy. Various fiscal initiatives were undertaken prior to the outbreak of the Second World War, but not much progress had been made in reducing unemployment or restoring industrial output to its pre-Depression levels. Most of the Bank's activities from 1939 to 1945 were directed towards financing the war effort. This involved extending cash advances to the government and overseeing the sale of Victory Bonds. Determined not to repeat the economic mistakes made during the previous war, the government tried to finance most of its expenditures through taxes and new bond issues. Consequently, the Bank's main responsibility immediately after the war was to keep interest rates as low as possible, to facilitate the rollover of the massive public debt that had accumulated. In the event, the reconversion of wartime production facilities and the absorption of decommissioned military personnel into the domestic labour force were much easier than many had imagined. By the late 1940s and early 1950s, however, inflationary pressures had started to build. The Bank and the government tried to suppress them by imposing temporary controls on certain types of bank financing. Some of this was accomplished through explicit legislation, the rest through private conversations between the Governor of the Bank and the presidents of the 10 chartered banks. These actions proved to be insufficient, however, in the face of rising world commodity prices, a booming U.S. economy, large foreign investment inflows, and increased defence expenditures to support the war effort in Korea. All of these factors put upward pressure on the Canadian dollar and made it difficult to control the domestic monetary expansion. With some reluctance, the government was forced to undertake a more decisive and, at the time, revolutionary action. that Today the Government, by order in Council under the authority of the Foreign Exchange Control Act, cancelled the official rates of exchange which, since September 19th of last year, had been calculated on the basis of a 10 percent premium for the United States dollar in Canada. It has been decided not to establish any new fixed parity for the Canadian dollar, at this time, nor to prescribe any new official fixed rates of exchange. Instead, rates of exchange will be determined by conditions of supply and demand for foreign currencies in Canada. With this announcement, Canada abandoned the Bretton Woods system of pegged exchange rates, which had been established at the end of the Second World War, and allowed its currency to float freely in international markets. The resulting appreciation would hopefully discourage some of the inflow of funds, defuse the inflationary pressures that the economy had been experiencing, and obviate the need to pick a new, more sustainable value for the dollar. The flexible exchange rate was expected to remain in place only until markets had settled and a more reasonable value for the dollar had been determined. In fact, the experiment lasted for almost 12 years and had far greater significance than anyone could have imagined. Canada was the only major country in the world operating under a flexible exchange rate through the 1950s and early 1960s, and was regarded as something of a renegade in international circles. By the end of 1951, we had also eliminated all remaining controls on foreign exchange transactions and most, if not all, controls on foreign investment inflows. Canada's financial markets were now open and exposed to external shocks. Our experience during this period would serve not only as a model for other industrial countries after the Bretton Woods system collapsed, but also as the catalyst for a revolutionary advance in the theory of international finance. Few students of Canadian economic history know that Milton Friedman played a role in Canada's decision to float. In 1948, Friedman, then a young Associate Professor at the University of Chicago, participated in a radio debate with Donald Gordon, Deputy Governor of the Bank of Canada, and William Mackintosh, a Professor at Queen's University and an adviser to the Department of Finance. One of the topics that they were asked to discuss was whether Canada should move to a flexible exchange rate. The Bank of Canada and the Department of Finance were both strong supporters of fixed exchange rates, as were most governments at the time. Friedman, as you might expect, spoke with great conviction about the advantages of a flexible exchange rate. Indeed, many of the arguments that he presented would later appear in his Although the debate did not have any noticeable effect on policy for the next two years, Friedman's ideas seem to have influenced official thinking in Ottawa. A number of secret memos were written within the Bank beginning in 1948, reviewing the feasibility and even desirability of his proposal. after 19 years of service and was replaced by James Coyne, one of the authors of the secret memos. Like many Canadians at the time, the new Governor had become increasingly concerned about the level of foreign ownership in Canada and was anxious to increase national savings as a means of reducing our dependence on foreign capital inflows. Another concern, which was not as widely shared, involved the domestic rate of inflation. Canada had experienced a sharp escalation in consumer prices during the Korean War, and inflationary pressures had persisted for some time after. While domestic spending had faltered in 1954, the subsequent recovery pushed inflation well above the level that the Bank implicitly associated with price stability. Coyne was convinced that the solution to both problems--low savings and high inflation--was a tighter monetary policy. Higher interest rates would reduce domestic demand and help raise national savings. Although a rudimentary money market had started to form in Canada, with the active encouragement of the Bank, it was not well developed. Popular wisdom, in any case, suggested that traditional monetary policy mechanisms were unlikely to be effective, even when they involved tightening monetary policy. As a result, Coyne decided to combine reductions in the supply of bank reserves with healthy doses of moral suasion, much as his predecessor had done in earlier periods. The Bank continued with this restrictive monetary policy stance through most of the late 1950s and into the early 1960s. In the face of rising unemployment and weakening economic activity, inflation dipped below one per cent by the spring of 1961. Relations between the Bank and the Minister of Finance had deteriorated sharply, and numerous government ministers had demanded a change in policy direction. However, any desire to remove James Coyne and replace him with a more sympathetic Governor ran up against the ambiguous nature of the legislation regarding the government's powers vis-a-vis the Bank. The academic community also became involved in the dispute and circulated a pamphlet entitled "The Economists versus A.W. Phillips had just published his famous paper on unemployment and the growth of money wages in the United Kingdom, and shown how higher (wage) inflation was typically associated with lower rates of unemployment. Not surprisingly, Phillips' work found a receptive audience in Canada, and researchers soon replicated his results with North American data. Much of the commentary in the popular press during this period was also critical of the Bank's policies, and reflected the widespread view that a little more inflation was not such a bad thing--provided it could bring higher employment and stronger output growth. James Coyne remained unconvinced, however. While he had no formal model or elaborate regression results to put forward in his defence, his instincts seem to have told him that any attempt to improve the economy's performance by targeting a higher inflation rate was misguided and could only end in difficulty: There are those who sometimes set out the false alternatives of either full employment with inflation, or stable prices with a high level of unemployment. They say the nation must choose between unemployment and inflation. No person in any position of responsibility could possibly subscribe to that doctrine. It is false. Full employment and stable prices are not only compatible, they are in the long run inseparable. The pathbreaking work of Milton Friedman and Edmund Phelps on the vertical Phillips curve would not be published until 1968, but their results were anticipated by Coyne in many of his speeches. He was convinced that there was no long-run trade-off between unemployment and inflation, except possibly in the sense that lower inflation might actually lead to higher output and employment. Experience and the new theory of rational expectations that would emerge 10 years later confirmed this result and showed that any positive employment effects associated with higher inflation were likely to be shortlived. There was one critical area, however, where Coyne and many other policy analysts, both within and outside the Bank, appear to have been misguided. Those who had questioned the effectiveness of monetary policy in earlier years had failed to appreciate that it was likely to be much stronger than fiscal policy under a flexible exchange rate system, especially when capital was highly mobile. The large capital movements triggered by any change in interest rates would put significant pressure on the exchange rate, amplifying the effects of monetary policy while undercutting the effects of any opposing fiscal policy. Coyne did not realize that, for similar reasons, it was unlikely that a tighter monetary policy would ever raise national savings or reduce foreign investment inflows. Robert Mundell, in his article on "The Appropriate Use of Monetary and Fiscal Policy for Internal and External Stability," was the first economist to explain this apparent reversal of Keynesian theory. Mundell's article was published in 1962, one year after Coyne had resigned in response to mounting criticism and ongoing efforts to remove him. The timing of Mundell's work was no coincidence. According to Mundell, the inspiration for his work on policy effectiveness under fixed versus flexible exchange rates was a conversation he happened to overhear while working at the International Monetary Fund (IMF). Wynne Plumptre, Canada's Executive Director at the IMF, was talking to another official in the elevator about a problem that the authorities back home had been wrestling with. The Bank of Canada had been pursuing a restrictive monetary policy in an apparent effort to reduce domestic spending, increase saving, and limit the flow of capital into Canada. While economic activity had slowed, very little progress had been made on improving the trade balance or reducing foreign investment, owing to Canada's strong dollar and high interest rates. Efforts by the Department of Finance to counter the negative effects of the Bank's monetary policy through fiscal stimulus and to return the economy to full employment had thus far been unsuccessful. Government analysts were at a loss to explain why. The rest, as they say, is history. Mundell had written a number of papers on international capital flows as part of his PhD thesis, and this chance encounter seems to have been something of an epiphany. Suddenly, many of the ideas that he had been working on were transformed into a coherent model of the way the global economy worked in the presence of capital mobility. The controversy surrounding James Coyne's departure in 1961, together with publicly expressed government concerns that the value of the dollar was too high and that a nationalist program was needed to reduce foreign investment, put downward pressure on the Canadian dollar. It fell from a slight premium vis-a-vis the U.S. dollar to roughly 95 cents (US) within a few months. Efforts to halt the decline through aggressive intervention in the foreign exchange market were unsuccessful. On 2 May 1962, the government decided to return to the Unfortunately, it took some time for academics and policy-makers to appreciate the full implications of Mundell's work. Indeed, there is nothing that I am aware of in the official documents written over the next few years that would indicate whether the Bank or the Department of Finance fully appreciated that, by returning to a pegged exchange rate system, the government would effectively neutralize whatever independent influence monetary policy might have on the macroeconomy. With domestic fiscal policy on a strong expansionary track, and monetary policy constrained by the new exchange rate peg, the Bank of Canada would have no way of resisting the inflationary pressures that were gradually building in the second half of the 1960s. Government expenditures in Canada were growing at an accelerating rate with the new health care and unemployment insurance systems that had been introduced. Similar pressures were emerging in the United States in response to the Vietnam War and President Johnson's program for a Great Society. With a fixed exchange rate, these pressures would inevitably spill over into Few serious concerns about inflation, however, were expressed outside central banking circles. Phillips and his followers had shown how a little bit of inflation might be beneficial, and monetary authorities were encouraged to be more forgiving. "Reasonable price stability" was touted as a preferred policy objective by the Economic Council of Canada, and "inflation-unemployment trade-off zones" were dutifully reproduced in many of its publications. Another development during this period is also worth noting. It concerns the clarification of the roles and responsibilities of the government and the Bank of Canada with regard to monetary policy. Louis Rasminsky, who had succeeded James Coyne as Governor in May 1961, had insisted as a condition of his appointment that the government's powers regarding monetary policy be clearly defined. The Bank of Canada Act was amended in 1967 to allow the government to issue a directive to the Bank in the event there was a serious disagreement over the conduct of monetary policy. Under this amendment, the government would have the right to override the Bank's policy decisions. To do so, however, the Minister of Finance would have to publish the reasons for his (her) dissatisfaction, indicating both the new measures that the Bank was supposed to undertake as well as the period during which they were to apply. It was generally agreed, I believe, that such a "nuclear weapon" would only be used when there was a fundamental disagreement between the Governor and the Minister, and that following its use, the Governor would resign. In this way, the rights of a democratically elected government to determine policy were balanced against the needs of the Bank for operational independence. While governments must always have the final say in important policy matters, the Bank had to be protected from undue political influence in its day-to-day operations. A key element that was missing from this solution was a clear measure by which the government and the public could judge the Bank's performance. The early 1970s began much like the 1950s. Foreign capital was flowing into Canada at an unprecedented rate and the Bank of Canada was finding it difficult to resist the upward pressure on the Canadian dollar. Rather than guess where the new equilibrium exchange rate might lie, the government again decided to let the currency float. As in the 1950s, this move was regarded as a temporary measure. Within three years, however, the rest of the Bretton Woods system had collapsed. While Canada's decision was in no way responsible for what followed, its positive experience with a floating exchange rate through the 1950s and the early 1970s did provide some assurance to other countries that the new regime was at least workable. Canada was now able to pursue an independent monetary policy. The Bank's efforts in the face of building international inflation pressures, however, proved to be insufficient. Outdated views about the Phillips curve, overly ambitious estimates of the natural rate of unemployment, and a concern about letting the Canadian dollar appreciate much above US$1, contributed to the problem. The Bank of Canada was not unusual in this regard, and its performance did not differ noticeably from that of most other central banks. Economic thinking among the major industrial countries was very similar, and received wisdom was, for the most part, imported from the United States. Although Canada's experience had, in effect, been providing the rest of the world with an example of how an open economy operates in the presence of near-perfect capital mobility, it went largely unnoticed. Closed-economy concepts continued to dominate most national policy discussions. While Mundell's results were slowly filtering through the academic community, they had not yet reached the ranks of practising economists. Little recognition was given to the effects that market liberalization and different exchange rate arrangements might have on policy outcomes. In the meantime, the combination of generalized excess demand in the world economy and the OPEC oil cartel had sent inflation and unemployment soaring to post-war highs. Policy-makers in Canada and elsewhere were having difficulty dealing with this stagflation and were initially confused by the twin phenomena of rising inflation and high unemployment. Within a short time, however, three things had become evident. First, higher inflation was not always associated with higher output and employment. The Phillips curve was not only vertical in the long run, but was probably upward-sloping. Second, efforts to fine-tune the real economy were likely to end in failure. Optimism about our ability to forecast and about the level of full employment introduced a strong inflationary bias to fiscal and monetary policies. Third, money mattered and was the ultimate source of all sustained inflation. Excessive government spending and other positive demand shocks could not generate ongoing inflation unless monetary policy was prepared to validate it. To avoid similar problems in the future, many central banks began to target the monetary aggregates. If, as Friedman suggested, inflation was always and everywhere a monetary phenomenon, a gradual deceleration in the rate of money growth would eventually squeeze it out of the system. Once this had been accomplished, money growth could be set just high enough to meet the legitimate needs of the economy--thereby ensuring long-run price stability. If the new money targets were publicly announced and fully credible, some monetarists argued, it might even be possible to achieve this disinflation without any significant loss in output. If this proved to be impossible, some deterioration in economic performance would have to be accepted. A "gradualist" approach, however, would ensure that this was kept to a minimum. While fixed money targets might not deliver the best of all worlds, they were regarded as the safest alternative in a second-best world. Trying to forecast the future and optimally adjust fiscal and monetary policy settings had proved not only to be impossible but also potentially destabilizing. Canada adopted a target for the narrow monetary aggregate, M1, in the autumn of 1975, a short time after the United States and Germany. For a while, the strategy appeared to be working. Inflation began to decelerate, and the economy began to recover from the 1974-75 recession. While some of this early success could be credited to the wage and price controls that the government had introduced in late 1975, proponents of the monetarist view believed that Canada would soon be on its way to price stability. Initial optimism over what the monetary targets could deliver soon gave way to frustration as inflation began to rise again in the late 1970s. A second oil shock and continued fiscal expansion added to the inflation pressures that were already in place. By the early 1980s, inflation had returned to double-digit levels, and inflationary expectations were again beginning to accelerate. Research at the Bank revealed that one of the reasons for the weak relationship between the movements in M1 and subsequent changes in prices was the high interest elasticity of the demand for this narrow money aggregate. The modest changes in interest rates that were required in the short run to keep M1 within its target band were not enough to have much impact on real output or prices. Another, more serious, problem in using M1 was the uncertain impact of financial innovation. Technological developments had allowed financial institutions to introduce a number of new products designed to help depositors protect themselves from high inflation by shifting their idle balances into daily interest savings accounts. This weakened the relationship between M1 and the other macroeconomic variables that normally influenced its behaviour, and made it difficult for the Bank to interpret its movements. In 1982, after several disappointments, the Bank of Canada reluctantly conceded that the monetarist experiment had not worked and that the Bank would no longer be targeting M1. Movements in the monetary aggregates would continue to be monitored for any information they might provide on future economic developments, but no aggregate appeared to be sufficiently reliable to serve as an intermediate target. Similar difficulties were experienced in other industrial countries that had adopted money targets and, one by one, they were forced to follow Canada's example. Gerald Bouey, who had succeeded Louis Rasminsky as Governor of the Bank of Canada in 1973, probably summarized the situation as well as anyone when he said: The search for a new nominal anchor had begun well before the Bank announced it would no longer be targeting M1, but without much success. Alternative definitions of money were tested and found to be equally unstable. For a time, nominal income was used as a guide for the Bank's internal forecasting exercise, but it was also deemed to be unsuitable as an intermediate target. While it included the two variables that macroeconomists cared about most--output and prices--precise judgments were still required about the state of the real economy in order to make it work. Moreover, explaining nominal-income targeting to the public would be difficult. Inflation and money growth were generally regarded as legitimate central bank objectives, but efforts to control the level of spending and income might be seen as too invasive and suspiciously close to trying to control the level of employment. Although conducting monetary policy without a clear objective posed certain problems, the eclectic approach that the Bank was forced to follow after it abandoned M1 did yield some results. The strong monetary policy medicine that Canada had applied in early 1981, following similar action in the United States, soon brought inflation down. And within a short period of time, output and employment also began to recover. Through most of the 1980s, inflation hovered in a range of 3 to 5 per cent. While the decade as a whole was viewed by many as a time of prosperity and growing optimism, much of this apparent affluence was based on speculative activities focused particularly on the real estate sector. Expansionary fiscal policies and rising world commodity prices were again generating strong inflationary pressures, which monetary policy was trying to resist. These pressures were largely masked, however, by the sharply appreciating exchange rate. Without an explicit target for monetary policy, the Bank had difficulty explaining its policy actions. In addition, there was no obvious basis on which to judge its performance. One could use rough qualitative benchmarks such as strong growth, rising employment, and the absence of high inflation as performance measures, but monetary policy needed a firmer place to stand. It was supposed to provide a nominal anchor for the economy, but seemed to be lacking an anchor of its own to help guide policy decisions and ensure accountability. As Gerald Bouey explained in 1982, Central bankers are always looking for more reliable guides to the conduct of monetary policy than they have had. Part of the reason is that they want to find a better place to stand against the constant pressures that arise from many sources-- almost irrespective of economic conditions--for easier money and lower interest rates. From today's perspective, explicit inflation targets might seem like an obvious alternative, but price stability had not yet been widely accepted as the pre-eminent objective of extolled the virtues of price stability and had regarded it as one of the Bank's most important objectives. But it had never been defined and the extent of the Bank's commitment to achieving it was not always clear. The major preoccupation of the 1970s and early 1980s had been to "get inflation down." How far down was a question that could be postponed for a later day, once we were within striking distance of this nirvana. The problems that arose because there was no clearly articulated and credible objective or end point for monetary policy were most evident in financial markets. Changes in U.S. interest rates or some other external shock would often produce exaggerated swings in Canadian interest rates and the exchange rate, and made it difficult for the Bank to control domestic monetary conditions. A sudden increase in U.S. interest rates, for example, would put sharp downward pressure on the Canadian dollar, causing import prices to rise and raising concerns about the future course of inflation. Because inflation expectations were not firmly anchored, prices in other areas of the economy would also come under upward pressure, setting off a potential inflationary spiral. Investors, worried about the future value of their money, would start to demand much higher rates of interest. The end result was higher interest rates, a weaker dollar, and much stronger inflation expectations than the domestic economic conditions alone would warrant. Any efforts to keep interest rates low and to support economic activity were often misinterpreted as signs that the Bank was, in fact, pursuing an inflationary policy and would only make matters worse. As a result, the Bank found itself having to follow the U.S. lead on interest rates and resist downward movements in the exchange rate for tactical reasons. Failure "to defend the Canadian dollar" would produce even larger increases in domestic interest rates and inflict more serious damage on the economy. A major step towards dealing with this problem was taken in January 1988, when of Alberta. Price stability was set out explicitly as the Bank's prime objective and, realistically, the only thing that it could deliver with the tools at its disposal. The hard lessons that had been learned from past experience were reviewed, as well as the advantages that might be realized with the consistent attainment of this objective: What pace of monetary expansion is most helpful to the development of the Canadian economy? Theory and experience--much of this experience not overly cheerful but certainly instructive--both point to a very clear answer. Monetary policy should be conducted so as to achieve a pace of monetary expansion that promotes stability in the value of money. This means pursuing a policy aimed at achieving and maintaining stable prices. The Hanson lecture contained probably the strongest commitment to price stability that had ever come from the Bank of Canada. It was designed to convince people that the Bank would do whatever was necessary to achieve price stability. Businesses, households, and the government were, in effect, put on notice--any investment and spending plans that were based on inflationary expectations were likely to end in disappointment. Price stability, although often referred to, was not, however, clearly defined. It was presumably much lower than the prevailing rate of inflation (which was hovering around 4 per cent and under upward pressure), but this was not made explicit. In addition, the path that inflation was expected to follow on the way to price stability was not outlined. A desired inflation path was an important part of the Bank's internal projection exercise, but it was not announced publicly. All of this changed in February 1991, when the Bank of Canada, in a joint statement with the Minister of Finance, announced the introduction of inflation-reduction targets. Academic economists had not been advocating targets focused directly on inflation. They had, however, already built a strong case for some form of nominal anchor, arguing that an explicit commitment of this sort would improve central bank accountability, help shape expectations, facilitate the disinflationary process, and allow central banks to avoid something known as the time-inconsistency problem. According to the time-inconsistency theory, monetary authorities were subject to a serious inflationary bias. If a central bank could initiate an unexpected easing in monetary policy, it might be possible to raise short-term output and employment. However, once businesses and households realized what had happened, they would quickly revise their inflation expectations, and output and employment would return to their original equilibrium levels. Because businesses and households knew that central banks were always subject to this temptation, they would assume that central banks might try to trick them (even when no monetary policy easing was being planned) and would raise their inflation expectations in anticipation. The end result was a kind of prisoner's dilemma, in which inflation was higher than it would otherwise be, while employment and output remained unchanged. Without some form of credible commitment that would allow monetary authorities to foreswear such policy actions, society was trapped in an inferior equilibrium. Inflation targeting, though it had not been proposed by any of the timeinconsistency authors, might be a way to correct this problem. The public nature of announced targets would raise the costs associated with any failure to meet them and, hopefully, move the economy towards the preferred, low-inflation equilibrium. Central banks were quite skeptical about whether the time-inconsistency literature provided a useful or accurate description of the situation in which they found themselves. so, the idea of inflation-reduction targets did have strong appeal, but central banks were still reluctant to adopt them. Their resistance can probably be credited to two things. First, central banks were worried about what would happen to their credibility if, for some reason, they failed to meet the inflation objectives. Second, they were concerned that the inflation targets might be too constraining. Their ability to deal with unexpected shocks, such as an oil crisis or a jump in other world commodity prices, would be severely restricted unless the target bands were quite forgiving. But if the inflation target range was wide enough to accommodate these sorts of disturbances, it was unlikely to provide much discipline or comfort in more tranquil periods. The answer to both problems is now clear. If central banks are unable to achieve and maintain their targets on a regular basis, this is something that should be shared with the public. Credibility is not enhanced by the absence of targets. Special exceptions can be made for commodity-price shocks and other unusual events, as long as the monetary authority has a plausible explanation. The advantage of inflation targets, even if they occasionally cannot be achieved, is that they provide a convenient basis from which policy actions and outcomes can be judged. It was one thing to understand these points on a conceptual level, it was another to put them into practice. Canada was the second country in the post-war period to introduce inflation targets (New Zealand was first). Even then, it is unlikely that targets would have been adopted as early as 1991 if the government had not been planning to introduce a new goods and services tax (GST). The government actively supported the introduction of inflation targets because it was seen as a way of preventing the one-time jump in prices associated with the GST from becoming entrenched in inflation expectations. More specifically, it would help to reassure government employees who were subject to salary restraints, as well as other wage earners, that inflation would be held in check. The lower and upper bounds of the original inflation-reduction targets were set at 2 and 4 per cent, respectively, with a midpoint of 3 per cent. These bounds were to gradually decline to 1 and 3 per cent by the end of 1995. At this point, a new inflation target was to be announced, consistent with long-run price stability and based on the experience of the previous four years. While the inflation targets have been renewed twice during the past nine years, neither the government nor the Bank were convinced on those occasions that the conditions were right for a final determination of where the long-run target should be set. The Bank decided that further research and experience with the existing targets were needed before committing itself in this manner. As I have pointed out elsewhere, inflation-control targets have had a major impact on the Bank and on the way it conducts monetary policy. Perhaps the most important influence has been to encourage greater transparency. With an explicit target for inflation and the central bank accountable for achieving that target, there is a strong incentive to be as forthright as possible about any trends in the economy likely to influence inflation, the decisions policy-makers may have to take to achieve the targets, the shocks that may temporarily push inflation outside the target range, and the pace at which inflation can be returned to the target. As monetary policy has become more transparent, it has become evident that it works more effectively when financial markets and the public understand what the Bank is doing and why. We no longer regard surprise as an important element in monetary policy actions. We prefer to see private agents anticipate, rather than respond to, monetary policy actions. Monetary policy has come a long way since 1935. It is now directed towards a single long-run objective: the attainment and maintenance of price stability. Monetary authorities in Canada and elsewhere have realized that this is the best contribution that monetary policy can make to economic welfare, and indeed the only one that they can deliver on an ongoing basis. There is no inherent conflict between price stability and most of the other objectives that are set out in the preamble to the Bank of Canada Act. Focusing on price stability helps us to guard against the sort of systematic errors that often occurred when we tried to aim directly at output and employment. Optimistic estimates of potential output and full employment in the early 1970s introduced a strong inflationary bias into the policy-formulation process and did not deliver any of the long-run improvements in real economic performance that the Phillips-curve literature had promised. Today's monetary policy differs from past approaches in yet another important way. It is conducted in a far more open and less-complicated manner. Secrecy and surprise are no longer critical elements of our modus operandi. The Bank tries to work with markets, rather than against them, to avoid surprising them with unexpected actions. Greater transparency facilitates the policy-transmission process by conditioning market expectations, and helps avoid unnecessary confusion about the reasons for our actions. Various techniques for manipulating domestic credit conditions and the external value of the currency by means of direct controls, moral suasion, and active foreign exchange market intervention are no longer used. Globalization and market liberalization have eliminated many of the barriers that used to separate different segments of the domestic financial system and have subjected them to increased international competition. As a result, these techniques became both less effective and more costly in terms of their impact on market efficiency. Monetary authorities now have a clearer understanding of the limitations of alternative policy measures, as well as more sympathy for indirect, market-based solutions. Monetary policy is now implemented in a more straightforward manner. Today, policy adjustments are effected and signalled to the market mainly through announced changes in the Bank Rate and the target band for the overnight interest rate. Private agents are then free to determine how these changes will be transmitted through the rest of the financial system and the economy in general. The Bank simply issues a press release indicating what the new Bank Rate is, and this in turn anchors the short-term end of the yield curve. Central bank independence and accountability have also been more clearly defined. As I explained earlier, the 1967 amendments to the Bank of Canada Act allow the Minister of Finance, acting on behalf of the government, to issue a directive to the Governor if serious differences arise on the conduct of monetary policy that cannot be resolved. The directive must indicate the specific policy changes that the Bank is supposed to undertake. Ultimate responsibility for monetary policy, therefore, rests where it should in a democratic society--with the elected government. But because of the consequences of issuing a directive, it is likely to be used only in unusual circumstances. Thus, a high degree of operational independence has, nevertheless, been preserved to allow the Bank to maintain its medium-term focus for monetary policy without the short-run pressures that arise in the political process. Moreover, the explicit targets for inflation control in Canada have been set jointly by the Bank and the Minister of Finance. It is then the Bank's responsibility to achieve the agreed target. An explicit objective, a clear assignment of responsibility for achieving it, as well as the appropriate instrument and independence of action to do what is required to meet the objective, are crucial ingredients in an effective process of accountability. That is what we now have in place in Canada for monetary policy. Where does all this leave us? We now have a much better understanding of what monetary policy should be asked to do, who should be responsible for it, and how it should be conducted. But has the evolutionary process been pushed as far as it can go? Is the transformation of monetary policy coming to an end? The answer, of course, is no. But I will leave it to my successor to return at some point in the future and update you on the evolving path of monetary policy in Canada.

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Release of the Monetary Policy Report

thiessen

This morning we released our latest . In the six months since the May , our economy has outperformed expectations, spurred by strong domestic and foreign demand for Canadian products. We now expect that growth will average 5 per cent in 2000 and 3 to 4 per cent in 2001. Despite this stronger-than-anticipated expansion and persistently high energy prices, the trend of inflation has so far been lower than expected. To get a fix on the trend of underlying inflation, the Bank uses a measure of core inflation that excludes fluctuations in volatile food and energy prices and the effect of changes in indirect taxes. This measure remains in the lower half of the Bank's 1 to 3 per cent inflation-control target range. And, despite shortages of skilled labour in certain sectors, increases in unit labour costs have been modest. Overall, these developments suggest that the economy had not yet moved into excess demand by mid-2000, but that the level of activity was close to capacity limits. We have concluded that our conventional estimate of potential output in the May was understating the actual amount of capacity in the economy. Accordingly, this estimate has been revised upwards in this . Let me now turn to our outlook. Although we see the pace of economic expansion moderating, primarily because of the projected slowing of the U.S. economy, the momentum of total demand for Canadian output is still expected to increase pressures on capacity. Consequently, core inflation is projected to rise to the 2 per cent midpoint of the inflation-control target range in the second half of 2001. If crude oil prices were to stabilize at levels just below US$30 per barrel, the rate of increase in the total CPI, which has been significantly above that of core inflation, should gradually move down to about 2 per cent by the end of 2001. There are three main risks to this outlook. They relate to demand, supply, and inflation expectations. On the demand side, the key question is whether the recent slowing of the U.S. economy towards a more sustainable pace will continue, or whether excess demand from the United States will again spill over into Canada's exports, increasing inflation pressures here. On the supply side, strong growth of business spending on machinery and equipment in Canada, coupled with the recent pickup in productivity gains, could raise our production capacity beyond currently projected levels. But until there is further evidence that productivity growth is on a higher path, the Bank must continue to be cautious about the likely future growth of potential output. A third area of uncertainty relates to world energy prices. Higher energy prices could feed into the prices of other goods and services and into expectations of future inflation. Given the strong pace and high levels of economic activity in Canada, as well as the increased energy prices, the challenge for monetary policy will be to ensure a sustainable balance between aggregate demand and supply. Our responsibility is to preserve the low trend of inflation and the benefits that it brings to our economy. [Malcolm and I are now ready to respond to questions]

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Why a Floating Exchange Rate Regime Makes Sense for Canada

thiessen

Governor of the Bank of Canada to the Chambre de commerce du Montreal metropolitain As I near the end of my term as Governor, I find myself looking back more and more, focusing on the broad, longer-term trends in our economy and in financial markets and on what those trends may imply for the future. One of the issues that has often surfaced over the years is the exchange rate for the Canadian dollar. Indeed, over the past couple of years, it has been a topic of considerable public discussion. That discussion has revolved around such questions as: Should we continue floating, or should we peg our currency to the U.S. dollar? In fact, should we even keep our own currency, or should we adopt the U.S. currency? That there is such interest in our exchange rate is hardly surprising. Some of the more recent attention no doubt stems from public concern about the relatively low value of the Canadian dollar in comparison to the U.S. dollar. But the fundamental reason for this interest is that the exchange rate is an important price in an economy, particularly in one as open as ours. Exports represent about 40 per cent of total Canadian output. And if we add imports, this proportion doubles to 80 per cent. In addition, more than 80 per cent of this trade is with the United States. So the value of our currency in terms of the U.S. dollar has always been particularly important for us. But we must be careful not to exaggerate this point, because when it comes to exports, we compete with many other foreign countries for a share of the U.S. market. And so the exchange rates of those currencies relative to ours also matter a great deal. In 1950, after the Second World War, Canada became the first major country to adopt a floating exchange rate. In 1962, we went back to a fixed exchange rate only to float our currency again in 1970. In all, the Canadian dollar has floated for 42 out of the past 50 years. No other major country has had as much experience with a floating exchange rate. This does not mean that our floating exchange rate regime has somehow outlasted all its critics! For the most part, though, the debate over the years has been about the market value of the Canadian dollar--whether it has floated too high or too low, especially from the viewpoint of certain exporters and importers. More recently, however, and certainly here in Montreal, some of the discussion has focused more on whether a floating currency is the right exchange rate regime for Canada. This particular debate has been kindled by the advent of the euro and its adoption by 11 members of the European Union at the beginning of 1999. I entered that debate early in 1999, arguing that the introduction of the euro was a remarkable achievement, but that it did not provide a useful role model for Canada and for our position in North America. Since then, with increased interest in the subject internationally, there has been considerable discussion of exchange rate alternatives for Canada and for other countries. In Canada, the debate about exchange rate regimes has been mainly among academic economists. But, with the decline of our currency against the U.S. dollar through the 1990s, the exchange rate has also been raised as a concern in the business community when comparing our less-impressive economic performance with that of the United States. Outside Canada, the debate on exchange rate regimes has also become more active, especially in parts of Latin America that have had a long history of high inflation and exchange rate crises. Indeed, in some of these countries, commentators have argued in favour of the outright adoption of the U.S. currency. Today, I would like to return to the issue of the right exchange rate regime for Canada. Having again considered the advantages and disadvantages of our current arrangements, I can tell you at the outset that I remain convinced that a floating exchange rate continues to make sense for us at this stage of our history. I propose to examine the different sides of the argument with respect to a floating currency in as simple and straightforward a manner as possible. The transactions costs of a floating currency When the amount of cross-border trade and financial transactions is as large as ours is with the United States, the need to exchange currency raises the cost of such transactions. Moreover, if the currencies involved are floating, so that the future level of the exchange rate is uncertain, there is also a foreign exchange risk to consider and to hedge against. For example, investors and borrowers must take into account not only the level of interest rates in Canada and the United States, but also potential movements in the exchange rate over the term of their investment or loan. So, yes, there are certain transactions costs in having a separate currency. A fixed exchange rate between the Canadian and U.S. currencies, such as we had from 1962 to 1970, does not do away with all these transactions costs. Conversions between the two currencies would still be required. Moreover, a fixed exchange rate does not eliminate currency risk. If there were any perceived risk of a future devaluation of the fixed rate for the Canadian dollar, the result would be persistently higher interest rates in Canada than in the United States to compensate for that risk. Even where countries have gone beyond a fixed exchange rate and have tied their currencies rigidly to the U.S. dollar--as Hong Kong and Argentina have, through a currency board--the costs, in terms of risk premiums in domestic interest rates, have not completely disappeared. So, in fact, the only way to eliminate cross-border transactions costs with the and eliminate premiums in our interest rates for potential exchange rate risk is not through a fixed exchange rate but through some sort of currency union with the United States. In reality, this would mean "dollarization." Dollarization versus monetary union But why not a common-currency arrangement, as in Europe? Wouldn't that be On the face of it, of course, a currency union would be better than dollarization. Under such an arrangement, we would, in principle, still have some say in determining a North American monetary policy. Presumably, we would also be able to keep some of the revenue (or seigniorage) from issuing that common currency. But we must understand what a North American monetary union would mean in reality. The European experience is rather enlightening in this respect. Economic and monetary union in Europe is the product of 50 years of increasing political and economic integration. The recent adoption of a common currency, which was a further step on the road to European integration, was taken mainly for political, rather than economic, reasons. And when it comes to decision-making at the European Central Bank, the three large countries in the euro area (Germany, France, and Italy) have agreed to a "one country-one vote" rule with their other eight medium- and small-sized partners. I do not see how we could possibly have similar arrangements in North America, given the clear dominance of the U.S. economy. In effect, a monetary union with the United States could only mean that Canada would adopt the U.S. dollar. The advantages of a floating exchange rate So far, I have been focusing on the costs of cross-border transactions and the exchange rate regimes that could reduce those costs. But that is not all that matters. The real world is a more complicated place, as I shall explain in a moment. And that is why a floating exchange rate regime makes sense for Canada. The case typically made for a floating rate for Canada is that it gives us the chance to run an independent monetary policy. That is true. But these days, there is really very little difference in the low-inflation objectives of industrial countries. The real value of a floating exchange rate for Canada is that it allows us to have different monetary conditions than the United States--monetary conditions appropriate to our own economic circumstances, even as we pursue the same general objective of low and stable inflation. The significance of having this option is our ability to respond to external economic shocks that affect us differently from our southern neighbours, or to respond to differences in domestic economic policies. Let me give you a couple of examples of economic shocks and policies that have reflected these differences. Fluctuations in world commodity prices are an important first example. Although our reliance on primary commodities has diminished substantially through the years, such goods still account for 30 to 40 per cent of Canada's exports. The United States, on the other hand, is a net importer of commodities. The Asian financial crisis of 1997-98, which led to a 20 per cent decline in the prices of the key primary commodities that we export, was a major negative shock for Canada. In contrast, the United States benefited from these lower prices. The decline in the value of our currency against the U.S. dollar at the time was in response to that economic shock. And it helped Canadian manufacturing and other noncommodity sectors to increase their exports to the United States. In this way, the impact of falling employment and incomes in our primary sector because of the lower commodity prices was largely offset by greater expansion in these other sectors. Another example involves the fiscal restraint measures that were undertaken by our federal and provincial governments, beginning in the mid-1990s, to deal with persistent deficits and the resulting unsustainable accumulation of public debt. The United States also had a budgetary problem. But the need for fiscal tightening was much greater here and so was the effect of the corrective measures on total demand in our economy. To help the transfer of resources from the public to the private sector and so support overall demand in Canada, we needed lower interest rates here than in the United States. These lower rates were maintained through most of the period from 1996 to the present. In today's globalized financial markets, such persistent interest rate differences in the circumstances I have described are possible only with a floating exchange rate. In both these examples, the exchange rate acted as a shock absorber between the U.S. and Canadian economies, helping to facilitate the needed adjustment in response to differing shocks and differing policy requirements. Even though our two economies are closely linked, they can move in different directions. And when that happens, the shock-absorber role of a floating exchange rate is invaluable. Although these recent examples involved downward adjustments in our currency, this has not always been the case. Indeed, there have been times when economic shocks and policy differences in the two countries have worked in the opposite direction, leading to increases in the value of the Canadian dollar. It is, of course, possible to cope with unexpected shocks and policy differences under a fixed exchange rate or a monetary union. But the adjustment process will take longer, will be more difficult, and will cost more overall. Imagine the adjustment in our economy that would have been required in 1997-98 in response to the fall in commodity prices, if the Canadian dollar had not been floating. To maintain a fixed exchange rate throughout that period, much higher interest rates would have been necessary to resist the downward pressure on our currency from the falling receipts for commodity exports. In effect, this would have meant a more serious economic slowdown to bring wages and salaries down to a level that would make other industries more competitive and allow them to increase their exports. Even under a common-currency arrangement, we would still have had to go through much the same adjustment over the longer term. But under such an arrangement, more of the short-term pain--in terms of declines in employment and incomes--would have been felt in the primary industries and in regions of Canada with a higher concentration of such industries. The bottom line is: There is no escaping the need to adjust to real economic shocks regardless of the currency regime. But a floating-rate regime does help to facilitate and smooth the adjustment process. Before concluding, I would like to quickly deal with a couple of common misconceptions about flexible exchange rates. The first one relates to the incentives for business to innovate and invest in new technology. If the argument here is that a low exchange rate gives exporting firms easier profits and blunts their motivation to innovate and become more efficient and competitive, I am inclined to say that this suggests a rather serious problem of corporate governance. Surely, the job of company directors is to ensure that management is doing everything necessary to maximize profits and stock values, no matter what the circumstances. Any company that does not operate this way will soon find itself losing to the competition. Another misconception is that a relatively low exchange rate puts a country at a disadvantage in terms of foreign takeovers. Here, I would say that if Canadian companies became more attractive in recent years to U.S. corporate buyers, it was primarily because of high stock market valuations in the United States, not because of a lower Canadian dollar. High stock prices essentially provided U.S. companies with very cheap financing for corporate takeovers in countries where market valuations were lower. We saw a similar process involving Canadian takeovers of foreign companies more recently, when stock market valuations hit very high levels in this country. Concluding thoughts Let me summarize my main points. In view of our close economic and financial links with the United States, I recognize the attractions of the reduced currency uncertainty and lower transactions costs that would be part of a fixed exchange rate arrangement with the U.S. dollar. Nonetheless, I believe that for Canada, the macroeconomic advantages of a flexible exchange rate continue to far outweigh the lower transactions costs of a fixed rate. As long as we remain a major producer of primary commodities, and as long as we want to pursue separate economic policies that are suited to our own circumstances and that require differing monetary conditions, the shock-absorber element of a floating currency will serve us well. Does a floating exchange rate regime mean that we are likely to have a persistently weak currency? No, it does not. Through the second half of the 1990s, we have seen a U.S. dollar that is strong against virtually all other currencies, reflecting the remarkable performance of the U.S. economy. In the process, however, the United States has also built up a very large cumulative deficit in its transactions with the rest of the world. At some stage, this external deficit will have to be reversed, and a lower U.S. dollar will be part of this adjustment. Here in Canada, after a slow start in the early 1990s, the fundamentals of our economy have improved. Growth has been more robust in recent years, employment and incomes have been rising, and inflation is low and stable. Government budget deficits have been eliminated, and the public debt relative to the size of our economy has been shrinking. Moreover, as part of a major restructuring effort by the private sector, businesses have been investing heavily in machinery, equipment, and technology. We may now be starting to see the payoff of these efforts, in the form of some larger productivity gains, which I hope will grow and continue, thereby providing the basis for improved standards of living for Canadians in the future. All in all, the prospects for our economy are very positive. If these prospects are realized, we will also see a stronger Canadian dollar over the medium term.

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Canada's Economic Future: What Have We Learned from the 1990s?

thiessen

Governor of the Bank of Canada to the Canadian Club of Toronto It was to the Canadian Club of Toronto that I gave my first speech as Governor of the Bank of Canada seven years ago. It is only fitting that I should be here again today, for my final public presentation before I retire. In early 1994, Canada's economic situation was not that favourable--our economy was facing some rather serious problems. Today, too, we face some challenges. But our overall economic and financial situation is much stronger now than it was seven years ago. What I intend to do today is to look back at Canada's economic performance during the last decade of the twentieth century and, with the benefit of hindsight, look at the factors behind that performance. I would also like to talk about the changes that have taken place in our economy over this period, and what these changes mean as we look ahead. The problems of the 1990s Let me take you back to the early 1990s. That is when the gravity of the problems that would dominate the Canadian economic landscape for much of the decade became clear. By 1990, the persistent inflation of the 1970s and 1980s had pushed the consumer price index (CPI) to a level nearly four times as high as in 1970. Inflation had come down through the first part of the 1980s, but, with an inflationary psychology still very much at work, it picked up again towards the late 1980s. During that whole inflationary period, many Canadians sought to protect themselves from the effects of inflation through indexed wage contracts and by investing in the housing market. Others saw an opportunity to benefit from high inflation by speculating in real estate or other assets. Since many of these transactions had been financed by borrowing, debt had risen to high levels. When the Bank of Canada's anti-inflationary policy actions in the late 1980s finally convinced Canadians that inflation would be brought under control, the inflationary excesses that had built up contributed to a severe recession in 1990-91. Partly because inflationary pressures in Canada were greater than in the United States, and the inflation psychology was more deeply entrenched, the recession here was more severe than in the United States. The effects of technological change, including a decline in communications costs, meant that, through the 1980s, national markets had become much more susceptible to international competition. In Canada, however, the relatively high inflation of the 1970s and 1980s had distracted Canadian firms: rather than focusing on product design and innovation, cost control, and productivity improvement, many of them had been looking for ways to take advantage of inflation. Thus, they had tended to postpone the adjustments needed to respond to a changing world economy. Meanwhile, U.S. companies that had earlier found themselves in strong foreign competition, especially against Japanese firms, had already begun the process of adjusting to globalization during the mid- to late 1980s. So, by the beginning of the 1990s, they were better placed than most to respond to the intensifying forces of technological change and global competition. By the early 1990s, the realities of the new world economic order were becoming clearer to Canadian companies too. Only at that time, they were also coping with the fallout from the high-inflation years, especially the sharp drop in the prices of speculative investments and the burden of servicing large debts, as well as with declining world commodity prices. Working their way out of these difficulties was disruptive and painful for Canadian businesses. Defaults, restructurings, and downsizings became the order of the day. With all this, unemployment took a long time to recover from the 1990-91 recession and, in many instances, wages and salaries were frozen or reduced. But whatever else one may say, through this period, our businesses responded to the challenge and did a remarkable job of restructuring their operations and adjusting to the new economic realities. Canada's other major economic problem in the early 1990s was large budget deficits--federal and provincial. Because of these deficits, public debt was accumulating at an unsustainable rate, and foreign and domestic investors were becoming very nervous about holding Canadian government bonds. As a result, significant risk premiums were built into our interest rates. By 1994, it had become clear that Canada could be facing a potentially very serious debt problem. If there was any doubt about that, it disappeared in early 1995, when Canada was sideswiped by the Mexican peso crisis. The Canadian dollar came under strong downward pressure, and interest rates rose sharply across all maturities as investors demanded even larger risk premiums. Just as I believe that the restructuring in our private sector in the 1990s was impressive, I also think that Canadian governments (federal and provincial) responded forcefully and effectively in the mid-1990s to the need to cut fiscal deficits and slow down the accumulation of public sector debt. The overall government sector moved from a total deficit of close to $45 billion or 6 per cent of gross domestic product (GDP) in 1995, to a balanced position in 1997 and 1998, and to surpluses thereafter. Moreover, net public debt as a ratio of GDP fell from close to 104 per cent in the fiscal year 1995/96 to an estimated 80 per cent in 1999/2000. That is some This fiscal restructuring, although essential, was difficult and disruptive. Like the private sector, the public sector too had to undertake significant downsizing and salary restraint. Overall, given the type and size of structural changes that had to be made, it is not surprising that, for much of the 1990s, unemployment rates in Canada remained high and incomes stagnated. The turnaround The economic problems of the 1990s that I have been recounting make for a rather sombre story. The next chapter of that story, however, is rather more cheerful. Although Canada was late in dealing with past economic imbalances, once our private and public sectors realized the extent of the problems, their response was prompt and effective. And our economic performance has improved materially as a result. Let me highlight some of the major improvements. I have already noted the influence of technology and globalization in changing the world economy during the 1990s. This influence continues and, if anything, is accelerating. Indeed, the world seems to be going through a real technological revolution--a revolution spawned by the increasing efficiency and declining costs of computers and fibre optics and their application to information processing and communications. The United States has been at the forefront of this revolution. But, as far as we can tell, Canada is not that far behind. Once Canadian businesses sorted out the required restructuring and reorientation of their activities in the first half of the 1990s, they quickly came to realize that they had to adopt and invest in the new technology to become more competitive. U.S. firms served both as a role model and a competitive prod in this regard. Investment in new machinery, equipment, and technology by Canadian businesses began to pick up in 1996 and, as a ratio of our GDP, has been rising continuously. This pattern looks remarkably similar to the one in the United States--only with a lag of about four years. In the United States, the investment in equipment and technology, which had begun early in the 1990s, started paying off around 1996, with rather impressive gains in productivity. Over the past five years, U.S. productivity growth (measured as output per personhour) has averaged 3 per cent. Although it is still early days, there have been encouraging signs of a pickup in Canadian productivity growth this past year. I see no reason why Canada cannot benefit from a process similar to the one that has been at work in the United States. However, the extent of any future gains in our productivity is still difficult to gauge at this point. There is, of course, more to the recent favourable economic news in Canada than just the early signs of a pickup in productivity growth. For example, there have also been substantial gains in employment. The unemployment rate, which had reached 11 per cent in the early 1990s, dropped to below 7 per cent in 2000--its lowest level in over 25 years. Incomes, too, have been rising. Adjusted for inflation, personal disposable income has increased by an average of almost 3 per cent per year over the past four years. The fiscal restructuring has also figured importantly in our improved economic performance. The reduction in deficits and the subsequent move to surpluses, together with the declining debt levels of the government sector, have helped to eliminate the risk premiums in our interest rates that cost us so dearly in the early 1990s. Indeed, for much of the period from mid-1996 to late 2000, Canadian interest rates were lower than comparable U.S. rates. This has, no doubt, been an important factor behind the surge in business investment in Canada since 1996, which is so important if we are to take advantage of new technology and enhance our ability to compete internationally. Low interest rates have also encouraged households to buy houses, cars, and other major consumer goods--purchases they had tended to postpone earlier in the decade. The role of monetary policy I have left a detailed discussion of the role of monetary policy (and of the Bank of To explain the role of monetary policy through the 1990s, I need to go back to the 1970s and 1980s. As I said before, this is when some of the serious economic policy problems in Canada, and elsewhere, really started. In the late 1960s and early 1970s, the world economy was booming. And the large U.S. military expenditures during the Vietnam war amplified the boom. OPEC took advantage of strong world demand to restrict the supply of crude oil and push prices up. In the face of these pressures, inflation went up everywhere, including here in Canada. It took monetary authorities around the world a while to realize that rising inflation was not just the product of a series of temporary special factors. By the time most central banks reacted, inflation had become entrenched and proved very difficult to bring down. The persistent inflation of the 1970s and 1980s undermined economic performance worldwide. Canada did not escape unscathed. Because inflation creates uncertainty, it makes it much more difficult for households and businesses to judge future prices and to make sound economic decisions. High inflation encourages speculation rather than productive investments. It raises interest rates. And, in the end, it exacerbates both the booms and the busts. Restrictive monetary policies in the United States and in Canada during the early 1980s finally brought inflation down from its double-digit levels. But fears of inflation lingered, encouraging continued debt-financed speculation in real estate and other assets. By the late 1980s, inflation pressures were on the rise again. In Canada, those pressures, and the fears of ongoing inflation that had been undermining our economic performance, finally eased after the successful implementation of the inflation-reduction targets adopted in February 1991. Inflation promptly declined to around 2 per cent, and inflation-related hedging and speculation gradually disappeared. I believe that the low-inflation environment that was firmly established in the first part of the 1990s contributed significantly to Canada's improved economic performance later in the decade. Since the early 1990s, there has been greater certainty about future prices. Investment and savings horizons have, consequently, lengthened. Interest rates have come down. And, in contrast to our experience during the Mexican crisis, Canada rode out the impact of the Asian financial turbulence of 1997-98 with only a limited slowdown in output and employment growth. The way ahead Partly because of the difficulties we experienced in the 1990s, many Canadians remain sceptical about our economic future. They look at the extraordinary performance of the U.S. economy through much of the past decade, and Canada's record looks lacklustre by comparison. But I believe that there are considerable grounds for optimism. I say that primarily because of the improvements in our economic fundamentals that I have described. Indeed, good economic performance starts with a foundation of prudent economic policies. In this regard, low and stable inflation, together with a declining public sector debt, now provides a stronger base for the Canadian economy than we have had in three decades. In addition, there is the shift in business attitudes towards greater focus on cost control, productivity, and international competitiveness. How well we do in the future will depend on us getting a number of things right. Above all, we must ensure that we sustain and build on the progress made on the inflation, fiscal, and business fronts. But other things are also important. We must find the level of taxation that offers scope for entrepreneurship and risk-taking, while also allowing a level of government services that gives Canadians the degree of social support that can help them accept, respond, and adjust to a rapidly changing world. We must also think about the skills Canada needs to be able to exploit fully the benefits of rapid global economic change. This means strategic partnerships between employers and employees to promote on-the-job training, and partnerships between industries and educational institutions to improve skills and to develop new ones, suited to today's advanced technologies. This is very important if we are to avoid skill shortages that could constrain the expansion of our economy. To conclude, our economy has been expanding robustly over the past five years, inflation has remained low, employment and incomes have been rising. And we are now seeing encouraging signs of a productivity payoff from the restructuring of the past decade--a payoff which, if sustained, would provide the basis for rising standards of living for all Canadians in the future. Some of you may wonder if this conclusion is not overly optimistic in the face of a slowing U.S. economy. Since tomorrow is our next pre-set date for announcing changes in the Bank Rate, I hope you can appreciate that I cannot comment on the current economic situation. We will be doing that in tomorrow's press release. What I can say is that the points I have been making here today are about the improvements we have seen in the fundamental, longer-term trends in our economy. Because of these improvements, our economy is now in a better shape than it has been for some time to deal with all kinds of external shocks--including fluctuations in U.S. demand for our products. What I see ahead are challenges, but not the serious problems we were facing ten years ago. Today, we have an economy with sound foundations, well-placed to rise to these challenges and prosper.

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Release of the

dodge

This morning, we released our to last November's . This was completed at the time of the Bank Rate announcement on 23 January. It presents the analysis on which we based our decision to reduce the Bank Rate by 25 basis points. As discussed in the , world economic growth has slowed more than we were anticipating three months ago, mainly because of a more pronounced slowdown in the U.S. economy since the third quarter of last year. Through the second half of 2000, despite lower U.S. demand for Canadian products, the pace of economic expansion in Canada remained solid, bolstered by strong growth in domestic demand. Indeed, real GDP in 2000 is estimated to have grown by 5 per cent, on an annual average basis. And by year-end, inflation, measured by the 12-month rate of increase in the core CPI, had moved up somewhat faster than anticipated--to close to 2 per cent. Let me now look ahead. Although the Canadian economy began 2001 from a strong base, with signs of pressures in some labour and product markets, recent developments have altered the risks and uncertainties in our economic outlook. Most importantly, the abrupt weakening of U.S. economic activity raises the question of what the implications for Canada will be. In the , we revised down our projection for Canada's economic growth this year to about 3 per cent. Core inflation is projected to stabilize at about 2 per cent, and total CPI inflation is expected to converge with the core rate in the second half, assuming that world crude oil prices stay at or below current levels. That projection also assumed that the U.S. economy would expand by 2.0 to 2.5 per cent, on average, in 2001, with a weak first half followed by a relatively strong rebound in the second half. Based on the accumulating evidence, it now appears that U.S. economic activity in the first half of the year will be weaker than projected in the , but we still expect it to rebound in the second half. This poses some near-term risks for the Canadian economy. At the same time, high levels of employment and rising disposable incomes are working to sustain domestic demand growth here in Canada. And our solid fundamentals--low inflation, a declining public sector debt relative to the size of our economy, and business restructuring--have put the Canadian economy in a better position to adjust to external developments. Overall, despite the near-term uncertainties, the Bank remains positive about our economic prospects for 2001. We will continue to monitor closely the evolving situation.

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The Bank of Canada and Monetary Policy: Future Directions

dodge

It's a pleasure to be here today, in my home town of Toronto, for my first public speech as Governor of the Bank of Canada. And I am particularly pleased to be speaking to the Board of Trade. One of my great delights as a boy was when my father would bring me to the dining room of the Old Board of Trade for lunch in June, if I had done well in school that year! That was my first contact with the Toronto business and financial community--a valuable contact that I have sought to maintain over the years. And it is a contact that I hope to strengthen while I am at the Bank of Canada. The Bank is well respected both inside and outside Canada for the quality of its professionals and the work that it does. I am honoured to join it and to lead it over the next seven years. My task will be to ensure that we build on the Bank's record to date and that we strengthen and deepen the progress made so far in fulfilling our responsibilities to Canadians. There are three main issues I want to address publicly as I begin my term: the Bank's contribution to good economic performance; the Bank's contribution to promoting financial stability, both nationally and internationally; and the importance of open and frank dialogue with business, labour, and the general public. Today, I would like to focus my comments on the first and the third of those issues. I hope to address financial stability as part of my next public speech. And I will conclude with a few remarks on the current economic situation. As the country's central bank, the Bank of Canada has a commitment to contribute to the economic well-being of Canadians. Fundamentally, this means that we must conduct monetary policy so as to promote sustained economic growth, create conditions conducive to rising investment, employment, and incomes, and encourage a more stable macroeconomic environment. How can the Bank of Canada foster such an outcome? The best contribution that the Bank can make to good economic performance is to preserve confidence in the future value of money. In practical terms, this means that Canadians should not have to worry about the effects of inflation when they make everyday decisions as consumers, business people, savers, and investors. It means that they should be able to go about their affairs confidently, knowing that they can count on their central bank to do whatever is necessary to keep future inflation low, stable, and predictable. In this way, they will be able to make sounder economic decisions, which will lead to better overall economic performance and rising incomes. Over the past several years, the Canadian economy has experienced low and stable inflation and a strong rate of expansion. Moreover, economic activity has been less variable than in the 1970s and 1980s, even though we had to face some important economic shocks, such as the Mexican and the Asian crises. Employment and personal incomes have risen, and business investment in machinery, equipment, and new technology has increased very substantially, particularly since 1996. At the same time, low inflation has encouraged Canadian businesses to operate more efficiently and to focus on cost control and productivity improvements. That is quite a change from our experience in the 1970s and 1980s. That experience amply demonstrated what a terrible price the economy and the people pay for high, unstable, and unpredictable inflation. I am thinking here of the increased uncertainty about the future, the distortion of vital signals and information that people rely on to make important decisions, the ups and downs in output and employment, and the waste of valuable economic resources as they are diverted from productive investments to speculative activities. All of this should be enough to strengthen our collective resolve not to let inflation break out again. And it convinces me that the focus of Canadian monetary policy since the early 1990s on low and predictable inflation as an essential building block of a productive, well-functioning economy has been exactly right. While low inflation is a necessary condition for good economic performance, it is not sufficient by itself. Other factors are also crucial. Clearly, it is very important that we all continue to work to improve the structure of our economy and the skills of our labour force, and to ensure that our product and labour markets operate efficiently. It is also critical that over the next decade all levels of government continue to focus on reducing their net indebtedness to lessen Canada's vulnerability to external shocks and to prepare for the pressures we will face with the projected decline in our working-age population. Let me now turn to the role of the inflation-control targets and the floating exchange rate in Canadian monetary policy. Explicit inflation-control targets were jointly introduced by the Bank and the Government of Canada in 1991. Since 1995, the target has been to hold the trend of inflation inside a range of 1 to 3 per cent, with a focus on the midpoint of 2 per cent. Inflation targets provide an anchor for policy and an anchor for people's inflation expectations. They supply the Bank with an effective mechanism for assessing and dealing with demand pressures in the economy in a way that reduces fluctuations in output. Here's how this 'stabilizer' feature of the targets works--bearing in mind that monetary policy actions take anywhere from one to two years to have their full effects on the economy and prices. If total demand was pressing on the economy's capacity to produce, so that the trend of inflation looked likely to move towards the top of the target range, the Bank would tighten in order to reduce demand and inflation pressures. Equally importantly, in a symmetric fashion, if demand was weak and inflation looked likely to move towards the bottom of the range, the Bank would ease, providing more room for the economy to expand to its production potential. Moreover, the focus on inflation control can help the Bank to gauge where the economy's capacity to produce really is, especially after periods of widespread restructuring that may have raised capacity above the levels estimated on the basis of past experience. By comparing actual inflation relative to what the Bank expected, we can draw inferences about the limits of capacity, which is important in setting monetary policy. The basic point here is that the focus on inflation control and the clarity of the targets provide the Bank with an effective mechanism for guiding monetary policy in a way that reduces output volatility and helps to assess the economy's production potential. What about the exchange rate, how does it fit in all this? If the inflation targets are the anchor of our monetary policy, we need a flexible exchange rate. That much is clear. But in addition, a floating exchange rate allows the economy to adjust to economic disturbances, including fluctuations in external demand for our products. A classic example of this is a sharp movement in the relative price of our exports compared with our imports. In cases like this, movements in the relative value of the Canadian dollar help our economy to adjust more quickly than if the exchange rate did not move. And when the currency does move in response to shocks, the inflation target serves to anchor expectations about its value, thus facilitating the adjustment process. All this is to say that, in my view, inflation-control targets and a flexible exchange rate have worked well and continue to make sense for Canada in the foreseeable future. So far, I have explained why I consider an ongoing commitment by the Bank to low and predictable inflation to be of paramount importance to sustained strong economic performance in Canada. I have also outlined why I think that the Bank should continue to pursue the objective of low inflation within the current framework of inflation targets supported by a floating exchange rate. All this is fine, you may say, but how will the Bank ensure that it continues to deliver a credible, effective monetary policy? In a world subject to all kinds of shocks, and with financial markets increasingly more open and globalized, there are no guarantees that monetary policy will be successful at all times and under all circumstances. Still, it helps if those who are affected by policy decisions--the financial markets and the general public--understand what their central bank is doing, and why. Put another way, central bank actions will likely be more successful if they are better understood and more predictable. Financial markets will then likely respond more effectively, and indeed anticipate, monetary policy actions. And the general public will be better able to take monetary policy into account when making plans for the future. Transparency actually leads to better policy outcomes. In Canada, the move towards greater openness, transparency, and accountability in monetary policy received a big boost with the adoption of the inflation targets in 1991. The targets established a clear objective for monetary policy. And they set a precise yardstick for measuring the Bank of Canada's success in meeting that objective. The Bank's explicit inflation target and our commitment to achieving it, have provided strong incentives for us to be as candid as possible about the external and domestic developments that are likely to influence inflation and the ability of monetary policy to respond to them. Under the stewardship of my predecessor, Governor Thiessen, who placed particular emphasis on encouraging greater openness and more effective two-way communications, the Bank made important strides in this area. Today, we provide large amounts of data and commentary on monetary policy in our regular publications and on our Web site. We also discuss the outlook for the economy, inflation, and monetary policy in the , the to the , and in speeches by Bank officials. Our latest initiative to improve public understanding of the Bank's actions is the adoption of a system of fixed dates for the announcement of decisions on the Bank Rate. The press release that we issue on each of these dates gives our latest assessment of the economy and the rationale for changing or not changing the Bank Rate. Communication, however, goes both ways. The Bank also needs to understand what is happening in the markets and in all key sectors of the economy and across the regions. We need your input, your information, and your views. We can only formulate good policy if we are good listeners. So I encourage you to talk to us. The phone lines and doors at our regional offices, here in Toronto and across the country, are open. Constructive two-way communication is particularly critical in times of increased uncertainty about the future. So let me now say a few words about how the Bank views the current economic situation. The Canadian economy began 2001 from a strong base--expanding by an estimated 5 per cent, on average, in 2000 and with solid growth continuing right through the second half of last year despite the slowdown of the U.S. economy. In our last to the , which was prepared on 23 January and released on 6 February, we revised down our projection for economic growth in Canada this year to about 3 per cent, primarily because of the more abrupt weakening of U.S. economic activity. That projection assumed that the U.S. economy would expand by 2 to 2.5 per cent, on average, in 2001, with a weak first half followed by a relatively strong rebound in the second half. When we released the on 6 February, we pointed out that, on the basis of accumulating evidence, it appeared that U.S. economic activity in the first half of the year would be weaker than we had projected on 23 January, even though we still expected a reasonable rebound in the second half of the year. We noted that this posed some near-term risks for the Canadian economic outlook. But, as we also pointed out then, despite the near-term uncertainties, the Bank remains generally positive about Canada's economic prospects for the year, given productivity increases and rising disposable incomes aided by tax cuts that are working to sustain domestic demand growth. Of course, there are some sectors and regions of the country that will feel the effects of the U.S. slowdown more than others, for example, those with heavier concentration in the production of cars and equipment, notably equipment related to communications and information technology. Offsetting those, there will be generally solid growth in construction and services, and particularly strong growth in energy-related sectors. Canadian and international data that have become available since 6 February have not caused us to alter the views outlined at that time. The Bank will continue to monitor the evolving situation closely, and we will have more to say on the subject in the press release on our next fixed announcement date, 6 March. Let me now conclude by underscoring my two main messages today. First, low, stable, and predictable inflation is the best contribution that monetary policy and the Bank can make to a productive, well-functioning economy. Second, effective dialogue between the Bank, the markets, and the general public is vital to the success of monetary policy. On both counts, my colleagues and I are determined to carry forward the Bank's commitment to Canadians.

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The Bank of Canada and Financial Stability

dodge

Governor of the Bank of Canada I am pleased to be in Montreal today. Last month, in my first public speech as Governor of the Bank of Canada, I talked about our contribution to good economic performance through low, stable, and predictable inflation. I also stressed the importance of frank dialogue with financial markets and the general public in helping the Bank formulate and implement monetary policy successfully, particularly at times of increased uncertainty. While monetary stability through low inflation is crucial to good economic performance, our economy cannot function properly unless it is also supported by an efficient and stable financial system. And as the world economy becomes increasingly interconnected, sound macroeconomic policies and sound financial systems across all countries are even more essential. Today, I would like to talk about the Bank's contribution to financial stability at home and abroad. I will also comment briefly on the current economic situation. As an open economy, Canada is very much affected by what goes on in the rest of the world. So we have more than a passing interest in promoting a sound and robust international environment. Since more than 80 per cent of our foreign trade is with the United States, it is developments in that country that have the most profound impact on our economy. Recent experience, however, has shown that even events in faraway places can reverberate back home. The Mexican peso crisis of 1994-95 and the Asian financial crisis of 1997-98 are cases in point. In both instances, Canada was sideswiped by those events. If this somehow leaves the impression that globalization--the increasing integration of economies and financial markets--has been of questionable value, I hasten to add that this is not how I see it. On the contrary, I believe that globalization has been, and will continue to be, a source of opportunity and growth for Montreal, for Canada, and for the rest of the world. Recent episodes, however, have highlighted certain vulnerabilities in the global financial system. And we must deal with them, if the benefits of economic and financial integration are to be fully realized by everyone in today's "global village." Let me tell you what the Bank is doing to promote financial stability. In addition to pursuing monetary stability through a low-inflation policy, all central banks, including the Bank of Canada, have a responsibility to promote the stability and soundness of their country's financial system. A market economy, like ours, cannot function well without the support of a strong financial system. Sound financial institutions, a robust financial infrastructure, and efficient financial markets are necessary to facilitate transactions and to properly channel savings into investments. For an economy to perform well, individuals and businesses must be confident that money and financial claims can be reliably and efficiently created, held, transferred, and settled. Now, if the arrangements that are in place do not work properly, the financial system can turn into a channel through which shocks are amplified as they are transmitted from one part of the system to the next and also beyond national borders. Whether such shocks are of an economic nature or whether they originate in the financial system itself, they can end up having an important impact on the economy as a whole. So there are good reasons why countries should ensure that their financial systems work well and that they do not trigger or spread instability domestically and internationally. In Canada, the Bank shares the responsibility for financial stability at the federal level with three other entities--the Office of the Superintendent of Financial Institutions, the bodies also play an important role. The Bank focuses its attention mainly on macro financial stability issues, leaving the principal responsibility for micro issues to the other entities. The Bank's overriding concern is to ensure that the financial system is sound and that it works efficiently. In this context, we provide liquidity to the system, in both ordinary and extraordinary situations. We give policy advice to the federal government on the design and development of the financial system. Through our oversight of major clearing and settlement systems, we act to make sure that the failure of a participant does not lead to domino effects and to generalized instability. And we provide banking services to these systems and to their participants. Finally, we collaborate with other domestic and international bodies that work on financial-stability issues. Thanks to the collective efforts of all those charged with the promotion of financial stability in Canada, we have a financial system that is efficient and robust. And, as recognized by the International Monetary Fund (IMF) in 1999, it complies with all major international standards. But the financial landscape is constantly changing. Under pressure from greater global competition, and with the benefit of new information technology, more sophisticated financial products are being developed, and new ways to deliver financial services are continually being devised. What does this mean in terms of the Bank's commitment to financial stability? It means that we, and the other federal and provincial agencies responsible for the health of our financial system, must monitor these developments and understand their potential implications for financial stability. And we must continue to strengthen the ability of our financial system to withstand shocks. Moreover, since, despite our best efforts, there will be rare occasions when difficulties will develop, it also means devising effective, cost-efficient ways of resolving problems. Because even if the probability of such difficulties is low, the consequences could be major. Let me now turn to the ongoing efforts to reform the international financial architecture and tell you about the Bank's involvement in this area. In the aftermath of the financial crises of the 1990s, new international bodies have been created, and existing ones strengthened, to help identify and deal with weaknesses in the global financial system. The Bank of Canada has been an active participant in several international forums where issues of financial stability are debated. And we have worked closely with other members to develop frameworks for the prevention, management, and resolution of international crises. I would highlight in particular our participation in two new international groups currently chaired by Finance Minister Martin, brings together national authorities from both industrial and major emerging-market economies to discuss key issues that are important for the proper functioning of the global economy. Such issues include exchange rate regimes, good practices on transparency in fiscal, monetary, and financial policies, and the role of the private sector in crisis resolution. The Financial Stability Forum is responsible for identifying systemwide vulnerabilities and has dealt with such issues as offshore financial centres, capital flows, and international financial standards and codes. Given our expertise, the Bank's focus in international forums has been, and will continue to be, on three key issues--exchange rate regimes, financial-system infrastructure, and private sector involvement in crisis resolution. In light of our long experience with flexible exchange rates and our strong reputation in inflation targeting, a number of emerging-market central banks have asked for, and received, assistance from the Bank in developing and operating policy frameworks based on inflation targets. We expect this to continue in the future. In the area of financial-system infrastructure , parallel to our work on the oversight of major payments systems and the provision of liquidity in Canada, we have been studying these issues from a global perspective as members of various committees at the Bank for International Settlements. And we have been contributing to the development of standards for the sound operation of such systems. The Bank has also been closely involved in international efforts to reduce the risks associated with the settlement of foreign exchange and securities transactions. Finally, there is the issue of private sector involvement in crisis resolution. all recognize that, even with the best prevention efforts, we will not totally eliminate the possibility that foreign economic and financial disturbances will affect national economies around the world. In the event of an emergency, the international community has agreed to new assistance facilities for distressed IMF member countries. IMF resources, however, are not limitless. So there is a need for the private sector to play a key role in the resolution of crises. Greater clarity about the size of available official assistance is essential to encourage private sector debtors and creditors to work together to find solutions in difficult circumstances. And although we hope that most situations could be resolved voluntarily, it is important to recognize that, under certain conditions, an orderly standstill (a temporary suspension of debt-service payments) may be appropriate to give a distressed debtor country some breathing space in which to take steps to address its problems. Broad international consensus on limits to official lending and on standstills is still lacking. So we will continue to work away at these issues. Before summing up my main points today, I would like to give you a quick update on the Canadian economy. In assessing the near-term course of the Canadian economy, we are all facing a number of uncertainties. The most important relates to the abruptness and extent of the slowdown in the U.S. economy. The fact that the recent economic data for North America are mixed adds to this uncertainty. While these data confirm a slowing in the pace of activity, some have come in weaker, and some stronger, than expected. This is certainly the case here in Canada. But even in the United States there have been both negative and positive reports. In the United States, the number of positive indicators, while not decisive, provides some hope that the end of the slowdown may not be far off. We continue to believe that U.S. economic growth will rebound in the second half of the year, supported by the decline in interest rates and by the moderation in energy prices. The exact timing of the U.S. recovery, however, remains uncertain and will depend importantly on how consumer confidence evolves in that country. Here in Canada, the latest national accounts data, which incorporate revisions to the growth profile in the first three quarters of last year, show that the level of economic activity was not quite as high at the end of 2000 as we had estimated earlier. And, based on more recent indicators, the pace of economic expansion in the first quarter of 2001 will be slower than in the final three months of last year. We can see this clearly in the automobile industry, where there have been production cutbacks mainly in response to weaker demand and excess inventories in the United States. Electronic goods and telecommunications products are two other areas where activity has slowed--although from very high levels--and where world production has been running ahead of demand. All three are high-profile sectors. So naturally they attract a lot of attention, especially in parts of Canada where there is a heavy concentration of these industries. But to keep things in perspective, there is still considerable strength in a number of other areas that are important to our economy. For example, investments in the energy sector and orders in the aerospace industry here in Quebec are extraordinarily strong. Or take retail sales other than autos, or housing, or non-residential construction: in all those areas, and in most other service industries, the level of activity remains high. When we considered the balance of this evidence earlier this month, we concluded that there was, in the near term, room for greater monetary stimulus without putting pressure on capacity and inflation. Therefore, we lowered the Bank Rate by 50 basis points on March, bringing the total decline since January to 75 basis points. In taking this action, we also considered the uncertainties attached to the timing and extent of the expected recovery in the United States and their implications for growth of total demand in Canada. The Bank continues to believe that the reduction in our interest rates and rising disposable incomes, bolstered by recent tax cuts, should help to support the expansion of domestic demand in Canada in the second half of the year. This additional stimulus to economic activity is consistent with keeping the core rate of inflation close to the 2 per cent midpoint of the 1 to 3 per cent inflation-control target range. As for total CPI inflation, we still expect it to move down to about 2 per cent in the second half of 2001, assuming world oil prices remain at about current levels. Thus, as we look ahead through this year and into the next, we remain positive about the prospects for the Canadian economy. But, given the uncertainties, we will continue to closely monitor developments at home and abroad. Let me now conclude. The growing interdependence of national economies, massive capital flows, and new sources of potential risks in a globalized environment have brought into full relief the importance of sound macroeconomic policies and robust and efficient financial systems. Canada's monetary policy approach of inflation targets, a flexible exchange rate, and policy transparency has proven its worth through the difficult times of the past decade. Canadians can also take pride in a financial system that is universally acknowledged as sound and efficient. To keep it that way, we must ensure that as financial markets evolve, those of us charged with financial stability evolve with them. The Bank of Canada will continue to work closely with its domestic and foreign partners to strengthen financial stability at home and abroad. For to paraphrase John Donne: these days, no country is an island!

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Opening Statement before the Standing Senate Committee on Banking, Trade and Commerce

dodge

I appreciate the opportunity to appear before your Committee for the first time since my appointment as Governor of the Bank. On this occasion, I would like to touch on the Bank's contribution to good economic performance, our emphasis on openness and transparency, and our role in promoting domestic and global financial stability. I will then comment on the Bank's view of current economic conditions and discuss any issues you may wish to raise. The Bank of Canada has a commitment to contribute to the economic well-being of Canadians. This means conducting monetary policy so that it fosters sustained economic growth, by creating conditions favourable to rising investment, employment, and incomes and by bringing about a more stable macroeconomic environment. The unique contribution that the Bank can make to good economic performance is to preserve confidence in the future value of money. This means that Canadians should be able to go about their business secure in the knowledge that their central bank will do whatever it takes to keep future inflation low, stable, and predictable. The cornerstone of our monetary policy approach is an explicit inflation-control target. The current target range of 1 to 3 per cent, with emphasis on the 2 per cent midpoint, was established jointly by the Bank and the government under an agreement that runs until the end of 2001. An announcement regarding a new agreement to extend beyond 2001 will be made well before the end of the year. In a world that is subject to all kinds of shocks and with financial markets increasingly more open and globalized, monetary policy actions stand a better chance of being effective if they are more predictable and better understood by the public. That is why the Bank emphasizes transparency and effective two-way communication. In this context, I would like to highlight our latest initiative to improve public understanding of the Bank's actions. We have adopted a system of eight fixed dates each year when we announce decisions to change or maintain the Bank Rate and explain the reasons for our action in a press release. For a market economy like ours to function well, there must be widespread confidence not only that money will retain its value, but also that Canada's financial institutions, markets, and infrastructure are sound and efficient. Individuals and businesses must be confident that financial claims can be reliably and efficiently created, held, and transferred. This is why the Bank of Canada works closely with other federal and provincial entities to promote financial stability. The Bank focuses its attention mainly on macro financial stability issues. Our contribution includes the provision of liquidity to the financial system, the oversight of major clearing and settlement systems, policy advice to the government on the overall framework for the financial system, and collaboration with other domestic and international bodies that work on financial stability issues. In an increasingly interconnected world, we also must--and do--work with other members of the international community to promote the development of robust national financial systems and to prevent or minimize the impact of global financial crises of the sort experienced in the 1990s. Canada has a financial system that is recognized worldwide as being sound and efficient. To keep it that way, we must ensure that as financial markets evolve we evolve with them. The Bank will, therefore, continue to work closely with its domestic and foreign partners to strengthen financial stability at home and around the world. Let me now give you a quick overview of the economy. Since last fall, most forecasters have marked down their projections of world economic growth for 2001, from just over 4 per cent to just over 3 per cent. While 3 per cent may not be a stellar performance, it would still be quite respectable. In the United States, positive developments in such areas as employment and housing provide some hope that the end of the slowdown may not be far off. The Bank continues to believe that the pace of economic expansion in that country will strengthen during the second half of 2001, supported by the substantial decline in interest rates, the moderation in energy prices, and the drawing to an end of the current inventory adjustment. The exact timing of the recovery is uncertain, however, and will depend importantly on how U.S. consumer confidence and business investment evolve. In Canada, somewhat slower growth had been foreseen for 2001 as the economy was beginning to press against capacity. In fact, growth eased in the fourth quarter of last year. And with data for the first three quarters revised, the level of economic activity at the end of 2000 was not quite as high as we had estimated. Based on recent indicators, growth in the first quarter of 2001 will be less than in the closing months of last year. The slowing is clear in the automotive sector, where there have been production cutbacks in response to weaker U.S. demand and excess inventories. Activity has also eased--from very high levels--in electronics and telecommunications, where world production has been running ahead of demand. These three high-profile sectors naturally attract a lot of attention, especially in parts of Canada with a heavy concentration in such industries. Weakness also continues in sectors that produce non-energy commodities. But we must keep a sense of perspective. There is still considerable strength in other important areas of our economy. The latest data show that investments in the energy sector are very strong. And, except for autos, retail sales are solid. In addition, activity in housing, non-residential construction, and most other service industries remains firm. When we weighed all of the evidence in early March, we concluded that there was, in the near term, room for more monetary stimulus without risking pressures on capacity and inflation. On 6 March, we cut the Bank Rate by another 50 basis points, bringing the total reduction since January to 75 basis points. These lower domestic interest rates and rising disposable incomes, aided by recent tax cuts, should help to support the growth of domestic demand in Canada in the second half of 2001. This additional stimulus to economic activity is consistent with keeping the core rate of inflation in Canada close to the 2 per cent midpoint of the inflation-control target range. We see total CPI inflation moving down to about 2 per cent in the second half of 2001, if world oil prices remain around current levels. All in all, as we look ahead through this year and into 2002, the Bank remains positive about Canada's economic prospects. The recent volatility in exchange rates, both here in Canada and in many other countries, has generated considerable public commentary, and I would like to say a word about that. What we have been seeing is a strengthening of the U.S. dollar against all major currencies despite the marked slowdown in U.S. economic growth. Since the exchange rate is a key price in the Canadian economy, the Bank recognizes that movements in its value can be a source of concern for Canadians. I want to reassure you that the Bank watches market developments closely and carefully assesses the effects of currency movements on aggregate demand and inflation in Canada. In closing, Mr. Chairman, let me emphasize two points. First, although we expect reasonable growth to resume in the second half of the year, there are risks and uncertainties attached to this projection. These risks stem from global and, especially, U.S. developments. Although a moderation of U.S. demand was needed to sustain non-inflationary growth over the medium term, the slowing has been more abrupt than anticipated. As we look ahead, the question is how quickly will the necessary adjustments in production and inventories be completed in North America. My second point is that Canada's economic fundamentals are sound--in fact, they are the best they have been in nearly 30 years. Canada continues to benefit from a climate of low, stable, and predictable inflation. Canadian governments are running budgetary surpluses. Canada is running a record trade surplus. Federal and provincial governments are reducing their public debts. Canada is reducing its net foreign indebtedness. And there has been a surge in investment in equipment and technology that is essential for rising productivity and improved standards of living. Canada's strong fundamentals should operate in favour of the Canadian dollar over time. Moreover, corporate balance sheets are strong, financial institutions are sound, and credit markets are functioning well. Although consumer debt loads have increased, with rising incomes and lower interest rates households are in a better position to service those debts. In sum, Mr. Chairman, I believe that Canada is well placed to weather this period of economic adjustment. Given the uncertainties, however, the Bank will continue to monitor developments closely with a view to maintaining the low inflation that helps our economy to achieve its full potential.

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The Bank of Canada's Contribution to the Economic Well-Being of Canadians

dodge

Governor of the Bank of Canada I am glad to have this opportunity to talk to the Vancouver Board of Trade. I know that you are anxious to hear the Bank's views on the current economic situation, and I will have some comments on that later. But first I would like to talk about how the Bank contributes to good economic performance and how we promote financial stability here in Canada and abroad. The Bank's contribution to the economic well-being of Canadians The Bank of Canada has a commitment to contribute to the economic well-being of Canadians. In other words, we must conduct monetary policy so that it fosters sustained economic growth. Fundamentally, this means creating conditions that favour rising employment and incomes, strong investment, and a more stable macroeconomic environment. Low, stable, and predictable inflation The best contribution the Bank can make to good economic performance is to preserve confidence in the future value of money. This means that Canadians should not have to worry about the effects of inflation when they make everyday decisions as consumers, business people, savers, and investors. It means that they should be able to go about their affairs confidently, knowing that they can count on their central bank to do whatever is necessary to keep future inflation low, stable, and predictable. In this way, they will be able to make sounder economic decisions, which will lead to better performance for the economy as a whole and to - - rising incomes. Since the early 1990s, inflation in Canada has been low and stable. And economic activity has been expanding solidly over the past several years despite some major global disturbances. Of course, a low-inflation policy by itself is not sufficient. It must be complemented by other policies: policies that seek to improve the structure of our economy; policies that seek to enhance the skills and flexibility of our workforce; policies that seek to make Canadian product and labour markets more efficient. In addition, all levels of government must continue to reduce their net indebtedness. This is extraordinarily important if we as a nation are to become less vulnerable to external shocks and to prepare for the pressures of a shrinking working-age population. Inflation-control targets and a flexible exchange rate Let me now talk briefly about the role of the inflation-control targets and the floating exchange rate in Canadian monetary policy. Explicit inflation-control targets were jointly introduced by the Bank and the Government of Canada in 1991. Since 1995, the goal has been to hold the trend of inflation inside a target range of 1 to 3 per cent, with emphasis on the midpoint of 2 per cent. Inflation targets provide an anchor for policy and an anchor for people's inflation expectations. They supply the Bank with an effective mechanism for assessing and dealing with demand pressures in the economy in a way that reduces fluctuations in output. Here's how this 'stabilizer' feature of the targets works. If total demand was pressing on the economy's capacity to produce, so that the future trend of inflation looked likely to move towards the top of the target range, the Bank would tighten in order to reduce demand and inflation pressures. Equally importantly, in a symmetric fashion, if demand was weak and future inflation looked likely to move towards the bottom of the range, the Bank would ease, providing more room for the economy to expand. The basic point here is that the focus on inflation control allows the Bank to support growth when the economy is weak and to prevent overheating when the economy is strong and is pushing against capacity constraints. The other important element of our monetary policy approach is a flexible exchange rate. A floating exchange rate allows our economy to adjust to economic disturbances such as a sharp change in foreign demand for our products or a sharp movement in the relative - - price of our exports compared with our imports. In cases like these, movements in the relative value of the Canadian dollar help our economy to adjust with less fluctuation in output and employment than if the exchange rate did not move. And when our currency moves in response to those shocks, the inflation target helps to anchor expectations regarding its value in world markets. So the inflation target and a flexible exchange rate work well together--indeed they reinforce each other--under our current monetary policy framework. Effective two-way communication In an increasingly interconnected world subject to all kinds of shocks and uncertainties, delivering a monetary policy that is credible and effective has become quite a challenge. The Bank believes that greater openness and clear, two-way communication are important ways in which it can influence the economy, particularly at times of increased uncertainty. Put another way, our actions will likely be more successful if those we seek to affect--the financial markets and the general public--understand what we are up to and why. The Bank has made considerable progress in this area, and efforts will continue. Today, we provide large amounts of data and commentary on monetary policy in our regular publications and in speeches such as this one. Very importantly, we have also developed an excellent Web site that contains more than 5,000 documents touching on every aspect of our operations. It includes economic and financial data, research and analysis, speeches, and even an inflation calculator. I strongly urge you to visit our Web site, at www.bankofcanada.ca. I also encourage you to stay in touch with our regional offices across Canada. Our latest initiative to improve public understanding of the Bank's actions is a system of eight fixed dates each year for the announcement of decisions on the Bank Rate. This system has been in place since last December. I believe that it is working well because it allows all of us here in Canada to focus on our own unique economic circumstances. The Bank's contribution to domestic and global financial stability As I said before, widespread confidence that money will retain its value is crucial to sound economic performance. But a market economy like ours cannot function properly unless it is also supported by a strong financial system--that is, sound financial institutions, efficient financial markets, and a robust financial infrastructure. Canadians should be able to count on financial claims being reliably and efficiently created, held, and transferred. If the financial system is not robust, it can turn into a channel through which the effects of shocks--financial or economic--are magnified as they are transmitted from one part of - - the system to the next, within a country or between countries. The experience of the 1990s with the Mexican and the Asian financial crises showed us how this can happen. The echo of those events reverberated around the world. And, in both instances, Canada was sideswiped by the disturbance. So there are compelling reasons why all countries have to ensure that their financial systems function well. Here in Canada, the Bank works closely with other federal and provincial entities to promote financial stability. Bodies such as the B.C. Securities Commission focus on individual markets. But the Bank of Canada focuses mainly on stability issues from a broad, system-wide perspective. We contribute to financial stability in a number of ways. The Bank provides liquidity to the Canadian financial system. It oversees major clearing and settlement systems. It gives policy advice to the government on the overall framework for the financial system. The Bank also collaborates with other domestic and international bodies that seek to improve national financial systems and to prevent or minimize the impact of global financial crises. Canada's financial system is recognized worldwide as being sound and efficient. To keep it that way, those of us charged with promoting financial stability will have to stay one step ahead of today's rapidly evolving financial markets. The Bank of Canada will continue to work closely with its domestic and foreign partners to strengthen financial stability here in Canada and around the world. This completes my brief overview of the Bank's role in promoting monetary and financial stability. I now propose to turn to the current economic situation. Let me start with the external environment in which Canada operates. The sharp easing in the pace of economic expansion in the United States has caused most forecasters to scale back their projections of world economic growth for 2001. Compared with an average projection of just over 4 per cent last fall, we are now looking at something a little over 3 per cent--not spectacular, but still quite respectable. This forecast assumes that, after a weak first half, economic activity in the United States will strengthen in the second half. Some of the recent U.S. data (such as housing, motor vehicle sales, and industrial production) indicate that the economic situation there may be stabilizing. The Bank expects that, with stable or lower energy prices and with the inventory adjustment process well advanced, U.S. economic growth should strengthen during the second half of the year. The reductions in interest rates by the U.S. Federal Reserve should underpin this recovery. But of course, its exact timing - - and precise strength are difficult to predict. Here in Canada, our economy was, by last summer, beginning to press against capacity limits. Thus, somewhat lower growth was anticipated for 2001. But, with the abrupt slowing of the U.S. economy, growth in Canada began to slow significantly in the final quarter of 2000. And by mid-2001, the Canadian economy will probably be operating somewhat below potential--that is to say, below what it is capable of producing over the long run without adding to inflation pressures. This slowing in economic activity has not been uniform. Some high-profile sectors such as the automotive, electronics, and telecommunications equipment industries have been affected the most. And the prices for many non-energy commodities have been weak. It is this weakness that has had an important effect here in British Columbia. But to keep a sense of perspective, let us not forget that there is still considerable underlying strength in other areas of our economy. This is certainly true of the energy sector, where production and especially investments to increase capacity are in high gear. And retail sales have held up well. In addition, activity in housing, non-residential construction, and most other service industries remains firm in most parts of Canada. On balance, looking at the economy as a whole, the Bank concluded that there was room to provide additional support to total demand consistent with our objective of keeping inflation close to 2 per cent over the medium term. To return to my earlier point, this is exactly how the inflation target is working today to guide us in our actions to support growth at a time when total demand is weak. So last Tuesday (17 April), we cut the Bank Rate by a further 25 basis points to 5 per cent, bringing the total reduction in interest rates since January to 100 basis points. This means that the overnight rate here in Canada is now at 4 3/4 per cent. It is this rate that corresponds to the federal funds rate in the United States, which is now 4 1/2 per cent. Easier domestic monetary conditions, rising disposable incomes (boosted by recent tax cuts), continued business investment in new technology, and a pickup in U.S. growth should support a stronger economic expansion in Canada in the second half of 2001 and in 2002. Consistent with this profile for output growth, core CPI inflation will likely average somewhat less than 2 per cent over the remainder of this year, but move back up to 2 per cent towards the end of 2002. (Core CPI focuses on the CPI without its volatile food and energy components, and without the effect of changes in indirect taxes.) Total CPI inflation is still expected to move down to about 2 per cent towards the end of 2001, if world oil prices remain around current levels. The Bank's spring , which will be coming out on 1 May, will provide more detail on the economic outlook. - - The increased uncertainty surrounding global economic prospects has been reflected in recent developments in financial markets. Despite the marked slowing in economic growth in the United States, the U.S. dollar has strengthened against all major currencies, at least partly because global investors have sought the safety and liquidity of U.S. financial assets at a time of market uncertainty. Although the Canadian dollar has remained firm against other major currencies, the decline in its value against the U.S. dollar has once again generated considerable public commentary in this country. Since the exchange rate is a key price in our economy, the Bank recognizes that movements in the external value of our currency can be a source of concern for Canadians. I want to reassure you that we watch market developments closely. And we carefully assess financial market sentiment towards the Canadian dollar and the implications of movements in its value for aggregate demand and inflation in Canada. In closing, let me leave you with two key messages regarding our economic prospects. First, the Bank continues to expect a pickup in growth in the second half of this year and further strengthening in 2002. However, there are uncertainties attached to this scenario, mainly stemming from external--especially U.S.--developments. For example, there is a risk that the slowdown in the United States could be more protracted than anticipated. The Bank will have to monitor developments in this area closely. My second message is that there are good reasons to be positive about Canada's economic prospects over the medium term. We have established a climate of low inflation. Most Canadian governments are running budgetary surpluses. As a nation, we have a large trade surplus with the rest of the world, and we are reducing our net foreign indebtedness. Moreover, there are no serious speculative excesses in the economy. Corporate and financial sector balance sheets are generally healthy. Credit markets are functioning well. And although consumer debt loads have increased, with rising incomes and lower interest rates households generally are in a good position to service those debts. All this gives us a more solid basis to stand on as we go through this period of economic adjustment. And it provides a platform for future growth. The Bank's role is to target low inflation and to work with others to promote financial stability. As I explained before, by targeting inflation the Bank is providing appropriate support for growth in output and employment at this time of increased economic uncertainty.

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Opening Statement before the House of Commons Standing Committee on Finance

dodge

I am pleased to appear before this Committee for the first time since my appointment as Governor of the Bank, on the occasion of the release today of our spring . Mr. Knight and I hope to be able to return on the day of, or shortly after, the publication of our every May and November. provides our latest assessment of the outlook for economic growth and inflation in Canada. Before I give you a flavour of that assessment, I would like to say a word about the objective of Canadian monetary policy and how we go about achieving it. The Bank of Canada has a commitment to contribute to the economic well-being of Canadians. Thus, we must conduct monetary policy so that it fosters sustained economic growth by creating conditions that favour rising output, employment, and incomes, and a more stable macroeconomic environment. The unique contribution that the Bank can make to sound economic performance is to preserve confidence in the future value of money. Canadians should be able to go about their business fully expecting that their central bank will keep future inflation low, stable, and predictable. In this way, they will be able to make sounder economic decisions. And this will lead to better overall economic performance. The Bank pursues low inflation within a monetary policy framework based on an inflation-control target and supported by a flexible exchange rate. The current target is to hold the trend of inflation inside a range of 1 to 3 per cent, with emphasis on the midpoint of 2 per cent. Inflation-control targets help to anchor policy and to anchor people's inflation expectations. And they provide the Bank with an effective mechanism for assessing demand pressures. In this way, we can take action to prevent overheating when the economy is strong and is pushing against capacity limits, and to support growth when the economy is weak. At the same time, a flexible exchange rate allows our economy to adjust to disturbances, such as changes in foreign demand for our products or changes in the relative prices of our exports compared with our imports. And it helps us to adjust with less overall fluctuation in output and employment than if the exchange rate did not move. With this brief overview of Canada's inflation-control strategy, let me now turn to the economic situation. When my predecessor appeared before you in May 2000, our economy was growing vigorously, bolstered by strong domestic and U.S. demand. Indeed, with signs of emerging capacity pressures, and with the need to sustain non-inflationary economic growth in Canada, the Bank raised interest rates the day after our appearance before this Committee. These higher interest rates led to some cooling off in domestic demand in Canada. What we, and most other analysts, did not anticipate was the abrupt slowing in U.S. economic growth. This is the factor that has contributed to a greater-than-expected moderation in economic activity in Canada. Since February, the Bank has been saying that we expect growth in the first half of this year to be very modest. And we have indicated that, by the middle of 2001, the Canadian economy will probably be operating somewhat below potential. Overall, the information received to date is broadly in line with the Bank's expectations. The monthly numbers have been volatile: some have been weaker and some have been stronger than anticipated. But they are generally consistent with our view that the weakness in the first half will be mainly associated with inventory adjustments in markets facing soft demand--in particular, motor vehicles--and with adjustments in other industries--notably electronics and telecommunications equipment. The Bank continues to believe that, after very modest growth in the first half of 2001, economic activity in Canada will pick up in the second half and strengthen further in 2002. Let me explain what we are basing this on. Despite lower production in the three high-profile sectors I just mentioned, aggregate economic activity continues to grow, buttressed by underlying strength in other areas, including the energy sector, retail sales, housing, non-residential construction, and most service industries. Supported by recent tax cuts that boost disposable income, final domestic demand should continue to expand. And we expect a recovery in foreign demand in the latter part of the year, encouraged by the substantial reductions in U.S. interest rates. Nonetheless, there are uncertainties about the exact timing and strength of the pickup in U.S. growth. Here in Canada, we have lowered interest rates significantly to support growth in total demand in line with our objective of keeping inflation close to 2 per cent over the medium term. Since January, the Bank of Canada has cut rates by a total of 100 basis points, bringing the overnight rate--the rate that corresponds to the U.S. federal funds rate--down to 4 3/4 per cent. With this monetary easing and with the strengthening in the pace of economic activity in the second half of the year, we now project annual average growth of between 2 and 3 per cent in 2001. For next year, we see output expanding at a rate slightly above the Bank's estimate of potential output growth of 3 per cent. Consistent with the Bank's expected path of output growth, core CPI inflation will likely average somewhat below 2 per cent over the remainder of 2001, then move back up to 2 per cent by the end of 2002. Total CPI inflation is expected to be volatile over the next few months, before moving down to about 2 per cent by the end of the year if world energy prices remain close to current levels. I would now like to say a word about recent developments in financial markets. These developments have essentially reflected the increased concerns and uncertainty surrounding world economic prospects. In the circumstances, global investors have, once again, sought the safety and liquidity of U.S. financial assets. And this has led to an appreciation of the U.S. dollar against all major currencies despite the marked economic slowdown in that country. Although the Canadian dollar has remained firm against other major currencies, the decline in its value against the U.S. dollar until just recently has been the subject of much public commentary in Canada. Since the exchange rate is a key price in our economy, the Bank recognizes that movements in its value can be a source of concern for Canadians. I want to assure you that the Bank monitors market developments very closely. And we carefully assess the implications of currency movements for aggregate demand and inflation in Canada. In closing, let me reiterate that the Bank remains generally positive about Canada's economic prospects in the period ahead. We continue to expect a pickup in growth in the second half of this year and further strengthening in 2002. The main risk to this outlook is the timing and strength of the projected pickup in U.S. growth. Given this uncertainty, we will continue to monitor developments closely and we will respond appropriately.

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Canada's Monetary Policy Approach: It Works for Canadians

dodge

Governor of the Bank of Canada to the Edmonton Chamber of Commerce I welcome this opportunity to talk to you today. In recent months, the debate over Canada's exchange rate system has heated up and calls for the adoption of a common currency with the United States have attracted a lot of attention. Today, I would like to revisit the issue of the appropriate exchange rate regime for Canada and to set out as clearly as possible the Bank's position. I propose to frame my discussion in terms of Canada's approach to monetary policy. I will conclude with some comments on the current economic situation. The goal of monetary policy and how to achieve it The Bank of Canada's commitment is to contribute to the economic well-being of Canadians. This means conducting monetary policy so that it fosters sustained economic growth--by creating conditions that favour rising output, employment, and incomes, and a stable macroeconomic environment. Low, stable, and predictable inflation Experience over time and across countries has taught us that the best contribution monetary policy can make to a sound economy is to preserve confidence in the value of money. Fundamentally, this means that Canadians should be able to count on their central bank to keep future inflation low, stable, and predictable. In this way, they can go confidently about their affairs, making sound economic decisions. This, in turn, should lead to better economic performance nationally. Seen in this light, the focus on low inflation is not an end in itself, but rather a means to an end--the end being the advancement of the economic well-being of Canadians. Of course, a low-inflation policy by itself is not sufficient to guarantee the best economic outcome for Canada. Fiscal prudence and other policies that aim to improve the structure and flexibility of the economy are also essential. But low inflation provides a crucial underpinning to a well-functioning economy. If the goal of monetary policy is to achieve and preserve low inflation, how would the central bank go about it? Anchors for monetary policy When a central bank raises or lowers its key policy interest rate, it sets in motion a series of events that starts with the financial markets, works through changes in spending, output, and employment, and ends with an effect on the rate of inflation. This series of events is known as the transmission mechanism of monetary policy. The problem is that the transmission process is lengthy. So it takes time for monetary policy actions to affect output and inflation. Some effects are felt relatively quickly. But the full effects are not felt for some time--3 to 6 quarters in the case of output and 6 to 8 quarters in the case of inflation. This means that, as central bankers go about their day-to-day business of implementing monetary policy, they must look ahead and anticipate what is likely to happen down the road. They have to work with assumptions and make judgment calls about future economic developments and about the timing and final outcome of any monetary policy action they take. All of this involves considerable uncertainty. This being said, as we look around the world, there have been different ways to focus the conduct of monetary policy and to give people greater comfort that things are on track, thus helping to tie down or "anchor" inflation expectations. Most countries have now adopted some kind of explicit target or anchor for monetary policy. The major exception is the United States, where a statement of general intentions with respect to inflation has, in recent years, proven sufficient to anchor monetary policy, in light of the U.S. Federal Reserve's strong credibility. In terms of explicit anchors, there have been targets for monetary aggregates, fixed exchange rates, and inflation targets. . . . targeting monetary aggregates Most industrialized countries, including Canada, have in the past tried to target the rate of money growth. However, in both Canada and the United States, targets for money growth have not proven to be an effective monetary anchor. Deregulation and financial innovation have weakened the reliability of money measures, and the relationship between money growth and the rate of inflation has proven unstable. But we still look at money for its information content about current and future developments in output and inflation. For all practical purposes, then, there are only two options today in terms of explicit anchors for monetary policy: fixing the exchange rate or targeting inflation. . . . fixing the exchange rate For many countries, especially smaller ones, tying their currency to that of a larger neighbour or major trading partner with a history of low inflation is one way to achieve a low rate of inflation. There are, of course, different forms of fixed exchange rates. They can range from 'softer' systems--such as a peg--to 'harder' fixes that lie at the opposite extreme from a free floating currency. These harder fixes can be a currency board, the outright use of another country's currency ("dollarization"), or a full monetary union. Pegged exchange rates that can be adjusted (that is, revalued or devalued) have been the most widely used anchor since the Second World War. They were the prevailing order under the Bretton Woods system, which was established after the war and lasted until the early 1970s, when it finally collapsed in the face of increasingly open financial markets, large capital flows, and U.S. expansionary policies. The problem with a fixed, but adjustable, exchange rate is that it does not guarantee that the value of the currency relative to other currencies, and thus its purchasing power, will not rise or fall. For example, the currency could come under downward pressure if it is pegged at a level that is out of line with the country's economic situation (say, because of large and growing fiscal deficits and debts). Should the markets then begin to question the authorities' commitment to the peg, domestic and foreign investors would scramble to get out, triggering a currency crisis. There is no shortage of such examples in recent history: repeated episodes in Latin America since the 1980s, crises in Europe in 1992 and 1993, Because pegs have proven problematic, a more realistic approach would involve adopting one of the more rigid fixes. I will have more to say about this later. But let me move on now to the third option for an explicit monetary policy anchor--inflation targets. . . . targeting inflation Among a number of industrialized countries that, like Canada, are operating a floating currency, there has been a tendency over the past decade to adopt explicit inflation targets as the anchor for monetary policy. The same tendency is now evident among a growing number of emerging-market economies that have recently moved to flexible exchange rates following the collapse of their pegged rates. The objective is to consistently maintain low and stable inflation, while the flexible exchange rate helps the economy to adjust to shocks. Why inflation targets and how do they work to guide monetary policy? In such a framework, the central bank targets the rate of inflation--say, 2 per cent--several quarters ahead. Then, based on its judgment of the current and projected strength of demand relative to the economy's production capacity, as well as the implications for future inflation relative to the target, it will take action now--because of the long lags involved--to ensure that the target is achieved down the road. The value of the inflation target as an anchor: the Canadian experience In Canada, explicit inflation targets were jointly introduced by the Government of Canada and the Bank of Canada in 1991. Since 1995, the goal has been to keep the trend of inflation inside a target range of 1 to 3 per cent. In adopting the targets, the Bank expected that they would provide a useful framework within which to assure Canadians that inflation would remain low and stable, thus leading to less fluctuation in output and employment. We also expected that the targets would provide a precise goal against which to measure the conduct of monetary policy, thus helping to increase the Bank's public accountability. After a decade of experience, it is clear that inflation targeting has proven to be an effective way of keeping inflation low, and that an inflation target provides an anchor for inflation expectations. Moreover, that target has supplied the Bank with a mechanism for assessing, and dealing with, demand pressures on future inflation in a way that helps to keep the economy on a more even keel. Indeed, there is already some evidence that the pronounced ups and downs in economic activity, so typical of the past, have diminished. Here's how the target helps the Bank to 'stabilize' the economy. When demand pushes against the economy's capacity to produce and seems likely to put upward pressure on future inflation relative to the target, the Bank will raise interest rates. This will help to moderate demand and reduce inflation pressures. Equally importantly, when demand is weak and seems likely to put downward pressure on future inflation relative to the target, the Bank will lower interest rates, thus providing more room for the economy to expand. In short, the emphasis on inflation control allows the Bank to support growth when the economy is weak and to prevent overheating when the economy is strong and is pushing against capacity constraints. Now, this goes back to what I was saying at the beginning--that monetary policy contributes to sound economic performance by means of its focus on low inflation. With a low-inflation climate encouraging further initiatives by Canadian businesses to improve cost control, efficiency, and productivity, and with marked fiscal progress by all levels of government, our economy has performed well over the past several years. And it has generated solid gains in employment and incomes. In light of the important economic and social benefits that low inflation and inflation targets have delivered, the federal government and the Bank of Canada recently agreed to retain the current target of 1 to 3 per cent. To increase the chances that inflation stays inside that range, the Bank will now be aiming expressly at the 2 per cent midpoint. Moreover, the new agreement runs for five years, instead of three, to the end of 2006. Both of these changes should help to increase predictability and to reassure Canadians that low inflation will be a continuing feature of the domestic economic scene. Now, let us see how the exchange rate fits in all this and why Canada needs a floating currency. Why do we need a floating exchange rate? If we want to set our own goal for inflation or, what's more relevant (since today all industrial countries pursue a similar low-inflation objective), if we want to run a monetary policy suited to our own distinct economic circumstances, we need monetary independence. Monetary independence can exist only within a flexible exchange rate system. The real value of a floating currency for Canada lies in helping our economy to absorb some of the impact of external shocks. A classic example would be a sharp movement in the value of our exports relative to our imports, such as occurred in 1997-98, when world commodity prices plummeted in the wake of the Asian crisis. In that instance, a downward movement in the value of the Canadian dollar helped offset some of the losses suffered by our commodity producers. More importantly, it strengthened the competitiveness of Canadian manufacturers. They, in turn, were able to expand production and offset some of the downward pressure on output and incomes from the decline in the commodity sector. In this way, our national economy was able to adjust more quickly, and with less overall fluctuation in output and employment, than if the exchange rate did not move. Consider what would have happened under a fixed exchange rate. With the exchange rate not allowed to move, domestic wages and prices would have had to decline to restore external competitiveness. And since neither wages nor prices are flexible enough to adjust quickly, much of that adjustment would have had to come through declines in output and employment. In a world where capital is free to move across national borders, a floating exchange rate can also help to absorb some of the pressures stemming from large capital flows and to facilitate any necessary economic adjustments. Indeed, I would remind you that the decision to float the Canadian dollar in 1950, and again in 1970, was taken in the context of large capital inflows (and rising commodity prices) that were causing concerns about their inflationary effects on our economy and were putting strong upward pressure on our currency. The key point in all this is that Canada cannot insulate itself from external shocks. Whether we are on a flexible or a fixed exchange rate, the reality is that those shocks require a domestic adjustment. And, in the end, that adjustment will be made--one way or another. But, without the flexibility a floating currency can provide, it will take longer, be more difficult, and cost more overall in terms of lost output and jobs. Now, when the exchange rate moves up or down, there has to be some way to anchor expectations about its value. Otherwise, the freedom of the currency to float could, in the context of a downward movement, undermine confidence in its value on world markets and at home. Under our approach to monetary policy, the domestic inflation target serves as that all-important anchor for the exchange rate. The inflation target and a floating currency work well together--indeed, they reinforce each other. And they both have very significant economic benefits for Canada. These days, the advantages of a monetary policy approach based on inflation targets and supported by a flexible exchange rate regime are being increasingly recognized by others around the world. And Canada is often held up as a model. Why then the calls in this country to go back to pegging our currency to the U.S. dollar or to enter into a currency union with the United States? Pegging would mean losing the macroeconomic benefits of a flexible exchange rate, without gaining the assurance that the exchange rate will not move in the future. So what people are talking about now is a currency union with the United States. On the face of it, the prospective gains from such an arrangement would seem to be attractive. After all, Canada is one of the most open economies in the world, exporting over 40 per cent of its output and importing about as much. Moreover, 80 per cent of this trade is with the United States. So, yes, by adopting the U.S. dollar, Canadians could save on the transactions costs of converting national currencies and hedging against currency movements. There could also be some other advantages linked to the improved efficiency that can result from reduced exchange rate uncertainty. The crucial question, however, is whether the savings from such an arrangement would compensate for the loss of monetary policy independence and for the loss of the buffer that a flexible exchange rate provides against economic shocks. Research by the Bank of Canada and by many outside analysts confirms that Canada benefits significantly from having a separate currency and a floating exchange rate. It is true that Canada and the United States share many characteristics. But when it comes to economic structure, there are many important differences. Not only is our economy far more open than that of the United States, but Canada is also more dependent on raw materials. Moreover, while we are net exporters of primary commodities, the Americans are net importers. Sharp swings in world commodity prices have a much greater impact on economic activity in Canada and, more importantly, they affect us differently than our neighbours. It is very clear that the structure of our economy is sufficiently distinct from that of the United States that a flexible exchange rate can play a key role in facilitating the domestic economic adjustment to such shocks. From a strictly economic perspective, it is always possible that, at some future time, the structures of our two economies could converge to a point that the benefits of a common currency could outweigh the macroeconomic costs of abandoning our flexible exchange rate. But it is also possible that those structures could diverge further (if more trade led to greater specialization). We simply do not know. I would emphasize, however, that the crucial factor here is not the extent of the integration between Canada and the United States, but rather how close or how far apart our economic structures are, or will be. Former Bank of Canada Governor Thiessen put it well last December when he said that "as long as we remain a major producer of primary commodities, and as long as we want to pursue separate economic policies that are suited to our own circumstances and that require differing monetary conditions, the shock-absorber element of a floating currency will serve us well." I fully associated myself with this view during my appearance last month before the House of Commons Standing Committee on Finance. I said: "it's quite clear that at this stage in our evolution, a floating currency for Canada vis-a-vis the United States . . . is a great advantage because the structures of our economies differ." Thus, one may not argue that, for all time and under all circumstances, a floating currency will be the right solution for Canada. But, what I can say is that, given the structure of our economy, for now and for as far into the future as I can see, the advantages of a flexible exchange rate, anchored by a domestic inflation target, clearly outweigh the benefits of a currency union. And they will certainly always outweigh those of a peg. I hope that I have made it clear today that Canada's monetary policy approach of a flexible exchange rate, anchored by an inflation target, works. There is no need to fix it. Let me now conclude my presentation by giving you our latest reading of the economy. Since late last year, the pace of economic expansion in Canada has slowed substantially, mainly because U.S. demand for our products has been much weaker than anticipated. Canadian manufacturers, particularly of motor vehicles, electronic products, and telecommunications equipment, have had to make very significant adjustments. At the same time, final domestic demand in Canada has remained firm, buttressed by underlying strength in the energy sector, retail sales, housing, nonresidential construction, and most service industries. National accounts data to the end of March and more recent indicators show that our economy has been expanding at a moderate pace since the last quarter of 2000. As we look ahead, we see domestic demand in Canada continuing to grow, supported by the easing that has taken place in monetary conditions, the recent tax cuts that are boosting disposable incomes, gains in employment, and the projected completion of the current inventory adjustment. We also continue to see U.S. demand growth picking up in the second half of 2001, given substantial reductions in interest rates, relatively high levels of consumer spending, the expected end of the inventory correction, and recently announced tax cuts (which include rebates beginning in July). But because of the ongoing weakness in U.S. capital investment, there is still uncertainty about the exact timing and strength of the projected pickup in U.S. growth in the second half of the year. While that uncertainty poses some risks for Canada, we continue to expect that the pace of economic expansion here will pick up in the second half of the year and strengthen somewhat further in the course of 2002. Total CPI inflation has recently been above the top of the Bank's 1 to 3 per cent target range because of rising energy prices, including higher electricity rates. Total CPI inflation will probably remain volatile over the next couple of months, before moving down to about 2 per cent by the end of the year, if world prices for crude oil and natural gas stabilize around current levels. The main risk to the Canadian economic outlook continues to be the possibility that the projected pickup in U.S. growth may be delayed. At the same time, even though the prices of crude oil and natural gas have eased from their recent peaks, the Bank will need to stay alert to any signs of energy costs spilling over into other consumer prices, and thus putting upward pressure on the trend of inflation. In light of these risks, the Bank will have to continue to monitor the situation very carefully. In sum, the Bank remains positive about Canada's economic prospects. We continue to expect that the economy will grow by between 2 and 3 per cent this year and return to a somewhat higher growth path in 2002. This judgment is based on recent evidence that is broadly in line with the Bank's expectations. And it is supported by the marked improvement in our economic fundamentals, which gives Canada a very good chance to weather the current economic difficulties.

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Current Developments in the Canadian Economy

dodge

Governor of the Bank of Canada For reasons explained in our media advisory of 17 September, the annual out-of-town meeting of the Bank's Board of Directors that was to take place on 19 September in Moncton was held in Ottawa instead. A scheduled speech by Governor Dodge to the Moncton Chamber of Commerce was postponed. The following is the section of that speech dealing with current economic developments. Right now, last week's tragic events in the United States are uppermost in people's minds. Like millions of people around the globe, Canadians are very concerned about the situation. We all share in the sheer horror of what has happened. In circumstances like these, part of our job as Canada's central bank is to respond by addressing the financial needs of the country. That is why the Bank of Canada, like other major central banks, moved swiftly last week to provide liquidity to ensure that financial markets continued to function effectively. In addition, the Bank of Canada and the U.S. Federal Reserve agreed to temporarily increase the amount of their existing swap facility to provide liquidity in U.S. dollars to Canadian banks, should they need it to settle their U.S. dollar transactions. And this past Monday, we took action to counteract potential effects on confidence in the aftermath of the extraordinary events in the United States, by lowering our key policy rate outside our normal schedule of announcement dates. Clearly, the events in the United States have increased the uncertainty surrounding global economic prospects in the short run. It is important, however, that we look through the short term to the longer-term trends and potential of our economy. The first decade of the twenty-first century will continue to bring to Canada and to the rest of the world important technological changes--changes that will transform our economies through the widening application of new information, communications, and other general-purpose technologies. This transformation can be expected to raise the potential of our economy to grow and to generate income gains in the decade ahead. Once the cyclical forces that are currently constraining investment and innovation are behind us, we should see productivity and income gains from past investments and adjustment. And the way will be clear for further innovation and growth. In addition, Canada has made great progress over the past decade in strengthening its economic foundations: low inflation has been firmly established; the fiscal health of governments has been largely restored; and Canadian businesses have undertaken major restructuring. Thus, the medium-term outlook for growth in output, employment, and incomes in Canada is very favourable. Let me now put the short term in perspective. Around this time last year, both the Canadian and the U.S. economies were pushing against, or through, their capacity limits. Because of that, some slowing was anticipated, and indeed was desirable, to keep inflation in check. However, the economic slowdown in the latter part of 2000 was more abrupt than had been foreseen, especially in the information and communications sectors. At the beginning of 2001, the Bank of Canada expected that the economic slowdown in this country would continue through the first half of the year and that inflationary pressures would therefore be reduced. Thus, we began to lower interest rates. We also expected that, as the process of adjusting inventories and excess capacity was completed in most industries, capital spending in the United States, which had been sharply curtailed, would begin to recover in the second half of 2001. With the pace of economic expansion thus picking up in the United States, we expected that growth in Canada would also rebound--to above the growth of the economy's production potential--during the first half of 2002. Consequently, the small output gap that had opened in 2001 would begin to close. The economic data received through last winter and spring were broadly consistent with this scenario, and the pace of monetary easing was set accordingly. By mid-summer, however, evidence began to accumulate that the U.S. slowdown would be more protracted than anticipated and that economic activity outside North America would be much weaker. At the same time, there were indications that domestic demand in Canada, which had held up well through the first part of the year, was softening. In view of these developments, at the time of our last fixed announcement date, on August, we revised down our expectations for economic growth in the period ahead. We projected that output growth in the second half of 2001 would be only slightly stronger than in the first half. The pace of economic expansion would then start to gain momentum in the first half of 2002 and would move above potential growth in the second half. This meant more economic slack going into next year than we had previously anticipated, and it would take longer to absorb. In these circumstances, the Bank lowered interest rates again, at the end of August, to support domestic demand growth and to keep inflation near the target of 2 per cent over the medium term. And in our press release of 28 August we indicated that, given the continuing uncertainties in the global economy, particularly the timing and strength of the recovery in investment in the United States, and the uncertainty surrounding domestic demand growth in Canada, we would continue to monitor developments closely. Last week's tragic developments in the United States, and their reverberations around the world, obviously bring with them further uncertainty with respect to the timing and extent of a rebound in economic activity. Although it is too early to fully assess the likely consequences for our economy, the Bank's initial efforts involve trying to estimate the direct effects of disruption in sectors such as transportation, finance, and tourism. The terrorist attacks on the United States will also affect consumer and business confidence worldwide, including here in Canada. It is precisely for this reason that we moved promptly this week to lower interest rates by one-half of one percentage point. This action, which leaves short-term interest rates 2 1/4 percentage points lower than at the beginning of the year, aims to provide further support for economic growth in Canada. The Bank also recognizes that a key factor in preserving the confidence of Canadians in the prospects of our economy is a financial system that continues to function effectively. That is why, as I said earlier, we took steps, together with the other G-7 central banks, to inject liquidity into the financial system to support its smooth functioning in the wake of the tragic events in the United States. We stand ready to do so whenever necessary. But it is encouraging that at this juncture, with each passing day, we seem to be moving back to a more normal state of affairs in the financial system. Right now, it is difficult to look too far ahead in terms of the economic implications for Canada of last week's events. Nevertheless, economic growth in the third quarter will likely be close to zero or slightly negative, and we will continue to feel the adverse effects into the fourth quarter. With the economic slack that is opening up, we continue to see core inflation falling to about 2 per cent by year-end. We also project that total CPI inflation will drop to close to 2 per cent over the same period, assuming that energy prices remain near current levels. There is a risk that world oil prices could rise sharply, depending on the fallout from last week's events. A more complete analysis of the impact of last week's events on the Canadian economy, including the effects on output and inflation in 2002, will be carried out as we prepare for our next policy announcement on 23 October. This analysis will be presented in our . Clearly, there are adverse effects that need to be assessed, but there will also be offsetting factors, from such activities as rebuilding in the United States and a return to more normal operations in both Canada and the United States, that need to be considered. Given the uncertainties surrounding all these elements, there will be a wider-thanusual confidence band around the economic outlook for next year.

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The Canadian Economy: Current and Future Challenges

dodge

Canada and to keep inflation close to the 2 per cent target over the medium term. Governor of the Bank of Canada and the Conseil economique du Nouveau-Brunswick It's a pleasure to be talking to you today, although I wish these were happier times. All of us at the Bank of Canada share a deep sorrow at the loss of so many lives in the September terrorist attacks in the United States. Among those who died were innocent citizens of many nationalities, including Canadians. To their families, friends, and colleagues we extend our heartfelt sympathy. As we strive to come to terms with this tragedy and its implications for all of us, we are tremendously encouraged by the co-operation, solidarity, and determination that are abundantly evident both at home and in the international community. Through this time of anxiety and uncertainty, we at the Bank of Canada will continue to fulfill our responsibility to support the economic well-being of Canadians and to promote the stability of the domestic and international financial systems. As we all struggle to fathom the dimensions of this tragedy and to get a measure of its immediate economic effects, it is important that we look through the short term to the longer-term trends and the potential of our economy. If we are to solidify our economic performance in the years ahead, we cannot lose sight of the challenges we must meet as a nation. Those longer-term challenges are my main topic for today. Of course, in the current circumstances, there are also important near-term challenges for monetary policy. So I will conclude with a brief discussion of the current economic situation and the steps that the Bank is taking to support domestic demand in Canada. Let me start with the longer-term challenges. The past decade was a watershed for the Canadian economy. Low inflation was firmly established, fiscal health was restored, and Canadian businesses undertook major restructuring. In short, we made remarkable progress in improving our economic performance. Let me quickly review that progress, starting with the achievement of a credible lowinflation record. . . . establishing a record of low and stable inflation Since the early 1990s, the focus of Canadian monetary policy on low, stable, and predictable inflation has helped to anchor inflation expectations and to reduce the ups and downs in economic activity. Canadians have been able to make spending, saving, and investment decisions with greater certainty, knowing that their central bank will hold the line on future inflation and that the economy will be more stable. . . . restoring fiscal health But low inflation, although essential to good economic performance, is not sufficient by itself. It has to go hand in hand with prudent fiscal management. Since the early 1990s, Canada has also taken action to put its fiscal house in order. And this is paying dividends. Wiping out deficits at all levels of government has helped to bring about low interest rates and relatively more stable financial markets. . . . undertaking business restructuring and embracing open markets Low interest rates and greater confidence about the future have, in turn, encouraged Canadian firms to undertake important restructuring initiatives to meet the challenges of sweeping worldwide technological change and intensely competitive global markets. Over the past decade, these restructuring efforts have taken place against a backdrop of sustained efforts to open up our economy even further. Indeed, building on the trade agreements that we forged in the late 1980s and early 1990s, such as the North American Free Trade Agreement (NAFTA), we have significantly increased our involvement with the world economy. Altogether, it is clear that, over the past decade, we in Canada have done a lot to strengthen our economic foundations. Because of this, we are now better positioned than we have been in a long time to weather economic turbulence and to take on new challenges. But, in a rapidly changing, increasingly competitive world, "they who stand still, fall behind." If we are to seize the opportunities out there in the global economy, we have to continue to move forward and make further progress. Before I focus on the new things we need to do to facilitate progress in the future, let me stress how important it is that we maintain the strong base on which everything else rests--sound macroeconomic policies. . . . sound macroeconomic policies Fostering a climate of low, stable, and predictable inflation is the best contribution monetary policy can make to good economic performance over the medium term. The Bank of Canada is carrying forward its commitment to preserve confidence in the future value of money--that you can bank on! On the fiscal side, it is critical that our public finances remain healthy and that all levels of government continue to reduce their net indebtedness over time. A declining public debt relative to the size of our economy will make us less vulnerable to external shocks. But I hasten to add that I do not mean to suggest that we should not let the "automatic stabilizers" work when faced with an economic shock. (These stabilizers are the built-in features of revenues and expenditures that work to offset economic fluctuations. For example, in an economic downturn, tax revenues automatically go down and some expenditures, such as employment insurance payments, automatically go up.) Let us remember, however, that it is because of the progress we have made over the past decade in restoring healthy public finances that we can now afford to let these automatic stabilizers work. Now, sound macroeconomic policies, while necessary, are not sufficient if we are to improve the structure and performance of our economy in coming years. I would like to think through with you what other policies and steps we might need. As we look ahead, the one thing we can be sure about is that world markets for goods, services, and finance will become more and more globalized and competitive. Canada, as a very open economy, must operate in full recognition of that fact. In particular, in light of the heightened security concerns in the United States, it is important that we all work to facilitate the continued flow of goods and services between our two countries. Beyond this issue, there are many challenges for all Canadians. But there are also new opportunities for our firms to increase their global reach and to reap the benefits of large-scale production--provided they pursue new initiatives to enhance productivity and find more efficient ways to deliver products and services to domestic and foreign customers. This is where innovation enters the picture. . . . exploiting the potential of new technologies The world is in the midst of far-reaching changes--changes that are transforming national economies and societies around the world through the widening application of new information and communication technologies. And more change is on the horizon--change that will come from dramatic advances in biotechnology and nanotechnology. Technologies like these take time to spread and spawn new applications across a broad range of economic sectors--pretty much like the electric motor did in the past. But to realize the full potential of these new applications, major changes in the organization of a firm, of an entire sector or, indeed, of a whole economy, are often necessary. It is the combination of these applications and adaptations that leads to rising productivity and rising incomes. Like many other economists who have studied these issues, I am optimistic that, over the next couple of decades, productivity will grow significantly faster than it did from 1975 to 1995, although perhaps not as fast as in the high-growth years of the 1950s and 1960s. But while experience shows that innovations take time to diffuse widely, it is important to remember that the prime opportunities go to those firms and those economies that are quick to take advantage of the new realities. Through the first half of the 1990s, Canada lagged behind the United States in making the investments that are necessary to take advantage of new technologies. But since 1996, there has been a surge in such investments in Canada. And in the last couple of years, we were beginning to see the first signs of a productivity payoff. Once the prevailing global uncertainty and the cyclical forces that are now constraining output and investment growth in Canada dissipate, we will likely see more efficiency gains from those past investments and more capital spending on innovations. And once the necessary adjustments are made to deal with the need for heightened security, those innovations will mean rising standards of living for Canadians. . . . redesigning organizational structures and upgrading skills But, as I just said, to benefit fully from technology, changes and improvements in the structure of our economy and in the way we run our businesses are necessary. At the company level--and that applies also to government departments and to the Bank of Canada--this means organizational changes and changes in management and work practices. It also means upgrading skills. Simply installing state-of-the-art equipment will not be enough. And it will, most certainly, not deliver efficiency and productivity gains if organizational structures and management practices are outmoded and if workers do not know how to use the new technology to advantage. Some of these issues will no doubt sound familiar to many of you here in the Atlantic provinces, where considerable effort and progress have been made in recent years to diversify the regional economy and to move into areas that make greater use of new technologies. And this is especially clear here in Moncton where, over the past decade, you have enjoyed the strongest employment growth in the province--12,000 new jobs created since 1990--thanks to your ability to attract call centres and other information-technology companies. . . . enhancing productivity Now, the reason for adopting new technologies, revamping management and work processes, and upgrading labour skills is that we, as a nation, can become more efficient and more productive. Productivity growth is the key to rising real incomes and improved standards of living over the longer run. But, you may ask, how does monetary policy fit in all this? And what can the Bank of Canada do to promote higher productivity and rising real incomes? An increase in real incomes is a key component of the good overall economic performance that the Bank aims at through a policy focused on low inflation. The Bank supports initiatives to improve productivity by delivering a climate of low and stable inflation that encourages well-informed, long-term business decisions, including decisions to invest in new high-tech machinery, equipment, and software. . . . ensuring that Canada's financial system and markets work efficiently The Bank also concerns itself with another factor in supporting good economic performance--a sound, innovative, and efficient financial sector. A stable, highly developed financial sector helps to channel savings into investments and allocates capital efficiently. This is particularly important in these times of rapid technological change, when we want companies that plan to adopt new technologies to have access to proper financing. But of course, we also want to ensure that this is done in a way that preserves the stability of the financial sector. Appropriate safeguards and sound policies aimed at fostering financial stability improve overall economic performance. The Bank of Canada is helping to promote financial stability in a number of ways. Here at home, we oversee major payments systems and provide ordinary and emergency liquidity to the financial system. We also work with other federal entities and provincial securities commissions to ensure that financial markets function well. And through international organizations, such as the Bank for International Settlements and the International Monetary Fund, we work with other central banks and financial regulators around the world to promote global financial stability. There are other medium-term issues that we could usefully spend time discussing. But given that time is limited, I would now like to turn to the current economic situation and the near-term challenges for monetary policy. Even before last month's events in the United States, evidence had begun to accumulate that the economic slowdown in that country would be deeper and last longer than had been widely expected. By mid-summer, economic activity outside North America had also begun to show more clearly the effects of weaker U.S. growth and of the ongoing global retrenchment in the information and telecommunications sectors. At the same time, there were signs that domestic demand in Canada, which had held up well through the first part of the year, was softening and that the inventory adjustment, particularly in the electrical and electronic sectors, still had some way to go. This evidence, which had been accumulating through the summer, led the Bank to scale back its previous expectations for economic growth during the second half of 2001 and the first half of 2002. Consequently, on 28 August, we lowered interest rates to support domestic demand growth and to keep inflation near the target of 2 per cent over the medium term. The events of 11 September, and their repercussions around the world, added a further major element of uncertainty to the near-term prospects for the global economy and for Canada. Because of this heightened uncertainty, the Bank took the exceptional step of lowering interest rates by one-half of a percentage point on 17 September, outside our regular schedule of fixed announcement dates. We also moved immediately after the attacks, as did other major central banks, to provide additional liquidity to the financial system to ensure its smooth functioning. At times like these, a key factor in preserving confidence in the prospects for our economy is a financial system that continues to work effectively. The ongoing economic effects of last month's shock are very difficult to assess. We know that there was a clear and immediate impact on certain sectors (such as air transportation and tourism) and on those industries that rely on cross-border, just-in-time delivery. But how large the total impact will be and how long it will last are very difficult to gauge. What is even more difficult to evaluate at this stage are the implications for consumer and business attitudes. The recent events are unlike anything we have ever experienced in North America. So it will take some time before we can fully understand their consequences. When we take into account the direct effects of the terrorist actions in the United States, their immediate negative impact on business and consumer confidence, and the adjustments necessary to deal with increased security risks, it is now clear that economic growth in Canada in the second half of 2001 will be close to zero or slightly negative. This means average growth for the year as a whole of about 1 1/2 per cent. How quickly growth will resume will depend crucially on geopolitical developments and on how soon consumer and business confidence return to normal. By their very nature, geopolitical developments are not easily predictable, although they will likely be more turbulent than usual for some time. Also difficult to predict is the evolution of consumer and business confidence. One could think of a scenario where confidence would be restored quickly. In such a case, fairly robust growth could resume by the second quarter of 2002. On the other hand, consumer and business confidence in North America could stay weak for quite some time. In these circumstances, growth could remain anemic through most of 2002. While the timing of a rebound in economic activity is unclear, we are confident that, once the uncertainty stemming from terrorist actions dissipates, healthy growth in output, investment, and employment will resume, given Canada's sound economic fundamentals. Under either of these scenarios, there will be less pressure on capacity through the balance of this year and during 2002 than we had thought earlier. Indeed, by the end of 2002, the economy will still be operating below potential. With less pressure on capacity, core inflation is expected to move below 2 per cent in early 2002, and to stay below through the remainder of the year. As for total CPI inflation, it will likely drop to about 2 per cent by the end of 2001 and move below that during 2002, if energy prices remain at or below their levels of early September. Based on these considerations, yesterday, on our pre-set announcement date, we cut our key policy interest rate--the target for the overnight rate--by 3/4 of a percentage point. It is now at 2 3/4 per cent--a full 3 percentage points lower than at the beginning of the year. This action aims to further support economic growth in Canada and to keep inflation close to our 2 per cent target over the medium term. I do not have to tell you that, because of the many unknowns in the global economic environment, and because of the uncertainty surrounding domestic demand in Canada, we will continue to monitor developments very closely. To conclude, as we in Canada find ourselves in the middle of economic difficulties, and especially as businesses, governments, and individuals struggle to come to grips with last month's tragedy, our main preoccupation is, naturally, with near-term issues. That is understandable. But, at the same time, it is critically important that we maintain a sense of perspective--that we step back and look past current developments, focusing also on the longer-term trends in our economy and its potential. Over the past decade, Canada has made remarkable progress in strengthening its economic foundations. This should stand us in good stead, no matter what economic turbulence and near-term uncertainties we face. And it gives us a firm basis to stand on as we embark on new initiatives to improve our longer-term economic performance and meet the challenges of the twenty-first century.

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Release of the Monetary Policy Report

dodge

United States have forced a reappraisal of global economic prospects. By midsummer, evidence began to accumulate that the economic slowdown, globally and in Canada, would be deeper and more protracted than previously anticipated. Thus, in late August, the Bank scaled back its projections for the Canadian economy. The terrorist acts in the United States, and their worldwide repercussions, have dramatically heightened the degree of uncertainty, further dampening near-term growth prospects. When we consider the direct effects of those acts, their immediate impact on consumer and business confidence, and adjustments to address increased security risks, economic growth in Canada is now expected to be close to zero or slightly negative in the second half of 2001. For all of 2001, this implies growth of about 1 1/2 per cent. As we look to 2002, the timing and strength of a recovery will depend crucially on geopolitics and on how soon confidence returns to normal in North America. With respect to confidence, one can envisage two scenarios. In one, confidence could be restored quickly, and robust growth could resume, supported by the substantial fiscal and monetary stimulus already in place. In the other, confidence could stay weak for some time and, consequently, growth would remain anemic through most of 2002. Under either scenario, by the end of 2002, our economy would still be operating at levels that are below capacity. Core inflation is thus expected to fall to about 1 1/2 per cent by the second half of 2002. Total CPI inflation is also expected to drop to about 2 per cent by the end of 2001 and to move below that during 2002, if energy prices stay at or below their early-September levels. Based on these considerations, on 23 October, we again lowered our key policy interest rate by 3/4 of a percentage point. The cumulative reduction of 3 full percentage points since January aims to support growth and to keep inflation close to the 2 per cent target over the medium term. Given the high degree and unique nature of the current uncertainty, the Bank will continue to monitor developments very closely.

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Opening Statement before the Standing Senate Committee on Banking, Trade and Commerce

dodge

Malcolm and I are pleased to appear before this Committee. We hope that we will be able to do so, on a regular basis, in the future. Today, I would like to start our discussion by spending a few minutes explaining how we at the Bank of Canada go about setting monetary policy. The Bank has a commitment to contribute to the economic well-being of Canadians. This means that we must conduct monetary policy so that it fosters sustained solid economic growth. As I said to you last March, the unique contribution that monetary policy can make to good economic performance is to preserve confidence in the future value of money. When people can count on their central bank to keep inflation low, stable, and predictable, they can make sounder economic decisions. The Bank pursues low inflation within a framework based on an explicit inflation target, supported by a flexible exchange rate. The current target is to aim at the 2 per cent midpoint of a range of 1 to 3 per cent over the medium term. I say "over the medium term" because monetary policy actions take time to have their effects on the economy and on inflation. Some effects are felt fairly quickly. But the full impact on inflation can take up to 18 to 24 months. So, in setting monetary policy, we have to look ahead and make judgment calls about future economic developments and about the timing and final outcome of any actions we take today. Since their adoption in 1991, inflation targets have proven very effective in keeping inflation low and in anchoring people's inflation expectations. They have also provided the Bank with a useful mechanism for assessing and dealing with demand pressures on future inflation in a way that helps to keep the economy on a more even keel. Let me explain how the inflation targets work to guide monetary policy and to allow the Bank to help stabilize the economy. At any point in time, there is a certain level of output that an economy can produce without putting either upward or downward pressure on inflation. Economists refer to that level of output as "potential output" or "production capacity." The level of potential rises over time as more workers join the labour force; businesses increase their investments in new technology, machinery and equipment; policy measures are taken to make product and labour markets more flexible; and all of us become more efficient and productive in what we do. Because potential output depends on many factors and their interaction, it is not something we can measure precisely--either in level or growth terms. But we can roughly estimate it, by analyzing the trends in those factors. At the Bank, we estimate that potential output in Canada is likely to rise by about 3 per cent per year over the medium term (as shown in In estimating potential output, we find the emphasis on inflation control to be particularly helpful. It helps us to avoid systematic errors in assessing potential. For example, if inflation was coming in persistently below our expectations, it would be a strong signal that production capacity was higher than our estimate, and vice versa. Now, in terms of setting monetary policy, the key question is where the economy is likely to be relative to potential several quarters down the road, and how that will affect future inflation. If the economy is likely to be operating close to, or above, its capacity to produce, it is reasonable to expect that this will put upward pressure on inflation in the future ( ). If this seemed likely to take inflation above target, the Bank would tighten monetary policy (that is, raise its key policy interest rate) to moderate demand and head off those pressures. On the other hand, if the economy is likely to be operating below potential, then there will be downward pressure on future inflation. If it looked that this would take inflation below target, the Bank would ease monetary policy to provide more room for the economy to expand. Thus, the emphasis on inflation control works symmetrically. It allows the Bank to take policy actions to prevent overheating, when the economy is strong and is pushing against its capacity limits, and to support growth when the economy is weak. Let me now try to relate this to our recent experience in Canada. If we go back to the fall of 1998, when the worldwide reverberations of the Asian and Russian financial crises were still very much with us, we can see from that our economy was operating below potential. Since this implied that there was a good chance future inflation would be below target, we eased monetary policy through the latter part of 1998 and the first part of 1999. Our economy rebounded strongly during 1999, and expectations were that it would continue to grow robustly--above potential--for some time, bolstered by strong domestic and U.S. demand. With signs of emerging capacity pressures, we then moved to gradually tighten policy in late 1999 and through the first part of 2000, to cool off demand and prolong sustained non-inflationary growth. The slowing of the U.S. economy that began in the second half of 2000 was welcome because that economy had been growing very rapidly for some time and it was in danger of overheating. But what we, and most other analysts, did not anticipate was the collapse in U.S. business investment, particularly in the information and telecommunications sectors. This led to a sharper slowdown than expected. When this became apparent early in 2001, the Bank's assessment was that it would lead to a moderation in growth in Canada, which would leave our economy operating somewhat below potential by mid-year. But we also expected that the pace of expansion would pick up in the second half of 2001 and strengthen further in 2002, returning us to potential output levels. So, although we proceeded to loosen monetary policy, we did so at a measured pace. In the first half of the year, available economic information was broadly in line with the Bank's expectations. By midsummer, however, evidence began to accumulate that the recovery in U.S. investment--a key factor in the expected pickup in growth in the second half of 2001--would be delayed and that the slowdown in that country would be deeper and last longer than anticipated. Economic activity outside North America had also begun to show more clearly the effects of weaker U.S. growth and of the ongoing global retrenchment in the information and telecommunications sectors. In Canada too, there were signs that domestic demand, which had held up through the first part of 2001, was softening and that the inventory adjustment was not as well advanced as expected. So we revised down our growth projections. The implication of this, as we looked out several months down the road, was that the economy would be operating substantially below potential and that inflation would be below target. That is why, at the end of August, we again lowered interest rates to support domestic demand growth. The terrorist acts in the United States, and their worldwide fallout, introduced a whole new layer of uncertainty into the global economic picture, further dampening near-term growth prospects. I do not have to tell you how difficult it is to assess the ongoing economic effects of those disturbances, which may have had a significant effect on the psychology of North American households and businesses. But, as I said before, because monetary policy is forward-looking, we have to make a best possible evaluation of likely developments several quarters ahead. As we look to 2002, the timing and extent of a recovery in economic activity will depend crucially on geopolitics and on how quickly confidence returns to normal. As we discussed in our November , one can envisage two scenarios ( ). In the first, confidence could be restored quickly, and robust growth could resume in early 2002, supported by the substantial monetary and fiscal stimulus already in place. In the second, confidence could stay fragile for some time, and growth would be anemic through most of 2002. Note that, under either scenario, the Canadian economy would still be operating at levels that are below capacity by the end of 2002. This means that inflation would continue to be below target through next year. How has the Bank responded to all this? To underpin confidence in the wake of the extraordinary uncertainty generated by the terrorist acts, we took the exceptional step of lowering our key policy interest rate by 1/2 of a percentage point on 17 September, outside our regular fixed announcement schedule. And we moved again to ease rapidly--by 3/4 of a percentage point, on 23 October, and by 1/2 of a percentage point, on 27 November. The cumulative reduction in policy interest rates since the beginning of the year amounts to 3 1/2 percentage points, of which more than half--2 full percentage points--occurring since late August. This substantial amount of monetary stimulus will work to support a resumption of healthy growth in output, investment, and employment, given Canada's solid economic foundations. In view of the ongoing uncertainties, it is still too early to characterize the economic outlook with great assurance. Nonetheless, signs that the geopolitical situation may be stabilizing and that households and firms are beginning to adjust to the new environment, suggest a somewhat greater likelihood that the Bank's more optimistic scenario may come to pass than was the case a month ago. In closing, let me stress that I have oversimplified how the Bank judges the performance of the economy relative to its potential. In addition, I have not mentioned all the factors that can influence the growth of potential or the future path of inflation. But I have provided the basic elements of the inflation-targeting approach that the Bank uses to help promote good economic performance. Mr. Chairman, in my remarks today I focused, appropriately, on the contribution monetary policy can make to sustained economic growth. But I want to emphasize that, while low inflation is essential in this context, it is not sufficient by itself. Other policies, both macro- and micro-economic, must continue to focus on enhancing productivity and raising our production potential over the medium term. This focus is extraordinarily important if we want to achieve sustained, solid economic growth and rising standards of living over time. We should not lose sight of it as we go through the current short-term difficulties.

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Inflation Targeting in Canada: Experience and Lessons

dodge

Governor of the Bank of Canada at a joint session of The American Economic Association Thank you, Andrew. I am pleased to be in Atlanta today to talk to you about the Canadian experience with inflation targeting. In the 1970s and 1980s we found--in common with many other countries--that high and variable rates of inflation created a lot of economic damage. And it took a long time and a lot of work with various monetary policy frameworks before we got back on track. I would point to two particular sets of arrangements for policy during that time that were both designed to lead to low inflation rates. The first was monetary targeting--specifically, targeting the narrow monetary aggregate M1, beginning in 1975. A close relationship between M1 growth and inflation held only over very long periods of time. Moreover, this relationship was subject to sizable downward shifts in the demand for money. Such shifts did indeed occur. Thus, after a period of disinflation between 1975 and 1978, inflation picked up again in 1979-82 despite the achievement of the M1 target. Because of the lack of longer-term success in bringing down inflation, this approach to monetary policy was unable to build confidence and understanding on the part of the public. The second policy approach took place from 1982-90, a period in which there was no clear monetary policy target. Rather, there was only a desire to bring inflation down and was no further progress in reducing inflation. And with no explicit target, there was still little understanding of monetary policy and no focus for inflation expectations. The economic boom at the end of the 1980s, together with an oil-price shock and the introduction of the goods and services tax, led to fears that inflation would again escalate and stay high. It was against this background that, in 1991, the Canadian government and the Bank of Canada agreed on targets for inflation reduction. Canada was the second country, after New Zealand, to set out formal, medium-term inflation targets. I would now like to turn to the question of how we adopted inflation targets in the first place. The Bank of Canada operates under the Bank of Canada Act . The preamble to the act notes that the central bank is established "to control and protect the external value of the national monetary unit and to mitigate by its influence fluctuations in the general level of production, trade, prices and employment, so far as may be possible within the scope of monetary action, and generally to promote the economic and financial welfare of Canada." In essence, this is like the Theory and empirical evidence suggest that there is no long-run trade-off between inflation and production levels. Indeed, there is evidence that a low-inflation regime supports higher productivity. Moreover, monetary policy has essentially only one instrument. Therefore, the best that monetary policy actions can do to promote the welfare of Canadians is to aim for low, stable, and predictable inflation with a medium-term target horizon, which will maximize sustainable production levels. This will have the important benefit of tending to mitigate fluctuations in production and employment. It is also the best way to protect the external value of the monetary unit under flexible exchange rates. The experience of the 1970s and 1980s left both the government and the central bank sensitive to the havoc wreaked by high and unstable inflation rates and thus moved them away from the notion of trying to directly fine-tune short-run output and employment levels. By 1990, there was therefore a growing shared desire to create a policy that would provide a better anchor for inflation expectations. It was important that both parties be involved. Since 1967, the Bank of Canada Act has granted a directive power to the government that allows it to openly instruct the Bank to carry out specific actions over a specific time period. This power has never been used. However, both it and the requirement in the act for regular consultations between the Governor and the Minister of Finance highlight the importance of consultations between the two parties on any major change in the objective of monetary policy. In a democratic society, the government must be comfortable with the overall direction of monetary policy. Moreover, for an objective to be credible, the government's backing is required. And, because of the expertise that resides in the central bank, it is important that the Bank provide the research and analysis regarding the framework that can deliver the agreed objective. An agreement was indeed reached. It was announced in the form of a joint press release on the inflation-reduction targets at the time of the February 1991 budget. The Bank issued a detailed background document at that time elaborating on the framework it would use to achieve the targets. Given the empirical evidence for Canada, showing that the appropriate horizon for aiming at an inflation target was about 1 1/2 to 2 years, the first formal target was set for December 1992 at a rate of 3 per cent (plus or minus 1 per cent). The series of targets announced in the agreement was aimed at bringing the 12-month CPI inflation rate down to 2 per cent (again, plus or minus The decline in inflation was achieved in fairly short order, indeed faster than was consistent with the targets. By January 1992, inflation was close to 2 per cent. The agreement with the government has been renewed three times; in each case, the midpoint of the inflation target range has been confirmed at 2 per cent. Through this period--and with two different governments--there has been a growing shared appreciation of what inflation control has been contributing to Canada's good economic performance. This includes the recognition of the automatic stabilizing feature of inflation targeting in response to demand shocks--a point that I will come back to later. Overall, the government and the central bank are on the same wavelength in terms of the objective of policy. The successful implementation of a monetary policy aimed at low, stable, and predictable inflation and a fiscal policy aimed, in most circumstances, at running a small surplus with the goal of bringing about a significant decline in the debt-to-GDP ratio has enhanced the credibility of both policies. The major lesson that we at the Bank of Canada draw from our experience with inflation control is related to the advantages of establishing a credible anchor for monetary policy by focusing on the predictability of inflation. That will be the theme of the rest of my talk. When the original inflation-reduction targets were announced in early 1991, the Bank was not relying on a credibility effect to reduce inflation. And subsequent studies have shown that this was the appropriate assumption--there was no evident reduction in the cost of disinflation arising from credibility. What the Bank did say was that The purpose of setting out formal targets is to provide a clear indication of the downward path for inflation over the medium term so that firms and individuals can take this into account in their economic decision-making. . . . The inflation targets also provide information on the specific objectives to which the monetary policy actions of the Bank will be directed in the period ahead and through the medium term. This information should make the Bank's actions more readily understandable not only to financial market participants but also to the general public and should provide a better basis than before for judging the performance of monetary policy. Credibility, inflation, and inflation expectations After inflation fell to 2 per cent, the expectations of forecasters and businesses soon began to fall in line with the targets. At first this was for expectations at the 2-year horizon. This then lengthened to the 6- to 10-year horizon. Finally, long-term expectations of inflation in financial markets, as expressed by the difference between 30-year yields on conventional and index-linked bonds, fell in line with the 2 per cent target midpoint in 1997. What was particularly noticeable after just a couple of years of targeting was that expectations over a 2-year horizon or longer tended to be affected very little by what was happening to current inflation rates, whether for the total CPI or for a measure of core inflation. This was in marked contrast to earlier periods in Canadian history, in which expectations for the future had been fairly tightly linked to recently observed inflation rates. With the low inflation target becoming increasingly credible, the whole nature of the inflation process seemed to change. The short-run response of inflation to measures of excess demand and supply appears to have fallen during this period. And the response of inflation to relative price shocks, such as changes in the exchange rate and energy prices, also seems to have declined. These changes have had the effect of reinforcing the stability of the inflation process and, therefore, of inflation itself. Overall, it became increasingly evident through the last decade that the inflation target deals with expectational problems. Among close observers of the economy, as well as businesses and those bargaining over wages, it promotes a much greater degree of confidence and understanding than monetary targets or a vaguely expressed desire for price stability ever did. People care about inflation. Therefore, when the focus of policy is on inflation itself and when accountability is in terms of a specific measure of inflation, the public can see and interpret both what the central bank aims to do and what it actually accomplishes. Inflation expectations are important in exchange markets. Canada has chosen to operate in a flexible exchange rate regime mainly because of the asymmetric shocks that it faces relative to the United States, its major trading partner. It is thus extremely important that Canada have a credible anchor for its monetary policy. The inflation target has played this role admirably. Shocks to the exchange rate have not threatened domestic monetary stability. Credibility and the real economy Greater stability on the inflation front was also associated with fundamental changes in the real economy in the 1990s. The average duration of union wage contracts and financial contracts lengthened markedly. New types of long-term financial contracts were created. And there were fewer work disruptions. While other factors also played a part in these changes, low and stable inflation was an important contributing factor. The real economy also became more stable. Both the output gap and the unemployment rate have been less volatile over the past decade of successful inflation targeting than in the preceding 10 years. And in the last two years the unemployment rate has been at its lowest level in 25 years. How is it that the variability of both inflation and output has fallen? I believe there are two main reasons. First, the increased credibility of monetary policy has led to a more stable behaviour of the economy, as I have alluded to above. Second, policy itself has been improved by the forward-looking framework of inflation targeting, which has allowed Canada to avoid the major boom and bust cycles experienced in the period from the late 1960s to the early 1990s by reacting promptly to new information. In particular, when there are demand shocks, the inflation-targeting framework acts as an automatic stabilizer for the economy. For example, a negative shock to demand leads to interest rates being lower than they otherwise would have been. This has the effect of moving output back towards potential output and inflation back to its target midpoint. In this regard, it is important to note the role of symmetric responses to positive and negative shocks, facilitated by the emphasis on the target midpoint. In response to supply shocks, which take the form of inflation being higher than expected for a given level of demand, the focus on inflation 1 1/2 to 2 years ahead means that temporary shocks can be ignored as long as they do not feed into inflation expectations. As noted above, they typically no longer do so. Consider price shocks coming from volatile components, like energy or fruit and vegetable prices. As our operating guide, we use a core measure of inflation that excludes such components. This gives us and the financial markets some confidence that we are looking at the underlying trend of inflation. Thus, the interest rate response to what is perceived to be a temporary price shock can be minimal. As a result, there will be little movement in output. Output will therefore tend to be more stable than in a situation where a lack of firmly held expectations meant that the monetary authority had to react more strongly to price shocks, even if it believed that they would be fairly short-lived. As the public's appreciation for the value of low, stable, and predictable inflation has grown, so has its predilection for discussing monetary policy choices in terms of the appropriate inflation-targeting framework. In the periods leading up to the renewal of the inflation-targeting agreement between the Bank of Canada and the Canadian government in both 1998 and 2001, the debate was about the appropriate level of the target (say, target midpoints of 1, 2, or 3 per cent) and some of the specific details, rather than about whether there should be a target for inflation at all. Refinements to increase predictability Our recent agreement in May of last year reaffirmed the target midpoint of 2 per cent. The Bank issued a background note describing the refinements in the way that it will implement the targeting arrangements. These refinements, which should increase the predictability of inflation over the longer term, are fourfold: first, extending the length of the agreement to five years from the three years of the previous two agreements; second, clarifying that the Bank aims at the midpoint of the 1 to 3 per cent inflation-target range; third, committing to give special attention in the and to situations where CPI inflation persistently deviates from the target midpoint; fourth, modifying the definition of the measure of core inflation to better capture the underlying inflation trend. The benefits, in terms of predictability, of having a longer agreement are self-evident. The reinforcement of the message that the Bank aims at the 2 per cent target midpoint, combined with the special attention to be given to persistent deviations from that midpoint, is meant to make it clear that we are not indifferent to the various outcomes in the target range. Rather, we consistently aim to get back to 2 per cent over a horizon of 1 1/2 to 2 years. Following such a practice means that the average inflation rate over successively longer periods of time will tend to be increasingly close to 2 per cent. Until last year, the Bank of Canada used as its core measure of inflation the CPI excluding food, energy, and the effect of changes in indirect taxes. Volatile food and energy prices tend to reverse themselves fairly quickly. Therefore, since monetary policy actions affect inflation over a longer period, it would be inappropriate for monetary policy to try to offset the short-run movements in the total CPI caused by these fluctuations. Among food components, however, only fruit and vegetable prices are highly volatile. And among energy components, electricity prices have not been particularly volatile in Canada. Thus, our new measure of core inflation excludes only the volatile components of food and energy, as well as the three other most volatile components of the CPI: tobacco prices, intercity transportation prices, and mortgage interest costs. As before, the effect of changes in indirect taxes on the remaining elements is also excluded. Not only does the new measure of core inflation have a stronger statistical basis for its creation, it is historically a better predictor of future total CPI inflation than the old measure. Overall, we expect that these refinements will help to further increase the predictability of inflation in Canada in the years to come. This should add to the benefits that the Canadian economy has experienced from having a credible anchor in the form of the inflation-control targets. Bank of .

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Release of the

dodge

This morning, we released our to last November's . In that , we indicated that, in the wake of the 11 September events, the timing and extent of a rebound in economic activity in Canada this year would depend crucially on geopolitical developments and on how soon consumer and business confidence returned to normal. Since then, the geopolitical climate has improved and consumer confidence has recovered in both Canada and the United States. So, even though robust growth is not yet underway, it is now clearer that our economy will gather momentum as the year unfolds. Economic developments in Canada since the November , and the profile for growth outlined in the , suggest that the amount of slack in the economy through 2002 will likely be somewhat greater than assumed in November. Thus, core inflation is now seen averaging just under 1 1/2 per cent in the second half of 2002. Total CPI inflation should remain below the core rate until late 2002. Against this background, the Bank has lowered its key policy interest rate by 375 basis points over the past 12 months. This substantial monetary easing should support growth in domestic demand. Thus, the rate of economic expansion should pick up during 2002 and the amount of slack should gradually diminish. Consequently, inflation should be back close to 2 per cent in about two years. I would now like to say a few words about recent exchange rate developments that are a source of concern. Over time, exchange rates should reflect underlying economic and financial developments and prospects. But in the short run, there can be volatility as markets gauge those prospects. As I have already noted, it is becoming clearer that our economy will strengthen as we go through this year and into 2003. Recent data increasingly support the view that a recovery is taking hold. Household spending in Canada, particularly on interest-sensitive purchases, has been stronger than expected. The latest data on exports and manufacturing activity show signs of recovery. The inventory adjustment is progressing. And with early evidence of a revival in the U.S. economy, the world prices of non-energy commodities appear to have bottomed out. These signs of a pickup in economic activity in Canada are encouraging. But the recent movements in the Canada-U.S. exchange rate do not appear to have reflected those developments and the recent depreciation is not helpful for the economy. Economic recovery in Canada does not hinge on the current low levels of the Canadian dollar against its U.S. counterpart. Let me sum up. When the final data come out, we could very well see positive, albeit modest, economic growth in both the fourth quarter of 2001 and the first quarter of 2002. Economic activity should gain momentum as the year progresses. Of course, some uncertainties remain, and the Bank will stay alert to unfolding developments.

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Challenges and Changes in an Eventful Year

dodge

Governor of the Bank of Canada Thank you for the invitation to speak to you today. I'm delighted to have the chance to visit Winnipeg. As you may know, the end of this week will mark the first anniversary of my appointment as Governor of the Bank of Canada. It was an honour to be appointed, and it has been a privilege to serve Canadians in this role. I have had the opportunity to work with an extraordinarily talented group of professionals at the Bank, as well as a supportive Board of Directors. Together, with input from Canadians across the country, we have worked hard to conduct monetary policy as well as we could during rapidly changing, and increasingly difficult, economic times. As I come to the end of my first year, it seems natural to look back on the past 12 months and review some of the challenges and changes that have taken place. The main economic concern of the past year was the slowdown that occurred not just here in Canada, but in most major economies. Compounding the economic concerns were the 11 September terrorist attacks in the United States. Inside the Bank of Canada, there were some major developments as well. Two things in particular stand out for me. We went through our first year with our new system of fixed announcement dates for interest rate decisions. And we renewed our inflation-control agreement with the federal government. In my remarks today, I'd like to talk to you about our fixed announcement dates and about the process we go through in reaching our interest rate decisions. Then I'd like to take a few minutes to review the current state of the economy and touch on Canada's economic outlook. I will also have a couple of words to say to reinforce the Bank's views about the Canadian dollar. Towards the end of 2000, under the leadership of my predecessor Gordon Thiessen, the Bank established a system of pre-set or fixed dates for announcing interest rate changes. We now set eight dates per year when we will announce either a change, or no change, to our key policy rate--the target for the overnight rate of interest. This system marks the latest development in the way the Bank implements its monetary policy. This process has been through quite a transformation in recent years. It was not that long ago that the Bank "announced" interest rate changes by conducting transactions in money markets. There was no press release explaining the rationale for our moves, no confirmation of the moves to the media, and no set time for these transactions, which could come on any business day. Over time, the deficiencies in this system began to be addressed. The Bank settled on a set time during the day--9 a.m. Eastern Time--to make its interest rate moves. It began to confirm the changes publicly, issuing a press release to explain the factors behind the moves. And now, with our new system of fixed announcement dates, Canadians know, in all but the most extraordinary circumstances, when the central bank will make an interest rate announcement. Previously, financial markets could not be sure on which day we might move. So, when there was an expectation that we were about to act, trading would be slow in the early mornings--sometimes for several days. We have found that removing this uncertainty has improved the workings of the market. But other benefits are more directly apparent to the public. When the Bank first announced this system, we said that we hoped it would help focus public attention and commentary on the economic factors behind our interest rate decisions. Indeed, from what we have seen in the past year, the commentary in the media and financial markets about monetary policy has become more focused and relevant to the Canadian situation. The fact that the media and the markets know when an announcement will be made has resulted in more and better analysis and market commentary leading up to the announcements, as well as afterwards. The media have used this approach to improve the depth and quality of their analysis. And the discussion now tends to be about the state of the Canadian economy and about the rationale for the Bank's decisions. Just as our fixed-date system has allowed the media to improve their coverage of the Bank, it has also provided the framework for financial analysts to improve their work as well. Their analysis is important. It should help the market work better, and should also help us to improve our understanding of the views in financial markets. But in the end, of course, we will take whatever actions that we think are appropriate for the economy, even if these actions are different from the expectations reflected in the market. The fixed announcement dates also give us another opportunity to bring Canadians up to date on the Bank's views about the economy. On every fixed date we issue a press release, whether or not we've changed interest rates. In it, we briefly explain our decision. These press releases work with our , the to the , and speeches by me and other senior Bank officials, to provide a regular, ongoing account of our views. In doing so, we hope to contribute to greater public awareness and discussion of both economic developments in Canada and the role of monetary policy. But information flows both ways. Through all of our communications, we are providing the opportunity for public critique of our economic analysis. And this critique is an essential part of the process by which we conduct monetary policy. I should point out that we have now shortened the time lag between the fixed announcement dates and the or that is released following four of the eight fixed dates each year. We will now publish the or in the week following the fixed date, rather than two weeks later as was the case last year. The decisions taken on fixed announcement dates reflect the consensus of the six and the four Deputy Governors. It might be helpful at this point to expand a bit more on the process we go through as we approach each announcement date. The Bank is always closely monitoring developments in the domestic and global economies. But the fixed-date calendar has led to a more structured process for considering the impact of these developments and their implications for monetary policy. In the week to 10 days leading up to an announcement, the Governing Council first receives views from staff at the Bank. Initially, we hear from our analysts in our Research Department who, with the aid of sophisticated economic models, provide projections for the Canadian economy. They also keep us informed of what private-sector forecasters are saying. Our International Department provides the outlook for the U.S. and overseas economies, and the global context in which we in Canada make our decisions. Bank staff from across the country report on economic developments, and on the views of businesses, in their regions. Our Monetary and Financial Analysis Department interprets the signals coming from credit markets and monetary aggregates. And our Financial Markets staff assess financial market developments and expectations. The staff present their analyses to Governing Council in a series of meetings during the week prior to each fixed announcement date. Since these staff analyses come from such different perspectives, it is probably not too surprising that they sometimes have differing viewpoints as to what is the appropriate stance for monetary policy. However, these differing viewpoints are very valuable, as they enrich the discussion during the decision-making process. The final staff views on the economy and the implications for policy are formally presented to Governing Council on the Friday morning before an announcement. It is the role of the Governing Council to take all of this analysis and apply our best judgment to it. It usually requires a lively and thorough discussion among Governing Council members to reach a consensus decision. The Governing Council reconvenes on Monday, and by the end of the day we tentatively decide on our action and on the wording of the accompanying press release. Our consensus decision is finalized on Tuesday morning, just before the 9 a.m. release time. With our press releases, periodic reports and speeches, we try to explain our thinking. In doing so, we hope to help Canadians, including those in the financial markets, anticipate the general direction of monetary policy. But this should not be interpreted to mean that we try to influence or condition market expectations about our likely policy moves just before an announcement date. The Bank puts a lot of emphasis on developing a complete picture of the economy, not on reacting to any particular piece of information or even a particular series of economic data. An almost constant stream of what is called "high-frequency data" is published by Statistics Canada and other government and other private agencies about various sectors of the Canadian economy. However, "high frequency" does not mean "high fidelity." In fact, there is a lot of "noise" in these data--incomplete or misleading signals about the future course of the economy. It is a crucial part of our job to filter out this noise, and put the pieces together to get to the underlying trends in the economy. Since monetary policy works over long periods of time, we cannot, and should not, have a knee-jerk reaction to each and every piece of these high-frequency data that we see. For this reason, we publish our and every three months, taking into account all the information that has come in during that past quarter. We don't generally provide material updates on our views of the trends in the economy and the implications for monetary policy between announcement dates. But sometimes there could be developments that lead us to significantly change our views from the scenario that we had most recently laid out in our public statements. In that case, we would seek to provide a clear signal of the change in our views. I hope I have been able to give you an idea of how we go about making our interest rate decisions. But I should stress that we always have a medium-term focus--our goal is to take whatever steps are needed to aim inflation at our 2 per cent target over a 6- to 8-quarter horizon. Let me now look back at a rather difficult year for the economy. During 2001, we lowered interest rates at every fixed announcement date, in order to adjust to the changing economic circumstances. At the beginning of the year, our main concern was the impact that a slowing U.S. economy would have on Canada. Although domestic demand in Canada was holding up, against a backdrop of weaker foreign demand, we lowered our target for the overnight rate through the first half of the year. But by mid-summer, evidence began to accumulate that the U.S. slowdown would be more protracted than anticipated, and that economic activity outside North America would be much weaker. At the same time, there were indications that domestic demand in Canada, which had held up well through the first part of the year, was softening. So at our 28 August fixed announcement date, we said that we had revised down our expectations for growth. Then came the terrorist attacks of 11 September. The immediate impact and the subsequent fallout from the attacks compounded the problems of the economic slowdown. The attacks presented a pressing challenge to the Bank of Canada and other central banks: to keep the world's financial systems operating smoothly. One of the Bank's key functions is to promote financial stability in Canada. That means keeping markets functioning well, even in times of extreme stress, such as the days immediately following 11 September. The Bank of Canada, as did other central banks around the world, stepped in to provide financial markets with ample access to domestic liquidity. And we reached an agreement with the U.S. Federal Reserve that would have permitted us to provide extra U.S.-dollar liquidity to Canadian banks had it been necessary. In short, we made sure that the disruption did not turn into gridlock. If there was one positive thing to emerge from this terrible event, it was that the global financial system kept running as well as it did. But in the aftermath of these events, we were left with another challenge. That was to try to minimize the economic impact of the attacks. It was obvious that consumer and business confidence would suffer. We needed to do our part to help keep the loss of confidence as small as possible, which would help the economy recover as quickly as possible. That is why in the days following the attacks, we took the extraordinary step of lowering interest rates outside our fixed announcement dates. It then became clear that the economy would continue to operate below its capacity throughout 2002, with resulting downward pressure on inflation. So we sped up the pace of interest rate reduction at the next two fixed announcement dates. We wanted to support economic growth, which would help keep inflation within our target range of 1 to 3 per cent. The terrorist attacks created all sorts of uncertainties--economic, political, and military. So it was extraordinarily difficult last fall to be very certain about the future track of the economy. Now however, a clearer picture is beginning to emerge. One way for us to get that clearer picture is to actually get out across the country to see what is going on in Canada's regions. These opportunities to get away from the frenetic world of financial markets, and to see what is happening in the real economy, are extremely important to me, and to the Bank. Let me focus on Manitoba for a moment. With economic growth estimated to have been about 1.75 per cent, the province appears to have posted the third fastest growth rate in the country last year, behind only Alberta and Newfoundland. Diversification, not just within the agricultural sector but across the whole economy, has been enormously helpful. This has allowed the province's unemployment rate to remain well below the national average. Manitoba has also been helped by a modest debt-to-GDP ratio and by a record of fiscal prudence that continues today. Still, the local economy has felt the after-effects of the terrorist attacks. The aerospace industry, in particular, has been hit hard by a downturn following the attacks. In a more indirect way, the slowing world economy has led to a weakening of many commodity prices, including agricultural commodities. This, coupled with low crop yields last year and the threat of poor growing conditions again this season, could lead to some difficulty for the agricultural sector. In looking at the country as a whole, some sectors of the economy have recovered smartly from 11 September, but in other areas the adverse effects have persisted. Certainly air travel, both for business and tourism, continues to be weak. Last week, we published our . In it, we said that the economy looked increasingly likely to find itself between the two extreme possibilities we had sketched out in last November's full . On the plus side, geopolitical developments have been positive. Indeed, consumer confidence seems to be recovering in the absence of new terrorist attacks. But it is difficult to pinpoint the exact moment that the economy will begin to recover or precisely how strong that recovery will be. What I can say is that the conditions for strengthening world economic growth are in place. Excess capital stock is being worked out of the system, leading to expectations of greater investment ahead. And low commodity prices should rebound as global demand picks up. All told, we see Canadian growth in the first half of 2002 averaging between 1 and 2 per cent on an annualized basis. But growth should accelerate in the second half, with an average in the range of 3 to 4 per cent on an annualized basis. What does this mean for inflation? We saw total consumer price inflation dip sharply in November, then stabilize in December. At the same time core inflation, which is a measure we use to predict future inflationary trends, also fell during those two months. This is consistent with an economy operating below its capacity. With the economy growing more slowly than potential output through the first half of the year, excess supply will continue to build. So both total and core inflation are expected to remain near current levels for the next few months. But by lowering our target for the overnight rate, the Bank of Canada has taken vigorous action to stimulate domestic demand. We expect that as this excess supply begins to be taken up, both core and total CPI inflation should move back up close to our target of 2 per cent in about two years. Businesses of all kinds are still adjusting to the security risks that the events of September have shown to us. In our view, this should be a one-time adjustment. But it probably means there will be a small reduction in the level of our economy's potential output. I would now like to say a few words to reinforce our views about recent exchange rate developments that are a source of concern. Over time, exchange rates should reflect underlying economic and financial developments and prospects. But in the short run, there can be volatility as markets gauge those prospects. As I have already noted, it is becoming clearer that our economy will strengthen as we go through this year and into 2003. Recent data increasingly support the view that a recovery is taking hold. Household spending in Canada, particularly on interest-sensitive purchases, has been stronger than expected. The latest data on exports and manufacturing activity show signs of recovery. The inventory adjustment is progressing. And with early evidence of a revival in the U.S. economy, the world prices of non-energy commodities appear to have bottomed out. These signs of a pickup in economic activity in Canada are encouraging. But the recent movements in the Canada-U.S. exchange rate do not appear to have reflected those developments and the depreciation we saw over the last couple of weeks is not helpful for the economy. Economic recovery in Canada does not hinge on the current low levels of the Canadian dollar against its U.S. counterpart. So to conclude, this past year has certainly been full of challenges. I know, however, that we have done the right things to get the economy growing strongly again, and that we are in good shape to take advantage of better times when they arrive. I feel confident in predicting that one year from now, when I'm looking back over my second year as Governor, I'll be looking back over a recovering economy, one that is much stronger than it is today.

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Inflation Targeting During a Difficult Year

dodge

Thank you for the opportunity to speak to you this morning. As you may know, the end of this week will mark the first anniversary of my appointment as Governor of the Bank of Canada. It was an honour to be appointed, and it has been a privilege to serve Canadians in this role. I have had the opportunity to work with an extraordinarily talented group of professionals at the Bank, as well as a supportive Board of Directors. Together, with input from Canadians across the country, we have worked hard to conduct monetary policy as well as we could during rapidly changing, and increasingly difficult, economic times. As I come to the end of my first year as Governor, it seems natural to look back and review some of the challenges and changes that have marked the past 12 months. The main economic concern of the past year was the slowdown that occurred not just here in Canada, but in most major economies. Compounding the economic concerns were the 11 September terrorist attacks in the United States. Inside the Bank of Canada, there were some major developments as well. Two things in particular stand out for me. We went through our first year with our new system of fixed announcement dates for interest rate decisions, and we renewed our inflation-control agreement with the federal government. Yesterday in Winnipeg, I spoke about our fixed announcement dates. Today, I'd like to talk to you about our inflation-control target system. Then I'd like to take a few minutes to review the current state of the economy and touch on Canada's economic outlook. Last May, the Bank and the federal government jointly announced the renewal of our inflation-control agreement. This was an important decision. It strengthened a policy framework that has given our economy low, stable, and predictable inflation for the past decade. One of the main benefits of the targets is that they help the economy to run more smoothly when there are surprises in the level of demand for Canadian goods and services. Let me elaborate. Under the agreement, the Bank of Canada aims to guide total consumer price inflation towards the 2 per cent midpoint of our 1 to 3 per cent target range over the medium term. So when demand for goods and services leads the Canadian economy to push the limits of its capacity, and there is a risk of future inflationary pressures, the Bank will raise interest rates to cool off the economy. But importantly, inflation targeting also works the other way. When the economy is operating well below its production capacity and inflationary pressures are likely to ease, the Bank will lower interest rates to stimulate growth. This was the situation we found ourselves in during the past year, as signs of the slowdown emerged. By working in a symmetrical way, inflation targeting helps to level out the peaks and valleys of the business cycle. It promotes sound growth while tempering economic ups and downs. And this benefits everybody. But the benefits of this framework go beyond its usefulness in setting monetary policy. It also helps reduce uncertainty about future inflation, by giving Canada a credible anchor for its monetary policy. Let me explain what that means. Once the original agreement between the Bank and the Government came into effect in 1991, inflation quickly came down into the target range. But more importantly, measures of began to fall in line with the target range as well. At first, this applied to expectations of inflation over a 2-year period. But the time frame lengthened gradually, and since 1997, inflation expectations have been essentially anchored on 2 per cent for 30 years into the future. This is important, because when inflation expectations are well anchored, the real economy works better. Wage bargaining can become less contentious. And we have seen a trend towards fewer labour disruptions and a lengthening of collective bargaining agreements. With stable inflation expectations, investors can better assess the future value of their investments. At the same time, savers know the future purchasing power of their money will not be eroded by inflation. Supporting our inflation-control framework is our flexible exchange rate system. Although from time to time there may be excessive volatility in exchange markets, having a flexible exchange rate is important. This is particularly true for Canada because we are a small, open, and relatively specialized economy. The structure of our economy is different from that of the United States. Now, when we renewed the inflation-control agreement with the federal government last year, we strengthened the framework in four ways. We lengthened the term of the agreement to five years, which should reinforce its credibility. We clarified that we are aiming inflation explicitly at the 2 per cent midpoint of the target range. This emphasizes that we pay equal attention to the top and the bottom of the target range. We committed to providing an explanation in our key publications - the and - if inflation persistently misses the target. This increases our accountability to Canadians. Finally, we refined the way we measure core inflation. I want to take a minute to explain what core inflation is, and why it is important. The Bank's inflation-control target applies to the annual increase in the total consumer price index. But we use core inflation as a guide to help us predict where overall inflation is likely to be in the future. In calculating core inflation, we exclude the prices of those goods and services that tend to be the most volatile; that is, subject to temporarily wide movements both up and down. Previously, we would strip out all food and energy items from the CPI basket of goods and services when we calculated core inflation. But not all components of food and energy are volatile. Similarly, there are other prices in the economy that are highly volatile. So we found it helpful to focus just on the volatile components in order to do a better job in predicting the future path of inflation. Let me give you an example that explains why core inflation is important. In late 2000 and early 2001, energy prices were shooting higher. Anybody who drives can remember paying a lot more at the gasoline pumps a year ago than now. Natural gas and heating oil prices were also rising sharply. These prices were being reflected in the overall inflation rate, which moved above 3 per cent for the first time in almost 10 years. This prompted some commentators to call on the Bank to raise interest rates. But the core rate of inflation was telling us that these higher energy prices were not significantly feeding into other prices. The core rate suggested that inflation would fall back around the midpoint of the target range, once the surge in energy prices either levelled off or reversed itself. In fact, this is exactly what happened. It would not have made sense for us to raise interest rates in the face of these temporarily very high prices for oil and gas. So even though total CPI inflation was high in the first half of 2001, the weakening economy indicated that downward pressure on inflation was coming. We expected core inflation to fall by the end of the year, as indeed it did, and to fall further in 2002. That led to our decision to lower, not raise, interest rates. In the last few months, we've seen rapid declines in volatile components, such as gasoline, fuel oil, and air fares. This means total consumer price inflation is now well below the core rate of inflation. And in such circumstances, it is equally inappropriate to base our policy actions on swings in total CPI inflation. Let me now look back at a rather difficult year for the economy. During 2001, we lowered interest rates at every fixed announcement date, in order to adjust to the changing economic circumstances. At the beginning of the year, our main concern was the impact that a slowing U.S. economy would have on Canada. Although domestic demand in Canada was holding up, against a backdrop of weaker foreign demand, we lowered our target for the overnight rate through the first half of the year. But by mid-summer, evidence began to accumulate that the U.S. slowdown would be more protracted than anticipated, and that economic activity outside North America would be much weaker. At the same time, there were indications that domestic demand in Canada, which had held up well through the first part of the year, was softening. So at our 28 August fixed announcement date, we said that we had revised down our expectations for growth. Then came the terrorist attacks of 11 September. Their immediate impact and subsequent fallout compounded the problems of the economic slowdown. And the attacks presented a pressing challenge to the Bank of Canada and other central banks: to keep the world's financial systems operating smoothly. One of the Bank's key functions is to promote financial stability in Canada. That means keeping markets functioning well, even in times of extreme stress, such as the days immediately following 11 September. The Bank of Canada, as did other central banks around the world, stepped in to provide financial markets with ample access to domestic liquidity. And we reached an agreement with the U.S. Federal Reserve that would have permitted us to provide extra U.S.-dollar liquidity to Canadian banks had it been necessary. In short, we made sure that the disruption did not turn into gridlock. If there was one positive thing to emerge from this terrible event, it was that the global financial system kept running as well as it did. But in the aftermath of these events, we were left with another challenge. That was to try to minimize the economic impact of the attacks. It was obvious that consumer and business confidence would suffer. We needed to do our part to help keep the loss of confidence as small as possible, which would help the economy recover as quickly as possible. That is why in the days following the attacks, we took the extraordinary step of lowering interest rates outside our fixed announcement dates. It then became clear that the economy would continue to operate below its capacity throughout 2002, with resulting downward pressure on inflation. So we sped up the pace of interest rate reduction at the next two fixed announcement dates. We wanted to support economic growth, which would help keep inflation within our target range of 1 to 3 per cent. The terrorist attacks created all sorts of uncertainties--economic, political, and military. So it was extraordinarily difficult last fall to be very certain about the future track of the economy. Now however, a clearer picture is beginning to emerge. One way for us to get that clearer picture is to actually get out across the country to see what is going on in Canada's regions. These opportunities to get away from the frenetic world of financial markets, and to see what is happening in the real economy, are extremely important to me, and to the Bank. Let me focus on this province for a moment. Here in Saskatchewan, the impact of a slowing world economy was felt mainly through a weakening in commodity prices. This hurt not just the agricultural sector, but the important mining sector as well. After posting very modest growth in 2001, Saskatchewan's economy is expected to show an improvement this year. A pickup in the global economy should boost commodity prices, which would be a big help to the province. Saskatchewan's agricultural sector would also be helped by a return to more normal weather patterns. There is an old farming saying that you can't lose a crop in January. But there is a clear critical need for more moisture in the soil and we all hope it comes soon. Of course my predecessor, Gordon Thiessen, has strong roots in this province and he understood well the difficulties faced by farmers year in and year out. But I want you to know that I too can relate to the trials of farming. I have a small cow-calf operation outside Ottawa, and I know how difficult this business can be. We can try to do something about the economy at the Bank of Canada, but sadly, we can't do anything about the weather. One clear positive for Saskatchewan has been the fiscal record of the provincial government, which is currently projected to post an eighth consecutive surplus. This strong fiscal record can only help the province deal with the sort of negative shock we experienced in the past year. In looking at the country as a whole, some sectors of the economy have recovered smartly from 11 September, but in other areas the adverse effects have persisted. Certainly air travel, both for business and tourism, continues to be weak. Last week, we published our . In it, we said that the economy looked increasingly likely to find itself between the two extreme possibilities we had sketched out in last November's full . On the plus side, geopolitical developments have been positive. Indeed, consumer confidence seems to be recovering in the absence of new terrorist attacks. But it is difficult to pinpoint the exact moment that the economy will begin to recover or precisely how strong that recovery will be. What I can say is that the conditions for strengthening world economic growth are in place. Excess capital stock is being worked out of the system, leading to expectations of greater investment ahead. And low commodity prices should rebound as global demand picks up. All told, we see Canadian growth in the first half of 2002 averaging between 1 and 2 per cent on an annualized basis. But growth should accelerate in the second half, with an average in the range of 3 to 4 per cent on an annualized basis. What does this mean for inflation? We saw total consumer price inflation dip sharply in November, then stabilize in December. At the same time, core inflation also fell during those two months. This is consistent with an economy operating below its capacity. With the economy growing more slowly than potential output through the first half of the year, excess supply will continue to build. So both total and core inflation are expected to remain near current levels for the next few months. But by lowering the target for the overnight rate, the Bank of Canada has taken vigorous action to stimulate domestic demand. We expect that as this excess supply begins to be taken up, both core and total CPI inflation should move back up close to our target of 2 per cent in about two years. Businesses of all kinds are still adjusting to the security risks that the events of 11 September have shown to us. In our view, this should be a one-time adjustment. But it probably means that there will be a small reduction in the level of our economy's potential output. I would now like to say a few words to reinforce our views about recent exchange rate developments that are a source of concern. Over time, exchange rates should reflect underlying economic and financial developments and prospects. But in the short run, there can be volatility as markets gauge those prospects. As I have already noted, it is becoming clearer that our economy will strengthen as we go through this year and into 2003. Recent data increasingly support the view that a recovery is taking hold. Household spending in Canada, particularly on interest-sensitive purchases, has been stronger than expected. The latest data on exports and manufacturing activity show signs of recovery. The inventory adjustment is progressing. And with early evidence of a revival in the U.S. economy, the world prices of non-energy commodities appear to have bottomed out. These signs of a pickup in economic activity in Canada are encouraging. But the recent movements in the Canada-U.S. exchange rate do not appear to have reflected those developments and the depreciation we saw over the last couple of weeks is not helpful for the economy. Economic recovery in Canada does not hinge on the current low levels of the Canadian dollar against its U.S. counterpart. So to conclude, this past year has certainly been full of challenges. I know, however, that we have done the right things to get the economy growing strongly again, and that we are in good shape to take advantage of better times when they arrive. I feel confident in predicting that one year from now, when I'm looking back over my second year as Governor, I'll be looking back over a recovering economy, one that is much stronger than it is today.

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canada

Bank of Canada's outlook for the Canadian economy

dodge

I am pleased to be here today and to have this opportunity to talk about the Bank of Canada's outlook for the Canadian economy and to update you on our monetary policy actions. This has been a very difficult year for all of us in North America, but especially for you here in New York City. The tremendous loss of human lives as a result of the 11 September terrorist attacks has been tragic. Among those who died there were family members, friends, and colleagues. And there were other innocent citizens of many nationalities caught in this tragedy, including Canadians. All of us at the Bank of Canada share a deep sorrow and extend our heartfelt sympathy. The immediate impact and the fallout from last September's events introduced new layers of uncertainty into the economic picture, compounding the effects of a deepening global economic slowdown that had become more evident during the summer. The Bank of Canada quickly responded to this extreme uncertainty by aggressively lowering interest rates in order to minimize the economic impact of the attacks and limit the loss of confidence. Since September, we have lowered our key policy interest rate by 200 basis points, bringing the total reduction since the beginning of 2001 to 375 basis points. This substantial monetary easing, together with measures taken by Canadian governments to reduce taxes and to strengthen national security, should support growth in domestic spending. On this basis, and with the improvement we have seen since the fall in the geopolitical climate and in consumer confidence, it is now clearer that the Canadian economy will gather momentum as the year unfolds. The timing and strength of the recovery will partly depend on how quickly business confidence and business investment, which remain weak in many countries, bounce back. Here, it is important to note that in Canada we did not have the same degree of overinvestment in fixed capital in the manufacturing sector during 1998-2000 as in the United States. So, the need for retrenchment and for adjustment of excess capacity in Canada would be less. The Bank of Canada's current view is that economic growth in Canada will be relatively modest in the first half of 2002--between 1 and 2 per cent, on an annualized basis--but that it will accelerate in the second half--to a range of 3 to 4 per cent--and strengthen further in 2003. This output profile means that there will be an appreciable amount of excess supply in the economy through 2002. Because of this, we see core inflation averaging just under 1 1/2 per cent in the second half of 2002--below our 2 per cent target. Total CPI inflation should remain below the core rate until late 2002. With slack in the economy starting to be taken up in the second half of 2002, and expected to disappear by late 2003, inflation should move back up close to 2 per cent in about two years. I would now like to reiterate some of the comments I made on current developments last week, when we released our to the November , and in two speeches I gave in western Canada earlier this week. It is now becoming clearer that the Canadian economy will strengthen as we go through this year and into 2003. Recent data increasingly support the view that a recovery is taking hold. Household spending in Canada, particularly on interest-sensitive purchases, has been stronger than expected. The latest data on exports and manufacturing activity show signs of recovery. The inventory adjustment is progressing. And with early evidence of a revival in the U.S. economy, the world prices of non-energy commodities appear to have bottomed out. These signs of a pickup in economic activity in Canada, and elsewhere, are encouraging. Over time, exchange rates should reflect economic and financial developments and prospects. But movements in the Canada-U.S. exchange rate do not yet appear to have reflected the recent developments in our economy. And to the extent that the recent depreciation of the Canadian dollar risks affecting consumer and business confidence in Canada, it is clearly not helpful for our economy. Furthermore, at this juncture, it is certainly the case that the economic recovery in Canada does not hinge on the current low levels of the Canadian dollar against its U.S. counterpart. Let me sum up. There is a good chance that when the final national accounts data for Canada come out, we will see positive, albeit modest, economic growth in both the last quarter of 2001 and the first quarter of this year. At this point, all available data suggest that final demand in the fourth quarter was stronger than we had anticipated. With production coming in at a much lower rate than final demand, the implication is that there has been a sharp rundown of inventories during the fourth quarter. This bodes well for the future, since it underpins the significant momentum we expect to see in economic activity as the year progresses. This is not to say that there are not uncertainties or risks in the economic outlook, or that the Bank of Canada will not remain alert to unfolding developments. But, overall, the prospects for the Canadian economy are looking up.

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canada

Canada's Experience with Inflation Targets and a Flexible Exchange Rate: Lessons Learned

dodge

Governor of the Bank of Canada The Canadian economy has undergone a dramatic transformation over the past decade. And it has emerged as a low-inflation economy, with declining levels of public and foreign debt and a private sector that is more cost-conscious, productive, and efficient, thanks to restructuring and investments in new technology. There is little resemblance between this economy and the one many of us had to contend with in the 1970s and 1980s--one that was racked by high and variable inflation and by unsustainably large and rising public deficits and debt. Since the 1990s, Canada's monetary policy framework, based on an explicit inflation-control target and a flexible exchange rate, has contributed importantly to putting the Canadian economy back on the right path to longer-term prosperity. This is the main theme of my talk today. I will conclude with a few remarks on recent developments and the outlook for the Canadian economy. To put Canada's inflation-targeting approach to monetary policy in context, a quick look into our economic history over the past three decades is in order. Through the 1970s and 1980s, Canada, like many other countries, found that high inflation, large fiscal deficits, and rising public debt exacted a heavy toll on the economy. Indeed, those of us who had to struggle with those unhappy times do not need to be reminded that high, variable, and unpredictable inflation increases uncertainty about the future. That it distorts the key signals and information individuals and businesses rely on to make important economic decisions. That it leads to exaggerated ups and downs in economic activity and employment. That it wastes valuable economic resources--resources that ought to be going into productive uses, but are instead diverted into hedging, as people seek protection from rising inflation. To make matters worse, through much of the 1970s and 1980s, Canadian governments were running large budget deficits. Those deficits were absorbing a major part of our national savings. The resulting accumulation of public debt meant high risk premiums in our interest rates. And these, in turn, discouraged the investments in equipment and technology that were necessary to improve productivity. To state the obvious, this was not a sustainable situation. Speaking for monetary policy, I can tell you that it took us a long time and a lot of work with different policy frameworks before we arrived at our current approach. By the late 1980s, it had become clear to the Bank that an explicit policy framework, which could be easily and clearly communicated to the public, was necessary to deal with the inflation problem. In January 1988, former Governor John Crow articulated a clear need to focus on achieving price stability. As the macroeconomic problems intensified through the late 1980s, it became evident that what we needed was an explicit commitment to a path for bringing inflation down. February 1991 marked a turning point in this process. At that time, the Bank of Canada and the Government of Canada, acting on a growing shared appreciation of the economic damage caused by high inflation, agreed to adopt explicit targets for inflation reduction. Subsequently, inflation came down quickly--indeed, faster than envisaged by the agreement. By January 1992, it had already fallen to close to 2 per cent. Now, I do not want to leave you with the impression that this was a quick and painless process. Far from it. Indeed, because of the magnitude of our imbalances, we had to take strong medicine and live with high interest rates for some time. This caused a lot of economic dislocation and pain in the short run. And even as interest rates came down, there was still an appreciable risk premium built into those rates that reflected, at least partially, our fiscal problems. But once the fiscal adjustment got underway, financial markets quickly took note of it and the risk premiums were reduced significantly. Thus, we were able to reap one of the key payoffs of low inflation. The original inflation-control agreement with the government has been renewed three times--most recently, in May 2001. The current agreement, which runs to the end of 2006, continues to aim at keeping inflation at the 2 per cent midpoint of a 1 to 3 per cent target range. The fact that we aim at the midpoint is of the essence, as I shall explain later. Through the past decade, and with two different governments, there has been increased shared appreciation among Canadian authorities of the important contribution that inflation control can make to good economic performance. I want to underscore that, in a democratic society, it is essential that the central bank and the government share the ultimate objective of a well-functioning economy. And that they both take action, and work co-operatively, to contribute to that common goal--hence my repeated emphasis today on words like "shared" and "agreement." Based on the Canadian experience, I can tell you that the combination of a monetary policy aimed at low, stable, and predictable inflation and a fiscal policy aimed at bringing about a significant decline in the debt-to-GDP ratio works to reinforce the credibility of both policies. When the Bank of Canada and the Government of Canada jointly announced explicit inflation targets in 1991, the purpose was to provide a clear path for inflation over the medium term to help Canadians make better economic decisions. To make those better decisions, Canadians had to understand what their central bank was trying to do. At the Bank, we were expecting that the targets would help us communicate clearly the specific policy objectives down the road and, in that way, make our actions more understandable to everyone. The targets would also provide a better basis for judging the effectiveness of monetary policy. The importance of communication in monetary policy is also something I would like to return to later. Right now, let me tell you what we have learned from our experience with inflation targeting. One lesson we draw is that a credible monetary policy requires a credible anchor. Inflation targets fulfill that role successfully. They do so because they make inflation more predictable and firmly anchor inflation expectations well into the future. With inflation expectations solidly anchored, investors can better assess the future value of their investments. Savers can be more confident that the purchasing power of their money will not be unexpectedly eroded by inflation. Wage bargaining can become less contentious and labour disruptions decrease. The duration of wage and financial contracts can lengthen considerably because people are confident that inflation will not greatly exceed 2 per cent over the medium term. Nor are they unduly concerned about the risk of deflation. Altogether, the real economy works better and is more stable. Moreover, the significance of the increased credibility of the targets is that it changes the whole dynamic of the inflation process. For example, sudden temporary changes in energy prices, or movements in the exchange rate, do not feed into other prices in the economy and into wages the way they did in the 1970s and 1980s. Again, this is because inflation expectations are well anchored. A main benefit of a credible monetary policy based on inflation targets is that it has helped the Canadian economy avoid the boom and bust cycles of the past. This is because the forward-looking framework of inflation targeting acts as an automatic stabilizer for the economy. Let me explain how that works. When demand is too strong, pushing the economy against its capacity limits, and there is a risk that future inflation will move appreciably above the target midpoint, the Bank will raise interest rates to cool off the economy. But this works also in the other direction. When demand is weak, and future inflationary pressures are likely to ease, as was the case in 2001, the Bank will lower interest rates to stimulate the economy, absorb economic slack, and return inflation to the target midpoint. Let me stress here that the midpoint of our inflation target range is a target , not a cap. That is to say, we pay equal attention to any significant movement away from the 2 per cent midpoint--whether above or below. By working in a symmetrical way in response to surprises in demand, our inflation-targeting system helps to smooth the peaks and valleys of the business cycle and to promote sound, and generally less variable, economic growth. In this connection, let me emphasize that our mandate, as expressed in the preamble to the Bank of Canada Act, is not dissimilar from that of the U.S. Federal Reserve or from those of many other central banks. Our Act enjoins the Bank "to mitigate by its influence fluctuations in the general level of production, trade, prices and employment, so far as may be possible within the scope of monetary action, and generally to promote the economic and financial welfare of Canada." The symmetry of monetary action that goes with our inflationtargeting framework is the best way to achieve inflation control and thus the objectives of the Act with respect to output and employment. In addition, a monetary policy that consistently delivers low, stable, and predictable inflation is likely to provide the greatest contribution to sustained growth in output and employment. This brings me to a key point I noted earlier. It is vital that the central bank communicate with the public and with financial markets on the goals of monetary policy. Here too, inflation targeting can play an important role--both in making monetary policy actions more understandable and transparent, and in making it possible for an independent central bank to be held accountable by the public. It can also provide financial markets with a clearer view of how the central bank will operate over time. Finally, let us not forget that monetary policy actions affect inflation with a lag of six to eight quarters. Because of that lag, in setting policy, one wants to emphasize those changes in prices that affect the underlying trend of inflation and downplay temporary fluctuations in very volatile components of the consumer price index. That is why, unlike some other central banks, we have explicitly chosen to focus on the underlying trend of inflation and use a core rate as our operating guide. The core rate excludes the eight most volatile components of the consumer price index as well as the effects of changes in indirect taxes. But I should add that the central bank can downplay those temporary price changes only if there is good reason to believe that they will not feed into other prices in the economy and affect inflation expectations. The reason we have been able to do that is because the inflation targets have helped to establish monetary credibility and to anchor inflation expectations. My review of Canada's current monetary policy framework would not be complete without reference to its other key element--our flexible exchange rate. Monetary policy can pursue only one objective--keeping inflation low as a means to promote the economic well-being of Canadians. In pursuing that goal, we have chosen an inflation target as our anchor. And that means that we have to have a floating exchange rate. But I want to emphasize that Canada is a small and very open economy, with a structure of production and trade that differs significantly from that of the United States. A floating exchange rate is important because it facilitates the adjustment to economic disturbances, such as fluctuations in the world demand for, and prices of, our products. It also facilitates adjustment to changes in savings and investment flows. Over the last few years, more countries around the world have moved to flexible exchange rate systems and have adopted inflation targets as their monetary policy anchor. Today, I have given you a flavour of the Canadian experience in this area, and I have talked about some of the lessons we have learned over the past decade. I hope that this has provided you with some useful insights. Let me now turn to recent economic developments and the outlook for the Canadian economy. The immediate impact and the fallout from last September's tragic events here in New York, and elsewhere in the United States, led to a sharp increase in economic uncertainty around the world, exacerbating the effects of the global economic slowdown that had become more evident by last summer. In those circumstances, the Bank of Canada moved quickly and aggressively to lower interest rates. The aim was to minimize the economic effects of the terrorist acts and to limit the loss of confidence at home. Since last September, we have cut our overnight rate target by 200 basis points, bringing the total reduction since the beginning of 2001 to 375 basis points. The substantial monetary easing undertaken in 2001 will have its maximum impact as we move through this year and into 2003. In addition, tax cuts implemented at the beginning of last year continue to provide significant support to the Canadian economy. Further stimulus will also come from spending on enhanced national security. Thus, both monetary and fiscal policies are providing very significant support as we move forward. Moreover, with the improvement since the fall in the geopolitical climate and in consumer confidence in North America and Europe, there are increasing signs that the global economy has turned the corner and will firm as the year progresses. For these reasons, the Bank of Canada expects that the Canadian economy will gain momentum through 2002. After growing modestly in the first half--by 1 to 2 per cent, on an annualized basis--it should accelerate in the second half--to something like 3 to 4 per cent--and strengthen further in 2003. Once our economy starts expanding at rates exceeding the growth of potential output later this year, the considerable amount of slack that has built up over the past several months will begin to be absorbed. Still, it could be late 2003 before the actual level of output in the Canadian economy will again reach its potential level . This implies that core inflation will probably average just under 1 1/2 per cent in the second half of 2002. Total CPI inflation is expected to stay below the core rate until late 2002, if energy prices remain near their current levels. Given the profile for output growth, the Bank expects inflation to move back up to 2 per cent in approximately two years. Recent economic indicators for Canada support the view that a recovery is starting. Household spending, particularly on interest-sensitive purchases, has been stronger than expected. Exports have lately shown signs of revival. The inventory adjustment is progressing. And with early evidence of a firming U.S. economy, the world prices of non-energy commodities appear to have bottomed out. Moreover, the national accounts data for Canada may well show slightly positive economic growth in both the last quarter of 2001 and the first quarter of this year. All available indicators suggest that final demand in the fourth quarter was stronger than anticipated. And the healthy employment data for January suggest that this strength is continuing. Also notable is the fact that production, especially in manufacturing, did not keep up with growth in final demand in the closing months of last year. So part of that demand was met by running down inventories. This bodes well for the coming months, because it means that production will likely begin to increase. This is another factor contributing to the momentum we expect to see in economic activity as the year unfolds. This is not to say that there are no uncertainties or risks in the economic outlook, or that the Bank of Canada will not remain alert to unfolding developments. While we expect fixed investment to begin to increase in the second half of the year, we are very much aware that this is conditional upon a recovery in business confidence, especially for large multinational enterprises. How quickly and how strongly profits and the confidence of those enterprises bounce back will have an important bearing on the strength and sustainability of the overall economic recovery. To sum up, over the past decade, Canada has made major economic strides. We now have a solid anchor for monetary policy, and inflation expectations are well grounded. Fiscal health has been restored and, even in the short run, we will continue to make progress in bringing down our public debt-to-GDP ratio. And significant business restructuring has taken place, with more to come. Thanks to these improvements, Canada fared better in 2001 than many other countries. And with encouraging signs of a turnaround in the global economy and strengthening final demand at home, prospects for the Canadian economy are favourable. As we look past the current difficulties to the more positive longer-term trends and the potential of our economy, I expect that we will be moving forward with an enhanced sense of the importance and contribution of sound macroeconomic policies to good economic performance. I have talked at length today of how Canada has gone about fostering a climate of low, stable, and predictable inflation by means of a monetary policy framework based on an inflation target and a flexible exchange rate. The inflation target and a floating exchange rate work well together--indeed they reinforce each other. This approach has worked extraordinarily well for us over the last decade. And we expect that it will continue to provide the foundation for a prosperous future.

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canada

Monetary Policy Choices: The Canadian Experience

dodge

Governor of the Bank of Canada It is a great pleasure to be with you today here in this wonderful and historic city. Canada and France share important links that cannot be weakened by time. There was, of course, a vibrant French presence in North America long before there was a country called Canada. The French contribution to Canada is not restricted to language alone. Canada's legal and political institutions, as well as our culture and way of life, retain a clearly visible French influence, and will continue to do so. Obviously, our economies and the economic links between our countries have come a long way over the years. The Chambre de Commerce France-Canada was established just after the Second World War. The Chambre has played an important role in reinforcing commercial ties between our two countries that reflect the historical and cultural links already in place. Les Canadiens en Europe is another organization that seeks to strengthen the many ties between us. Today, France and Canada are both members of the G-7--partners at the forefront of the global economy. The strong links between our two countries are also reflected in the close working relationship between the Bank of Canada and the Bank of France. Since becoming Governor of the Bank of Canada last year, I have been pleased to continue this relationship. I am happy to be working once again with Jean-Claude Trichet, the Governor of the Bank of France. Bank of Canada staff regularly attend the annual seminars hosted by the Bank of France. And I hope we will continue to strengthen the working relationship between our two institutions. Over the years, both Canada and France have had to make decisions about the framework guiding monetary policy. The authorities in the two countries have made choices that reflect the differences in our economies. Today I'd like to talk about some of these choices, and what they have meant for our countries. As well, I will give you a brief update on Canada's current economic situation and outlook. In the early 1990s, most of the world's central banks found themselves facing a common problem. They needed to make sure that their economies did not return to the high and volatile inflation seen in previous decades. Further, they were looking for a way to keep inflation expectations under control. In general, central banks did a good job with this. Certainly the Bank of France was successful in the early 1990s in building credibility as an inflation-fighting central bank. At that time, the Bank of Canada and the Government of Canada had come to a shared appreciation of the damage that inflation can do. So they made an important decision in early 1991. They announced a joint agreement to adopt explicit inflation-control targets. The agreement has been very successful in giving Canada low, stable, and predictable inflation. It has been renewed three times--most recently for five years until the end of 2006. Today, both the Bank of Canada and the European Central Bank are working to strengthen the economies in their jurisdictions. We both want to promote stable growth and rising living standards. And, importantly, we agree that promoting low and stable inflation is the best means to those ends. There are similarities between our inflation-control systems. For example, we both focus on inflation, and we both aim for price stability over the medium term. But there are also some differences that I want to highlight for you today. The Bank of Canada aims for price stability through its inflation target of 2 per cent. On the other hand, the European Central Bank has an inflation ceiling of 2 per cent, as measured by the Harmonized Index of Consumer Prices. This may look like a subtle difference, but it is important. For the Bank of Canada, 2 per cent is the midpoint of our 1 to 3 per cent inflationcontrol target range. It is a target , not a ceiling. Our focus on that midpoint makes it clear that we run monetary policy in a symmetrical way. That is to say, we pay equal attention to any significant movement away from 2 per cent--whether above or below. When demand is strong, it can push the economy against the limits of its capacity to produce. This will tend to raise future inflation above its target midpoint. In these circumstances, the Bank will raise interest rates to cool off the economy, and return inflation to the target. But this process also works in the other direction. When demand is weak, as we saw in 2001, this means that future inflationary pressures are likely to ease. So the Bank will lower interest rates to stimulate the economy, absorb economic slack, and return inflation to the target. By working in a symmetrical way in response to surprises in demand, our inflationtargeting system helps to smooth the peaks and valleys of the business cycle. This promotes sound, and generally less variable, economic growth. In our experience, we have found that operating this way around our inflation target is an effective way to anchor inflation expectations. Indeed, in recent years, inflation expectations have become firmly anchored on the 2 per cent target. This is important for the economy. With inflation expectations solidly anchored, investors can better assess the future value of their investments. Savers can be more confident that their purchasing power will not be eroded unexpectedly by inflation. Similarly, debtors can better assess the real burden of their interest payments. Wage bargaining can become less contentious so labour disruptions decrease. The duration of wage and financial contracts can be lengthened considerably. All of this is possible because people are confident that inflation will neither greatly exceed, nor greatly fall below, 2 per cent over the medium term. In short, the real economy works better and is more stable. Moreover, the credibility of the targets has changed the whole dynamic of the inflation process. Sudden temporary swings in energy prices, or movements in the exchange rate, do not feed into other prices in the economy the way they did in the past. Again, this is because inflation expectations are well anchored. I should be clear that adopting the inflation targets was not the only thing that happened in the past 10 years to improve Canada's economy. The federal government, and the provinces, proceeded to clean up their balance sheets. Because of that, our public debt-to-GDP ratio is on a sustainable downward path, even during a period of economic slowdown. This improvement in the public sector balance sheet has led to a sharp increase in national savings. As a result, our net foreign indebtedness fell from a peak of 44 per cent of GDP in 1993 to about 20 per cent today. It is important that we continue to reduce our net foreign debt. In Canada, it is particularly important that we do this before the baby-boom generation retires. So, based on our experience, I can say that a monetary policy aimed at low, stable, and predictable inflation and a fiscal policy aimed at reducing the public debt-to-GDP ratio work well together. Prudent monetary and fiscal policies reinforce each other's credibility. Let me now turn briefly to the role of exchange rates. This is one area where our two countries have made different choices. France is one of a dozen European countries that have chosen a monetary union with a single currency. This remarkable effort reached a crucial milestone at the start of this year. After existing in electronic form for three years, the euro finally began to circulate as notes and coins. By all accounts, the transition went extremely smoothly. The European Central Bank, and the 12 national central banks, deserve a great deal of credit for handling it so well. Indeed, the completion of the process has rekindled the debate in Canada: If it is advantageous for France and 11 other European countries to form a monetary union with a common currency, would a similar arrangement for Canada and the United States also be advantageous? After analyzing the costs and benefits, in my view, a separate, floating currency continues to make the most sense for Canada for the foreseeable future. Let me take a few minutes to explain why. A floating exchange rate is beneficial for Canada, primarily because our production and trade structures are quite different from those of our major trading partner, the United States. Let me give you a couple of examples. Canada is a net exporter of primary commodities, while the United States is a net importer of commodities. And unlike the United States, Canada's auto industry is geared heavily toward exports. We produce two cars for every one that is sold in Canada. Because of the differences in our economic structures, major changes, such as large swings in relative prices, affect Canada and the United States differently. One way or another, the Canadian economy must adjust to these changes. A floating exchange rate is important because it helps the economy adjust to economic disturbances, such as fluctuations in world demand for, and prices of, our products. Equally importantly, it also facilitates adjustments to changes in savings and investment flows. It is true that the Canadian and U.S. economies are becoming more integrated. It is also true that by forming a monetary union, there would be some savings for Canadians in terms of the transactions costs of converting currencies and hedging against currency movements. So the question might well be asked: Since most of Europe has moved to a monetary union with a single currency, what From a Canadian perspective, there are at least three major arguments against monetary union in North America. First, in Europe you have single markets for goods, capital and labour. In North America, we do not have a single labour market. Second, the structures of the largest economies in the euro zone are more similar than the structures of the Canadian and U.S. economies. Finally, the euro zone is a collection of 12 countries. Although they differ in size, no single nation dominates the group. In contrast, in North America, the United States is dominant, both in terms of population and economic power. So yes, North American economies are becoming more integrated. But it does not necessarily follow that the structures of our economies are becoming more alike. As long as those structures remain different, the benefits of a flexible exchange rate will outweigh the associated transactions and risk costs. For Canada, our best choice is to have inflation targets as an anchor for our monetary policy, and a distinct, floating currency. As I have said before, this should remain the case for the foreseeable future. Now let me turn briefly to the current state of Canada's economy and the outlook for the future. The immediate impact and the fallout from last September's tragic events in the United States led to a sharp increase in economic uncertainty around the world. This exacerbated the effects of the global economic slowdown, which had become more evident by last summer. In those circumstances, the Bank of Canada stepped up the pace of interest rate reduction that had begun earlier in 2001. The aim was to minimize the economic effects of the terrorist acts and to limit the loss of confidence at home. Since last September, we have cut the target for our overnight interest rate by 200 basis points. The total reduction since the beginning of 2001 has been 375 basis points. This substantial monetary easing will have its maximum impact as we move through this year and into 2003. In addition, tax cuts implemented at the beginning of last year continue to provide significant support to the Canadian economy. Further stimulus will also come from spending on enhanced national security. Thus, both monetary and fiscal policies are supporting our economy as we move forward. Moreover, there has been an improvement since last autumn in the geopolitical climate and in consumer confidence, both in North America and in Europe. Signs are increasing that the global economy has turned the corner and will firm as the year progresses. For these reasons, the Bank of Canada expects that the Canadian economy will gain momentum through 2002. While growth in the first half will be moderate, it should accelerate in the second half--to something like 3 to 4 per cent--and strengthen further in 2003. This means that later this year, our economy should start expanding at rates exceeding the growth of potential output. At that point, the slack that has built up over the past several months will begin to be absorbed. Still, it could be well into 2003 before the actual level of output in the Canadian economy will again reach its potential level . This implies that core inflation will probably average about 1 1/2 per cent in the second half of 2002. Total CPI inflation is expected to stay below the core rate until late 2002, if energy prices remain near their current levels. Given the profile for output growth, the Bank expects both total and core inflation to move back up to 2 per cent in approximately two years. Recent economic indicators for Canada show that the worst of the downturn is over. A recovery is underway. There were several positive signs in the fourth quarter national accounts data published last month, including strong household spending. Overall, Canada's economy grew at a 2 per cent annualized rate in the fourth quarter of 2001. In addition, there was a sizable reduction of inventories in the fourth quarter. This bodes well for the coming months, because the lower level of inventories will underpin future production. Data for the first two months of this year show that the Canadian economy has added 82,000 new jobs. Car sales are continuing to show strength, as is the housing sector. The Bank expects that fixed investment in Canada and the United States should start to pick up in the second half of the year. But we are very much aware that this depends on a recovery in business confidence, especially for large multinational enterprises. How quickly and how strongly profits and the confidence of those firms bounce back will have an important bearing on the strength and sustainability of the overall economic recovery. To sum up, Canada has made some difficult choices in recent years to face the challenges of today's globalized economy. We have found that our framework of a symmetrical inflation target and a floating exchange rate is appropriate for our economy. We have a solid anchor for monetary policy, and inflation expectations are well grounded. Fiscal health has been restored and we will continue to make progress in bringing down our public debt-to-GDP ratio. Thanks to these improvements, the effects of last year's global economic slowdown on Canada were not as pronounced as they might have been. And with encouraging signs of a turnaround in the world economy and a domestic recovery underway, prospects for the Canadian economy are favourable.

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The Conduct of Monetary Policy in the Presence of Economic Shocks

dodge

Globalization--the trend towards greater economic integration around the world--has brought important benefits to us all. It has boosted world trade, opened up access to sources of global finance, and facilitated the diffusion of far-reaching technological advances in transportation, communications, and information processing. A more integrated world also tends to speed up the transmission of economic and financial disturbances across national frontiers and increase their spillover effects. Over the past decade, monetary authorities around the world have had to deal with a number of such disturbances. In 1994-95, we had the Mexican financial crisis. In 1997-98, we had the Asian and Russian crises. And last year we had the global economic slowdown, which was greatly exacerbated by the tragic events of 11 September in the United States. To be sure, the conduct of monetary policy has become more complicated and challenging--but not impossible or ineffective. In fact, I would argue that in most countries, including Canada, monetary policy has been very effective in mitigating the impact of global shocks on the domestic economy. Today, I would like to discuss how Canadian monetary policy has been conducted in the presence of economic surprises or shocks--both domestic and external. I would also like to add some thoughts on the issue of the appropriate monetary response, nationally and internationally, to common economic disturbances. To put things in context, let me start by providing a bit of background about Canada's inflation-targeting system. When it comes to conducting monetary policy, our formal mandate is not dissimilar to that of the U.S. Federal Reserve or to those of many other central banks. The preamble to the Bank of Canada Act enjoins the Bank "to mitigate by its influence fluctuations in the general level of production, trade, prices and employment, so far as may be possible within the scope of monetary action, and generally to promote the economic and financial welfare of Canada." We have chosen to achieve the objectives of the Act through a policy focused on inflation control. This is because we believe that a monetary policy that consistently delivers low, stable, and predictable inflation is likely to be the greatest contribution that the central bank can make to sustained growth in output and employment. Since 1991, the Bank and the Government of Canada have agreed to pursue low inflation within a framework based on an explicit inflation target. The current agreement, which runs to the end of 2006, aims at continuing to keep inflation at the 2 per cent target midpoint of a 1 to 3 per cent range over the medium term. There are two elements I would like to underscore here--the emphasis we place on the 2 per cent midpoint as our and the emphasis on the . The significance of the first will become apparent in a moment. As for the focus on the medium term, it has to do with the fact that monetary policy actions take anywhere between one and two years to have their full effects on output and inflation. So, when setting monetary policy, we have to consider what will be the effect of actions we take today on the economy and on inflation several months down the road. In practice, setting monetary policy means raising or lowering interest rates to maintain a balance between the demand for goods and services and the economy's capacity to supply those goods and services. As long as there is a balance between demand and supply, inflation will remain stable. When we look at it this way, the rate of inflation is more than a number that tells us how the purchasing power of the average consumer is holding up. It is also a measure that the central bank can use to gauge how close to capacity the economy actually is. The presence or absence of inflationary pressures can tell us a lot about the balance between demand and supply. Our objective is to help the economy achieve potential output--that is to say, the maximum level of output and employment that can be sustained over the medium term without putting upward pressure on inflation. Over the past decade, a monetary policy based on an inflation target has helped us realize important economic benefits, particularly solid gains in output, employment, and incomes. It has also helped us to avoid the boom and bust cycles of the past, even in the presence of important surprises. This is because the forward-looking framework of inflation targeting works like an for the economy, with interest rates being raised or lowered in response to expected movements in future inflation relative to our 2 per cent target midpoint. For the most part, such movements reflect changes in the pressure of demand on potential output. Thus, our focus on the 2 per cent midpoint allows us to operate monetary policy in response to surprises in demand. And this helps to reduce the ups and downs of the business cycle and to promote sustained economic growth. The forward-looking framework of inflation targeting also allows us to handle temporary supply shocks, so long as these shocks do not feed into inflation expectations. The monetary credibility gained through our inflation-targeting system means that changes in volatile energy or food prices no longer feed into other prices and into wages the way they did in the past. That is why, unlike some other central banks, we focus on the underlying trend of inflation, and use as our operating guide a core rate that excludes the eight most volatile components of the consumer price index (CPI) and the effect of changes in indirect taxes on the remaining components. Such a measure of core inflation is a better predictor of future inflation than the total CPI. With this approach, monetary policy responds only to fundamental trends and does not turn temporary price shocks into something that can destabilize the economy. So far, I have described how our monetary policy framework, based on an inflation target, helps us respond to, and deal with, important surprises that have an impact on our economy. I would now like to say a few words about how the Bank of Canada incorporates external economic shocks into its decision-making process. Canada is a small and very open economy. We export more than 40 per cent of what we produce and, in general, we are price-takers (that is to say, the prices of what we buy and sell abroad are largely determined in world markets). Thus, the external environment is extraordinarily important to us. As part of its decision-making process, the Bank has always followed world economic developments very closely. The Bank's Governing Council starts its deliberations by looking at changes in the external environment. In particular, we focus on economic prospects for the United States and the major overseas countries, as well as on world commodity prices. Then we look at the implications of all this for aggregate demand in Canada. Next, we focus on domestic demand, taking into account anecdotal information gathered by our regional offices, as well as trends in credit, money, and financial markets. All this feeds into our decision on interest rates. Let me try and relate this to recent experience. Take last year, for example. Through the first half of 2001, we moved to loosen monetary policy at a measured pace. This approach was based on a view that the economic slowdown in the United States, although sharper than initially expected, would lead to only a moderate slowing of growth in Canada. By midsummer, however, evidence had begun to accumulate that the slowdown in the United States and elsewhere would be deeper and last longer than anticipated. Because of this, and because of signs that domestic demand in Canada was softening, we came to the conclusion, as we looked ahead, that our economy would be operating substantially below potential for some time, and that inflation would fall below target. The extraordinary uncertainty introduced by the 11 September terrorist acts in the United States pushed the recovery further back, so that, even under a relatively optimistic scenario, our economy was expected to be operating at levels below capacity well into 2003. That is why, as of mid-September and through to the end of 2001, we stepped up the pace of interest rate reductions. As I said in my last speech in Paris earlier this month, more recently, there have been encouraging signs of a turnaround in the world economy, and the latest economic indicators for Canada show that a recovery is indeed underway. Having discussed how Canadian monetary policy has been conducted in the presence of economic shocks, I would now like to broaden the scope of my presentation somewhat by providing some thoughts on the appropriate international policy response to common shocks. Clearly, it is very important that individual central banks do their best to assess the implications of such shocks and that they respond promptly, within their respective monetary policy arrangements, to mitigate the effects on their own economies and on the world economy as a whole. But given the increasing interconnectedness of national economies, a legitimate question is whether there should not be greater policy cooperation, or even concerted action, in response to major common shocks. Here's how I respond to that question, and I will certainly be very interested to hear the views of others. First, let me note that we central bankers greatly value our bi-monthly meetings at the Bank for International Settlements, and our regular meetings at the International Monetary Fund, where we systematically discuss the world economic situation. So there is an important process in place for exchanging information on what is going on in our domestic economies as well as globally. Now, when it comes to policy , I would argue that the best way to deal with common shocks, such as last year's global economic slowdown and the 11 September events, is prompt response by individual central banks. This response should be based on individual circumstances. But it should also take into account what is happening elsewhere and what fiscal and monetary authorities around the world are doing to deal with the situation. Otherwise, there is a risk that individual central banks will either under- or overreact, with potentially undesired consequences for the world economy. But the way that I and a number of my central bank colleagues around the world see it, prompt action does not mean concerted action. Indeed, to be clear, I would say yes to co-operation; yes to exchange of information; and yes to taking into account what is happening elsewhere. But I do not believe that formal coordination or concerted action are necessary. Provided that there is a good collective appreciation of the significance of certain global shocks, there is no reason why individual monetary authorities should not be the ones to take action tailored to their own domestic circumstances to deal with the implications. For example, in the days immediately after 11 September, there was no formal joint decision-making, although the major central banks did exchange information, leading to a shared appreciation of the grave risks for the world economy. And policy action was taken quickly--although not simultaneously and not by equal amounts. Judging from the signs of economic recovery we are now seeing around the globe, I would say that this process of international consultation and prompt policy action by individual central banks worked well to help us weather the very difficult circumstances we all faced last year. I would also like to highlight the significance of personal contacts among central bankers. Regular contacts build trust. And trust is very important when we have to act quickly, as we did last September to deal with the pressures faced by financial institutions, markets, and infrastructures immediately following the terrorist attacks. For example, in Canada, we were able to move very quickly and secure a temporary increase of our existing swap facility with the U.S. Federal Reserve. This arrangement was made to facilitate the functioning of Canadian financial markets and to provide liquidity in U.S. dollars to Canadian banks to settle their U.S.-dollar transactions, if the need arose. Let me conclude. Last year, as in previous episodes over the past decade, Canada's inflation-targeting approach to monetary policy allowed the Bank to respond quickly and successfully to buffer the effects of worldwide shocks on our economy. In a very open and increasingly integrated world, it is important that individual central banks take prompt action, based on their own circumstances and needs, but taking also into account what is going on outside their borders. Such action has the best chance of mitigating the effects of global shocks on their economies and, by extension, on the international economy. When we all do what is right for our domestic economies, we are also most likely to do what is right for the world economy.

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Opening Statement before the House of Commons Standing Committee on Finance

dodge

When Malcolm and I appeared before you last November, a heavy cloud of uncertainty hung over the outlook for the world economy and for Canada. Much of that uncertainty stemmed from the September terrorist acts in the United States, which came at a time when the global economy had slowed more than expected. To counter that uncertainty and bolster consumer and business confidence, the Bank of Canada moved aggressively to provide monetary stimulus. Between last September and January 2002, we lowered interest rates by 200 basis points, bringing the total reduction since January 2001 to 375 basis points. As it turned out, consumer confidence was not as badly shaken in the aftermath of those tragic events as had been widely feared. Indeed, confidence bounced back as perceived geopolitical and economic uncertainties diminished. The world economy has begun to strengthen. Here in Canada, a robust recovery appears to be underway. Growth in the fourth quarter of last year and the first quarter of 2002 was appreciably stronger than expected, so that the of economic activity is now higher than we thought it would be six months ago. This momentum is reflected in the extraordinary number of new jobs created since the beginning of 2002. In terms of the two scenarios we had painted last November, clearly, we are into the more optimistic one, in which a recovery in consumer confidence leads to an early resumption of economic growth. What do we see now as we look ahead? The Bank projects that, in the first half of 2002, the Canadian economy will grow by between 3 1/2 and 4 1/2 per cent, at annual rates. And we expect that it will continue to expand in the second half of the year and in 2003 at a rate somewhat above that of its production capacity (or potential), which we estimate to be around 3 per cent a year. This means that our economy should return to full capacity in the second half of 2003. The output path I have just sketched is consistent with core CPI inflation being at 2 per cent by about the end of next year. Total CPI inflation will probably continue to fluctuate in coming months as oil and natural gas prices move around. But, like core inflation, we expect it to be at the 2 per cent target midpoint by about the end of 2003. Although we no longer face the same degree of uncertainty as we did last fall, there are still important risks and uncertainties in the outlook--some of which are working on the upside and others on the downside. Given the amounts of monetary and fiscal stimulus in the economy, output growth could be even stronger than projected. But it is also possible that some of the recent strength in spending on consumer durables was borrowed from the future, so that the growth of household expenditures will be weaker than expected. At the same time, there is still considerable uncertainty about the timing and strength of the pickup in business investment in North America, mainly because of the continued weakness in profits. Moreover, tensions in the Middle East could have implications for crude oil prices and the global economy. But what do recent economic developments in Canada mean from a policy perspective? With our economy now operating at a significantly higher level than we had expected, the amount of spare capacity is smaller, and is projected to be absorbed sooner, than we thought last November. In these circumstances, our job will be to gauge the strength of the economy as it approaches its capacity to produce and to reduce the amount of monetary stimulus in place in a timely and measured manner. We want to ensure that inflation stays close to the target so that, over the medium term, our economy can continue to grow at full capacity. Over the past year, we put the "pedal to the metal" to help us get up the hill of economic difficulties. The prudent thing now, as we return to more normal driving conditions, is to ease off on the gas pedal--ease off, slam down on the brakes--to make sure that we continue our journey along the highway at a safe cruising speed. It is in line with this that we moved, on 16 April, to raise the target for the overnight interest rate by 25 basis points.

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The Interaction Between Monetary and Fiscal Policies

dodge

Governor of the Bank of Canada to the School of Policy Studies Thank you for the invitation to give the Gow Lecture for 2002. Donald Gow had a great interest in public administration and in budgetary reform in the federal government. He was one in a long line of Queen's professors who have focused on various budgetary matters at the federal level. The late Doug Purvis was another. In 1998, when I was asked to give the Doug Purvis In that lecture, I discussed the past practice of fiscal policy in Canada and drew from that experience some lessons that might guide its future practice. In that context, I touched briefly on the interaction between fiscal policy and monetary policy. Today, after some experience on the monetary side of the fence, I would like to reflect more fully on this important interaction. In doing so, I will be restricting myself to the macroeconomic aspects of fiscal policy. Thus, I will be dealing with deficits and debts--both in terms of fiscal planning and in terms of the responses of fiscal policy to economic surprises. These are the key aspects of fiscal policy in terms of its interaction with monetary policy. To begin, I find it helpful to look back to May 1970 when Canada returned to a floating exchange rate. At that time, there was no formal anchor for monetary policy and therefore no anchor for nominal economic variables. Nor had much thought been given to a medium- to longrun goal for fiscal policy. Both policies had a rather short-run focus, and economic fine-tuning was still in its heyday. Unfortunately, the early 1970s soon brought a number of surprises that were damaging to an economy with no policy anchors--world energy prices skyrocketed, the underlying trend rate of productivity growth slowed, and revisions to the employment insurance system increased the longer-run equilibrium unemployment rate in the economy. By 1975, inflation had climbed above 10 per cent, and the general government budget had moved into a deficit of 3.5 per cent of . In response to this rise in inflation, two policies were put in place. The Bank of Canada adopted targets for the growth of the narrow monetary aggregate , and the federal government established an Anti-Inflation Program in the autumn of 1975, which was in force until 1978. Although the controls aspect of this program was aimed at facilitating the transition to lower inflation, the fiscal and monetary policies under the macroeconomic aspect of this program were insufficiently restrictive to achieve permanently lower inflation. monetary targeting was not as effective in bringing down inflation as had been anticipated. The links between money growth and inflation over a policyrelevant horizon were not as tight as had been expected. The high interest rate elasticity of money demand meant that interest rates did not have to be raised by much to slow down money growth. And, at times, this problem was compounded by unexpected downward shifts in the desire to hold balances. Thus, although the targets for the monetary aggregate were achieved, spending and inflation did not decline as much as had been hoped. In the 1970s, fiscal policy was concentrating on cushioning shocks in a discretionary manner and on expanding the amount of public goods and services. There was little realization that it was going off track when examined from a medium- to long-term perspective. This was partly because real interest rates were very low (and, indeed, often negative) throughout the decade. This situation could not last forever, and it did not. Once real interest rates returned to higher levels and the economy continued to experience lower trend growth rates, the vicious circle of debt dynamics set in. Overall, one can view the period since 1970 as one in which the authorities struggled to establish appropriate medium-term anchors for both monetary and fiscal policies. During this time, they learned about the appropriate interaction between those two policies in the context of economic stabilization and growth under a flexible exchange rate regime. In the rest of this lecture, I will deal with four interrelated topics: the appropriate goals for fiscal and monetary policy, building policy credibility, the appropriate stabilization role for the two policies, and policy co-operation. I will conclude with some thoughts about the future. I will start with the topic of the appropriate goals for monetary and fiscal policies. In the 1970s, it was not only Canada, but most industrialized countries, that went off track in terms of their economic performance and budgetary outcomes. The global economic surprises that occurred during the course of the decade were partly to blame. But, more fundamentally, the problem was that central banks and governments had not yet established an appropriate macroeconomic framework for dealing with such surprises. This framework would have to operate in a world of floating exchange rates with high capital mobility and a high degree of substitutability between assets denominated in domestic currency and assets denominated in foreign currencies. Although Canada had been on a flexible exchange rate regime for most of the 1950s and into the early 1960s, it had operated on a fixed-rate regime from 1962 to 1970. Most other industrialized countries did not float their currencies until 1973 or later. And, although Canadian capital markets had historically been closely linked with those in the United States, the same could not be said for most other countries. Much of the academic literature around 1970 was focused on short-run stabilization, short-run changes in policy instruments, and static analysis. Not much attention was paid to changes in the stocks of assets and liabilities, which influence economic behaviour in the medium to longer run. Even though the large econometric models that were being constructed at that time did have dynamic behaviour and some limited role for asset accumulation, they were not typically used to look at alternative policy rules or regimes. Apart from the literature linked to the monetary aggregates, little had been written that dealt with a coherent medium-term policy. And there was also little or no concentration on the long-run effects of fiscal policy. Given all this, it was not surprising that we struggled to come to grips with our problems here in Canada. Short-run static analysis There was still an active debate in the early 1970s as to whether there was a long-run trade-off between inflation and unemployment. Those who believed that there was, were more willing to engage in a high level of fine-tuning the real economy. Models were used to mimic finetuning exercises, with interest rates or fiscal policy levers changed to get back quickly to desired output levels. Empirical models of the Canadian economy under flexible exchange rates were hampered by the fact that the experience was all from the 1950s--a time when the economic structure was much different from that of the 1970s and the exchange rate did not fluctuate very much. Not surprisingly, it proved difficult to develop an equation that explained exchange rate movements very well. Fortunately, there were some extremely powerful theoretical models of the short-run effects of monetary and fiscal policy, developed in the early 1960s by Robert Mundell and Marcus The sharpest prediction of the early models occurred under the assumption of perfect substitutability between domestic and foreign assets and a fixed domestic price level. In a flexible exchange rate regime, only monetary policy (and not fiscal policy) would affect the level of output ("internal balance"). Expansionary fiscal policy would, however, lead to a sizable deterioration of the current account of the balance of payments. Conversely, in a fixed exchange rate regime, only fiscal policy (and not monetary policy) would affect the level of output, while monetary policy would affect the balance of payments through its implications for changes in official reserves. Mundell had used quite restrictive assumptions regarding prices and expectations of exchange rate changes and inflation in his simple models. It is important to note, however, that relaxing these assumptions, while maintaining a hypothesis of perfect asset substitutability, still leads to the conclusion that monetary policy has no effect on output under a credible fixed exchange rate regime (because it must be used to defend the fixed rate and therefore is endogenously determined). Moreover, with perfect asset substitutability, monetary policy has a more powerful effect on output--and fiscal policy has a less powerful effect on output--under a flexible exchange rate regime than a fixed exchange rate regime. This comes about because the domestic effects of monetary policy are augmented by its impact on the exchange rate, whereas the domestic effects of fiscal policy are reduced by exchange rate movements. Even though Mundell's models dated from the early 1960s, it is not clear that policymakers had taken their implications into account for the change in exchange rate regime when Canada floated in 1970. Medium-run analysis Central banks, including the Bank of Canada, had long favoured a goal of price stability. And the Economic Council of Canada, founded in the mid-1960s, favoured "reasonable price stability" as one of its preferred policy objectives (but it did believe in "inflation-unemployment trade-off zones"). But by 1970, the only anchors for obtaining price stability or good inflation performance that were given prominence in the literature were monetary aggregates. The 1960s and 1970s saw a battle between the "monetarists," who favoured low and stable growth of a monetary aggregate, and the "Keynesians," who believed in fine-tuning and (in some cases) considered monetary policy to be ineffective. On the fiscal policy side, there was little analysis of medium- to long-run effects. In large part, this was because the federal debt-to- ratio had been on a long downward trend since the end of the Second World War to 1974. It was only after this ratio had increased for a number of years that it became obvious that there was a problem with sustainability. As the Canadian economy moved into the 1980s, taking with it a legacy of problems from the 1970s, attention turned more and more to the importance of policies that would be sustainable over the long run, as well as to what policies should be expected to accomplish over the medium to long run under a floating exchange rate regime. Evolution of thought about monetary policy in the 1980s and early 1990s In 1982, and just before the Bank dropped its target, Governor Gerald Bouey gave the Per Jacobsson Lecture. In that lecture, he discussed the "search for a better analytic framework within which monetary policy choices are made." Importantly, he noted that the Bank had found itself "taking a view of policy that is more forward-looking than one based solely on monetary targets on the grounds that it is wise to respond immediately to any potentially inflationary shocks rather than to wait until such shocks are reflected in higher inflation and higher money growth." In the 1982-86 period, the Bank looked for a target--monetary aggregate or other measure--that would provide a nominal anchor as a medium-term guide to policy (that is, a target that would prevent cumulative policy error) a place to stand that would be used to communicate policy to the public, and an anchor that could potentially affect the formation of inflation expectations. Research failed to turn up a monetary aggregate that could fulfill these conditions. But to aid policy-making, Bank staff set out a desired path for inflation that would lead to price stability in the context of internal economic projections. laid out the case for price stability as the best way that monetary policy could contribute to raising living standards. He also made it clear that, in his view, 4 per cent inflation was not price stability. It is important to review the case for low and stable inflation that the Bank has been making since 1988. The first key element in this case is that there is no long-run trade-off between inflation and output--a belief fully borne out by events. Moreover, low and stable inflation would be expected to actually increase output or economic welfare by reducing uncertainty about the future (and thus aiding planning and investment) reducing the costs of having to cope with inflation increasing equity and fairness leading to a more stable economy The government was also sensitive to the problems caused by volatile inflation and by inflation expectations that were not solidly anchored. Thus, by late 1990, there was a growing shared desire to have an explicit target that would provide a better anchor for inflation expectations. The fact that the credibility of monetary policy can potentially be frustrated by inappropriate fiscal policy--a theme to which I will return later--is one of the reasons that it is essential for both the government and the central bank to sign on to an agreement. In fact, an agreement was reached on specific inflation-reduction targets and was announced in a joint press release at the time of the February 1991 budget. You may recall that a series of targets was announced in that agreement, aimed at bringing the 12-month inflation rate down to 2 per cent (plus or minus 1 per cent) by December 1995. The target has subsequently been extended three times, retaining the 2 per cent target midpoint. For ten years now, inflation has been low and stable, and households and businesses have increasingly come to believe in its predictability. The increased transparency of the Bank's conduct of policy and its enhanced communications strategy have played key roles in this success. An understanding of the appropriate medium- to long-run goals for monetary policy, both conceptually and quantitatively, was thus solidly in place in the early 1990s. Moreover, the quantitative targets were achieved in short order. It took longer, however, for medium- to long-run goals to be established and achieved on the fiscal side. The evolution of thought about fiscal policy in the 1980s and early 1990s While central bankers and monetary theorists had always kept at least one eye on price stability or low inflation, the fiscal authorities in industrialized countries had typically not had to deal with rising debt-to- ratios during peacetime. Therefore, it took a while before there was any recognition that there was a longer-run problem on the fiscal side. The recognition lag was exacerbated by an unexpected decline in the trend rate of productivity growth, now dated at around 1973, and a rise in the actual real interest rate to some longer-run equilibrium that occurred sometime in the early 1980s. used . . . as a substitute for appropriate structural policies." This was particularly true with regard to the response to the two oil-price shocks. Thus, the contribution that fiscal policy could make to savings and longer-run growth was largely neglected in discussions during that period. During the 1983-85 period, academic economists began to discuss the sustainability of public deficits and the appropriate role for fiscal policy. (Queen's professors Neil Bruce and Doug Purvis were key contributors to this discussion.) The sustainability problem really comes down to two things. First, the stock of government debt cannot grow faster than the economy indefinitely. Eventually, fiscal policy must be adjusted. Second, because of this, when the rate of interest on government debt exceeds the growth of the economy, a rise in the government deficit relative to the size of the economy today means that there must be a rise in tax rates or a cut in the ratio of government program expenditures to sometime in the future. That is, there are important transfers among generations. Economists were also becoming more convinced that deficits and debts have significant real effects on the economy. These effects occur because, in practice, changes in private sector savings do not fully offset changes in government saving. That is, reduced government saving leads to some decline in overall national saving. In a small open economy such as Canada's, when the international substitutability of assets is very high, the most important effect of changes in government debt will be on foreign indebtedness. It works this way. A decrease in the deficit lowers domestic expenditures relative to domestic production and thus increases the current account balance. There is a corresponding decrease in net capital inflows and thus in foreign indebtedness. The decline in foreign indebtedness will lower the interest and dividend payments flowing abroad and thus raise domestic net income relative to gross domestic product. To the extent that domestic interest rates decline when the domestic government debt-to ratio falls, a decrease in government debt will tend to increase business investment and the capital stock. This is the second major effect of a decline in deficits and debts on the Canadian economy. Combining these two major effects, one can say that the appropriate longer-term goal for fiscal policy should be increased savings, investment, and output through an appropriately low debt-to- ratio. A decline in the debt-to- ratio can have additional favourable effects. First, to the extent that a lower debt-service burden leads to lower taxes, rather than higher expenditures, it leads to a reduction in the usual distortionary effects of taxes. Second, to the extent that it reduces the effect of a given change in interest rates on the government's balance, it makes fiscal planning much easier. Third, in situations of very high (and perhaps rising) debt-to- ratios, markets may build a premium into interest rates to cover the perceived probability that debt will be monetized. Lower debt ratios reverse this effect. Finally, when the economy weakens, governments facing high debt ratios may feel that they have to override the automatic stabilizers to avoid making a bad situation even worse--as often had to be done in the 1990s. This effect will tend to disappear at lower debt ratios. I will come back to the last two points later in this lecture. In the mid-1980s, the Canadian federal government developed a plan to gradually deal with the rising debt-to- ratio. But little progress was made, and thus more significant measures had to be taken in 1993 and 1994. It was not until the budget of February 1995, however, that the cumulative effects of all the measures taken were perceived to have put fiscal policy back on a sustainable track. Since that budget, the debt-to- ratio at the federal level has fallen from 70 per cent to 50 per cent, and the provinces have, by and large, also put their fiscal houses in order. Largely as a result of these fiscal moves, the ratio of Canada's international indebtedness to has been halved from 40 per cent to around 20 per cent. Differentials in nominal long-term bond rates between Canada and the United States have come down from over 2 per cent in 1990 to between 1/4 and 1/2 per cent over the past year. Canadian long-term interest rates in real terms have also declined. With lower government financing needs, Canadian corporations could more easily issue debt in Canada. All these changes have favoured increased business fixed investment in Canada, which rose from 10.3 per cent of As for future objectives, it is plain that the federal government and many provinces clearly intend to pursue further significant declines in their debt-to- ratios over the medium term. The federal government, for example, has a framework of targets and contingency reserves in each annual budget that reduces to low levels the probability of running a deficit. The usual nominal growth in the economy will thus reduce the debt-to- ratio. While the objective in the fiscal area may not be as specific as in the monetary area, it is the most definitive and operational medium- to long-term objective that there has been for Canadian fiscal policy in recent memory. What medium- to long-term objectives accomplish Whether one is thinking about monetary policy or fiscal policy, there are two important results when medium- to long-term objectives are established and achieved. First, a sustainable situation is created over time. Policy instruments are forced to adjust to surprises--particularly permanent surprises--because there is a longer-run anchor. Second, in choosing long-term objectives, appropriate consideration is given to the type of policy framework that will raise our living standards over the longer run. The longer-run outcome should be more than the result of a series of ad hoc short-run decisions aimed at economic fine-tuning. As a by-product, the economy gets the appropriate "assignment" of policies: long-run "internal balance"--that is, low and stable inflation--is assigned to monetary policy and long-run "external balance"--wealth accumulation coming, at least partly, from an increase in net foreign assets--is assigned to fiscal policy. This should be taken as only a rough parallel to Mundell's results for short-run policy under flexible exchange rates with perfect international asset substitutability. It misses the richness of the dynamic process through which both the capital stock and the stock of net foreign assets can be affected, as discussed earlier. I would now like to turn to the credibility of monetary and fiscal policies. After establishing appropriate medium- to long-term objectives for monetary and fiscal policies, it is important to achieve them. This is not only because in a democratic system it is important to be accountable, but also because there are gains to be reaped from having credible policies. The short- to medium-run credibility of monetary policy was established quite quickly, as inflation fell to 2 per cent in early 1992, more than three years before the inflation-reduction target itself was slated to be 2 per cent. By early 1993, the inflation expectations of private sector forecasters and businesses for short-run horizons had fallen in line with the midpoint of the target range. It took a while for these same inflation expectations at a 6- to 10-year horizon to fall to 2 per cent. This occurred by about early 1996. And at a 30-year horizon, as measured by the spread between the yields on conventional and Real Return bonds, expectations remained above 3 per cent until late 1996, before falling quite sharply to around 2 per cent by late 1997 and staying there. The significant deviation of long-term expectations from the target was partly a result of concerns about pressures that could arise because of a fiscal situation that was still not perceived to be fully in control. That is, financial markets were concerned with "fiscal dominance" over monetary policy in that period. There are a couple of strands in the theoretical literature on the interaction between fiscal and monetary policy, which essentially assert that fiscal policy will eventually dominate in determining long-run monetary policy. Both these strands, however, require that the fiscal authorities will either eventually require the monetary authorities to monetize the debt or convince the financial markets that, ultimately, the fiscal authority will have the upper hand. These appear to be extreme assumptions because they depend on the view that fiscal authorities are unconcerned with any inflationary consequence of their actions and ignore the many legal and institutional separations that exist between fiscal and monetary authorities. Nonetheless, market concerns about the potential for fiscal dominance can potentially have significant effects in financial markets, particularly on longer-term bond rates. These concerns were definitely at play in Canadian financial markets in the early and mid-1990s. As I noted earlier, it was only in February 1995 that the Government of Canada was perceived to have established an objective for fiscal policy that was specific enough to provide a basis for achieving a reduction in deficits to zero and setting the economy on a path that would reduce the debt-to- ratio. This objective was regarded as a foundation on which to build credibility for fiscal policy. As in the case of monetary policy, credibility did not come immediately. It had to be earned. Considerable credibility was gained, however, over the 2- to 2 1/2-year period after the 1995 budget. The deficit-reduction milestones were more than achieved and successive budgets reinforced the intention to stay the course. It is important to note the supporting role that the credibility of monetary policy played in this process. In part, because the short- to medium-run credibility of monetary policy was high, short- to medium-term interest rates on government debt had fallen significantly. Even long-term rates were much lower than in the early 1990s. These lower interest rates reduced the real cost of the existing government debt as it was rolled over. Thus, there was an interaction between the credibility of fiscal and monetary policies. The joint credibility of the two policies led to lower rates on long-term bonds as risk premiums related to the debt-to- ratio and to inflation uncertainty fell. The spreads between Canadian and U.S. long-term bond rates even became negative for most of the period from mid-1997 to late Canada's experience in the 1990s thus strongly suggests that there are important spillovers in credibility between fiscal and monetary policies. Moreover, it is easier for everyone--policymakers and the private sector alike--when the frameworks for both monetary and fiscal policy are clear and understandable. In discussing the establishment of credibility, I have so far put the emphasis on achieving the established objectives. This is certainly the most important factor. But communication has also played a key role--communication about the quantitative objectives and about the framework of the mechanisms that enable us to attain those objectives. Communication has been equally important for both monetary policy and fiscal policy. Policy credibility has led to important gains for the Canadian economy. The joint credibility of the two policies has lowered long-term interest rates in real terms, favouring business investment and, therefore, economic growth. The credibility of monetary policy has apparently led to a change in the nature of the inflation process itself. In the short run, inflation does not seem to respond as strongly to measures of excess demand and supply. As well, because inflation expectations have been well anchored near the 2 per cent target midpoint, the labour market today operates much more efficiently than it did during the high-inflation years. Union contracts have lengthened considerably and wages are rarely indexed to the cost of living. Moreover, there are no immediate reactions of wages to big changes in oil prices. Thus, relative wages are better anchored and tend to better reflect demand and supply conditions in particular markets. I regard all this as an extraordinarily important contribution, since I spent two years with the Anti-Inflation Board struggling to settle down a labour market that had become terribly distorted by high inflation in the early 1970s. Overall, credibility has stabilized the inflation process and, therefore, inflation itself. Moreover, effective monetary policy seems to have reduced the variability in the real economy as well. The credibility of fiscal policy has enhanced investment planning by the business sector since it has drastically reduced the risk of future increases in taxes stemming from a need to deal with fiscal problems. Thus, credibility has led to a more stable Canadian economy and one that is better positioned for future economic growth. There is a connection between credibility and my next topic--stabilization policy. The achievement of policy credibility has meant that the automatic stabilizers in the economy--those features of macro policy that tend to stabilize output--can be allowed to work fully. When the monetary and fiscal authorities are attempting to establish credibility, there is a natural inclination--and sometimes a necessity--to err on the side of overachieving the targets. This means that explicit actions may have to be taken to prevent the automatic stabilizers from working, as was the case with fiscal policy in the 1990s. Moreover, the lack of a credible fiscal policy was one of the factors that seemed to hinder the Bank's ability to achieve the monetary conditions that it desired at certain points in the early- to mid-1990s. Thus, the stabilizing properties of monetary policy were not able to fully work at that time. Now that the credibility of both policies is very high, both the federal government and the Bank can allow the automatic stabilizers to do their job. Monetary policy and stabilization In the case of monetary policy, interest rates actually have to be changed to get the stabilizing result. Nonetheless, although judgments are made based on the special factors at play and the balance of inflation risks going forward, the changes in rates can be considered as more or less automatic in response to surprises in demand. Our 2 per cent inflation target limits our discretion. Changes in interest rates independent of those in the United States are made possible by our flexible exchange rate regime. Let me explain how monetary policy focused on an inflation target plays a stabilizing role when there are demand surprises. Suppose that the economy is operating at its production potential, and inflation is at the 2 per cent target midpoint. A downward shift in demand--coming from, say, a tightening in fiscal policy--would create excess supply in the economy, putting downward pressure on inflation. To bring inflation back to 2 per cent over an 18- to 24-month horizon, the Bank of Canada would lower its target for the overnight interest rate. This action, through its effect on market interest rates and the exchange rate, would increase the level of output in the economy towards its production potential. Inflation would therefore return to target shortly after the excess supply disappeared from the economy. Because the inflation-targeting framework operates symmetrically, the same process would occur in reverse in response to an upward shift in demand. Supply shocks--which take the form of higher (or lower) inflation than expected for a given level of demand--are always more difficult for policy-makers to deal with than demand surprises. Nevertheless, the Bank's framework for inflation-targeting allows temporary supply shocks to be largely ignored, so long as they do not feed into inflation expectations. The credibility that has been established means that they no longer do so. Consider price surprises coming from the most volatile components of the consumer price index--components such as fruit and vegetables or oil and gas. As our operating guide, we use a measure of core inflation that excludes such components. This gives us, and economic observers, some confidence that we are looking at the underlying trend of inflation. Thus, our interest rate response to price shocks that are perceived to be temporary can be minimal. As a result, there will be little effect on output. In other words, monetary policy does not turn temporary supply shocks into something that is destabilizing for aggregate output. Fiscal policy and automatic stabilization On the fiscal side, the automatic stabilizers are tax revenues and employment insurance payouts. When the economy weakens, tax revenues tend to fall, and employment insurance payouts tend to increase. This buffers the effect on personal disposable income of the decline in output and therefore tends to reduce the amplitude of the output shock. If households based their spending decisions on their expected permanent level of income, as opposed to current income, there would be little role for the automatic stabilizers. But the evidence shows that many households, particularly those with lower incomes, cannot borrow freely against future income and therefore are often significantly constrained by their current level of disposable income. Thus, automatic stabilizers on the fiscal side play a significant role. Some have argued that a significant rise in the propensity to import, which can act as an automatic stabilizer in the economy, has perhaps decreased the importance of the automatic fiscal stabilizers. While this is true at the aggregate level, its effect has not been uniform across shocks affecting various final expenditure categories. The greatest increases in the propensity to import have come on the export side, because of the growing importance of two-way trade. Components of domestic expenditure such as housing investment, non-residential construction, and consumption of services, however, still have very low marginal propensities to import. Comparing and contrasting the automatic fiscal and monetary stabilizers Some of the automatic fiscal stabilizers work almost immediately--for example, the personal income tax deducted by the employer. Others, such as employment insurance payments and social assistance payments, work with a fairly short lag. These types of fiscal stabilizers are very effective in dampening an output cycle. But they do not come close to fully offsetting the change in output. Other elements of the automatic fiscal stabilizers do not take hold until income tax is settled in the spring of each year. The lags in the effects of monetary policy mean that there is no contemporaneous dampening effect on output. While changes in monetary policy can have some impact in the very short run, the full impact on output is not normally felt for 12 to 18 months. It is largely because of these lags that the Bank aims to bring inflation back on target over an 18- to 24-month horizon. As I noted earlier, the automatic fiscal stabilizers at the federal level will no longer have to be offset. What difference does that make for monetary policy? The most important factor is that fiscal policy will be more symmetric and predictable. Discretionary stabilization policy While the automatic stabilization provided by monetary and fiscal policies is very desirable, the question remains whether there is a role for something further--a role for a discretionary stabilization policy. In the case of monetary policy, the nature of our response is the more or less automatic one described earlier. As I said earlier, judgment is key to the process. That is particularly true at times of great uncertainty, as existed last autumn. But our clear inflation target means that, in principle, our discretion is limited relative to that of fiscal policy. The arguments for and against discretionary fiscal policy as an important element in macroeconomic stabilization in an open economy tend to revolve primarily around lags, and around the effectiveness of short-run fiscal policy relative to monetary policy. If the timing was close to perfect, fiscal policy measures that lasted for two or three quarters could, in principle, and under ideal circumstances, shorten the time to move output back to its desired level. Thus, in principle, discretionary fiscal policy is an important tool. But, as a practitioner, I can tell you that the great problem here is that temporary measures are both difficult to start quickly when the need arises and extraordinarily difficult to stop once the need is past. Thus, as a practical matter, not a philosophical one, there are some severe limitations to the use of discretionary fiscal policy as a stabilizer. Now let me turn to policy co-operation and coordination. I want to start by emphasizing that the inflation targets are joint targets. They are not just the Bank's targets--they are the targets of the Government of Canada as well. Put another way, "coordination" came through the joint agreement on inflation targets. With clear agreement on the medium-term policy objectives and an understanding of the policy framework, there is no need for coordination on the setting of interest rates or fiscal policy instruments. The economic literature on policy coordination tends to be about situations where the fiscal and monetary authorities have one or more of the following: very different views of economic welfare, inconsistent policy objectives, policy that is totally discretionary, or a tendency to get involved in game-like behaviour with one another. None of these applies in Given the policy framework, when the government changes fiscal policy, it needs to think of how these changes will affect inflation and, consequently, interest rates. Similarly, the Bank needs to consider how changes in fiscal policy will affect demand and inflation, and thus its setting of interest rates. Therefore, it is to the mutual benefit of both parties to co-operate in the sharing of information and analysis as they set their policies. For example, it is important for the Bank to recognize that government policies can affect the production potential of the economy through their effect on sustainable labour utilization rates and the level of productivity. The Bank needs to consider this information when making its policy decisions. Co-operation between the Bank and the federal Department of Finance occurs on a number of levels. I have frequent discussions with the Minister and Deputy Minister. My colleagues on the Governing Council stay in touch with the associate and assistant deputy ministers who are their counterparts. And there are meetings at the staff level to share, for example, information from economic forecasts, surveys, and contacts with various groups and organizations. One of the key reasons for our regular discussions is so that each institution understands the details of the framework within which the other organization is pursuing its objectives and how this framework applies to current economic surprises. With our inflation-targeting regime, provincial fiscal authorities--especially those in large provinces--also know that the Bank will react to the effect that their policies could have on the course of future inflation. At the same time, we at the Bank are obligated to keep the provincial authorities informed of our views on future inflation. Some of you may be surprised that I have not said anything about the appropriate mix of monetary and fiscal policies when talking about coordination and co-operation. As you might remember, policy mix was a hot topic in Canada in the late 1980s. That was before we had explicit frameworks for our monetary and fiscal policies. With these frameworks in place, the whole issue of policy mix becomes moot. In particular, interest rates are not adjusted to deal with problems of deficits and debts, and taxes and fiscal spending are not adjusted primarily to achieve an inflation objective. This does not mean, however, that there are no implications for financial and policy variables as a prolonged fiscal tightening puts the economy on a course for a new longer-run equilibrium with a lower debt-to- ratio. All else being equal, the fiscal tightening will initially lead to lower real interest rates and a temporary real depreciation of the Canadian dollar, so that interest-rate-sensitive components of and net foreign demand can make up for the loss in domestic demand stemming from the tightening. But as Canadian net foreign assets rise, the wealth effect on consumption will become large enough to support demand and to allow the Canadian dollar to rise to a permanently higher real value than prior to the change in fiscal policy. Related to what I have said about the need for co-operation rather than coordination of policy variables domestically, I would argue that, if each major industrial country had clear medium-term objectives for monetary and fiscal policies, along with transparent frameworks for achieving those objectives, there would be no need or desire to have any strong form of international coordination. Again, it would be co-operation in terms of information-sharing that would be important. Overall, I believe that the clear longer-term objectives and frameworks of monetary and fiscal policies have created an environment where co-operation in the form of sharing information and analysis is most effective. Just over 25 years ago, in the absence of appropriate anchors, Canadian monetary and fiscal policies both went badly off course. It then took 15 to 20 years to establish the appropriate focus for those policies and to bring them back on course. Now there are clear monetary and fiscal objectives and clear accountability for meeting those objectives. The transparent framework that has been established will be extremely helpful in meeting the challenges that the future is sure to bring. Two of these challenges are already apparent--a possible increase in the trend rate of productivity growth and a slowdown in population growth combined with an aging population. Both these factors create uncertainty about the growth and level of production potential of our economy. Fortunately, this broad type of uncertainty is not new, either for the Bank of Canada or for the fiscal authorities. The medium-term frameworks that have been set up for monetary and fiscal policies mean that the required adjustments in the economy will take place against a relatively stable background. That is to say, the Bank will react so that inflation does not stray too far from 2 per cent, and the government will react so that the debt-to- ratio remains on a downward trend. We have come a long way in the past 25 years in understanding the relationship between monetary and fiscal policies and what those policies can best accomplish. As we go forward, this will help to underpin strong economic growth and a more stable Canadian economy. ------. 2001. "Joint Statement of the Government of Canada and the Bank of Canada on the from the International Experience. , edited by D.W. research coordinated by J. Sargent, volume 21 of the Royal Commission on the Economic . Fillion, J.-F. 1996. "L'endettement du Canada et ses effets sur les taux d'interet reels de long Handbook of research coordinated by J. Sargent, volume 21 of the Royal Commission on the

r020430a_BOC

canada

Opening Statement before the Standing Senate Committee on Banking, Trade and Commerce

dodge

When Malcolm and I appeared before you at the end of last November, a heavy cloud of uncertainty hung over the outlook for the world economy and for Canada. Much of that uncertainty stemmed from the September terrorist acts in the United States, which came at a time when the global economy had slowed more than expected. To counter that uncertainty and bolster consumer and business confidence, the Bank of Canada moved aggressively to provide monetary stimulus. Between last September and January 2002, we lowered interest rates by 200 basis points, bringing the total reduction since January 2001 to 375 basis points. As it turned out, consumer confidence was not as badly shaken in the aftermath of those tragic events as had been widely feared. Indeed, confidence bounced back as perceived geopolitical and economic uncertainties diminished. The world economy has begun to strengthen. Here in Canada, a robust recovery appears to be underway. Growth in the fourth quarter of last year and the first quarter of 2002 was appreciably stronger than expected, so that the of economic activity is now higher than we thought it would be six months ago. This momentum is reflected in the extraordinary number of new jobs created since the beginning of 2002. In terms of the two scenarios we had painted last November, clearly, we are into the more optimistic one, in which a recovery in consumer confidence leads to an early resumption of economic growth. What do we see now as we look ahead? The Bank projects that, in the first half of 2002, the Canadian economy will grow by between 3 1/2 and 4 1/2 per cent, at annual rates. And we expect that it will continue to expand in the second half of the year and in 2003 at a rate somewhat above that of its production capacity (or potential), which we estimate to be around 3 per cent a year. You may recall, Senators, that at our last visit I spoke about the concept of potential output. We set monetary policy so as to keep inflation low and stable, thus contributing to sustaining economic growth at its full potential. Six months ago, we assumed that our economy would be growing at a pace well below the rate of capacity growth in the fourth quarter of last year and the first quarter of this year. We thought that the gap between the actual level of economic activity and the level of potential would be widening throughout this period. Instead, growth has turned out to be much stronger than expected. This means that our economy is operating at a much higher level than we thought. So the output gap is smaller than we had predicted and is currently narrowing. Indeed, we expect that it will close in the second half of 2003. The output path that we are now projecting is consistent with core CPI inflation being at 2 per cent by about the end of next year. Total CPI inflation will probably continue to fluctuate in coming months as oil and natural gas prices move around. But, like core inflation, we expect it to be at the 2 per cent target midpoint by about the end of 2003. Although we no longer face the same degree of uncertainty as we did last fall, there are still important risks and uncertainties in the outlook--some of which are working on the upside and others on the downside. Given the amount of monetary and fiscal stimulus in the economy, output growth could be even stronger than projected. But it is also possible that some of the recent strength in spending on consumer durables was borrowed from the future, so that the growth of household expenditures will be weaker than expected. At the same time, there is still considerable uncertainty about the timing and strength of the pickup in business investment in North America, mainly because of the continued weakness in profits. Moreover, recent tensions in the Middle East could have implications for crude oil prices and the global economy. While we face many of the same risks as the United States, there are a couple of differences in our situations that are worth noting. First, as we pointed out in the , we expect that in Canada final demand will make up a larger share of the growth in the first quarter, while inventory rebuilding will constitute a smaller share than in the United States. Second, while weaker-than-expected confidence among large businesses remains a risk for both countries, the sectors that face the biggest challenges, such as computer equipment and telecommunications, make up a larger share of the U.S. economy than of the Canadian economy. So what do recent economic developments in Canada mean from a policy perspective? As I mentioned, our economy is now operating at a significantly higher level than we had expected. So the amount of spare capacity is smaller, and is expected to be absorbed sooner, than we assumed last November. In these circumstances, our job will be to gauge the strength of the economy as it approaches its capacity to produce and reduce the amount of monetary stimulus in place in a timely and measured manner. We want to ensure that inflation stays close to the target so that, over the medium term, our economy can continue to grow at full capacity. What do we mean by "timely and measured"? "Timely" relates to the fact that there is always a lag between our policy actions and their effect on the economy. We must be timely and forward-looking because our actions take a year to 18 months to have their full effect on output, and 18 months to 2 years to have their full effect on inflation. "Measured" relates to the judgments that we will make as we approach full capacity. If the economic data going forward tell us that we are taking up excess capacity more quickly than expected, we would have to reduce monetary stimulus more quickly. But if the data suggest that the return to full capacity is going more slowly than we thought, we would then need to move more slowly. Allow me to close by using the familiar car analogy. Over the past year we put our foot on the gas to help us get up the hill of economic difficulties. The prudent thing now, as we return to more normal driving conditions, is to ease off on the gas--ease off, slam on the brakes--to make sure that we continue our journey along the highway at a safe cruising speed. It is in line with this that we moved, on 16 April, to raise the target for the overnight interest rate by 25 basis points.

r020509a_BOC

canada

Canadian Consul General's residence

dodge

Governor of the Bank of Canada at a luncheon at the Thank you for the invitation to this luncheon and for the opportunity to speak to you this afternoon. I want to take this time to review Canada's recent economic performance and prospects and to hear your views as to how you see things evolving in the U.S. economy. In Canada, the economic weakness that we experienced was really concentrated in the third quarter of last year, particularly in September. The terrorist attacks in September created a great deal of uncertainty, and so the Bank of Canada, like the U.S. Federal Reserve, provided an extraordinary amount of stimulus by aggressively lowering interest rates. But with the improvement in the geopolitical situation, consumer confidence recovered rapidly, and consumers responded strongly and quickly to the monetary stimulus. Interest-sensitive sectors, such as housing and automobiles, showed remarkable strength. As a result, we saw annualized growth of 2 per cent in the fourth quarter of last year, when many analysts were expecting the Canadian economy to continue to shrink. In the , which we published a couple of weeks ago, we forecast growth in the first half of this year of between 3 1/2 and 4 1/2 per cent at annual rates, although data released since then suggest that the first quarter may have been slightly stronger than we had thought. Second-half growth is expected to be in a range of 3 to 4 per cent. With growth at the end of last year and early this year being stronger than we had earlier assumed, the economy is operating at a higher level than anticipated. Indeed, this strength led us to sharply raise our forecast for average annual growth this year. In the published in January, we pegged average annual growth for 2002 at just over 1 per cent. When we published our full in April, we raised that forecast to between 2 1/4 With the economy now operating at a considerably higher level, the gap between the actual level of economic activity and the level of potential output is smaller than we had predicted, and is currently narrowing. We now expect that the output gap will close in the second half of 2003. In these circumstances, our job will be to gauge the strength of the economy as it approaches its capacity to produce and to reduce the amount of monetary stimulus in place in a timely and measured manner. What do we mean by those terms? "Timely" relates to the fact that there is always a lag between our policy actions and their effect on the economy. We must be timely because our actions take a year to 18 months to have their full effect on output, and 18 months to 2 years to have their full effect on inflation. "Measured" relates to the judgments that we will make as we approach full capacity. If the economic data going forward tell us that we are taking up excess capacity more quickly than expected, we would have to reduce monetary stimulus more quickly. But if the data suggest that the return to full capacity is going more slowly than we thought, we would then need to move more slowly. There are still important risks and uncertainties in the outlook. Some are working on the upside and others on the downside. Given the amount of monetary and fiscal stimulus in the economy, output growth could be even stronger than projected. But it is also possible that some of the recent strength in spending on consumer durables may have been borrowed from the future, so that the growth of household expenditures may be weaker than expected. At the same time, there is still considerable uncertainty about the timing and strength of the pickup in business investment in North America, mainly because of the continued weakness in profits. Moreover, recent developments in the Middle East could have implications for crude oil prices and the global economy. On 16 April, Canada became the first G-7 country to raise interest rates following the most recent economic slowdown. Central banks should always tailor their monetary policies to their own circumstances. And while Canada faces many of the same risks as the United States, there are some differences in our situations that are worth noting. Although the first-quarter national accounts data are not yet out in Canada, we expect that final demand has made up a larger share of Canada's growth in the first quarter, while the contribution to growth from inventories constituted a smaller share than in the United States. It is always difficult to measure excess capacity with precision. However, it is clear that the Canadian economy is now nearer its level of potential than we expected it to be just a few months ago. The key issue facing both the U.S. and Canadian economies is business investment--when it will resume and how strong that pickup will be. In this context, I would certainly be very interested to hear your views on the situation here in the Midwest, and in the United States as a whole. As I recently said to our Parliamentary committees, we see two or three key differences in the Canadian and U.S. situations. First, it is clear that there was a tremendous buildup of capacity in the telecommunications and information technology sectors in recent years, and some analysts expect that it will likely be well into 2003 before we see any recovery in investment there. But I would note that these sectors represent a smaller proportion of the Canadian economy than the The second issue we have noted is that small- and medium-sized firms tend to be more bullish about their outlook and investment intentions than large, multinational firms. I'd certainly be interested in hearing your perspective on this. But again, I'd point out that these smaller companies make up a larger share of the Canadian economy than of the U.S. economy. The final point I made to the committees has to do with the potential impact of higher oil and natural gas prices on investment. While higher oil and natural gas prices stemming from developments in the Middle East could hurt consumers, they could lead to much greater drilling and exploration activity in Canada. Of course, that sector remains a significant part of our economy.

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canada

International Financial Architecture and the Resolution of Financial Crises

dodge

Governor of the Bank of Canada to the Canadian Club of Ottawa and I am pleased to be here today to talk about the Bank of Canada's contribution to international financial stability and the resolution of financial crises. The preamble to the Bank of Canada Act calls on us to promote the economic and financial welfare of Canada. In this context, we aim to foster good economic performance through monetary stability--that is to say, through low, stable, and predictable inflation. But no market economy can function properly unless it is also supported by an efficient and stable financial system. Sound financial institutions, a robust infrastructure, and well-functioning financial markets are necessary to facilitate transactions and to properly channel savings into investments. This is true for Canada's domestic economy. But in today's interconnected world, it is equally true for the global economy. Recent experience has shown that world events can have serious repercussions on national financial markets, including ours, and indeed on our entire economy. The Mexican crisis of 1994-95 and the Asian and Russian crises of 1997-98 are cases in point. In both instances, Canada was sideswiped. And while the recent acute economic and social problems in Argentina have not had a major economic impact beyond that country's borders, they have nevertheless had implications for Canadian banks operating in, or holding claims on, Argentina. So Canadians have more than a passing interest in a healthy global financial environment. Sound macroeconomic policies and sound financial systems across all countries are becoming even more important as the world becomes more and more integrated. The episodes of financial stress that the world has experienced in recent years have revealed weaknesses in the foundation of the international financial architecture. Those problems have to be addressed, and the foundation fortified, if we want to reduce the incidence and the impact of global financial disturbances. In the aftermath of the crises of the late 1990s, the international community has acted to identify and to begin to deal with financial vulnerabilities. Canadians have been actively involved in this work. And we at the Bank of Canada have played our part. The Bank participates in several international forums where issues of financial stability are being debated. And we work closely with others to strengthen the international financial architecture by developing frameworks for the prevention, management, and resolution of crises. Today, I would like to update you on some of the progress that has been made to date and on what remains to be done. But before doing that, it is important to briefly review the lessons we have learned, or ought to have learned, from recent financial disturbances. What are some of the factors that led to the serious problems experienced by In various combinations, there were large current account and fiscal deficits, heavy reliance on short-term borrowing, weak banking systems, poor risk management, overvalued exchange rates, and lack of transparency in fiscal, monetary, and financial policies. Moreover, the presumption that the international community would come to the rescue if things turned sour, appeared to offer some form of protection to emerging-market borrowers and lenders. This distorted market signals and encouraged overborrowing and overlending. So what has been done, and what can be done, to minimize the risks of future A sound macroeconomic policy framework It is now broadly recognized that sound and credible macroeconomic policies are the best defence against financial crises. As we know from our own experience in Canada, this means a fiscal policy focused on keeping public sector deficits and debts on a sustainable track and a monetary policy focused on keeping inflation low and stable. A viable macroeconomic framework for growth requires that both fiscal and monetary policies be credible. But many emerging-market countries lacked credibility. To provide an anchor for their policy framework, they chose to peg their currencies to another major international currency or a basket of currencies. But a peg can only provide temporary credibility. And when countries fail to develop appropriate fiscal, monetary, and regulatory policies, even small economic shocks can put pressure on the peg. Markets can then begin to question the authorities' commitment to the peg, and domestic and foreign investors can rush for the exits, triggering a crisis. In fact, that is exactly what happened in those economies that ended up in trouble during the past decade. So, many of these countries were forced to abandon the peg as an anchor and had to opt for a flexible exchange rate. But an anchor is still needed. Otherwise, the freedom of the currency to float could undermine confidence in its value, both at home and on world markets. Targets for domestic inflation provide such an anchor for the currency. In the last few years, a growing number of emerging-market economies have moved to flexible exchange rate regimes, and have also adopted inflation targets. In several cases, Canada has played an important role in that process. Because of our long experience with flexible exchange rates and our strong reputation in inflation-targeting, several emerging-market central banks have asked for the Bank of Canada's assistance in developing and operating frameworks based on inflation targets. A robust financial infrastructure Another important lesson drawn from recent crises is the need for a strong financial infrastructure. Weak banking systems were at the heart of nearly every one of the recent financial crises. To perform well their important role of intermediating between lenders and borrowers, banks and other financial institutions need to work within a strong framework--a framework distinguished by clear accounting and disclosure standards, appropriate regulatory and supervisory practices, and well-defined bankruptcy rules. In many cases, these institutional arrangements were found wanting. The international community has done a lot to contribute to the strengthening of financial systems in emerging-market economies and to improve risk management in major Forum (FSF), have worked hard to establish globally accepted guideposts--codes and standards--for the sound operation of financial institutions and systems. But guideposts are not much use if they are not followed. So it was also essential to develop the means for assessing adherence to key standards and for public disclosure of important economic and financial information. If there is a lasting lesson in recent history, it is that we need greater transparency. Better and more timely data should lead to more informed judgments about how risky certain investments are. And this should help avoid the crises that can be set off by the sudden revelation of problems. As I said earlier, the Bank of Canada and the Government of Canada have fully participated in, and contributed to, many of these initiatives. I would highlight, in particular, our involvement with the FSF and with the G-20, until recently chaired by Finance Minister Paul Martin. The Office of the Superintendent of Financial Institutions and provincial securities commissions have also been working with the FSF and with the BIS to identify system-wide weaknesses and to develop worldwide financial standards and codes. The Bank of Canada, together with the Bank of England, has also been promoting the idea of clear, upfront limits on official lending (that is, lending from international financial institutions, such as the IMF) as a means of conditioning the expectations of creditors and borrowers and thus helping to prevent crises. I will have more to say about this in a moment. Before I move on, let me add that, in the context of assessments of how well countries are doing in strengthening their financial systems, Canada was the first industrial country to place its financial system under IMF scrutiny. And we passed with flying colours. Of course, this does not mean that we can afford to rest on our laurels. On the contrary, it is vital that we continue to look for ways to improve the efficiency and soundness of our national financial systems. As you can see, important preventative actions have been taken to reduce the risk of future crises. But of course, even with the best preventative efforts, we will not totally eliminate the possibility that, from time to time, there will be a crisis in some part of the world because of one shock or another. As I said before, when there is a shock, national macroeconomic policies must be adjusted in response. But this takes time. And where policies are not particularly credible and markets are getting jittery, the prospect of adjustment down the road may not be enough to restore confidence in the short run. So domestic and foreign investors and creditors may have a strong incentive to pull their funds out of the affected country. This could precipitate a crisis. If creditors can be encouraged to stay put and to negotiate a solution in an orderly fashion, it would be in their collective interest as well as that of the whole international community. But how can this best be accomplished? This has proven to be a rather contentious issue, with the debate centered on the proper roles and responsibilities of the official and private sectors in crisis management and resolution. The key question here is how much emergency assistance should be presumed to be available from the official sector and how much should be left for private debtors and creditors to sort out by themselves. Traditionally, the IMF has been the main provider of emergency official assistance to a country that runs into financial difficulties. But IMF resources are limited. And when debtors or creditors presume that there will be large official bailouts, there is the possibility of "moral hazard"--debtors have less incentive to make adjustments, and creditors feel less pressed to use effective risk management. More importantly, with no limits on official money, there is less motivation for creditors to be careful with risk assessment when loans are made. And there is little motivation for early, serious discussions between a debtor and its creditors when problems begin to arise. In fact, the only serious motivation comes when the crisis is full-blown and official money runs out. Clear limits would encourage better risk assessment, earlier negotiations, and conceivably, a quicker and more orderly resolution of the crisis. Of course, one could eliminate official assistance altogether and leave debtors and creditors to work it all out on their own. But with no official lending, disorderly defaults could occur more frequently, resulting in unnecessary output losses and financial-system disruptions in the affected countries and elsewhere. Over the past couple of years, the Bank of Canada and the Bank of England together have developed a "middle ground" approach, designed to encourage private lenders to work closely with debtors to find timely, orderly solutions. In our joint work with the Bank of England, we set out a framework for the resolution of international financial crises. This framework has three basic elements. First, official assistance should be limited, and the limits should be well known in advance. (These limits are often referred to as the "presumptive limits.") The second key element of our approach is the possibility of exceptional official lending in the unlikely event that a crisis threatens global financial stability. But such lending would be based on explicit criteria and procedures. Third, it is recognized that, under certain conditions, an orderly standstill (that is, a temporary suspension of debt-service payments) may be appropriate to give distressed debtors some time to take steps, including debt rescheduling, to address their problems. In addition, the framework encourages greater use of what is known as "collective-action clauses." These clauses are intended to discourage "rogue" creditors from blocking or rejecting a reasonable offer for debt restructuring. Such a framework, by providing greater clarity upfront about the size and terms of the official assistance available, allows debtors and creditors to form more realistic expectations. In so doing, it helps to prevent crises; and, should they occur, it creates the right incentives for their timely resolution. to encourage the adoption of such a framework. And last month, G-7 finance ministers and central bank governors adopted an Action Plan that aims to address many of these issues. The current problems in Argentina have served as a catalyst to refocus the attention of the international community on what was needed "to increase the predictability and reduce the uncertainty about official policy actions in the emerging markets." The G-7 Action Plan identifies the key elements of a successful framework for crisis prevention and resolution, and how these elements fit together to help align incentives for debtors and creditors. First, it recognizes the need for limits on official lending. Second, it recognizes the need for rules in loan contracts to allow a cooling-off or standstill period and prevent small groups of creditors from blocking a reasonable restructuring deal. The Plan also encourages the IMF to continue its important work to find some mechanisms for sovereign debt restructuring analogous to domestic corporate bankruptcy procedures, such as Chapter 11 in the The G-7 countries have pledged to work with borrowers and creditors to make sure that these ideas can be effectively put into practice. Clearly, a lot more needs to be done, including work on operational and legal issues. But let us not lose sight of why this work is important. The Action Plan, by helping to reduce the incidence of financial crises and to better resolve them when they do occur, will create conditions that encourage sustained and sustainable growth of private investment in emerging-market countries, thus helping to raise their living standards. To conclude, considerable progress has been made in defining the elements of a strategy to reduce the incidence of crises in the future. When it comes to crisis management and resolution, the international community is still hard at work. Many issues on how to put in place a framework for promoting orderly debt restructuring remain outstanding. But significant progress is being made. The stakes are high--not only because of the economic costs, but because of the social costs and the human suffering caused by financial crises. And, in an increasingly integrated world, more than ever, we are all in this together.

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canada

Convocation address

dodge

Queen's motto is , which we generally translate as "Wisdom and knowledge shall be the strength of thy times." This motto is especially pertinent to you as engineers graduating today. At no time in our history has the development and use of knowledge played a more critical role in the economic development of this country. And at no time has the application of wisdom to public policy been so critical to the future of Canada and the world. Today, I want to say a few words about the challenges you will face in applying knowledge and wisdom to generate economic growth and social development. In 1776, Adam Smith published what he called --the first treatise on the discipline of economics as we know it today. He asked the fundamental economic question, Why do some nations grow and prosper while others do not? His basic answer was that prosperity comes through the efficient allocation of resources, through the competitive marketplace, and through the rapid accumulation of capital. And for almost two centuries thereafter most economists developed and refined these ideas within a framework in which the creation of knowledge had little or no part to play in explaining economic growth. Most economists developed models of the economy in which the state of technology was taken as a given--exogenous to the models--and hence the process of technological innovation as a determinant of growth was largely ignored by most (but not all) economists. But over the last couple of decades, a new "growth economics" has emerged. It relies on models in which technological change is endogenous and, in fact, fundamental to the process of growth. (Of course, engineers have known this all along--economists are just slow learners!) Today, the emphasis of growth economics is not just on efficient allocation of resources and capital accumulation, but also on knowledge generation and diffusion and on policies that promote technological progress. Four key issues emerge: These are four key issues that you of the applied science class of '02 will have to deal with as you leave Queen's. Let me say a word about your challenge in each. Research and knowledge creation New knowledge is fundamental to growth. While Canadians can simply use ideas from the research of others, that won't take us to the leading edge. To lead the world, we must generate our own research. The quantity of that research is important, but even more important is the excellence of the research effort. Excellent research is, simply put, a key to strong and sustained growth. In our universities and in our private labs we must pursue the . Your challenge is to be excellent in knowledge creation. I hope a number of you will go on to graduate school and into research and teaching and that you will always strive for excellence. Application of knowledge to the development of new products and processes Developing new products and more cost-efficient processes is the very stuff of engineering, and is absolutely critical to economic growth. But Canadian companies have, over the past few decades, lagged somewhat behind their international competitors in applying research to product and process development. Put quite simply, without innovation in this area, Canadian economic growth will lag that of others and, over time, our relative standard of living will fall. Your challenge over the next few decades is to use knowledge to make Canada a world leader in the development of new products and processes. The management of knowledge and of knowledge workers is absolutely critical to the growth of productivity and to the profitability of firms. We are only now beginning to understand the importance of knowledge management, and both the techniques and processes of knowledge management require extensive development. Research and experience have proven that spending money on new technology is wasted unless everyone in the enterprise embraces that technology and integrates it into the way they do their business. Unfortunately, Canadian senior managers--myself included--have not paid sufficient attention to this issue. We have not yet done enough to adapt our businesses and institutions to get maximum value from our technology investments. We don't fully understand the impact of new technology on workers. And we haven't sufficiently examined whether our corporate organizational structures are appropriate for integrating new technologies and processes. You are the future knowledge managers. I hope you take up the challenge to make Canadian firms and institutions leaders in this area. Public policy Perhaps the most daunting challenge of all will be for you to find the right public policy framework to encourage technological progress and productivity growth. Governments are struggling with this now, and you will struggle with it throughout your careers. Answers are elusive. I have wrestled with this issue in tax policy, in fiscal policy, in health policy, and I continue to struggle with it now, as I oversee the country's monetary policy. In the area of macroeconomic policy, I think we can claim some very modest success. But we have had less success in the difficult fight to establish an optimal public policy framework to grow and sustain a nation of innovators. I hope some of you will join the public sector and take up this challenge. So, collectively and individually, you, the class of 2002, face these four challenges as you leave Queen's. I know you will strive to do not just a good job in meeting these challenges but an excellent job. I wish you success. May wisdom and knowledge be the strength of your times.

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canada

Trust, Transparency, and Financial Markets

dodge

Governor of the Bank of Canada Thank you for the invitation to speak to you today. It is a pleasure to come to Halifax and see the exciting things happening in this city and this province. I'd like to congratulate the Greater Halifax Partnership for its role in community development. You have been recognized for your outstanding work in community economic growth, and your innovative approach makes this partnership a model for private and public sector co-operation. My remarks today will concentrate on two themes. Later on, I want to talk a bit about the Bank of Canada's view of the economy. But first, I would like to address an important subject; that is, how to promote the efficient operation of Canada's financial markets. Rather than approaching this topic in a detailed, technical way, I want to speak about two qualities that are essential to their efficient operation: trust and transparency. Let me take a few minutes to describe why these qualities are important to the Bank. I think this can provide a good illustration as to why these same qualities are equally important for the private sector, particularly in light of Enron, and related questions about corporate practices. I will start with a quick definition of what I mean by trust. It's a term that's closely related to two other very important words: confidence and credibility. Trust, as I will use the term today, is more than a simple belief in something or someone without supporting evidence. Trust is what develops when a group of people share an understanding that the rules for behaviour governing their system or society work well and make things better for everyone. With trust, less effort is expended in keeping tabs on others, so systems can run more efficiently. With - - trust, people can develop confidence that others will, in fact, do what they say they will do. And over time, as trust builds, so does the credibility of those who are trustworthy. I can tell you from our own experience that trust is an important enabler for all of the Bank of Canada's key functions. And nowhere is this more true or more relevant than in the conduct of monetary policy. We have worked hard over the past decade or so to build up trust in our policy of explicit inflation targets. And this effort has been bolstered by our moves towards greater transparency. During the 1970s and 1980s, the Bank of Canada had ample experience with operating in an environment where Canadians had significantly less confidence in the Bank's ability to safeguard the domestic value of the currency. Inflation was choppy and unpredictable, and the Bank of Canada was struggling to come up with an appropriate anchor for monetary policy. However, in recent years, Canadians have gained confidence that we will keep inflation low, stable, and predictable, thanks to our system of explicit inflation targets and our success in meeting them. This trust can be thought of as a kind of social capital--a shared asset that benefits everyone, including the central bank. This capital is very valuable and must not be squandered. What does this have to do with efficiency? Quite a bit. If you think back to the 1970s and 1980s, people spent a great deal of time and effort trying to hedge against inflation. Resources that should have been put to more productive uses were spent devising ways to protect the value of savings. Then, in 1991, the Government of Canada and the Bank agreed on a system of explicit inflation-control targets. As you may know, under the current agreement our target is the 2 per cent midpoint of a 1 to 3 per cent band for the total consumer price index. Since we adopted this inflation-control system we have been consistently successful in meeting the target. As a result, inflation expectations have fallen in line with the target and are now well anchored, not just for the near term, but well into the future. With this trust in place, this social capital earned, the list of economic benefits for Canada is long indeed. Less time, energy, and money is being spent on protecting oneself against inflation. Labour and financial contracts have lengthened, while the amount of time lost to strikes and lockouts has dropped. What is more, the dynamics of the inflation process have been changed, to the point that inflation itself has become much more stable and predictable. Inflation expectations are less vulnerable to swings in the external value of the Canadian dollar, and to changes in key energy prices. - - All this allows the Bank to conduct monetary policy more easily. And it allows financial markets and businesses to operate more efficiently. Of course, the economy has also undergone a number of other necessary changes, including a massive restructuring of the private sector and a restoration of fiscal health. Together, these changes have led to better economic performance. Before I move on, I want to say a few words about transparency. Like many other major central banks, we have embraced the notion that it is better for the conduct of monetary policy if people can understand what their central bank is thinking and why. The Bank of Canada has dramatically increased the number of opportunities for updating Canadians on the economic outlook. We use our four and , as well our eight fixed announcement dates each year, to share our thinking on the economy. We want Canadians to have a good grasp of what our goals are and of the framework we use to achieve those goals. Our explicit inflation target gives Canadians a yardstick for measuring how their central bank is doing. In our view, the less flexible the yardstick, the better. It is one thing to have a goal of "low inflation" or "price stability." But the Bank and the Government of Canada agree that it is much more effective to have an explicit target for inflation so people know if we are meeting our commitment. So the result of all this effort at increased transparency is to give people a clear yardstick they can use to measure performance. All of this enhances the Bank's accountability and reinforces the trust we have fostered through inflation targeting. After all, it's a lot easier to have trust in an institution if it is open about its goals and strategies, and if it offers a clear way to measure its performance. This is relevant not just to central banks but to the entire business and financial community. Trustworthy business standards are one of the most important forms of social capital. Trust is paramount to the efficient operation of financial markets. And financial markets are a key ingredient of a well-functioning economy. This trust includes confidence in the players involved--the people who run the companies, and those who watch them. It also includes trust that the information required to make sound investment decisions is disclosed fully and accurately. Moreover, the disclosure must be fair--there must be confidence that insiders are not trading on information not available to everyone. Only when all these components of trust are in place can we have healthy, efficient financial markets that benefit everybody. - - Generally speaking, these components are in place in Canada. But the Enron collapse in the United States reminds us here that we cannot be complacent about our own situation. So what is lost when something like Enron occurs? Skepticism sets in about the truthfulness of routine financial disclosures. Companies find it more expensive to raise funds because once trust is broken, fewer investors are willing to participate, and those who remain demand a premium for the increased risk of being misled. A lack of reliable information also leads investors to make poor investment decisions, so capital is misallocated. In short, financial markets operate less efficiently, with fewer benefits for everyone. Avoiding a widespread loss of trust requires a systematic and coordinated effort to fix the flaws and weaknesses that can undermine investor confidence. It is important that there be a set of reasonable rules--so that chief executives, boards, and their auditors truly and fairly disclose the financial position of public companies--and that the investing public can rely on the truth, fairness, and completeness of that disclosure. Now, in spite of the specific flaws that the Enron collapse has revealed, it has become clear that much of the public's confidence in the efficient operation of financial markets remains intact. But we must continue to be vigilant. Financial statements form the foundation on which financial markets operate. I have already spoken of the way that a clear yardstick has helped the Bank improve its transparency. The same idea holds true for financial statements. Clear and accurate corporate reporting, together with other reliable information for investors, are essential. Equally importantly, information must be presented in a straightforward manner. Earnings reports should be used to disclose information, not bury it. We can't pretend that hundreds of complicated pages lead to the type of disclosure that facilitates efficiency. Next, confidence must be constantly earned by corporate managers and directors, auditors, analysts and investment advisors, rating agencies and regulators. Reputations have been threatened by events like Enron, and by the suspicion that some insiders have been feathering their nests at the expense of shareholders. Obviously, it is wrong for analysts who actively own shares in a firm to use their assessments to promote that firm. But there can be more subtle conflicts of interest that don't involve illegal or fraudulent activity--for example, auditors who are not truly independent of the companies they audit. Risk assessment is another issue that needs more attention, particularly by companies outside the financial sector. This involves more than just listing in a financial filing - - all the things that could go wrong. Companies need to tell investors how they are handling both the external risks that they face and the risks they have chosen to take on as part of their business strategy. After all, investors are required to sign a form that tells their broker about their risk tolerance before they buy a stock. Surely then, the company issuing that stock should be able to give those investors some honest disclosure of their assessment of the risks involved in that investment. The fallout from Enron has prompted debate about the need for tougher financial market rules. If it is determined that new rules need to be written, they must not be picayune regulations that simply give the unscrupulous a roadmap to evade the spirit of the rules. It is the observance of the spirit as well as the letter of the regulations that we all must aspire to achieve. And when unscrupulous market participants or practices are revealed, authorities must come down on them with full force. To do otherwise is to do markets a disservice. Only strict reprobation will restore and maintain confidence that the rules are being enforced. Regulatory and supervisory bodies around the globe have begun to deal with the fallout from Enron and other high-profile bankruptcies. In the United States, the Financial Accounting Standards Board is looking at proposals to determine when so-called "specialpurpose entities" should be consolidated on company balance sheets. The Securities and Exchange Commission has proposed new rules for more detailed and timely corporate disclosure. its Accounting Standards Oversight Council to closely monitor the accounting and financial reporting issues raised by Enron. The CICA is also looking at ways to boost auditor independence. I am also aware that the accounting profession and its regulators are working to develop an oversight body to promote high-quality audits of public companies. The Toronto Stock Exchange has made changes to its guidelines for effective corporate governance. Parliamentary committees such as the Senate Banking, Trade and Commerce Committee have also launched their own investigations into the Canadian market post-Enron. We have seen much self-evaluation by market participants in recent months. I am very encouraged by how seriously these issues are being taken. The market is enforcing its own discipline. Corporate boards are re-examining their roles and taking a closer look at what is being done in their companies. Investors are demanding greater reconciliation between pro forma financial statements and generally accepted accounting principles. Major firms, in response to those demands, are changing their corporate reporting methods. For example, some firms have announced plans to include, as an expense, the cost of executive stock options. And Standard and Poor's has introduced new benchmarks for reporting - - corporate earnings. Those changes aim to more accurately describe the revenues and costs associated with companies' primary businesses. We feel steps like these are helpful in advancing the debate about the most fair and accurate methods for reporting a company's true financial state. These are all positive examples of participants working together to enforce the spirit--not just the letter--of the rules under which financial markets operate. In the end, everyone needs to have trust in the financial markets--to know that the right rules are in place and that those rules are being enforced. We must continue to build on that social capital, to promote the efficient operation of financial markets, and the benefits that those markets can bring to everyone in society. Now, I would like to say a few words on the Nova Scotia economy. Like the rest of Canada, Nova Scotia's economy has proven to be stronger than expected over the past year. Indeed, Statistics Canada reported last week that the province's employment rate has returned to an all-time high in May. Nova Scotia was buoyed by strong offshore oil and gas production last year. The study commissioned by the Greater Halifax Partnership paints an exciting picture of the future impact of offshore development. The province has also been making important strides in building other sectors to diversify its economy, and this bodes well for the future. We've seen tremendous expansion in the information technology and life sciences sectors. That includes commercializing some of the excellent research being done at Nova Scotia universities and fostering technology companies to capitalize on the province's telecommunications infrastructure. Turning to the outlook for Canada as a whole, the economy has been growing robustly--expanding at an annual rate of 6 per cent in the first quarter--well above expectations. And this has been reflected in the extraordinary number of jobs created since the beginning of the year. Employment has grown by almost a quarter of a million jobs in the past five months. Canada is demonstrating clear economic momentum. Consumer spending, particularly on interest-sensitive items, continues to show strength. Business investment is no longer acting as a drag on growth, and there are signs of the beginnings of a recovery in investment in machinery and equipment. Corporate profits are rebounding, which should continue to support business investment. While this domestic performance bodes well, geopolitical uncertainties and weaker profits among large multinational firms may inhibit a strong rebound in investment around the world for a period of time. - - Let me sum up. Canada's economy is growing at a faster pace, and is operating at a higher level, than had been anticipated. And this means that it is moving towards full production capacity more quickly than we had expected. Core inflation has also been running slightly higher than we anticipated, at 2.2 per cent in April. Against this backdrop, last week, the Bank raised its target for the overnight rate by 25 basis points to 2.50 per cent. This was the second increase in the target rate, aimed at withdrawing some of the substantial amount of monetary stimulus in the economy. With the domestic economy showing strong momentum, the Bank will take whatever action is necessary to keep inflation near its 2 per cent target over the medium term. And that is the best contribution the Bank of Canada can make to promoting a strong, sustainable economy for all of Canada.

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canada

Release of the

dodge

Today, we published our to the April , in which we discuss economic and financial trends in the context of Canada's inflation-control strategy. Canada's economic recovery, which began in the last quarter of 2001, gathered momentum in the first half of 2002. Over the period to the end of 2003, the Bank projects continued solid economic expansion at an annual rate of 3 to 4 per cent. This will result in growth of close to 3 1/2 per cent on an annual average basis in 2002 and in 2003. Both the total and core rates of inflation are projected to be slightly above 2 per cent in the second half of 2002, before steadying out at close to 2 per cent in 2003. Given that the Canadian economy grew at a faster pace than anticipated in the first half of 2002, there is now less excess capacity than was projected in our April . The economy is expected to be operating at full capacity in early 2003--sooner than previously anticipated. In light of these developments, the Bank has continued to reduce the amount of monetary stimulus in the economy, raising the target for the overnight interest rate by 25 basis points on three occasions--in April, June, and July--to bring the rate to 2 3/4 per cent. It remains the Bank's view that the underlying economic situation will require further reductions in the amount of monetary stimulus. The timing and pace of policy adjustments will depend on the strength of the various factors at play and their implications for pressures on capacity, and thus on inflation. There are both upside and downside risks to the outlook for Canadian economic growth. On the positive side, growth of domestic demand could turn out to be stronger than projected because of the substantial amount of monetary stimulus still in place. On the negative side, there are the uncertainties associated with global corporate and financial market developments and their potential effects on confidence and world economic growth. At this time, the risks to our projected rate of growth of 3 to 4 per cent growth appear to be balanced. As we go forward, the Bank will remain focused on taking actions to achieve the 2 per cent inflation target. Keeping inflation low and stable is the best contribution that monetary policy can make to sustained economic growth in Canada.

r020831a_BOC

canada

Macroeconomic Stabilization Policy in Canada

dodge

Governor of the Bank of Canada to a symposium sponsored by What I propose to do on this panel today is to talk about stabilization policy and policy cooperation from the viewpoint of an industrial country that has a floating exchange rate and both an explicit inflation target for monetary policy and a clear objective for fiscal policy. While my perspective has been particularly influenced by my time as Deputy Minister of Finance and now as Governor of Canada's central bank, the broad outlines of my conclusions are widely shared, not only in those two institutions, but in Canadian academic and public policy circles as well. Moreover, I believe that our experience and the lessons that can be drawn from it are applicable to all open economies with flexible exchange rates. In the 1990s, the Bank of Canada and the Government of Canada reached a series of joint agreements on inflation-control targets. As well, the government established a framework that greatly reduces the probability of running a fiscal deficit and thus puts the debt-to-GDP ratio on a clear downward track. Initially, the credibility of these policies was not high; so it was essential to demonstrate clearly our resolve to achieve greater fiscal prudence and lower inflation until credibility was gained. Thus, it was sometimes necessary to override the automatic stabilizers of fiscal policy in order to establish credibility. And for monetary policy it meant that we could not always implement the easing warranted by our inflation targets. But as the targets were achieved, the public's trust that the authorities were going to do what they said they would do increased. That trust is tremendously important. Now that the credibility of both monetary and fiscal policies is firmly established, the stabilizers are able to do their job. I would like to begin by considering stabilization policy, then say a few words on policy co-operation. Monetary policy and stabilization In aiming to achieve a 2 per cent inflation target over an 18- to 24-month horizon, Canadian monetary policy plays an important role in stabilizing the economy in response to demand and supply shocks. When there are shifts in demand, the direction of changes in our policy interest rate is quite clear. Suppose that the economy is operating at its production potential and that inflation is at the 2 per cent target. A downward shift in demand would create excess supply in the economy, putting downward pressure on inflation. To bring inflation back to 2 per cent over a period of 18 to 24 months, the Bank of Canada would lower its target for the overnight interest rate. Through its effect on market interest rates and the exchange rate, this action would increase the level of output in the economy, moving it back towards production potential. Inflation would, therefore, return to the target shortly after the excess supply disappeared from the economy. An upward shift in demand would, of course, generate symmetric responses. While the theory is clear about the appropriate response to demand shocks, the magnitude and persistence of shocks--and hence the size and timing of interest rate adjustments--are always difficult to judge. This is where the art of monetary policy-making comes into play. It is even more difficult, of course, to gauge the appropriate monetary policy response to supply shocks--which take the form of higher (or lower) inflation than expected for a given level of demand. The Bank's framework for inflation targeting allows temporary supply shocks to be largely ignored, as long as they do not feed into inflation expectations. The credibility that has been established means that they typically no longer do so. Consider price surprises coming from the most volatile components of the consumer price index--components such as fruits and vegetables or fuel oil and natural gas. As our operating guide, we use a measure of core inflation that excludes these components. This gives us, and economic observers, some confidence that we are looking at something close to the underlying trend of inflation. Thus, our interest rate response to price shocks that are perceived to be temporary can be minimal. As a result, there will be little effect on output. In other words, monetary policy does not turn temporary supply shocks into something that is destabilizing for aggregate output. A more difficult situation occurs when persistent increases or decreases in prices coming from the most volatile components of the consumer price index threaten to keep the total index away from the target for a significant period of time. Credibility helps here too, but the Bank must be particularly cautious that these movements in inflation do not feed into inflation expectations. Supply shocks that take the form of a change in the level, or growth rate, of potential output are often hard to recognize. Here, however, the key is for the central bank to return the trend of inflation to the target if it has moved away. Since the trend of inflation relative to the target is the best indicator of where demand is relative to potential output, this will be consistent with moving demand back into line with the new path of potential output over the medium term. Fiscal policy and automatic stabilization In Canada, the main automatic fiscal stabilizers are various types of tax revenues, as well as employment insurance payouts. Some of these fiscal stabilizers work almost immediately--for example, personal income tax deducted by the employer. Others, such as employment insurance payments, work with a fairly short lag. Comparing and contrasting automatic fiscal and monetary stabilizers Automatic fiscal stabilizers are very effective in dampening an output cycle. But they offset only part of the change in output. In contrast, monetary policy can fully offset a change in output, but it takes time to work, with the full impact on output normally felt only after 12 to 18 months. Discretionary stabilization policy While the automatic or quasi-automatic stabilization provided by monetary and fiscal policies is very desirable, the question remains as to whether there is a role for something further--a discretionary stabilization policy. In the case of monetary policy, the nature of the response is the more or less automatic one described earlier. As I implied then, judgment is key to the process. That is particularly true in times of great uncertainty, such as last autumn. But a clear inflation target means that, in principle, the discretionary choice for monetary policy-makers is limited relative to that of the fiscal authorities. The arguments for and against discretionary fiscal policy as an important element in macroeconomic stabilization in an open economy tend to revolve primarily around lags and around the effectiveness of short-run fiscal policy relative to monetary policy. If the timing were close to perfect, fiscal policy measures that lasted for two or three quarters could, in principle, and under ideal circumstances, shorten the time it takes to move output back to its desired level. Thus, in principle, discretionary fiscal policy is a useful tool. But, as a practitioner, I can tell you that the great problem here is that temporary measures are both difficult to initiate quickly when the need arises and extraordinarily difficult to stop once the need is past. Thus, as a practical matter, not a philosophical one, there are some severe limitations to the use of discretionary fiscal policy as a stabilizer. My views about this have been reinforced by the way the business cycle in Canada has developed over the last 18 months or so. In early 2001, we were expecting that the slowdown in both the U.S. and Canadian economies would be modest. In Canada, an earlier announced tax cut was fortuitously coming into effect. It was not until the middle of last summer that it became evident that the Canadian economy was undergoing a more pronounced slowdown than we had expected. Between January and August 2001, we had lowered our policy interest rate by 175 basis points. Even the most ardent supporters of discretionary fiscal policy would not have thought about doing anything major until August. With the horrific events of 11 September, economic forecasters marked down their forecasts for 2001 and 2002 significantly. We, like other major central banks, accelerated the pace at which we were cutting interest rates--from September through January 2002, we lowered our policy interest rate by a further 200 basis points. Fortunately, the Canadian government added only a small amount to spending in its budget announcements in late 2001--and that consisted mainly of necessary spending for security and border issues. I say "fortunately" because, based on the national accounts published at the end of May 2002, growth in the Canadian economy actually rebounded in the fourth quarter of 2001 and accelerated to about 6 per cent in the first quarter of this year. Thus, with the benefit of hindsight, it is evident that there was more underlying strength in the economy than we expected. Combined with the large amount of monetary stimulus that was applied, this meant that the economy could recover rapidly. Therefore, added fiscal stimulus was not necessary to get the economy going. And the monetary stimulus provided is proving much easier to turn around. Since mid-April, we have raised our policy rate by 75 basis points. To be sure, other uncertainties have arisen and will continue to arise in the future. Our best judgment about these uncertain factors will continue to be taken into account. But, overall, this episode is clearly showing that monetary policy actions can be used more flexibly than fiscal policy actions. I would stress that discretionary fiscal policy can also get governments into trouble if it leads them to neglect their long-run fiscal anchor--particularly since discretionary action is more likely to be associated with an easing in policy than a tightening. This neglect would risk eroding fiscal credibility--the trust that the public has that the fiscal targets will be met. Now let me turn to the issue of policy co-operation and policy coordination. Our inflation targets are joint targets. They are not just the Bank's targets--they are the targets of the Government of Canada as well. Our view is that, essentially, "coordination" came through the joint agreement on inflation targets. With clear agreement on the medium-term policy objectives and with a shared understanding of the policy framework, there is no need for coordination on the setting of interest rates and fiscal policy instruments. The economic literature on policy coordination tends to be about situations where the fiscal and monetary authorities have one or more of the following: very different views of economic welfare, inconsistent policy objectives, policy that is totally discretionary, or a tendency to get involved in game-like behaviour with one another. None of these applies in Canada--and none should apply anywhere. Given our policy framework, when the government changes fiscal policy, it needs to think of how these changes will affect inflation and, consequently, interest rates. Similarly, the Bank of Canada needs to consider how changes in fiscal policy will affect demand and inflation, and thus its setting of interest rates. Therefore, it is to the mutual benefit of both parties to co-operate in sharing information and analysis as they adjust their policy settings. Co-operation between the Bank and the federal Department of Finance occurs on a number of levels. I have frequent discussions with the Minister and Deputy Minister. And there are meetings at the staff level to share, for example, information from economic forecasts, surveys, and contacts with various groups and organizations. One of the key reasons for our regular discussions has been to ensure that each institution understands the details of the framework within which the other one is pursuing its objectives and how this framework is being implemented with respect to current economic surprises. The Bank also keeps in close touch with provincial fiscal authorities. Thus far, I have not said anything about the appropriate mix of monetary and fiscal policies when talking about coordination and co-operation. Quite simply, with explicit frameworks in place for monetary and fiscal policies, the whole issue of policy mix becomes moot. The fiscal and monetary authorities are both adjusting their policy instruments to attain their respective objectives. There is no other mix of interest rates and fiscal thrust that the authorities will perceive as consistent with meeting the monetary and fiscal objectives. Clear monetary and fiscal objectives, combined with clear accountability for meeting those objectives, provide the background for policy co-operation and stabilization in Canada. The monetary and fiscal policy frameworks have created an environment where co-operation in the form of sharing information and analysis is most effective. Fiscal and monetary credibility is high. In other words, economic agents trust that the monetary authorities and the fiscal authorities will maintain these frameworks. With trust in place and with expectations well anchored, the automatic fiscal stabilizers can be allowed to operate fully and monetary policy actions can be directed to achieving the inflation targets. In addition, when major shocks occur, with trust in place, there can be a temporary overshoot or undershoot of the fiscal or monetary targets without unhinging confidence in the framework or in expectations that the targets will be met over time. I believe that Canada's experience and the lessons we have learned about having clear policy objectives and supportive, transparent policy frameworks have broad applicability in open economies with a flexible exchange rate. from the International Experience. and Banking

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Canada's Economic Performance After an Eventful Year

dodge

Governor of the Bank of Canada at the University of British Columbia Good afternoon. I was delighted to accept your invitation to speak to you today. I'd like to spend some time reflecting on the evolution of the Canadian economy and what we as Canadians have achieved in the past few years. Then I will talk a bit about the outlook and the uncertainties facing the global economy, and how Canada's successes on the fiscal and monetary fronts will help us weather those uncertainties. But first, I'd like to say how much I appreciate the chance to return to the University of British Columbia campus. Five years ago, I was here as a Senior Fellow in the Commerce Faculty. While my current job is different, there is one common thread that unites this institution and, indeed, all Canadian universities, with the Bank of Canada--a commitment to excellence in research. Indeed, a strong research environment has long been a hallmark of the Bank. We also want to encourage research relevant to our business, especially with respect to monetary policy and financial system stability, at universities all across Canada. That is why I am very pleased to announce today that the Bank of Canada is launching a Fellowship Program to foster high-calibre research in crucial economic areas. The program will be open to professors at Canadian universities who have a record of high-quality research. The Bank fellowships will pay a salary stipend and provide funding for graduate research assistants and expenses. We plan to award two fellowships the first year, and one each year after that, for a total of six fellowships by 2007. We hope the program will expand the pool of leading-edge research conducted across this country and strengthen Canadian expertise in areas critical to our mandate, such as macroeconomics, monetary economics, international finance, and the economics of financial markets and institutions. - - Expanded research and a broader knowledge base will benefit the Bank of Canada, universities working to build strong economics departments and, indeed, all Canadians. And I am particularly pleased to be launching our Fellowship Program here, at a university that is committed to producing the type of ground-breaking analysis we hope to encourage. When I first arrived at UBC in the fall of 1997, Canada was completing a decade of struggle to get our economic policies right. During the period 1988 through 1997, we took some important steps towards improving both our monetary and fiscal policies. The Bank of Canada, responding to the high and unpredictable inflation rates of the 1970s and early 1980s, adopted at the end of the 1980s a monetary policy aimed at achieving price stability. To make this commitment more concrete, the Bank and the Government of Canada agreed in 1991 on a series of inflation-control targets aimed at bringing the 12-month CPI inflation rate down to 2 per cent--plus or minus 1 per cent--by December 1995. The decline in inflation was achieved in fairly short order--by January 1992, inflation was close to 2 per cent. The agreement has subsequently been extended three times, retaining the 2 per cent target midpoint. For almost ten years now, inflation has been well under control, and households and businesses now believe we will continue to achieve the inflation targets. Inflation expectations are well anchored, not just for the near term, but well into the future. Almost a decade of low inflation makes it easy to forget how difficult it was to achieve our inflation targets, and the economic price that was paid to achieve the tremendous benefits of low and stable inflation. Back when I was teaching here, federal and provincial governments were in the midst of the painful but necessary process of fiscal consolidation. The federal government had been working to curb the rising debt-to-GDP ratio, but it really wasn't until 1995 that the government had done enough to tip the scales decisively toward deficit reduction. And it was 1997 before the cumulative effects of all those deficit-reduction measures put federal fiscal policy back on a sustainable track. The debt-to-GDP ratio at the federal level has since fallen to less than 50 per cent, from a peak of 71 per cent in 1995. And while some provinces are still struggling to maintain budget surpluses, all have taken important steps to put their fiscal houses in order. Governments and the Bank of Canada were working to get public policies--the fiscal and monetary framework--right. The private sector was also restructuring to take advantage of the opportunities provided by the Canada-U.S. Free Trade Agreement and to increase its productivity and competitiveness. It is not surprising that during those years of adjustment we had slower growth than the United States. But by the late 1990s, our economy was beginning to reap the benefits of those restructuring efforts. The end result of all this - - effort--the adoption of inflation targets, the fiscal improvement and the private sector restructuring--was that Canada's economy became better able to weather major shocks such as the Asian crisis, or last year's global slowdown. Indeed, over the period from 1997 to 2001, Canada averaged annual economic growth of about 4 per cent, while the U.S. average was about 3.5 per cent. And while the U.S. economy fell into recession last year, ours did not. Although the productivity growth of Canadian companies has not been as strong as that of firms in the United States, we have seen encouraging signs that investments in technology and training are leading to greater productivity gains here. Indeed, business sector labour productivity in Canada grew at an annualized rate of 2.0 per cent from 1997 to 2001, much higher than the 1.2 per cent average over the 1990-96 period, and only a bit below the revised 2.3 per cent rate of productivity growth recorded in the United States. As we look forward, we see positive signs for future productivity growth in Canada, thanks to the efforts of Canadian firms to adjust to new technologies and incorporate them into their business processes. Indeed, the economy has held up remarkably well when you consider that we have been hit with four major shocks during the past couple of years. First, there was the meltdown in the technology and telecommunications industries, which began in late 2000 and the effects of which are still being felt today. The second was the broader economic slowdown in 2001 that affected, to various degrees, the economies of most countries. Third, and overshadowing every other event last year, was the 11 September terrorist attacks. With the first anniversary just passed, this seems like an appropriate time to reflect on the extraordinary events that have buffeted the North American economies since that terrible day, and to review how the Bank of Canada responded to those events. Our most immediate responsibility was to keep Canada's financial system functioning. Our next responsibility was to promote consumer and investor confidence. Therefore, the Bank of Canada took extraordinary monetary policy action. On 17 September last year, we reduced our key policy interest rate outside our scheduled announcement dates. Between September 2001 and January 2002, we lowered interest rates by a total of 200 basis points to help mitigate the impact of 11 September on an already-weakening economy. It turned out that consumer confidence in Canada was not as badly shaken as had been feared. As the immediate geopolitical and economic uncertainties diminished, consumers responded strongly and quickly to the monetary stimulus. Interest rate-sensitive sectors, such as housing and automobiles, showed remarkable strength. Indeed, in the fourth quarter of last year we saw annualized GDP growth of almost 3 per cent, when most analysts were expecting the Canadian economy to shrink. - - However, as we recovered from the 2001 slowdown and from 11 September, the U.S. economy was hit by a fourth shock--loss of confidence in the integrity of financial reporting and analysis as a result of Enron, WorldCom, and other accounting and corporate governance scandals. Unfortunately, the uncertainty caused by these problems in the United States has spilled over into other financial markets, including ours. This has created additional caution for businesses and appears to have delayed the expected recovery in investment worldwide. In spite of these four economic shocks, Canada's economic performance has been, in comparison with other countries, rather good. Clearly, this has been a difficult year for the mining and forestry industries in British Columbia, for grains and oilseeds producers in the Prairies, and for the telecom industry across the country. But overall, our economy has consistently exceeded the average growth rates of the G-7 countries since 1997. And both the IMF and the OECD predict that Canada will post the strongest growth rate of the G-7 in both I want to emphasize that Canada's recent strong performance isn't just good luck. It is the result of having a solid policy framework, both in terms of inflation and fiscal control. The benefits of this framework are well understood, not just by the government and the Bank of Canada, but by Canadians in general. We stuck to that framework during the recent economic turmoil, and we are now seeing a clear payback for the tremendous investment that Canadians made in opening this country to free trade, and in getting our macroeconomic framework right in the 1990s. That framework holds and will continue to serve us well. If anyone still needs convincing of that, Canada's recent economic performance provides compelling evidence. Canada's economic growth so far this year has exceeded expectations. Real GDP jumped by 6.2 per cent at annual rates in the first quarter of 2002 and rose by 4.3 per cent in the second quarter. The Bank of Canada believes that keeping inflation low, stable, and predictable is the best contribution monetary policy can make to strong and sustained growth in Canada. We run monetary policy in a symmetrical way. That is to say, we pay equal attention to persistent pressures that could move us away from our 2 per cent target--whether above or below. When strong demand pushes the economy against the limits of its capacity and threatens to raise future inflation above the target, the Bank will raise interest rates to cool off the economy and mitigate those inflation pressures. When demand is weak, as we saw in 2001, future inflation is likely to ease. So the Bank will lower interest rates to stimulate the economy, and absorb economic slack, consistent - - with keeping inflation on target. The significant easing of monetary policy during 2001 was a key factor behind the strong growth of household demand in the first half of this year. Let me now turn to the outlook. In our April , we said that the recovery in the Canadian economy began sooner, and was considerably stronger, than anticipated. Consumer spending and residential construction were reflecting the stimulus from both monetary and fiscal policy. Canada's export volumes had begun to grow once again, as the U.S. economy began to recover. By the time of our in July, we were also seeing a rebuilding of inventories and an increase in spending on machinery and equipment. These were suggesting a broadening of the recovery across economic sectors. still reflects our view of the economy. As we said two weeks ago, domestic demand in Canada remains stronger than expected, bolstered by the substantial amount of monetary stimulus still in the economy. Canada's record of job creation has been nothing short of remarkable, with almost 400,000 new jobs since the beginning of the year. This strong job growth is reinforcing the confidence of Canadian consumers. In addition, medium and small businesses continue to invest. All this paves the way for higher output and ongoing strong domestic demand. But at the same time, there are downside risks and uncertainties, mostly originating from outside Canada. Near-term prospects for growth in the United States and the major overseas economies appear to have weakened. Private and public sector economists have revised down their near-term growth forecasts for the United States, Europe, and Japan. This could imply that Canada's exports, which were already slightly weaker than anticipated in the second quarter, could continue to be affected by slower growth in global demand. The geopolitical situation remains quite unsettled. Finally, in the United States and Canada, we are still working through the corporate governance issues that have contributed to this year's financial market volatility. History has taught us that during periods of uncertainty, business and consumers tend to sit on their hands until the outlook is clearer. Let me conclude. It remains the Bank's view that as the Canadian economy continues to expand and to approach capacity, further timely and measured reductions in the amount of monetary stimulus will be necessary. Let me remind you what I mean by "timely and measured." "Timely" relates to the fact that there is always a lag between our policy actions and their effect on the economy. "Measured" relates to the judgments that we make at each fixed announcement date about the pace at which the economy is approaching full capacity, taking into account new information and data as they become available. Our current view is that the fundamental underlying strength of the Canadian economy has not changed since our July Domestic demand may well be stronger; at the same time, the external uncertainties bearing on the outlook appear to be greater than they were in early July. - - We will provide a detailed view of our outlook for the Canadian economy in our next , on 23 October. This past year has certainly been full of challenges. Over the last decade, Canada has put in place the right macroeconomic policy framework to weather major shocks and take advantage of opportunities. We are confident that this framework will stand us in good stead in the future.

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Dollarization and North American Integration

dodge

Governor of the Bank of Canada to the Chambre du commerce du Quebec Good morning, ladies and gentlemen. Thank you for inviting me to this Congress, and for choosing to spend part of your weekend listening to the discussion on this important topic. dollar?" But the issues are complicated. I will not pretend that I can cover all the nuances of this topic in my allotted time. So I am running the risk that I may oversimplify matters. I should also say that I want to stick to economic facts and arguments. There is, of course, a big political dimension to the question, but I will leave that to the politicians. I want to confine my arguments today to the field of economics. In the years following World War II, many countries operated under an exchange rate regime that one might call "fixed until further notice." This system, known as the Bretton Woods system, saw most countries peg the external value of their currencies to some other currency, most often the U.S. dollar. But for a number of reasons, this system of "fixed until further notice" exchange rates proved unstable. It has been abandoned by many countries in favour of one of two options--either a floating-rate regime or the use of another currency. Most have chosen a floating-rate regime. A few countries have decided to join some kind of monetary union or to use a foreign currency to replace their own. Canada was one of the first countries to adopt a floating-rate regime. It did so at the beginning of the 1950s and, generally, this regime has served us well. But with increasing integration of the Canadian and U.S. economies, the question now being asked is whether Canada might be better off giving up the Canadian dollar, either through dollarization or by entering into a monetary union with the United States. What I want to do today is to discuss the benefits and costs of a floating exchange rate versus dollarization at the present time, given the current degree of integration of the U.S. and Canadian economies. Then I will talk briefly about the implications for our floating exchange rate should the two economies become more integrated. Let me just add here that Canada is not being inevitably drawn into adopting the U.S. dollar, or being de facto dollarized, as some have claimed. Recent research conducted at the Bank of Canada shows clearly that, if anything, Canada is now less dollarized than it was two decades ago. We are not drifting towards dollarization. If we go down that road, it will be a deliberate choice. When choosing an exchange rate regime, it is crucial to remember that monetary policy needs to have a nominal anchor. In Canada, monetary policy is anchored by our use of an explicit inflation target. If a country chooses not to float its currency, it essentially adopts the monetary policy of the country to which it is tied. This may, or may not, provide an effective nominal anchor. Let me briefly explain how the floating exchange rate fits into Canada's monetary framework. Our monetary policy aims to keep inflation at the 2 per cent midpoint of a 1 to 3 per cent target range. We protect the domestic purchasing power of our currency by keeping inflation low, stable, and predictable. By doing so, we support the conditions necessary for strong, sustainable economic growth. With a floating currency, our exchange rate acts as a mechanism that allows the Canadian economy to adjust to important economic changes, or what economists call "shocks." These can include movements in relative world prices, changes in capital flows, or divergent economic conditions across countries. Consider commodity prices, for example. As you know very well, Canada is an important producer of commodities such as metals, paper, and chemicals. When the world prices of these goods rise, it means that Canadian producers receive more income. This rise provides a boost to the Canadian economy. When commodity prices fall, it means less income for Canadian producers. This has a negative impact on the economy. Changes in these sorts of relative prices are a signal to shift real resources out of some sectors and into others. The Canadian economy needs to respond to such signals. Under a floating-rate regime, movements in the currency help to smooth that process and attenuate the adjustments in output, employment, wages, and prices. Without a floating currency, the Canadian economy would still need to absorb the effect of changes in relative prices. But the burden would fall initially on output and employment and, eventually, on all wages and prices. This would be a far more difficult and costly process for many. There will always be economic shocks that require adjustments. But because the structures of the U.S. and Canadian economies are so different, the two economies often require very different adjustments to shocks. Canada's floating exchange rate facilitates these adjustments by reducing the amount of lost income and output during the adjustment process. Our empirical analysis shows that these adjustment benefits are quite large during periods of significant shocks. But there is no free lunch. There are costs involved in choosing a floating currency, and these could be avoided under dollarization. These include the costs of currency transactions and the need to mitigate currency risk--costs that can be considerable. At the present time, however, the adjustment benefits clearly outweigh the costs. This is an empirical statement, not a philosophical one. It is possible that, at some future time, the structures of our two economies could converge to the point that the reverse would be true. But for now, and as far into the future as I can see, the floating exchange rate is the best choice for Canada given the degree of integration of the Canadian and U.S. markets for goods and services and labour. markets change this assessment?" The fact that the structures of the Canadian and U.S. economies are so different argues against using the same currency. But this could conceivably be overcome if there was much greater integration of all markets between Canada and the United States. It is this integration that could help us reduce the costs of adjusting to shocks that I described earlier. Specifically, the markets for goods and services, and particularly for labour, would need to become much more unified with those in the United States before it would make economic sense to adopt the U.S. dollar. Right now, our capital markets are fairly well integrated. Our markets for goods and services are supposed to be deeply integrated under NAFTA. But as any exporter will tell you, we are not quite there. There is always the threat that the United States could take a countervailing or anti-dumping action. In addition, NAFTA does not cover all goods and services. Still, by far the largest problem is the labour market. Wages tend to be "sticky"; that is, adjusting wages often takes time. So, under dollarization, the brunt of the economic adjustment to shocks would be borne by the labour market. This would create a huge problem if workers were not free to move across the border in both directions. At times it would create periods of much higher unemployment in Canada than would otherwise be necessary, and at other times it would lead to periods of labour shortages. One important feature of the U.S. labour market and, in my opinion, perhaps the most important source of the U.S. economy's success, is that workers do, in fact, migrate easily--not just from job to job, but also from place to place within the United States. We would need to share in that flexibility. But clearly, Canada and the United States are a long way from integrating their labour markets, and further integration of markets for goods and services is proving difficult. If these markets--for labour, capital, and goods and services--became much more highly integrated, then the benefits from having a separate currency could decline enough to make considering the adoption of the U.S. dollar worthwhile. Here, the European experience is relevant for us. Some observers look at the successful launch of the euro and suggest that this shows that Canada could easily adopt the U.S. dollar. But the euro marked the end of a long process of political and economic integration, not the beginning. The countries in the euro zone undertook a massive effort to integrate their markets for goods and services, capital, and labour, and to harmonize their fiscal and regulatory policies. Only after all of this was in place did they move to launch the common currency. It would not have made economic sense to go through the process in reverse. It would not make sense in North America either. We would first need to more closely integrate trade in goods and services, and, particularly, our markets for labour. Only then would it make sense to deal with the currency issue. As I said at the beginning, this is an important topic for discussion and research. At the Bank of Canada, we have been contributing to this debate for some time by laying out the economic facts and by promoting the research needed to determine the facts and carry out our analysis. We will continue to do this. But right now, our analysis tells us that Canada derives a significant benefit from having a floating currency--a benefit that far outweighs the costs. This system helps the economy to adjust to economic shocks, and allows us to have a monetary policy accountable to all Canadians. The floating exchange rate system serves the interests of all Canadians very well.

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The Search for Higher Productivity

dodge

Governor of the Bank of Canada to the Chambre de commerce de Quebec Given the extent of uncertainty in the world today, we are all naturally preoccupied with near-term issues and prospects. That's understandable. But, at the same time, it's critical that we look past the short-term to the longer-term trends and potential of our economy. That's why today I have chosen to talk about some of the issues surrounding productivity. Productivity is not something that only economists should care about. Every one of us has a stake in it. Here's why. Why do we care about productivity? Productivity plays a critical role when it comes to our national standard of living. Of course, it's not the only factor. But without a doubt, productivity growth is the main element that contributes to continued improvements in real incomes and our overall prosperity. Rising productivity is also what lets businesses pay higher wages and still keep costs down and remain profitable. As you can see, there are very good reasons why all of us--as workers, consumers, business people, and managers--should have a better understanding of what generates productivity growth over time. And we should all search for ways to improve our performance on this front. - - What drives productivity growth? What are the factors that work to raise productivity over time? Labour productivity--that is, the output of goods and services produced per worker--depends on the education and experience of the workers, the amount of capital equipment available to them, and certain other factors that, together, influence how "smartly" human and capital resources are used. Among these are technological innovation and changes in the organizational structures and management practices of enterprises. Other broader factors that help shape the key determinants of productivity I just mentioned include: competition; openness to foreign trade and investment; public policies; and financial market development. As you can well imagine, it's exceedingly difficult to disentangle and measure the individual contributions of all these factors to productivity growth. In any case, my intention today is not to focus on numerical estimates of productivity. Rather, I want to talk about the key elements that determine productivity and about the things we need to do to increase productivity growth in Canada. What will it take to raise productivity growth? If we think back to what determines productivity, there would seem to be four ways to improve our performance: higher capital investment, the application of new technology, better business practices, and improvements in the quality of labour. But, in fact, all four are very much interrelated. Let's start with capital investment. Improvements to productivity can come through the increased use of machines or through the replacement of old with new machines (which, more often than not, incorporate high-tech features). This brings me right to the second way of boosting productivity--through the adoption of new technology. A large part of the recent surge in U.S. productivity reflects efficiency gains from the production and use of information and communication technology (ICT). ICT typically includes computer hardware, computer software, and telecommunications equipment. ICT is what we call a "general-purpose technology." It can spread and spawn new products, processes, and applications that enhance productivity across a broad range of economic sectors--pretty much like the electric motor did in the late 1800s. - - Experience shows that "general-purpose" technologies, like ICT, take time to spread. That's why through this decade and the next, there will still be opportunities to exploit the technologies that were developed in the 1980s and 1990s. So, the basis is there; and there are probably more productivity gains in the pipeline. But even though new technologies take time to spread, the pace at which they do so is important. That pace depends on how quickly we are out of the blocks innovating, and on what we do after to use those advanced technologies to advantage and to facilitate their diffusion. I don't have to tell you that this is a clear case of "you snooze you lose." The prime opportunities go to those firms and those economies that are quick to take advantage of the new realities. Through the first half of the 1990s, Canada lagged the United States in making the investments that are necessary to benefit from the new technologies. But since 1996, there has been a marked increase in such investments in Canada. We are now beginning to see the first signs of a productivity payoff, and our analysis suggests that there will be more efficiency gains from past investments. Redesigning organizational structures, upgrading skills, managing knowledge The third key factor that can raise productivity growth is better business practices--better management. To realize the full potential of new technology, we have to pay a lot more attention to how we integrate it into our business practices, and how we organize ourselves to do business. Experience shows that spending money on state-of-the-art technology will not guarantee sustained large productivity gains unless managers and workers know how to use the new applications to advantage. It has always proven difficult for managers to think how to change their business practices and organizational structures to fully exploit the advantages of advanced technologies. Today, all of us--in enterprise, in government, or at the Bank of Canada--have a lot to do to adapt our businesses and institutions to get maximum value from our technology investments, and to encourage knowledge sharing among our employees. Knowledge management is of the essence. The fourth way to increase productivity growth is by upgrading labour skills. This does not just mean more schooling. It means continuous, on-the-job training to have the skills necessary to reap maximum benefits from new capital investment, and to turn those investments into profits. This, by the way, applies to all employees--not just post-graduates--and to all industries--not just high-tech. We can no longer neglect training for middle managers and other workers. And neither can we neglect training for construction and industrial trades. - - Let me also note that technology increases the potential for providing employees with the information necessary to resolve job-related problems, right at their workstations. Banks and insurance companies have taken advantage of this new type of training, and more of us should, too. The role of public policies But recognizing these four productivity enhancers--increased investment, adoption of new technology, better management, and improved labour skills--is one thing. Finding the right public policy framework that will allow and promote adjustment, and sustain a nation of innovators, is quite another. Yet, it's extraordinarily important that we do so. What challenges do we face as we look ahead? The first challenge is to preserve the sound macroeconomic policy framework that we have worked so hard to achieve. Over the past decade, two key initiatives have resulted in low, stable, and predictable inflation and a significant reduction in public debt. I would like to note that the federal government continues to reduce the public debt relative to the size of our economy (debt-to-GDP ratio); and that, for the first time since 1985 this ratio has fallen below 50 per cent. Federal government program spending has also been declining, and it's now less than 12 per cent of GDP. A low-inflation policy, together with healthy public finances and a declining public debt-to-GDP ratio, is keeping interest rates at levels that are favourable to financing innovation initiatives. Low inflation encourages business to operate more efficiently and provides the basis for well-informed, long-term decisions, including decisions to invest in new high-tech machinery, equipment, and software. Inflation control also encourages cost control by businesses. And cost reduction is the flip side of productivity improvement. A monetary policy focused on low inflation and a flexible exchange rate helps the economy to achieve its full potential. In the context of what I've discussed today, this is extremely important because unemployment and excess capacity in the economy are not conducive to investment and innovation. But even though a sound macroeconomic policy framework is essential, it cannot, by itself, guarantee higher productivity. For that to happen, a number of other conditions must be met. That's where we all face more challenges. One of those challenges is to avoid propping up outmoded methods of production. If we don't exit the low-productivity activities, we will be limiting the potential overall productivity gains. So our biggest challenge is to facilitate transformation towards more - - productive economic activities. For an example of that, look no further than the Beauce, where there has been some remarkable economic transformation in recent years. I remember what this region was like in the early 1960s, when its economy depended heavily on traditional industries, such as weaving and spinning mills. Since then, those operations have been replaced by small- and medium-sized innovative, dynamic enterprises. Another challenge relates to competition. Competition and the openness of an economy are important drivers of productivity growth. Large companies in Canada have certainly learned how to exploit the benefits of openness and competition. They are out there on world markets and they have to survive. So they are taking steps to become more productive. But many of our smaller firms have not yet ventured into global markets. From a public policy perspective, the issue is to encourage those firms to see that it is in their role as entrepreneurs, and in their best interests, to be more outward looking, and to undertake initiatives to increase productivity and reduce costs. Yet another challenge has to do with channelling savings into investments and allocating capital efficiently. Here, I cannot stress enough the need for a sound, innovative, and vibrant financial sector. This is particularly important at a time when we want companies that plan to adopt new technologies to have adequate access to innovative financing. This means that the financial industry has to evolve from what it was at the end of the 20 century to what it should be at the beginning of the 21 , but without compromising the soundness and stability of our financial system. Concluding thoughts Let me conclude. Right now, we are all too focused on our day-to-day concerns with the global uncertainty. What, I hope, I have done today is to encourage us to look past the short term and to remember that, over the long haul, the key to growing incomes and rising standards of living is higher productivity. In this context, I have discussed some of the challenges we face, and the steps we can take, in our search for higher productivity. The Bank of Canada will continue to do its part by fostering a climate of low, stable, and predictable inflation conducive to initiatives in innovation, risk-taking, and investment. But all of us have a role to play in raising productivity and enhancing our prosperity.

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canada

Opening Statement before the House of Commons Standing Committee on Finance

dodge

Good afternoon, Madame Chair, members of the committee. Earlier today, we released our October , in which we discuss economic and financial trends in the context of Canada's inflation-control strategy. The Canadian economy has been expanding strongly so far this year and is now operating fairly close to its full production capacity. Consumer price inflation has risen above the 2 per cent target and is expected to rise further before year-end because of high oil prices and a number of other relative price movements. What is important for monetary policy is that these one-off influences on specific prices not feed more generally into price and wage inflation. The Canadian economy has grown more rapidly than those of all other G-7 countries over the past year. Annualized growth exceeded 5 per cent in the first half of 2002--well above the growth of the economy's potential. We estimate that Canada's economy grew at an annualized rate of about 4 per cent in the third quarter. Thus, we have seen a significant reduction in the amount of excess supply in the economy so far this year. As we look ahead, global economic, financial, and geopolitical uncertainties are likely to moderate the rate of Canada's economic growth over the next three quarters. Growth should come in at the bottom of, or slightly below, the 3 to 4 per cent range that we anticipated in our last . Bear in mind that the output gap is very small. Assuming the uncertainties now clouding the outlook dissipate in the second half of next year, we expect growth to accelerate to above potential at that time, absorbing the remaining small amount of excess supply. The Bank's core measure of inflation is running above our earlier projections. This largely reflects sharp increases in home and auto insurance premiums and, in Ontario, electricity prices. Core inflation is also being pushed up by strong demand for housing. All told, core inflation is expected to peak at about 3 per cent by the end of this year. But, as the one-time influences that I just mentioned fade, core inflation is expected to decline in the second half of 2003, provided those one-time factors do not feed into price and wage inflation more generally. We must remember that the Canadian economy is now operating not far from its capacity. In order to sustain non-inflationary growth, we will need to continue to remove monetary stimulus before the excess supply in the economy is completely absorbed. The pace and extent of this action will depend on the balance of domestic and external developments and on their implications for pressures on capacity and inflation in Canada. Now Malcolm and I will be happy to answer your questions.

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canada

Release of the

dodge

Yesterday, we released our October , in which we discuss economic and financial trends in the context of Canada's inflation-control strategy. The Canadian economy has been expanding strongly so far this year and is now operating fairly close to its full production capacity. Consumer price inflation has risen above the 2 per cent target and is expected to rise further before year-end because of high oil prices and a number of other relative price movements. What is important for monetary policy is that these one-off influences on specific prices not feed more generally into price and wage inflation. The Canadian economy has grown more rapidly than those of all other G-7 countries over the past year. Annualized growth exceeded 5 per cent in the first half of 2002--well above the growth of the economy's potential. We estimate that Canada's economy grew at an annualized rate of about 4 per cent in the third quarter. Thus, we have seen a significant reduction in the amount of excess supply in the economy so far this year. As we look ahead, global economic, financial, and geopolitical uncertainties are likely to moderate the rate of Canada's economic growth over the next three quarters. Growth should come in at the bottom of, or slightly below, the 3 to 4 per cent range that we anticipated in our last . Bear in mind that the output gap is very small. Assuming the uncertainties now clouding the outlook dissipate in the second half of next year, we expect growth to accelerate to above potential at that time, absorbing the remaining small amount of excess supply. The Bank's core measure of inflation is running above our earlier projections. This largely reflects sharp increases in home and auto insurance premiums and, in Ontario, electricity prices. Core inflation is also being pushed up by strong demand for housing. All told, core inflation is expected to peak at about 3 per cent by the end of this year. But, as the one-time influences that I just mentioned fade, core inflation is expected to decline in the second half of 2003, provided those one-time factors do not feed into price and wage inflation more generally. We must remember that the Canadian economy is now operating not far from its capacity. In order to sustain non-inflationary growth, we will need to continue to remove monetary stimulus before the excess supply in the economy is completely absorbed. The pace and extent of this action will depend on the balance of domestic and external developments and on their implications for pressures on capacity and inflation in Canada. Now Sheryl and I will be happy to take your questions.

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canada

Staying the Course

dodge

The dramatic events of the last two years and growing concern about the near-term prospects for the global economy have created a climate in which policy-makers focus only on current economic developments and lose sight of longer-term goals. There's a natural tendency to focus on the here and now, and to use any tools that are readily at hand to deal with today's problems, without proper regard for their long-term consequences. It's easy to forget the hard-learned lessons of the past and overlook the longer-term fundamentals that are necessary to support a strong recovery and sustained positive economic performance over time. What are those fundamentals? Mr. Greenspan, in his opening remarks to this conference, talked about the importance of the fundamentals, going all the way back to Adam Smith. What's interesting is that things have not changed that much. But we don't have to reach that far in history for guiding principles. We can look at the four key principles that emerged as part of the OECD consensus during the 1980s. The first principle relates to monetary policy. It basically recognized price stability as the appropriate goal for monetary policy over the medium term. Policy-makers were advised to respond symmetrically, and in a forward-looking manner, to excess demand and supply so as to keep the economy on an even keel, thus achieving price stability and maximizing output over the medium term. The second principle applied to fiscal policy and the need for a more disciplined approach to managing the public purse. Rising debt levels and an aging population made it clear that concrete action was necessary to eliminate deficits and put the debt-to-GDP ratio firmly on a declining path. Automatic stabilizers should still be allowed to work during economic downturns. But in good times, surpluses would be generated that would help preserve the budget balance and keep the debt-to-GDP ratio on a downward trend. The third principle focused on the need for wide-ranging structural reform to reduce rigidities and inefficiencies. This meant removing burdensome regulations and legislative restrictions and eliminating wasteful government expenditures and distortionary tax and subsidy systems. The fourth, and final, principle called for trade liberalization. It was based on the premise that only through freer international trade can countries fully exploit the gains from increased specialization, enhanced productivity, and greater competitiveness. These four principles can be likened to the four legs of a chair. The chair is steadier when all four legs are the same length. Similarly, an economy is more stable when progress is made on all four policy fronts. But what should we be doing during periods of unexpected, pronounced economic turbulence? The latest worldwide economic slowdown has increased pressures on policy-makers to take action on a number of fronts. Some of them are being encouraged to erect trade barriers in order to protect favoured national sectors from foreign competition. But experience shows that such beggar-thy-neighbour policies not only impose costs on the rest of the domestic economy, they also undermine global economic welfare. Other policy-makers are being advised to forget about structural reforms in the short term, for fear of exacerbating economic weakness. Unfortunately, this approach virtually guarantees suboptimal performance in the future and maximizes the long-term costs of dealing with the structural problems--in many cases, sowing the seeds of future crises. In many countries, weak economic growth, coupled with rising government expenditures, has recently led to a deteriorating fiscal position, reversing the hard-won gains made over the past decade. To the extent this result is driven by the automatic stabilizers in place, it is unavoidable and desirable in the short run. But policy-makers should be very careful about calls for more extensive, discretionary fiscal measures taken for stabilization purposes. Such measures typically take effect long after the need for additional stimulus has passed, and they are often difficult to reverse. In the end, they often simply weaken a country's structural budget position. Without a doubt, the most suitable tool for dealing with any short-term cyclical problems in the economy is monetary policy. It is flexible, easily reversible, and general in scope. If monetary policy is allowed to perform this function, then there will not be inordinate pressure on other, less appropriate, instruments and policies. But let me be clear: this is not to say that we should use monetary policy to allow us to avoid taking the necessary steps on the other three fronts. For example, it is inappropriate to erect trade barriers and then say we need more monetary stimulus. It is inappropriate to allow rigidities to build in the economy and then call on central banks to provide stimulus. The right thing to do is to continue working on steadying the other three legs of the chair and to use monetary policy appropriately. Central bankers must guard against turning monetary policy itself into a source of instability. So here too, the bottom line is to never lose sight of our longer-term objective of low and stable inflation. The prevailing worldwide economic weakness, together with geopolitical uncertainty and financial market volatility, has led to significant monetary easing in most countries. This easing has been broadly appropriate and, in some cases, indeed even more may be needed. But it is extremely important that the monetary authorities keep their eyes firmly on the economic horizon. By concentrating on developments 18 to 24 months ahead, not only will they ensure that the critical medium-term objectives are met, but the short-term needs of the economy are also addressed. Monetary policy-makers should also be wary of taking on too many additional responsibilities, such as trying to stabilize selective market assets. This is not to say that we should not pay attention to what is happening in financial markets. We certainly should. These markets can convey important information about future developments. And they exert direct and indirect influences on the real economy. But monetary authorities must resist the siren calls for active management of financial markets and the pleas for regular intervention to help stabilize asset prices. It would be unfortunate if we were to repeat costly past mistakes for the sake of near-term expediency. Canada, like most other countries, has committed itself to the four principles of sound economic performance: low and stable inflation, fiscal prudence, structural reform, and trade liberalization. As a country, we have made great progress on all four fronts in recent years. Of course, pressures have emerged which threaten to undermine those commitments. These pressures have been resisted vigorously. While particular interest groups are unhappy with this resistance, the Canadian public as a whole supports sound policies. Canadians remain convinced that the authorities will follow these policies; and that is why both household consumption and investment by SMEs continue to be strong. Even in the face of geopolitical and international economic uncertainties, sound medium-term policies are helping to maintain strong domestic demand. To conclude, the current uncertainties will dissipate, and stronger growth will resume, provided we continue to pursue sound macro, trade, and structural policies. What is important is to anticipate the institutions, structures, and policies that we want to have in place once this latest turbulence subsides, and not to focus too narrowly on the present. Although the near-term challenges that we face may seem daunting, it would be unfortunate if, in attempting to deal with them, we impaired the prospects for future growth and improved economic performance. Canada is committed to staying the course. The same is true, I hope, of all other countries gathered here today. We all have an important responsibility to make sure that the lessons we have learned, and our continuing strong commitments to prudent policies, are understood more broadly.

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canada

Promoting Canada's Economic and Financial Welfare

dodge

Governor of the Bank of Canada to the Calgary Chamber of Commerce Good afternoon, and thank you for inviting me here today. It's been a difficult year for many sectors of the Alberta economy. Certainly, the severe drought hurt many western farmers, and investment in the energy sector was held back by low oil and gas prices. In addition, the slump in the telecom sector has affected Calgary. This said, we believe that the outlook is positive for the province's economy, and I would be very interested to hear your views about this in our discussion later. In a few minutes, I will spend some time talking about the Canadian economy and its prospects. But first, I want to discuss something that has preoccupied business leaders and public officials for most of this year--the need to restore trust in financial markets, in corporations that raise funds in these markets, and in the financial professionals who monitor them. Let me tell you why the Bank of Canada is concerned about these issues. The Bank is not a regulator of financial institutions or markets. But we do have a responsibility to promote financial stability and to oversee systemically important clearing and settlement systems. And we are the fiscal agent of the government, so we are actively involved in the functioning of fixed-income markets. Therefore, we have a keen interest in the efficiency with which financial markets operate. Confidence is key to the efficient operation of financial markets. In the United States, that confidence has been shaken by Enron, WorldCom, and other corporate and accounting scandals. Despite the fact that problems of that magnitude have not emerged in Canada, confidence in Canadian markets, and markets worldwide, has been affected by events in the United States. That is why we are watching closely the current efforts to restore confidence and trust in corporate reporting and in financial markets more generally. It seems that there have not been exactly the right incentives in place for corporate management, boards, and their auditors and investment bankers to disclose all relevant information and to always act in a manner that is fully conducive to fair and open markets. The market itself will provide some of the solutions to the problems currently undermining investor confidence. But others may best be dealt with by regulation. The market does impose its own discipline. It rewards firms that successfully maintain investor confidence, and punishes those that have abused investor trust or are not sufficiently transparent. I have been impressed by how seriously the private sector has responded to the challenges raised by the events of this year. Accounting bodies and regulatory agencies are also seeking ways to improve practices and restore confidence. They are re-examining the role and the responsibilities of external auditors to boards and shareholders--and how these can differ from other duties that auditors are sometimes asked to carry out by management. And they are asking if shareholders and boards have the tools and the power to hold management accountable. It's important that we continue to work on these issues and, moreover, that we are seen to be working on them. We live in a world where impressions matter and where capital markets are increasingly global. Canadian issuers will be judged not only against our own standards, but also against the worldwide standards for accounting, disclosure, and governance. At the same time, we must be careful not to impose an overly onerous burden of processes and paper on businesses, particularly on smaller firms, given their importance to the Canadian economy. Let me be clear: the same principles must apply to all public companies. While all businesses must abide by the spirit of the new standards, it may well be appropriate that larger, more widely held firms should face more detailed requirements than smaller firms whose shares are not as widely held. The challenge of developing an appropriate Canadian formula is made more difficult because we do not have a single lead securities regulator, as do the United States, the United Kingdom, and Australia. I'm not here to argue whether or not Canada should have a single lead regulator. The point is we need to improve our current system, and we need to do it now. If we don't, we risk damaging our reputation in world capital markets. In sum, the best way to restore investor confidence is to put in place a system of incentives that encourages managers and boards to always act in the best interests of shareholders. Disclosure is key. In every case, shareholders are best protected with full, fair, and accurate disclosure of information. To quote a recent C.D. Howe report, "if reforms cannot help investors distinguish good and bad investment prospects, there is no avenue for improving This brings me to an important issue for the Bank. We have a shared responsibility to promote a sound financial system--together with the Department of Finance, Corporation, as well as provincial and other regulatory bodies. For years, the Bank has been conducting analysis and research related to the Canadian financial system, much of which has been published in the , and in technical reports and working papers. We are now prepared to take a further step in the interest of making the information about our financial system more widely available. I am pleased to announce that the Bank of Canada will introduce a new semi-annual publication, . We are planning for the first issue to be available late next month. In it, we will publish some of the Bank's ongoing work in monitoring financial system developments and analyzing the direction of financial sector policy. The aims to promote knowledge of, and discussion about, changes and developments in the Canadian financial system. I would point out that we are not the only central bank to publish such a document. For example, the Bank of England, the Swedish Riksbank, and the International Monetary Fund also produce similar reports. While we work to promote financial stability in conjunction with other agencies, we alone are responsible for monetary policy. The foundation for that policy is the inflationtargeting system. How this system works may be familiar ground for some of you, but it is worth discussing again, especially during these uncertain economic times. The Bank of Canada Act calls on us "to promote the economic and financial welfare of Canada." We want strong and sustainable economic and employment growth. The best way we can help to achieve that is to promote confidence among Canadians in the future purchasing power of their currency. In other words, we want Canadians to be confident that inflation will remain low, stable, and predictable. For over a decade, following a joint agreement with the federal government, the Bank has operated with a system of inflation-control targets. Under the current terms of the agreement, the Bank aims to keep the trend of consumer price inflation at the 2 per cent midpoint of a 1 to 3 per cent range. Since we instituted the agreement, inflation expectations have become firmly anchored on our 2 per cent target. Well-anchored expectations promote economic growth and stability. Why? Investors can better assess the future value of their investments. Savers can be more confident that their future purchasing power will not be unexpectedly eroded by inflation. Debtors can better assess the real burden of their interest payments. Wage and financial contracts can be set for longer terms. All of this is possible because people are confident that inflation will stay around 2 per cent over the medium term. Our inflation-targeting system also helps to smooth the peaks and valleys of the business cycle and to avoid the boom-and-bust pattern seen in earlier decades. We do this by acting in a symmetrical manner; that is, we pay equal attention to any significant movement in inflation away from the 2 per cent target, whether above or below. The crucial task in controlling inflation is to judge how the economy is performing relative to its economic potential. Economic potential is a very important concept, so I want to take a minute to describe it. Potential output, or production capacity, is the amount of goods and services that can be produced without putting pressure--in either direction--on inflation. When the economy is producing less than its potential, economists say there is an output gap. That gap tends to put downward pressure on inflation, so the Bank will ease monetary policy to stimulate growth. We do this by lowering our target for the overnight interest rate. When the economy is operating above its potential, excess demand builds. This puts upward pressure on inflation, and the Bank will tighten monetary policy to try to cool the economy, bring it back down to its level of production potential, and return inflation to the target. Keep in mind that changes in our policy rate work their way through the economy slowly. It takes up to two years for a change in interest rates to have its full impact on demand, output, and ultimately, on prices and inflation. So we have to be forward-looking in our interest rate decisions. At our fixed announcement dates, we are not trying to affect today's inflation. What we are aiming at is future inflation and acting pre-emptively to achieve a balance in supply and demand going forward. This may sound easy in theory, but the reality is complicated. For one thing, it is impossible to measure the economy's potential with precision. All economists can do is to make their best estimate--a highly educated estimate, I might add, but an estimate nonetheless--of the level of economic activity that represents full capacity. And since one cannot measure potential with precision, it is impossible to measure the exact size of the output gap or the amount of excess demand. So the Bank looks at a wide variety of indicators to assess how much pressure there is on capacity. We monitor Statistics Canada reports on how closely factories are operating relative to their capacity. We survey businesses across the country to see where firms are feeling production constraints. We look at data from the labour market, as well as figures on input costs and wages. We look at real estate market indicators. And, of course, we pay careful attention to financial market developments. We also measure inflation and inflation expectations. One key indicator is core inflation, which strips out the eight most volatile components of the consumer price index, along with the effects of changes in indirect taxes on the remaining components. We have found that this measure gives a good indication of the trend of future inflation. Indeed, it has done a better job of predicting the path of total inflation than the CPI itself. All of this gives us a comprehensive view of how the economy is operating relative to its capacity, now and in the future. And I should point out that on the Bank's Web site, you can now find the latest data on the indicators that we look at when we assess capacity pressures. Let me now turn to our economic outlook, and tell you how our views have evolved over the year. In last April's , we projected that economic growth would be in a range of 3 to 4 per cent, at annual rates, from the second half of this year to the end of next year. Excess capacity in the economy was expected to be eliminated in the second half of 2003. And we noted that since we had taken our policy interest rates down to historically low levels in 2001, we would have to raise interest rates in a timely and measured way. So we began to tighten monetary policy, raising our target for the overnight rate three times between April and July, by a total of three-quarters of a percentage point. By late summer, however, uncertainties stemming from beyond our borders were beginning to mount. We noted that slower growth in demand in the United States was likely to hurt our exports in the short run. We also noted that global financial headwinds could affect spending by Canadian businesses and households. Finally, we said that concerns about corporate governance and the unsettled geopolitical situation could cause some firms and households to delay their spending. By October, the cumulative impact of slower global growth and the financial headwinds led us to reduce our near-term growth projection for Canada. In our latest , we say that we expect growth to average slightly less than 3 per cent, at annual rates, through to the middle of 2003. But assuming that the financial headwinds and geopolitical concerns dissipate in the second half of next year, we should see a strengthening of domestic and foreign demand and the resumption of above-potential growth in Canada. It is interesting to note that our current view on the level of economic activity in Canada by the middle of next year is not far from where it was back in April, although the quarterly growth profile has changed. We still project that the small amount of excess supply remaining in the economy should be taken up as output growth moves above potential growth in the second half of 2003. Finally, let me say a few words on inflation. In our October , we noted that core inflation over the next few months would likely be higher than had been previously anticipated. We cited some specific, one-off movements in relative prices, including insurance premiums and the effects of changes in the structure of Ontario's electricity market. We also said that core inflation would likely move still higher in the fourth quarter of this year, because of the "echo effect" of the price discounting that took place in 2001 following the 11 September terrorist attacks. But we said that core inflation should return to 2 per cent in the second half of next year. We are still of that view. However, because of the change in electricity pricing in Ontario, the monthly pattern of price movements will likely be different than earlier expected. In October, we had indicated that higher crude oil prices could continue to push total CPI significantly above the target range at the end of this year. But crude oil prices have moderated in recent weeks. Should this moderation continue, total CPI will likely peak at a lower level than we thought in October. We also continue to expect that the total CPI will converge with the core rate, around 2 per cent, in the second half of next year. However, we will continue to watch this closely, to make sure that the one-off influences I mentioned earlier do not feed into prices more generally. To conclude, let me repeat what we said in our last . As we go forward, we will need to remove some of the monetary stimulus now in place before the economy reaches its level of full potential. The pace of this action will continue to depend on the balance of domestic and external developments and on their implications for pressures on capacity and inflation in Canada.

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canada

Release of

dodge

Good morning, ladies and gentlemen. Today, we released our Update to the October Monetary Policy Report, in which we discuss economic and financial trends in the context of Canada's inflation-control strategy. Core inflation has been higher than anticipated in recent months. This reflects not only a stronger-than-expected increase in premiums for auto and home insurance, but also some broadening of price pressures resulting from strong demand in the economy. Based on analysis of the inflation data and other indicators of pressures on capacity, we believe that the economy may be operating closer to its production potential than we thought previously. In the second half of 2002, the Canadian economy slowed to an annual growth rate close to potential, which we estimate to be 3 per cent. This slowing reflected the effects of financial and geopolitical uncertainties and weakness in the global economy. In the Bank's base-case projection for the Canadian economy, demand pressures are expected to strengthen in the second half of 2003 and into 2004, following growth at slightly below potential in the first half of this year. We project that the core and total inflation rates will decline through 2003, as the effects of the one-off factors diminish. But both core and total CPI will likely still be somewhat above 2 per cent at the end of the year. Total CPI inflation will continue to be affected by developments in crude oil prices. If these prices were to stay at current levels of just over US$30 per barrel, total inflation could move up to between 4.0 and 4.5 per cent in the first quarter. If, however, oil prices ease back in the second half of the year, as indicated by futures prices, total inflation is projected to move down, back in line with core inflation. Monetary policy is currently very stimulative, and a reduction of this stimulus will be needed to return inflation to the 2 per cent target over the medium term. A number of elements will come into play in determining the pace of increase in policy interest rates. Although much of the recent rise in inflation has been the result of one-off factors, we cannot rule out the possibility that demand pressures are becoming more prominent. As well, there is a risk that inflation persistently above the 2 per cent target might lead to an increase in inflation expectations. Although we have seen an improvement in financial conditions, business and investor confidence remain fragile because of uncertainty about the geopolitical situation. And the way in which events in the Middle East unfold could affect demand and inflation, both globally and in Canada.

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canada

Monetary Policy: Meeting the Challenges of an Uncertain World

dodge

Governor of the Bank of Canada at the Speakers Forum I want to talk today about some of the uncertainties surrounding Canada's economic prospects and how the Bank of Canada is dealing with them through its conduct of monetary policy. In particular, I'll discuss what's happening to prices in the economy and how Canada's macroeconomic policy framework protects it from the risks of persistent inflation or deflation. Finally, I will update our outlook for the Canadian economy. Two weeks ago, I was in Basel, Switzerland, for one of our regular meetings at the Bank for International Settlements. This meeting, as well as others during the past year, have been particularly interesting for Canadians. Other participants always ask us, "How come you Canadians are doing so well, when the rest of us seem to be struggling?" We have been telling them that one of the reasons why Canada has been less affected by the recent worldwide economic slowdown is that we made extraordinary efforts during the 1990s to get our macroeconomic framework--that is, our monetary and fiscal policies--right. We all know it was painful to adjust to free trade and to conquer inflation in the early 1990s, and to eliminate public sector deficits over that decade. Canada paid an economic price for those efforts during the 1990s. But they are now yielding clear economic dividends. Of course, we've also had some good luck. We are less exposed to sectors that are struggling the most. But Canada's economic strength during the past two or three difficult years for the world economy reflects, for the most part, the fact that Canada stuck to its basic policy framework. As we move forward, this underscores the importance of maintaining that framework--especially now, when the near-term world economic outlook is not strong, and the geopolitical climate is uncertain. With all this economic uncertainty, it is not surprising that we hear concerns these days about both the risks of accelerating inflation and the risks of deflation. I think it is important to place these concerns into some context, so that Canadians can better understand the risks and implications of price shifts in the economy. That is why I'm going to concentrate most of my comments today on this subject. After all, the goal of the Bank of Canada's monetary policy is to maintain low, stable, and predictable inflation. For over a decade, following a joint agreement with the federal government, the Bank has operated with a system of inflation targets. We aim to keep the trend of consumer price inflation at the 2 per cent midpoint of a 1 to 3 per cent range. Because we have managed to keep inflation inside the target range through most of the past decade, Canadians' expectations for inflation have become firmly anchored around the 2 per cent target. Right off the top, let me assure you that the Bank of Canada will continue to pursue a monetary policy focused on returning inflation to that 2 per cent target, should it deviate in either direction. Canada's inflation-targeting framework operates symmetrically; that is, we minimize the chances of both a sustained upward drift in inflation and the threat of deflation. Recently, rates of inflation in Canada have come in higher than expected. At the same time, a weak global economic environment, the huge drop in equity prices, and declines in the prices of some manufactured goods are raising fears of deflation in other countries. Let's look at both these risks. First, let's consider the upside risk of accelerating inflation. It has been more than a decade since Canada has experienced prolonged high inflation. Since the targeting system was put in place, both the trend of inflation and inflation expectations have come down to near 2 per cent and stayed there. In recent months, CPI inflation has risen substantially, for several reasons. We've seen higher oil and gas prices, higher home and auto insurance premiums, higher tobacco taxes, and, in Ontario, higher electricity prices. There has also been the "echo effect" of temporary price discounting in late 2001, following the 11 September terrorist attacks. At the same time, stronger demand in Canada has been pushing up prices in some sectors, such as housing and some services. These pressures are starting to show up somewhat more broadly in the CPI data; and, without offsetting declines in other components of the CPI, these pressures are having an impact on all our measures of trend inflation. This suggests to us that demand conditions may be strong enough now to make it easier to raise prices and widen profit margins. The Bank's policy aims to maintain total CPI inflation at 2 per cent, or to return it to that point within 18 to 24 months. With that horizon in mind, we need to look through any short-term volatility--and there's been a lot of short-term volatility in recent months. Mostly, we do that by focusing on our measure of core inflation, which excludes the eight most volatile components of the CPI, as well as the effect of changes in indirect taxes on the remaining components. Of course, any measure of core or underlying inflation won't perfectly predict future inflation. We also look carefully at what is happening to individual CPI components, to gauge the size and persistence of any price changes. So, for example, recently we have spent a lot of time examining the factors driving the prices of electricity, insurance, and some foods. Many of the relative price movements churning the current inflation numbers will likely prove to be temporary . But the recent pattern of persistently higher-than-expected rates of inflation, together with other signs of capacity pressures, may be indicating that our economy is operating closer to capacity than the Bank had previously thought. Let me now turn to the potential downside risks on the price front--deflation, which is a persistent decline over time in the average prices of goods and services. We have all heard a lot about the toll that deflation has taken on Japan. In some other countries, including the United States, concerns about deflation have also arisen because prices for goods have been falling. Their economies have been operating below capacity, and the resulting output gap is putting downward pressure on prices. Why is the possibility of falling prices so worrisome? Well, when North Americans think of "deflation," they usually think of the 1930s and the terrible economic and social consequences of the Depression. Back then, deflation was the result of a spectacular drop in demand. That kind of deflation can lead to a vicious circle of declining profits and share values, increased debt burdens, business bankruptcies, lower investment, and a further weakening of demand. The goal of macroeconomic policy should be to avoid this type of situation. It is precisely for this reason that Canada's inflation-targeting framework operates symmetrically. But weak demand isn't the only thing that may pull down prices. A drop in prices that is triggered by increased productivity would not harm an economy, because the higher productivity would boost profits, stimulate business spending, and improve real incomes. With that in mind, let's look at what has been happening to prices around the world. In many of the world's biggest economies--Japan being the exception--inflation has been averaging around 2 per cent. That's low by historical standards, but still well above zero. In some of these economies, as I've mentioned, the prices of goods are actually falling. But much of that drop has come about as a result of higher productivity. Productivity growth has been more concentrated in goods-producing industries. That is why we see sharp divergences in goods and services prices. In the United States, for example, over the past year, goods prices--based on the core measure of inflation--fell 1 1/2 per cent, while services prices rose by about 3 1/2 per cent, resulting in an overall core inflation rate of about 2 per cent. A similar scenario is playing out in the United Kingdom. If technological advances and productivity growth cause lower goods prices, profitability in the goods-producing industries will be preserved, wages and salaries can increase, and there will be no adverse effects on total employment and spending. In Canada, goods prices are rising more slowly than services prices. However, we're not seeing actual declines in the overall price of goods. Although this may have something to do with structural differences in our economy, fundamentally it reflects the fact that domestic demand in Canada is stronger than in the United States, and our economy is operating closer to capacity. Here is some of the evidence we have to date to support this view. Capacity utilization among Canadian goods producers is getting close to the point where production constraints start to emerge. In some sectors, businesses are reporting shortages of skilled labour. And profit margins for consumer-related industries trended up through the first three quarters of 2002. All of this suggests that most goods prices in Canada are not being discounted because of weak demand, as appears to be the case in the United States. Moreover, Canadian corporate balance sheets are improving and are, indeed, in relatively good shape compared with those in other countries. So, those are both sides of the price picture. I've laid out for you some of the factors that are moving prices at home and abroad. Now, I'd like to spend some time explaining how Canada's monetary policy framework reduces the risk of both persistent inflation and persistent deflation. As I said before, Canadian monetary policy acts in a symmetrical manner--that is to say, we pay equal attention to any significant movement in inflation, whether above or below the 2 per cent target. We respond to shocks that would push inflation trends away from that target. For example, following the 11 September 2001 terrorist attacks, we quickly and aggressively cut our policy interest rate to shore up confidence. Then, in the spring of 2002, evidence started to build that demand was growing faster than the economy's potential. So, even though this was not yet showing up in prices, we raised our key policy rate three times between April and July, by a total of three-quarters of a percentage point. Last fall, when inflation was rising, we refrained from raising rates because we expected that global economic weakness would restrain total demand for Canadian goods. As we go forward, the Bank will be acting to prevent the current high headline inflation rates from feeding into expectations and to return inflation to the 2 per cent target. We will also be assessing all measures of capacity pressures in the economy. And this brings me to the Bank's economic outlook for the next 18 months or so. While Canada's economy has outperformed those of our major trading partners, our prospects are still very much influenced by developments abroad. After all, we sell to the world. So let me start with the external outlook. Since last summer, we have been worried about financial headwinds and geopolitical uncertainty and their effect on global demand. In our that we just published , we said that global economic prospects may have weakened further in the first half of the year. However, we continue to expect global economic growth to pick up in the second half of the year and into We also expect that risk premiums in financial markets will continue to decline, which should further improve the environment for business investment later this year. But on the geopolitical front, the possible outbreak of war in the Middle East remains the great uncertainty. Let me outline the implications of some of the scenarios we face. A negotiated early resolution of the standoff in Iraq, or even a short, decisive conflict, could reduce geopolitical tensions fairly quickly. But a prolonged war would make the world economic outlook even more uncertain and would hurt business and consumer confidence. In the case of a war, oil supplies might be disrupted, which would lead to higher oil prices, further restrain global economic activity, and raise total CPI inflation around the world. I would note, however, that higher oil prices would raise the value of Canada's oil and gas exports. Finally, a prolonged war could boost U.S. government spending and, hence, Of course, we don't know how the situation in the Middle East will be resolved. So, we have made an assumption that the related uncertainties will dissipate in the second half of 2003. Our projections for the global and Canadian economies are based on this assumption. So, let me now turn to the Canadian outlook. After growing significantly faster than potential during the first half of 2002, Canada's economy slowed to a growth rate close to potential in the second half of the year. Even with this slowdown, the level of demand has remained near capacity since the middle of last year. As we look forward, we foresee below-potential growth in the first half of the year. But we anticipate increased demand pressures in the second half of 2003 and into 2004, as global uncertainties diminish. However, with an appropriate reduction in the amount of monetary stimulus, we see the level of output remaining close to capacity during 2003 and into 2004. As I said earlier, recent inflation rates have come in somewhat higher than expected. This reflects certain one-off price increases, such as higher insurance premiums, but also some broadening of price pressures as a result of stronger demand. The one-off factors will hold the core rate of inflation well above the 2 per cent target in the first half of this year. In the second half and into 2004, we expect the core rate to ease, as the effect of the one-off factors diminishes and the removal of monetary stimulus keeps demand pressures in check. The outlook for total CPI inflation this year will continue to be importantly affected by developments in crude oil prices. With oil and gas prices where they are now, we could see CPI inflation rates between 4 and 4.5 per cent in the first quarter. If oil and gas prices decline in the second half, as futures prices suggest they will, then total CPI inflation would move back down in line with core inflation. Let's remember that the stance of monetary policy remains stimulative. To return inflation to the 2 per cent target over the medium term, we will need to remove some of the stimulus. In other words, we will need to raise interest rates. A number of elements will come into play in determining the pace at which we will reduce monetary stimulus. Let me reiterate them. First, although much of the recent run-up in inflation was the result of special factors, we can't rule out the possibility that demand pressures are becoming more prominent. So, we will watch these pressures carefully. Second, the Bank must guard against the risk that inflation above the 2 per cent target might lead to an increase in inflation expectations. These, too, we will monitor closely. Third, the confidence of investors and financial markets has improved but remains fragile because of geopolitical and world economic uncertainty. We will be watching credit and financial market developments to gauge the climate for business investment. Fourth, the way in which events in the Middle East unfold could affect demand and inflation, globally and in Canada. To conclude, let me repeat that this is not an easy time to predict the course of the global economy. But Canada's economy, while feeling the impact of world uncertainties, is showing sustained strength. That strength reflects the extraordinary work Canadians have done in creating and maintaining a sound macroeconomic framework. I can assure you that monetary policy, as a key part of that framework, will continue to serve Canadians well in meeting the challenges of an uncertain world.

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canada

Meeting Global Challenges: The Importance of Sound Economic Policies

dodge

Governor of the Bank of Canada I am delighted to be in London to speak with you today. We are facing a time of great economic and political uncertainty. While economic activity is close to potential in Canada, most other countries are facing very weak demand and lacklustre economic prospects. And, of course, there is the overriding prospect of a war in Iraq. Voltaire said that "doubt is not a pleasant condition, but certainty is an absurd one." We policy-makers are rarely burdened with certainty at the best of times, and definitely not these days! In an environment as unsettled as this one, it is easy to become preoccupied with the here and now. But, during such times, it is even more important that we remain focused on the medium-term goals of macroeconomic policy. And that's what we're trying to do in Canada. Many of my colleagues at international meetings this year have commented on Canada's economic strength. It is true that we've had some good luck. But Canada's strong performance during the past two or three difficult years for the world economy primarily reflects extraordinary efforts made during the 1990s to get our macroeconomic framework--that is, our monetary and fiscal policies--right. Canada, of course, was not alone in making these efforts. During the 1980s, a consensus developed among OECD nations on the combination of policies most likely to deliver sound economic performance. The consensus grew out of the unhappy experiences of earlier policy experiments. And it was built around four key principles: trade liberalization, structural reform, fiscal prudence, and low and stable inflation. These four principles work like the four legs of a chair. The chair is steadier when all four legs are equally sturdy. Similarly, an economy is more stable when progress is made on all four policy fronts. And when one of the legs starts to weaken, the best way to restore stability is to build that leg back up, not to cut down the other three. Canadians spent a great deal of effort over the past decade or so putting the four elements of this policy framework into place. It involved considerable short-term economic pain. But the phrase "short-term pain for long-term gain" is more than just a cliche. Canada is now receiving the economic payoff from this effort. Since 1997, our economy has consistently exceeded the average growth rates of the world's most industrialized countries. And it is expected to do so again this year. Let me briefly review those four principles and the progress that Canada has made on each. I'll start with the principle of trade liberalization. We all know that freer international trade helps countries to more fully exploit the gains that come from increased specialization and greater productivity and competitiveness. Canada's economy made some difficult adjustments to freer trade during the late 1980s and early 1990s. First, we signed the Canada-U.S. Free Trade Agreement, which came into effect in 1989. Then, in 1994, Mexico joined the group through the Both of these agreements sparked a great deal of political controversy. And many Canadian companies were understandably anxious to avoid increased competition. As well, the Free Trade Agreement came into effect at a time when monetary policy was tight, to fight the high inflation rates of the day. Despite initial misgivings, Canadian companies rose to the challenge of increased competition. Some of the sectors that we used to protect the most--such as furniture, clothing, and wine--have since established a strong presence in international markets. Overall, Canadian exports have flourished under these agreements. And that strengthens our resolve to see freer trade extended beyond regional trading blocs. Canada is hoping to see meaningful progress at the World Trade Organization's Doha round of multilateral talks. Clearly, agriculture is going to be a major hurdle. The developed countries, including all of us in the G-7, have a considerable way to go in terms of liberalizing agricultural trade. And there are other sectors where major effort is required. This effort must be made so that the global economy can benefit. It won't be easy but, in the long run, it will be worth it. Complementing trade liberalization is the second principle, which focuses on the need to improve the structure of national economies. The goal here is twofold: first, to increase the flexibility of our economies to adjust to changing world economic conditions; and second, to ensure the longer-run viability of our social- and income-security arrangements. Structural adjustments are always difficult because reforms will affect various groups in differing and often painful ways. Further, the economic benefits of increased flexibility may take a fairly long time to emerge. But these difficulties should not sway us from the task of reducing rigidities and increasing efficiency. Canada has made some progress on a number of fronts. For example, governments have taken steps to reduce distortions in the personal income tax system, and have implemented a goods and services tax to replace the outdated tax on manufacturers. Unemployment insurance benefits were also reduced and restructured to strengthen the incentive to work. Another important structural reform was to our public pension system. In 1996, Canadian federal and provincial governments agreed to changes that would put the Canada and Quebec Pension Plans on a sustainable footing. This meant some restructuring of benefits and a sharp increase in contributions--moves that were as unpopular as they were necessary. The surpluses in the Canada and Quebec Pension Plans now represent almost 1 per cent of GDP. Furthermore, these surpluses are set aside in special funds that cannot be touched by governments for general use. The assets of the public plan are now managed by the Canada Pension Plan Investment Board, a body that is entirely independent of government. Its sole mandate is to invest the contributions in markets, in order to generate the best possible returns, consistent with prudence, over the long term. This leads me to the next principle, which relates to fiscal policy and the need for a more disciplined approach to managing the public purse. Fiscal policy must be guided by the principle of putting the ratio of public debt to GDP on a sustainable, downward track. In Canada's experience, this was a difficult hurdle to overcome. To be sure, the fiscal consolidation of the 1990s was painful. I was federal Deputy Minister of Finance at that time, and I can tell you that many difficult and unpopular decisions had to be taken. Equally important, the provinces had to make tough choices as they reduced their public spending and restored their fiscal health. But as difficult as those years were, waiting would only have made matters worse. Well, here's the good news: the vicious circle of rising deficits and debt has become a virtuous circle of balanced budgets and falling debt. Reducing the deficit in the 1990s helped Canada's international credibility. This led to a reduction in the risk premium demanded by international investors. The fiscal improvement meant that the Bank of Canada was able to lower interest rates more easily when economic circumstances warranted. Not only did lower interest rates reduce debt-servicing costs, they also stimulated economic growth, which brought in more revenues to the government. The extra revenues and lower debt-servicing costs, in turn, led to an even better fiscal position. At the end of 2002, Canada's total government surplus represented just over 1 per cent of GDP--not including the surplus in the pension plans. Last month, Finance Minister John Manley announced a fifth consecutive surplus in the federal budget and projected that the budget will continue to be in a balanced position or better for the next three years. The budget maintained the fiscal planning framework of previous years. That framework includes a $3 billion contingency reserve, which is used to reduce debt if it is not needed. It also includes $1 billion in the upcoming budget year for additional economic prudence, and $2 billion in the following year, as further assurance that Canada won't fall back into deficit. Canada is expected to have one of the lowest debt burdens in the G-7 this year. Not only have we reduced the debt-to-GDP ratio, but we have paid down almost $50 billion of federal debt. This has led to the restoration of Canada's Triple-A credit rating and has freed up about $3 billion of resources every year for the federal government. The main point is that while the initial work of fiscal consolidation is certainly difficult, it is necessary in order to enjoy the dividends later on. The fourth principle relates to monetary policy--the responsibility of the Bank of Canada. This principle recognizes that, over the medium term, monetary policy should work to keep inflation low, stable, and predictable. Let me explain how we do this. Since 1991, following a joint agreement with the federal government, the Bank of Canada has operated with a system of inflation-control targets. I don't plan to spend a lot of time explaining our system to this audience, because the United Kingdom adopted a system very similar to ours a couple of years after we did. We aim to keep consumer price inflation at the 2 per cent midpoint of a 1 to 3 per cent range. If the trend of inflation moves away from the target in either direction, the Bank will take action so that inflation returns to the target within 18 to 24 months. Canada's inflation-targeting framework works in a symmetrical way, minimizing the chances of both a sustained upward drift in inflation and the threat of deflation. Indeed, through most of the past decade, we have managed to keep inflation around the 2 per cent target midpoint. And so, Canadians' expectations for inflation have become firmly anchored around 2 per cent. This climate of low, stable, and predictable inflation has helped to smooth out the ups and downs in the economy and to create the best possible environment for longer-term economic growth in Canada. Let me now give you the Bank of Canada's views on the state of the Canadian economy and the outlook. First, a bit of history. Following the 11 September 2001 terrorist attacks in the United States, the Bank of Canada, like other major central banks, moved quickly and aggressively to cut its policy interest rate to shore up confidence. That dramatic monetary policy action helped a great deal. By the spring of 2002, it became evident that our economy hadn't been knocked off track by the events of 11 September. Indeed, evidence was starting to build that the economy was growing faster than its production potential, taking up the remaining small amount of economic slack. So, we raised our key policy rate three times between April and July, by a total of three-quarters of a percentage point. But by late last summer, we were seeing the effects of financial headwinds, geopolitical uncertainties, and continued weakness in the global economy. These factors remained in play through the autumn. As a result, we refrained from raising interest rates, even though inflation was accelerating. Our initial analysis was that this increase in inflation would be temporary. However, both core and total CPI inflation remain well above target. This reflects the impact of higher-than-expected prices for crude oil and natural gas, continuing increases in auto insurance premiums, and price pressures in certain sectors, such as housing, food, and some services. The higher inflation also suggests an underlying firmness in the price-setting environment. In other words, relative price increases wouldn't be pushing up trend inflation if there was not sufficient demand. Indeed, final domestic demand--especially household spending--has remained robust. However, economic growth in Canada moderated in the final three months of 2002, largely because of weaker exports--most notably, a decline in automotive shipments to the Even with this slowing growth in the fourth quarter, upward revisions for previous quarters leave the level of economic activity slightly higher than we had been monitoring. In fact, Canada's economy remains near full capacity. Let me list some of the indicators that support this view: high industrial capacity utilization; near record-high labour force participation rates; a record-high employment-topopulation ratio; corporate profits at their highest level since early 2001; and, as I said a few moments ago, above-target trend inflation. While we continue to foresee growth somewhat below potential in the first half of this year, we expect increased demand in the second half of 2003 and into 2004, as global uncertainties diminish. But with an appropriate reduction in the amount of monetary stimulus, we see the level of output remaining close to capacity during this year and into 2004. So, in making our interest rate decision on 4 March, we weighed the following considerations: domestic inflation pressures, the expectation that Canadian economic activity will remain near potential in 2003 despite geopolitical uncertainties, the stimulative stance of monetary policy, and improved conditions in capital markets. Taking all of these factors into account, the Bank raised its key policy rate by one-quarter of a percentage point to 3 per cent. Even with this increase, the stance of monetary policy remains stimulative. Thus, over time, further reductions in monetary stimulus will be required to return inflation to the target over the medium term. But, as we have said, the timing and pace of increases in policy interest rates will continue to depend on a number of considerations. These include the strength of demand pressures; the evolution of inflation expectations; the impact on confidence of geopolitical and global economic uncertainties; and the way in which developments in the Middle East affect demand and inflation, both globally and in Canada. The Bank will continue to closely monitor all of these factors. Let me conclude. At the beginning of my talk today, I noted that, for over a decade now, Canada has followed a policy based on the four key principles: trade liberalization, structural reform, fiscal prudence, and inflation control. It's never easy to follow those principles, but, over the medium term, they do lead to better economic performance. Canada's recent economic record is evidence of that. We have maintained an enviable growth performance through what has been a very difficult period for the world economy. We remain optimistic--and so do others--that we will continue to do so. Both the OECD and the IMF predict that Canada's economy will outperform those of other G-7 countries this year. But these are difficult times. Significant geopolitical and global economic uncertainties continue to overhang the economic outlook for all countries. It is during times like these that policy-makers may be tempted to put the four principles aside and focus instead on short-term economic problems. In Canada, we have learned that it is by sticking to these principles that we create economic structures that can withstand turmoil. The four policy principles have proven to be the most effective tools for meeting the challenges of a very uncertain world.

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The Benefits of Sound Economic Policies

dodge

Governor of the Bank of Canada It is truly a pleasure for me to visit this magnificent and historic city. I certainly appreciate the opportunity to speak to your association today. Canada and Italy share many similar characteristics. We both belong to the G-7, and we are among the smaller members of that group. Our two economies vary greatly from region to region, both in terms of structure and strength. Overcoming these regional disparities is one of the great challenges we both face. After the serious inflation problems of the 1970s and early 1980s, Canada and Italy are now enjoying the benefits of a low-inflation environment. And we both trade a great deal with a large partner--in our case, with the United States, in your case, with the rest of the euro zone. We in Canada and you in Italy have recently taken steps to overhaul our tax systems, and we both face the challenges of an aging population. Given our similarities, there is clearly much we can take from each other. What I would like to do today is talk about some of the lessons that we in Canada have learned about economic policy in recent years. During the 1980s, a consensus began to take shape among OECD countries on a set of economic policies that would provide the strongest base for sustained economic growth. There are four principles involved in this consensus. I like to think of them as the four legs of a chair. Just as a chair is steadiest when all of its legs are the same length, policy-makers can get the best results by paying equal attention to all four principles. And when one of the legs starts to weaken, the best way to restore stability is to build that leg back up, not to cut down the other three. Over the past decade or so, Canadians spent a great deal of effort putting the four elements of this framework into place. It certainly was not easy. It involved a fair bit of shortterm economic pain. But the phrase "short-term pain for long-term gain" is more than just a cliche. Canada is now reaping the economic benefits of this effort. Of course, part of the reason for our recent good performance is the basic structure of our economy. For example, the current global economic uncertainties are having their greatest effect on large, multinational firms. But Canada's economy consists more of small and mediumsized enterprises. As well, while the hard-hit technology sector has become an increasingly important part of the Canadian economy in recent years, it still represents a smaller share of our economy, compared with, for example, the United States. But good fortune is only part of the story. Without Canada's commitment to the OECD's "four legs" of sound economic policy, our recent performance would no doubt have been poorer. So, what are the "four legs" of the OECD consensus? The principles that I am referring to deal with monetary policy, fiscal policy, trade liberalization, and structural reform. I will spend a few minutes on each of these, drawing on Canada's experience in recent years. Let me start with the one that relates most directly to the Bank of Canada's primary responsibility--monetary policy. The OECD consensus holds that price stability is the appropriate goal for monetary policy over the medium term. In Canada, we try to achieve this goal through an inflation-targeting framework. The Bank of Canada reached an agreement with the federal government and introduced this policy in 1991. Under that agreement, we aim to keep inflation, as measured by the consumer price index (CPI), at the 2 per cent midpoint of a 1 to 3 per cent target range over the medium term. We have found that this inflation-targeting system has been very effective in promoting low, stable, and predictable inflation in Canada. Following a period of higher and more variable inflation in the 1970s and 1980s, the inflation-control targets have helped to anchor monetary policy. After the agreement came into effect, inflation quickly fell into the target range. Subsequently, inflation expectations have become focused on the target, helping to promote sustained economic growth. Here in Italy, the inflation-targeting monetary authority is the European Central Bank (ECB). Italy's recent inflation record is certainly favourable. But there is a slight difference in the approaches of the ECB and the Bank of Canada that I will mention. At the Bank of Canada, we explicitly run monetary policy in a symmetric way around our 2 per cent target. The ECB's only explicit commitment is to keep inflation below 2 per cent. There are always challenges to operating a single monetary policy in a country with diverse regions. As I said earlier, Canada, like Italy, has several regions with different economic structures. The ECB faces the even more daunting challenge of conducting monetary policy for an entire continent! But the important point I want to make here is that both the ECB and the Bank of Canada are determined to keep price stability as the medium-term policy goal. That is the first of the four legs. The second leg of the consensus has to do with fiscal policy. In the years leading up to the mid-1990s, provincial and federal governments in Canada were in the habit of running budget deficits. These deficits built up as governments continued to borrow, primarily to finance current consumption. It was an unsustainable situation, made more serious by our aging population. Clearly, social spending had to be put on a viable long-term course. And so fiscal policy needed to be based on a plan for putting the ratio of public debt to GDP on a steady downward track. In Canada's experience, this was a difficult hurdle to overcome. The fiscal consolidation of the 1990s was painful. I was the federal Deputy Minister of Finance at the time, and I can tell you that many difficult and unpopular decisions had to be taken. Equally important, the provinces had to make hard choices as they reduced their public spending and restored their fiscal health. But as difficult as those years were, waiting would only have made matters worse. Now, here's the good news: the vicious circle of rising deficits and debt has become a virtuous circle of balanced budgets and falling debt. Reducing the deficit in the 1990s helped Canada's international credibility. And this led to a reduction in the risk premium demanded by international investors. The fiscal improvement meant that the Bank of Canada was able to lower interest rates more easily when economic circumstances warranted. Not only did the lower interest rates reduce debt-servicing costs, they also stimulated economic growth, which brought in more revenues for the government. The extra revenue and lower debt-servicing costs, in turn, led to an even better fiscal position. Canada's total government surplus at the end of 2002 represented just over 1 per cent of GDP, which does not include the surpluses in public pension plans. Last month, Finance Minister John Manley announced a fifth consecutive surplus in the federal budget and projected that the budget will continue to be in a balanced position or better for the next three years. The budget maintained the fiscal planning framework of previous years. That framework includes a $3 billion contingency reserve, which is used to reduce debt if it is not needed for other purposes. It also includes $1 billion in the 2003-04 budget year for additional economic prudence, and $2 billion in the following year, as further assurance that Canada won't fall back into a deficit position. Not only have we reduced the debt-to-GDP ratio, but the federal government has paid down almost $50 billion of debt. This has led to the restoration of Canada's Triple-A credit rating and has freed up about $3 billion of resources every year for the federal government. The main point is that while the initial work of fiscal consolidation is certainly difficult, it is necessary in order to enjoy the fiscal dividends later on. The third leg of the consensus deals with trade liberalization. Countries need freer international trade to exploit the gains that come from increased specialization, enhanced productivity, and greater competitiveness. Canada's recent experience in this area first involved signing the Canada-U.S. Free Trade Agreement, which came into effect in 1989. In 1994, Mexico joined the group a great deal of domestic political controversy. But they also opened markets and created tremendous opportunities. Canada's exports have flourished as a result. But freeing up trade means more than setting up regional free-trade blocs, such as NAFTA and the European Union. Canada is hoping to see meaningful progress at the World Trade Organization's Doha round of multilateral talks. Clearly, agriculture is going to be a major hurdle. The developed countries, including all of us in the G-7, have a considerable way to go in terms of liberalizing agricultural trade. And a number of other sectors will also require a major effort. This effort must be made so that the global economy can benefit. It won't be easy, but in the long run, it will be worth it. The fourth policy leg has to do with structural reform. These adjustments are always difficult because reforms will affect various groups in differing and often painful ways. Further, the economic benefits of the increased flexibility may take a fairly long time to emerge. But these difficulties should not sway us from the task of reducing rigidities and increasing efficiency so that our economies can better adjust to a rapidly changing world. Canada has made some progress in a number of areas. The federal government has made changes to its system of unemployment insurance, trying to base the program more on insurance principles and to improve the employability of labour. Canada has also taken steps to reduce distortions in the personal income tax system and has implemented a goods and services tax to replace the outdated tax on manufacturers. More recently, we made some major changes to our public pension system. The changing demographics put pressure on the plans, as they are doing in Europe. By 1996, the federal and provincial governments agreed to changes that would put the Canada and Quebec Pension Plans on a firmer footing. This meant some restructuring of benefits and a sharp increase in contributions--moves that were not popular, but they were certainly necessary. The Canada and Quebec Pension Plans now generate surpluses that represent almost 1 per cent of GDP. These are set aside in special funds that cannot be touched by governments for general use. Indeed, the federal and provincial governments agreed to set up the Canada Pension Plan Investment Board, an entirely independent body. Its sole mandate is to invest the contributions in markets, in order to generate the best possible returns, with due consideration for prudence, over the long term. I should also point out, because the Canadian and Italian systems are different, that all public sector employees in Canada belong to pension plans that are fully funded. I know that you in Italy are struggling with pension reform, and I know how difficult the issue is. But such reforms are important, and I wish you well in your efforts. The challenges you are facing serve to highlight the fact that implementing the fourth leg of the OECD policy consensus is not easy. But we must all continue to make progress and not lose sight of the four principles. The payoff that Canada is now seeing gives me confidence in the value of the OECD consensus. Despite the global economic slowdown, despite the collapse of the share prices of many technology firms, despite the effects of the September 2001 terrorist attacks against the United States, and despite the corporate governance and accounting concerns, Canada's economy has remained strong. And most forecasters expect us to lead the G-7 in economic growth again this year. Given all the uncertainty in the global economy, it is more important than ever that national authorities around the world stick to this policy framework. It is only by staying the course that we can establish a steady base for sustained growth over the long term. Let me now give you the Bank of Canada's views on the state of the Canadian economy and the outlook. First, a bit of history. Following the 11 September 2001 terrorist attacks in the United States, the Bank of Canada, like other major central banks, moved quickly and aggressively to cut its policy interest rate to shore up confidence. That dramatic monetary policy action helped a great deal. By the spring of 2002, it became evident that our economy hadn't been knocked off track by the events of 11 September. Indeed, evidence was starting to build that the economy was growing faster than its production potential, taking up the remaining small amount of economic slack. So, we raised our key policy rate three times between April and July, by a total of three-quarters of a percentage point. But by late last summer, we were seeing the effects of financial headwinds, geopolitical uncertainties, and continued weakness in the global economy. These factors remained in play through the autumn. As a result, we refrained from raising interest rates, even though inflation was accelerating. Our initial analysis was that this increase in inflation would be temporary. However, both core and total CPI inflation remain well above target. This reflects the impact of higher-than-expected prices for crude oil and natural gas, continuing increases in auto insurance premiums, and price pressures in certain sectors, such as housing, food, and some services. The higher inflation also suggests an underlying firmness in the price-setting environment. In other words, relative price increases wouldn't be pushing up trend inflation if there was not sufficient demand. Indeed, final domestic demand--especially household spending--has remained robust. However, economic growth in Canada moderated in the final three months of 2002, largely because of weaker exports--most notably, a decline in automotive shipments to the Even with this slowing growth in the fourth quarter, upward revisions for previous quarters leave the level of economic activity slightly higher than we had been monitoring. In fact, Canada's economy remains near full capacity. Let me list some of the indicators that support this view: high industrial capacity utilization; near record-high labour force participation rates; a record-high employment-topopulation ratio; corporate profits at their highest level since early 2001; and, as I said a few moments ago, above-target trend inflation. While we continue to foresee growth somewhat below potential in the first half of this year, we expect increased demand in the second half of 2003 and into 2004, as global uncertainties diminish. But with an appropriate reduction in the amount of monetary stimulus, we see the level of output remaining close to capacity during this year and into 2004. So, in making our interest rate decision on 4 March, we weighed the following considerations: domestic inflation pressures; the expectation that Canadian economic activity will remain near potential in 2003 despite geopolitical uncertainties; the stimulative stance of monetary policy; and improved conditions in capital markets. Taking all of these factors into account, the Bank raised its key policy rate by one-quarter of a percentage point to 3 per cent. Even with this increase, the stance of monetary policy remains stimulative. Thus, over time, further reductions in monetary stimulus will be required to return inflation to the target over the medium term. But, as we have said, the timing and pace of increases in policy interest rates will continue to depend on a number of considerations. These include the strength of demand pressures; the evolution of inflation expectations; the impact on confidence of geopolitical and global economic uncertainties; and the way in which developments in the Middle East affect demand and inflation, both globally and in Canada. The Bank will continue to closely monitor all of these factors. So, to conclude, these are certainly challenging economic times. But we in Canada remain convinced of the merits of the economic policy consensus reached at the OECD. To reiterate, these policies are: a monetary policy aimed at medium-term price stability; a fiscal policy aimed at reducing public debt-to-GDP ratios; trade liberalization; and meaningful structural reform. Canada's positive economic experience over the past couple of years, in the face of stressful times for the global economy, is strong evidence that this framework is the right one. In Canada, there is a determination to stick with these policies which, especially during these uncertain times, are demonstrating their value.

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Focusing on the Long Term

dodge

Governor of the Bank of Canada Thank you for the invitation to join you this evening. It was exactly a year ago that I met with you in Montreal. It has not been an easy year. All of you have been running companies and making decisions under very uncertain conditions. You have had to deal with corporate and accounting issues. Markets have been volatile. And geopolitical events have shaken confidence. At times like these, it's easy to get caught up in trying to make one's way through current events that cloud the outlook. But the present uncertainties make it even more important to maintain a focus on strategies that will promote the health of businesses over several years--not just over the next few months or quarters. The same holds true for economic policy-makers. Failed experiments in previous decades have taught us that, in times of uncertainty, it is extremely important to stick to policies that will foster long-term economic growth. A longer-term focus Many of us in this room have reached a stage in life where we have at least two pairs of glasses--one for close-up, and one for distance. We're acutely aware that wearing glasses to focus on something very close makes us lose perspective on things further away. And if we focus only on the here and now, we can lose sight of the future. We need a set of economic bifocals, if you will, to see the impact of current events, as well as the best path to future prosperity. Tonight, I'd like to speak about that longer-term economic vision. Through more than a decade of macroeconomic reform, we Canadians have created a framework to meet both immediate and longer-term challenges. Even as short-term events have buffeted our economy, we have followed four key long-term policy principles: trade liberalization, structural reform, sound fiscal policy, and low inflation. Recent Canadian economic performance demonstrates the merit of continuing to set policies with a longer-term view. Short-term adjustments are sometimes unavoidable in the face of extraordinary events--and we've had more than our share of extraordinary events in the past few years! But, on the whole, these basic principles have stood Canada in good stead through the recent difficulties in the world economy. Let me talk about each one in a bit more detail. The first principle is trade liberalization, and our economic relationship with the United States has reflected that goal. As you and I discussed last year, the Canadian and U.S. economies made difficult adjustments to freer trade in the early 1990s. The Canada-U.S. Free Trade to stiffer competition. But freer trade also opened up new markets. And Canadian companies have risen to the challenge. Some of the sectors that we used to protect the most--such as furniture, clothing, and wine--have established a strong presence in international markets. On the whole, Canadian industry has flourished with the competitive pressures generated by these agreements. And so has the trading relationship between Canada and the United States. As you can see from , freer trade has clearly meant increased volumes of exports and imports. And now that we have made the adjustment, the more open trading environment is clearly helping to raise living standards for Canadians. That should strengthen our resolve to see freer trade extended both within and beyond North America. We need to continue to work towards reduced trade barriers, both within NAFTA and at the Doha round of multilateral talks. It won't be easy, but the long-term economic benefits will make our efforts worthwhile. The second principle focuses on improving the structure of national economies, to facilitate adjustment to changing economic conditions and to ensure the longer-term viability of social- and income-security arrangements. A number of initiatives have been undertaken in Canada, but I'm going to focus on only three. I am sure that you're familiar with them, and many of you have participated in the debate surrounding these reforms. incentive to work. With these changes, and with improved economic performance, EI payments as a share of GDP have declined significantly over the past decade, from more than 2 1/2 per cent to just over 1 per cent, as shown in . Second, the Canada and Quebec Pension Plans were revamped, to put them on a sustainable footing. The reforms meant some restructuring of benefits and a sharp increase in contributions--moves that were necessary, if unpopular. The results are shown in . The assets of the CPP are now managed by the independent Canada Pension Plan Investment Board, the mandate of which is to invest the contributions in markets, in order to generate the best possible returns. These changes mean that Canadians no longer have to worry about the sustainability of their CPP and QPP pensions. Third, governments have improved the efficiency of their tax and spending programs. I know that you are familiar with the major federal and provincial efforts to make direct government spending more efficient. Although more work always needs to be done, governments in Canada have also undertaken significant structural changes to our tax regime. They have reduced distortions in the personal income tax system and implemented the goods and services tax to replace the outdated manufacturers sales tax. Structural reform has also included changes to Canada's corporate tax regime--changes that, when completed, will eliminate the federal capital tax and reduce the average statutory corporate tax rate in Canada to a level that is below current U.S. rates. Of course, there are other structural improvements left to be made. I'm sure many of you have views and suggestions about how to make them. You have been discussing some of them here today. In my view, it is critical that Canada's private and public sectors continue to work together to further improve the structure of our economy and increase our ability to adjust to changing world economic conditions. Now, the key to good economic performance is sound macroeconomic policy. The Bank of Canada is responsible for monetary policy. But monetary policy operates within a larger macroeconomic context. So, let me start with fiscal policy. For Canada, the commitment to the principle of sound fiscal policy has meant putting our public debt, as a proportion of GDP, on a sustainable downward track. Many of you remember the difficult and unpopular decisions that had to be taken by federal and provincial governments during the 1990s to achieve this goal. Those efforts are paying off. Today, not only does Canada have one of the lowest debt burdens in the G-7, but, as shown by the arrows in , that burden is expected to continue to decline. The federal government has paid down almost $50 billion of its debt--bringing it down from a high of almost 70 per cent of GDP in 1996 to about 45 per cent in 2002, as illustrated in . Thus, the vicious circle of rising deficits and debts of the 1970s and 1980s has become a virtuous circle of balanced budgets and falling debt. Program spending for all levels of government has dropped from 42 per cent of GDP in 1993 to 34 per cent last year, as you can see in the table . And debt-servicing costs have dropped from about 9 per cent of GDP to less than 6 per cent. Here's how Finance Minister Manley summed up this principle of fiscal discipline in his February budget speech: "Keeping a balanced budget, cutting debt and getting the best value for money are a constant challenge and a constant imperative. These are the bedrock of our fiscal and economic strategy." Complementing a sound fiscal policy is a monetary policy focused on keeping inflation low and stable--that's the fourth principle, and that is the Bank of Canada's responsibility. Canada's inflation-targeting framework works in a symmetrical way to keep consumer price inflation at the 2 per cent midpoint of a 1 to 3 per cent range. If the trend of inflation moves away from the target, in either direction, the Bank will take action to return it to the target within 18 to 24 months. Through most of the past decade, we have managed to keep inflation around the 2 per cent target midpoint, as you can see in . As a result, Canadians' expectations for inflation have become firmly anchored around 2 per cent, as shown in . That is extremely valuable for decision-makers in business, government, and households. This climate of low, stable, and predictable inflation has helped to smooth out the ups and downs in the economy and to create the best possible environment for longer-term economic growth in Canada. Let me now spend a few minutes describing the circumstances in which monetary policy is currently operating. Even though growth slowed in the fourth quarter of 2002, reflecting global economic and geopolitical uncertainties, our economy continues to operate close to capacity. As we said in our January a number of indicators support this view. They include high industrial-capacity utilization; a record-high labour force participation rate; a record-high employment-to-population ratio; corporate profits at their highest level since early 2001; and trend inflation that is running above target. Canada's inflation numbers continue to reflect the impact of higher-than-expected prices for crude oil and natural gas, further increases in auto insurance premiums, and price pressures in certain sectors, such as housing, food, and some services. This higher inflation also suggests an underlying firmness in the price-setting environment. Relative price increases wouldn't be pushing up trend inflation if there was not sufficient demand. So, in making our latest interest rate decision on 4 March, we weighed not only domestic inflation pressures and the expectation that Canadian economic activity will remain near potential in 2003, but also the stimulative stance of monetary policy and improved conditions in capital markets. Taking these factors into account, we raised our key policy rate by one-quarter of a percentage point to 3 per cent. Even with this increase, the stance of monetary policy in Canada remains stimulative. Thus, over time, further reductions in monetary stimulus will be required to return inflation to the target in the medium term. But, as we have said, the timing and pace of increases in policy interest rates will continue to depend on a number of considerations. These include: the strength of demand pressures; the evolution of inflation expectations; the impact on confidence of global economic uncertainties; and the way in which the war in Iraq affects demand and inflation, both globally and in Canada. The Bank continues to monitor all of these factors and will adjust monetary conditions to keep Canadian inflation low, stable, and predictable over the medium term. The Bank's next , to be released on 23 April, will provide a full update of our assessment of the economy and of the outlook for inflation. In closing, let me repeat that, in these trying times, it is tough indeed to maintain a clear view of the current economic picture. But, if we spend all our energy focusing on the near term, we risk losing sight of what's farther out. Your job is to build enterprises that will flourish over the longer term. And our job as policy-makers, whether on the monetary or fiscal side, is to create the best possible climate for sustained economic growth. In an uncertain world, the best thing we can do is to stick to sound economic policy principles. They have proven to be the most effective tools to deal with short-term turbulence and, at the same time, promote solid, sustainable economic growth and prosperity over the longer term.

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Release of the

dodge

Today, we released our spring , in which we discuss economic and financial trends in the context of Canada's inflation-control strategy. First, let me say that I am delighted to introduce to you our newly appointed Senior Deputy Governor, Paul Jenkins. Paul has a deep understanding not only of economic and monetary policy issues but also of the Bank and its staff. I know he will provide energetic leadership in helping the Bank continue its tradition of excellence in promoting the economic and financial welfare of Canada. , both core and total CPI inflation have been well above the 2 per cent inflation target. In this environment, inflation expectations have edged up. In view of the domestic inflation situation and the underlying momentum of domestic demand, we raised our target overnight rate on each of our last two policy announcement dates by 25 basis points, bringing it to 3.25 per cent. Economic, financial, and geopolitical uncertainty has figured prominently in the global economic picture over the past six months. Some of the geopolitical and financial uncertainty has lifted more recently, and the Bank expects that it will continue to recede. However, over the near term, a degree of global economic uncertainty remains, and in Canada, there is uncertainty about the possible economic impact of SARS, particularly in the Greater Toronto Area. Overall, the risks confronting the world economy now appear to be better balanced compared with last autumn, and by year-end, business and household confidence levels should be higher. Economic activity should begin to strengthen towards the end of this year and through 2004, particularly in North America. In Canada, most of the small amount of economic slack that is likely to open up during 2003 will have closed by the end of 2004. Core inflation is expected to remain near 3 per cent through mid-2003. It is projected to fall to about 2 per cent by early 2004. Total CPI inflation will continue to be importantly affected by swings in crude oil prices. At the Bank, we continue to believe that further reductions in monetary stimulus will be necessary over time to return inflation to the 2 per cent target and to sustain output levels close to capacity. The timing and pace of further increases in policy interest rates will depend on the strength of domestic demand, the evolution of inflation expectations, and the pace of economic expansion in the United States and in overseas economies.

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Opening Statement before the House of Commons Finance Committee

dodge

Good afternoon, Madame Chair and members of the committee. I would like to start by saying how much we at the Bank of Canada appreciate the opportunity to come here twice a year, following the release of our semi-annual . We are very aware of the need to keep Members of Parliament and, indeed, all Canadians informed about what we're doing and why. It's important that we explain our views on the economy and on inflation. So, thank you for the opportunity. I'm going to spend a few minutes summarizing for you our most recent . But, before I do that, I'd like to say a few words about my colleagues here with me today. I am delighted to introduce to you our newly appointed Senior Deputy Governor, Paul Jenkins. Paul has been with the Bank of Canada since 1972 and, for the past 11 years, he has served as a Deputy Governor. In that role, Paul has been responsible for the Bank's analysis of international economic and financial issues and for our liaison with related international bodies, such as the International Monetary Fund. He's also been in charge of the strategic direction and oversight of the Bank's public communications. Paul has a deep understanding not only of economic and monetary policy issues, but also of the Bank and its staff. I know he will provide energetic leadership in helping the Bank continue its tradition of excellence in promoting the economic and financial welfare of Canada. Also with me today is Deputy Governor Chuck Freedman. Chuck will retire in September, after almost 30 years at the Bank. He's been a Deputy Governor since 1988, and his leadership in the areas of monetary policy, financial institutions, and Canada's clearing and settlement systems has been invaluable. One of Chuck's most important contributions has been his tireless promotion of bilingualism at the Bank. I can't begin to say how much we will all miss him--especially those of us on the Bank's Governing Council--not only for his expertise, but also for his enthusiasm and keen wit and intellect. Last week, we released our spring , in which we discuss economic and financial trends in the context of Canada's inflation-control strategy. I last testified before this committee in October, following the release of our autumn . To place our recent experience in some context, let me go back a bit further than that. Following the 11 September 2001 terrorist attacks in the United States, the Bank of Canada quickly and aggressively cut its policy interest rate to shore up confidence and support domestic demand. By the spring of 2002, evidence had already started to build that demand was growing faster than the economy's production capacity. Monetary policy actions must always be forward looking. So, even though demand pressures were not yet showing up in prices, we raised our key policy rate three times between April and July 2002, by a total of three-quarters of a percentage point. When we met with you last autumn, inflation in Canada was on the rise. But we refrained from raising interest rates because of the prevailing geopolitical and financial uncertainties, high yield spreads and restricted access to funding for riskier corporate borrowers, and the expectation that global economic weakness would restrain total demand for Canadian goods. Since then, inflation has been above the 2 per cent target. The total year-over-year CPI inflation rate reached a peak of 4.6 per cent in February, falling back somewhat to 4.3 per cent in March. Key factors behind the jump in inflation are the sharp rise in oil and natural gas prices, increases in insurance premiums, and strong domestic demand. That demand has led to price pressures in certain sectors, such as shelter and some services. In this environment, some indicators of short-term inflation expectations have edged up. These include data from the survey taken by the Bank's regional offices and the average private sector consensus forecast. Longer-term expectations of inflation, however, remain around 2 per cent. To assess the future trend of inflation, the Bank uses a measure of core inflation, which strips out the eight most volatile items in the CPI basket, and the effect of changes in indirect taxes on the remaining CPI components. Core inflation now sits around 3 per cent. It should fall to about 2 1/2 per cent in the second half of this year, and to about 2 per cent by early 2004. Total CPI inflation will continue to be importantly affected by swings in crude oil prices. If oil prices were to settle at about $25 per barrel by mid-2003--as futures prices suggest--and if the Canadian dollar were to stay close to current levels, total CPI inflation would likely fall temporarily below the core rate in the first half of 2004, before steadying out at a rate close to core inflation. In view of the domestic inflation situation and the underlying momentum of domestic demand, we have raised our target overnight rate by 25 basis points on each of our last two policy announcement dates--in March and in mid-April--bringing it to 3.25 per cent. As I said before, economic, financial, and geopolitical uncertainty figured prominently in the global picture last October. Some of the geopolitical and financial uncertainty has lifted in recent months, and the Bank expects that it will continue to recede. However, weak domestic demand in some regions of the world is still a concern. So, over the near term, a degree of global economic uncertainty remains. Even with all this, the risks confronting the world economy now appear to be better balanced than they were last autumn. And, by year-end, we expect that business and household confidence levels should improve. In Canada, domestic demand has remained quite strong. There is uncertainty, however, about the possible economic impact of Severe Acute Respiratory Syndrome (SARS), particularly in the Greater Toronto Area. As I said last week, we expect that economic growth in the second quarter will be somewhat weaker than we projected in the because of the impact of SARS. But it is too soon to make an assessment of the magnitude of its effect on economic activity. We continue to monitor the situation very closely. We expect that the Canadian economy will strengthen towards the end of 2003, partly thanks to a pickup in economic activity in the United States. Average annual growth in Canada is expected to be about 2 1/2 per cent this year. During 2004, our economy should strengthen further, expanding at a rate above its 3 per cent growth of potential. This means that most of the small amount of economic slack that is likely to open up in Canada during 2003 will have closed by the end of next year. For this reason, the Bank continues to believe that further reductions in monetary stimulus will be necessary over time to return inflation to its 2 per cent target and to sustain output levels close to capacity. The timing and pace of further increases in policy interest rates will depend on the strength of domestic demand, the evolution of inflation expectations, and the pace of economic expansion in the United States and in overseas economies. Paul, Chuck, and I will now be glad to answer your questions.

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Opening Statement before the Senate Banking, Trade and Commerce Committee

dodge

Good afternoon, Mr. Chairman, members of the committee. I would like to start by saying how much we appreciate the opportunity to meet with you following the release of the Bank's semi-annual . It's important for us to be able to explain our views on the economy and on inflation. I'd like to spend a few minutes summarizing the key points of our most recent , which we released last week. But first, I'd like to introduce my colleagues--Deputy Governors Chuck Freedman and Pierre Duguay. Chuck will retire in September, after almost 30 years at the Bank. His leadership in the areas of monetary policy, financial institutions, and Canada's clearing and settlement systems has been invaluable. We will all miss his expertise, his enthusiasm, and his keen wit and intellect. The last time I testified before this committee was in the spring of 2002, because we were unable to arrange our regular meeting last fall. You will recall that following the 11 September 2001 terrorist attacks in the United States, we quickly and aggressively cut our policy interest rate to shore up confidence and support domestic demand. By last spring, evidence had already started to build that demand was growing faster than the economy's production capacity. Monetary policy actions must always be forward looking. So, even though demand pressures were not yet showing up in prices, we raised our key policy rate three times between April and July 2002. By the autumn, inflation was on the rise. But we refrained from raising interest rates because of geopolitical and financial uncertainties, high yield spreads and restricted access to funding for riskier corporate borrowers, as well as the expectation of weaker foreign demand for Canadian goods. Since then, inflation has been above the 2 per cent target midpoint. The total CPI inflation rate peaked at 4.6 per cent in February, falling back somewhat to 4.3 per cent in March. The jump in inflation reflected the sharp rise in oil and natural gas prices, increases in insurance premiums, and strong domestic demand that had led to price pressures in certain sectors, such as shelter and some services. In this environment, certain indicators of short-term inflation expectations have edged up--although longer-term expectations remain around 2 per cent. Core inflation, which strips out the eight most volatile items in the CPI basket and the effect of changes in indirect taxes on the remaining CPI components, is a better indicator of the future trend of inflation. It now sits around 3 per cent. But it should fall to about 2 1/2 per cent in the second half of this year, and to about 2 per cent by early 2004. Total CPI inflation will continue to fluctuate with swings in crude oil prices. If these prices settle at about US$25 per barrel by mid-2003--as futures prices suggest--and if the Canadian dollar stays close to current levels, total CPI inflation will likely fall temporarily below the core rate in the first half of 2004, before steadying out at a rate close to core. In view of the domestic inflation situation and the underlying momentum of domestic demand, we raised our target overnight rate by 25 basis points on each of our last two policy announcement dates. It now stands at 3.25 per cent--still relatively low by historical standards. Some of the geopolitical and financial uncertainty we saw last fall has lifted in recent months, and we expect that it will continue to recede. Economic uncertainty in some regions of the world is still a concern. But overall, the risks confronting the world economy now appear to be better balanced than last autumn. And business and household confidence should improve by year-end. In Canada, domestic demand has remained quite strong. But now there is uncertainty about the economic impact of Severe Acute Respiratory Syndrome (SARS), particularly in the Greater Toronto Area. Second-quarter economic growth will be somewhat weaker than we projected in our latest because of SARS. But, while the developments of the past few days suggest the worst is behind us, it is still too soon to put a number on the effect of SARS on economic activity. The Canadian economy should strengthen towards the end of 2003, partly thanks to a pickup in U.S. economic activity. Average annual growth in Canada is expected to be about 2 1/2 per cent this year. During 2004, our economy should expand at a rate above its 3 per cent growth of potential. Therefore, most of the small amount of economic slack that is likely to open up this year will have closed by the end of 2004. For this reason, we still believe that further reductions in monetary stimulus will be necessary over time to return inflation to its 2 per cent target and to sustain output levels close to capacity. The timing and pace of further increases in the Bank's target overnight rate will depend on the strength of domestic demand, the evolution of inflation expectations, and the pace of economic expansion in the United States and overseas.

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Policies to Sustain Growth Domestically and Internationally

dodge

Good afternoon, ladies and gentlemen. I have been looking forward to coming to Amsterdam since Governor Wellink extended the invitation last year. I must say that when you consider what has been happening in the world economy, it is certainly an interesting time to be a Canadian at international meetings such as the BIS meeting I attended yesterday. My colleagues from other central banks have often commented on Canada's relatively strong economic performance over the past two or three years. In response, I have told them that there is certainly an element of good fortune in that performance. But, fundamentally, it reflects the extraordinary efforts made during the 1990s to put a coherent economic policy framework in place, and I want to begin by talking about that framework. Let me quickly add that this is not simply a Canadian story. The framework that I'm talking about emerged from international discussions and has relevance for all national economies. In the 1980s, a consensus was reached among OECD countries on a set of economic policies that would provide the strongest base for sustained economic growth. This consensus is based on four principles: trade liberalization, structural reform, fiscal prudence, and inflation control. I will spend a few minutes on each one of them, drawing on Canada's experience in recent years. Let me begin with trade liberalization . Your own mission statement acknowledges the importance of the free flow of goods and services, as well as of capital and people, within the European community. Freer international trade allows countries to better exploit the gains made from increased specialization and enhanced productivity. Canada has promoted reduced barriers to multilateral trade since the Havana Conference of 1947, which launched the General Agreement on Tarriffs and (NAFTA). Both of these agreements initially sparked a great deal of political controversy in Canada. However, they have opened up markets and created tremendous opportunities for Canadian entrepreneurs. Our exports have flourished as a result. But freeing up trade means more than setting up regional free-trade blocs, such as NAFTA and the European Union. Canada is hoping to see meaningful progress at the World Trade Organization's Doha round of multilateral talks. Clearly, agriculture and a number of other sectors are going to require a major effort. This effort must be made so that the global economy can benefit. It won't be easy, but in the long run, it will be worth it. The second principle in the OECD policy consensus has to do with structural reform . There are two goals here: one, to increase the flexibility of our economies in order to adjust to changing world economic conditions; and two, to ensure the longer-run viability of our social- and income-security arrangements. These adjustments are always difficult, because reforms will affect various groups in different, and often painful, ways. Further, the economic benefits of the increased flexibility may take a fairly long time to emerge. But these difficulties should not sway us from the task of reducing rigidities and increasing efficiency. Canada has made some progress in a number of areas. The federal government has made changes to its system of unemployment insurance, trying to base the program more on insurance principles and to improve the employability of labour. Canada has also taken steps to reduce distortions in the personal income tax system and has slashed industrial subsidies by roughly two-thirds. More recently, we made some major changes to our public pension system, to better prepare for the inevitable pressures that will develop as our population ages. This meant some restructuring of benefits and a sharp increase in contributions--moves that were not popular, but were certainly necessary. In addition, the federal and provincial governments agreed to set up the Canada Pension Plan Investment Board, an entirely independent body. Its sole mandate is to invest the contributions in markets, in order to generate the best possible returns over the long term, with due consideration for prudence. Demographic pressures are also being felt, perhaps even more strongly, in some European countries, where various governments have dealt with, or are struggling with, this issue. The third principle in the OECD policy consensus has to do with fiscal prudence and the need for a disciplined approach to managing the public purse. In the years leading up to the mid-1990s, provincial and federal governments in Canada ran large budget deficits. These deficits built up as governments continued to borrow, primarily to finance current consumption. It was an unsustainable situation, made more serious by our aging population. Clearly, social spending had to be put on a viable longterm course. And so fiscal policy needed to be based on a plan that would put the ratio of public debt to GDP on a steady downward track. This was a difficult hurdle to overcome, and the fiscal consolidation of the 1990s was painful. Now, here's the good news. Since that time, the vicious circle of rising deficits and debt has become a virtuous circle of balanced budgets and falling debt. Reducing, and ultimately eliminating, the deficit in the 1990s helped with Canada's international credibility. And this led to a reduction in the risk premium demanded by investors. The fiscal improvement meant that the Bank of Canada was in a position to lower interest rates more easily when economic circumstances warranted. The lower interest rates reduced debt-servicing costs, stimulated economic growth, and boosted government revenues, which led to an even better fiscal position. The main point here is that, while the initial work of fiscal consolidation is certainly difficult, it is necessary in order to enjoy the fiscal dividends later on. The final policy principle is the one that relates most directly to the Bank of Canada's primary responsibility--monetary policy. The OECD consensus holds that price stability is the appropriate goal for monetary policy over the medium term. In Canada, we try to achieve this goal through an inflation-targeting system. The Bank of Canada reached an agreement with the federal government in 1991 to try to keep inflation, as measured by the consumer price index, at the 2 per cent midpoint of a 1 to 3 per cent target range over the medium term. Importantly, we take a symmetric approach to our inflation target. This means that we worry as much about the trend of inflation falling below the target as we do about inflation rising above the target. We have found that this symmetric approach has been very effective in promoting low, stable, and predictable inflation in Canada. Following a period of higher and more variable inflation in the 1970s and 1980s, the inflation-control targets helped to anchor monetary policy. Inflation quickly fell into the target range, and inflation expectations became focused on the target. This has helped to smooth out the ups and downs of the business cycle and, more generally, has led to stronger economic growth in the long term. Those are the four principles on which the OECD policy consensus is based: trade liberalization, structural reform, sound fiscal policy, and monetary policy focused on inflation control. Canadians spent a great deal of effort putting the four elements of this framework into place over the past decade or so. It certainly was not easy. It involved a fair bit of short-term economic pain. But the phrase "short-term pain for long-term gain" is more than just a cliche. Canada is now reaping the economic benefits of that effort. In the face of all the negative shocks that hit the global economy in the past two or three years--war, terrorism, corporate governance and accounting concerns, and the collapse of the technology sector--our economy has proven resilient. With all of the uncertainty in the global economy, it is more important than ever that national authorities around the world stick to a sound economic policy framework. It is only by staying the course that we can establish a steady base for sustained economic growth over the longer term. I don't want to leave the impression that the way Canada has implemented the OECD policy consensus is the only way to go. Nor do I want to suggest that we have achieved perfection. There is still work to be done in all four areas of the framework, particularly in relation to microeconomic policies. Policy-makers should always be looking for ways to improve economic performance. In that vein, I now want to return to the topic of monetary policy and talk briefly about the potential role of asset prices in monetary policy. Let me emphasize that I believe that our monetary policy framework, based on an explicit inflation-control target and a floating exchange rate, is the best choice for Canada. Our floating currency helps facilitate the economic adjustments that will always be necessary when shocks occur. This is particularly important for a relatively small and open economy such as ours. All told, Canada has a coherent monetary policy regime that has proven its worth--one that gives us a solid base for sound long-term economic growth. But the recent dramatic fall in the share prices of so many technology firms--the so-called bursting of the tech bubble--highlighted the debate about the role of asset prices in the conduct of monetary policy. It somehow seems appropriate that I should talk about this question here in the Netherlands, the location of one of the most famous asset-price bubbles in history--the tulip bubble of the seventeenth century. This episode, where mass speculation led to the dramatic rise and subsequent collapse in the price of tulip bulbs, illustrates that asset-price bubbles can have serious repercussions for a country's economy when they burst. There has been a tendency recently, particularly in the United States, to ask whether central banks "should try to pop bubbles when they see them, before they get too large." Let me be clear: I do not believe that central banks should try to target asset prices in the same way that we target the inflation rate. And I do not believe that we should be in the business of popping bubbles. To do so would be unrealistic. It would presume that central bankers know better than anyone else what represents fair value for assets. We don't. Instead, the real issue is, What is the role of asset prices in the setting of monetary policy? Central banks--and here I'm speaking about the Bank of Canada in particular--do take into account the information contained in asset prices in a number of ways. When we set interest rates, we look at cost-of-capital effects and wealth effects, as well as the impact of changes in asset prices on confidence. And there are some asset prices, expressed as the yield spread between high- and low-risk bonds, that give an indication of credit conditions in the economy, so we look at those too. Other asset prices, such as the cost of new houses, form part of the Bank of Canada's core measure of consumer prices, and are therefore taken into account directly. So clearly, movements in asset prices do play a role and are taken into consideration when we set monetary policy. All of these ways of looking at asset prices provide some information about the future inflation environment within our 18- to 24month horizon for inflation targeting. But the broader question is, Are there ways in which asset prices can give central banks information about price pressures beyond this medium-term horizon? If so, what should be done about it? Let me give you a more concrete example. Consider the following scenario for an inflation-targeting central bank. Let's assume that inflation is near its target, but demand in the economy is weak, and the output gap is widening. This situation would normally call for an easing of monetary policy. But what if, at the same time, there was evidence that the prices of assets such as equities or real estate were rising well above historical norms, or that there was a real surge in credit issuance relative to historic levels, or evidence of speculative overinvestment? Should a central bank then adopt a somewhat tighter policy than it otherwise would? And if it did, would this be effective in limiting the rise in asset prices? Should the central bank run the risk of inflation falling below the target, to help guard against a much more serious disinflationary correction of financial imbalances later on? There are no easy answers to these questions, but we have to continue to think hard about them. That hard thinking must equally be applied to what is, in effect, another class of asset prices. I am referring to the price of a country's currency--the exchange rate. This is particularly true at times when we see large movements in exchange rates. So it is an issue that faces us all, given the recent sharp depreciation of the U.S. dollar against the Canadian dollar, the euro, the pound, the Australian dollar, and others. What does this movement mean for the Bank of Canada? As with other asset prices, the Bank does not have a target level for the currency. Its price is determined by the markets, and the floating exchange rate is an important part of our monetary policy system, as I mentioned earlier. Thus, in setting monetary policy in the context of this system, we do take into account these movements, and what they tell us about demand and inflation. Insofar as movements in the exchange rate do affect the prices of imported goods, we must take them into account because they bear directly on what we do target; that is, the inflation rate. However, we have found in recent years that the pass-through from exchange rates to prices has been less pronounced than in the past. We also try to ascertain the primary causes of the movements in exchange rates, and whether these movements are giving any information about factors that are affecting real economic performance. To the extent that movements in the Canadian dollar reflect fundamental factors at work in the Canadian economy, such as strong economic performance or higher prices and stronger demand for non-energy commodities, then we clearly need to take these into account. Let me close by reiterating that aiming for low, stable, and predictable inflation is a crucial component of the OECD policy framework, along with sound fiscal policy, structural reform, and trade liberalization. In my view, the debate about the role of asset prices in monetary policy is not an argument for moving away from inflation targeting. But I hope that my discussion of the potential role of asset prices in monetary policy underscores the idea that we should never stop looking for ways to improve our economic policy framework, so that we can continue to promote sustainable economic growth and prosperity.

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canada

How Sound Economic Policies Help During Uncertain Times

dodge

Notes for remarks by David Dodge Governor of the Bank of Canada It is an honour and a privilege to address the German-Canadian Business Club of Berlin-Brandenburg at its inaugural meeting. Groups such as this one serve many important purposes, not the least of which is the development of trading links that help to strengthen the economies of both our countries. Creating and strengthening international trading links has been one of the keys to the success of the Canadian economy in recent years. But there is much more to the story. So what I propose to do today is talk about some of the economic policies that Canada has put in place in recent years and, in doing so, touch on some of the challenges we still face. Let me start with the policy area for which we at the Bank of Canada are responsible--monetary policy. The preamble to the calls on us to conduct monetary policy "in the best interests of the economic life of the nation," and "to promote the economic and financial welfare of Canada." We know that too much demand can lead to inflationary pressures, and that too little demand means that resources are being wasted. So our aim in conducting monetary policy, insofar as monetary policy can influence demand, is to have the economy operating very close to its level of potential output. Over time, we have found that the best contribution that monetary policy can make is to try to keep inflation low, stable, and predictable, in order to provide the best setting for strong and sustained economic growth. The question then becomes, What should a central bank target in trying to bring this about? Following Canada's return to a floating exchange rate system in 1970, the Bank of Canada tried to achieve a low-inflation environment by targeting the growth of money from 1975 to 1982. But the relationship between money growth and the rate of inflation proved to be unstable. So, in 1991, the Bank adopted an explicit inflation-targeting approach. Under a joint agreement with the federal government, we aim to keep consumer-price inflation at the 2 per cent midpoint of a 1 to 3 per cent range. If the trend of inflation moves away from the target, the Bank will take action to return inflation to the target within 18 to 24 months. Our framework is symmetrical. This means that we worry as much about inflation falling below the target as we do about it rising above the target. Through most of the last decade, we have succeeded in keeping inflation close to the target. And so, Canadians' expectations for inflation have become anchored around 2 per cent. All this has helped to smooth out the ups and downs in the economy and to create the best possible environment for longerterm economic growth. This framework may sound simple in theory. But it is quite complex in practice. Our monetary policy decisions are based on economic projections, which can always be thrown off by unforeseen events. Because monetary policy actions take time to have their full impact on the economy, we must aim these actions at where we see the economy sitting 18 to 24 months into the future. In doing so, we are always looking at what is called the output gap--the difference between the actual level of production in the economy and the level of potential output. If the economy is operating above its potential capacity and inflation appears likely to be above target in the future, then we would tighten monetary policy. This would cool demand and bring inflation back down to the target. On the other hand, if the economy is operating below its potential capacity and inflation appears likely to be below target in the future, we would ease monetary policy in order to stimulate demand, close the output gap, and bring inflation back to its target. This means that we are always looking at demand and supply in the economy and trying to bring them into balance. So, in carrying out our policy, a large part of the analysis we do is concerned with the many factors that can influence demand and supply. The most important factor is, of course, the strength of domestic demand. But Canada is a trading nation, and so the strength of world demand is also important to us. In particular, the United States is a major customer for Canadian goods, so we closely monitor the health of the U.S. economy. Economic activity is also affected by movements in exchange rates. As you well know, there has recently been a significant adjustment in the value of the U.S. dollar against major currencies, including the Canadian dollar. As always, we need to understand the causes of this movement, as well as its effect on the Canadian economy. Furthermore, movements in exchange rates have a direct effect on the prices of traded goods and services and, therefore, on inflation. However, our research has shown that, in economies such as Canada's, the effect of exchange rate movements on consumer prices has been less pronounced in recent years, when inflation was relatively low, than was the case in earlier years, when inflation was high. Many other considerations go into our monetary policy decisions. We hear from the Bank's regional offices across Canada, which are in constant contact with Canadian businesses. We look at the economic clues in the data on credit conditions, monetary aggregates, and some asset prices--though I should make it clear that we don't have targets for those aggregates or for asset prices. Finally, we look at the expectations of financial markets. All of this information goes into our decisions, which always have the goal of aiming inflation at the 2 per cent target over the medium term. And as I said earlier, we are convinced that keeping inflation low, stable, and predictable is the best way for monetary policy to contribute to a healthy economy with strong and enduring economic growth. But more is needed to ensure economic health. A doctor will tell you that, besides strength and endurance, healthy bodies need to be flexible. The same is true of an economy. Financial policy-makers not only need to encourage strong and sustainable economic growth, they also need to work on improving economic flexibility. At the outset, I spoke briefly about trade. Removing barriers to trade is one important way of making an economy more flexible. We all know that freer international trade helps countries to more fully exploit the gains that come from increased competition and specialization. It is true that adjusting to freer international trade is not always easy. Canada's economy had to make some difficult adjustments after the Canada-U.S. Free Trade Agreement came into effect in 1989 and after the North American Free Trade Agreement added Mexico to the group in 1994. Both of these agreements sparked a great deal of domestic political controversy. Many Canadian companies were understandably concerned about their ability to compete. But despite initial misgivings, Canadian companies rose to the challenge. Some of the sectors that we used to protect the most--such as furniture, clothing, and wine--have since established a strong presence in international markets. Overall, Canadian exports have flourished. The success we have had strengthens our resolve to see freer trade extended beyond regional trading blocs. Canada is hoping to see meaningful progress at the World Trade Organization's Doha round of multilateral talks. Clearly, agriculture is going to be a major hurdle. The developed countries, including all of us in the G-7, have a considerable way to go in terms of liberalizing agricultural trade. And there are other sectors where major effort is required. This effort must be made so that the global economy can benefit. It won't be easy, but, in the long run, it will be worth it. Improving economic flexibility can also require structural reform. Improving the structures of our economies should help us not only to adjust to changing world economic conditions, but should also ensure the longer-run viability of our social- and income-security arrangements. Clearly, most structural reforms are not easy to accomplish. Adjustments can be difficult because reforms often affect different groups in painful ways. Further, the economic benefits of increased flexibility may take a fairly long time to emerge, making it harder to muster the political will to carry out needed reforms. But these difficulties should not sway us from the task of reducing rigidities and increasing efficiency. In Canada, we have made progress on a number of fronts over the past decade or so. In the early 1990s, Canada began to reform its system of unemployment insurance, reducing and restructuring benefits with a view to strengthening the incentive to work. In the mid-1990s, industrial subsidies were slashed by roughly two-thirds. In 1996, Canada's federal and provincial governments agreed to changes that would put the Canada and Quebec Pension plans on a sustainable footing. This meant some restructuring of benefits and a sharp increase in contributions--moves that were not popular, but were necessary. In 2000, the federal government implemented a five-year, $100-billion tax-reduction plan that lowered personal and corporate tax rates. And in the last federal budget, the government announced that Canada's tax on capital is being phased out. I would be remiss if I did not also mention how Canada cleaned up its public sector balance sheets during the 1990s. Many difficult and unpopular decisions had to be taken, by both the federal and provincial governments. But Canada has turned a vicious circle of rising deficits and debt into a virtuous circle of balanced budgets and falling debt. Reducing, and ultimately eliminating, the deficit in the 1990s helped Canada's international credibility and led to a reduction in the risk premium demanded by investors. The fiscal improvement gave the Bank of Canada the flexibility to lower interest rates more easily when economic circumstances warranted. Not only did lower interest rates reduce debt-servicing costs, they also stimulated economic growth, which brought in more revenues for the government. The extra revenues and lower debt-servicing costs, in turn, led to an even better fiscal position. consecutive surplus in the federal budget and projected that the budget will continue to be balanced this year and next, despite slower-than-expected growth. The federal government is committed to following a prudent path for its budget planning. Canada is expected to have one of the lowest debt burdens in the G-7 this year. Not only have we reduced the debt-to-GDP ratio, but we have paid down almost $50 billion of federal debt. This has freed up about $3 billion of resources every year for the federal government. The main point is that, while the initial work of fiscal consolidation is certainly difficult, it is necessary in order to enjoy the dividends later on. These policies I've mentioned--fiscal consolidation; a monetary policy focused on low, stable, and predictable inflation; and improving flexibility through trade liberalization and structural reform--have all been difficult to implement. Putting Canada's strong economic policy framework into place involved short-term pain. But our economic performance in recent years is compelling evidence, in my opinion, that these policies are the right ones to follow. I don't want to suggest that we've achieved perfection in Canada. Far from it. There is much more to be done, particularly in regards to microeconomic policy. Nor do I want to suggest that the precise ways in which we've implemented these policies should be followed by every country. Instead, the messages I want to leave you with are: that these economic principles are important, and implementing them is difficult, but the economic payoff is ultimately worth the effort. In times of global economic uncertainty, there is a natural tendency to put off difficult reforms or to backtrack on hard-won policy gains. But it is precisely during these difficult times that it is most important to stay the course. Canada is committed to staying the course and to building a strong, vibrant, and flexible economy.

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canada

It All Starts with the Data

dodge

Governor of the Bank of Canada to the Conference of European Statisticians It's a pleasure to be talking to you today, although I regret that I could not join you in person. Still, to give technology its due, this is almost as good. Let me first take this opportunity to pay tribute to the Chief Statisticians at this conference and, indeed, to all statisticians around the world. You are truly the unsung heroes behind central bankers and other policy-makers. You constantly labour under tight resource, financial, and time constraints, to satisfy our insatiable appetite for data. As users of those data, we tend to focus on what can be done to improve them, rather than on recognition for what is already there. But I can assure you that central bankers hold statisticians in high regard for the breadth and quality of information they provide. The data that you painstakingly produce form the base for the analysis and research that informs the formulation of monetary policy and our understanding of trends in financial systems and markets. So it really all starts with the data! Your efforts to ensure the accuracy, integrity, relevance, timeliness, and international comparability of statistics are vital to our decision-making process. Having told you how much we value your contributions, I must also tell you that I won't pass up this opportunity to make still more demands of you, on behalf of all of us in central banking! But, at the same time, I hope to be helping you, by giving you a sense of priority and some general principles to guide your efforts in addressing those demands. So, what drives us central bankers to put more and more demands on you? Our statistical needs are fundamentally shaped by what we are expected to do under our mandate. The primary goal of most central banks today is to conduct monetary policy so as to achieve and maintain price stability. Low, stable, and predictable inflation is the means to our ultimate objective of solid economic performance over time. In addition to price stability, we are charged with promoting the safety, soundness, and efficiency of our national financial systems. Some among us are also expected to regulate financial institutions. I should add here that, in the process of carrying out these responsibilities, we are collecting and generating significant amounts of statistical information ourselves. Data are a public good. We need to work together to make them accessible to researchers and the public in a convenient format. From our side, we could do more to share with you the data we collect and make the most of limited national statistical resources. Central banks that are regulators, in particular, produce significant amounts of data that could be shared. But for that, a robust legal framework would have to be in place, to allow the exchange of information. Let me now turn to what we need from our statisticians. In this context, I will focus on the two central bank functions I just mentioned: the pursuit of price stability and the promotion of financial system stability. In either one of those cases, the objectives have not changed. But our economies are continually changing and becoming more interdependent under the effect of globalization and large and growing trade and capital flows. As policy-makers, it is extraordinarily important that we understand how, and to what extent, these forces are likely to affect the achievement of our objectives, so that we can adjust our policies accordingly. Identifying the sources of potential challenges and threats to the achievement of our objectives, and determining how we should adjust to changes, is quite a task. But finding ways to measure the effect of changes in our economies and in our financial systems is no less important or complicated a job. For that, naturally, we turn to you! So, what are the broad trends and challenges facing those of us concerned with price stability, and those concerned with financial system stability? And what do these challenges mean in terms of what we need from our statisticians? I will deal first with those related to inflation control. In conducting monetary policy, we aim to keep the economy operating close to the level of its production capacity, so as to maximize output, employment, and income gains over the longer term, while keeping inflation low. When making interest rate decisions, we always try to gauge the extent of demand pressures--current and prospective--on production capacity (or aggregate supply). And we try to assess the actions required to maintain or restore balance between aggregate demand and supply in the economy, so as to keep inflation under control. As you can appreciate from this description, the range of statistical information that we have to look at, for purposes of our decision-making, is quite wide. But for those of us, in particular, who are operating with explicit inflation targets, the most important indicators, besides price indexes, are measures of output, productivity, and capacity. These measures directly affect our ability to estimate the production potential of the economy and to assess the balance between demand and supply. I have made these general comments to serve as a marker for what I have to say next about the broad trends and challenges relevant to the goal of price stability and the associated statistical needs. Much of that discussion will, one way or another, hark back to price and productivity measures. (That's what you get when you talk to central The growing importance of services An important feature of all major economies these days is the growing share of services. But service output is less tangible than that of the traditional goods industries. Indeed, in some service industries, such as banking, there is not even agreement on the appropriate definition of output. And in many countries, certain services, such as health care, are not delivered through the market, which makes it even more difficult to measure. As if all this were not enough, now, we also have to contend with "virtual" service output--that is, software, music, movies, and data that people can download from the Web. You certainly don't need me to tell you how tricky it is to measure output, prices, and productivity in the services sector. Or, how tentative some of those estimates can be. With the importance of services growing in our economies, the need for better output and price measures for this sector is becoming increasingly pressing. So, if you were looking to allocate limited statistical resources according to priority, my view would be that this particular area merits a higher ranking than in the past. What I'm saying is that, if you are trying to determine whether additional resources should be put in, say, quality adjustments for consumer goods or quality adjustments for services, the choice ought to be services. Better price and output measures for services would improve our ability to assess overall economic conditions by providing better information on current trends in aggregate output and prices. They would also help us identify other emerging trends or structural changes in the economy. For example, these days, an important issue is to evaluate the productivity gains from the use of information and communication technology (ICT). Knowing the effects of ICT would help us predict future growth in the production capacity of the economy. One way to identify the contribution of ICT to overall productivity is to examine whether productivity gains have been strongest in those sectors that are heavy users of ICT. We know that services is one such sector. But if we do not have the right price deflators for services, we will never get reliable measures of productivity growth and of the ICT effect in that sector. And so, it will be more difficult to judge the contribution of ICT to total productivity and to production capacity. Risk and insurance The increased occurrence of unpredictable events (conflicts, new diseases, and natural disasters) means that the world has become a riskier place; or, at least, that our perception of the risk has increased. In this type of environment, insurance and hedging have assumed a bigger role than before. Not only has the provision of insurance become a more globalized operation; it has undergone significant structural change. There has also been significant repricing of insurance worldwide, for both consumers and businesses, mainly because of marked increases in the value of claims. In Canada, we have recently seen large effects from higher insurance premiums in our inflation data. The United Kingdom and Australia have had similar experiences. It is for these reasons that I am identifying insurance separately from other services. The challenge here is how to measure something that we hope never happens. I can see that we will have to devote more statistical resources to this issue. We need to think conceptually about how to measure the economic value of insurance and how to correctly measure the price of the service. In addition, central bankers have to think about the implications for economic activity and potential output of the increased risks and higher costs of mitigating those risks. And from the perspective of financial system stability, we must see to it that those who hold the risk price it correctly and that they are in a position to carry it. But let me now move on to the next issue of relevance to the goal of price stability. The implications of rising trade flows and firms operating globally Changes in the way certain economic activities are carried out in today's "global village" have been so rapid that all of us have had a hard time keeping up. In many cases, it is not so much the nature of the transaction that creates difficulties for measuring what is happening, as it is the location and the price at which it gets done. International trade is a primary example. Thanks to trade liberalization and falling transportation and communication costs, the share of international trade has been rising in most economies and, within that, the share of services. The activities of firms that are operating globally have also been expanding, as have the number of mergers. National frontiers are thus blurring, and there is a whole lot more intra-firm trade going on. As encouraging as this growth in global trade is from the perspective of bettering the lot of more people around the world, it is not without challenges for policy-makers and statisticians alike. From your perspective, the more direct challenge is that it has become harder to collect information and to accurately measure economic activity within, and outside, national boundaries. These are not necessarily new issues, and neither are those related to services that I discussed earlier. But, with the growing importance of trade in services and of multinational firms, these issues are coming to the fore, and the need for better information becomes more pressing. What are the most important statistical needs with respect to trade and First, clearly, we need better information on intra-firm trade and on trade in services in order to get better aggregate trade statistics. Second, central bankers will always tell you that they are especially interested in better data on prices in different currencies. That is because we need to assess the economic effects (for example, which margins "get squeezed") when exchange rate movements are passed, or not passed, on to domestic prices. This is what we call the exchange rate pass-through. This pass-through seems to have been less pronounced recently than in the highinflation years of the 1970s and 1980s. There may be more pricing to markets, that is to say, firms may increasingly be setting prices based on what local markets can bear. A thorough analysis of the exchange rate pass-through issue is complicated by the fact that national statistical agencies often use a mechanical approach to convert foreign currency prices into domestic ones, rather than collecting actual import prices. Transfer pricing by multinationals adds yet another dimension to the problem. I know that it is virtually impossible to get good information on transfer pricing. But better data on intra-firm trade and work with global enterprises may still help us get a better fix on import prices. Real estate prices Fluctuations in asset markets have become a more prominent feature of modern economies in recent years. Considering that property is by far the world's biggest single asset class, it is not surprising that movements in the real estate market are drawing a lot of attention. In many countries, housing prices, in particular, have been rising rapidly, raising some concerns about a possible sharp correction at some point. Given that investment in housing represents a big chunk of household spending, and that for most people their homes represent their most valuable asset, it is surprising that, in many countries, there are no comprehensive quality-adjusted data on housing prices and rents. In its recent survey of global property markets, commented that "official statistics offices typically collect more information about the price of shoes or cement than housing, despite its far greater importance." There is a need to expand the current limited international experience in constructing standardized housing price and rent indexes. And so, I am encouraged that are convening a joint conference of experts in the autumn to support work to improve data availability in this field. Given how often real estate booms have triggered banking crises around the world, this issue is clearly important from the point of view of financial system stability as well--to which I would now like to turn. Financial market liberalization has led to tremendous growth in global financial activity in recent years and to more integrated financial markets. The demand for financial services has also risen in response to the growth in the operations of crossborder firms. And in many countries, there has been a merging of the traditional segments of the financial sector and a proliferation of financial products, including derivatives and hybrids. Unfortunately, with globalization and with increasingly complex financial markets, the effects of any disturbance have tended to reverberate around the world. Concern about these spillover effects has led to efforts to strengthen the analytic capability of many central banks with respect to financial system stability. Central banks and investors now demand more and better information about the financial behaviour of both industrial and financial enterprises. After the Asian crisis of 1997-98, which highlighted the lack of transparency and proper surveillance of financial systems in several countries, more resources were dedicated by national authorities, including central banks, to understanding the workings of the financial system and to communicating that understanding publicly. The policy objectives of the various national agencies that are involved in setting standards and codes for the financial system are safety, soundness, and efficiency. No economy can function properly, unless supported by a robust, efficient financial system and sound financial institutions that can help to appropriately channel savings and investments. By their very nature, central banks take a systemwide approach to financial stability. So, our focus is on the nature and causes of vulnerabilities with potential systemwide implications. After all, we are paid to worry about these things! Once such vulnerabilities are identified, we would work with other standard-setting bodies to find ways to prevent or contain them. In addition to the real estate price indexes that I discussed earlier, there is at least one other area where we could use your help to achieve our goal for the financial system. To better understand financial behaviours and their implications for systemwide vulnerabilities, we need to link financial market data (new issues of bonds and equities, secondary pricing of bonds and equities, etc.) to industry or sector characteristics and to economic activity. We have found this to be a rather cumbersome and time-consuming exercise. This is where you can help us, by undertaking to link financial data to the firms involved, in a more transparent, systematic, and consistent way. In most cases, these would be firms to which you have already assigned an industrial classification code, and for which you have other relevant information (such as characteristics and surveys on their economic activities). The ability to cross-reference financial and economic data would allow us to explore in a more scientific manner questions of financial vulnerabilities from a systemwide perspective. I am, of course, aware of the privacy concerns, particularly in this area, and, hence, the need to find ways to deal with them. It would also be useful if central banks and national statistical agencies could work together to define needs and to share expertise on financial statistics. In Canada, advisory groups of this nature have worked well in a number of areas. Members of such groups can also share knowledge on international initiatives related to financial system data. As you know, there are a number of initiatives underway to improve such data from various perspectives. For example, the IMF is coordinating a project to develop national Financial Soundness Indicators. The BIS is looking to provide data on ultimate risk. And the Financial Stability Forum (FSF) is monitoring the consistency and comprehensiveness of international financial standards and codes. I am now coming to the last part of my remarks. Here, I intend to stay away from specific data needs. Rather, I will talk about the general principles that I see as relevant in guiding your efforts and in determining statistical priorities as we move forward. Central bankers have to make policy decisions in real time and often not under the best of circumstances. For this, we need the best available information. To be sure, it is important that the data we rely on for those decisions be of high quality. But this does not mean that we should let our quest for high-quality standards prevent the publication of potentially useful data. In other words, we should never "let the best become the enemy of the good." So, this is my advice: if you have imperfect data, don't sit on them. Put them out, together with your professional assessment of their quality and vulnerability. Remember, as policy-makers, we are used to taking decisions under uncertainty, in less than perfect conditions. We would rather have imperfect data than no data at all. Data comparability Data comparability--now, there's a big issue! With national economies and financial systems becoming more and more integrated, national central banks increasingly have to rely more on information and concepts from other jurisdictions to read the trends, and to figure out what is going on in their own economies. But for this to be effective, statistical agencies need to collect and aggregate data on a comparable basis. Comparability is also very important in that we use cross-country variation as a way of identifying and distinguishing between hypotheses as to what is working and what is not. But if we cannot really compare the data, then we lose a major source of identification of the cross-country differences that are relevant to the decision-making process. We also lose a valuable yardstick for measuring our performance relative to other countries. For an example, I will refer again to productivity measures, which, as you may have gathered by now, are at the top of my list--for good reason. I have already talked about their relevance for estimates of the economy's production potential and the implications for capacity pressures and inflation. But our interest in productivity measures is also driven by the important link between productivity growth and improvements in living standards. Over the past few years, a hot issue for a number of countries, including Canada, has been to understand why the trend growth of productivity differs across countries. Basically, we need to understand the reasons for these differences in productivity levels and growth, if we are to formulate appropriate policy responses. But if the data are not comparable, then we do not know how much of a problem we really have to begin with. I have used productivity measures as an example to make the point about the importance of comparability across countries. But this applies equally to other key data including, importantly for us central bankers, various price measures. In particular, we need to understand deviations from "the law of one price." And so we see merit in, and support, the ongoing program by the World Bank on the international comparison of purchasing-power parities. It is primarily in the context of, and in the interest of, cross-country data comparability that I will make my final remarks today. This is where the importance of co-operation among national statistical agencies comes in--in a big way. There are several reasons for that, and I have already touched on them as I went along. But since I attach a great deal of importance to this issue, let me summarize them again. In the first place, as I said before, the demands on our national statistical agencies for additional, more timely, and more accurate information keep growing. Given staffing and financial constraints, they need to use their resources more effectively. All the more reason then to work "smart" by pooling resources on how to address common data challenges. Another reason is that, as firms become global, they report to many statistical agencies. It would be helpful to gain better understanding of their operations by pooling our resources. Right now, we are a bit like the fabled blind men describing an elephant! Still another reason for co-operation among national statistical offices is in the interests of better cross-country comparability of data. Statisticians often face a trade-off between designing data that best fit the particular structure and circumstances of their country and adhering to international standards that allow for better comparability across countries. In a perfect world, we would all like to see both sets of statistics. But in the presence of resource constraints, I would be willing to give up a little on the best fit for my own country in exchange for better international comparability. One way or another, it is extraordinarily important that the Chief Statisticians of the world have the opportunity to get together to discuss and agree on common concepts, definitions, and methodology. That's a key step on the road to more comparable data. Not to mention, that such meetings also provide excellent learning opportunities for the participants--as, I am sure, this conference will, too. I wish you all much success and many fruitful discussions--today and in the future. I will now be happy to take your questions.

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canada

Recent Economic Developments and the Conduct of Monetary Policy

dodge

Governor of the Bank of Canada to the Conseil du patronat du Quebec Good afternoon, and thank you for the invitation to speak with you today. It's always a pleasure to be in Montreal. It has given me particular pleasure to visit in the past two or three years, and to see the renewed vitality that is transforming this wonderful city. I want to talk to you about the Canadian economy--how it has evolved over the past few months and what are the prospects ahead. In doing so, I will review the economic forecast from our latest , which we published in April. Then I will talk about what has changed since that time. After we published the , I spoke to committees of both the House of Commons and the Senate about our views on the economy. One of the senators asked me what keeps me, and my colleagues at the Bank of Canada, awake at night. I told him that we central bankers are paid to worry. But it's true that we've had lots to keep us awake over the past few months. The economic picture has been clouded by extraordinary events in Canada and abroad. Indeed, it's been a bit like the old saying: if you're not confused, you haven't been paying attention. We have been closely monitoring the events that have buffeted the Canadian economy, as well as global geopolitical, economic, and financial conditions. At the Bank of Canada, we do this with a view to keeping inflation near the midpoint of Canada's inflation target range of 1 to 3 per cent. Delivering an environment of low, stable, and predictable inflation is the best contribution that monetary policy can make to a healthy economy with strong and enduring growth, thereby increasing the standard of living of Canadians. Low inflation also helps keep our economy near its production potential over time. To that end, we keep a close eye on the factors influencing demand and production--factors that will, in turn, influence inflation over the medium term. And we adjust monetary policy to keep the future trend of inflation near the 2 per cent target midpoint. Now, to place our recent experience in some context, let me remind you where we've come from over the past year and a half. Following the 11 September 2001 terrorist attacks in the United States, the Bank of Canada quickly and aggressively cut its policy interest rate to shore up confidence and support domestic demand. By the spring of 2002, evidence had already started to build that demand was recovering more quickly than had been anticipated. So, even though demand pressures were not yet showing up in prices, we began to remove some of the monetary stimulus that we had put into the economy following 11 September. Our key policy interest rate rose three times between April and July 2002, by a total of three-quarters of a percentage point. By last autumn, inflation in Canada was on the rise. But we refrained from raising interest rates any further at the time, because we judged that the pickup in inflation was mainly the result of one-off factors, and would be reversed over the next year or so. As well, there was considerable geopolitical and financial uncertainty which, combined with global economic weakness, pointed to restrained total demand for Canadian goods. Through the first quarter of this year, CPI inflation climbed well above the 2 per cent target. Much of the rise was the result of higher energy prices. We also saw a marked increase in our measure of core inflation, which strips out the eight most volatile items--including gasoline, heating oil, and natural gas--from the CPI basket, as well as the effect of changes in indirect taxes on the remaining CPI components. The rise in core inflation was exacerbated by further increases in automobile insurance premiums. But even allowing for the extraordinarily large increases in insurance premiums, inflation was well above target. This suggested that strong domestic demand was putting pressure on production capacity. In this environment, some indicators of short-term inflation expectations edged up, although longer-term expectations remained around 2 per cent. In view of these inflation developments, the momentum of domestic demand, the narrowing of interest-rate spreads in credit markets, and diminishing geopolitical uncertainty, we raised our target overnight rate by 25 basis points in March and again in mid-April--bringing it to 3.25 per cent. , we stated that the risks confronting the world economy appeared to be more evenly balanced than they had been in the autumn. The Canadian economy was projected to start expanding at a rate above potential towards the end of 2003, thanks to a pickup in economic activity in the United States and further improvements in business and consumer confidence. We concluded that although growth would likely remain somewhat below potential in Canada for the first three quarters of this year, most of the small amount of economic slack that would open up this year would have closed by the end of 2004. We projected that core inflation would likely fall to about 2 1/2 per cent in the second half of this year and to about 2 per cent by early 2004, as some of the special factors pushing up inflation ran their course. We also pointed out that total CPI inflation would continue to be importantly affected by swings in crude oil prices and that it would likely fall temporarily below the core rate in the first half of 2004, before steadying out at a rate close to core inflation. , we listed a number of factors that we intended to watch closely as we set monetary policy. These factors are the pace of economic expansion in the United States and overseas, the strength of domestic demand, financial market conditions, and the evolution of inflation and inflation expectations. So, let me review how we have seen these factors evolving. I'll start with the external environment. In Europe, domestic demand and economic growth have continued to disappoint. Japan's economy has also remained weak. While demand growth in the rest of Asia has been strong, the outbreak of Severe Acute Respiratory Syndrome (SARS) is clearly going to slow growth in some countries. In the United States, domestic demand has not been recovering as quickly as expected, which has implications for Canadian exports, at least over the short term. Consumer spending continues to underpin economic activity in that country. However, business fixed investment has not picked up, and expectations as to when this recovery will occur have been pushed back until late this year, when confidence levels should improve. Now, let's turn to the second factor, domestic demand in Canada. On the whole, demand has remained quite strong, supported by a healthy employment market, low interest rates, and a recovery in corporate profits. While growth in consumer spending slowed slightly in the first quarter, it was still quite strong, especially for housing. Governments and businesses both increased their spending. As a result of strong domestic demand, gross domestic product grew at an annual rate of almost 2 1/2 per cent in the first quarter, up from about 1 1/2 per cent in the final quarter of 2002. A number of recent adverse developments are going to reduce near-term economic growth in Canada. SARS is having a significant impact on the hospitality industry, not just in Toronto, but across the country. More recently, the closure of export markets because of the discovery in Alberta of an isolated case of Bovine Spongiform Encephalopathy (BSE) is having an impact on the beef and beef-processing industry across Canada. A third factor on our watch list has been the evolution of conditions in financial markets. Last autumn, we witnessed sharp increases in risk premiums in response to uncertainty in financial markets. In recent months, these risk premiums have declined, and conditions in both debt and equity markets continue to improve. That reflects reduced uncertainty and bodes well for business spending going forward. As you well know, since mid-April there has also been a sharp adjustment in the value of the U.S. dollar against major currencies, including ours. The magnitude and speed of the Canadian dollar's rise has been greater than anyone had anticipated, and will have a dampening influence on aggregate demand later this year and next. In setting monetary policy, we have to take this influence into account. We also need to understand all other factors behind these exchange rate movements and take them into account as well. In addition to their impact on aggregate demand, movements in exchange rates have a direct effect on the prices of traded goods and services and, therefore, on inflation. However, our research has shown that, in economies such as Canada's, the effect of exchange rate movements on consumer prices has been less pronounced in recent years, when inflation was relatively low, than was the case in earlier years, when inflation was high. This leads me to the fourth factor that we watch closely in setting monetary policy--the evolution of inflation and inflation expectations. Let me start with inflation. In the 3 June press release that announced our latest interest rate decision, we pointed out that inflation has declined more than expected. Some of this decline is due to transitory factors, most notably, the rebate on electricity prices in Ontario. Thus, we expect some rebound in core inflation in the coming months, as these factors unwind. Nevertheless, it now appears that both core and total CPI inflation will return to the 2 per cent target somewhat earlier than the Bank had anticipated in April. This is because of an expected moderation in auto insurance premium increases, and because of some near-term softness in demand. As I said earlier, the appreciation of the Canadian dollar is not expected to have a large direct effect on core CPI, although it will act to dampen the rise in total CPI. Now, a word on inflation expectations. As I mentioned, we were concerned that the sharp rise in CPI inflation last winter was starting to push up Canadians' expectations of inflation. The recent easing in inflation is likely to act as a moderating influence on those expectations. We will be seeking evidence of this in our regular survey of businesses prior to our next fixed announcement date. Let me sum up. Today, I have outlined some of the recent developments that will influence the demand for Canadian goods and services. They include continuing weakness in the U.S. and global economies, and concerns about the economic impact of SARS. These developments point to some near-term softness in the Canadian economy. The appreciation of the Canadian dollar against the U.S. dollar is another factor influencing demand--although it is also an outcome of other influences at work in the economy. Looking forward, it remains our view that growth in Canada's economy will be underpinned by the strength of domestic demand and a rebound in the U.S. economy towards the end of 2003 and through 2004. We will continue to assess the economic data carefully. We will continue to talk to businesses about their plans. And we'll pursue our analysis to try to better understand the forces operating on our economy over the medium term.

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canada

Recent Economic Developments and the Conduct of Monetary Policy

dodge

Governor of the Bank of Canada Good afternoon, and thank you for the invitation to speak with you today. It's great to be back in Halifax, one of Canada's most colourful port cities. It is the wonderful juxtaposition of the new with the old--Halifax's modern focus with its rich maritime traditions--that makes this city special. It's been a year since I last spoke in Halifax, and a lot has changed since then. We've witnessed some extraordinary events, both in Canada and around the world. On the whole, Canada's economy has withstood the turmoil quite well. The impact of some more recent events is not yet clear. Still, I will try today to outline how our economy has evolved over the past year and to lay out the issues that we'll be assessing as we prepare our July . As we at the Bank of Canada set monetary policy, we watch all the events affecting our economy, including global geopolitical, economic, and financial conditions. We do this with a view to keeping domestic inflation near the 2 per cent midpoint of Canada's inflation target range of 1 to 3 per cent. As we have often said, delivering an environment of low, stable, and predictable inflation is the best contribution that monetary policy can make to a strong, sustainable economy and rising living standards for Canadians. Such a low-inflation environment also helps keep our economy near its production potential over time. To achieve those goals, we keep a close eye on the factors influencing demand and production capacity--factors that will, in turn, influence inflation over the medium term. And we adjust monetary policy to keep the future trend of inflation near the 2 per cent target midpoint. As I've said, it's been a year since I last spoke in Halifax. But to place our recent experience in some context, I should go back a bit further than that--to the September 2001 terrorist attacks in the United States. In the wake of that terrible event, the Bank of Canada quickly and aggressively cut its policy interest rate to shore up confidence and support domestic demand. This action, together with earlier reductions in our policy interest rate, meant that the Bank had injected considerable stimulus into the economy. By the spring of 2002, evidence had already started to build that demand was recovering more quickly than had been anticipated. So, even though demand pressures were not yet showing up in prices, we began to remove some of that monetary stimulus. We raised our key policy interest rate three times between April and July 2002, by a total of three-quarters of a percentage point. By last autumn, inflation in Canada was on the rise. But we refrained from raising interest rates any further at the time, because we judged that the pickup in inflation was mainly the result of one-off factors and would be reversed over the next year or so. As well, there was considerable geopolitical and financial uncertainty, which, combined with global economic weakness, pointed to restrained total demand for Canadian goods and services. Through the first quarter of this year, CPI inflation climbed well above the 2 per cent target. Much of the rise was the result of higher energy prices. We also saw a marked increase in our measure of core inflation, which strips out the eight most volatile items--including gasoline, heating oil, and natural gas--from the CPI basket, as well as the effect of changes in indirect taxes on the remaining CPI components. The rise in core inflation was exacerbated by further increases in automobile insurance premiums. But even allowing for the unusual and extraordinarily large increases in insurance premiums, inflation was well above target. This suggested that strong domestic demand was putting pressure on production capacity. In this environment, some indicators of short-term inflation expectations edged up, although longer-term expectations remained around 2 per cent. In view of these inflation developments, the momentum of domestic demand, the narrowing of interest rate spreads in credit markets, and diminishing geopolitical uncertainty, we raised our target overnight rate by 25 basis points in March and again in mid-April--bringing it to 3.25 per cent. , we stated that the risks confronting the world economy appeared to be more evenly balanced than they had been in the autumn. The Canadian economy was projected to strengthen appreciably towards the end of 2003 and to grow somewhat above its production potential during 2004, thanks to a pickup in economic activity in the United States and further improvements in business and consumer confidence. We concluded in April that although growth would likely remain somewhat below potential in Canada for the first three quarters of this year, most of the small amount of economic slack that would open up this year would have closed by the end of 2004. We projected that core inflation would likely fall to about 2 1/2 per cent in the second half of this year and to about 2 per cent by early 2004 as some of the special factors pushing up inflation ran their course. We also pointed out that total CPI inflation would continue to be importantly affected by swings in crude oil prices and that it would likely fall temporarily below the core rate in the first half of 2004 before steadying out at a rate close to core inflation. , we listed a number of factors that we intended to watch closely as we set monetary policy. These factors are the pace of economic expansion in the United States and overseas, the strength of domestic demand, financial market conditions, and the evolution of inflation and inflation expectations. So, let me review how we have seen these factors evolving. I'll start with the external environment. In Europe, domestic demand and economic growth have continued to disappoint. Japan's economy has also remained weak. While demand growth in the rest of Asia has been strong, the outbreak of Severe Acute Respiratory Syndrome (SARS) is clearly going to slow growth in some countries. In the United States, domestic demand has not been recovering as quickly as expected, which has negative implications for Canadian exports, at least over the short term. Consumer spending continues to underpin economic activity in that country. However, business fixed investment has not yet picked up. Expectations as to when the U.S. recovery will occur have been pushed back until late this year when confidence levels should improve, and when the impact of very expansionary monetary and fiscal policies should begin to be fully felt. Now, let's turn to the second factor--domestic demand in Canada. On the whole, demand has remained quite strong, supported by a healthy employment market, low interest rates, and a recovery in corporate profits. While growth in consumer spending slowed slightly in the first quarter, it was still quite strong, especially on housing. Governments and businesses both increased their spending. As a result of strong domestic demand, gross domestic product grew at an annual rate of almost 2 1/2 per cent in the first quarter, up from about 1 1/2 per cent in the final quarter of 2002. In Nova Scotia, we are seeing some fall-off in consumer spending. Business investment prospects have also been dampened by the postponement of natural gas projects. Still, most forecasters predict Nova Scotia's economy will continue to grow at the Canadian average rate this year. A third factor on our watch list is the evolution of conditions in financial markets. Last autumn, we witnessed sharp increases in risk premiums because of uncertainty in financial markets. In recent months, these risk premiums have declined, and conditions in both debt and equity markets continue to improve. This reflects reduced uncertainty and bodes well for business spending going forward. Before moving on to the fourth factor, I'd like to mention several developments since April that have implications for the economic outlook. Together, these developments point to near-term growth in Canada that will be lower than we expected at the time of our April . SARS is having a significant impact on the hospitality industry, not just in Toronto, but across the country--including here in Atlantic Canada. More recently, the closure of export markets because of the discovery in Alberta of an isolated case of Bovine Spongiform Encephalopathy (BSE) is having an impact on the beef and beefprocessing industry. And, of course, problems in several important East Coast fisheries are affecting employment and production in this region. As you well know, since mid-April there has also been a further sharp adjustment in the value of the U.S. dollar against major currencies, including ours. The magnitude and speed of the Canadian dollar's rise has been greater than anyone had anticipated and will have a dampening influence on aggregate demand later this year and next. We are working to understand all the factors behind these exchange rate movements. In setting monetary policy, we have to take into account the effects on aggregate demand of these factors, as well as the effect of the exchange rate movements themselves. Exchange rate movements also have a direct effect on the prices of traded goods and services and, therefore, on inflation. However, our research has shown that, in economies such as Canada's, the effect of exchange rate movements on consumer prices has been less pronounced in recent years, when inflation was relatively low, than was the case in earlier years when inflation was high. This leads me to the fourth factor that we watch closely in setting monetary policy--the evolution of inflation and inflation expectations. Let me start with inflation. In the 3 June press release that announced our latest interest rate decision, we pointed out that inflation has declined more than expected. Some of this decline is due to transitory factors, most notably, the rebate on electricity prices in Ontario. Thus, we expect some temporary rebound in core inflation in the coming months, as these factors unwind. Nevertheless, it now appears that both core and total CPI inflation will return to the 2 per cent target somewhat earlier than the Bank had anticipated in April. This is, in part, because of some near-term softness in demand. Also, the appreciation of the Canadian dollar will somewhat dampen the rise in total CPI, although it is not expected to have as large a direct effect on core CPI. Now, a word on inflation expectations. As I mentioned, we were concerned in April that the sharp rise in CPI inflation last winter was starting to push up Canadians' expectations of inflation. The recent easing in inflation is likely to act as a moderating influence on those expectations. We will be seeking evidence of this in our regular survey of businesses prior to our next fixed announcement date. Let me sum up. Today, I have outlined some of the recent developments that will influence the demand for Canadian goods and services. They include continuing weakness in the U.S. and global economies, and concerns about the economic impact of SARS and BSE. These developments likely mean a very weak second quarter and point to some continuing softness in the Canadian economy in the third quarter. Looking forward, it remains our view that growth in Canada's economy will be underpinned by the strength of domestic demand and a rebound in the U.S. economy towards the end of 2003 and through 2004. However, the appreciation of the Canadian dollar against the U.S. dollar, which is an outcome of various influences at work in both the Canadian and global economies, will be a factor influencing aggregate demand. We will provide Canadians with a more considered and complete picture of our views on the economy in our next , which will be published on 17 July. Ladies and gentlemen, Halifax is a city that has withstood some extraordinary events in its long history. The Canadian economy, too, has been buffeted by some remarkable winds this year--some fair and some foul. But we have weathered them well, and I believe we will continue to do so. I can assure you that the Bank of Canada will continue to provide monetary policy that contributes to a strong, stable, and sustainable economy.

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canada

Release of the

dodge

Today, we released our to the April . The reviews economic and financial trends in the context of Canada's inflation-control strategy. , a number of unanticipated developments have changed the outlook for economic activity and inflation in Canada. Economic activity has been undercut by the effects of severe acute respiratory syndrome (SARS) and an isolated case of bovine spongiform encephalopathy (BSE) in Canada. Foreign demand for Canadian products has also been weaker than expected. Moreover, the substantial rise in the value of the Canadian dollar against the U.S. dollar will have a dampening effect on the future growth of demand for Canadian goods and services. Inflation, and importantly, inflation expectations, have eased. And more slack is developing in the economy than was previously expected. It now appears that, by the end of this year, core inflation will fall below the 2 per cent target. In response to these changing circumstances, we left the target for the overnight rate unchanged on 3 June, seeing less need to reduce the amount of monetary stimulus in the economy. On 15 July, we lowered our target for the overnight rate by 25 basis points to 3 per cent. This change in policy stance should help support domestic demand growth and maintain demand levels that are consistent with keeping inflation near 2 per cent over the medium term. We expect that growth in Canada's economy will strengthen towards the end of 2003 and through 2004. Here are the factors supporting this outlook: We will closely monitor the strength of domestic and external demand with a view to keeping inflation on track to meet the 2 per cent target. Paul and I will now be happy to take your questions.

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canada

Economic Integration in North America

dodge

For more than 70 years now, the Couchiching Institute on Public Affairs has been bringing Canadians together with the purpose of asking some thought-provoking questions and encouraging lively, stimulating debates and action on a variety of key public policy issues. For example, it was at Couchiching, 56 years ago, that the idea of creating a North Atlantic Treaty Organization (NATO) was first floated publicly by Escott Reid, a senior official with the Canadian Department of External Affairs. NATO was established a year and a half later, reflecting almost exactly the vision that Reid outlined in his speech at Couchiching. I am delighted to have been invited to participate in this year's conference, the theme of which is "Continentalism: What's in It for Us?" True to form, here again is a topic that is thought-provoking and, some might say, provocative! Before I venture any thoughts on the subject, let me make it clear that I am not here as an for greater North American integration. This is very much a decision for Canadians and their elected governments. It is a big decision, and all of us, as a democratic society, will have to determine what we really want. I'm not a politician; I'm an economist. So, what I intend to do tonight is to lay down some parameters for an appropriate discussion of the issues relevant to greater integration in North America. First, I would like to review the benefits and costs of economic integration. By economic integration, I mean the free movement of goods and services, capital, and labour and the harmonization of the rules governing the operations of these three key markets. I will briefly review the progress Canada has made on each of those fronts, and the benefits we have derived from opening up our markets to international competition and to the free flow of capital. Next, I will talk about the remaining impediments to fuller economic integration. And finally, I will briefly discuss where we might go from here. International trade in goods and services takes place because countries have different resource endowments and labour skills and because consumer tastes vary from country to country. -century British economist, argued that a country could gain from trade even when another country had an advantage in producing all goods and services. He argued, rightly, that by concentrating on producing those goods and services in which a country was more efficient, and importing those products in which it was less efficient, it could increase its national income. And this would be so even if that country was less efficient in producing all products. This is the famous principle of . It is on this principle that economists base their view that barriers to trade reduce economic welfare in all countries. When countries export goods and services in which they are most competitive and import those in which they are less competitive, consumers everywhere benefit, the potential output of all nations increases, and so does the global standard of living. Opening up national borders also opens the door to greater global competition. And this acts as a potent incentive for businesses everywhere to become more efficient and productive. To relate this to Canada, international competition puts pressure on our domestic market to be more competitive, even in industries where the optimal scale may have only one or two Canadian firms operating. In the end, competitive pressure leads to greater efficiency, greater productivity, and higher standards of living. So there are clear economic benefits to greater economic integration with the rest of the world. Of course, there are adjustment costs to be borne as barriers to trade are removed. Some firms and some industries will not be able to meet the foreign competition, and will die or contract. This is part of the process of releasing resources--both human and physical--to those industries or firms that are taking advantage of new markets abroad. So some kind of mechanism to equitably share the short-run costs of adjustment is important to reap the medium- and longer-run benefits of freer trade. Since the Second World War, Canada has had a history of being open to global markets for goods and services. In my view, this interaction with the rest of the world has proven very successful and has benefited Canadians, and our foreign partners, enormously. As you know, the Canada-U.S. Free Trade Agreement (FTA) of 1989 and the North American Free Trade Agreement (NAFTA) of 1994, which added Mexico to the partnership, were initially viewed with a great deal of skepticism in this country. And at first, the adjustment to the FTA was difficult. But, by the late 1990s, it was clear that freer trade in North America was bringing major benefits to Canada. FTA and NAFTA have opened up U.S. and Mexican markets, providing Canadian businesses with tremendous opportunities. They have also put pressure on our entrepreneurs to be more efficient--a challenge they have clearly risen to. Canadian exports have flourished, and consumers in this country now benefit from greater product choice and lower prices. Under the FTA and NAFTA, we have achieved much freer trade in manufactured goods. And we have gone quite a distance with respect to certain services. But we still have problems in some key sectors. For example, we certainly have a long way to go when it comes to agriculture. And even though, nominally, we have free trade in forest products and steel, complications do arise because the United States retained its ability to apply trade-remedy laws. The current softwood lumber dispute is an example of the problems we face with U.S. trade-remedy laws, specifically anti-dumping and countervailing duties. It is partly because of such problems that some analysts in Canada have recently been advocating a customs union, or some type of common market, with the United States. Clearly, some sections of NAFTA need further work if we are to eliminate all non-tariff barriers (such as countervailing and anti-dumping duties) and reduce the costs to industry of complying with a number of special rules, such as rules of origin. Dealing with these problems also means closer integration of regulatory regimes in North America. Let me now turn from issues related to trade in goods and services to issues related to capital flows. Canada eliminated wartime foreign exchange controls in the early 1950s. Thus, for most of the post-war period, we have benefited greatly from the free movement of capital and from competition in financial markets. Capital flows have played a very important role in Canada's development as a modern economy. Indeed, particularly through the 1950s, 1960s, and early 1970s, we were able to use foreign savings to finance the large investment projects that were necessary to develop our industrial infrastructure and increase our production potential, especially in the resource and manufacturing sectors. At the same time, Canadians have been able to set up businesses and pursue investment opportunities abroad. Through two-way direct investments, Canada has also had access to, and benefited from, technological innovations and processes developed elsewhere. In a North American context, freeing up capital flows has not been part of formal negotiations between Canada and the United States. In both countries, this has largely been a domestic endeavour. By that, I mean that the integration of Canada-U.S. capital markets has proceeded as fast as we, and the Americans, have been able to reduce impediments to freer capital flows. Now, let me consider labour markets and the movement of labour between Canada and the United States. Back in the 19 century, there was considerable labour mobility between the two countries. But the movement of workers across the border suffered a serious setback after the First World War, particularly in the wake of the Great Depression. Today, the border between Canadian and U.S. labour markets is somewhat more open than it was at the end of the Second World War. But, in comparison with the markets for products and capital, it is still least open. This is because of immigration policies and a multitude of different provincial, state, or federal licensing laws in the two countries. To achieve the full benefits of a single market, significant freeing up of laws and regulations that impede labour mobility would be needed. But I recognize that this is extremely difficult, particularly in a Canada-U.S.-Mexico context. This completes my brief review of the key Canada-U.S. markets for goods and services, capital, and labour. Having done that, I believe that it would be fair to say that, although there are now fewer "formal" tariff and non-tariff barriers between the two countries than there were 15 years ago, the reality is that borders still do matter. As John Helliwell reminds us, "border effects are still too large to be ignored and too complex to be easily classed as good or bad." As I just pointed out in discussing labour markets, there are many non-tariff impediments to achieving the full benefits of economic integration. Among these, importantly, are the different national, provincial, or state regulatory regimes. Here, it seems to me that one of the key questions we should be asking ourselves is whether we have given sufficient consideration to "harmonizing" a number of our regulations with those of the United States. By "harmonizing," I mean working to make the regulations of the two countries compatible or convergent, but not necessarily identical. My sense is that, on this score, we have made some but not much progress. I will expand on this point later. So, where do we go from here? Free trade within North America has brought us great benefits. Of that, there is no doubt. Ideally, though, what we should be striving for, as a country, is the removal of barriers to trade, so that the whole world can be open for business. The world community has been trying to do this since 1947. But it has been a very slow process because building consensus continues to be an uphill battle, as we are witnessing with the current Doha round of trade negotiations. For me, free trade is still the ideal. We in Canada cannot, and should not, lose sight of that goal by focusing on free trade in North America. But, we cannot tear down barriers multilaterally, we should at least continue to tear them down between provinces in Canada, between Canada and the United States, between Canada and Mexico and, indeed, throughout the Americas. As I said earlier, a number of analysts in this country have recently been calling for fuller economic integration in North America--to be pursued through arrangements ranging from a customs union to some type of common market, and all the way to full economic and monetary union. Of course, not everyone in Canada is convinced of the merits of fuller economic integration within North America. In fact, as you will probably hear later in this conference, many Canadians are concerned about the implications of such a move for our political sovereignty and policy independence. Once again, I am here as an economist. So I will leave the political questions aside and focus instead on the factors that I see as relevant in the context of pursuing fuller integration. But I should point out that, although the interest for Canada in further integration is primarily economic, it is quite clear that the Americans see border security as an important element of that integration. So, as we in Canada consider deeper economic integration, we also have to consider what measures we would take to actually build a common security perimeter around North America. I do not intend to elaborate on this, since there are others at this conference who are much more knowledgeable and able to comment. But it is very important to recognize that, for our southern neighbours, security integration and economic integration are clearly linked. With that, let me return to the question, Where do we go from here? Let's start with . The key issue for Canada is to reduce "border risk," that is, guarantee Canadian producers and service providers access to U.S. markets without hassle and expense at the border, and without the risk of suddenly being shut out of those markets by some discretionary U.S. action. This is important. Here are some of the steps that could help in this respect: We could also work towards broadening NAFTA coverage to include agricultural products, although there are clear difficulties in this area. And we could work to remove barriers to trade in cultural, legal, financial, and communication services, although, here again, harmonizing regulatory regimes at the federal and state/provincial levels would be very difficult. I must tell you that arriving at an agreement on measures to reduce border risk or to broaden the scope of NAFTA won't be easy. Most of the easier steps have already been taken. Remember, too, that the Americans have different concerns with respect to Mexico than they have with respect to us. There are many practical and political challenges to be overcome on the way. But if we could reach agreement on deepening and/or broadening NAFTA, it would be extremely valuable. It would spread the benefits of competition across more industries, reduce uncertainty stemming from unilateral trade actions, and greatly reduce non-tariff barriers (which are often even greater impediments to trade than tariffs). And if we could agree on common external trade rules and tariffs, rules of origin could be eliminated and matters at the border would be enormously simplified. Let me now turn from trade in goods and services to other issues related to economic integration, or what the Europeans call, the creation of a "single market." These issues largely relate to the harmonization of regulatory regimes, not only with respect to the market for goods and services, but also the markets for capital and labour. There are efficiency gains to be made from moving to common in North America. Not only would common standards reduce the costs of compliance; they would also allow our entrepreneurs to compete with the Americans on a more level playing field. But, as the European experience demonstrates, achieving such common standards is a long, painstaking, and difficult process. What the Europeans did, in many instances, was to write a whole new set of rules to replace the often very divergent rules in the 15 member countries of the European Union. We do not face as daunting a problem in North America (at least in Canada and the United States) because the basic structure and philosophy of the regulatory frameworks governing commerce, labour, and financial markets are similar--though far from identical. So the job of harmonization at the national level will be somewhat less onerous than in Europe. But it will still be a lengthy and difficult process. Furthermore, the problem for us is that, given the size and weight of the United States, reaping the benefits of harmonization will mean that, by and large, we would probably have to move towards U.S. regulatory standards. Clearly, there are some drawbacks to harmonizing our regulatory standards and procedures with those existing in the United States. U.S. standards may not always be absolutely ideal in a Canadian context. But the point is that we should not reject them out of hand because they are not perfect. Rather, we should assess them very carefully. And we should always be asking, Would we be better off adopting U.S. standards, so we can have harmonized regulatory regimes across North America, rather than adhering to our own, even though ours might be better suited to our unique circumstances? What I'm saying is that, if we are going to preserve different regimes of economic regulation, we'd better have solid reasons for doing so. And we'd better make sure that the differences we maintain will indeed lead to better outcomes for Canadians. To be sure, there are some things that we may want to do differently in Canada, based on social or political grounds. For example, one issue that Canadians are currently debating is the provision of health care and the regulation of public health and drugs. Immigration policy is another. All these issues deserve careful consideration. And we should encourage our analysts to examine closely the benefits and costs of maintaining divergent regimes versus the benefits and costs of pursuing regimes that move us closer to harmonization. One last point I would like to make with respect to regulation is that, , we have a big problem in Canada. I am referring, of course, to the diversity of provincial standards in such key areas as labour markets, financial markets, and the markets for some services. Different criteria for professional certification of tradespeople, different provincial securities regulations, and different rules related to transportation come readily to mind. By and large, this kind of diversity does not serve us well. So it is very important that we also harmonize regulatory standards at home. While most of the regulatory integration issues I have spoken about tonight apply to labour and capital markets as well as markets for goods and services, I want to make a couple of points specifically related to further integration in labour and capital markets. Labour market integration would be greatly aided if Canada and the United States had procedures in place--procedures that were rapid, simple, and inexpensive--to grant work permits allowing citizens of either country to cross the border to take up jobs. Needless to say, this would be easier to negotiate if we were to simultaneously adopt a common immigration security perimeter for North America, although, logically, adoption of such a perimeter is not a prerequisite. To ensure that there are welfare gains, initiatives to open up labour markets would also call for greater harmonization of licensing standards, so that people could actually be employed on both sides of the border. Of course, a good first step in this area would be harmonization of policies and adoption of common licensing standards in labour markets across provinces within Canada! Canadian and U.S. capital markets are already highly integrated and, as I said earlier, Canadians (and Americans) have benefited greatly from this open, transparent, and competitive market. As we all seek to improve corporate governance and to achieve greater transparency in the wake of recent corporate scandals, this is a real opportunity to achieve greater harmonization of rules in North America--not to mention globally. There is a willingness at the moment, on the part of authorities everywhere, to try to find a reasonable mix of principles and rules for accounting standards and securities regulation. We should seize the opportunity--and I believe we are in the process of doing so--to achieve greater uniformity of standards, not only with the United States but also among Canadian provinces. In sum, to achieve maximum economic benefits, harmonization of regulatory standards and practices, particularly with respect to capital and labour markets, should be a priority as we move forward. One last issue I would like to address briefly tonight is that of monetary integration. I have been asked the question, there was a political decision in Canada to adopt policies of deeper North American integration, would it still make sense for us to keep our own currency? Or should we be thinking about adopting the U.S. dollar as our currency? First, let me stress that monetary union is an issue that should be considered once we have made more progress towards establishing a market for goods and services, capital, and labour. Without a single, well-functioning market for labour, a single currency could impose great adjustment costs on workers. But suppose we were on track to achieve a single market. Should we then be thinking of a monetary union as well? The response to this, which I have set out in earlier speeches, is that it depends, to an important extent, on how close or how far apart are the industrial structures of the two countries. Although it is always possible that at some future time those structures could converge (they could also diverge!), the reality is that, right now, they are quite different. This means that economic shocks tend to affect our two economies differently. In these circumstances, a separate floating currency facilitates adjustment to those shocks at least cost, in terms of lost output or higher inflation. we were well on our way to achieving a true single market for goods and services, labour, and capital. Then it would be sensible to consider a common currency in the context of the industrial structures prevailing at that time, with a view to ascertaining whether the benefits of lower transaction costs associated with a common currency outweighed the higher costs of economic adjustment. Let me wrap up by summarizing my main points. Fundamentally, the decision to deepen economic integration in North America is a political one that Canadians and their governments will have to make. From a purely perspective, I have, as an economist, a strong predilection for continuing to tear down barriers to trade--preferably, multilaterally, but, realistically, first within Canada and North America. Over the long haul, that is going to encourage a more efficient, productive economy, greater opportunities for Canadian entrepreneurs and workers, and, most importantly, higher living standards for Canadians. To be sure, certain costs involved in all of this. Fuller integration with the United States could make us more vulnerable to fluctuations in economic activity in that country. And we may no longer be able to tailor policies to fully meet our own needs or to foster particular Canadian industries. These are issues that we ought to be aware of and analyze very carefully. But economic theory and our experience so far support the view that, on balance, the benefits of opening up to the rest of the world outweigh the costs. Tonight, I have laid down some of the factors that I consider relevant in trying to come to a judgment about the desirability of further economic integration in North America, and about what needs to be done Canadians decide to pursue this. I am looking forward to the insights that others may have on this issue as the conference unfolds.

r030905a_BOC

canada

Spruce Meadows Roundtable

dodge

Thanks to my colleagues from around the world for giving such a comprehensive review of the vital issues facing the global economy. One of the hazards of speaking last in these kinds of sessions is that those who speak before you may cover all the interesting territory, leaving you with the unenviable task of trying to tie everything together. In this case, however, going last is not so bad. That's because, in order to tie together the issues discussed so far, we need to take a global view of the economy. And as far as Canada is concerned, taking a global view has always been important. Of course, every country is affected to some extent by what happens in the world economy. But Canada, with its very open economy, has a particular need to keep an eye on the changing fortunes of the international scene. Canada's reliance on foreign trade has required us to be active internationalists for decades. Louis Rasminsky, who went on to become Governor of the Bank of Canada, was one of Canada's delegates at the Bretton Woods Conference that led to the creation of the International Monetary Fund (IMF) and the World Bank. Rasminsky played an important role, formal and informal, at the talks. Not only was he the Chair of the drafting committee, he was also the peacemaker between the British delegation, led by John Maynard In the months leading up to Bretton Woods, it was Rasminsky who kept the two key delegations talking. Without his work, both as a skilled drafter and as a go- between, it's entirely possible that the talks at Bretton Woods c ould have ended in failure. Canada was also present at the 1947 Havana Conference, where we pushed for the establishment of an international trade organization. This was meant to be a body parallel to the IMF, designed to establish and monitor a set of global trade rules. We didn't get quite what we wanted, but the result was still certainly positive: the birth of the General Agreement on Tariffs and Trade (GATT). In 1995, nearly five decades later, we were more successful, as we Canada's credentials as a supporter of institutions designed to promote free trade and a sound international financial system are well established. Of course, much has changed in the global economy during the more than half-century since those institutions were founded. Of profound significance, transportation and communications have become very much cheaper and faster today than they were after World War II. Because of this, the potential economic gains from increased international trade and finance are now much greater than ever before. At the same time, individual countries are more vulnerable to economic and financial shocks originating outside their borders. So the need for a coherent international financial system is also much greater today. And our international institutions must evolve to take all of this into account. To help us maximize the potential gains from increased trade, and to minimize the risks stemming from greater interdependence, we need to encourage trust, domestically and internationally. Let me explain what I mean. When I use the word trust, I am talking about the understanding that can develop when people recognize that everyone benefits when everyone plays by the rules. In this atmosphere, the rules that govern behaviour reinforce people's actions and help them choose to "do the right thing." This kind of trust allows for what game theorists call "positive-sum outcomes," where progress can come through "win-win" situations. It also allows national economies, as well as the global economy, to be strengthened. This kind of trust begins at home. What all of us as national public policy-makers must do, and must be seen to be doing, is work to maintain and increase trust. We need to put in place the right incentives so that, in general, people will do the right thing. To be sure, the need to enforce sanctions when people do the wrong thing is critical. But when people can operate in an atmosphere of trust, they can spend less energy keeping tabs on others, and can concentrate on more productive activities. We have seen over the past decades that trust is important to a well-functioning financial system. And a well-functioning financial system is necessary if we are to have an appropriate allocation of savings, which is a fundamental element of solid economic growth. I would argue that five lessons can be drawn from our experiences since the time of the Bretton Woods and Havana agreements. All of them underscore the importance of trust. The first lesson we have learned is the critical importance of having a robust legal framework. When a country has the appropriate legal structures, it creates a sense of certainty. Citizens, investors, and corporations have the security of knowing that contracts will be honoured, and that those who break the rules will be caught and punished. The protection of property rights and a tradition of contract law are prime examples of these structures. Certainly, in recent years, we have all recognized the importance of a robust legal framework as we have watched countries in Eastern Europe, Latin America, and Asia struggle to make the transition to a market economy. But we in North America have also learned over the past two years, in a rather painful way, that issues of corporate governance are extremely important as well. So when we think of legal structures, we should now also think about high standards for accounting, transparency in corporate reporting, and adequate enforcement of the rules. The second lesson we have learned is that our fiscal policies must always be based on prudence. When public debts are allowed to mount unabated, the trust of investors and citizens can vanish quickly. In its place comes fear that the debt will either be inflated away, or that a future government may default. Since the late 1990s, Canada has seen the benefits that can come from fiscal prudence. Putting our fiscal house in order has helped to establish credibility for our macroeconomic framework. And once fiscal credibility is established and a country has a low public debt-to-GDP ratio, the "automatic stabilizers"--which kick in to increase government spending to cushion the impact of difficult economic times--can operate without undermining the trust of citizens and investors. The third lesson we have all learned is the importance of being open to trade. When a country opens its industries and markets to international trade, this may force painful short-term adjustments in some sectors. But at the same time, the country gains from ongoing competitive pressures which act to spur productivity improvements and raise living standards. In the end, the country as a whole is better off. But what is equally important is that those countries that have opened up to international trade play by the rules. Otherwise, we run the risk of falling into destructive "lose-lose" situations, where countries don't trust each other and resort to unilateral actions that escalate trade disputes. Fourth, we have learned the importance of a central bank that promotes trust in the value of money, free from political interference. When a central bank delivers an environment of low, stable, and predictable inflation, the public, and especially middle- and lower-income groups, can feel more confident that their savings and purchasing power will not be eroded by high inflation. And all borrowers can be more confident that the burden of their debt will not be increased through deflation. Low inflation also helps to win the public's trust in the functioning of a market economy. As former Bank of Canada Governor Gerald Bouey put it, "inflation melts the glue that holds free societies together." In Canada, we focus on inflation in a symmetric way. In doing so, we aim to avoid inflation while also minimizing the risks of deflation. Such an approach brings important economic benefits. But it also assures creditors that the value of their investment will not be eaten away over time. And it assures debtors that the burden of their debt will not increase in the future because of deflation. The fifth lesson has to do with capital flows and exchange rates. Open markets and the free flow of capital can greatly accelerate development. But, as I noted before, open markets and capital flows can make individual countries vulnerable to shocks that originate elsewhere. So there is a need for countries to have a mechanism in place that helps their economies adjust to shocks. Recent experience has taught us how important it is to have this kind of adjustment mechanism in place and, in particular, how a floating exchange rate can play this role. I know that not everyone here would agree that the floating exchange rate is the best adjustment mechanism for every country. Based on Canada's long experience with a floating currency, I can certainly say that it has served us well. But I'm sure that we can all at least agree that there will always be shocks, that such shocks will have different effects on national economies, and that flexible exchange rates can help to facilitate the necessary adjustments. This lesson was clearly brought home during the Asian crisis of 1997-98. Many Asian countries, but also countries like Canada that are particularly vulnerable to sharp fluctuations in commodity prices, made relatively quick adjustments to a difficult situation through the floating exchange rate mechanism. How does this relate to trust? Through the need to trust in market forces, I would say. When exchange rates float and capital moves freely, investors can trust that market forces are being allowed to do their job. There is an assurance that when shocks arise, countries will not be shielding their economy from market forces through restrictive trade practices, arbitrary controls on capital flows, or fixed exchange rates. So those are some of the key lessons we can draw from our experiences of the past few decades. In Canada, we have tried to apply these lessons to our own economic situation. And I would argue that doing so has helped us handle economic shocks better recently than in the past. Now, if we apply the principle of trust that is behind those lessons to our international financial institutions, we can get some idea of how these institutions might evolve to better work for the global economy. Game theorists will tell you that the best results come when the players see each other's behaviour and learn from it. Put simply, actions speak louder than words. We have already seen the GATT evolve into the WTO, which establishes the ground rules for international trade and calls to account those countries that are not playing by the rules. Such an institution is essential if we are to reduce the frequency of "lose-lose" trade disputes I mentioned earlier. But for the WTO to go further, as it should, it is clear that progress needs to be made in the areas of greatest interest to the poorer nations. After all, the current round of talks is supposed to be the "Development Round." So it is incumbent on us in the developed world to "do the right thing," and overcome domestic political difficulties to open our markets in areas such as agriculture and textiles. Recently, we have seen the IMF take steps to strengthen its surveillance function. These steps should be supported. Countries should strive to meet the highest standards for data dissemination and should welcome assessments of their economies and financial systems. Only when all the players have complete trust in the numbers--whether they are part of a nation's economic statistics or a firm's balance sheet--will investments be made most efficiently and effectively. The IMF's other role, for which it is perhaps better known, is as provider of emergency liquidity. By the end of the 1990s, the Fund had increasingly found itself providing financial assistance many times in excess of a country's quota, in situations where sustainability, not a lack of liquidity, appeared to be the real issue. This is problematic, for a number of reasons. Perhaps most importantly, when debtors or creditors presume that there will be large official bailouts, there is the possibility of "moral hazard." This is a case where policy- makers have not provided the incentives for debtors and creditors to do the right thing. In recent years, the Bank of Canada and the Bank of England worked together to develop a "middle-ground" approach to crisis resolution. This approach, which was detailed in a joint paper published in 2001, was designed to provide the right incentives for debtors and creditors. It contained three basic elements. First, "presumptive limits" to official assistance, which would be known in advance. Secondly, the possibility of exceptional official lending, but only in the unlikely event that a crisis threatened global financial stability. Third, orderly standstills or temporary suspensions of debt-service payments to give distressed debtors some time to take steps, including debt rescheduling, to address their problems. Since that time, the G-7 finance ministers and central bank governors have adopted much of this approach in the context of their Action Plan for crisis prevention and resolution. What is important now is that we support that Plan and enforce the rules that have been put in place. If we ignore the rules that have been established, we risk losing the trust that we are trying so hard to build. To conclude, I hope that I have been able to illustrate the importance of trust. By strengthening this trust, we can make the global financial system work better. And by doing so, we can deal with the changing fortunes of the world economy and find a more efficient means of financing world growth.

r030910a_BOC

canada

Fostering Confidence

dodge

Governor of the Bank of Canada to the Vancouver Board of Trade Good afternoon. It's great to be back in Vancouver and to renew acquaintances at the Board of Trade. I'm going to spend some time today discussing the Bank of Canada's outlook for the Canadian economy and inflation, and how we are responding. But in order to understand the current economic situation, we need to look at some of the extraordinary events of the past year or so and how those events have affected the economy. My last public speech here was almost exactly a year ago. You will recall that, at the time, markets were still in turmoil in the wake of Enron, WorldCom, and other corporate governance and accounting scandals of late 2001 and early 2002. In the United States and Canada--as well as in many other countries--corporations, regulators, and governments were beginning to respond with measures aimed at restoring and maintaining investor confidence. There was the war in Iraq, which is still being played out. The worldwide outbreak of severe acute respiratory syndrome (SARS) was a blow to Canada and to Asia. The human toll of SARS in Toronto was accompanied by a severe drop in Canada's tourism and travel industry. We also had an isolated case of mad-cow disease that blocked our exports of beef and cattle. Many of these export restrictions remain. And the forest fires in British Columbia have caused extensive financial and emotional pain. Meanwhile, the softwood lumber dispute with the United States has not been resolved. And recently, Ontario suffered through North America's biggest-ever power outage. However, the good news is that Canadian consumers and businesses have been remarkably resilient through the past year or two in the face of all these shocks. But these kinds of shocks can have a significant impact on consumer and business confidence, especially when they happen in quick succession. Today, I want to talk about the role that confidence plays in our economy and the measures that are being taken to strengthen it. Trust and confidence are essential if markets are to operate efficiently, so that businesses can finance themselves in good times and bad. And Canadians need to maintain confidence in the macroeconomic framework so that we can all reap the benefits of a smoothly functioning economy. At the Bank of Canada, we spend a lot of time thinking about confidence, because it is important to the conduct of monetary policy, which is focused on inflation targeting. We aim to keep the trend of inflation at the 2 per cent target midpoint of a 1 to 3 per cent range. When the trend strays away from that midpoint, either upwards or downwards, we take action to return it to 2 per cent over the medium term. We do that by adjusting our target for the overnight interest rate. Over the past decade or so, we have successfully kept inflation at around 2 per cent, on average. Here's where the confidence factor enters into the equation: Canadians now expect that inflation will stay near the target--not just for the near term, but into the future. They believe that the value of their earnings and savings won't be eroded by inflation and that the real burden of their debt won't be increased by deflation. That confidence has paid a real dividend in terms of monetary policy effectiveness. Inflation targeting works best when Canadians believe that it will work--in other words, when they have confidence that we will keep inflation near the 2 per cent target. With this confidence, inflation and inflation expectations, as well as interest rates, have become more stable--and this benefits the whole economy. How did we achieve this confidence dividend? By establishing a track record of credible, consistent monetary policy, together with greater accountability and transparency. Like many other major central banks, we have embraced the notion that monetary policy is more effective when people can understand what their central bank is doing and why. That is the motivation behind our semi-annual and , our eight interest rate announcements every year, and our many public appearances and speeches. Of course, monetary policy does not function in isolation. It works best when it is complemented by fiscal policies aimed at avoiding deficits and lightening government debt burdens. Reducing, and ultimately eliminating, the federal deficit in the 1990s helped Canada's international credibility, lowered the risk premium demanded by investors, and gave Canada more flexibility to adjust to changing economic circumstances. And continued fiscal prudence has given us the flexibility to weather the recent economic turmoil rather well. Canadians have now seen the benefits of low, stable, and predictable inflation, and balanced budgets. And they expect that their central bank and their governments will continue to deliver those benefits through responsible monetary policy and prudent fiscal management. So, good monetary and fiscal policies deliver a confidence dividend. But, of course, trust and transparency are crucial factors all across the economy and the financial system. We all know that a business will not last long if it squanders the confidence of its customers, suppliers, and investors. The corporate finance and accounting scandals of 2001 and 2002 hurt more than just profits and portfolio gains. They also sideswiped the confidence of financial market participants. The problems that brought down Enron, WorldCom, and others were not limited to those companies. In fact, the international task force appointed by the International Federation of Accountants--and chaired by John Crow, a former Bank of Canada Governor--correctly notes that Enron was the event which, by its sheer size, awoke many to issues that had been significant for some time. What's encouraging is that this awakening has happened quickly and that considerable effort is being made to address those issues and reinforce trust in the financial system. The Sarbanes-Oxley Act in the United States, for example, is aimed at restoring trust in corporate financial reporting. Other international efforts are underway to improve both reporting and monitoring of public companies. In Canada, federal and provincial governments have been working with the private sector to review and improve the framework governing public companies and capital markets. These initiatives are summarized in a document entitled , which can be found on the Efforts are focused on four areas: improving financial reporting and disclosure enhancing the quality of the audit process strengthening corporate governance and management accountability, and toughening enforcement All of these efforts are aimed at building the confidence needed to allow markets to protect the interests of investors and creditors and to operate efficiently so that businesses can finance their operations at the lowest cost. Let's look first at what's been done to date to improve financial reporting and disclosure. Our system, which has already worked quite well for Canadians, is being strengthened. The proposed new changes are aimed at building confidence while keeping compliance costs relatively low. New guidelines on continuous disclosure obligations of public companies are being drafted by the Canadian Securities Administrators. The goal is to implement them by January 2004. There are also new guidelines from the Canadian Institute of rules to promote the independence of financial analysts. To improve the quality of the audit process, a new Canadian Public Accountability Board will oversee the practices of firms that audit publicly listed companies. Its chairman is Gordon Thiessen, my predecessor as Governor of the Bank of appointed as CEO. The Board will inspect audit firms and will make recommendations on accounting and assurance standards, rules of conduct, and governance practices. Its efforts are being augmented by the new Auditing and Assurance Standards Oversight Council, which is designed to provide perspectives from outside the accounting profession on the oversight and setting of corporate audit standards. Critical initiatives to restore investor confidence are also being taken in the areas of corporate governance and management accountability. Most importantly, many companies have taken, or are taking, action on their own in this regard. Their efforts are being supported by the actions of provincial securities commissions. In January, the Office of the Superintendent of Financial Institutions released new guidelines on corporate governance for federally incorporated financial institutions. In last February's budget, the federal government announced a plan to strengthen the corporate governance standards in the Canada Business Corporations Act and the financial institutions statutes. Institutional investors have also been pushing for better corporate governance practices and management accountability. They have established the of Finance. The Coalition recently published new . There has been a perception that the authorities have not been vigilant in enforcing the rules with respect to fraud and insider trading violations. Recent studies suggest that Canadian firms pay a penalty, in terms of their market valuations, as a result of this perception. That is why it is encouraging to see that steps have been taken to toughen enforcement. The B.C. government has draft legislation to increase fines, give more power to the provincial Securities Commission, and increase the rights of investors. Ontario and Quebec have passed legislation to increase penalties and to broaden the investigative powers of their securities commissions. New guidelines from the IDA include stiffer penalties for securities dealers that break IDA rules. In last February's budget, the federal government announced stronger enforcement measures to combat fraud in capital markets. Amendments to the Criminal Code will make it easier to prosecute lawbreakers. More money will be dedicated to investigating serious cases of capital market fraud. And special teams of investigators, forensic accountants, and lawyers will be set up in key financial centres. These are just some examples of the progress that has been made in Canada by companies, regulators, and governments to build investor confidence in our financial markets. Of course, these efforts also promote better corporate decision-making, greater efficiency, and stronger corporations. That is why it's in the interest of all of us that we make further progress. What should we bear in mind as we continue to make these improvements? First, we must not be lulled into thinking that all the problems are behind us. Unless we remain vigilant and rigorous in our efforts, we risk squandering the good work done so far. Second, while we must apply the same principles to all companies, they must be applied in ways that do not impose undue compliance costs, especially on smaller businesses. Third, while our standards don't have to be identical to those in other countries, they must be seen to be as effective. Canadian and U.S. capital markets are already highly integrated and Canadians (and Americans) have benefited greatly from these open, transparent, and competitive markets. Indeed, since world markets are increasingly integrated, there is a great benefit to having standards that are globally consistent. Right now, there appears to be willingness on the part of authorities in a number of countries to find a reasonable mix of principles and rules for accounting standards and securities regulation that could be Accounting Standards Board are cooperating in such an undertaking, with the support of other countries, including Canada. It is important that Canada continue to work towards sensible global standards. We must identify how our practices should change to fit those standards in order to help our capital markets stay competitive in an increasingly global environment. Markets work more efficiently when they all operate under clear, transparent, and reasonable rules and principles--both internationally, and also within Canada. That is why we at the Bank of Canada encourage efforts to achieve uniform securities law, regulation, and enforcement across this country. Finally, as we set new rules to promote confidence, we must be careful to avoid creating a regime that stifles financial market innovation. We need to create a framework that balances the necessity for effective and enforceable rules to promote confidence with the need to facilitate new and innovative methods of corporate financing to improve the allocation of capital. This type of framework is the best support we can provide for the efficient operation and continued growth of our financial markets. But it won't do the whole job. A sound legal and regulatory framework must be combined with strong and widespread ethical standards. CEOs and other corporate officers must take it upon themselves to communicate with investors clearly, openly, and fairly. Investors, for their part, have a responsibility to take into account all available information. And regulators, politicians, and public servants must all perform their functions in a way that reinforces trust. We all benefit when everyone plays by the rules. Only by reaffirming the integrity of individuals, corporations, and public institutions can we restore and maintain the confidence dividend. Indeed, as I said at the outset, the resiliency of Canadian consumers, investors, and businesses has helped us weather recent economic shocks. Confidence will be critical to strengthening our economy in the months ahead and to a sustained expansion over the medium term. So let me now briefly discuss the Bank's views on the economy and inflation. Since our in July, inflation pressures in Canada have continued to ease. Part of the recent decline in inflation has come from an increase in the amount of slack in the economy. The pace of growth in the second quarter of this year was interrupted by a number of near-term factors, especially SARS and trade restrictions on Canadian exports of cattle and beef because of an isolated case of bovine spongiform encephalopathy (BSE). Growth in the third quarter will also likely remain below the economy's potential because of the remaining trade restrictions on beef and cattle, as well as the effects of the power blackout in Ontario and of forest fires in The prices of some services have been temporarily depressed by SARS. In addition, there has been a greater-than-anticipated reduction in the prices of a number of goods, such as motor vehicles, clothing, and household furniture and appliances. We had expected our core rate of inflation--which strips out the eight most volatile components of the consumer price index, as well as the effect of changes in indirect taxes on the remaining components--to decline below the 2 per cent target. In fact, that happened earlier than the Bank had anticipated. Our core inflation measure is likely to decline somewhat further in the next few months. And we see the trend of inflation remaining below the 2 per cent target for some time. As I've said, part of this lower trend in inflation is a result of the slack in the economy that has opened up in 2003. In addition, prices of many traded goods have fallen worldwide because of excess supply. The rise in the Canadian dollar earlier this year pulled down the price of imported goods, and some retailers have passed on these savings to consumers. As well, vendors are lowering prices to clear their inventory, especially in the automobile sector. Price pressures that we saw from higher insurance premiums earlier this year appear to be dissipating as the year progresses. The total CPI inflation rate has come down from 4.6 per cent in February to 2.2 per cent recently, because of the decline in core inflation and because of smaller increases in energy prices. Swings in energy prices remain a risk to our total inflation outlook in the months ahead, although we assume oil prices of about US$27 per barrel in Notwithstanding the temporary factors that have affected the economy in the second and third quarters of this year, we see indications that the conditions are in place for stronger economic growth. Here's why. Growth of final domestic demand has remained robust, and the adverse effects of the shocks that I just mentioned are beginning to dissipate. The economic rebound in the United States began earlier, and will be stronger, than previously expected. More robust consumer demand and strengthening business investment in the United States should augur well for Canadian exports. We are also seeing a strengthening trend in Asia. As well, the tone of capital markets remains favourable. So, despite current weakness, the accumulation of economic evidence to date reinforces the Bank's view that growth in the Canadian economy will strengthen towards the end of 2003 and through 2004. Last week, we lowered our target for the overnight rate by one-quarter of one percentage point, to 2 3/4 per cent. With this decision, policy interest rates will support the return to levels of economic activity that are consistent with an overall balance between supply and demand in the economy. Achieving that balance will work to return inflation to the target over the medium term. Canadians have been through a lot this year. But each shock also represented an opportunity--to learn, to improve our ability to handle a crisis, and to strengthen our sense of community. No one can predict what kind of shocks our economy will face in the future, but we know that shocks will occur. What's important is that we have a robust economic and financial framework that allows us to deal with those disturbances and to seize opportunities as they arise. It is that strong framework that gives businesses and investors the confidence to take risks and to innovate. We are making progress in building the framework that supports the confidence dividend. During the 1990s, we improved our fiscal and monetary policies. Now, as I have described, we're working to make our financial systems more robust and efficient. These continuing efforts promote confidence. They improve our ability to withstand all types of economic shocks and to capitalize on opportunities.

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canada

Release of the

dodge

Today, we released our October . The reviews economic and financial trends in the context of Canada's inflation-control strategy. , the Canadian economy has been hit by a number of unusual shocks: SARS, BSE, the Ontario electricity blackout, and the severe forest fires in British Columbia. Inflation has also fallen faster and further than expected. This drop in core inflation reflected several unforeseen developments. These included a broad-based weakness in the prices of goods, substantial reductions in the prices of tourism-related services because of SARS, and a slightly faster easing of pressures from auto insurance premiums. The substantial fall in the value of the U.S. dollar added to the weakness in goods prices. We now estimate that there is more slack in the economy than was projected in April. The prospects for near-term growth in the global economy have improved since April, and geopolitical uncertainty has continued to decrease. The near-term outlook for the U.S. economy is much improved. The economy in the euro area is still weak, but prospects for Asia look bright, led by China and India. The Japanese economy is performing better than anticipated. We expect growth in the Canadian economy to strengthen during the fourth quarter and through 2004. On balance, the expansion should be above the rate of potential growth, relying primarily on solid household spending and increased business investment. Stronger growth abroad should boost foreign demand for Canadian products, but this will be dampened by the higher value of the Canadian dollar. Growth is expected to average a little over 3 per cent in the second half of 2003 and 3 1/4 per cent in 2004. With growth above potential, the slack in the economy should be absorbed by early 2005. We expect core inflation to average just over 1.5 per cent for the rest of 2003, and to fall to just above 1 per cent in early 2004, as the effects of earlier increases in auto insurance premiums dissipate. Core inflation should return to 2 per cent by mid-2005, as economic slack is taken up. Total CPI inflation will continue to be importantly affected by swings in the price of crude oil. If prices ease to US$27 per barrel next year, total CPI inflation would likely fall below core inflation in 2004. However, there are significant risks to this economic outlook. These risks relate to the timing and magnitude of global demand, price, and exchange rate adjustments to economic imbalances. In particular, there is uncertainty both about the likely changes in key global exchange rates and their effect on the Canadian economy. There is also uncertainty about the sustainability of U.S. growth beyond mid-2004. We continue to assess the implications of all these developments--both past and future--for output and inflation in Canada, and what this means for monetary policy.

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canada

Opening Statement before the Senate Banking, Trade and Commerce Committee

dodge

We appreciate the opportunity to meet with you twice a year, following the release of our . These meetings help us to keep Senators and all Canadians informed about our views on the economy, and about the goal of monetary policy and the actions we take to achieve it. The last time that I appeared before this committee was after the release of our April . Since then, our economy has been hit by a number of unusual shocks. Because of these shocks and other factors, growth has been weaker than expected. We now estimate that there is more slack in the economy than we had projected in April. The prospects for near-term growth in the global economy have improved since April, and geopolitical uncertainty has continued to decrease. Looking forward, we expect growth in the Canadian economy to strengthen during the fourth quarter of this year and through 2004. On balance, the expansion should be above the rate of potential growth, supported primarily by solid household spending and increased business investment. Stronger growth abroad should boost foreign demand for Canadian products, but this will be dampened by the higher value of the Canadian dollar. Growth is expected to average a little over 3 per cent in the second half of 2003 and 3 1/4 per cent in 2004. With growth above potential, the slack in the economy should be absorbed by early 2005. We expect core inflation to average just over 1.5 per cent for the rest of 2003, and to fall to just above 1 per cent in early 2004, as the effects of earlier increases in auto insurance premiums dissipate. Core inflation should return to 2 per cent by mid-2005, as economic slack is taken up. But I want to emphasize that there are significant risks to this economic outlook. These risks relate to the timing and magnitude of adjustments to global economic imbalances. In particular, there is uncertainty about both the likely changes in key global exchange rates and their effect on the Canadian economy. There is also uncertainty about the sustainability of U.S. growth beyond mid-2004. Let me also stress that we are assessing, and will continue to assess, the implications of all developments--both past and future--for output and inflation in Canada, and what this means for monetary policy going forward. Mr. Chairman, Paul and I will now be glad to answer the committee's questions.

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On Economic Education

dodge

It's an honour to be here with you tonight and to receive this award. One of the great privileges of working in the public sector is interacting with so many outstanding individuals from all parts of Canada and, indeed, from around the world. To be here tonight, surrounded by people I have worked with over the years, and whom I can truly call my friends, is very exciting and tremendously rewarding. The program this evening focuses on the value of public service and the importance of economic and financial literacy for the well-being of Canadians. These two themes have special significance for me, as my career has involved time spent in the public service as well as teaching. My long-standing interest in public service and economic education (indeed, education more generally) was sparked and nourished through my formative years at Ridley College and Queen's University. Ridley's motto is (which roughly translates into (that is, So there it is: wisdom, knowledge, and service. Education focuses on wisdom and knowledge. And education confers an obligation to serve. Others here tonight have explored ways to strengthen the contribution of the public sector to our well-being. But I would still like to make some general remarks on the subject before moving on to economic education. As an economist, the question I most often ask myself is, How can we as a country increase our economic well-being? And when I look around the world, one thing is clear to me. The societies that have been the most successful in improving the welfare of their citizens are those that have provided a social climate in which the dynamism and creativity of individuals and businesses can thrive. They are societies that, in the words of Robert Wright, are able to create "win-win" situations for their citizens. They are the "efficient societies" that Joseph Heath talks about in his book of the same title. To move in that direction, we should, among other things, continue to work towards strengthening the relationship between the public and the private sectors. In particular, it is important that we get the right for those working in government to encourage and facilitate the drive in the private sector towards higher productivity and innovation. But we should also have the right incentives for the private sector to work towards enhancing the public good and the productivity of collective action by governments. The problem is that the private and the public sectors too often act as if they are completely different worlds. So, the difficulty and the challenge is for both to more fully recognize the symbiotic nature of their relationship and thus the importance of interaction and cross-fertilization. The bottom line here is that, as a society, we cannot afford to have the private and the public sectors operating as two solitudes. Individuals and businesses need a well-functioning public sector to ensure, first, the efficient operation of markets and, second, the cost-effective provision of public goods. At the same time, the public sector has a responsibility to understand how individuals and businesses work in order to provide the appropriate framework for the efficient functioning of markets. While this applies to all parts of the public sector, it is perhaps most critical for those of us (including the Bank of Canada) who are responsible for the economic and financial framework within which businesses and individuals operate. A moment ago, I talked about the symbiotic relationship between the public and private sectors. Nowhere is that relationship more important than in the development of human capital through education, training, and learning-by-doing. What I want to explore here is how the public and private sectors can interact to enhance the development of the "economic" capital of individuals. By "economic" capital I mean the ability of individuals to contribute more productively at work--as employees or entrepreneurs--or in their personal lives, as managers of their own economic and financial affairs. To frame this issue in economists' terms, if we are looking to increase our output of goods and services, to become more productive, and to improve our well-being as a nation, we need to augment our investment in physical capital. But, as technology becomes more complex and the global environment more competitive, it is equally, if not more, important that we also augment our investment in human capital. This primarily means improving the skills of our workforce. So it is incumbent on all of us to think hard about how to do this. And about how to give individuals the tools they need to become more efficient at work more knowledgeable and competent in conducting their own affairs. This requires that we focus on both the quantity and the quality of education--whether that education be formal or informal. There is a vast body of literature on the returns to investment in formal education. Much of this literature focuses on the benefits of completing high school and post-secondary education. This kind of analysis generally shows that more formal education leads to higher earnings. Partly because of this analysis, we in Canada have focused on keeping children in school longer and ensuring that they go on to complete post-secondary education. This has paid enormous dividends, and should continue to feature on our agenda. But what we should also consider is how to make schooling more productive. And that is not simply about increasing the resources for education, but also about using more effectively the most critical and most valuable resource in this process--students' time. How do we do that? For starters, in the future, we will have to pay more attention to early childhood development, so that a greater proportion of our 6-year-olds arrive in school ready to learn. I have talked about this at some length in a speech I gave last May to the Sparrow Lake Alliance. We should also focus more on the development of literacy skills in primary grades, given evidence that this really pays dividends later on. But one of the keys to making schooling more productive and relevant for our times lies in linking formal education to practical experience--in other words, "building a bridge to the real world." Learning-by-doing can help build that bridge. These practical forms of education can be delivered by the community inside and outside the school, by parents, and by businesses--in other words, pretty much by everyone in this room here tonight! Unfortunately, this type of education has been largely neglected in the economic literature, which is why I would like to spend the next few minutes talking about it. When I was in Russia in the early 1990s, the thing that struck me was that, even though people had technical skills and some of them also had theoretical knowledge of a market economy, they could not relate to markets intuitively. They had not had the opportunity to absorb informally, by "doing," the skills that are absolutely critical in order to function effectively in a market economy. What does this mean? In part, it means ensuring that our school system does a better job of bringing students to a level of "functional literacy," and I will have more to say about this in a moment. But it also means ensuring that children have an opportunity to really understand how the economy works. Based on my experience in Russia, it is not that the Russians that I worked with had not studied the theory of the market economy at university, but that they did not have the opportunity to experience at an early age how a market economy works, and to learn from that experience. The great advantage that we in Canada have is that most of us do understand intuitively how the market system works. That's because we have had exposure to it while growing up, in one of two ways: as mini-entrepreneurs, delivering newspapers, cutting grass, or babysitting; or as young employees, working at a fast-food joint, or packing and carrying out groceries at a supermarket. As mini-entrepreneurs, we learned that, if we delivered a wet newspaper, we wouldn't get paid. If we didn't show up on time for babysitting, we wouldn't be called again. As young employees, we learned that, if we flipped the hamburger onto the floor, or if were rude to the customer, we would get fired. Importantly, we also learned that there is a relationship between the quality of our service and remuneration. Today, some of these "early commerce" experiences and learning opportunities for children are gone. For example, the morning paper is now delivered by adults who can get up at 3 a.m. And, in the interests of health and occupational safety, some Canadian provinces have labour laws that prevent anyone under 16 years of age from even being on a construction site. Because some of these "early commerce" experiences are gone, and because more are likely to disappear as technology changes, all of us, as parents, employers, and public policy-makers will have to keep thinking of ways to provide new opportunities for our youth to learn by doing. As parents, we can encourage our children to seek out "early-commerce" experiences. As employers, we can offer opportunities to teenagers, as interns or part-time workers. As educators, we can do more to integrate work experiences with schooling. And as public policy-makers, we can ensure that workplace regulations do not prevent youth in school from gaining valuable work experiences. We should all be doing what we can to provide opportunities for high-school kids to work with skilled tradespeople on the shop floor, with computer technicians and programmers in our businesses and offices, and even with economists at the Bank of Canada. As we all know, kids are fascinated with computers. We should build on this fascination to provide opportunities for children to be exposed to the working world. Computers also provide boundless opportunities for interactive learning in our schools, which we should try to exploit more fully. Textbooks still have an important role to play--especially if done well and if properly adapted to Canadian youth. But the Internet, and especially interactive tools, such as games that simulate real-life situations, can be very valuable, effective learning vehicles. Kids can have fun with them and learn a lot in the process--about money and credit, about how the economy works, and about how government and other institutions function. Again, as I said earlier, the problem is that we often tend to think of the world as separate boxes--private sector here, public sector there; academic world here, work world over there. But, in fact, there are great benefits to be had by building bridges between the academic experience and the real world--both the world of business and the business of daily living. We must encourage our youngsters, while still in school, to start familiarizing themselves with the world of banking, finance, and the economy more generally if we want them to be "functionally literate," capable of handling their daily affairs effectively as tomorrow's adult citizens. Individuals with a good knowledge of economic and financial basics can make more informed decisions--to their benefit and to the benefit of the entire economy. Not only can they manage their personal affairs and their households better, they can be more effective and productive members of society. They can also be better citizens, capable of making reasonable judgments on public policy issues that have a bearing on their personal prospects and those of the nation. Now, children are not the only ones who need to learn. In our rapidly changing world, adults too need to keep up with developments and advances in many areas. Learning ought to be a lifelong experience if we are to keep pace with a rapidly changing economic, financial, and technological environment. In this sense, it is important that all of us, as employers, pay greater attention to the management of knowledge and the management of learning. That way, our employees can continue to develop and function effectively in an increasingly complex, demanding environment. Community programs and organizations such as the Canadian Foundation of Economic Education (CFEE) can also provide learning opportunities for youths and adults to improve their economic and financial knowledge. I know that the CFEE, on its own and through strategic partnerships with educators and business, has already done a lot to further economic literacy in schools and among adult Canadians. And it plans to do considerably more as we look ahead. We at the Bank of Canada feel very strongly about the need for improved economic and financial literacy in Canada. An economically more literate public means a more effective monetary policy. When Canadians understand our functions, responsibilities, and policies, particularly with respect to the economy and inflation, they can plan for the future with greater confidence and make better economic decisions. I spoke at the beginning about the need to ensure that the private and public sectors in Canada do not operate as two solitudes, but that, instead, they talk to each other, work together towards national objectives, and do business in a more open and transparent way. It is in this spirit that the Bank of Canada has undertaken important initiatives to communicate with Canadians and to provide economic and financial intelligence. We do this through several vehicles. Our Web site is one. It supplies a wealth of information on economic and financial topics as well as interactive features, such as a graphic depiction of the transmission mechanism of monetary policy and an inflation calculator. We also intend to use our Web site to provide learning opportunities for our kids. For example, we have developed a program called "Inflation Busters," designed to help senior high-school students learn about monetary policy through games, simulations, discussions, and group activities. This is currently available, on-site, in our Currency Museum, but will be up on our Web site in the new year. In addition, we have "Museum in a Bag" kits that teachers and others can use for presentations to students. And on-site, in our Currency Museum, we provide exhibits and interactive games for students to learn about money and inflation. Given the importance we attach to improving economic and financial literacy in this country, we will continue to develop educational programs and materials for students. We will also continue to enhance our communications with the Canadian public at large. Let me conclude. In an increasingly complex and competitive global economic environment, furthering our national economic welfare will depend importantly on the quality of our labour force. But it will also depend on the ability of our citizens to conduct their daily economic affairs competently and effectively. Improving skills and raising the level of economic and financial literacy in Canada will require, first, concerted efforts from all of us--parents, educators, employers, community organizations, and policy-makers--and, second, greater understanding, interaction, and co-operation between our private and public sectors. Organizations like the CFEE have played, and must continue to play, a very important role. You are leading a nationwide initiative--the "Building Futures Program"--to promote economic and financial literacy among Canadians. We at the Bank applaud your efforts. Ladies and gentlemen, thank you very much for being here tonight. Your presence and your friendship over the years is my greatest personal reward.

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canada

Global Challenges, Canadian Opportunities

dodge

Good afternoon, ladies and gentlemen. Let me begin by congratulating OPAS for its work in advancing partnerships between industry and universities. These partnerships will be increasingly important for Canada in the years ahead. Let me also say how honoured I am to receive the OPAS Visionary Award for 2003. When I look at the list of distinguished business leaders who have received this award in the past--Charles Baillie and John Cleghorn, Ted Rogers and Mike Lazaridis, John Sheridan and Jean Monty--I must say that I am absolutely delighted to join them. It's a particular pleasure to receive this award since it marks the first time that it is being given to a person who has made a career in the public sector. This award recognizes that the public sector has an important role to play in promoting the economic health of a country. Far too often, people think that the private sector is solely responsible for creating wealth, and that the best the public sector can do is to redistribute that wealth. The reality is far more complex. That's what I want to talk about today: how those complexities give rise not only to challenges, but also to opportunities. In particular, I want to talk about the challenges posed by the globalization of the world economy, and how Canadians in the public and private sectors can take advantage of the opportunities that the global economy presents. It is certainly nothing new to say that economies have become increasingly globalized. In his 1962 book, , Marshall McLuhan observed that the electronic mass media were collapsing time and space barriers. This enabled people to communicate on a global scale. He coined the term "global village" to describe this change. Of course, even McLuhan couldn't have foreseen the developments in transportation and communications that have taken place over the four decades since his book was published. These developments have converted McLuhan's abstract concept into reality. Satellite technology gives us live broadcasts from anywhere in the world. Ideas are available simultaneously to those who have access to the Internet--and that number continues to grow at an exponential rate. As I stand here today, I can talk to, and hear from, thousands of people across the country at the same time. More to the point, these technological advances have allowed markets, not just of goods and services, but also of ideas, to expand as never before. Think of technology as the enabler of so many of the trends leading towards globalization. Technological advances have slashed the cost and the time it takes to reach across borders. But whether that turns out to be good or bad depends on all of us here today. For while technology enables us to make huge progress, it does not guarantee that this progress will occur. We are all working to understand the impact of globalization on economic and social development. We still have a lot to learn. But one thing is clear: the societies that have progressed the furthest in the last century are those that have embraced the opportunities that stem from being open and adaptive. As I look around the world, I see a number of societies that are seizing these opportunities for the good. What I also see is that those societies that are open both to ideas and to economic competition from abroad are societies that are making the most progress in improving the well-being of their citizens. The technological advances that created McLuhan's global village will continue. While the pace of evolution may speed up or slow down, the world economy seems destined to become ever more global in nature. The question is then, What challenges and opportunities will this present? Let me raise three points, which can serve as the basis for our discussion later. The first is the importance of having a global point of view. The old adage tells us to "think globally and act locally." But we should really think act globally. Let me put that idea in more concrete terms. During the 1980s and 1990s, free-trade agreements with the United States and Mexico focused Canada's attention on the opportunities south of the border. Individual Canadians and businesses have been making the tough adjustments that are necessary to face increased competition and to take advantage of new opportunities. While keeping that continental focus, it is now important that we broaden our sights and focus on opportunities that are opening up in the rest of the world. In a very real sense, the rest of the world is becoming part of our world. With rising incomes, foreigners are acquiring a taste for Canadian products and ideas. At the same time, our tastes and interests are becoming more international. We're all shopping in the same global village market--for goods, for services, and for ideas. Still, this is a large planet with a wide variety of cultures, each with its own perspective and ways of doing things. We Canadians need to continue to broaden our horizons, and to think of ourselves as citizens of that world. That means getting as much global exposure as we can. Canadians are fortunate to have much of the world's diversity reflected across our country at large, and in our universities. Six continents' worth of culture can be found here in one country, sometimes in one city. That diversity allows for mutual enrichment that benefits us all. It is important for those from different backgrounds to learn about the strengths and rich traditions of this country. It is equally important that those of us who were born here, into families with deep roots in Canada, to learn from the backgrounds and cultures of those who come from other continents. By listening to each other, we learn how to listen to the world. By speaking to each other, we learn how to speak to the world. That two-way learning adds a new dimension to the metaphor of the Canadian mosaic--the colours in the mosaic remain distinct, but they blend together to create a vibrant and dynamic picture. In short, Canada's diversity is a real strength, and it will fall to you, the next generation of leaders, to ensure that we use this strength to our advantage. So that's the first message I have: think globally, act globally, and experience the world's diversity. During my career, I have spent a lot of time working with the financial sector in one way or another. From a global perspective, I have seen how people's lives can be made better when countries choose to open their economy to outside investment. So let me now take a few minutes to talk about my second point--the opportunities that lie within the financial sector, in the context of increased openness and globalization. Nowhere have the advances in communication and information technologies had a greater impact than in the financial sector. Technological advances and increased openness have led to greater flows of capital and new methods of financing development. Capital flows have become global, as investors look across national boundaries for the best opportunities for their savings. This has benefited not only countries that receive investment, but also allowed our aging society to generate higher returns on its savings, both private and public. Of course, a country that truly embraces openness in its markets leaves itself open to increased risks. We have all seen what can happen when investment flows into countries with unreliable or underdeveloped financial sectors. We have also seen what can happen when investors send large capital flows abroad without doing their due diligence first. So seizing the opportunities that have come from being more open has required more effective risk management. For savings to flow smoothly around the world, the financial sector has had to evolve, inventing new instruments that facilitate appropriate investments. These trends are likely to continue, and those countries that have financial sectors that can deliver services efficiently, at home and abroad, will have an important advantage. But it is not only the private sector that has made advances in risk management. International financial institutions, such as the International Monetary Fund, have made significant strides in developing a more robust international financial architecture. And co-operation among governments and central banks has played an important part, whether within the G-7, the G-20, or the several specialized groups that have emerged, such as the Financial Stability Forum. These efforts have paid off. Despite several dramatic events that might have rocked financial systems worldwide, the work done by these groups has led to the development of ways to mitigate shocks that, in previous decades, would have been very destructive. But obviously, huge challenges remain both for private financial institutions and for the public sector--nationally and internationally. The public sector in every country must take the necessary steps to ensure that its financial sector is appropriately regulated. And countries need to continue to work together to develop and implement best practices to promote financial stability. Once again, with the trend towards increasing globalization, the importance of the financial sector and the need to ensure that it is appropriately regulated will become even greater. So that's my second message--recognize the opportunities that the world of finance offers not just in the private sector, but in the public sector as well. That leads me to my third point, which is the role of the public sector. As I said earlier, there is a popular but simplistic view that it is the private sector's job alone to create wealth, and that the most the public sector should do is to make minimal attempts at income redistribution. Such a view grossly underestimates the nature and the scope of the public sector's role in promoting a country's economic health. It ignores history, which clearly shows that those societies that have done the most to improve the economic well-being of their citizens are those where the public sector has provided the right social climate for the dynamism and creativity of individuals and businesses to thrive. In practice, this means that those working in government must have the right incentives to provide the appropriate framework--one that facilitates higher productivity and innovation in the private sector. The flip side of the coin is that we should also have the right incentives for the private sector to work towards enhancing the public good and the productivity of collective action by governments. The bottom line is that we cannot afford to have the private and public sectors operating as two solitudes. To work efficiently, individuals and businesses need a well-functioning public sector and the appropriate framework that provides the right incentives. The public sector has a responsibility to understand how businesses and individuals work in order to provide the appropriate setting and support. While this applies to all parts of the public sector, it is perhaps most critical for those who are responsible for the country's economic and financial framework--including us at the Bank of Canada. Creating and maintaining this framework, in the context of a changing global environment, will be a daunting challenge indeed. Part of that challenge will come from developing a public policy framework that has two dimensions. First, it must have enough consistency with the rest of the world so that we remain open to competition and to the flow of ideas from abroad. Second, our policy framework must create unique strengths for Canada so that our public sector is a source of competitive advantage and does not detract from our other advantages. What does this mean for students in terms of opportunities for tomorrow? It means that you should be thinking of careers that combine public and private sector experience, as well as academic. The lessons you learn in one place will give you a greater ability to work and contribute elsewhere. And this diversity of experience will give you a set of skills that you will find are in great demand. And it really doesn't matter where you begin. For example, if you want to make a real contribution as an academic, some experience in either the private or the public sector will be tremendously important in letting you bring more to the table as a teacher. In the private sector, academic or public sector experience will let you view the world strategically, which is difficult if your experience is confined to just one firm or industry. And if you want to contribute in the public sector, as I have already said, it is extraordinarily important to have private sector experience so that you can better understand how business functions. Why? Because, in the end, public policies must foster the effective and efficient delivery of public goods and provide the incentives to encourage private activities that will create positive outcomes for the benefit of everyone. Developing such policies is much easier said than done. But in the last 15 years, we in Canada have made considerable progress in our macroeconomic policies. The challenge in the future will be to maintain that progress and to make comparable progress in microeconomic policies. Progress will need to come from the federal, provincial, and municipal levels of government, in such diverse areas as labour market policies, intellectual property law, health, environment, and infrastructure investments. This is where challenges lie, but it is also where opportunities present themselves. Having mentioned opportunities, let me close by saying a few words about the opportunities for Canada and young Canadians in the years ahead. I talked earlier about the great advantage of Canada's cultural mosaic. In a globalized world, this provides a real opportunity because it gives us the ability to understand what is going on elsewhere on the planet, while at the same time drawing on the real strengths we have in terms of our unique Canadian social and economic culture. When I travel abroad, I am always amazed by how welcoming foreign businesses and public entities are towards Canadian participation. At the same time, I am also amazed by how little effort we sometimes make to take advantage of this good will. As young people, you are going to have to capitalize on these opportunities. So I hope that you will take my three messages to heart: have a global perspective, recognize the importance of the financial sector, and understand the crucial role of the public sector. With the global economy continuing to evolve, it will become increasingly important to act on these ideas, no matter where your career path leads you.

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canada

Low and Predictable Inflation and the Performance of Canadian Labour Markets

dodge

Governor of the Bank of Canada to the Memorial University of Newfoundland The goal of Canadian monetary policy is to contribute to solid economic performance and rising living standards. The best way we can do this is by keeping inflation low, stable, and predictable. This has important implications for labour market performance. Although inflation is now low, stable, and predictable, this has not always been the case. Indeed, in the 1970s, inflation was high, unstable, and unpredictable. This led to the establishment of the Tonight, I would like to reflect on what we have learned since the AIB closed its doors almost 25 years ago to the day. I'll begin with a brief discussion of the theoretical foundation for the role that inflation expectations play. Expectations are important for both price- and wage-setting, but I will concentrate on the wage-setting aspects. I would next like to discuss the Bank of Canada's inflation-targeting framework, which serves to anchor inflation expectations. I will also address the issue that our inflation target may be too low because nominal wages are downwardly rigid. And I will discuss Canada's labour market performance and how it has improved substantially with the change in our monetary policy framework since 1991. Finally, I will say a few words about the conduct of monetary policy today, and offer some brief concluding remarks. Let me begin by going back to the 1970s. When we started that decade, the inflation rate was around 3 per cent. But it quickly rose to over 12 per cent in the span of three years. Not only was inflation rising, it had become more variable, creating uncertainty over the future rate of inflation. This made it difficult for workers and employers to decide on the appropriate rate of inflation to incorporate into wage settlements. In this environment, it was not surprising that some workers demanded wage increases, both as compensation for past inflation and as a precaution against future inflation. And many employers granted them. When they did not, workers often went on strike. On average, in the 1970s, over seven million person-days were lost to strikes each year. This was an enormous loss of output. High and variable inflation also triggered large wage settlements. This fuelled inflation expectations and contributed to both a wage-price spiral and a wage-wage spiral. In the economics literature of the day, there was a lot of confusion over the role that inflation expectations play in the wage-formation process. The literature stressed that workers and unions sought to catch up with inflation that had already occurred. But against this background, Milton Friedman argued that forward-looking expectations were more important in wage bargaining than catching up with past inflation. In particular, he stressed that workers bargain over real, and not nominal, wages. When signing a new contract, workers demand higher wages if they expect prices to increase over the life of the contract so as to preserve their real wages. Thus, he argued that it is not the recently observed rate of inflation, but rather the expected rate of inflation that plays a prominent role in wage setting. But with inflation rising and becoming more variable, there was considerable uncertainty over what the future rate of inflation would be. Indeed, high and variable inflation meant that there was no anchor for inflation expectations, and this lack of an anchor led to considerable turbulence in wage setting. Although contractionary macroeconomic policies were required to lower the double-digit inflation rate, such policies operate with a lag and would have resulted in higher levels of unemployment during the transition period. One train of thought in the early- to mid-1970s was that temporary wage and price controls could alleviate the negative impact on unemployment by ensuring that, over a period of time, wage- and price-setting behaviour would become consistent with the more restrictive macroeconomic policies. The Anti-Inflation Board was therefore established to try to anchor inflation expectations through wage and price controls. The objective was to ensure that wage growth was in line with a set of targets for inflation of 8, 6, and 4 per cent over a 3-year period. This was done with the assumption that monetary and fiscal policy would be set to be consistent with such a result. The imposition of wage and price controls was very controversial, to say the least. One wellknown academic even described them as "how to do a lot of harm by trying to do a little good." There were three principal arguments against the use of controls. The first was that they would create distortions in the economy and that the longer the controls were in place, the greater these distortions would grow. The second was that controls are very difficult and costly to administer. Third, there was doubt as to whether the controls could really engineer a permanent reduction in inflation. In particular, would policy-makers place too much emphasis on controls and not enough on supporting macroeconomic and structural policies? The empirical evidence that followed suggested that the controls were responsible for a reduction of about 2 to 3 percentage points in wage increases. Ultimately, however, neither monetary nor fiscal policy was restrictive enough to maintain a lower rate of inflation, although, at the time, monetary policy was thought to be sufficiently tight. Subsequent research at the Bank, however, showed that the links between movements in the narrow monetary aggregate M1 and changes in prices were not as close in the short run as had been expected. And the size of the short-run changes in interest rates required to keep the money stock within its target band were not enough to have much of an impact on real output or prices. The fact that the link between any monetary aggregate and inflation did not prove to be very tight over time led the Bank to suggest in 1988 that it should focus directly on price stability as the anchor for monetary policy. This led to the introduction of the inflation-targeting framework in 1991, one important objective of which is the anchoring of inflation expectations. We did this because we had learned that, once inflation expectations are anchored, they contribute to more stable output and employment growth, allowing for more durable gains in real income over time. In February 1991, the Bank and the Government of Canada jointly announced a series of inflation-reduction targets. These targets were aimed at gradually bringing the 12-month rate of inflation down to 2 per cent, the midpoint of the inflation-control target range, by December 1995. Given the empirical evidence for Canada, which showed that the appropriate horizon for aiming at an inflation target was about 1 1/2 to 2 years, the first formal target was set for December 1992 at a rate of 3 per cent (plus or minus 1 per cent). Since that initial agreement, the inflation target has been extended three times, with the latest agreement covering the period to the end of 2006. In each case, the midpoint of the inflation-control target range has been maintained at 2 per cent. The measure of prices chosen for the target was the consumer price index (CPI). This index is well understood by workers, unions, and employers, partly because of its use in cost-of-living (COLA) agreements. The operational guide for the Bank, however, is core inflation. reason for using a core inflation measure is to focus on the underlying trend in inflation on which monetary policy can have an effect. Given the lags between monetary policy actions and their impact on inflation, shocks that are expected to dissipate within that time frame are generally outside the scope of central bank action, unless such shocks have an impact on inflation expectations. Since the adoption of inflation targeting, the inflation rate has fallen significantly. Indeed, by January 1992, inflation was already close to 2 per cent, down from its average of over 5 per cent between 1988 and 1991. Although at times it has approached the boundaries of the range, and exceeded it earlier this year, over the medium term, the average inflation rate has remained around 2 per cent. Indeed, over the six-year period from 1996 to 2002, it was just under 2 per cent. Moreover, not only has the inflation rate fallen, it has become more stable. In other words, movements away from the target have not been persistent. When inflation has moved away from the midpoint, it has shifted back towards 2 per cent as the shocks have worn off. Not surprisingly, the Bank has undertaken considerable research to better understand the dynamics of inflation. One strand of this research has examined the persistence of inflation by allowing for potential changes in inflation regimes. The results show that the inflation process in Canada can be divided into three distinct regimes: one with extremely high persistence and high inflation rates, one with fairly low persistence and moderate inflation rates, and one with low persistence and low inflation rates. In the first regime, which prevailed in the 1970s and early 1980s, when inflation moved up, it tended to stay up. Since that time, the economy has moved into the second and third regimes, with inflation becoming much less persistent. Indeed, persistence fell considerably over the 1980s and essentially disappeared in the late 1990s. This decline in the persistence of inflation was the result of the change in the monetary policy regime that has fostered more forward-looking inflation expectations. Traditional analysis of the inflation-unemployment trade-off using the Phillips curve, however, has typically modelled inflation expectations as the weighted sum of past lags of inflation. More recent research has therefore moved towards embedding forward-looking expectations in this analysis. Crosscountry analysis covering OECD inflation-targeting countries indicates that, since the adoption of the targets, inflation expectations have become more forward-looking, and that they are anchored around the official targets. In our own empirical research for Canada, we have also found that expectations have become more forward looking. Another fact about the inflation process in Canada is that inflation has become less uncertain--in other words, more predictable. After the oil-price shocks of the 1970s, inflation variability rose sharply. Although it fell during the years when the AIB was in operation, it rose again in the 1980s. However, between the 1980s and the latter part of the 1990s it dropped almost fourfold. This reduction in inflation variability linked to the low-inflation environment allows people to take a longer-term view with respect to their planning, which leads to a better allocation of economic and financial resources. In Canada, policy credibility has clearly increased over time. Work carried out using data to the mid-1990s suggested that, while central bank credibility had improved in inflation-targeting countries, it was difficult to say whether explicit inflation targets had made any additional contribution to that credibility. More recent evidence suggests that the inflation target has, in fact, played an important role in enhancing credibility. For example, since the mid-1990s, longterm inflation expectations have fallen close to the midpoint of the target range, which is also close to the mean of inflation. In Canada, expectations of forecasters and businesses began to fall in line with the targets soon after they were introduced. At first, this was for expectations at the 2-year horizon. Gradually, this lengthened to 6 to 10 years. By 1997, long-term expectations of inflation in financial markets, as expressed by the difference between 30-year yields on conventional and index-linked bonds, had fallen in line with the 2 per cent target midpoint. They have been firmly anchored at that level ever since, despite the various shocks that have hit the Canadian economy. This is in strong contrast to earlier periods in our history when future expectations had been fairly tightly linked to recently observed inflation rates. And this change in behaviour is not because there have been fewer economic shocks. In fact, over the past few years, we have witnessed economic crises in Asia and Russia, oil-price shocks, and the tragic events of 11 September 2001 in the United States. Despite all of this, inflation expectations have remained well anchored. This is in absolute contrast to earlier periods. And it points to the important role that monetary policy plays in anchoring inflation expectations. In general, there is real evidence to support the argument that, with the inflation target becoming increasingly credible, the whole nature of the inflation process has changed. The short-run response of inflation to measures of excess demand and supply appears to have fallen. And similarly, the response of inflation to relative price shocks, such as changes in the exchange rate and energy prices, also seems to have declined. These changes have had the effect of reinforcing the stability of the inflation process and, therefore, of inflation itself. And this, in turn, has produced a more stable macroeconomic environment. Moreover, by keeping average rates of inflation close to the inflation target, and by indicating that the Bank will act symmetrically to shocks that drive inflation away from the target in either direction, we have been able to contain inflation expectations. Indeed, under a credible monetary regime, there should be fewer forecasting errors in the bargaining process, since uncertainty about inflation is low. Thus, there is less need for workers to demand additional wage increases to protect themselves against the risk of unexpectedly high future inflation--increases that can contribute to a wage-price spiral. Nor are employers as likely to offer such increases. Similarly, both employers and workers can look through periods when inflation is below the target. Thus, wage-setting becomes focused on actual developments in the particular sector. And workers and unions are able to place greater emphasis on real factors, such as productivity, that will help to boost income and living standards. Now I would like to turn to concerns by some analysts that the level of the inflation target is set too low. Inflation targets, whether in Canada or elsewhere, have typically not been set at zero. One argument for excluding zero is that there is downward rigidity in nominal wages. More specifically, it says that a little inflation is needed to "grease the wheels" of the labour market because nominal wages are downwardly rigid. Thus, it is argued, that the target for the inflation rate should be in the 2 to 4 per cent range to facilitate adjustments in the real wage. You will recall that, in Canada, the target range is set at 1 to 3 per cent. One reason behind this argument is the belief that inflation allows firms to provide real wage increases to workers whose productivity is rising, while reducing real wages to less-productive staff without having to cut nominal wages. Therefore, for firms to achieve the desired adjustment in real wages in the face of adverse demand shocks, inflation would have to be above zero. Otherwise, unemployment would rise, perhaps at an increasing rate, as inflation approaches zero, because firms would have to resort to layoffs to keep wage bills at their desired level. Why might nominal wages be downwardly rigid? This could result from money illusion--for example, workers refusing to accept nominal wage cuts when, in fact, they may have suffered a similar reduction in real wages in the past because of inflation. Firms might also be reluctant to cut nominal wages because of notions of fairness. They might also have concerns that such cuts would adversely affect the quality of candidates they seek to attract, or lead to higher quit rates. On the face of it, downward nominal wage rigidity would seem to have little relevance for Canada. As I will discuss in more detail later, in the late 1990s, the unemployment rate fell sharply even though inflation had stabilized around 2 per cent. The question is how far above zero should the inflation target be set? This is an empirical question about how important downward nominal wage rigidity is in practice. Is there evidence that there is so much resistance to nominal wage cuts in Canada that our inflation target of 2 per cent is too low? In the period leading up to the May 2001 renewal of the latest inflation target, the Bank undertook considerable research using a variety of tools and addressing a number of hypotheses to determine the extent of nominal wage rigidity in Canada. One way to examine the likely impact of downward nominal wage rigidity is to estimate what the wage distribution would look like in the absence of rigidity. On balance, this line of research demonstrates that downward nominal wage rigidity has not been an important feature of the Canadian labour market. Relatively more wage freezes do occur at low inflation rates, but this would be expected anyway, since the mean of the wage-change distribution varies with the rate of inflation. Econometric estimates suggest that the net effect of downward nominal wage rigidity on wage growth was in the range of only 0.07 to 0.18 per cent in the unionized private sector in the 1990s. It is important to note that what might appear to be downward nominal wage rigidity could also be a form of menu costs. By this, I mean the fixed costs associated with changing pay scales, a task that firms may be reluctant to undertake unless a large wage adjustment is required. estimates of rigidity that I just mentioned incorporate these effects. Another strand of research has examined the employment effects of downward nominal wage rigidity in Canada. There are relatively few papers on this subject. Moreover, estimates of the employment impact tend to be sensitive to model specifications, which are typically reducedform equations linking changes in employment growth to changes in output growth and to a variable that measures wage cuts or freezes. On balance, however, these studies do not support a significant employment impact. Most of the data used in the research I have cited come from wage-settlements in the unionized sector, which begs the question as to whether the results would hold more generally for all workers in the economy. Evidence suggests that the wage-settlements data tend to overstate the amount of nominal wage rigidity in the economy, since base wage rates for workers outside the unionized sector are typically more flexible. For example, small firms tend to have more flexible pay practices, while variable compensation, including adjustments to non-wage benefits, also allows for more nominal wage flexibility. In addition to using micro-level data to examine downward nominal wage rigidity, aggregate data can also be used to examine the effect of unemployment or the output gap on inflation--in other words, the slope of the Phillips curve. If downward nominal wage rigidity exists, then the slope of the Phillips curve should have become flatter in the period of excess supply during the low-inflation period of the 1990s. Evidence from this research, however, does not support this hypothesis. Another line of argument that has been tested using aggregate data has been referred to as "nearrational" wage setting. It suggests that workers and firms might not worry as much about inflation when it is at low levels and, therefore, do not fully incorporate small changes in inflation into their inflation expectations. Supporters of this line of reasoning argue that unemployment can be sustained below the equilibrium rate over a range of low and moderate rates of inflation. Thus, there is some positive inflation rate that should be chosen as the target. One problem with this argument is that it is difficult to imagine why agents would continuously ignore the negative impact of low inflation. Although the cost might be small in a single period, it would clearly accumulate over time, which should induce them to become fully rational in their wage- and price-setting. There is little Canadian evidence in this area. That which exists, however, suggests implausibly high estimates of near-rational behaviour when inflation is at 3 per cent. In summary, there is little substantive evidence to suggest that downward nominal wage rigidity or near-rationality in wage-setting impedes appropriate adjustment at our currently targeted inflation rate of 2 per cent. But equally, there is little substantive evidence to suggest that a target lower than 2 per cent would lead to a measurable improvement in economic behaviour. Thus, because inflation expectations have become well anchored around 2 per cent, maintaining the 2 per cent target was judged to be appropriate. In this part of my lecture, I would like to discuss how the labour market functions better than it did a decade ago and, indeed, better than when the AIB was wrapped up in 1978. As I said, inflation has become low, stable, and predictable. The impact of this development can be seen in the path of nominal wages. Indeed, the growth in nominal wages has also slowed, along with falling inflation. Since the introduction of the inflation target, average annual growth in nominal wages has been about 4 per cent, down from the approximately 14 per cent average growth recorded in the 1970s and the 8 per cent witnessed in the 1980s. In addition, the distribution of wage changes has narrowed as inflation has become more predictable. There are at least a couple of reasons why this might be the case. First, research points to a significant link between higher inflation and greater inflation uncertainty. Where there is increased uncertainty about inflation, firms and workers may set inflation adjustments incorrectly, creating relatively more dispersion in wage changes. Thus, as uncertainty about inflation falls in line with declining inflation, so should the dispersion around average wage changes. I will have more to say on inflation uncertainty in a few moments. Second, a lower cross-sectional variation in wage settlements could arise because downward nominal wage rigidity would impose a floor on the distribution. As I have already discussed, this seems unlikely to have had a significant impact in Canada. By contrast, others have argued that the variability of relative wage changes decreases when inflation rates accelerate. Essentially, the argument here is that higher inflation leads to a greater demand for indexed wage contracts--either explicitly through COLA clauses or implicitly when setting wages with employers--to protect workers from unexpected increases in inflation. Clearly, what actually happens to the dispersion of wage settlements when inflation and inflation uncertainty decline is an empirical proposition. A stylized fact of the Canadian economy is that, in the unionized private sector, the variance in wage settlements fell by about two-thirds as inflation declined. Although some have suggested that this could be because of greater downward nominal wage rigidity, this is not the case. We know this because the variability of wage changes above the median has also fallen significantly. Moreover, it has become apparent that wages no longer react quickly to large changes in relative prices such as those generated by oil-price shocks or, more recently, by auto insurance premiums. This is a very important contribution to labour market performance in Canada because it suggests that relative wages tend to better reflect demand and supply conditions in particular markets. There is, however, very little research in this area, and it is one where more in-depth analysis would be useful. Another development in the 1990s was the relatively sharp increase in the average duration of labour contracts in the private unionized sector of the economy. Compared with the 1980s, the average duration increased by almost 10 months. Reduced inflation uncertainty is one explanation for this. As the variability of inflation has fallen, this has likely lowered the amount of uncertainty in the economy and has led to labour contracts that are longer in duration. Theoretical work in the late 1970s and early 1980s showed that lower uncertainty about inflation should result in longer contracts. Empirical evidence for Canada gathered in the early 1980s was consistent with this theoretical work. Using several measures of inflation uncertainty, researchers at the Bank of Canada have confirmed a robust negative relationship between inflation uncertainty and the duration of union contracts in the private sector. In other words, as uncertainty about inflation has fallen, the duration of labour contracts has lengthened. Indeed, it has been estimated that each percentage point decrease in inflation uncertainty increases contract length by about two months. positive implication of longer labour contracts is a savings in the resources dedicated to negotiation, or in other words, lower transactions costs. Another interesting finding is that the proportion of COLA clauses in private sector contracts has not changed much over the last decade, even though contract duration has increased. unions have bargained for such clauses, they appear reluctant to give up them up, even if they are seldom triggered. Unions, of course, bargain for more than just wages and cost-of-living agreements. In the early 1990s, they became more preoccupied with job security for their members in the face of weak aggregate demand, increased contracting out, and the move towards hiring temporary staff as employers sought to contain costs. Thus, uncertainty over developments in the real side of the economy--which I shall refer to as real uncertainty--may have become more prominent at that time. Work at the Bank, however, finds no empirical support for the proposition that this type of uncertainty affects contract length. Another concrete benefit of low, stable, and predictable inflation has been less disagreement over future inflation, leading to fewer strikes and, therefore, lower output losses. The number of person-days lost to strikes peaked in the early to mid-1970s when inflation was at double-digit levels and uncertainty was high. Since then, the number of days lost has trended down. Between the 1970s and 1980s, the number of days lost to strikes fell by about one-third. In the 1990s, it declined again by over 50 per cent relative to the previous decade. This represents a clear gain for workers and, indeed, for all Canadians. , and very importantly: greater stability has also been observed in output growth. Several reasons have been put forward for this, including better inventory management. The conduct of monetary policy has certainly been an important factor. By responding promptly and symmetrically to demand shocks, and by focusing on the underlying trend of inflation-- thus ignoring temporary inflation shocks unless they feed into inflation expectations-- monetary policy will produce greater stability in output growth. Alongside greater stability in output growth, there has been more stable employment growth and less volatility in the unemployment rate. On the margin, other factors may have been at play as well. For example, there is evidence that the use of variable forms of compensation has increased over time. Variable compensation programs allow firms to adjust pay in the face of adverse shocks, rather than resorting to layoffs. This contributes to greater employment stability. It is also worth noting that changes in compensation practices that link individual performance to that of the firm also move in the direction of bolstering productivity growth. Greater stability in output growth has paved the way for a labour market with rising labour force participation rates, higher employment/population ratios and lower unemployment rates. Indeed, both Canada's participation rate and the employment/population ratio hit record high levels this year. Moreover, this rising employment/population ratio has helped to boost our standard of living, and is a reflection of just how well the labour market is functioning. Newfoundland has also seen its aggregate labour force participation rate and employment/population ratio rise to record levels , although they still remain below the national average. The current situation is in contrast to that of the late 1980s and early 1990s when Canada faced a number of economic challenges that required painful policy action and difficult adjustments. Among these, inflation had to be lowered and public sector deficits had to be tamed. I discussed the linkages between monetary and fiscal policy elsewhere. Overall, an extraordinary effort was made to get the macroeconomic framework--that is, both monetary and fiscal policies-- right, and we are now reaping the benefits of those efforts. To be sure, a number of other difficult policy choices have also contributed to better labour market performance, although it is difficult to isolate the specific contribution of each one of them. For example, there were reforms to labour market institutions such as changes to the Unemployment Insurance program. Trade has also been opened up to improve the efficiency of markets, namely through the FTA and NAFTA. The main point here is that all of these policies have worked in the same direction--towards improved labour market performance. Now let me turn to prospects for income growth. An important determinant of aggregate income growth is labour-productivity growth. On an economy-wide basis, productivity growth averaged about 1.4 per cent between 1970 and 1997. It then picked up, accelerating to 1.8 per cent, on average, between 1997 and 2002. This is still well below that in the United States, but the acceleration is a promising sign. Indeed, increased investment in machinery and equipment as well as in communications technologies in the late 1990s, combined with sound economic policies, will likely see productivity gains remain strong in the near and medium term. Furthermore, as I discussed earlier, the Bank of Canada plays an important role here by keeping inflation low, stable, and predictable, which is conducive to innovation, risk-taking, and investment. But keeping inflation at the 2 per cent target is not an easy task. And there are times when inflation temporarily moves away from the target because of unexpected developments and shocks. Recent experience provides a case in point. In early 2003, inflation was well above the 2 per cent target, and short-term inflation expectations had edged up. Although inflation was being pushed up by special factors, such as sharply higher oil prices and auto insurance premiums, there were also signs that strong domestic demand was working to broaden price pressures. Since then, however, the economy has weakened more than expected, and core inflation has fallen to 1.8 per cent. And virtually all measures of inflation expectations have decreased. Although we at the Bank had expected core inflation to ease, several unforeseen developments ha ve caused this to occur sooner, and to be more pronounced, than we projected last April. These have included a slightly faster easing in pressures from insurance premiums and price discounting in certain service industries because of SARS. As well, the U.S. dollar has fallen substantially, adding to the recent weakness in goods prices in Canada. The average value of the Canadian dollar in terms of the U.S. currency in recent months represents a sharp increase from 69 cents in April. Clearly, the appreciation of the Canadian dollar is an important factor that we at the Bank are considering carefully as we evaluate the economic situation and the risks attached to our outlook. At the same time, we continue to assess other developments, notably a somewhat stronger-thanexpected recovery in world demand. In this context, if it looked as though the appreciation of the Canadian dollar would more than offset the effects of stronger world demand, or that world demand was weakening, we would act to stimulate domestic demand with the intent of returning inflation to the 2 per cent target over the next 18 to 24 months. Such action would take the form of lowering interest rates. As I said in my recent testimony before the Senate Banking, Trade and Commerce Committee, the Bank continues to assess the implications of all past developments? domestic and external? for output and inflation in Canada. This kind of analysis and the typically difficult assessment of future developments are what we at the Bank have to consider at each monetary policy decision date. Let me now conclude. Changes in the conduct of monetary and fiscal policy, as well as increased emphasis on structural policies, have worked together to produce a better-functioning labour market in Canada. The Bank's particular contribution has been to anchor inflation expectations at the 2 per cent target. Because our monetary policy framework reduces uncertainty about inflation, it helps both firms and workers make better planning decisions. Thus, wage bargaining can be concluded by focusing on factors that are relevant to wage setting, such as productivity growth, without the noise of variable inflation. This, in turn, leads to a more efficient bargaining process with lower transactions costs and less loss of output, as well as to a more productive allocation of labour in the economy. This has contributed to an economic environment where there are rising employment/population ratios, higher participation rates, and lower unemployment rates. . Conference Board of of Canada. des sciences economiques, Universite du Quebec a Montreal, July. , edited by M. Feldstein, , cibles d'inflation sur la credibilite de la politique monetaire." Bank of Canada Working

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canada

Past Adjustments and Future Trends in the Canadian Economy

dodge

Governor of the Bank of Canada to the London Chamber of Commerce Good afternoon, ladies and gentlemen. I'm happy to have this opportunity to visit the Forest City and to finally honour your long-standing invitation to address you. When giving a speech near the end of a year, it is common practice to look back over the past 12 months, consider what we have learned from the events and experiences of the year, and think a bit about what might lie ahead. I became Governor of the Bank of Canada in 2001 and, since that time, I have found myself saying at the end of each year, "Well, we won't see another year like that again." In 2001, we saw the bursting of the tech bubble and the 9/11 terrorist attacks in the United States. Last year, we had the fallout from Enron and other examples of corporate malfeasance, as well as the growing threat of war in the Middle East. And our currency dropped to an all-time low against the U.S. dollar. Not to be outdone, 2003 has also had more than its share of momentous events that had an impact on the Canadian economy. The list seems almost Biblical: war, pestilence, in the form of SARS and mad-cow disease, fires, floods, a hurricane, and a power outage. This year also brought another type of shock to keep Canadians preoccupied, and that is the sharp rise of our currency in foreign exchange markets. The Canadian dollar has jumped from under 64 cents U.S. at the start of the year to over 76 cents at the end of last week--an unprecedented movement. The Bank of Canada has closely followed the economic effects of all these events, including the rapid movement of the Canadian dollar. But to better understand what has happened in the economy over the past year or so, I will place my comments in the context of longer-term economic trends. Let me start by recalling the state of our economy as the 1990s began. Although inflation had come down from the very high levels seen in the early 1980s, it was still quite high by today's standards. Several approaches had been tried to bring about an environment of low, stable, and predictable inflation. These included wage and price controls and the targeting of the money supply. But none of these methods provided a suitable medium-term anchor for inflation expectations. This made it difficult for individuals and businesses to form long-range plans with any degree of certainty. On the fiscal side, the picture was pretty grim at the start of the 1990s and getting worse. Public sector deficits would eventually peak at around 8 per cent of Canada's GDP, and public debt levels were continuing to mount. Clearly, the situation was not sustainable. Adjustments were urgently needed. The first of these adjustments came in 1991, when the Bank and the Government of Canada agreed to adopt a series of explicit inflation-control targets. The agreement called for an inflation target--defined in terms of the annual rate of increase of the consumer price index--that descended gradually to 2 per cent, the midpoint of a 1 to 3 per cent range. That initial agreement has been extended three times, with the latest agreement covering the period to the end of 2006. In each case, the midpoint of the inflation-control target range has been kept at 2 per cent. This framework has worked well--better than might have been expected. By January 1992, inflation was already close to 2 per cent, and from the end of 1994 to today, inflation has averaged almost exactly 2 per cent. Moreover, not only has inflation fallen, it has become more stable. Indeed, the trend of inflation--as measured by what we call core inflation--has stayed within the target range almost continuously for the past 10 years. Just as importantly, we found that, after a few years of inflation targeting, the inflation expectations of Canadians fell into line with the 2 per cent target. And expectations have remained close to the target in recent years. The point of all this is that we have been successful in using monetary policy to create an economic environment of low, stable, and predictable inflation. With a credible monetary policy, the whole nature of the inflation process has changed. Inflation itself has become more stable and, in turn, this has led to a more stable and betterfunctioning economy. The second big adjustment began in earnest around the middle of the 1990s. As I said before, at that time, Canada was facing an unsustainable fiscal situation. Compounding this immediate fiscal problem were the looming challenges posed by our aging population. Spending had to be put on a viable long-term course, and the ratio of public debt to GDP on a steady downward track. By the middle of the decade, governments--federal and provincial--had begun to take the painful steps to balance their books and reduce their debt burdens. It did not take long for the benefits of those tough decisions to materialize. In most jurisdictions, the vicious circle of rising deficits and debts became a virtuous circle of balanced budgets and falling debt burdens. This fiscal adjustment helped Canada's economic policy credibility and reduced the risk premium that investors demanded on Canadian government bonds. Not only did lower interest rates reduce debt-servicing costs, they stimulated economic growth, which brought in more revenues for governments. The federal government recently announced a sixth consecutive surplus in its budget. Our public pension plans are once again on a sound footing. The federal debt-to-GDP ratio has fallen to about 44 per cent, from close to 70 per cent at its peak. The ratio of total government liabilities to GDP has declined from a peak of about 100 per cent to about 80 per cent, according to the OECD. And Canada's Triple-A credit rating has been restored. I don't mean to suggest that inflation targeting and fiscal adjustments were the only factors behind Canada's overall improved economic performance. Of equal importance was the difficult restructuring that had to be done in the wake of free-trade agreements in the 1990s. Businesses and employees made some difficult adjustments. None of this was easy, but it did leave Canada's economy in a better position to grow sustainably and to handle economic shocks. Our economic record over the past few years, even in the face of all the events I have mentioned, is testament to that. Now, let me talk about the role of the Canadian dollar in this long adjustment process. On a day-to-day basis, there are a number of factors that can drive movements in the value of the Canadian dollar in foreign exchange markets. But my intention is to stick to a discussion of long-term trends. From this perspective, there were really two major factors at work on the currency in the 1990s. Governments were cutting spending to address their fiscal problems, and that led to a reduction in domestic demand. On top of this, commodity prices were down sharply in the second half of the decade. Historically, there has been a fairly strong correlation between the prices of non-energy commodities and the external value of the Canadian dollar. In the face of these two factors, Canada's floating exchange rate did its job as a "shock absorber" for the economy. How? Given the tight fiscal policy of the time, the lower dollar--in the context of an easing in monetary policy--played an appropriate role in encouraging foreign demand for Canadian products at a time when domestic demand was weak. Further, while the lower currency cushioned the shock of falling commodity prices on resource producers, it also boosted the profitability of other sectors that were able to expand in the wake of free-trade agreements and strong foreign demand. This helped to facilitate the transfer of resources within the economy from sectors that were shrinking to those that were growing. The depreciating Canadian dollar of the 1990s also changed the relative price of labour and capital. At the time, there was a fair bit of excess labour in the economy, because of the structural adjustments that were taking place. The lower dollar raised the cost of machinery and equipment relative to labour. And that made it easier for some of the labour that was released by the shrinking sectors of the economy to be absorbed by those that were growing. That's a quick look back at the 1990s. So what can we expect in the future? What are the major issues that we will have to grapple with in the coming decades? What adjustments will be needed? I don't have a crystal ball, but a couple of issues seem fairly clear to me. As I already mentioned, the first important issue is demographics. The Canadian economy must prepare for the retirement of the baby boomers. Under current projections, Canada's working-age population--those 15 to 64 years of age--will start to decline in about 15 years. Given this demographic outlook, there are two points to be made. The first is that we need to continue to lower our ratio of public debt to GDP. This will help to ensure that Canada will be able to support its growing elderly population. The second point is that we will need to make adjustments to help us deal with a labour force that will soon be shrinking in relative terms and, ultimately, in absolute terms as well. What kinds of adjustments? We will need to make sure that the older segment of the working-age population is not discouraged from participating in the labour force. But more importantly, we need to raise productivity if Canadians are to continue to enjoy rising incomes. It will not be easy to get those productivity gains. We will need to see greater investment in new, improved machinery and equipment. We will need to see more and better application of information and communications technology. We will need to ensure that our workers have the skills and receive the training they require to take advantage of productivity-enhancing technology. And we will need to improve business organization and practices, to fully exploit the potential of new technologies, and to minimize any barriers to their application in the workplace. Raising productivity will also require a major effort to ensure that our microeconomic policies facilitate innovation and higher productivity in both the private and public sectors in Canada. In thinking about our macroeconomic policies, we can't assume that all the shocks are behind us. We have seen the buildup of economic imbalances recently, with large current account surpluses in Asia and a large current account deficit in the United States. And fiscal imbalances are growing in Europe and the United States. So how can the Bank of Canada help to prepare for the challenges ahead? Most importantly, we must stick with the monetary policy framework that we built in the 1990s. That means keeping our commitment to low, stable, and predictable inflation. And it means that our floating exchange rate will continue to be an important part of our monetary policy framework. This framework will continue to help the economy adjust to changing economic circumstances, both at home and abroad. Of course, exchange rates don't always move as smoothly as desired or expected. Still, let me repeat what I have said many times before: having a floating exchange rate to facilitate economic adjustments is by far the best option for the Canadian economy. Let me now turn to the current economic situation, starting with the outlook for inflation. As we noted in our October , we expect that Canada's inflation rate will fall over the next few months. The core rate of inflation--a measure that removes the eight most volatile components of the consumer price index-- will likely move down close to the bottom of our 1 to 3 per cent inflation-control range early next year, before starting to move back up towards 2 per cent. On the Bank's latest fixed announcement date last week, we decided to leave our key policy rate unchanged. In doing so, we noted a few developments that have altered our outlook since we published the . Let me review some of them. At the end of November, Statistics Canada released its national accounts data for the third quarter. These data showed that Canada's economy had grown at an annualized rate of just 1.1 per cent in the third quarter, a rate tha t was well below expectations. What's more, there were downward revisions to growth in previous quarters. This meant that, at the end of the third quarter, the re was more excess capacity in the Canadian economy than we had anticipated. In the , we said that we expected the economy to close its output gap and return to its level of full capacity by early 2005. Closing the output gap over that period would be consistent with inflation returning to the 2 per cent target by mid-2005. But because we now know that the output gap is larger than we had expected in October, we also know that the economy will have to grow at a faster rate during the fourth quarter and through 2004 to close that output gap by early 2005. While growth earlier this year was disappointing, we are now seeing a number of encouraging signs suggesting that stronger growth will resume, beginning in the current quarter. I will mention three of those signs. First, while the overall growth rate in the third quarter was just 1.1 per cent, it should be noted that this figure was depressed because businesses met demand in large part from inventories. Final domestic demand grew quite strongly--by close to 6 per cent--thanks to healthy household spending and rising business investment. This investment bodes well for higher future production. And, with continuing employment growth, we expect household spending to remain robust. Second, the reduction in inventory investment is probably over. While this adjustment depressed growth in the third quarter, it should not do so in the fourth quarter. In fact, the completion of the inventory correction should contribute to growth in the fourth quarter. Third, Canada's export sector should receive a boost from rising foreign demand, in particular, from the United States. Remember that the U.S. economy grew at an annualized rate of about 8 per cent in the third quarter, and Canadian exporters should see some benefit from this and from the continuing strong growth expected in the U.S. economy over the months ahead. Rising non-energy commodity prices should also be a boost to the economy. All told, the Canadian economy should be poised for solid growth ahead, beginning in the fourth quarter. We would expect economic growth in this quarter to be well above 4 per cent on an annualized basis. However--and let me stress this--the effect of the recent sharp appreciation of the Canadian dollar is a major uncertainty at this time. It is not clear to what extent the increase in foreign demand I have just mentioned will be offset by the effects of a stronger currency. Nor can we be sure that there is enough monetary stimulus in the economy to support the increases in household spending and business investment that would be required to return the economy to full capacity by early 2005. Some important economic data are expected between now and our next fixed announcement date, on 20 January. These should give us a better sense of how Canada's export sector is doing, and how household spending went over the holiday season. We will be closely watching all the data ahead for evidence that the economy is growing at a rate solidly above the growth of potential. This past year, like the two years before it, was full of "interesting" economic challenges for Canada and the world. It is tempting to hope that next year will be somewhat less "interesting" and bring fewer challenges. But regardless of what next year brings, what is critical is that we keep our eyes on the longer-term horizon and focus on the challenges ahead. These challenges include adapting to shifting demographics, raising productivity, and getting our microeconomic policy framework right. At the Bank of Canada, we remain committed to the sound monetary policy framework that will help us rise to tomorrow's challenges. And that's good news for all of us, no matter what the coming years may bring.

r040122a_BOC

canada

Release of the

dodge

Today, we released our to the October . The reviews economic and financial trends in the context of Canada's inflation-control strategy. Three developments have led us to modify our outlook for economic growth and inflation in Canada, since our October . These include: stronger-than-expected world economic activity, the continued sharp depreciation of the U.S. dollar against major world currencies (including the Canadian dollar), and a somewhat larger output gap in Canada at the end of 2003. Weighing these developments and their likely persistence, we lowered our projection of output in Canada over the next year and a half. In this context, we cut policy interest rates to support aggregate demand and thus return inflation to 2 per cent over the medium term. In Canada, economic growth in the period ahead will need to come primarily from private domestic demand, supported by monetary stimulus and by strong business confidence. We now project growth to average about 2 3/4 per cent in 2004, and to pick up to about 3 3/4 per cent in 2005. This would imply that the output gap would not change materially before the end of 2004, but would be substantially closed by the third quarter of 2005. We project that core inflation will fall below 1 1/2 per cent in early 2004, before gradually moving back to the 2 per cent target by the end of 2005. Total CPI inflation should remain below core inflation through 2005 if oil prices ease gradually from their current levels. The main uncertainties in the outlook relate to the adjustment of the Canadian economy to global changes. Canadian monetary policy facilitates the overall adjustment process by helping to sustain aggregate demand in Canada. Paul and I will now be happy to take your questions.

r040211a_BOC

canada

Adjusting to a Changing Economic World

dodge

Governor of the Bank of Canada to the Board of Trade of Metropolitan Montreal Good afternoon, ladies and gentlemen. It's a pleasure to be with you here in Montreal today. These are turbulent times, not just for business people, but for all Canadians. We have come through a very difficult year, a year filled with surprises that have challenged us all. At times like these, it is easy to focus on the near-term issues and problems. But by doing that, we risk losing sight of the big picture. The Bank of Canada had plenty to say about the near-term outlook in its a few weeks ago. So today, I want to talk about the longer-term trends at work in our economy. In doing so, I want to take a quick look back at some of the major economic events of recent decades, and examine how we approached the issues of adjustment at the time. Then, I will discuss the adjustments that are needed now and in the future. In this way, I hope to draw on the lessons learned from the past. I will frame this discussion in terms of structural economic policies, macroeconomic policies, and the role of the exchange rate in facilitating adjustments. I will start by going back to the 1970s. There were at least two forces at play that highlighted the need for economic adjustments. The first was a significant drop in the rate of productivity growth. Canada, like the United States, had become accustomed to productivity rising at a rapid pace during the 1950s and 1960s. With this growth in productivity came steady advances in real incomes. But the trend towards higher productivity slowed abruptly in the early 1970s. At the time, policy-makers, business, and labour assumed that the slowdown was cyclical. It wasn't. Economists still don't have a complete explanation for it. But what we now understand more clearly is that the productivity increases of the 1950s and 1960s had a lot to do with the application throughout the economy of earlier advances in general-purpose technology. Businesses took advantage of various technological advances in many diverse fields, enabling them to realize significant productivity gains. When productivity growth slowed in the 1970s, many people assumed that the slowdown was temporary and that rapid growth would resume on its own. This was a mistake. Without solid productivity gains, the economy was unable to deliver the increases in real incomes that everyone had come to expect. This situation was compounded by the second major event of the 1970s: the energy crisis. Unfortunately, we in Canada didn't recognize the full implications of the energy crisis. We were slow to realize that higher oil prices also meant a reduction in the economy's production capacity. Canadian policy-makers tried to cushion the impact of the higher energy prices and slower productivity through increased transfers, subsidies, and easier monetary and fiscal policies. For example, the Bank of Canada added to liquidity by expanding the money supply too fast in relation to the slower growth in the economy's production capacity. In the wake of these structural and macroeconomic policies, inflation rose, and fiscal deficits grew. This slowed the structural-adjustment process in the late 1970s and early 1980s. All of this was made worse by the shared misperceptions about the productivity slowdown. Businesses, households, and governments all thought that economic growth would recover and that real incomes could continue to rise at their previous rate. But without strong productivity growth the economy could no longer satisfy these demands. But that difficult period from 1975 to 1985 taught us a lesson. We learned that structural adjustments are important and inevitable, and that macroeconomic policies have a role to play in making those adjustments work quickly and with less disruption. Canada had the opportunity to apply those lessons in the 1990s. Let me explain how. To begin, recall the state of Canada's economy as the 1990s began. Although inflation had come down from the very high levels seen in the early 1980s, it was still relatively high by today's standards. On the fiscal side, the picture was pretty grim and getting worse. Public sector deficits eventually peaked at around 8 per cent of Canada's GDP, and public debt levels were continuing to mount. Clearly, the situation was not sustainable. Changes were urgently needed. The first major change came in 1991, when the Bank and the Government of Canada agreed on a series of explicit inflation-reduction targets. The agreement called for an inflation target--defined in terms of the annual rate of increase of the consumer price index--that descended gradually to 2 per cent, the midpoint of a 1 to 3 per cent range. The agreement has been extended three times, with the latest one covering the period to the end of 2006. Each time, the midpoint of the target range has been kept at 2 per cent. This framework has worked very well. From the end of 1994 to today, inflation has averaged almost exactly 2 per cent. Moreover, not only has inflation fallen, it has become more stable. Indeed, the trend of inflation--as measured by what we call "core inflation"--has stayed within the target range almost continuously for the past 10 years. More importantly, we found that, after a few years of inflation targeting, the inflation expectations of Canadians fell into line with the 2 per cent target. And expectations have remained close to the target in recent years. Another major adjustment began in the middle of the 1990s. At that time, Canada was facing an unsustainable fiscal situation. Spending had to be put on a viable long-term course, and the ratio of public debt to GDP put on a steady downward track. By the middle of the decade, governments--federal and provincial--had begun to take the painful but necessary steps to balance their books and reduce their debt burdens. This fiscal adjustment helped improve the credibility of Canada's economic policies and reduced the risk premium that investors demanded on Canadian government bonds. Lower interest rates reduced debt-servicing costs and stimulated economic growth, which brought in more revenues for governments. The federal debt-to-GDP ratio has fallen to about 44 per cent, from a peak of close to 70 per cent. The ratio of total government liabilities to GDP has declined from a peak of about 100 per cent to about 80 per cent, according to the OECD. The other major change in the 1990s was the structural adjustments that took place in the public and private sectors. In both cases, these adjustments were enormously helpful, because they made the Canadian economy more flexible. In the public sector, governments moved to reduce distortions in the economy, by eliminating many industrial subsidies, lowering income taxes, and putting the Canada and Quebec Pension Plans on a sustainable basis. Further, the government made changes to its system of unemployment insurance, basing the program more on insurance principles and improving the employability of labour. In the private sector, businesses and employees faced restructuring in the wake of free-trade agreements, as Canada opened up further to international competition. None of this was easy, but it did leave Canada's economy more flexible, and in a better position to handle economic shocks and, therefore, to grow sustainably. Canada's floating exchange rate helped facilitate the adjustments that were taking place on these various fronts. It helped by sending signals to businesses about the kinds of adjustments that were needed. Firms that produced traded goods and services, and that were able to take advantage of free-trade agreements and strong foreign demand, saw their profits increase. And because the depreciating Canadian dollar raised the cost of machinery and equipment relative to labour, businesses in expanding sectors of the economy were encouraged to absorb some of the excess labour that had been released by shrinking sectors. The floating exchange rate also helped on the macroeconomic side. The depreciating Canadian dollar in the late 1990s helped to encourage foreign demand, as demand from the government sector was being restrained. So you can see how these three factors converged in the 1990s to lay the groundwork for a stronger economy in the future. A sound macroeconomic policy framework, appropriate structural adjustments, and a floating exchange rate, all did their part to help the economy adjust to the changing circumstances of the 1990s. That's a quick look back. Now, I'd like to talk about some of the longerterm forces we can expect to see at work in the economy in the years ahead and the economic adjustments that will likely be necessary. The first point I would make is that we have an opportunity in the next few years to again register solid productivity gains. This time, the information and communications technology sector is providing the general-purpose technologies that can drive sustained gains in productivity and incomes. Of course, the mere presence of technology is not enough to guarantee higher productivity. We also need investment, as well as training and organizational changes and flexibility. In the latter part of the 1990s, Canadians had begun to invest in productivity-enhancing technologies. After a pause at the beginning of this decade, such investments seem to have resumed. These efforts are particularly important, especially in light of the serious demographic challenges we will face over the next few years. That is my second point: our workforce is aging. Current projections are that the share of the population that is of working age--those aged 15 to 64--will begin to decline in about 15 years. We will need to take these population shifts into account, and to remove impediments for older workers who wish to remain in the labour force. The third point I would make is that there are powerful forces in the global economy that bear watching. The significant imbalances that we now see in the world's current- and capital-account flows need to be corrected. Emerging markets, particularly in Asia, are becoming increasingly powerful players in the global economy. All these forces will have an impact on the Canadian economy in the years ahead. Against this backdrop, what kinds of economic adjustments will be needed in the future? Let me suggest a few. First, Canada's economic structures must continue to adjust to changing circumstances. There will need to be more high-productivity activities in the economy and fewer low-productivity ones. But for significant gains in productivity to resume, governments must ensure that their microeconomic policies encourage flexibility and do not hinder innovation in the public and private sectors. Workers will need to have the training and skills to take advantage of new technologies. And businesses will need to ensure that their organizations and practices allow the potential of new technologies to be fully realized. Second, Canada must keep its fiscal house in order. Canada's ratio of public debt to GDP will need to decline further. This will free up more resources to help us support our aging population. At the same time, this implies that governments at all levels will be keeping their budgets more or less balanced, if not in surplus. What about monetary policy in the future? In the Bank's last month, we said that the role of monetary policy is to facilitate adjustments by helping to sustain aggregate demand. What does this mean? As always, it means that we will aim to return inflation to its 2 per cent target, by trying to keep the economy operating as close as possible to its full production capacity. That is our constant goal. But it also means that we will be aware of the forces that are driving adjustments in the economy in the years ahead. We know that with a stronger currency, the economy will have to rely more on domestic demand and less on foreign demand for ongoing, solid growth. We will take this into account as we set monetary policy. This leads me to my last point, which concerns the exchange rate. A floating exchange rate will continue to be an important part of our monetary policy framework, facilitating the necessary adjustments and sending important price signals. Canadian businesses should continue to be guided by price signals, including those being sent by exchange rates. Just as businesses reacted to the signals of a weaker Canadian dollar in the 1990s, they should now respond to the signals of a stronger currency against the U.S. dollar, as well as to the changing exchange rates against other currencies. A stronger Canadian currency is consistent with the adjustments that are going to be needed in our economy, even if the speed of the recent appreciation has made these adjustments more difficult. Because it makes machinery and equipment less expensive relative to labour, a stronger currency is in line with our need to increase productivity, as well as with the future demographic pressures on our labour force. A stronger currency is also consistent with the increase in commodity prices relative to those of manufactured goods and services. And it increases the price of non-tradable goods relative to that of tradable goods. This should encourage the shifting of labour and capital into those sectors that are oriented to meeting domestic demand. We are already seeing signs that Canadian businesses are indeed adjusting to the stronger dollar. Each quarter, the Bank of Canada surveys Canadian firms about the state of their business. Recent surveys show that Canadian firms are reasonably optimistic about the future. Obviously, the appreciation of the Canadian dollar has affected different companies in different ways. In particular, some manufacturers who have not benefited from rising commodity prices have struggled to adjust. But most firms are acting to raise productivity, as well as cutting costs, adjusting supply chains, and hedging their currency exposure, among other efforts. Those businesses that have been helped by the stronger currency are also adjusting, by lowering prices, strengthening their balance sheets, and in some cases, increasing productivity. Information from the Bank's latest survey can be found on our Web site. Our surveys, as well as those conducted by the Export Development Canada and the Conference Board of Canada, suggest that business investment will increase. I can appreciate that making some of these adjustments is not easy. For many firms and employees, it can be a painful and difficult process. But in today's world, not adjusting is not an option. Fortunately, thanks to a sound economic policy framework, we have a relatively favourable climate in which to take these necessary steps. Many elements currently support investment: inflation remains low, stable, and predictable, and credit conditions are favourable. Business confidence and balance sheets are strong, and equity markets are performing well. Let me close by talking about the lessons we can learn from the past. To me, the key points are clear. Economies must have the flexibility to adjust as circumstances change. This means having the right structural policies in place, as well as appropriate macroeconomic policies. Along with the right economic policies, a floating exchange rate will help the economy make adjustments more smoothly. All of us, whether as economic policy-makers or business people, must be quick to recognize the need to adjust. We ignore economic realities at our own peril. When adjustments are too slow, the economy suffers. When inappropriate policies are followed, the damage can take years to undo. But when the right adjustments are made quickly, the whole economy can benefit. As business people making your own adjustments to future economic challenges, you can count on the Bank of Canada to pursue the appropriate monetary policy to help you get on with the job.

r040217a_BOC

canada

Policies for Changing Times

dodge

Governor of the Bank of Canada Good morning. I am glad to have the opportunity to meet with business leaders in Mexico today. I am also glad to have this opportunity to meet with our colleagues at the Banco de Mexico. Our two central banks have had a long and fruitful relationship, one that includes swap facilities, joint research, and close consultations. I believe that public servants and business leaders in Canada and Mexico have a great deal in common and much to learn from one another. Indeed, in many ways, Canada and Mexico are partners. We share common issues and challenges. We both share borders with the United States, the most important export market for each of us. Both Canada and Mexico have recently faced setbacks in cross-border trade with the United States. These stem not only from weaker U.S. domestic demand, but also from specific trade problems and from border-crossing delays associated with tighter security. We have both been affected by the slowdown in the world economy and by global economic imbalances--although the impact of these factors appears to have been somewhat less in Canada than in Mexico over the past three years. And we are both working on the structural adjustments that are necessary to weather shocks and to thrive in a changing environment. Today, I want to focus my remarks on Canada's adjustment to global economic changes. I will talk about our efforts to adjust to longer-term economic forces and about our challenges in this regard. And I will talk about some of the lessons that we have all learned during the past couple of decades. Policy-makers in both Canada and Mexico have drawn on these lessons to improve our macroeconomic policy frameworks, and thus to better manage and adjust to change. I will conclude with some thoughts about how Canada and Mexico can continue to adjust to the economic changes that face us in the future. The most important lesson that we have all learned is that structural adjustments are key in adapting to change, and that macroeconomic policies have a role to play in making those adjustments with a minimum of economic and social disruption. Canada has experienced two periods in recent decades when significant economic adjustment was required. The first was during the 1970s, when we were hit by a rapid slowdown in productivity growth and by the effects of the oil crisis. Policymakers in Canada used macroeconomic and microeconomic policies to try to cushion the economy from the impact of those events. As a result, our adjustment was slower and more painful than it needed to be. We ended up with a weak economy, high inflation, and large government budget deficits. The lesson that Canadians learned from this period is that macroeconomic and microeconomic policies must be clearly focused on facilitating adjustment to economic change. By the beginning of the 1990s, it was clear to us that we needed a framework of policies to help with that adjustment, to bring down inflation, and to put our public finances in order. The first major change came in 1991, when the Bank and the Government of Canada agreed on a series of explicit inflation-reduction targets. The agreement called for an inflation target that would gradually reduce the rate of inflation to 2 per cent, the midpoint of a 1 to 3 per cent range. The agreement has been extended three times, with the latest one covering the period to the end of 2006. Each time, the midpoint of the target range has been kept at 2 per cent. This framework has served us very well. Since the end of 1994, inflation has averaged almost exactly 2 per cent. Moreover, not only has inflation fallen, it has become more stable than it was in the 1970s and early 1980s. Just as importantly, we found that inflation expectations quickly fell into line with the 2 per cent target. And expectations have remained close to 2 per cent in recent years. One of the most important consequences of adopting a system of inflationcontrol targets is that we at the Bank of Canada can now explain more clearly to business, to labour , and to the general public what we are doing and why. One should not underestimate the benefits that arise from having the public understand the policies and actions of its monetary authority. This understanding makes the conduct of monetary policy easier, and gives citizens a measure by which to judge the performance of their central bank. While no single mechanism is perfect in this regard, our experience suggests that the outcomes of monetary policy are better with a clear, well-understood framework. The second major adjustment that we had to make in Canada was to get our fiscal situation under control. In the early 1990s, the combined federal and provincial deficits were running at about 8 per cent of GDP. This was clearly unsustainable. And so between 1993 and 1997, governments in Canada made a determined, and successful, effort to eliminate their deficits. This fiscal adjustment helped improve the credibility of our economic policies and reduced the risk premium on Canadian bonds demanded by investors. Canada's economy, like that of Mexico and many others, also underwent structural adjustments in the 1990s, in both the public and private sectors. These adjustments were enormously helpful, because they made the Canadian economy more flexible. Governments moved to reduce distortions in the economy by eliminating many industrial subsidies, reducing personal income taxes, and reforming the unemployment insurance system. At the same time, enterprises responded to the challenges of trade liberalization by improving the quality of their products and marketing them aggressively to new North American customers. These adjustments were not easy. But they did leave Canada's economy in a better position to handle economic shocks and, therefore, to grow on a sustained basis. Canada's floating exchange rate helped facilitate these structural adjustments. The depreciating Canadian dollar in the late 1990s encouraged foreign demand, which helped to compensate for reduced demand from the government sector. It also helped by sending signals to businesses about the kinds of adjustments that were needed. In sum, a sound macroeconomic policy framework, appropriate structural adjustments, and a floating exchange rate all did their part to help Canada's economy adjust to the changing circumstances of the 1990s. While these adjustments were difficult, the payoff came quickly. By the end of the decade, Canadians were beginning to see higher real incomes. So that's a quick backward look. Let's now consider the ongoing international forces at work in our economies. Both Canada and Mexico are going to need to increase productivity in the face of fierce competition from China and other lower-cost countries. Indeed, it is clear that all countries are going to have to find ways to become more competitive. In Canada, we have an opportunity in the next few years to again realize solid, steady productivity gains, thanks to past investments in information and communications technology. Of course, technology alone is not enough to guarantee higher productivity. To actually realize productivity gains, enterprises must make the necessary investments and organizational changes. And they must train their staff to use technology to its best advantage. Other forces in the world economy bear watching. These include significant imbalances in global current- and capital-account flows. And new players, particularly in Asia, are becoming increasingly powerful in the global economy. As I've mentioned, that increases the competitive pressure facing our manufacturers. But it also means new, fast-growing sources of demand, and new opportunities. Adjustments in the Future In the face of all of these forces, what kinds of economic adjustments will be needed in the future? Let me speak about the adjustments that we in Canada will have to make. First, our economy will need more high-productivity activities. For significant gains in productivity to resume, governments must ensure that their microeconomic policies encourage flexibility and do not hinder innovation in the public and private sectors. Canada already benefits from an educated and skilled labour force. Nevertheless, workers must continue to have access to the training they need to take advantage of new technologies. And businesses need to ensure that their organizational structure and practices allow them to realize the potential of these new technologies. Second, Canada, like Mexico, must keep its fiscal house in order. As I have said, we have made great strides in reducing our ratio of public debt to GDP. That ratio will need to decline further to give Canada the flexibility to meet the demands of our aging population. Third, we must provide the appropriate microeconomic policies with regard to labour markets, intellectual property law, environment, and foreign investment, among others. Fourth, we must ensure that our social policies strike a balance between facilitating the adjustments that need to be made and supporting those members of our society who are displaced by structural adjustment. Fifth, I believe that it is crucial that Mexico and Canada continue working together, and with our U.S. partners, to make NAFTA even more successful. And the benefits we have seen from NAFTA should strengthen our resolve to see freer trade globally. We need to continue to work towards reduced trade barriers at the Doha round of multilateral trade negotiations. It won't be easy, but the long-term economic benefits will make our efforts worthwhile. What is the role of monetary policy in all of this? As always, it is to facilitate adjustments by helping to maintain the balance between supply and demand in our economies. For the Bank of Canada, this means that we will aim to maintain inflation near 2 per cent by trying to keep the economy operating as close as possible to its full production capacity. That is our constant goal. But it also means that, at the same time, we will be aware of the longer-term forces that are driving adjustments in our economy. In Canada, we know that, with a stronger currency, the economy will have to rely more on domestic demand and less on foreign demand for ongoing, solid growth. We will take this into account as we set monetary policy. Both Canada and Mexico have, as a critical element of their monetary policy frameworks, a flexible exchange rate. This gives monetary authorities the ability to set monetary policy tailored to our own domestic economic circumstances. A floating Canadian dollar, or floating Mexican peso, facilitates the necessary economic adjustments and sends important price signals to economic participants. Let me conclude. For many firms and many employees, we know that adjustment can be painful and difficult. But in today's world, not adjusting is not an option. Fortunately, in both our countries, we are making these adjustments under relatively favourable conditions. Global demand is strengthening, and credit conditions are good. We have a better knowledge of what we need to do. And we have made important progress in strengthening our macroeconomic frameworks. The challenges that we will face make it even more important that we continue to strengthen our policy frameworks in order to adjust to changing circumstances and to take advantage of potential gains. The faster we are able to adjust, the greater the wealth we can create for our citizens. That is not to say that adjusting will be easy. Indeed, the experience of recent decades proves that it can be difficult, at least over the short term. But if we take the leap, and seize the opportunities that change will bring, our societies will surely benefit.

r040310a_BOC

canada

Adjusting to Global Economic Change

dodge

Governor of the Bank of Canada Good morning. I am glad to have the opportunity to meet with business leaders in Sao Paulo today. I am also pleased to meet with my counterpart, Governor Henrique Meirelles, and with some of his colleagues at the Banco Central do Brasil. Geographically, Brazil and Canada are far apart. But from an economic viewpoint, we have more in common than some might think. We share common issues and challenges. We both operate monetary policy systems based on inflation targets and floating exchange rates. We are both being affected by the recent slowdown in the world economy and by global economic imbalances. And we are both working on the structural adjustments that are necessary to weather shocks and to thrive in a changing environment. Today, I want to focus my remarks on Canada's adjustment to changes in the global economy. I will talk about our efforts to adjust to longer-term economic forces and about the challenges that these forces present. Some of our experiences may be relevant to other economies that are making similar adjustments in the face of similar economic circumstances. Our experience over the last couple of decades has taught us that structural adjustments are key to adapting to change, and, just as important, that sound macroeconomic policies have a role to play in making those adjustments with a minimum of economic and social disruption. These lessons may seem self-evident. But Canadians have been reminded of their importance through some significant and painful economic adjustments during the past 30 years. For example, Canada was hit by an abrupt slowdown in productivity growth during the 1970s. That slower productivity growth made it impossible to continue to provide the gains in real wages to which Canadians had become accustomed. The situation was exacerbated by the OPEC oil embargo of 1973 and by the subsequent energy crisis that hit economies around the globe. The consensus of the day was that the impact of those events on Canada would be temporary. And so Canadian policy-makers used macroeconomic and microeconomic policies to try to shield our economy from the impact of those events. Instead of making the necessary adjustments, we tried to avoid them. As a result, the eventual adjustment was slower and more painful than it needed to be. And we ended up with slower growth, relatively high inflation, and large government budget deficits. Canadians learned during this period that economic policies must be focused on adjusting to change--even if that adjustment causes short-term difficulties. By the beginning of the 1990s, it was clear that we needed a framework of policies to help with adjustment, to bring down inflation, and to put our public finances in order. The first major change came in 1991, when the government and the Bank of Canada agreed on an explicit anchor for monetary policy. That anchor was a series of inflation-reduction targets that would gradually lower the rate of inflation to 2 per cent, the midpoint of a 1 to 3 per cent range. The agreement has been extended three times and currently covers the period to the end of 2006. Each time, the midpoint of the target range has been kept at 2 per cent. I want to note here that while the Bank and the government established the monetary policy anchor jointly, the Bank alone takes responsibility for the conduct of monetary policy and for achieving the inflation target. I want to stress the importance of that independence. Experience around the world has shown that there are distinct advantages to having monetary policy carried out by an independent central bank, not the least of which is separating the power to print money from the power to spend it. Central bank independence is also a mechanism for building credibility among investors. Central banks have a choice to make as to how to anchor their monetary policy. Some countries have chosen a fixed exchange rate as the ir anchor. In doing so, their central banks give up the power to control domestic inflation. In contrast, other countries--such as Canada--have chosen domestic inflation as their anchor. By doing this, they leave it to foreign exchange markets to set the external value of the currenc y. The key point is that, since capital is mobile, no central bank can successfully control inflation and the exchange rate at the same time. The choice of an inflation-targeting framework has served Canada very well. Since the end of 1994, inflation has averaged almost exactly 2 per cent. Moreover, not only has inflation fallen, it has become more stable than it was in the 1970s and early 1980s. Just as importantly, inflation expectations have fallen into line with the 2 per cent target and have remained there. As for the floating exchange rate, it helps the economy adjust to disturbances and fluctuations in the world prices of our products, notably commodities. It also helps our economy adjust to changes in global savings and investment flows. One of the most important advantages of adopting a system of inflationcontrol targets is that we at the Bank of Canada can now explain more clearly to business, to labour , and to the general public what we are doing and why. We do this through eight regularly scheduled interest rate announcements each year, plus our regular and . One should not underestimate the benefits that arise from having the public understand the policies and actions of its monetary authority. This understanding makes it easier for us to conduct monetary policy, and it allows citizens to judge the performance of their central bank. It has been less than five years since Brazil adopted its own inflationtargeting system in July 1999, after floating its currency in January of that same year. The system is already proving to be extremely helpful in reducing inflation rates in this country, even in the face of some large shocks. Establishing a track record of credible inflation targeting leads to lower inflation expectations. These lower expectations create a virtuous circle--they lead businesses and consumers to make pricing and spending decisions that, in turn, help the central bank meet inflation targets. And consistently meeting inflation targets allows citizens to make investment and savings decisions with confidence that inflation will rema in close to the target. The second major adjustment that Canada had to make in the 1990s was to get its fiscal situation under control. In the early part of that decade, the combined federal and provincial primary deficit (which excludes debt-service costs) peaked at just under 3 per cent of GDP, and the total deficit was close to 8 per cent. The combined public debt reached a peak of 100 per cent of GDP. While some of the shortfall reflected cyclical factors, it was clear that the situation was unsustainable. So between 1993 and 1997, both federal and provincial governments in Canada made a determined, and successful, effort to eliminate their deficits and run consistent primary budget surpluses. The fiscal adjustments made by both levels of government helped to improve the credibility of our economic policies and reduced the risk premium that investors demanded on Canadian bonds. While this credibility is always useful, it is particularly beneficial during periods of crisis, when the spreads on riskier investments tend to widen. Consider Canada's experience with the Mexican currency crisis of 1994, before the credibility of our monetary and fiscal policy was fully established. Spreads on Canadian bonds widened significantly during that event, and consumption and investment slowed, leading to a period of weaker economic growth. Our credibility was better established by 1997, and so we were able to weather the financial crises in Asia and Russia with only a slight widening of spreads. There was minimal uncertainty, and growth actually strengthened in the wake of those events. When you compare these two experiences, you can see that there is a real payoff from the achievement of fiscal and monetary credibility. And it does not take too long for that payoff to be realized. Canada's public and private sectors also made structural adjustments in the 1990s , leading to a more flexible economy. This added flexibility helped us to weather the recent global economic slowdown. Our governments, both federal and provincial, also took steps to reduce distortions in the economy. In the latter half of the 1990s, federal industrial subsidies were cut by more than 60 per cent. Provinces eliminated many of their own subsidy programs. The federal government reformed its unemployment insurance system, and Canada's public pension plans were overhauled to make them self-financing in the decades ahead. This involved some restructuring of benefits and an increase in contribution rates. And contributions are now being invested in markets in order to generate the best possible returns--with due consideration for prudence-- over the long term. Throughout this difficult period, governments worked hard to ensure that the burden of adjustment did not fall disproportionately on those segments of the population that were least able to bear it. It was only after the adjustment process was well underway that the federal government began to reduce corporate and personal income taxes. As governments take steps to improve the structure of their economies, it is equally important that businesses make their own adjustments. During the 1990s, Canadian firms responded to the challenges of freer trade by improving the quality of their products and by marketing them aggressively to new North American customers. These adjustments were not easy. But they did leave Canada in a better position to handle economic shocks and, therefore, to grow on a sustained basis. To recap, a sound monetary policy supported by a floating exchange rate, sound fiscal policy, and appropriate structural adjustments all did their part to help Canada's economy respond to the changing circumstances of the 1990s. While these adjustments were difficult, the payoff came quickly. By the end of the decade, Canadians were beginning to see higher real incomes. Adjustments in the Future So that's a quick look at the lessons we have learned from past experience. Let's turn now to the international forces at work in our economies and talk about what these forces will mean for economic policies in the future. In the global economy today, we see significant financial imbalances. The United States is faced with a large fiscal deficit and a high and growing current account deficit, while some Asian countries are accumulating record current account surpluses. The economies of China and India, as well as yours here in Brazil, are becoming increasingly powerful players on the world stage. This increases the competitive pressure facing Canadian producers. But it also means new, fast-growing sources of demand and new opportunities. So in the face of these forces, what kinds of adjustments are needed? I will talk about our situation in Canada, but what I have to say is applicable to most economies. The first thing I would say is that maintaining fiscal balance must remain a priority for Canada in the years ahead. Our federal and provincial governments have made great progress on this front, but we in Canada cannot afford to give back these hard-won gains. Neither can governments in this country. Maintaining fiscal balance is as important for Brazil as it is for Canada. This priority is heightened in Canada by our longer-term demographic challenges. Our ratio of public debt to GDP will need to decline further to give us the flexibility to meet the demands of our aging population. My second point is that we must provide the appropriate microeconomic policies in areas such as labour markets, intellectual property law, the environment, and foreign investment. The right microeconomic policies are essential in order to increase productivity and raise living standards in the future. This is true for every country. However, we know that implementing the right economic policies can mean that some groups will bear an unfair share of the burden of adjustment. This does not mean that we should shy away from the task. But it does lead to my third point, which is that authorities must put in place the right policies to facilitate adjustment, such as providing access to training, or helping workers relocate or shift into expanding areas of the economy. In doing so, we should keep in mind that government help should be directed towards people, and not towards specific businesses or industries. So what can policy-makers do to provide a supportive economic environment for business? In my view, promoting an efficient and robust financial system, including a strong banking sector, is critical. And that is my fourth point. This is particularly true in countries such as Canada, where small and medium-sized businesses create the majority of jobs. Growing firms must have access to credit within a wellfunctioning financial system. Further, people need to have confidence in the banking sector, so that savings can be efficiently recycled to help businesses expand. A robust financial system can also be a country's best defence against international financial crises. A key lesson from the Asian and Russian crises was that countries with strong banking sectors are much less likely to be affected than countries where the banking sectors are weak. Beyond the banking sector, countries should also work to develop healthy and efficient financial markets. This is not a new idea. Canada's efforts to build domestic money markets go back over 50 years. And we built these markets living next door to the country with the deepest, most liquid financial markets in the world--the United States. Now, and in the future, we will need to remain focused on promoting healthy and efficient markets. This topic is an ongoing priority for research at the Bank of Canada. In fact, later this year we will host, along with the German Bundesbank, a G-20 workshop on building strong domestic financial systems. My fifth and final point has to do with trade. Canada has a long history of supporting multilateral trade agreements. We have seen, first-hand, how our economy has benefited from opening our borders to trade. That is why we are committed to trying to extend the benefits of free trade to the whole of the Americas through the Free Trade Area of the Americas (FTAA). It is why we also support your efforts in Mercosur. And, most importantly, it is why we are committed to lowering trade barriers at the Doha round of multilateral negotiations. I have seen many examples of the challenges that governments face in reducing trade barriers and subsidies. We in Canada have our own difficulties in this regard but, as an economist, I know that the economic benefits of freer trade make the effort worthwhile. So those are the five areas that should be priorities for Canada in the years ahead: fiscal prudence, the right microeconomic policies, appropriate social policies, a strong and stable financial system, and more open trade. Monetary policy, for its part, will continue to be focused on keeping inflation low, stable, and predictable, thus giving citizens, businesses, and investors confidence in the future value of their money. To achieve this, we will try to keep supply and demand in balance. Since the Bank of Canada has chosen low domestic inflation as its monetary policy anchor, we will continue to have a flexible exchange rate. We recognize that a floating currency implies some volatility. But I can tell you that Canada derives enormous benefits from having a floating currency working in conjunction with a solid monetary policy anchor. It gives us the ability to set monetary policy tailored to Canada's specific economic circumstances. It sends important price signals to economic participants and helps our economy to make the necessary adjustments. Let me conclude. For many firms and many employees, adjustment can be painful and difficult. But in today's world, not adjusting is not an option. Fortunately, in both our countries, we are making these adjustments under relatively favourable conditions. Global demand is strengthening, and credit conditions are good. We have a better knowledge of what we need to do. And we have made important progress in strengthening our economic policy frameworks. The challenges that we will face make it even more important for us to continue to strengthen those frameworks in order to adjust to changing circumstances and to take advantage of potential gains. The faster we are able to adjust, the greater the wealth that Canada and Brazil can create for their citizens. That is not to say that adjusting will be easy. Indeed, the experience of recent decades proves that it can be difficult, at least over the short term. But if we take the leap and seize the opportunities that change will bring, our societies will surely benefit.

r040316a_BOC

canada

Adjusting to Global Economic Change

dodge

Good morning. I am happy to have the opportunity to be in Buenos Aires and to meet with all of you here at the Canadian Embassy. I am also glad to have the opportunity later on to meet with my counterpart, President Alfonso Prat-Gay, and with some of his colleagues at the Banco Central de la Republica Argentina. There is a great physical distance between our two countries--in terms of latitude, there are about 80 degrees of separation between Buenos Aires and Ottawa. But despite that distance, Canada and Argentina are closer, and have more in common, than you might think. We are both federations, with a certain natural tension between the national government and relatively powerful provinces. We have roughly the same number of people, and we share the challenge of living next door to a much larger neighbour. Both our countries have an abundance of natural resources. We are both important producers and exporters of agricultural products, and we have worked together for years in the Cairns group as allies in the effort to eliminate trade-distorting agricultural subsidies. And we are both being affected by changes in the global economy. Today, Argentina faces significant financial difficulties. As a Canadian, I can appreciate the tremendous pressure that the citizens of Argentina and its policy-makers must now be feeling. A little over a decade ago, Canada was facing very difficult economic and financial circumstances. While the declines in incomes and employment we saw were not as severe, we too had a debt problem. At one point, the Government of Canada was spending one out of every three dollars it took in on servicing its debt--a situation not unlike the one Argentina faced in 2001. In my remarks today, I want to focus on Canada's adjustment to global economic changes. I will talk about our efforts to adjust to longer-term economic forces and the challenges that these forces present, in the hope that some of our experiences may be relevant to you here today. Our experience over the past few decades has taught us that structural adjustments are key to adapting to change and, just as important, that sound macroeconomic policies have a role to play in making those adjustments with a minimum of economic and social disruption. These lessons may seem self-evident. But Canadians have been reminded of their importance through some significant and painful economic adjustments during the past 30 years. For example, Canada was hit by an abrupt slowdown in productivity growth during the 1970s. That slower productivity growth made it impossible to continue to provide the gains in real wages to which Canadians had become accustomed. The situation was exacerbated by the OPEC oil embargo of 1973 and by the subsequent energy crisis that hit economies around the globe. The consensus of the day was that the impact of those events on Canada would be temporary. And so Canadian policy-makers used macroeconomic and microeconomic policies to try to shield our economy from the impact of those events. Instead of making the necessary adjustments, we tried to avoid them. As a result, the eventual adjustment was slower and more painful than it needed to be. And we ended up with slower growth, relatively high inflation, and large government budget deficits. During this period, Canadians learned that economic policies must be focused on adjusting to change--even if that adjustment causes short-term difficulties. Towards the end of the 1980s, Canada was facing a number of economic and fiscal challenges. Government spending levels were near historic highs. Public debt levels were increasing rapidly, as was the percentage of that debt held by foreigners. Real estate prices were rising quickly, adding to fears that inflation was poised to accelerate. By the beginning of the 1990s, it was clear that we needed a framework of policies to help with adjustment, to bring down inflation, and to put our public finances in order. The first major change came in 1991, when the federal government and the Bank of Canada agreed on an explicit anchor for monetary policy. That anchor was a series of inflation-reduction targets that would gradually lower the rate of inflation to 2 per cent, the midpoint of a 1 to 3 per cent range. The agreement has been extended three times and currently covers the period to the end of 2006. Each time, the midpoint of the target range has been kept at 2 per cent. In Canada's case, the central bank and the federal government jointly established our inflation-targeting policy. But it is the Bank alone that decides how to conduct monetary policy in order to meet the inflation target. I want to stress the importance of that independence. Experience around the world has consistently shown that there are distinct advantages to having monetary policy carried out by an independent central bank, not the least of which is separating the power to print money from the power to spend it. Central bank independence is also a mechanism for building credibility among investors. Central banks have a choice to make as to how to anchor their monetary policy. Some countries have chosen a fixed exchange rate as their anchor. In doing so, their central banks give up the power to control domestic inflation. In contrast, countries like Canada have chosen low domestic inflation as their anchor. By doing this, they leave it to foreign exchange markets to set the external value of the currency. The key point here is that, since capital is mobile, no central bank can successfully control inflation the exchange rate at the same time. The choice of an inflation-targeting framework has served Canada very well. Since the end of 1994, inflation has averaged almost exactly 2 per cent. Moreover, not only has inflation fallen, it has become more stable than it was in the 1970s and early 1980s. Just as importantly, inflation expectations have fallen into line with the 2 per cent target and have remained there. As for the floating exchange rate, it helps our economy adjust to disturbances and to fluctuations in the world prices of our products, particularly commodities. It also helps our economy adjust to changes in global savings and investment flows. Another important consequence of adopting a system of inflation-control targets is that we at the Bank of Canada can now explain more clearly to business, to labour, and to the general public what we are doing and why. One should not underestimate the benefits that arise from having the public understand the policies and actions of its monetary authority. This understanding makes it easier to conduct monetary policy and gives citizens a measure by which to judge the performance of their central bank. Canada's experience with inflation targets is consistent with the experience of other countries that have adopted this type of framework. Inflation targets have been found to be particularly useful in helping countries with high inflation make the transition to a low-inflation environment. Targets can also help establish and maintain overall policy credibility. I know that Argentina is considering the establishment of formal, explicit inflation targets. I am glad that we at the Bank of Canada are able to share our positive experience with your central bank. In our case, it took a bit of time for all the benefits of inflation targeting--such as well-anchored inflation expectations and improved policy credibility--to become entrenched. But now that they are, they are tremendously helpful for our economy. The second major adjustment that Canada had to make in the 1990s was to get its fiscal situation under control. In the early part of that decade, the combined federal and provincial primary deficit (which excludes debt-service costs) peaked at just under 3 per cent of GDP, and the total deficit was close to 8 per cent. In terms of debt levels, federal and provincial government debt reached a peak of about 100 per cent of GDP. While some of the shortfall reflected cyclical factors, it was clear that the situation was unsustainable. So between 1993 and 1997, both federal and provincial governments in Canada made a determined, and successful, effort to eliminate their deficits and run consistent primary budget surpluses. The fiscal adjustments made by both levels of government helped to improve the credibility of our economic policies and reduced the risk premium that investors demanded on Canadian bonds. This credibility is particularly useful during periods of crisis, when the spreads on riskier investments tend to widen. Consider Canada's experience with the Mexican currency crisis of 1994, before the credibility of our monetary and fiscal policy was fully established. Spreads on Canadian bonds widened significantly, and consumption and investment slowed, leading to a period of weaker growth. By 1997, our credibility was better established, so we were able to weather the financial crises in Asia and Russia with only a slight widening of spreads. There was much less uncertainty, and growth actually strengthened in the wake of those events. When you compare these two experiences, you can see that there is a real payoff from the achievement of fiscal and monetary credibility, and it does not take too long for that payoff to be realized. Canada's public and private sectors also made structural adjustments in the 1990s, leading to a more flexible economy. The added flexibility helped us to weather the recent global economic slowdown. Our governments, both federal and provincial, also took steps to reduce distortions in the economy. In the latter half of the 1990s, federal industrial subsidies were cut by more than 60 per cent. Provinces eliminated many of their own subsidy programs. The federal government reformed its unemployment insurance system, and Canada's public pension plans were amended to make them self-financing in the decades ahead. This involved some restructuring of benefits and an increase in contribution rates. In addition, contributions are now being invested in markets in order to generate the best possible returns--with due consideration for prudence--over the long term. Throughout this difficult period, governments worked hard to ensure that the burden of adjustment did not fall disproportionately on those segments of the population that were least able to bear it. It was only after the adjustment process was well underway that the federal government began to reduce corporate and personal income taxes. As governments take steps to improve the structure of their economies, it is equally important that businesses make their own adjustments. During the 1990s, Canadian firms responded to the challenges of freer trade by improving the quality of their products and by marketing them aggressively to new North American customers. These adjustments were not easy. But they did leave Canada in a better position to handle economic shocks and, therefore, to grow on a sustained basis. To recap, a sound monetary policy supported by a floating exchange rate, sound fiscal policy, and appropriate structural adjustments, all did their part to help Canada's economy respond to the changing circumstances of the 1990s. While these adjustments were difficult, the payoff came quickly. By the end of the decade, Canadians were beginning to see higher real incomes. So that's a quick look at the lessons that we have learned from past experience. Let's turn now to the international forces at work in our economies and talk about what these forces will mean for economic policies in the future. In the global economy today, we see significant financial imbalances. The United States is faced with a large fiscal deficit and a high and growing current account deficit, while some Asian countries are accumulating record current account surpluses. Several emerging-market economies, particularly in Asia, are becoming increasingly powerful players on the world stage. This increases the competitive pressure facing Canadian producers. But it also means new, fast-growing sources of demand and new opportunities. So in the face of these forces, what kinds of adjustments are needed? I will speak about our situation in Canada, but what I have to say is applicable to most economies. The first thing I would say is that maintaining fiscal balance must remain a priority for Canada in the years ahead. Our federal and provincial governments have made great progress on this front, but we cannot afford to give back these hard-won gains. Canada also faces longer-term demographic challenges. Our ratio of public debt to GDP will have to decline further to give us the flexibility to meet the demands of our aging population. The second point is that we must provide the appropriate microeconomic policies in areas such as labour markets, intellectual property law, the environment, and foreign investment. The right microeconomic policies are essential in order to increase productivity and raise living standards in the future. This is true for every country. However, we know that implementing the right economic policies can mean that some groups will bear an unfair share of the burden of adjustment. This does not mean that we should shy away from the task. But it does lead to my third point, which is that authorities must put in place the right policies to facilitate adjustment, such as providing access to training, or helping workers relocate or shift into expanding areas of the economy. In doing so, we should keep in mind that government help should be directed towards people, and not towards specific businesses or industries. So what can policy-makers do to provide a supportive economic environment for business? In my view, promoting an efficient and robust financial system, including a strong banking sector, is critical. And that is my fourth point. This is particularly true in countries such as Canada and Argentina, where small and medium-sized businesses create the majority of jobs. Growing firms must have access to credit within a well-functioning banking system. Further, people need to have confidence in the banking sector, so that savings can be efficiently recycled to help businesses expand. A robust financial system can also be a country's best defence against international financial crises. A key lesson from the Asian and Russian crises was that countries with strong banking sectors are much less likely to be affected than countries where the banking sectors are weak. Beyond the banking sector, countries should also work to develop healthy and efficient financial markets. This is not a new idea. Canada's efforts to build domestic fixed-income markets go back over 50 years. And we built these markets living next door to the country with the deepest, most liquid financial markets in the world--the United States. Now, and in the future, we will need to remain focused on promoting healthy and efficient markets. This topic is an ongoing priority for research at the Bank of Canada. In fact, later this year we will be hosting, along with the German Bundesbank, a G-20 workshop on building strong domestic financial systems. My fifth and final point has to do with trade. Canada has a long history of support for multilateral trade agreements. We have seen, first-hand, how our economy has benefited from opening our borders to trade. That is why we are committed to trying to extend the benefits of free trade to the whole of the Americas through the Free Trade Area of the Americas (FTAA). It is why we also support your efforts in Mercosur. And, most importantly, it is why we are committed to lowering trade barriers worldwide at the Doha round of multilateral negotiations. I have seen many examples of the challenges that governments face in reducing trade barriers and subsidies. We in Canada have our own difficulties in this regard. But, as an economist, I know that the economic benefits of freer trade make the effort worthwhile. So those are the five areas that should be priorities for Canada in the years ahead: fiscal prudence, the right microeconomic policies, appropriate social policies, a strong and stable financial system, and more open trade. Monetary policy, for its part, will continue to be focused on keeping inflation low, stable, and predictable, thus giving citizens, businesses, and investors confidence in the future value of their money. To achieve this, we will try to keep supply and demand in balance. Since the Bank of Canada has chosen low domestic inflation as its monetary policy anchor, we will continue to have a flexible exchange rate. We recognize that a floating currency implies some volatility. But I can tell you that Canada derives enormous benefits from having a floating currency working in conjunction with a solid monetary policy anchor. It gives us the ability to set monetary policy tailored to Canada's specific economic circumstances. It sends important price signals to economic participants and helps our economy to make the necessary adjustments. Let me conclude. For workers, for firms, and for governments, adjustment can be painful and difficult. But in today's world, not adjusting is not an option. This is true for every economy. Fortunately, the external environment is favourable for making adjustments. Demand in the global economy is strengthening, and the geopolitical risks have eased. We have a better understanding of which policies are the right ones. And we have made important progress in strengthening our economic policy frameworks. The challenges that we will face make it even more important for us to continue to strengthen those frameworks in order to adjust to changing circumstances and to take advantage of potential gains. The faster we are able to adjust, the greater the wealth that Canada and Argentina can create for their citizens. That is not to say that adjusting will be easy. Indeed, the experience of recent decades proves that it can be difficult, at least over the short term. But if we take the leap and seize the opportunities that change will bring, our societies will surely benefit.

r040330a_BOC

canada

Asia and the Global Economy

jenkins

It's a pleasure to be back in Vancouver. I'm especially honoured to be able to address faculty and students here at the University of British Columbia. UBC and the Bank of Canada have a long-standing relationship. Professor Mick Devereux was one of the first recipients of the Bank's research Fellowship, Professor Angela Redish was a Special Adviser at the Bank in 2000-01, and Professor John Helliwell is our current Special Adviser. As well, David Dodge was on the faculty here, in the Commerce Department, in 1997-98. And, of course, there have been numerous UBC graduates who have joined the Bank over the years. Let me now turn to my topic for today: Asia and the global economy. To state the obvious, Canada is a very open economy, heavily dependent on foreign trade. What goes on in the rest of the world can have a substantial impact on our domestic economy. Naturally, we tend to focus on the United States because roughly 80 per cent of our trade is with that country. But nowadays, the world for Canada is not just the United States. This was made very clear to us during the Asian crisis of 1997-98. At that time, events on the other side of the globe, in countries that were not even our major trading partners, had significant consequences for Canada's economy. The most important of these was the collapse of Asian demand for commodities, which led to a sharp decline in the world prices of major Canadian exports and to downward pressure on our currency. These days, Asia is once again in the news--although for different reasons. Today, I would like to talk about the increasing importance of that region, particularly China and India, in the global economy. I will also talk about the implications for policy in industrialized countries and in the emerging-market economies of Asia. I will then conclude my presentation with a few words on the Bank's outlook for the economy and inflation in Canada. To begin, let me just point out that what we are witnessing today is not a new phenomenon. Since the early nineteenth century, many countries have, at different times, emerged as major forces on the international economic scene. During the 1830s, productivity gains associated with the Industrial Revolution launched the United Kingdom as an economic powerhouse. Germany and the United States followed in the latter part of the nineteenth century, by adopting the new technology of the time, as did Russia for a while before the First World War. Through the 1950s and 1960s, Japan emerged from the Second World War to become a major economic power. Then Korea took off in the 1970s, followed by other so-called "Asian tigers" during the 1980s and 1990s. Now, it's China's turn. And India is not far behind. What differentiates China and India from these other countries is their sheer size. Together, these two countries represent close to 40 per cent of the world's population. By comparison, Japan accounted for only 3 per cent of the world's population at the time of its emergence as an economic force. What's also breathtaking is the speed of China's rise to economic prominence. In 1980, the Chinese economy produced less than 3 1/2 per cent of global output, measured on a purchasing power parity basis. By 2003, this share had risen to more than 13 per cent, roughly half that of the United States. In fact, China is now the fourth-largest exporter in the world, having surpassed Canada in 2001 and the United Kingdom and France in 2002. As for India, while its economy is also very large, equivalent to about a quarter of that of the United States, it is not yet a major global exporter. But, with advancements in communications and with a large number of well-educated workers, India is establishing itself as a significant and growing presence in the international service industry. Not surprisingly, many perceive the growing competition from China and India as a significant threat. And some are wondering how anyone can compete against countries that have such huge pools of cheap labour and access to the latest technologies. To be sure, China's rising production of manufactured goods and India's rapidly growing services industry represent a serious competitive challenge to other producers around the world. And, in an environment in which firms everywhere are under constant pressure to lower costs, many are finding that China and India are attractive places to establish production facilities and service centres. Indeed, a significant percentage of China's export companies are subsidiaries or affiliates of multinationals from industrialized countries. The same is true of the many call centres and software manufacturers that have located in India. The loss of jobs in the home countries of those companies can be a sensitive social and political issue and can contribute to protectionist pressures, especially during periods of relative economic weakness and subdued employment growth. In the United States, outsourcing has become a major issue in the political debate leading up to this year's presidential election. The perceived threat to jobs and domestic production from the growing integration of the emerging Asian economies into the global economy is one point of view. But, to put things in perspective, there is another viewpoint. Increased competition is beneficial, even if somewhat painful at times. Competition spurs innovation. And efforts to increase productivity benefit consumers everywhere. In industrialized countries, lower prices for goods and services mean that consumers and firms have more money to spend on other goods and services. This, in turn, contributes to increased overall demand in the economy. Competition is also part of the normal market process of "creative destruction," which sees dated, low-productivity activities replaced by more innovative, dynamic enterprises. Let us not forget that higher productivity leads to durable increases in real incomes. And while jobs may be lost in sectors facing heightened competition, others are being created elsewhere. It is also important to keep in mind that international trade is based on comparative advantage. A country will tend to specialize in, and export, those goods and services that it can produce at a low, not an low, cost. Put another way, even if a country has an absolute advantage in producing all goods and services, it and its trading partners would still be better off by focusing on the products they can produce more efficiently and importing those they can produce less efficiently. Robust economic growth in Asia, which is lifting hundreds of millions of people out of poverty, is creating more demand for goods and services from the industrialized countries, thus providing a much-needed boost to global economic growth. Indeed, preliminary data for 2003 suggest that China may have vaulted into third place among the world's most important importers, behind only the United States and Germany. We in Canada have certainly benefited from sharply higher U.S.-dollar commodity prices, which again reflect strong demand from Asia, notably China. Clearly, the growing integration of the Asian economies into the global economy presents challenges to policy-makers everywhere--in industrialized countries that are their principal markets, in other developing countries that may be losing market share in certain products to Asian competition, and in the Asian economies themselves. This integration process is being complicated by large external imbalances among major countries. Most importantly, a large U.S. current account deficit has its counterpart in large surpluses elsewhere. While China's overall current account surplus narrowed in 2003, its trade share of the U.S. market has been rising rapidly in recent years, reflecting its growing specialization within Asia. China is increasingly becoming an "assembly platform" for firms from other countries in the region: it is essentially importing materials from its neighbours for assembly and for final export to the United States. Collectively, the Asian economies are running a very large current account surplus with the rest of the world. The flip side of these imbalances has been a sharp rise in the net foreign liability position of the United States and a massive accumulation of foreign exchange reserves by the Asian countries. China has amassed more than US$400 billion of reserves, mainly because of efforts to maintain a fixed exchange rate against the U.S. dollar in the face of a persistent current account surplus and large capital inflows. India has permitted a modest appreciation of its currency against the U.S. dollar; but it, too, has seen a marked rise in international reserves, to roughly US$100 billion. Even more striking, as of the end of 2003, all of Asia (including Japan) had accumulated US$1.9 trillion in foreign exchange reserves. How these global imbalances will be corrected is currently a major topic of debate in international policy circles. Now, what does all this mean for policy-makers around the world? First, let me be clear about one thing: market forces will come to bear on these imbalances. The external indebtedness of a country, even a country as big as the United States, cannot grow indefinitely as a proportion of its GDP. At some point, investors will begin to balk at increasing their exposures to the United States. Similarly, the buildup of foreign exchange reserves in countries with balance-of-payment surpluses cannot be sustained indefinitely without repercussions for their domestic economies. So, market forces will, in the end, bring about an adjustment. But appropriate policy action by national authorities around the world can help to address these global imbalances and facilitate an orderly adjustment process. What we need is a multifaceted policy approach. Let's start with policy-makers in the industrialized countries. What can they do? Above all, they should resist the siren song of protectionism. Trade--whether in goods or services--is a positive-sum game. That is to say, in the end, all countries can be winners. If countries yield to protectionist pressures, everyone in the international community will be worse off in the long run. Moreover, protectionist actions that focus on bilateral imbalances will not reduce the size of a country's overall current account deficit. If the underlying cause of that deficit is not addressed, say, through efforts to increase domestic savings, protectionism would only result in trade flows being diverted to other countries. Policy-makers everywhere can certainly take steps to improve their domestic economic situations through appropriate national policies. Macroeconomic policies should aim to promote sound, sustained economic growth--that is, growth at an economy's production capacity. Fundamentally, this means a fiscal policy that keeps the public debt-to-GDP ratio on a sustainable track, and a monetary policy that is directed towards low, stable, and predictable inflation. Structural policies designed to make product and labour markets more flexible are also key to facilitating the movement of labour and resources from sectors that are shrinking to those that are expanding. Finally, social policy has an important role to play in spreading the cost of adjustment more evenly. Here in Canada, federal and provincial governments have done a great deal to clean up their balance sheets over the past decade. And we at the Bank of Canada have kept inflation low. We have done this by working within an inflation-targeting framework, supported by a flexible exchange rate that allows us to respond to shocks that threaten to take inflation above or below the 2 per cent target. In addition, Canada has made progress in improving its economic flexibility through structural reforms. We have seen the payoff from these investments in sound policies. That payoff is solid underlying economic growth and an improved ability to adjust to changing circumstances and adverse shocks and to take advantage of new global opportunities. Emerging-market economies in Asia could also contribute to the orderly and timely adjustment of global imbalances through greater policy flexibility. First of all, greater exchange rate flexibility would help to head off growing protectionist pressures among their major trading partners. More importantly, such flexibility is likely to be in their best domestic interest. As I said before, the persistent accumulation of reserves, stemming from official efforts to preserve a "competitive" nominal exchange rate, will eventually have repercussions for their economies. Although, in theory, a country can accumulate reserves indefinitely, in practice, this can be difficult. Often, it leads to a loss of monetary control and to rapid credit expansion, which can set in motion a boom-bust cycle. It was precisely this kind of cycle that contributed to the financial crises in some Asian economies in 1997-98. It is possible that history may be repeating itself in China. Bank lending is growing rapidly, contributing to overinvestment in certain areas of that economy--most notably property development. The fixed exchange rate itself may also be encouraging a misallocation of resources, with too much investment going into export-oriented industries. It is well known that China faces serious challenges in strengthening its financial system. And many argue that financial sector reform is a prerequisite for greater exchange rate flexibility. But the risks of adopting that view are twofold: one, macroeconomic instability, in the form of higher inflation, and two, financial instability, in the form of an increased number of bad loans due to excessive credit expansion. The Chinese authorities are aware of these risks. Indeed, late last year, the central bank raised the reserve requirements of commercial banks in an effort to slow bank lending and moderate the torrid pace of economic growth that topped 9 per cent in 2003. And last week, additional measures were announced to tighten monetary policy. Ultimately, rapid money growth and credit expansion would lead to higher inflation in China and thus to an appreciation of the exchange rate of the Chinese currency, even as the nominal exchange rate remains fixed. Remember, it is the real exchange rate that matters when it comes to international trade. Greater exchange rate flexibility would help to mitigate the risk of China's economy overheating. It would also help the adjustment to rising productivity, by facilitating an upward movement in real wages. But one needs to go one step further and think about how greater exchange rate flexibility fits into an overall framework for monetary control. Policy-makers in China, as well as in other Asian countries, might want to think about adopting a monetary policy framework similar to Canada's. An explicit inflation target to anchor expectations, combined with a flexible exchange rate, enables monetary authorities to maintain price stability in the face of domestic and external shocks. Such a framework would provide the Chinese authorities with an effective approach for addressing the needs of their economy. With China being a linchpin of the Asian economy, greater exchange rate flexibility in that country would probably encourage similar moves by other countries in the region. Together with actions by countries on other policy fronts--especially policies to promote strong domestic demand and sustainable fiscal positions--we would be looking at a powerful, multifaceted approach to addressing global imbalances. To recap, the emerging economies in Asia, particularly China and India, are fast becoming important players and formidable competitors in global markets. From a historical perspective, their rise to economic prominence is not unusual. There have been many examples, and there will be more, as part of the economic convergence that sees poor countries catching up to richer ones. The economic ascent of China and India brings with it many benefits, not just for them, but for the rest of the world. To be sure, given the size of these two economies, their rise to prominence also raises a number of policy issues for the international community. I hope that policy-makers in the industrialized countries will not respond with protectionism, but that they will instead continue to focus their efforts on doing what is right for their domestic economies. This means, providing a stable macroeconomic environment, making their economies more flexible in order to meet the growing competitive challenge, and facilitating the transfer of resources from shrinking to expanding economic sectors. For the Asian economies, a key issue is the choice of a monetary policy framework, including an exchange rate system that will best serve their needs over the longer term as they become more and more integrated into the world economy. Adjustments in those countries will also require a focus on social policies aimed at sharing the gains from global integration across income groups. Let me now turn to the Bank's outlook for the economy and inflation in Canada. I don't need to tell you that 2003 was a particularly eventful and challenging year for the Canadian economy. In addition to the fallout from the war in Iraq, we had to contend with a number of other shocks--SARS, mad-cow disease, a large-scale electricity blackout in Ontario, and forest fires, floods, and drought in Western Canada. But perhaps the most significant and persistent shock to our economy, as a whole, over the past year, has been the rapid appreciation of our currency against the U.S. dollar. The stronger Canadian dollar has held back export growth and increased competition from imports. Under the effect of all these shocks in 2003, output growth slowed and, at the end of the year, our economy was operating further below its production capacity than we had predicted earlier. With this, the inflationary pressures that had started to be felt a year ago eased significantly, and inflation fell below the 2 per cent target. To support aggregate demand and return inflation to 2 per cent over the medium term, we have cut our policy interest rate four times since last July, by a total of one percentage point, to 2 1/4 per cent. , we lowered our projection for output over the next year and a half. Information received since then has been broadly consistent with the base-case scenario that we laid out in the . Although final domestic demand might be marginally weaker than projected, net external demand could be somewhat stronger because of the pickup in global economic activity, especially in the United States and Asia, and higher commodity prices. On balance, then, our economic projection is essentially unchanged from January. We still expect output growth to average about 2 3/4 per cent this year and to accelerate to 3 3/4 per cent next year. This should help absorb most of the slack in the economy by the third quarter of 2005. Core inflation--which excludes the most volatile components of the consumer price index, thus providing a better reading of the underlying trend of inflation--fell close to the bottom of the 1 to 3 per cent target range in February. But we expect it to move back up within the next few months and to stay around 1 1/2 per cent through the rest of this year, before rising towards 2 per cent by the end of 2005. To conclude, our economy is going through a period of adjustment to new global forces. These include stronger world economic growth, higher commodity prices, and heightened competition, particularly from countries like China and India, as I have discussed at some length today. In addition, there is the realignment of world currencies, including the Canadian dollar, in response to large global imbalances. And this is another shock that we will have to adjust to. The main uncertainty for the Canadian outlook continues to relate to the adjustment of our economy to these global forces. The Bank of Canada has a role to play in facilitating these adjustments. That role is to support aggregate demand and to keep inflation low, stable, and predictable. To this end, we will continue to closely monitor the evolution of domestic and foreign demand, and the pressures on inflation, as the economy adjusts to global changes.

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Release of the

dodge

Today, we released our April . The reviews economic and financial trends in the context of Canada's inflation-control strategy. The Canadian economy continues to adjust to developments in the global economy, such as stronger world demand, higher commodity prices, and the realignment of world currencies, including the Canadian dollar. Emerging-market economies, especially China and India, are contributing to intensified competition but are also creating new trading opportunities for Canada. These developments require shifts in activity among sectors and create a need for adjustments by many businesses. Monetary policy is facilitating these adjustments by supporting aggregate demand, with the goal of keeping the economy near its full potential and inflation on target. The Canadian economy was affected by a number of shocks in 2003. Thus, despite a broadening of the global economic recovery and higher commodity prices, economic growth in Canada at the end of the year was well below the level projected by the Bank in its October . Preliminary indications are that growth in the first quarter of this year was marginally below 3 per cent. The Bank's view is that the economy is operating significantly below its potential. The Bank's outlook for economic growth and inflation is essentially unchanged from that of the January . The economy is expected to grow by about 2 3/4 per cent in 2004, picking up to about 3 3/4 per cent in 2005. This stronger growth is expected to come from private domestic demand, reflecting the current monetary stimulus in the economy and high levels of business and consumer confidence. Such growth would return the economy to close to its production potential by the third quarter of 2005. Core inflation--which removes the most volatile components of the consumer price index and the impact of indirect taxes on the remaining components--should average 1 1/2 per cent over the remainder of this year. As excess supply in the economy diminishes, core inflation is expected to move back to 2 per cent by the end of 2005. The main uncertainty for the outlook continues to relate to how the Canadian economy adjusts to global developments. Overall, the risks to the outlook appear balanced. Now Paul and I will be happy to answer your questions.

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Economic and Financial Policies for Growth in the Americas: A Canadian Perspective

dodge

Governor of the Bank of Canada to the Council of the Americas It's a pleasure to be here today. The invitation to speak to you comes at an opportune time, as I have recently completed a round of visits to Mexico, Brazil, and Argentina. While there, I spoke on the subject of adjustment to global change and the policies needed to facilitate that change, drawing on Canada's experience. I also exchanged views with central bankers and finance ministers in all three countries about their efforts to promote economic growth and adjust to the new forces at work in the global economy. I hope that the insights I have gained from those discussions will better inform the Canadian view that I bring you today concerning the economic policies needed for sustainable growth in the Americas. Today, all of us in the western hemisphere face quite a different world economic order from that of a decade or two ago. As we look across the Atlantic to Europe, there is a sense that, with countries in the Far East rising to economic prominence, trade across the Atlantic may become relatively less important than trade across the Pacific. The giant emerging-market economies of China and India are truly changing the economic balance across the Pacific in a way that none of us can afford to ignore. The sheer size of these two economies is very impressive in itself: together, they account for close to 40 per cent of the world's population. And they produce about 18 per cent of world output. Moreover, that output is growing more than twice as fast as that of Canada or the United States. Here in North America, the fact that the combined population of the United States and Canada is only 300 million means that, in the future, we will account for a smaller fraction of the global, and even the hemispheric, economy. This is a good thing? not because our relative weight will be shrinking, but because that of the others will be growing. Still, this is going to be a challenge for the United States, which, since the Second World War, has been producing such a large portion of the global output. And so it is particularly important at this time, when the United States still has so much leverage, that it continue to provide leadership in building a strong rules-based world trade order. Beyond this, just as the countries south of the Rio Grande have to do, Canada and the United States will have to confront the challenges of Asian competition and find ways to seize the opportunities presented by some of these huge, growing markets. The other major challenge that we all face is demographics. In Canada and the United States, the issue is aging populations. But south of the Rio Grande and in the Caribbean, there are large and growing numbers of young people who will be looking for jobs. Our problem in the north is how to support an aging population without placing undue strain on a shrinking work force. Theirs in the south is to grow fast enough to create jobs for the large number of young people that will be entering the labour market. This, then, is the economic and demographic environment in which we in the Americas now have to operate. So, in this context, we have to ask ourselves, How does each country run its own economic policies to enhance growth and maximize the chances of improving standards of living over time? Right off the top, let me make a key point. Most of the elements of good economic policies for growth apply equally to Canada, the United States, and every other country in the rest of the hemisphere. To be sure, there will always be nuances because of the particular stage of a country's development or institutional framework. But, in my view, it is very dangerous to excuse significant divergence from sound medium- and longer-term policies on the basis of short-run or apparent local political exigencies. For, over time, we have learned an awful lot about policies for growth. And we now know that any departures from good policies, even for relatively short periods of time, should be viewed with real skepticism. This is particularly true of macroeconomic policies, but it is equally true of structural (microeconomic) policies. So with that, let me now talk about some of the fundamental policy underpinnings that apply to all of us as we forge ahead in pursuit of solid economic growth. In doing so, I will draw on Canadian experience. Economic policies for growth We Canadians have had our share of economic and financial ills during the past 30 years. Some of what we have learned in dealing with those ills may now seem selfevident. But it is through significant and rather costly economic adjustments that we have come to appreciate their importance. The first lesson is that solid economic growth depends crucially on the confidence that comes from well-managed macroeconomic--that is, monetary and fiscal? policies. The second lesson is that, given the ongoing changes that I discussed earlier, continuous adjustment will be necessary. We have also learned that, even though economic adjustments can be difficult and painful in the short run, there is really no way around them. As a central banker, I would like to focus more on macroeconomic policies today. But structural policies that aim to increase the flexibility of our economies are every bit as important for economic growth. So, I will begin with a few points on those policies. Structural policies The first point relates to security. Security is one of society's most basic needs, and it is fundamental to economic growth. So, the first element of good economic policy for every government is to provide a reasonable level of security for its citizens. I know that I do not have to say more on this subject to this New York audience. Equally important is the rule of law, particularly laws regarding the enforcement of contracts. We know that where these are unreliable, or perceived to be unreliable, even well-intentioned and well-executed macroeconomic policies can easily falter. Nowhere is the enforcement of rules more critical than in cross-border trade. And this leads me to my next point, which is the importance of keeping our borders open? within the Americas and across the oceans. This is not easy. There are always pressures in every country to protect domestic producers. And yet, both you in the United States and we in Canada have learned that it is through the opening of those borders and the tearing down of barriers that domestic competition and efficiency are spurred and higher living standards are achieved. That is why Canada strongly supports efforts to extend the benefits of free trade why we are, most importantly, committed to lowering trade barriers at the Doha round of multilateral negotiations. To be sure, adjusting to strong competitive pressures, such as those now coming from China, is a major challenge. And for some countries in the Americas this may be a bigger challenge than for others. But we have learned that the way forward is to adjust to competition, not suppress it. That means not yielding to protectionist pressures, but rather continuing to focus on doing what is right for our domestic economies? providing a stable macroeconomic environment and making our economies more flexible. If we yield to protectionism, everyone in the international community will be worse off. This is one area where Canada and the United States have a real opportunity to continue to provide leadership. The other thing we have to keep in mind is that the Asian countries that are now formidable global competitors, are also a great source of demand for our products, whether for raw materials, machinery and equipment, or high-end technology goods. And they are important investment destinations for our firms to produce increasingly higherquality inputs and intermediate goods, at lower cost? goods that can be shipped back here, helping us to enhance our own competitiveness. In addition to freer trade, it is important that all of us in the western hemisphere have other appropriate structural policies in place. Such policies facilitate necessary economic adjustments and help to increase productivity and raise living standards over time. Here, I am thinking of policies that, among other things, work to reduce industrial subsidies, to reform labour markets, unemployment insurance, and pension plan systems, to establish intellectual property law, and to develop rules for the efficient regulation of financial markets. Now, we all know that implementing some of these policies may mean that certain groups in society will bear an unfair share of the adjustment. And quite naturally, some will resist? and resist strongly? changes that mean the loss of their job, even though society as a whole stands to benefit from those changes. And so it is critical that we also have arrangements in place to facilitate the training and retraining of workers, their relocation, or their movement from shrinking to growing areas of the economy. Such arrangements are vital for all countries, although their specific nature will vary depending on the structure of the individual country. Promoting an efficient and robust financial system, including a strong banking sector, is also of the essence. This is especially so for countries that, like Canada, have a large number of small and medium-sized firms. To grow, these firms must have access to credit within a well-functioning banking system. And people need to have confidence in their domestic financial system if savings are to be efficiently recycled to help firms expand, and if governments are to obtain financing from domestic sources. Moreover, as we have learned from the Asian and Russian financial crises, a strong banking sector can be the best defence against international financial crises. Also, let us not forget that it is through the financial system that monetary policy actions are transmitted to the economy. So, a strong and efficient financial system is critical to the conduct of monetary policy? to which I will now turn, as I talk about the role of macroeconomic policies in promoting growth. Macroeconomic policies Here, I can speak from the vantage point of a country that is a "reformed" past sinner, particularly with regard to fiscal management. And I can speak with a certain conviction; for, as the Chinese say, "those who fall in a pit, gain in wit". To put all this into context, let me quickly sketch for you Canada's situation in the late 1980s, when we were facing serious economic and financial difficulties. Government spending was near historic highs relative to the size of our economy. Public debt was rising rapidly, as was the share of it held by foreigners. To service that debt, the government was spending one out of every three tax dollars taken in. Real estate prices were also rising quickly, adding to fears of a return to the high inflation rates of the 1970s and early 1980s. Those concerns were fully reflected in the large risk premiums that domestic and foreign investors demanded. By the early 1990s, it had become abundantly clear that the situation was untenable, and that Canada could no longer put off major adjustments. We started tightening monetary policy in 1989. Then in 1991, together with the federal government, we took a major step towards a commitment to price stability, by agreeing on an anchor for monetary policy. This was an explicit inflation target that would lower inflation to 2 per cent? the midpoint of a range of 1 to 3 per cent. Over the past 13 years, we have kept inflation around 2 per cent, on average. And inflation expectations have fallen into line. The emphasis that we place on keeping inflation around 2 per cent means that we will raise interest rates when the economy looks about to overheat. But it also means that we will lower rates to stimulate demand if it looks as though the economy will be operating below full capacity, thus threatening to take inflation below target. This symmetric response helps to smooth the ups and downs of the business cycle. Our inflation-targeting strategy thus works to stabilize fluctuations in demand and to put the economy on a track to achieving maximum sustainable growth over time. Most importantly? and that is relevant for all countries, including the United States? inflation targets have enabled us at the Bank to explain more clearly to business, labour, and the general public what we are doing and why. The benefits from this approach are far from trivial. Better public understanding of central bank policies and actions makes monetary policy easier to conduct and more effective. And this understanding, together with an explicit inflation target, allows citizens to better gauge the performance of their monetary authorities. Not to mention that it also makes it harder for governments to follow bad policies. Canada and other inflation-targeting countries, including Mexico, Chile, and now Brazil, have also found that targets can be particularly useful in helping economies with a past record of high inflation to make the transition to a low-inflation environment. Targets help to establish and maintain policy credibility. All told, we have found that a monetary policy based on an inflation-targeting approach can be particularly helpful in keeping inflation low, stable, and predictable, thus contributing to good economic performance. Still, a sound monetary policy is a necessary, but not sufficient, condition for solid, sustainable growth. This is because monetary policy works best when it goes hand in hand with other sound economic policies, particularly a prudent fiscal policy. This is another key message drawn from Canadian experience. Although inflation in Canada came down quickly after the adoption of the inflation targets, through the first part of the 1990s, the Bank of Canada was still constrained in its ability to reduce interest rates to support the economy. With the combined federal and provincial budget deficit close to 8 per cent of GDP, and with the overall public debt at a peak of 100 per cent of GDP, investors continued to demand large risk premiums. It was only after the mid-1990s, when federal and provincial governments made a determined, and successful, effort to eliminate their deficits, that policy credibility improved. This increased credibility led to smaller risk premiums, allowing the Bank to take action, as needed, to support economic activity. One thing is very clear: implementing and maintaining a sound fiscal policy is fundamental to good economic performance. A sound fiscal policy means a more effective monetary policy. But it also means , most importantly, that citizens can have confidence that the authorities will manage public finances prudently and, consequently, that social programs that are important to individuals and to the cohesion of societies will be preserved. For Canada and the United States, this is especially important with regard to public pensions, in light of expected demographic pressures. We in Canada have dealt with our public pensions issue. I expect that the United States, too, would want to do the same. Sound fiscal management also ensures that governments will not inflate problems away or renege on public debt. When the fiscal situation becomes unsustainable and is not taken in hand, confidence can be quickly frittered away. And in more extreme cases, as we have seen, savers and investors rush for the exits, triggering a crisis. In Canada, we came uncomfortably close to a serious loss of confidence in the early 1990s. Fortunately, Canadians understood the need to take decisive action, and supported government efforts to that effect, despite the short-term economic difficulties and costs that this entailed. One extremely important lesson that I draw from recent Canadian experience is this: whether on the monetary or the fiscal side, you need a plan, you set a target, you make sure that you hit the target year after year, and you don't change the rules when the going gets tough. This is how you earn credibility and how you provide confidence. But I do not want to leave you with the impression that targets are mechanical rules to be followed slavishly. For example, fiscal targets must allow for inevitable shortfalls or surpluses of revenues because of unanticipated developments. What is critical here is that such targets be based on the longer-term needs of a particular country. Thus, for us in Canada and the United States, it is appropriate that we focus on a reduction, over the medium term, in the level of our public debt, so that we will be able to cope with demographic pressures 10 or 20 years out. It is for this reason that Canada's most recent federal budget sets an explicit target for reducing the ratio of public debt to GDP to 25 per cent within 10 years. For us in Canada, this makes sense. Similar action would make sense in the United States. But, in countries with young and growing populations, different approaches might be needed. To recap, whether it is monetary or fiscal policy we are talking about, reasonable targets are a great aid. They help citizens to understand why specific actions? and sometimes very difficult actions? are being taken. They also enable citizens to hold their monetary and fiscal authorities accountable. Most importantly, with targets, and with a good record of achieving those targets, workers and investors? domestic and foreign? can look to the future with greater confidence. And in these circumstances, macroeconomic policies can make their maximum contribution to economic growth. Concluding thoughts Let me conclude. Sound macroeconomic and structural policies are fundamental to achieving sustainable economic growth. Such policies are always difficult to implement. Fortunately, the current external environment is favourable for taking the steps to do what needs to be done. World demand is strengthening, financial conditions in mature and emerging-market economies have improved, and we all have a better understanding of which policies are the right ones. The best time to fix the roof is when the sun shines. More open trade, appropriate structural policies, and sound macroeconomic policies all have an important role to play in helping us cope with, and make the most of, ongoing global changes. No single policy is a silver bullet. They are all essential and they all work together, reinforcing each other, to promote solid economic growth.

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Opening Statement before the Senate Banking, Trade and Commerce Committee

dodge

Good morning, Mr. Chairman and members of the Committee. As always, we appreciate the opportunity to meet with you twice a year, following the release of our . These meetings help us keep Senators and all Canadians informed about the Bank's views on the economy and about the goal of monetary policy and the actions we take to achieve it. The Canadian economy continues to adjust to developments in the global economy such as stronger world demand, higher commodity prices, and the realignment of world currencies, including the Canadian dollar. Emerging-market economies, especially China and India, are contributing to intensified competition but are also creating new trading opportunities for Canada. These developments require shifts in activity among sectors and create a need for adjustments by many businesses. Monetary policy is facilitating these adjustments by supporting aggregate demand, with the goal of keeping the economy near its full production potential and inflation on target. When Paul and I appeared before this Committee last October, we told you that economic growth in Canada was weaker than expected and that there was more slack in the economy than we had projected six months earlier. As you know, the Canadian economy was affected by a number of shocks in 2003. Thus, despite a broadening of the global economic recovery and higher commodity prices, it turned out that the economy at the end of the year was operating well below the level that we had projected in our October . Preliminary indications are that growth in the first quarter of this year was marginally below 3 per cent. Thus, the Bank's view is that the economy is still operating significantly below its potential. Our outlook for economic growth and inflation is essentially unchanged from that of the January . The economy is expected to grow by about 2 3/4 per cent in 2004, picking up to about 3 3/4 per cent in 2005. This stronger growth is expected to come from private domestic demand, reflecting the current monetary stimulus in the economy and high levels of business and consumer confidence. Such growth would return the economy to close to its production potential by the third quarter of 2005. Core inflation--which removes the most volatile components of the consumer price index and the impact of indirect taxes on the remaining components--should average 1 1/2 per cent over the remainder of this year. As excess supply in the economy diminishes, core inflation is expected to move back to 2 per cent by the end of 2005. The main uncertainty for the outlook continues to relate to how the Canadian economy adjusts to global developments. Overall, the risks to the outlook appear balanced. Mr. Chairman, Paul and I will now be glad to answer the Committee's questions.

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Opening Statement before the House of Commons Finance Committee

dodge

Good afternoon, Mr. Chairman and members of the Committee. We appreciate the opportunity to meet with you twice a year, following the release of our . These meetings help us keep Members of Parliament and all Canadians informed about the Bank's views on the economy, and about the goal of monetary policy and the actions we take to achieve it. The Canadian economy continues to adjust to developments in the global economy such as stronger world demand, higher commodity prices, and the realignment of world currencies, including the Canadian dollar. Emerging-market economies, especially China and India, are contributing to intensified competition but are also creating new trading opportunities for Canada. These developments require shifts in activity among sectors and create a need for adjustments by many businesses. Monetary policy is facilitating these adjustments by supporting aggregate demand, with the goal of keeping the economy near its full production potential and inflation on target. When Paul and I appeared before this Committee last October, we told you that economic growth in Canada was weaker than expected and that there was more slack in the economy than we had projected six months earlier. As you know, the Canadian economy was affected by a number of shocks in 2003. Thus, despite a broadening of the global economic recovery and higher commodity prices, it turned out that the economy at the end of the year was operating well below the level that we had projected in our October . Preliminary indications are that growth in the first quarter of this year was marginally below 3 per cent. Thus, the Bank's view is that the economy is still operating significantly below its potential. Our outlook for economic growth and inflation is essentially unchanged from that of the January . The economy is expected to grow by about 2 3/4 per cent in 2004, picking up to about 3 3/4 per cent in 2005. This stronger growth is expected to come from private domestic demand, reflecting the current monetary stimulus in the economy and high levels of business and consumer confidence. Such growth would return the economy to close to its production potential by the third quarter of 2005. Core inflation--which removes the most volatile components of the consumer price index and the impact of indirect taxes on the remaining components--should average 1 1/2 per cent over the remainder of this year. As excess supply in the economy diminishes, core inflation is expected to move back to 2 per cent by the end of 2005. The main uncertainty for the outlook continues to relate to how the Canadian economy adjusts to global developments. Overall, the risks to the outlook appear balanced. Mr. Chairman, Paul and I will now be glad to answer the Committee's questions.

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Research in Financial Services and Public Policy - Filling the Gaps

dodge

Governor of the Bank of Canada Good evening, ladies and gentlemen. It gives me great pleasure to open this important conference on research in financial services and public policy. In his invitation to this event, my former colleague , Fred Gorbet, referred to the need for "highly focused academic research in Canada on the linkages between public policy and financial services." I certainly concur with this assessment, and so I am happy to be a participant here today. For five years, the research program here at Schulich has helped to support and nurture a Canadian academic community focused on financial services. In doing so, the program has encouraged researchers to fill the gaps in our knowledge and help policy-makers and regulators to do a better job. After five years, it's useful to think back and recall the motivations for establishing this program in the first place. It goes without saying that the economy works better when a country's financial services sector is as sound and as efficient as possible. And the importance of promoting soundness and efficiency was certainly highlighted by the events of the late 1990s. Five years ago, the global economy was emerging from the Asian and Russian financial crises, and the near-collapse of Long-Term Capital Management. During these events, we saw that financial markets are a key channel through which crises can spread. And among the countries most affected, we saw that one common element was a weak banking system. So one clear lesson to be learned was that the strength of a country's financial system is crucial. This is particularly true in times of stress, because a strong financial system gives an economy a better chance of making necessary adjustments, before a stressful economic situation turns into a full-blown crisis. It may be tempting to look at today's relatively benign economic and financial environment and conclude that the urgent need to strengthen financial systems has passed--tempting, but wrong. Now is precisely the time to get the work done, when there is considerable liquidity in the global system, and interest rates and spreads around the world are low. Because, at some point down the road, there will be less liquidity, and interest rates and spreads will be higher. So if we wait, the task will only become more difficult. It may be a cliche to say that we should fix the roof when the sun is shining, but the point is valid. During the past five years, other events have also underlined the importance of the research you are doing here at Schulich. Following the collapse of Enron, and in the wake of other scandals, we have heard a great deal about corporate governance, transparency, and accountability. As businesses and policy-makers address these issues, we all need to understand how current rules are affecting the efficiency and stability of the financial sector, and how any proposed new rules will do so in the future. Regulators must always keep in mind that their actions may have unintended consequences, thus making the solution worse than the problem they were trying to correct. The Bank of Canada has been a source of funding for the research program at Schulich since its inception. It is fair to ask why the Bank cares so much about financia l services and public policy research. Our interest stems from our mandate to further the economic and financial welfare of Canada. There are several ways that we do this, and the work that you do here has relevance for all of our roles. The most high-profile way that we promote the economic well-being of Canadians is, of course, through the conduct of monetary policy. We know that the financial sector and financial markets are at the heart of the transmission mechanism for monetary policy. And we know that monetary policy is more effective when markets function well. So it is absolutely critical that the Bank understand the financial sector and the markets as thoroughly as possible. We also promote Canada's economic well-being through our role as lender of last resort. We have a mandate to oversee those payment, clearing, and settlement systems that have the potential to pose systemic risk. And we have a less formal, but still important, role in providing advice to the Department of Finance on financial sector policies. In all of these areas, it is clear that we have a strong interest in promoting sound institutions, efficient financial markets, and well-functioning systems to support them. Of course, financial markets and institutions play a critical role in the economy by serving borrowers and savers, and by bringing about the efficient allocation of credit. But the financial sector itself is an important contributor to economic growth. So policy-makers also have an interest in providing a framework that will allow our financial institutions and markets to compete in an increasingly globalized world. With global standards evolving rapidly, Canada must be at the forefront in terms of efficiency and soundness. One thing that the Bank can do is to help policy-makers and financial service providers have the best available research at their disposal. Indeed, in our most recent medium-term plan, the conduct and promotion of leading-edge research was identified as one of the Bank's strategic priorities. Of course, the Bank does a significant amount of research in-house. We have established an ambitious research program for 2004 and beyond. It includes such topics as how to improve our economic modelling, how regulatory initiatives and frameworks can help or hinder financial markets and institutions, and an investigation into the effects of various types of asymmetric information on capital markets. We are proud of the work that we do. But we recognize that we can't do it all ourselves. There will always be large gaps in our research program. And we recognize that our research, and the research that is being carried out in universities, can be mutually strengthened through collaboration. And so we promote good research by actively collaborating with academics and seeking out partnerships. Finally, we try to inform others of what we are doing by publishing working papers and summarizing our work in our semi-annual And we post a summary of our research program on the Bank's Web site annually. We also know that good research requires good data. There is a widespread need for better data on the Canadian financial system, and the Bank has begun to seek out data sources through its Financial System Database Project. We know that pulling together more complete sources of data about financial institutions, financial markets, and payment, clearing, and settlement systems, will not be simple. Indeed, it will be a complex and costly project, and one where collaboration with external partners will be necessary, and enormously helpful. If we co-operate and build the databases properly, we can all share in the benefits. This is a priority for the Bank, and I would be happy to hear your suggestions on the best way to proceed with this ambitious project. That is an explanation of why we care about your work. Now let me take the opportunity--given this audience--to expand upon some of the areas where we at the Bank of Canada would like to see more research done. I will organize my remarks by talking about the three areas I have already mentioned: financial institutions; financial markets; and payment, clearing, and settlement systems. Within each area, I will raise a number of questions. What I want to do is to stimulate ideas, in the hope that some of you may be inspired to continue to probe into these issues. Over the past 15 years or so, regulators and policy-makers have been working hard to improve the soundness of financial institutions. Clearly, this is important and necessary work. But in carrying it out, we must always strive for a balance. That balance is between maintaining and strengthening the key elements of regulation and supervision that promote appropriate risk management, and the necessity to promote efficiency by keeping compliance costs to a minimum. So the question that can be asked is, How do regulators best encourage good risk management without unduly discouraging risk taking and without stifling innovation? Rather than putting the emphasis on compliance with a vast number of detailed rules, it seems to me that the goal of the regulator should be to encourage financial institutions to identify and measure the true nature of the risks being taken, and to see that methods are being developed to mitigate these risks. Policy-makers and regulators do not want to discourage appropriate risk taking to the point where incentives are created for appr opriate risk-taking activities to move outside the regulated financial system. Given the development of a wide range of new financial instruments and the exponential growth in their use, the need to find this regulatory balance is becoming more and more acute. It is certainly true that through these instruments, banks have become better able to manage risk by shifting some risks to others. But as banks do this, the question arises, Where do these risks ultimately reside? And are the bearers of these risks able to manage potential losses in times of economic stress, so that the financial system is ultimately more stable? The evolution in accounting standards also has many implications for financial institutions and markets. Does compliance with some of our accounting rules lead to large swings in reported earnings that do not reflect the true economic state of a firm? If we are to use fair-value accounting, how do we ensure that both assets and liabilities are correctly and equally marked to market? And we need to understand how particular elements of accounting rules can affect the risk-taking behaviour of financial institutions and investors. The issue of the right regulatory balance can also be looked at in relation to questions about the most efficient structure of financial institutions. This relates to the powers of institutions to do business, the types of business lines that can be offered by a single institution, and the corporate structures of institutions. As we approach the quinquennial review of the Bank Act in 2006, now is the time for researchers to be making their contributions to these areas. Let me now turn to financial markets. This is one area where considerable research has already been done, particularly in equity markets, and we now know more about how markets work than we did in the past. However, markets are constantly evolving, driven by technological and other forces. Given this, policy-makers and regulators should always be asking a basic question, while providing reasonable protection against inappropriate conduct and minimizing systemic risk, are we still allowing sufficient incentives for markets to innovate, develop, and become more Let me give you some concrete examples. Are there inefficiencies in the way that our markets provide financing for Canadian firms? Specifically, is there something about the structure of our markets that leads non-investment-grade issuers to go abroad for their long-term debt financing? Or are our banks remarkably efficient in providing longer-term capital through their corporate loan business? Or are other instruments, such as income trusts, providing a substitute mechanism? To begin to answer those questions, we need to have answers to even more basic questions, such as, What determines the cost of capital, and how does the cost of capital in Canada compare with that in other countries? Exactly how do Canadian firms access capital? And are there particular market impediments here in Canada that small and medium-sized issuers are facing? Again, we know much more than we used to in these areas, but our knowledge is still far from complete. One particular cost-of-capital issue that we have been investigating is related to the so-called "Canadian discount"--the fact that firms listed only on Canadian exchanges tend to have lower price-to-earnings ratios than comparable U.S. firms or Canadian firms listed on U.S. exchanges. This increases the cost of raising equity capital and may interfere with the ability of Canadian financial markets to provide the most efficient match between issuers and investors. Whether the source of the discount is a matter of perception or something more substantial, we need to understand the forces that are causing it. If policy-makers are to find the best ways to promote market efficiency, they need a better understanding of market microstructure. They need answers to questions such as, How do transparency and liquidity affect the cost of capital? How do different structures affect the optimal rules for transparency and liquidity in each market? Is the Canadian situation unique? And what lessons can be learned from the experiences of other countries? The Bank recently held a workshop on these and related topics, with input from many financial market participants. A summary of this workshop will appear in our next . Market microstructure will continue to be an important area of research at the Bank and, I hope, in the Canadian academic community as well. So far, I've talked about issues related to the architecture of the financial system. But as researchers, it is also important to pay attention to the plumbing--the critical infrastructure that supports the activities of institutions and markets. So let me ask a few questions regarding payment, clearing, and settlement systems. As I mentioned, the Bank of Canada is responsible for the oversight of those systems that have the potential to pose systemic risk. Of course, financial service providers are major participants in these systems. At the Bank, one major research project involves efforts to model payment, clearing, and settlement systems so as to better understand how they work. Further research into the best oversight processes for these systems is also a priority. While the Bank's objective is to see that risks are minimized, we need to do so in ways that do not unduly inhibit the development of even more efficient systems. Do any current practices create unnecessary inefficiencies? What issues are raised by the current drive towards straight-through processing? How can cross-border clearing and settlement be improved, particularly where the ownership of securities and the posting of collateral are involved? As you can see, there are still many questions that need to be answered. There are still gaps in our knowledge, and the need to fill these gaps is pressing. You, as academics and researchers, can do your part so that policy-makers, supervisors, and institutions are all better informed and more productive. As I said earlier, Canada's economic health depends on a strong financial services sector. So your work is crucial, not just for the Bank of Canada, but for all Canadians. I hope that I have been able to convince you that there are many research topics that are not only inherently interesting for academics, but relevant for public policy. I look forward to you filling the gaps in our knowledge.

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Town Hall Meeting

dodge

Good morning everyone and welcome. Welcome also to those of you joining us by videoconference. Today's gathering is very important, so I'm glad you have taken the time to attend. Before I begin I want to say hello to the members of the Management Forum and Executive Management Committee who are with us today. These Town Halls are becoming a bit of a springtime tradition. The snow melts and the time comes for us to get together. We take stock of where we are, where we're going, and how we want to get there. As you know, many institutions, both governmental and private, are currently concerned about governance structures, accountability and rules of behaviour. Of course we focused on these issues a couple of years ago when we established our Compass. And it's our Compass I'd like to focus on now. It is an amazing document. I think it captures the essence of who we are. And one of the truly great things about it is how it came to be. Creating the Compass was a comprehensive exercise. It was top down, bottom up and side to side. Staff had an opportunity to take part in the consultation, debate, and careful consideration that went into the making of it. Together, we produced a remarkable set of commitments to Canadians, to excellence, and to each other. We really don't need to worry about producing something new. But it is useful as we get together, to remind ourselves of what it is that we created. Our commitment to Canadians placed our legislated mandate into very concrete terms. Canadians need to have confidence in the value of the money they earn and the quality of the bank notes that they carry around. They need to have confidence in Canada's financial system. They want to know that the Bank is managing the government's funds with integrity. And that we are communicating and being accountable for what we do. When we say we are committed to Canadians, we're saying we're committed to fostering their confidence in our integrity as a central bank. Our second commitment is to excellence. It reflects the high standards we set for ourselves in our work on behalf of Canadians. It goes hand in hand with the statement we made when we launched the Compass and the Medium Term Plan. Namely: that we are committed to performance that is second to none among the central banks of the world. It was a challenging goal then, and it still is. But we're getting there. We're doing outstanding work in monetary policy; I'm very proud of the way we have continued to meet our inflation control targets. In the area of currency we're producing new bank notes in the Canadian Journey series. The new $100 bill represents the first of three new notes being issued this year; notes that are designed to be secure, durable and well-accepted. Here at the Bank we are fostering an ongoing atmosphere of trust, respect and innovation through our strong system of values. We continue to place a strong emphasis on research and analysis in all aspects of our work. How else is our commitment to excellence in evidence? There are the partnerships we are cultivating both within and outside the Bank. We are communicating clearly and openly. We are nurturing leadership at all levels. And we are cultivating diversity, both of people and of ideas. Together, in all of these ways, we have been achieving excellence. The third commitment we made was to each other. We were clear that we wanted our work environment to be founded on a strong set of values. The first of these is that we articulate our own ideas and listen to those of others. We agreed to share knowledge and experience so that we could all learn from each other. Then, there was a pledge to develop our talent and careers to achieve personal excellence. Your own development, of course, has always rested first and foremost with you. But the Bank has been providing some of the impetus, and helping to create an environment that is conducive to learning and growing and an environment where the two official languages is vital to our organization. I hope that together we can progress further in making the Bank a true knowledge-sharing institution as we complete our medium-term plan. And while the Bank is encouraging you to excel by developing yourself, there is also the recognition of the fact that you have a life outside the Bank. We committed ourselves to working in an environment where each employee is respected. When we respect each other as individuals, then we can have the kind of debates that we need to help us become the best we can be. We can have clashes of ideas secure in the knowledge that there are no winners or losers. Or rather, that we're all winners, because what we're doing is exploring all aspects of an issue. And finally, we said we would recognize those who demonstrate our commitments. I encourage you to continue to think about ways that you can recognize people in your areas who live these values. We need to celebrate their successes. We need to share their ideas. That was the direction we laid out. Three strongly stated commitments, and a number of simply stated values intended to help us meet them. I was impressed by the Compass when it was written, and I've been impressed by how well we are all living by it. You showed real leadership in making this strong statement about who we are and what we stand for. The Compass serves us well. But as you know, with today's emphasis on corporate governance and accountability, other organizations, both private and public, are now searching for ways to achieve what we have already achieved. Many of these organizations are setting about doing this by putting in place a set of highly detailed rules to constrain behaviour. But I am sure that a lot of highly detailed rules is the answer for us. I don't think we need much more than the Compass. I think, to a large extent, it is a part of us now. And I think the proof of that is that integrity--your integrity--is clearly one of the towering strengths of this institution. So I don't think we need a lot of new rules to govern our behaviour. And where we do need more explicit guidelines and procedures, I'd like us to tread rather lightly. But I do want to say a couple of words today about two particular areas: disclosure of wrongdoing and conflict of interest. First, let me deal with disclosure of wrongdoing. We have had a policy for some time now, but we on the Executive Management Committee thought it was important that we also have procedures that conform more generally with procedures that the government of Canada is proposing. I encourage you to examine those procedures closely; if you have any questions, please talk to your manager. The second point I wanted to make was regarding our conflict of interest policy. The sign-off we all do here is important. Not because anything wrong is going on, but because our policy helps ensure that we don't run into these kinds of conflicts. So we do have, as an organisation, a few things in place beyond the Compass. But the Compass is what I always find myself coming back to. Practically everything we need is in there. And it's a respectful document. It gives each of us the responsibility of exercising good judgment. And more importantly, it says that we trust each other to do so. I'm really proud to be in an institution where we can operate that way. And the fact that we is something I believe each of you should take pride in. Because, let's face it, it's not something that happened by itself. It's not a coincidence. It was your ideas that shaped the Compass. And it's no coincidence that the Compass is even more relevant today than when we put it together. So, congratulations not only for creating it, but for living by it.

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The Changing World Economy: What It Means for Canada

dodge

Governor of the Bank of Canada to the Hamilton Chamber of Commerce Good afternoon. I am very glad to be in Hamilton today. This city has undergone tremendous change over the past couple of decades, and it's certainly exciting to see the revitalization efforts taking place here. And now, Hamilton is working to diversify its economic base. It's obvious that adjusting to change is not a new thing for The same is true of the Canadian economy, which must always adjust to changing domestic and world circumstances. During 2003 and so far this year, some of those adjustments may have felt more like overhauls, particularly for some manufacturing firms here in Ontario. One of the most important changes that we have all seen since 2002 has been the realignment of major currencies in the face of global trade imbalances. This has been driven primarily by weakness in the U.S. dollar against other currencies, including our own. A second change has been the weaker demand for Canadian exports in 2002 and 2003. In addition to the exchange rate effects, some of this weakness has been linked to growing competitive pressures arising from the rapid integration of China and, to a lesser extent, India, into the global economy. These countries are becoming increasingly important exporters and importers of a wide range of goods and services. Third, last year, the Canadian economy faced a number of specific domestic shocks, such as SARS, mad-cow disease, floods, fires, and the power blackout in Ontario. All of these developments since 2002 have left us with an economy that is operating below its production potential. I'll come back to Canada's specific economic outlook later on. But I'll spend the bulk of my time today discussing the major changes that are taking place in the global economy, and how Canada is adjusting to this new environment. I will also talk about how the macroeconomic framework we have developed in Canada during the past couple of decades gives us more flexibility to adjust to global economic shocks and to embrace the new opportunities that change brings. We've all heard the old saying that the only thing we can be sure of is change. And we have certainly seen sweeping changes in the world economy over the past 20 years. Today, we are seeing significant swings in the balance of economic power, as large emerging markets have opened up to trade. But let's remember that integrating new regions of the world into the international trade order is not a new phenomenon. Since the early nineteenth century, various countries have emerged at different times as major forces on the international economic scene. After the Second World War, the world trade order, which had broken down in the 1930s, had to be rebuilt. The war-torn countries of Western Europe were slowly reintegrated back into that order. Through the 1950s and 1960s, Japan re-emerged as a major economic power. Then Korea took off in the 1970s, followed by other not far behind. What makes the ascent of China and India different from that of other countries is their sheer size. Together, these two countries represent close to 40 per cent of the world's population. Their combined economies, measured on the basis of purchasing-power parity (which compares economies by equalizing the purchasing power of their currencies for a similar basket of goods and services) add up to more than 85 per cent of the U.S. economy. In fact, by that measure, China's economy is the second largest in the world, after that of the United States, and India's is fourth, after Japan's. Their influence is intensifying the competitive pressure facing producers in other countries, including Canada. But it also means new, fast-growing sources of demand and new opportunities for us. Let's remember that some of the early emerging-market economies have become important markets for Canadian goods and services. The integration of China and India into the world trade order is taking place as other emerging-market economies, such as Mexico and Brazil, continue to carve out their niches in world markets. Now, I'd like to spend a few minutes discussing the adjustments that all open trading nations must make in this changing environment, and recall some of the lessons that past adjustments have taught us. First, let me say a few more words about the competitive environment. Not surprisingly, some perceive the growing competition from China and India as a threat. Companies everywhere are under constant pressure to lower costs, and many of them are finding that China and India are attractive places to establish production facilities and service centres. The loss of certain jobs in the home countries of those companies is a sensitive social and political issue and can contribute to protectionist pressures, especially during periods of relative economic weakness. But as we consider the impact of increased competition from Asia, it is important to remember that economic growth in Asia is lifting hundreds of millions of people out of poverty. That's an absolute good. And it is a new source of opportunity, creating more demand for goods and services from the industrialized countries and thus providing a boost to global economic growth. As our economies have become more open, we have also been reminded of the importance of a solid, efficient financial system. In any country, growing firms need access to credit from a sound, well-functioning financial sector, including a healthy banking sector. Countries with strong financial systems are much less likely to trigger or to amplify international financial crises than countries where those systems are weak. With the increasing integration of world markets, it is in everyone's interest to promote efforts to limit the impact and the spread of financial shocks. Since the Asian and Russian financial crises of 1997-98, countries have worked to improve the transparency and reliability of their domestic financial systems. Mexico, for example, has made tremendous efforts to improve the health of its banking sector, partly by drawing on the sound business practices of large banks from other countries, including Canada. In some countries, however, progress is less evident. And in China, the building of a strong commercial banking sector presents an enormous challenge. But it is not just domestic financial systems that need to be strong and flexible. As the global economic environment evolves, it is important that international financial institutions adjust in response. That is why institutions such as the International Monetary Fund and the World Bank must continue to modernize themselves, to remain relevant in a changing world. While the IMF and the World Bank have evolved somewha t since their creation in 1944, they have changed much less than the global economy they oversee. So it is encouraging that a strategic review of their mandates and operations has begun. This review is a first step towards a much-needed updating of these institutions. I've spent some time outlining some of the structural forces at work in the world economy. Now I'd like to talk about some of the adjustments that are being made following the recent sharp rise in global demand. The first adjustment is to higher commodity prices. The rapid growth of some emerging-market economies and the strong recovery in the United States are fuelling demand for raw materials. And that, in turn, is pushing up the prices of these raw materials. Certainly, we have seen the effect of this demand on most commodity prices. Of course, one price increase that we all feel acutely is that of oil. The recent surge in crude oil prices is another example of pressure stemming, at least in part, from strong world demand. This stronger demand has not yet been met by compensating growth in the supply of crude oil--although a recent agreement by OPEC to boost production will help. Nor have we seen substantial efforts by price-sensitive consumers to use less oil and gas. Meanwhile, geopolitical events have contributed to concerns about potential supply disruptions, exacerbating the run-up in oil prices. It is reasonable to expect that oil prices will remain relatively high until some of the geopolitical uncertainty dissipates, world production capacity expands, and further conservation efforts take hold. Higher energy costs mean that it will be more expensive to produce many goods and some services. It is not clear to what extent companies will be able to offset rising costs and limit price increases to consumers. What is clear is that economies need to adjust to these higher costs--and economic policies must support that adjustment. We have learned this from the mistakes made during the oil crisis of the 1970s, when many countries, including Canada, tried to shield their economies from the effects of rapidly rising energy prices. The result was an eventual adjustment that was slower and more painful than it needed to be. A second adjustment underway in the global economy is the return to more normal interest rates and somewhat wider spreads on risky investments. After the global economic slowdown of 2000 and the terrorist attacks of central banks around the world lowered their policy interest rates to provide the liquidity to help their economies recover and absorb excess capacity. The world economic recovery we are seeing is due, in large part, to accommodative monetary policy--that is, historically low interest rates. Through 2003 and the early part of 2004, interest rates in some countries hit their lowest levels in 50 years, and global credit conditions were very expansionary. But we know from experience that, as growth resumes and economies get closer to their production capacity, inflationary pressures start to build. And so central banks in many countries will have to remove some of the stimulus, and interest rates around the world will have to return to more normal levels. This process has already started, with market rates adjusting in anticipation of future increases in policy interest rates. There is no doubt that over the next year, we will see upward adjustments in policy interest rates around the world. The timing and the magnitude of these adjustments will vary from country to country, according to each one's economic circumstances. The good news is that all this is happening before economies reach the limits of their production capacity, and before inflation takes off and inflation expectations start to rise. That bodes well for sustained economic growth without the credit crunches or accelerating inflation that occurred in earlier global business cycles. I have painted a reasonably sanguine view of the world economy and its ability to meet challenges. I don't mean to suggest, however, that there aren't any economic risks in the adjustments that I have outlined. As you all know, we are again facing heightened geopolitical uncertainties. And there are significant global economic imbalances that must be corrected over time. But, over the past couple of decades, central bankers and governments, as well as corporations and financial institutions, have learned a great deal about managing global risks. And most countries agree on the critical elements and policies necessary to adjust to global economic change. So, just how well is Canada's economy adjusting? Let me look at some of the important efforts we have made and at the policies that are necessary to help us manage change and seize new opportunities. First, maintaining solid economic growth in Canada requires confidence based on well-managed monetary and fiscal policies. As you know, the Bank of Canada is responsible for monetary policy. You may also recall that in 1991, together with the federal government, we agreed on an anchor for monetary policy. This anchor was an explicit inflation target that would gradually lower the annual rate of consumer price increases to 2 per cent--the midpoint of a range of 1 to 3 per cent. Since then, we have kept inflation around 2 per cent, on average. And inflation expectations have fallen in line with this target. Our inflation-targeting system means that the Bank of Canada lowers rates when we see the trend of inflation heading below 2 per cent. And it also means that we raise rates when it looks as if the trend of inflation will be moving above the target. This symmetric response helps to smooth the ups and downs of the business cycle. In our decision-making process, we must allow for the fact that it takes 18 to 24 months for changes in interest rates to have their full effect on the economy and on inflation. Therefore, we must constantly look ahead to make timely decisions that will help to smooth the business cycle, rather than exacerbate its volatility. Another important benefit is that inflation targets have enabled the Bank to explain more clearly to business, labour, and the public what we are doing and why. Better public understanding of central bank policies and actions makes monetary policy more effective. Canada's experience shows that monetary policy works best when it goes hand in hand with other sound economic policies. In particular, implementing and maintaining sound fiscal policy at all levels of government is fundamental to good economic performance. This gives a country the credibility and flexibility to manage economic challenges. And it gives citizens confidence that the authorities will manage public finances prudently. I talked earlier about the impact of increased global competition. Canada has clearly felt that impact, and we continue to adjust to meet competitive pressures. Canada has a long history of supporting multilateral trade agreements. Opening up to global competition and to new markets has made us a more innovative and competitive economy. As we see the integration of major new players in the world economy, our firms must continuously adapt, innovate, and improve their efficiency. That means continued investments in research and development, as well as education and training. And, in a changing world economy, our firms must continue to find and to exploit new opportunities. I noted earlier that the booming growth of large economies like China and India means that demand for both energy and non-energy commodities will likely remain strong. And so Canada will need the flexibility to shift resources into the production of those commodities, as demand requires. It is important that our resource sector strives to remain among the world's most efficient, and that our manufacturing sector continues to innovate. The steps that I have just described will help us meet the long-term challenges that we, as well as other national economies, face. Canada's economy continues to adjust to global economic developments. Monetary policy has been facilitating these adjustments by supporting aggregate demand, with the goal of keeping the economy near its full production capacity and inflation on target. Before I close, I want to spend a couple of minutes on the Bank's views about the current economic outlook and inflation in Canada. Growth in the first quarter of this year was 2.4 per cent, below the economy's estimated potential growth rate of about 3 per cent. This implies that the level of output in the economy is still significantly below its production potential. However, both final domestic demand and exports grew strongly in the first quarter. These indicators, along with more recent data, suggest that growth in the first half of 2004 is likely to be somewhat above 3 per cent. , we said that we expected the economy to grow by about 2 3/4 per cent in 2004 and by about 3 3/4 per cent in 2005. We also said that core inflation--a measure of trend inflation obtained by removing eight volatile components from the consumer price index, as well as the impact of changes in indirect taxes on the remaining components--was expected to average 1 1/2 per cent over the remainder of 2004 and to move back up to 2 per cent by the end of 2005. Information received since the release of our April has been generally consistent with expectations about core inflation. But the sharp rise in world oil prices, in response to stronger-thananticipated global demand for oil and heightened geopolitical uncertainties in the Middle East, means that total CPI inflation over the next several months will be higher than the Bank expected in April. It is important to note that while higher oil prices may push up the total CPI over the next few months, they should not feed through into higher trend inflation, as long as inflation expectations remain anchored around the 2 per cent target. To conclude, the world economy has undergone tremendous change in recent years. And we can be sure that there is more to come. While we Canadians can remain confident of our ability to adjust to change, we must not be complacent. We should continue to work at strengthening our macroeconomic framework, enhancing our productivity, and opening up further to trade. That is the best way to ready ourselves for the challenges and opportunities that lie ahead.