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r040624a_BOC

canada

Co-operation and the Conduct of Economic Policy

dodge

Governor of the Bank of Canada Good afternoon, ladies and gentlemen. I am delighted to be here and to have the opportunity to speak at this conference. The theme of this event is "Policy Coordination in an Integrated Global Economy." It seems as if the idea of policy coordination is making a comeback these days. This is probably because of the growing interconnectedness of the global economy and the series of shocks that have recently reverberated around the world. While globalization has affected different countries to varying degrees, it has brought many benefits to the world economy--including increased trade, broader sources of financing, and more rapid diffusion of technology. But globalization has also left countries more exposed to developments beyond their borders. From a central bank perspective, globalization has made the conduct of monetary policy somewhat more challenging. In order to gauge the prospects for the domestic economy, it is more and more necessary for central bankers to take into account how their economy will be affected by events elsewhere. And of course, central bankers in very large economies must be cognizant of the effects that their actions may have on the global economy and, hence, on their own economy. Canada has had a very open economy for many years. So, not only is it in our interest to ensure that our domestic economic policies are the right ones, it is also in our interest that other countries pursue appropriate policies. As globalization continues, it will increasingly be in everybody's interest that all countries follow sound economic policies. Given this growing integration of the world economy, it might appear that there is a need for closer international coordination of economic policies. Traditionally, talk of coordination has made people think of more formal arrangements, such as the Plaza and Louvre Accords of the 1980s. Not only did those agreements attempt to influence global exchange rates, they spelled out detailed prescriptions for individual countries in areas such as fiscal and monetary policy. I will argue today that the scope for macroeconomic policy coordination is very limited, although it is vital for policy-makers to co-operate in the sharing of information and views on monetary and fiscal policy. But I will also argue that there are some areas where coordination is required, most particularly in establishing and maintaining rules and standards that will allow global financial markets to function well and global trade to expand. Let me start with macroeconomic policies and information sharing. I'll begin with a question. If there is no international macroeconomic policy coordination, how can countries determine which policies they should choose to strengthen their domestic economies and thus contribute to global growth? In answering that question, I would say that policy-makers should always look to their own economies first. Promoting policies that encourage sustainable growth and financial stability in their own domestic economy is the best contribution that national authorities can make to the growth and stability of the global economy. But which policies are the right ones? The OECD, among other organizations, has been working on this question for decades. I can recall attending OECD meetings here in the 1980s, when a consensus began to take shape on a set of policies that would provide the strongest base for sustainable economic growth. These policies relate to four basic areas. First, monetary policy should be directed at keeping inflation low and stable. Second, fiscal policy should take a disciplined approach to the public purse. Third, structural policies should encourage economic flexibility. And fourth, countries should work towards trade liberalization. Let me take a few minutes to discuss these areas, beginning with monetary policy. In Canada, as in many other countries, the goal of monetary policy is to maintain the public's confidence in the future value of money. We do so by working to keep inflation low, stable, and predictable. Over the years, the Bank of Canada, like many other central banks, has struggled to find the right anchor for its monetary policy--an anchor to guide its actions and to give the public a way to measure its performance. Since 1991, our monetary policy anchor has been our system of explicit inflation targeting. Under this system, we aim for a 2 per cent annual rate of consumer price inflation over the medium term. This target is spelled out in a formal agreement between the Bank and the Government of Canada. But the Bank is solely responsible for the implementation of monetary policy. It's important to note that we conduct our policy symmetrically around the 2 per cent target. We will lower interest rates to stimulate total demand when we see that the trend of inflation is threatening to fall below the target over the next 18 to 24 months . Similarly, we will raise interest rates to dampen demand when we see that the future trend of inflation is poised to rise above the target. In this way, monetary policy acts as the primary tool for stabilizing the economy. Although inflation targeting has a relatively short history, the experience of many countries so far suggests that this approach brings with it important economic benefits. By smoothing the peaks and valleys of the economic cycle as a whole, inflation targeting helps the economy to achieve maximum sustainable growth over the medium term. But if a central bank wants to have the monetary policy independence needed to pursue low and stable domestic inflation, then it has to be prepared to allow the external value of its currency to fluctuate. That independence, which is typically lost under a fixed exchange rate regime, has been a tremendous asset for Canada. Further, given the somewhat sticky nature of both wages and prices, a floating exchange rate can serve as an important economic stabilizer, helping to facilitate the adjustment to shocks and the resolution of global imbalances. It is true that under a floating exchange rate regime, currencies can experience short-term volatility. This volatility can certainly be unnerving. However, in my view, central bankers ought to be extremely cautious about trying to smooth these fluctuations. It is extraordinarily difficult to judge whether sharp currency movements simply represent market "noise" or more fundamental forces. So, there is great potential for policy error when central bankers try to smooth currency volatility. Besides, businesses can take advantage of highly efficient hedging tools available in financial markets to help them deal with short- term currency movements. Let me now turn to fiscal policy. A country should have a medium- term fiscal plan that is appropriate to its particular situation. Citizens and investors need to know that their government will not let debt levels get out of hand. When public debt is controlled, people can have confidence that their governments will not inflate the debt away, impose an overly onerous tax burden in the future, or simply repudiate the debt. In attempting to keep levels of public debt under control, governments should be wary of using "discretionary" fiscal policy to stabilize the economy. Let me be clear that I am talking here about discretionary action and not the use of automatic stabilizers, such as unemployment insurance payments. For one thing, it is very difficult to get the timing of discretionary action correct. For another, as we know from bitter experience around the world, tightening fiscal policy is politically much more difficult than easing it. And so the use of discretionary fiscal policy as an economic stabilizer increases the chances of a country getting into an unsustainable debt situation. Further, the economic evidence suggests that in open economies under a floating exchange rate regime, monetary policy can be a much more effective stabilizer than discretionary fiscal policy. In the 1990s, governments in Canada--both federal and provincial--struggled not only to eliminate budget deficits, but to run surpluses in order to bring down public debt-to-GDP ratios. Given Canada's demographics, with an aging population and a workforce that is likely to stop growing within 15 years or so, aiming to reduc e the debt-to-GDP ratio is an entirely appropriate fiscal anchor. Of course, other countries may have different considerations that shape their medium-term fiscal plans. So far, I have argued that formal coordination of macroeconomic policies is unlikely to lead to better economic outcomes than if all countries simply followed the right policies for their own circumstances. In addition, coordination risks amplifying the effects of a mistake in judgment about the state of the global economy. But co-operation in the form of information sharing does play an extremely important role in the development of macroeconomic policy. Let me elaborate. Countries can put an appropriate policy framework in place; but, without accurate and reliable information on the state of other economies, it is difficult to determine what policy actions will deliver optimal results. The Canadian economy provides a clear example. Given Canada's dependence on international trade, the Bank of Canada needs to thoroughly understand the forces at work in the world economy in order to adopt the appropriate monetary policy stance at home. Otherwise, we risk misjudging the state of total demand in the domestic economy, and that can lead to policy errors. The increasingly interconnected nature of the world economy means that policy-makers in all countries must have a thorough understanding of global economic and financial developments. It is fitting that we should be discussing this topic here, in this building, given the OECD's long history in economic co-operation. How does this information sharing among countries take place? In addition to OECD meetings, central bankers gather at the Bank for International Settlements every two months. In fact, I will be headed to Basel for such a meeting in a couple of days. One of the most important features of these meetings is our systematic, detailed discussion of the world economic situation. These meetings, as well as the periodic meetings of the International Monetary opportunities for policy-makers. Not only can we hear directly from our counterparts, but we also have the chance to ask questions about their policies and prospects. And between these meetings, senior officials from finance ministries and central banks talk frequently to each other. This kind of information sharing can also be useful in areas other than macroeconomic policy. I mentioned before that the OECD policy consensus includes the idea that countries should strive for economic flexibility through their structural policies. In particular, that means the creation and maintenance of effective and efficient labour and capital markets. Again, the sharing of information about experiences and best practices can be invaluable in helping authorities design policies and programs that are appropriate to their own economies. Information sharing can also help to reduce uncertainty and to promote economic security by demonstrating the most effective ways to strengthen the rule of law and reduce the risk of abuses. And information sharing is an important part of the effort to combat money laundering and terrorist financing--an effort led by the Financial Action Task Force here in Paris. So is there any scope for outright policy coordination in a global economy? As I said at the beginning, I would argue that, when it comes to international trade and finance, actual coordination is not only desirable, it is probably necessary to facilitate the expansion of commerce and to promote well- functioning global financial markets. Let me explain, starting with international trade. A moment ago, I said that trade liberalization is a crucial part of an appropriate economic policy framework. But in order to have freer trade worldwide, countries need to come together to draw up and enforce a set of rules governing the exchange of goods and services. In this regard, Canada has been a consistent supporter of the Unfortunately, in recent years, there has been insufficient international support for strengthening the global trade order, and talks on difficult sectors, such as agriculture, have floundered. Collectively, developed countries still have a considerable way to go in terms of reducing subsidies and liberalizing trade for a number of goods, including agricultural products. In my view, we have a responsibility to do this in order to promote growth in the most impoverished nations. That is why Canada has been pushing for an early resumption of the Doha round. And there are other sectors, such as financial services, 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. International coordination is also important in efforts to establish a framework to allow financial markets to function efficiently. In recent years, this has been reflected in the drive towards greater transparency. Unless countries develop and implement a clear and coherent way of disseminating relevant information, global financial markets will be unable to function at peak efficiency. This applies to both the public and the private sectors. Following the Asian and Sector Assessment Program to identify strengths and weaknesses in national financial systems. This effort is backed by Reports on Observance of Standards and Codes, which are conducted by the IMF. These reports can bolster confidence by demonstrating to markets the level of commitment that countries have to boosting their transparency. Other efforts to improve transparency in the wake of Enron and similar scandals include initiatives to improve corporate reporting, accounting, and dissemination of financial market information. These efforts to further domestic transparency will certainly be helpful on their own. But if we coordinate our efforts, we can spread the benefits of transparency and help global financial markets to operate more efficiently. This applies to the development of market codes of conduct, as well as to compliance and enforcement efforts. And it also applies to the development of accounting standards that are universally applicable. It is only through coordination that we will all get the full benefit of improved standards and codes. Unlike macroeconomic policy, where the best collective outcome depends on each country following appropriate domestic policies, when it comes to international trade and global financial markets, the best collective outcome will require strong, coordinated efforts. Let me sum up. As globalization continues, it may appear that there is a need for national authorities to coordinate their macroeconomic policies through formal agreements and arrangements. I have argued that this is not the case. I hope that I have convinced you that such coordination is unlikely to be helpful. But I hope that I have also convinced you that information sharing among countries remains extremely important. What is crucial is that national authorities pursue sound domestic policies, while being fully cognizant of what is happening elsewhere in the world. These policies include a well-anchored monetary policy focused on inflation control and a prudent fiscal policy conducted within an appropriate medium-term plan. Such policies should be supplemented by a set of structural policies that foster economic flexibility, as well as by policies that encourage openness to international trade. By strengthening their domestic economies while taking global developments into account, policy-makers will be helping to improve the world economy. Where I think we do need coordination is in the establishment of frameworks that facilitate international commerce and strengthen the global financial system. We do need a coordinated international trade order, and the strengthening of that order remains a worthy goal for us all. We do need a coordinated, transparent framework to support and maintain effective and efficient global capital markets. And we do need to promote the coordination of accounting standards. Finally, let me say that, as we take part in this conference here, at the home of the OECD, economic co-operation remains as important now as it was on the day that organization was founded. The sharing of information among national governments and regulatory bodies is absolutely essential. Co-operation helps policy-makers follow sound domestic economic policies appropriate to their own circumstances while being cognizant of the actions of others. That, in turn, should lead to better global economic performance.

r040722a_BOC

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. The Bank's outlook for economic growth and inflation in Canada is little changed from the April . Let me start with our outlook for inflation. Higher-than-expected world oil prices mean that total CPI inflation is likely to remain above 2 per cent through the rest of this year, before falling slightly below core inflation in the second half of 2005. Core inflation is projected to remain just above 1.5 per cent for the rest of 2004, before gradually moving back up to the 2 per cent target by the end of 2005. Economic growth in Canada should average about 3 1/2 per cent through the remainder of 2004 and in the first half of 2005, before easing to 3 per cent in the second half. This would imply average annual growth of about 2 3/4 per cent in 2004 and 3 1/2 per cent in 2005. This profile suggests that the Canadian economy will reach its production capacity by mid-2005. As economies approach their production capacity, monetary stimulus must be removed to avoid a buildup of inflation pressures. In Canada, the timing and magnitude of interest rate increases will depend on the evolving prospects for inflation and for pressures on capacity. Three factors will play an important role in this respect. The first is the assessment of the size of the output gap. The second is the future growth of Canadian imports and exports, which is particularly uncertain because of the ongoing adjustments to global changes and the recent patterns in trade growth. The third is the overall effect on the Canadian economy of movements in the world prices of oil and non-energy commodities. In addition, there continue to be heightened geopolitical concerns. Paul and I will now be happy to take your questions.

r040920a_BOC

canada

Canadian Monetary Policy in an Evolving World Economy

dodge

Governor of the Bank of Canada to the Canadian Chamber of Commerce Good afternoon. I'm glad to be back in Calgary. We at the Bank of Canada welcome these opportunities to get out across the country, to speak to business people, and hear your perspectives on the economy. The feedback we receive from businesses from coast to coast is an important part of our monetary policy deliberations. I know that the staff of our regional office here in Calgary work hard to stay on top of local business conditions on the Prairies, as do our other offices for their regions. I am happy to have the opportunity to meet with the national body of the Chamber of Commerce. I can tell you that my regular contacts with the Ottawa liaison group are very valuable to me. The Bank does look to the Chamber to help us understand how economic developments are unfolding at the industry level. And I particularly want to thank the Chamber for being an ongoing partner in our efforts to smoothly introduce three new high-denomination bank notes this year. This is the second straight year in which we have set up a currency-education kiosk at your annual meeting, to help spread the word about our new bank notes. You can learn about the security features that we have included in our high-denomination notes. And we have materials about our new $20 note that we unveiled last month, and which goes into circulation beginning next I should add that I'll be back here in Calgary on 13 October to unveil the new $50 bank note, which goes into circulation beginning in mid-November. During the past year, powerful forces have continued to shape the global economy. Alberta, and indeed all of Canada, have felt the impact of these forces. Of course, the evolution of the global economy is not a short-term event. Some of the forces currently at work have been building for years. Similarly, today's developments may have repercussions , and raise the need for adjustments, for years to come. So today, I want to talk about Canada's economic outlook and the prospects for monetary policy within the context of the evolving world economy. I will start with a brief review of our monetary policy framework. Let me remind you of the goal of Canadian monetary policy. Experience has taught us that the best contribution the Bank of Canada can make to good economic performance is to keep inflation low, stable, and predictable. By doing so, we can provide the backdrop that best allows our economy to grow in a strong and sustainable way. We aim to keep inflation--as measured by the annual rate of increase in the consumer price index--at 2 per cent. It's important to note that we conduct monetary policy in a symmetric way. This means that we will raise interest rates to dampen total demand when we see that inflation is threatening to rise above our 2 per cent target over the next 18 to 24 months. In the same way, we will lower interest rates to stimulate demand when we see that the trend of inflation is poised to fall below the target. This symmetric approach to monetary policy has delivered an average rate of inflation that has been very close to 2 per cent since inflation targeting was adopted in 1991. It is also important to keep in mind that monetary policy actions take time to have their full effect. The lags are variable, but it typically takes a year and a half to two years for a change in interest rates to have its full impact on the economy and inflation. That is why we say that we need to be forward looking with our monetary policy, and that is why we are always trying to assess the state of the economy 18 to 24 months into the future. Specifically, we try to evaluate the various factors that will affect supply and demand, to help us estimate the future size of the output gap. What do I mean by "output gap?" That term refers to the difference between actual output--what the economy is producing--and potential output--the maximum amount the economy could produce without triggering higher inflation. Another way that we sometimes refer to this concept is to talk about how close the economy is to its production capacity. This idea is important because when economies operate above their capacity--or, as economists like to put it, there is excess demand and a positive output gap--inflationary pressures can build. But when economies operate below capacity--meaning that there is excess supply and a negative output gap-- disinflationary pressures can set in. Ideally, we want to see the economy operating close to its capacity, with total demand roughly in balance with total supply. If we achieve this, we can have the best outcome over time--strong, sustainable growth that avoids booms and busts, along with rising employment and low inflation. One major problem is that we cannot directly measure potential output. Further, the economic data that measure actual output are often revised--sometimes significantly so. The challenge for us, then, lies in estimating the size of the output gap, and there is always a significant degree of uncertainty around that estimate. So we look at a number of other economic variables to help us form an opinion about how large the output gap is. You can find out more about these variables on our Web site. They include, among others, indicators of capacity in goods markets, signs of tightness in labour markets, and signals of pressures in the real estate market. Some of these are quantitative, and some are qualitative, based on surveys of businesses conducted by our regional offices. Another indicator is the rate of inflation itself. If core inflation--which strips out eight highly volatile components of the consumer price index--is consistently coming in above or below our expectations, it may lead us to adjust our view about the current size of the output gap. Earlier, I said that when the economy is operating near its capacity, total demand for Canadian goods and services--or what economists like to refer to as "aggregate demand"--is roughly in balance with total supply. Total demand has two components--domestic demand and foreign demand. Assessing foreign demand is difficult, but because it represents such a large share of total output in Canada, we at the Bank spend a great deal of time and effort trying to gauge that demand. Of course, it is nothing new to say that our economy is importantly affected by events abroad. Canada has always relied on international trade. For a long time now, the United States has been the focus of attention in assessing the world economy. But many of today's global economic developments have their origins outside North America, most notably in Asia. Before I talk about their current implications, I would like to take a few minutes to discuss the nature of these developments and their likely implications over the next decade or so. Just as Japan and Korea emerged as major players on the global stage in previous decades, China is now quickly becoming an economic powerhouse. And India is not far behind. When you consider that these two countries account for 40 per cent of the world's population, it is not hard to see why they are having such an impact on the global economy. As we look ahead, it is clear that China and India will be major global competitors, not just in labour-intensive industries, but increasingly in skill-intensive industries as well. It's a pattern of development that the world has seen before. Established firms in many industries will feel competitive pressure from China and India, until the large pool of surplus labour in those countries can be absorbed. But at the same time, this process will create income and wealth in China and India and, hence, increase their ability to buy more goods and services from abroad. So, the integration of these countries into the global economy represents both a competitive challenge and a tremendous opportunity for the industrialized world. These emerging markets are just that--markets. China is already one of the largest importers in the world and its importance will increase over the next decade. This source of growing demand can provide a much-needed boost to the global economy in general and to the Canadian economy in particular. We have already seen some Canadian commodity producers step in to fill the demand from Asia. Indeed, Statistics Canada recently reported that the value of Canadian exports to China in the first seven months of this year rose by 58 per cent compared with the same period in 2003. There will also be opportunities for Canadian firms to integrate low-cost components into their own production processes, through direct investment or joint ventures. This will be an increasingly important way for Canadian firms to maintain cost competitiveness. Over the medium term, it will be absolutely crucial for all Canadian businesses and governments to continue to take advantage of these opportunities as they arise. At the same time, Canadian businesses and governments need to recognize that these global developments will require adjustments here in Canada. There will be some activities, particularly those that are labour-intensive and lower-value-added, where Canadian firms will not be well placed to compete with lower-cost producers in Asia. The key will be to adjust by shifting resources into expanding, higher-value-added activities, where Canadian firms can exploit the opportunities presented by the changing world economy. By making these adjustments, we will be able to increase productivity and raise our standards of living over the medium term. Of course, it is not just developments in Asia that will require us to make adjustments here in Canada. We will also have to adjust as the U.S. economy reduces the size of its fiscal and current account deficits. But the subject of adjustments to global imbalances is beyond the scope of my remarks today. What I can say, though, is that the Bank of Canada will facilitate whatever adjustments are necessary by keeping inflation low, stable, and predictable. This will help Canadian firms and individuals read market signals more clearly and allow them to make plans with confidence in the future value of their money. That's a look at the medium term, and it is important for business people and economic policy-makers to always keep an eye on the horizon. But, as you run your business from day to day, and as we at the Bank conduct monetary policy, it is the shorter-term developments that are the greater focus of attention. So, let me spend a few minutes on the near-term outlook for the world economy, and what that outlook implies for foreign demand for Canadian goods and services. As I said before, the emergence of China and India is having an important impact on the Canadian economy through an increase in demand for many of the commodities that we produce. This has caused a run-up in the prices of nickel, potash, and steel, among others. And, in turn, this has boosted the income of many Canadian producers, even after taking into account the effects of the large appreciation of the Canadian dollar that we saw in 2003. Of course, the most high-profile price increase recently has been that of oil. Very rapid growth in Asia has led to unexpected additional demand for oil. For the time being, this unanticipated demand is putting pressure on a market that already had little spare capacity. Over the medium term, oil production will, in all likelihood, increase to meet this additional demand. But it takes time for new production to come on line. Thus, it is not unreasonable to think that oil prices will be higher in the near term than what we might expect them to be over the medium term. Our best judgment at the moment is that high levels of growth in Asia will continue over the next couple of years, and that demand for commodities will continue to grow, although perhaps not quite as rapidly as in the past couple of years. This is based on the not-unreasonable assumption that the Chinese authorities will be able to manage economic growth at a more sustainable pace. While developments in Asia are likely to play a very important role in supporting continued strength in the global economy, developments in the United States will still have the largest impact on the volume of Canada's exports over the short term. As we said in our July , recent data point to some slowing of U.S. growth from the red-hot pace of the second half of 2003 and the first quarter of 2004. Higher oil prices appear to be having some restraining effect on U.S. consumer spending, and both consumers and businesses seem to be somewhat less optimistic than they were earlier this year. Nevertheless, we still expect growth to be similar to what we forecast in July--that is, faster than the growth rate of U.S. production capacity. This strong U.S. growth bodes well for continued high levels of Canadian exports, although they are unlikely to continue to grow at the rapid pace of the first half of this year. Consistent with this profile for solid U.S. and global economic growth and with the expectations of financial markets, we continue to assume some upward movement in global policy interest rates to moderate inflation pressures as output levels approach production capacity. Let me now turn to Canada, beginning with a quick recap of the first half of 2004. At the start of the year, we said that we did not expect net exports--the difference between what we export and what we import--to make a significant contribution to Canada's economic growth in 2004 or 2005, because of the sharp appreciation of the Canadian dollar last year. We also said that economic growth would have to come primarily from domestic demand in order to eliminate the excess supply that existed at the start of the year and to close the output gap. To facilitate growth in domestic demand, we reduced our key policy interest rate from 2 3/4 per cent to 2 per cent in three steps earlier this year. However, Canada's economic performance in the first half of 2004 turned out somewhat differently from our expectations. The volume of exports grew much more rapidly than we had anticipated. So did imports, but not to the same extent as exports. As a result, net exports made a very significant contribution to growth, and aggregate demand in the first half of the year grew more strongly than we had expected at the beginning of 2004. So the output gap at mid-year was smaller than we had projected. Indeed, the Bank judges that the Canadian economy is now operating close to its production capacity. As we look ahead to the remainder of this year and to 2005, we expect that exports will grow more slowly than in the first half of 2004. But there are lots of uncertainties that cloud the outlook for foreign demand and Canadian growth. These include uncertainty about the western grain crop, the re-opening of the U.S. border to live cattle exports, and auto production, as the "Big Three" automakers face softer markets for their products. Despite these caveats, aggregate demand will likely grow at a rate equal to, or marginally above, the rate of growth of production capacity over the next four quarters. With the economy currently operating close to capacity, we reduced the amount of monetary stimulus in the economy two weeks ago by raising our key policy interest rate to 2 1/4 per cent. Inflation, both total and core, has been volatile in recent months, primarily because of swings in energy prices and because of automobile purchase-incentive programs. But despite this volatility, we continue to project that core inflation will be a bit above 1.5 per cent for the second half of 2004, before gradually moving up to the 2 per cent target in 2005. Looking forward, we will need to continue to reduce monetary stimulus to avoid a buildup of inflationary pressures and to contribute to sustainable, solid economic growth. However, the pace of our actions will depend on our continuing assessment of the evolving prospects for pressures on capacity and inflation. In this context, there are several key factors that the Bank will be watching closely. As always, there is uncertainty about the exact size of the output gap. There is also considerable uncertainty at this time about the future growth rate of both exports and imports, and about the evolution of world prices for energy and non-energy commodities. And we will be watching the impact of geopolitical developments on global confidence and demand. We will update our outlook for the Canadian economy in our next , which will be published on 21 October. Let me conclude by going back to my earlier point about the need to adjust to changes in the world economy. We can be certain that the powerful global economic forces I spoke of today will continue to be felt as the world economy continues to evolve. This evolution will lead to challenges that we must face, but it will also lead to opportunities that we must seize. At the Bank of Canada, we will continue to monitor these global forces closely and assess their impact at home and abroad. This will help us contribute to Canada's future economic prospects through low and stable inflation. For Canada to grow and prosper over the long run, Canadian businesses and governments will need to make the right adjustments to the evolving world economy. As leaders in the business community, your job will not be easy. But over the past several years, we have seen ample evidence that you can face challenges and take advantage of opportunities. I am confident that you will continue to do so in the future.

r041007a_BOC

canada

Global Economic Developments and the Implications for Ontario

dodge

Governor of the Bank of Canada Good afternoon. I am glad to be here, and to participate in this very important summit. It's not easy to come up with something fresh to say this late in the conference agenda. My topic is "Ontario's Place in the World," but, of course, you've already spent a day and a half listening to the opinions of smart people who spend a great deal of their time studying this very subject. You've discussed at length the forces at play in the world economy, and how they are influencing Canada's economy and, of course, the economy of Ontario. Unfortunately, I have not been able to attend the entire event, so I have missed hearing many of the interesting speakers and presentations that have gone before. So, to contribute to this discussion about Ontario and its place in the world, I thought that I would begin by giving you a brief synopsis of what I heard this past weekend at the meetings of the G7 and the International Monetary Fund in Washington. I'll recap what was said about the challenges facing the global economy, both over the next year and further out over the medium term. Then, I will talk about how those themes and their implications relate to the Ontario economy. One theme that I heard repeatedly in Washington is that 2004 is turning out to be a better year than many had thought, particularly over the first half of the year. Indeed, the IMF is now projecting global economic growth of 5 per cent in 2004, which would be a marked improvement from the 3.9 per cent rate seen in 2003. Globally, while the United States continues to be an important source of growth, it is encouraging to note the very strong growth in Asia and the improved momentum in Europe. There have been a few factors underpinning this growth, including a still-favourable financing environment, and a general improvement in the banking sector and in private sector balance sheets and profitability. The outlook for consumption and investment in most countries continues to be good. This outlook bodes well for the rest of this year and 2005, even though there was a sense at the meetings that growth over this period will not be quite as strong as we saw in the first half of 2004. The IMF's own forecast, for example, pegs global growth for 2005 at 4.3 per cent--still above the trend rate, but off a bit from 2004. However, this optimistic outlook came with a clear caveat. The balance of risks for the global economy in 2005 has shifted slightly to the downside. Let me briefly mention some of the risks that were talked about. There was a general sense that the sharp rise in oil prices could become a more significant drag on growth next year, particularly if prices were to stay at current levels. Higher oil prices have cut into the rate of economic growth, but the consensus is that, so far, the overall effects appear to be manageable. Geopolitical events remain a risk to the world economy. As well, we are beginning to see the potential for inflationary pressures in some countries, as economies approach the limits of their production capacity. The challenge for monetary authorities will be to manage the transition from a very low interest-rate environment to one where policy rates are somewhat higher. Looking beyond 2005, there was a general consensus that economic policy-makers around the world need to move ahead with addressing the problems that the global economy will face. So let me now take a few minutes to discuss what was said about the medium-term challenges for the global economy. In 2006 and beyond, a key concern will be how economies will adjust to the current global economic imbalances. A large U.S. current account deficit has its counterpart in the large current account surpluses in almost every other region of the world, most notably in Asia. At the same time, we have seen 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. Looking forward, the U.S. current account deficit is likely to continue to deteriorate, and current account surpluses in emerging Asia may remain larger than desired for longer than desired. For now, there is no reason to believe that world capital markets cannot manage these imbalances. But, over the longer haul, the magnitude of these current account imbalances cannot continue, and no country can pile up foreign exchange reserves indefinitely. Global adjustment will be needed to restore balance. This global adjustment could take place in several ways and through several channels. Hopefully, these will allow the adjustment to take place in an orderly way. The first channel is through changes in the global pattern of savings and consumption. Domestic savings in the United States could rise--both government and household savings rates can be expected to head up. And foreign consumption could increase, as economies and markets continue to expand. It is worth noting that in North America, household consumption is running well over 60 per cent of GDP. As we look ahead, and take into account the aging population, it is important that savings rates increase in North America. At the same time, household consumption in emerging Asia is only about 40 per cent of that region's GDP. As Asian incomes rise, there is great potential for household consumption in that region to increase. So these are natural forces that will be working towards the adjustment of these imbalances. The second channel for adjustment will undoubtedly involve changes in real exchange rates; that is, the relative value of currencies taking into account the effects of inflation. Changes in real exchange rates could come about either through movements in relative inflation rates, or movements in nominal exchange rates, or some combination of the two. With respect to nominal exchange rates, the big issue is the need for some effective depreciation of the U.S. dollar against the currencies of emerging Asia. A key element here is China's fixed exchange rate, and how successful the Chinese authorities will be in meeting their stated goal of moving to a floating currency. In all likelihood, both of these channels of adjustment will play some part in facilitating the correction of global imbalances. As these adjustments take place, two things will be critical to ensuring that real incomes continue to rise worldwide. First, global trade flows must continue unimpeded. That is why we must push for continued progress at the Doha Round of trade negotiations under the World Trade Organization. It is also why we must fight against any outbreak of protectionism. Second, all economies must take steps to enhance their flexibility so that the adjustment doesn't have to take place through loss of real incomes. Here in Canada, we have to continue to increase the flexibility of our markets for goods and services, for capital, and crucially, for labour. At the same time, all of us leaders of corporations and public sector institutions must work to enhance the productivity of our workplaces. That leads me to the issues that we have to consider here in Ontario. The remainder of my remarks today will deal with these issues. Now, as I mentioned, I was not able to participate in your earlier discussions about the structure of Ontario's economy. But, having outlined the forces that the international experts believe will be at work in the years ahead, let me now spend a few minutes talking about the competitive and structural issues that we face here at home in light of these global forces. Experience has taught me that one has to be very careful in trying to predict exactly how structures in an economy are going to evolve. But I think that we can safely predict that the first and most obvious adjustment will be a transformation of manufacturing processes around the world, as low-cost, highly efficient capacity is built in Asia. This means tremendous and continuing competitive pressure on industries that have traditionally been mainstays of the Ontario economy--automobiles and parts, other transportation equipment, and some areas of light manufacturing. Over time, those pressures will increasingly be felt by industries such as steel and heavy manufacturing. There are no signs that these pressures will abate in the years ahead. A second adjustment will be to higher energy costs in the years ahead. This is a major issue for all countries, and poses a problem for Canada and Ontario, which are energyintensive by world standards. But energy cost increases and supply concerns are not limited to oil and natural gas. The blackout of August 2003 was a spectacular example of the need to have adequate and failsafe electricity supplies. We know that our electricity supplies are often stretched to the limit. And we know that demand in Ontario will continue to grow in the future, and that there is no clear plan to replace the capacity that has been slated for closure. A third adjustment relates to non-energy commodities. Strong demand from the booming economies of Asia is behind the rise in non-energy commodity prices such as nickel and iron ore. In response, we are seeing significant efforts in countries around the world to find new sources for these commodities and to improve their efficiency in extracting them. This province's commodity producers must take advantage of this healthy environment to boost their own productivity to meet new competitive challenges. Fourth, we are in the process of adjusting to the fact that services, once thought to be non-tradable, are increasingly open to worldwide competition because of changes in technology. Ontario's service-producing industries are facing increased competitive pressure from new suppliers, such as India's burgeoning information technology and business services industries. All indications are that this pattern will continue, and will be repeated in other service industries. Perhaps the biggest challenge for Ontario's service sector will be from the continued consolidation within financial services industries around the world. This poses a real competitive challenge to the financial services industry that is so important to the Greater Toronto Area. Indeed, while financial services companies may be concentrated around Toronto, they are important to the whole province--the finance, insurance, and leasing sector represents almost 15 per cent of Ontario's GDP. All these competitive challenges are compelling Ontario's businesses, politicians and policy-makers to find ways to increase industrial productivity and market efficiency. Let me just stop for a second, because what I've said so far may sound overly negative about Ontario's economic prospects. We need to keep in mind that changes in the global economy are also creating income and wealth in China and India, thus increasing their demand for goods and services from abroad. These emerging markets are just that-- markets. This source of growing demand can provide a boost to the global economy in general, and the Ontario economy in particular. Now, in the past two days, you have heard from people who are far more expert than I am about how individual sectors can meet this competition and take advantage of these opportunities. So I'm not going to try to add my own specific policy prescriptions to the debate. But I would like to point out some issues that I believe must receive considerable focus in order to position Ontario to meet the global challenges facing us over the medium term. The first is the need to improve the efficiency of labour markets and the quality of Ontario's human resources . This is a critical element of Ontario's ability to meet future competitive challenges. To develop the skilled workers that this province will require to meet its labour demands, Ontario must ensure that its education and training systems are second to none. This applies to early childhood education and development, the provincial school system, and post-secondary education and skills training. And all employers, both public and private, have a responsibility to provide their workers with opportunities to upgrade their skills. Appropriate investment by individuals, by employers, and by governments, will be needed. But even the best-educated and trained workforce will still face inevitable economic adjustment that will lead to displacement and additional bur dens on some groups in society. This does not mean that we should shy away from the task. But it does mean that a second area of focus should be to have policies in place that help to smooth the adjustment . These include providing access to training, or helping workers relocate or shift into expanding areas of the economy. The third area would be to improve the efficiency of capital markets and the financial system in Ontario and Canada. We all know that an economy works better when its financial services sector is sound and efficient. A robust and well-functioning financial system is key, so that growing firms have access to credit, and savings can be efficiently recycled to help businesses expand. Now, I am not here with a prescription for what needs to be done in this area. But we must not lose sight of the fact that the financial sector is an important contributor to economic growth in Ontario. An efficient financial sector will continue to be a competitive advantage for this province, both in maintaining efficiency in our own market, and in providing an opportunity to export expertise around the world. So policymakers 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 and Ontario must be at the forefront in terms of efficiency and competitiveness. A fourth area of focus is the province's infrastructure --it needs to be a contributor to industrial efficiency, not an impediment. An important part of this is transportation infrastructure. And this applies not only within the province, but also to the links with our trading partners in other provinces, other parts of North America, and overseas. But it is not just physical infrastructure that is important. We also need the right policy infrastructure in areas such as security, inter-provincial trade, and regulation. For example, as industries increasingly rely on just-in-time delivery, border delays can cause real damage to businesses. That is why it is critical to develop and maintain border crossings that are as safe as these times require, yet open enough to allow the rapid flow of goods and people. The fifth issue would be securing reliable sources of cost-effective energy for the future. Ways must be found to foster the development of new sources of energy and to provide the right incentives for the efficient use of that energy. Clearly, there is a need for an appropriate framework to encourage investment in electricity transmission and generation, including renewable energy and alternative technologies. So those are five critical elements that I see as part of Ontario's efforts to meet the challenges that lie ahead , and to take advantage of the opportunities presented by growing world markets. It is by no means a comprehensive list. There are many other important issues that I have not discussed. But I have tried to point out five areas that, in my opinion, policy-makers and business leaders cannot ignore. We know that the challenges facing our economy will not be easy to meet. We know that tough choices will have to be made to secure an economic framework that enhances Ontario's efficiency and its flexibility. We know that the burden of adjustment will fall disproportionately on some individuals and groups and that we have a collective responsibility to help with that adjustment. But we also know that Canadians and Ontarians have made tough choices in the past that have proved right. These choices have yielded an economy that is resilient, and capable of competing with the best in the world. That tradition must continue. The choices Ontarians make in the years ahead will determine our ability to meet the challenges thrown at us by this changing world economy, and to seize the opportunities that growth in world markets will bring. This province has tremendous human and natural advantages. I am confident that it also has the will to make the choices that will help Ontario thrive in this new world economy.

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Famous 5 Foundation

dodge

Governor of the Bank of Canada Good evening. I am very glad to be here tonight. This has been an exciting day for the Bank of Canada. This morning, we unveiled a new $50 note that celebrates nation building: shaping the political, legal, and social structures for democracy and equality. As you know, one of the events and themes commemorated on the new $50 bank note is the Persons Case. I am especially pleased to be here tonight, helping to celebrate the 75th anniversary of that historic case, and honouring the Famous Five, who helped to enshrine the rights of all individuals, in Canada and other countries around the world, to participate on equal terms in political life. Like the Persons Case, the new $50 note is about more than the rights of women to participate in public office. This new bank note celebrates the ability of individuals to make a profound difference and to help make Canada a country where rights and freedoms are secure. That is why we have also included on the new note a tribute to Therese Casgrain, a pioneer of civil rights in Canada. Through her involvement in provincial, national, and international organizations, Therese Casgrain worked to help the disadvantaged, improve the rights of women, and reform society for the benefit of all citizens. In honour of this remarkable Canadian, the Therese Casgrain Volunteer Award medallion, pictured on the back of the note, celebrates Canadian volunteers who advance a worthy cause and contribute to the well-being of their fellow citizens. We were honoured to have Renee Casgrain-Nadeau, Therese Casgrain's daughter, help us to unveil the $50 note earlier today. And I'm very glad to see members of the Casgrain family here tonight. Above all, the $50 note celebrates the right of all people to participate fully in society and to enjoy the benefits of living in a culture that protects their individual rights and freedoms. That is why we have included on the $50 note a quote from the Universal Declaration of Human Rights: "All human beings are born free and equal in dignity and These rights help to shape and advance a democratic society. And it is through a nation's laws and public institutions that these rights are supported and protected. The Bank of Canada has played an integral role in Canadian society since 1935. We're just a little younger than the Persons Case--next year, we celebrate the 70th anniversary of our founding. And we're keenly aware of our place in this country's civic infrastructure. The Bank was founded at a time when this country was struggling to define itself and to survive the economic and social turmoil of the Great Depression. Let's remember that, during the 1930s, Canada's economy shrank by more than that of any nation other than the United States and took longer to recover. The Depression hit especially hard in Western Canada--at its peak, an estimated two-thirds of the people in the rural Prairies were on some form of government relief. During this time, the first elements of Canada's social welfare system were being created. And new social pressures were altering the economic and political life of the nation. In this environment, the Bank of Canada opened its doors in March 1935, to provide an effective, centralized monetary authority for Canada. Then, as now, our mandated role has been to regulate credit and currency in the best interests of the economic life of the nation and, generally, to promote the economic and financial welfare of Canada. To that end, the Bank's monetary policy contributes to solid economic performance and rising living standards for Canadians by keeping inflation low, stable, and predictable. We issue bank notes that Canadians can use with confidence that they will be widely accepted. The new $50 is a good example of that. We also promote a safe, sound, and efficient financial system, and provide funds -management services for the Government of Our work is hardly the stuff that usually gets people excited. No one has erected a statue to celebrate really effective monetary policy. But no civic infrastructure is more important than one that allows all citizens to have confidence in the value of money and in the soundness of their economy. Building a civic infrastructure that promotes social, economic, and political confidence is no easy task. It requires hard work by dedicated individuals. Irene Parlby was such an individual. Her support of the United Farmers of Alberta, and her subsequent political career, began as a struggle to improve the incredibly harsh conditions faced by women on Alberta's farms. As societies have progressed, and economies have become more open and connected around the world, there has been growing attention paid to the ideas of economic, social, and cultural rights. These are part of a larger body of human rights law that developed following World War II. In 1948, they were enshrined in the Universal Declaration of The Famous Five recognized the importance of economic rights much earlier than that, and worked to put in place laws that extended these rights to women. For example, Dower Act in 1917, which granted Alberta women property rights in marriage. And Nellie McClung spent much of her political life fighting for mother's allowances, better public health services, and improved property rights for married women. Now, in Canada, we have created a society where most of us can take for granted our right to earn a fair wage and provide for our families. But we should not underestimate the importance of macroeconomic policies, frameworks, and institutions that support the standard of living that we enjoy. For example, low, stable, and predictable inflation means that our salaries and our savings aren't eroded by rising prices, nor will our economy be devastated by deflation as it was in the 1930s. Good monetary policy means that we can plan for the future with confidence. A sound financial system means that we can conduct financial transactions with equal confidence. A secure currency means that we can use cash with confidence that bank notes will be readily accepted, and without fear of being stuck with a counterfeit bill. At the Bank of Canada, we are always mindful of our commitment to Canadians--to contribute to the economic well-being of this country. Part of that commitment is to communicate our objectives openly and effectively and to stand accountable for our actions. The Famous Five and Therese Casgrain remind us of the tremendous influence that individuals can have on society. As Louise McKinney said, and I quote, "The purpose of a woman's life is just the same as the purpose of a man's life--that she may make the best possible contribution to the generation in which she is living." We each have a responsibility to contribute to the society in which we live. As a public institution, the Bank of Canada takes this responsibility seriously. We know that by fulfilling our economic role in Canadian society--by giving Canadians confidence in the value of money--we make an important social contribution as well. The Bank of Canada will continue to promote the economic well-being of Canada and Canadians. That is our commitment to you. Tonight, we celebrate the commitment of five individual Canadians to the advancement of human rights in our country. This is something truly worth celebrating, and I thank the Famous 5 Foundation for inviting me to join you on this occasion of the 75th anniversary of the Persons Case.

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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 grown faster than was projected in last April's and the July , largely because of a surge in exports. It is now operating near its production capacity and continues to adjust to global economic developments. The Bank's base-case projection for the period to the end of 2006 calls for aggregate demand for Canadian goods and services to expand, on average, at about the same rate as potential output. Given the effects of higher oil prices and the past appreciation of the Canadian dollar, the Bank projects economic growth to be slightly less than 3 per cent in 2005, and slightly more than 3 per cent in 2006. With the economy expected to remain near its production capacity throughout this period, core inflation is projected to move back up to the 2 per cent target by the end of 2005. Given the path suggested by futures prices for crude oil, the Bank expects total CPI inflation will rise to the top of the 1 to 3 per cent target range in the first half of 2005, before falling slightly below core inflation in early 2006. Against this background, the Bank raised its target for the overnight rate to 2.5 per cent on 19 October. The base-case projection assumes further reduction of monetary stimulus over time, to keep the economy near its production potential and to achieve the inflation target. The pace of interest rate increases will depend on the Bank's continuing assessment of the prospects for factors that affect pressures on capacity and, hence, inflation. There are significant risks and uncertainties around this base-case projection, related to the adjustment to changes in the global economy, including changes in commodity prices and exchange rates. The risks surrounding global economic prospects relate primarily to the evolution of oil prices, the pace of expansion in China, the way in which current account imbalances in the United States and East Asia will be resolved, and geopolitical developments. Now Paul and I will be happy to answer your 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 this committee twice a year, following the release of our . These meetings help us keep Members of Parliament and, through you, all Canadians informed about the Bank's views on the economy, and about the objective of monetary policy and the actions we take to achieve it. Since we last met, we are pleased to have issued Canada's new $20 bank note with enhanced security features. The new note began circulating on 29 September. Last Thursday, we released our October , which reviews economic and financial trends in the context of Canada's inflation-control strategy. When Paul and I appeared before this Committee last April, we told you that the economy was judged to be operating significantly below its potential. That is no longer the case, because the Canadian economy has grown faster than was projected in last April's and the July . This stronger growth was largely due to a surge in exports. The economy is now operating near its production capacity and continues to adjust to global economic developments. The Bank's base-case projection for the period to the end of 2006 calls for aggregate demand for Canadian goods and services to expand, on average, at about the same rate as potential output. Given the effects of higher oil prices and the past appreciation of the Canadian dollar, the Bank projects economic growth to be slightly less than 3 per cent in 2005, and slightly more than 3 per cent in 2006. With the economy expected to remain near its production capacity throughout this period, core inflation is projected to move back up to the 2 per cent target by the end of 2005. That is the same projection that we made last April. However, given the path suggested by futures prices for crude oil, the Bank expects total CPI inflation will rise to the top of the 1 to 3 per cent target range in the first half of 2005, before falling slightly below core inflation in early 2006. Against this background, the Bank raised its target for the overnight rate to 2.5 per cent on 19 October. The base-case projection assumes further reduction of monetary stimulus over time, to keep the economy near its production potential and to achieve the inflation target. I want to emphasize that the pace of interest rate increases will depend on the Bank's continuing assessment of the prospects for factors that affect pressures on capacity and, hence, inflation. There are significant risks and uncertainties around this base-case projection, related to the adjustment to changes in the global economy, including changes in commodity prices and exchange rates. The risks surrounding global economic prospects relate primarily to the evolution of oil prices, the pace of expansion in China, the way in which current account imbalances in the United States and East Asia will be resolved, and geopolitical developments. Mr. Chairman, Paul and I now will be happy to answer your questions.

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Governor Dodge's speech on behalf of Canada's Finance Minister, Ralph Goodale

dodge

It is an honour to be with you today. As you may know, this is the second time that I have visited Berlin. In June 2003, I had the honour to speak at this group's founding ceremony in my role as the Governor of the Bank of Canada on the need, based on Canada's experience, for a solid economic policy during uncertain times. I have very fond memories of this visit and I am pleased to see so many familiar faces today. Since that time you have made great efforts to pr omote strong German-Canadian trade relations and build a better understanding of the economic and social conditions in both of our countries. Today I would like to speak to you on behalf of Canada's Minister of Finance, Ralph Goodale, who sincerely regrets not being able to be with you today. remarkable strength and resiliency of the Canadian economy following numerous shocks in 2003, including SARS, a single, isolated case of "mad cow" disease and the strong appreciation of the Canadian dollar. Canada weathered this period of economic slowdown, and has recovered from relatively weak growth of two per cent in 2003. In fact, Canada saw growth of 3.4 per cent in the first half of the year--much stronger than expected. Private sector forecasters now expect growth of three per cent for all of 2004, and 3.2 per cent growth in 2005. In the Bank of cent in 2005 and 3.2 per cent in 2006. The origins of this success can be found in policies that began a decade ago. In 1993 Canada had the second-worst government debt-to-GDP ratio among G-7 countries. It had high unemployment. It had low productivity growth. Federal debt servicing costs were absorbing 38 cents of every dollar of government revenue. This situation was clearly unsustainable, and many difficult and unpopular decisions had to be taken to clean up public sector balance sheets during the 1990s. In 1994 the Government launched a series of expenditure reductions which, by 1997, had reduced program spending by almost 20 per cent. In 1996, action was taken to introduce major reforms to our nation's public pension plan, to put it on a sound financial footing. Taking these actions was very difficult. So, what was essential during this time was clearly communicating to Canadians the steps that had to be taken to get our fiscal house in order, and the ominous consequences of not doing so. Fortunately, Canadians understood that you can't forever consume more than you produce. They displayed the innate good sense necessary to make short-term sacrifices for the long-term interests of their families. As a result, Canadians transformed a vicious circle of rising deficits and debt into a virtuous circle of balanced budgets and surpluses, and falling debt. Reducing, and ultimately elimating, the deficit in the 1990s helped Canada's international credibility and led to a reduction in the risk premium demanded by investors. This fiscal improvement allowed for lower interest rates, and made easier the implementation of monetary policy. 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. The results have been striking. Canada has been among the G-7 leaders in economic growth since 2000. Canada is the only G-7 country expected to post a total government sector surplus this year and next. As a result of this reduction in the federal debt, public debt charges as a share of revenues have fallen from 38 per cent to just over 19 per cent--the lowest level since the 1970s. The federal debt-to-GDP ratio has fallen from a peak of 68 per cent to 41 per cent last year. And the Government has set the objective to reduce that to 25 per cent within 10 years. Business confidence is also high, and investment is increasing. The main point here is that, in the end, tough choices pay off. While the initial work of fiscal consolidation is certainly difficult, it pays dividends later on. Now that Canada is in the midst of this virtuous circle, the Government has the means to invest in key priority areas, while at the same continuing to meet its fiscal targets. One of these priority areas is health care. In September, the federal government and Canadian provinces and territories announced a 10-year, $41 billion heath accord that would focus on streamlining health care delivery, training more health professionals, investing in better equipment, and enhancing research and innovation. The Government is also focused on the delivery of other key commitments to Canadians, High-quality early childhood development; Predictable and long-term funding to municipalities for critical infrastructure needs; Meaningful action on the disparities that impede opportunities for Aboriginal Canadians; and Meeting the imperatives of national defence and national security. As Minister Goodale said in his Economic and Fiscal Update presentation, meeting these priorities will require ongoing fiscal discipline. It will also require attention to improving productivity. But given the current high ratio of employment to population, and given that Canada's population will soon begin to age rapidly, we will have to rely increasingly on productivity to raise living standards in the future. To increase productivity, we Canadians need to invest in human capital, physical capital and innovation--the three drivers of productivity growth.The key will be to adapt to change through policies that promote flexibility. That's why Canada is investing in the skills and knowledge of our people, and is creating a competitive environment through lower taxes that encourage investment in physical capital and reward the efforts of entrepreneurs. These flexibility-enhancing policies, along with lower barriers to trade, smart regulation and openness to international investment, are the building blocks of Canada's modern and prosperous economy. Collaboration between Canada and Germany is part of this effort to encourage international investment. As one example, our two countries have a long-standing relationship in science and technology. The driving force behind this relationship is the Bilateral S&T Cooperation Agreement, signed in 1971. And there is the very successful partnership between the National Research Council of The Canadian Embassy in Berlin deserves real credit for encouraging this flourishing collaboration, and promoting technology-oriented partnerships. Such cooperation is critical in an increasingly connected global economy. So, too, are forward-looking initiatives such as the Trade and Investment Enhancement Agreement between Canada and the EU, which would allow qualified workers to move much more easily between the EU and Canada and would enhance the ability of our financial sectors to seize investment opportunities. Once concluded, this Agreement would present Germany, Europe and Canada with a unique opportunity to make our economies more global, more efficient and more prosperous. Now let's turn to a different issue. As you know, G-20 Finance Ministers and Central Bank Governors met in Berlin over the weekend. Among the themes of our discussions were the importance of promoting flexibility in national economies to help adjustment to changing circumstances, and the need for reductions of global imbalances. The importance of a sound domestic and international financial system to facilitate the trade, savings and investment necessary to bring about a reduction of these imbalances was also discussed. So let me conclude these remarks this morning with a few thoughts on the importance of international monetary arrangements to facilitate the reduction of imbalances. Most major industrialized countries and a large number of emerging market countries are operating with flexible exchange rates. The notable exceptions are China and a number of countries in Southeast Asia which, either explicitly or implicitly, tie their currencies to the yuan, which is in turn pegged to the U.S. dollar. With two systems operating, not everyone is playing by the same "set of rules," and imbalances are building. The concern is two-fold: First, the sense that some countries are not playing by the rules could give rise to protectionism, with potentially very serious negative consequences for the global trading system. And second, a disproportionate burden of adjustment to changing economic circumstances is being borne by those of us with flexible exchange regimes, including Canada and Europe. So there is a real need, going forward, to think hard about these international monetary arrangements. Of course, there is much more to the resolution of global imbalances than just exchange rate regimes. There are issues of savings and investment flows and of promoting strong economic growth worldwide, through strong domestic demand in each country. But the issue of international monetary arrangements deserves critical attention and debate, as we look out over the medium- and longer-term to the challenges facing the global economy. To conclude, I hope these remarks give you a good perspective on the fiscal health of the Canadian economy and on some of the bilateral initiatives between our two countries. As well, I hope that I have given you some food for thought on international monetary arrangements. Thank you for your attention. Let's now turn to hear your views.

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

dodge

Good afternoon, Mr. Chairman and members of the Committee. We appreciate the opportunity to meet with this committee twice a year, following the release of our . These meetings help us keep Parliamentarians and, through you, all Canadians informed about the Bank's views on the economy, and about the objective of monetary policy and the actions we take to achieve it. When Paul and I appeared before this Committee last April, we told you that we judged the economy to be operating significantly below its potential. That is no longer the case. The Canadian economy grew faster in the first half of the year than we had projected, largely because of a surge in exports. The economy is now operating near its production capacity and continues to adjust to global developments. Our latest , released on 21 October, presents the Bank's base-case projection for the period to the end of 2006. It calls for aggregate demand for Canadian goods and services to expand, on average, at about the same rate as potential output. Given the effects of higher oil prices and the past appreciation of the Canadian dollar, economic growth in the is projected to be slightly less than 3 per cent in 2005, and slightly more than 3 per cent in 2006. With the economy expected to remain near its production capacity throughout this period, core inflation is projected to move back up from the current level of 1.4 per cent to the 2 per cent target by the end of 2005. This is essentially the same projection that we made last April. However, in October we expected that total CPI inflation would rise to near the top of the 1 to 3 per cent target range in the first half of 2005 before falling slightly below core inflation in early 2006. This projection incorporates the path suggested by futures prices for crude oil in mid-October, when we finalized the . It is against that background, that the Bank raised the target for the overnight rate to 2.5 per cent on 19 October, our most recent fixed announcement date. The base-case projection in our October assumes further reduction of monetary stimulus over time, to keep the economy near its production potential and to achieve the inflation target. We also emphasized that the pace of interest rate increases will depend on the Bank's continuing assessment of the prospects for factors that affect pressures on capacity and, hence, on inflation. Paul and I have just returned from last weekend's meeting of the G-20 in Berlin. The issues we discussed there line up very closely with those issues we identified and analyzed in our --commodity prices, realignment of currencies, global imbalances, and the growing presence of emerging-market economies such as China and India. While we remain broadly comfortable with the global growth scenario we outlined in our , discussions this weekend and at other recent international meetings suggest a slight moderation in global growth prospects, despite the fact that both spot and futures prices for oil have declined somewhat during the past month. , one of the most significant developments has been a further depreciation of about 5 per cent in the value of the U.S. dollar against other major floating currencies, including the Canadian dollar. If current exchange rates were to be sustained--and if all other economic and financial factors were to remain unchanged--this would have a dampening effect on aggregate demand for Canadian goods and services. Since monetary policy aims to keep aggregate demand and supply in balance in order to keep inflation close to our target, we need to assess the implications of movements in the currency for aggregate demand and the context in which they occur--that is, the changes in other economic and financial factors. In conclusion, I want to stress that the Bank assesses the full set of information before each of its fixed announcement dates, and we will do so again before our 7 December announcement. Mr. Chairman, Paul and I now will be happy to answer your questions.

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Financial System Efficiency: A Canadian Imperative

dodge

Governor of the Bank of Canada to the Empire Club of Canada and the Canadian Club of Toronto Good afternoon. It is a privilege for me to address this joint meeting of the Empire and Canadian clubs, and I thank you for the opportunity to do so. I am particularly pleased to speak to you today because this is a bit of a red-letter day on the Bank of Canada's calendar. Today, we released the latest edition of our semi-annual ). This publication, which is only a couple of years old, examines issues that relate to Canada's financial system. Each edition of the takes a look at recent developments and trends in the financial system, as well as issues that have an impact on its efficiency, safety, and soundness. This is because the overall role of the Bank in the financial system area is to promote its safety, soundness, and efficiency. Today's edition contains a number of articles that focus on the promotion of financial system efficiency and stability. And it is the issue of financial system efficiency that I will talk about today. I will begin with a brief discussion of how the Bank of Canada contributes to the efficiency of the financial system at the macroeconomic level. Then, I will spend most of my time discussing how we can improve efficiency in Canadian financial institutions and markets; that is, the microeconomic aspects of efficiency. But before I do that, I should start by defining what I mean by "financial system" and "efficiency." Then, I will explain why it is so critically important for Canada to improve in this area. When I talk about the "financial system," I am referring to financial institutions and markets, the infrastructure, laws, and regulations that govern and support their operations, and the macroeconomic framework within which they operate. My message for you is that improving the efficiency of Canada's financial system is imperative. But what is an efficient financial system? In economic terms, an efficient financial system is one that helps to allocate scarce economic resources to the most productive uses, in a cost-effective way. The ultimate goal is to have Canada's financial institutions and markets match investors and their savings with appropriate, productive investments. Put more directly, if Canadians want sustainable economic growth and prosperity, our financial system must function as efficiently as possible. Let me explain why efficiency is so important. With an efficient system, investors can get the highest risk-adjusted returns on their investments and borrowers can minimize the costs of raising capital. Inefficiencies can drive a wedge between what borrowers pay and what investors receive. I'll give you some examples of how inefficiencies can interfere with the saving and investment process that is so crucial to economic growth. If adequate information isn't available, potential investors can't tell whether a particular investment fits with their tolerance for risk. If financing costs are too high because of inefficiencies, borrowers won't be able to secure the funds they need to expand. If competition isn't encouraged, the various players in the financial system won't have the right incentives to innovate. This is why it's so critical for the financial system to work efficiently. Efficiency and the Bank of Canada I would now like to spend a few minutes on the Bank of Canada's role in promoting an efficient financial system. In order to have such a system, we need above all a supportive framework of macroeconomic policies that minimize uncertainty and enhance confidence about the future value of money. This includes prudent fiscal policies, which are the responsibility of ministers of finance. It also includes effective monetary policy, which is the Bank of Canada's responsibility. We achieve effective monetary policy through our system of inflation targeting. One of the key benefits of this regime is that inflation expectations have become well anchored on the 2 per cent target, not just in the short term, but also in the long term. As a result, borrowers now pay a much smaller premium to compensate investors for inflation risk. This is particularly important at the long end of the yield curve. Reduced uncertainty has led to lower costs for borrowers and to a more efficient allocation of resources. The promotion of a safe and sound financial system that reduces uncertainties and systemic risk can also contribute to efficiency. We work in partnership with federal and provincial agencies, regulators, and market participants in this area, in order to actively foster the safety and soundness of the financial system. We also have a number of unique responsibilities. It is our role, for example, to oversee those payment, clearing, and settlement systems that could pose systemic risk. These systems have been designed to provide certainty that large -value payments or securities transactions will settle in real time. In addition, they have been designed to operate using a relatively small amount of liquidity compared with systems in other countries. This frees up resources that can be put to more productive use elsewhere. The Bank of Canada is also the "lender of last resort"--the ultimate provider of liquidity to the financial system. Indeed, we've just concluded a review of that role, and the details can be found in the that we released today. There is also an international element to our efforts. The Bank of Canada works with partners in other countries on initiatives to strengthen the international financial system. The goal is to minimize the risk of a financial crisis in one part of the world spreading across borders. But that's a topic for a whole other speech. So to summarize, Canada's macroeconomic and prudential policies generally do the job they are supposed to do in supporting efficiency. But let me be clear--we are not complacent; we are always looking for ways to improve. Continuous improvement is essential. Now, I want to talk more specifically about the microeconomic aspects of efficiency in financial institutions and markets, including the promotion of competition and the provision of an appropriate legal and regulatory framework. Competition drives innovation and efficiency gains. And an appropriate legal and regulatory framework gives all investors fair access to necessary information, while minimizing the costs of raising capital. The evidence shows that Canada's financial institutions and markets have generally been efficient when compared with those in other countries. But over the past decade, markets and financial institutions elsewhere have become--and are becoming-- more efficient. To stay competitive in this environment, Canada's financial system must also constantly increase its efficiency. If we don't make this effort, the Canadian economy will suffer. The status quo won't cut it. So what should our priorities be? I'll talk about financial institutions first and then about financial markets. In terms of financial institutions, a quick look backward may show us the way forward. I want to go back 40 years, to 1964, and recall the Royal Commission on Commission was well ahead of its time, with groundbreaking analysis and policy recommendations. In the post-World War II environment, where extensive government controls on the economy were still thought desirable, Porter came out strongly in favour of greater competition, freer markets, and effective regulation that served to enhance efficiency. In the wake of the Porter Commission, Canada revised its financial legislation in some crucial ways. Canadian banks responded to the new competitive environment by innovating and enhancing efficiency. Canadian institutions became world leaders, as financial institutions in many other countries were still operating under more restrictive and less-efficient regulatory regimes. Over the next three decades, Canada continued to lead the world. Successive revisions of legislation covering financial institutions encouraged greater cross-pillar competition in some areas, leading to lower costs and improved efficiency. But over the past decade, other countries have caught up and are forging ahead. During this time, two trends changed the global environment for financial institutions. First, with the expansion of world trade, national markets became truly global. Financial institutions had to find ways to provide enhanced services to customers worldwide. Second, other countries--particularly the United States and the United Kingdom--began to align their regulatory frameworks with the competitive philosophy of the Porter Commission. The regulatory barriers that had held back competition, both geographically and among different types of institutions, began to fall rapidly. Out of this more open and competitive environment came consolidation-- not just among institutions but across pillars and jurisdictions. As a result, foreign institutions were better placed to exploit new technologies in order to enhance efficiency, and to offer new instruments and combinations of services to their clients. These two trends have led to great benefits for consumers worldwide, and they are continuing. In these circumstances, Canada faces a difficult policy challenge. How can we enhance our policy framework to provide greater incentives for innovation by encouraging competition while, at the same time, giving our institutions the scope to improve efficiency? This is the challenge for Canadians in considering mergers, both within and across pillars, and the removal of barriers to foreign competition. The questions about the best ways to enhance competition--to balance incentives for efficiency with other legitimate public policy concerns --are complex. And I don't have simple answers. But efficiency must be at the heart of the debate. Because, in the end, an efficient financial system is key for the future--not just of the institutions, but of the Canadian economy as a whole. Let me now turn to financial markets. When it comes to the competitiveness of global financial markets, size, depth, and liquidity do matter. So Canadian financial markets--whether equity, fixed-income, derivatives, or foreignexchange --have an inherent disadvantage compared with those in New York or London. To compensate, Canadian financial markets have to be relatively even more efficient. So what can Canada do to improve the efficiency of its markets? One area that has received a lot of attention, not just in Canada but in many other countries, is securities regulation. The key issue is to reduce what economists call "information asymmetries" by as much as is practical. What that means is that our regulatory framework should aim--in general--at having market prices reflect all relevant information, and that all parties to a transaction should have fair access to that information. We can enhance efficiency by reducing information asymmetries up to the point where the cost of additional compliance would outweigh the benefits. Following events such as Enron, Parmalat, and Livent, it became clear that investors were not always receiving sufficient and accurate information. Corporate scandals prompted many an investor to say: "There oughta be a law!"--a law to make publicly traded companies disclose all information. But in the rush to write laws and regulations, too much attention has been paid to detailed rules that govern how companies disclose information, rather than focusing on what they disclose. We have seen a large increase in the costs of providing information--particularly in the United States--without commensurate progress towards improving the relevance of the information being disclosed. The concept of relevant disclosure is particularly important for a country like Canada, where public companies range in size from the very small to the large and multinational. The precise nature of what constitutes relevant information differs depending on the size and complexity of the firm. Corporate disclosure regulations should recognize this. For large, complex firms, more complex rules are required in order for investors to receive appropriate information. But for smaller firms, less-complex disclosure regulations--and lower costs of compliance--may result in the best costbenefit balance. The Canadian Securities Administrators recognized this point in putting forward new proposals for guidelines for corporate governance that are based on a firm's size. There is another consideration, and that is the need for some companies to have access to global capital markets. Firms that want to list on international exchanges will have to follow the disclosure rules that apply in those markets. And large Canadian firms that want to raise capital abroad need regulations here that are recognized as meeting international standards. But smaller, less-complex firms --which make up the vast majority of publicly listed companies in Canada--may not want to raise capital abroad. So it may not make sense for Canadian regulators to force these smaller firms to comply with the kinds of detailed rules that would be appropriate for large firms. Let me be clear. The principles at the heart of Canada's regulatory framework must be as good as, or better than, those of any other country. But keep in mind that companies considered to be mid-sized in terms of capitalization in Canada would be regarded as micro-capitalized by international standards. Historically, Canada's public markets have done very well in funding these smaller companies efficiently. This should continue in the future. So it is clear to me that our regulatory framework should take into account differing levels of size and complexity when establishing rules for disclosure. The rule requiring CEOs to sign-off on their financial statements is a case in point. The principle behind the rule is to try to make sure that investors have sufficient and accurate information. Holding the CEO accountable is a good way to go about this. The principle can work equally well for large and small firms. But we need to be careful. For very large and complex organizations, setting out some detailed rules in terms of procedures may be helpful. However, we do not need a whole raft of complex rules that tell the CEOs of smaller firms what procedures they must follow before they can put their signatures on their financial statements. We need to be careful not to write rules that govern only the inputs that come before the CEO sign-off. Rather, we need to focus on getting the output right, so that the document that the CEO signs actually gives investors sufficient and accurate information. Efficiency dictates that Canada should have uniform securities laws and regulations, based on principles that apply to everyone. Some have taken this idea further and advocated for a single, pan-Canadian securities regulator. I'm not here today to weigh in on that debate. But I do want to stress that, whatever the structure of the regulator, we must strive for efficiency in regulation--the best regulation, at the lowest cost. Now let me talk briefly about another important information issue, and that is the issue of price transparency in markets. Here, I am referring to timely, public disclosure of transaction details, such as price and volume. It is not difficult to see how this information leads to better resource allocation. The appropriate level of transparency may vary from market to market. Generally, the more liquid the market, the higher the level of transparency it can support. However, the world is moving to greater transparency in all markets through the spread of technology. The Bank of Canada is conducting research and working with market participants and regulators on ways to increase transparency in Canadian markets, with due regard for liquidity, equitable access, and fair play. Together with price transparency, these are the ingredients that help to create efficient, well-functioning markets. It is important that we get transparency and regulation right. But we also need to devote the appropriate time and effort to making the most of whatever rules we write, including existing ones. This means focusing on a range of smaller initiatives that can enhance efficiency. For example, provincial and territorial legislatures need to make the Uniform Securities Transfer Act a priority. Such an act would provide a sounder legal basis for the holding and transfer of rights in securities that are held in book-entry form, and would replace the current patchwork of legal rules in this area. Another initiative is the Canadian Capital Markets Association's focus on trade-matching to support progress towards straight-through processing. There's one more area where it is absolutely critical for Canada to continue to improve, and that is enforcement. There is a widely held perception that Canadian authorities aren't tough enough in punishing fraud and enforcing insidertrading and other rules. That's why it is encouraging to see that steps to toughen enforcement are being taken, by provincial securities commissions, by the Investment Dealers Association, by law-enforcement agencies, and by the federal government. These kinds of steps to improve enforcement must continue. Let me conclude. To improve the economic and financial welfare of Canadians, we need an efficient financial system. The Bank of Canada has been contributing to this goal by enhancing Canadians' confidence about the value of their money and by reducing risks to the safety and stability of the financial system. Our is part of this effort. But the effort must extend far beyond the central bank. I've raised some issues today that I think are critical to enhancing the efficiency of our financial system. None of these issues are new. They have been studied and analyzed thoroughly. But while Canada has been studying and analyzing, the rest of the world has been acting. It's time for us to act, too. We have to get on with the job of improving efficiency. The future health of our economy and the prosperity of Canadians depend on it.

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Release of the

dodge

Today, we released the to our October . The reviews economic and financial trends in the context of Canada's inflation-control strategy. The outlook for the Canadian economy continues to be shaped by global developments, including the realignment of world currencies. The near-term outlook for the global economy is a touch weaker than projected in the October , but more solidly based because of somewhat lower oil prices and greater confidence in the momentum of the U.S. economy. We expect the Canadian economy to operate a little further below its full production capacity in 2005 than was anticipated at the time of the last , largely reflecting the dampening effects on aggregate demand of the recent appreciation of the Canadian dollar. For 2006, we project growth to pick up to slightly more than 3 per cent, consistent with returning the economy to its production capacity in the second half of the year, and returning core inflation to 2 per cent around the end of 2006. In line with this revised outlook, the pace of reduction in monetary stimulus is likely to be slower than that envisioned in the October . There are both upside and downside risks around the outlook, which continue to relate to the adjustment to global developments. As circumstances change, we always need to be ready to re-assess the policy implications. The Bank of Canada today released its to the October . The discusses current economic and financial trends in the context of Canada's inflation-control strategy.

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Monetary Policy and Exchange Rate Movements

dodge

Governor of the Bank of Canada to the Vancouver Board of Trade Good afternoon. It is always a pleasure for me to return to Vancouver, a city I called home for a year. And now that I live in Ottawa, I can tell you that it is particularly nice to get the chance to come here in the middle of February. Every year, the Canadian Press surveys news directors and editors to select the top business story of the year. In 2004, they picked the rise of the Canadian dollar. That was not a surprising choice. The dollar's appreciation drew a lot of attention from the media, from business people, from individual Canadians, and indeed, from the Bank of Canada. Changes in the external value of the dollar are one of the key factors that we scrutinize and work hard to understand. We watched the dollar closely as it depreciated during the 1990s, as it fell to an all-time low against the U.S. dollar in early 2002, and as it rose by roughly 25 per cent between January 2003 and January of this year. With the rapid appreciation of our dollar has come an increase in public commentary about the currency--its effects on the Canadian economy in general, and the Bank of Canada's monetary policy in particular. There has been no shortage of stories broadcast or articles written. At the Bank, we welcome this increased interest. Canadians should discuss important economic issues that affect their daily lives. However, some of this commentary has oversimplified how movements in the exchange rate affect the Canadian economy and monetary policy. I don't mean this as a criticism. The relationship between the exchange rate, the economy, and monetary policy is complex. So today, I want to talk about the various factors that influence the exchange rate, examine how these factors affect the Canadian economy, and lay out how the Bank takes them into account as we conduct monetary policy. In doing so, I will elaborate on the contents of a technical box in our latest , published on Let me begin with a brief review of Canada's monetary policy framework. At the heart of our monetary policy is the idea that the best contribution the Bank can make to the Canadian economy is to keep inflation low, stable, and predictable. By aiming to keep the annual rate of inflation at the 2 per cent midpoint of a 1 to 3 per cent target range over the medium term, we lay the groundwork for the economy to grow in a strong and sustainable way. To keep inflation low and stable, we aim to maintain a rough balance between demand and supply in the economy. When aggregate, or total, demand exceeds aggregate supply, the economy will push against its capacity limits--and inflationary pressures will tend to build over time. If we see that inflation is threatening to rise above target over the next 18 to 24 months, the Bank will tighten monetary policy to dampen demand. Similarly, if there is too little aggregate demand relative to supply, the economy will operate below its capacity. If this gap between aggregate demand and supply were to persist, the projected trend of inflation would fall below target. The Bank would then ease monetary policy to stimulate demand and close the gap. That's why it is important for us to understand how developments in the Canadian and world economies affect the balance between demand and supply in Canada. Now let's bring the exchange rate into the picture. To understand the effect of exchange rate movements, we need to understand why exchange rates are moving, and how these movements affect the balance between demand and supply. Exchange rate movements tell us something about economic developments that may be having a direct impact on Canadian aggregate demand. And the movements themselves have their own impact on aggregate demand, by changing relative prices for Canadian goods and services and by shifting demand between domestic- and foreign-produced products. The challenge for the Bank is to evaluate these movements, together with other data, and set a course for monetary policy that works to keep demand and supply in balance and inflation low and stable. With this general framework in mind, let me now talk in more detail about the forces that can influence the exchange rate. Here, I want to emphasize a key point: From the Bank's point of view, the causes of a movement in the exchange rate are just as important as the movement itself. I will spend the balance of my time today explaining why this is so. For monetary policy purposes, there are two basic types of exchange rate movement--and no, I don't mean "up" and "down." I mean movements in the Canadian dollar that directly reflect changes in the demand for Canadian goods and services, and those that do not. Consider the first type of movement, which I'll call Type One. Growing world demand for Canadian goods or higher world prices for Canadian products both prompt a direct increase in aggregate demand in Canada. And both tend to cause an appreciation of the Canadian dollar. Put simply, when demand for our goods and services increases, our currency tends to appreciate. Conversely, when demand for our goods and services decreases, our currency tends to depreciate. But not all exchange rate movements are Type One. Some movements, let's call them Type Two, reflect the rebalancing of portfolios in financial markets, which may have nothing to do with current demand for Canadian goods and services. example of a Type Two movement would be a flight to so-called "safe havens" during an international financial crisis. Another example is a movement that relates to expectations of what might be necessary to resolve global imbalances. I'll say a bit more about this later on. But for now, let me just stress the key point about Type Two exchange rate movements. While they are more difficult to describe, their defining feature is that they do not reflect current changes in demand for our goods and services. It's important for us at the Bank to try to distinguish between exchange rate movements that reflect changes in demand for our goods and services and those that do not. That's because these movements have different implications for aggregate demand and, hence, for monetary policy. This is a complicated issue, all the more so because both types of currency movement sometimes occur at the same time. So I want to spend some time talking about these two different types of exchange rate movement. I'll give you some real examples and explain their different implications for monetary policy. Let me start with Type One. I've already noted that when global demand for Canada's goods and services rises, the demand for our dollar also increases, so it tends to appreciate. Similarly, when global demand for Canada's goods and services falls, so will the demand for our currency, which then tends to depreciate. But the exchange rate, by reacting to these changes in demand, also acts as a shock absorber. For example, when global demand for our goods and services weakens, and our dollar depreciates in response, the lower dollar pulls down the relative prices of Canadian goods and services, making them more attractive. And, of course, the opposite happens when global demand rises for Canadian goods and services; the increase in demand is dampened by the associated appreciation of our dollar. Let me give you an example from here in British Columbia. In 1997 and 1998, the world economy was dealing with the effects of economic crises in Asia, Russia, and other emerging markets. In this environment, global demand for the primary commodities that Canada produces was very weak. That weakness resulted in falling prices for many commodities, including some of the raw materials produced in British Columbia or shipped through its ports. At that time, there was a sharp depreciation of the currencies of countries that export raw materials--Canada, Australia, and New Zealand--while the U.S. dollar appreciated. While there were other forces driving the exchange rate at that time, the drop in global demand for raw materials was a direct, negative shock to Canadian aggregate demand, and this shock led to a depreciation of the Canadian dollar. The lower dollar, in turn, helped to offset the shock by making other Canadian exports more attractive to global markets, and by making foreign products and services less attractive to Canadians. Over the past two years, we have seen this movement work in the opposite direction. In 2003 and most of 2004, both the demand for, and prices of, Canadian products rose. Once again, there were other factors at work on the exchange rate during this time. But this direct, positive shock to Canadian aggregate demand led to increased demand for our currency and an appreciation of the Canadian dollar. The stronger Canadian dollar, in turn, increased the relative price of Canadian goods compared with foreign products, and helped to restore the balance between demand and supply. In these two instances, the flexible exchange rate helped to absorb positive and negative shocks to our economy. That's the first type of exchange rate movement. Let's now turn to Type Two. You may wonder: if this second type doesn't reflect changes in demand for Canadian goods and services, what does it reflect? What are the forces behind this type of Quite often, it reflects changes in foreign demand for Canadian financial assets or changes in Canadian demand for foreign financial assets. For example, if investors develop a greater appetite to hold Canadian equities or bonds, this drives up the demand for our currency, which then tends to appreciate. The reverse also holds true. A shift in investor sentiment away from our bonds and equities reduces the demand for the Canadian dollar, and it tends to depreciate. But let's remember that these changes in demand for equities and bonds are not related to current changes in aggregate demand for goods and services produced in Canada. The fact that these movements are not related to changes in aggregate demand is the essential difference between a Type One and a Type Two currency movement. A textbook example of a Type Two currency movement occurred during the Mexican Peso Crisis of 1994-95. As a result of the Mexican situation, investors became less comfortable with holding the financial assets of countries with governments that were heavily in debt--and this included Canada at the time. As a result, investors sold the financial assets of those countries and sought the relative safety of investments in the United States. This was one of the factors behind the sharp depreciation of the Canadian dollar during this period. Let me give you another example of an exchange rate change that is not driven by a change in Canadian aggregate demand. The period near the end of the 1990s saw investors become increasingly optimistic--some have said irrationally exuberant-- about the prospects for the U.S. economy. The associated financial flows into the United States helped to drive up the U.S. dollar over this period--at the expense of other currencies, including the Canadian and Australian dollars, the euro, and the yen. This optimistic view about the U.S. economy, combined with the decline in commodity prices that I mentioned earlier, helped push down the value of the Canadian dollar from 71 cents Of course, the process also works in the other direction. During the past two years, investors have become more concerned about the large and growing U.S. current account deficit--which has arisen out of that country's large fiscal deficit and its very low level of private savings. While the United States saves too little, Asian countries are saving too much, and this situation cannot be sustained indefinitely. More domestic demand in Asia and some other countries, and more savings in the United States, are needed to help restore global economic balance. Against this backdrop, market participants have come to the view that further depreciation of the U.S. dollar will be needed to help resolve these imbalances. The earlier "irrational exuberance" about the prospects for the U.S. economy has been cooled by an increased focus on the risks facing that economy. And so we have seen the U.S. dollar fall against many major currencies, including the Canadian dollar. Let me stress the relevant feature that is common across all Type Two movements. These movements do not reflect a change in the aggregate demand for our goods and services. However, the exchange rate movements, by having the usual effect on relative prices, still lead to changes in Canada's net exports and, thus, in Canadian aggregate demand. At this point, it might be tempting to say, "So what?" After all, Canadians looking to head south for a winter break probably don't care what is causing the exchange rate to move. They only want to know how many U.S. dollars or Mexican pesos they can buy with their hard-earned Canadian dollars. But it is important for us at the Bank, and for those who follow our actions, to understand what is causing the exchange rate to move. This is because the monetary policy implications of a currency movement depend on its cause, and on what other forces might be at work in the economy. Let's look at examples of the two types of exchange rate movement that result in a stronger Canadian dollar. In Type One, we start with an increase in foreign demand for our goods and services and, hence, an increase in aggregate demand. The Canadian dollar strengthens in response, increasing the relative price of Canadian goods. This increase offsets some of the higher foreign demand by encouraging imports and dampening exports. In other words, the appreciation of the Canadian dollar works to dampen the initial increase in aggregate demand. To the extent that the dampening effect on aggregate demand exactly offsets the direct increase in demand, there would be no need for a monetary policy response. A Type Two appreciation is a different story. Consider the example where the U.S. dollar weakens, driven by market concerns about global imbalances. In this case, there is no initial increase in Canadian aggregate demand. But the stronger Canadian dollar still raises the relative prices of domestic products and leads to a decline in net exports. The overall effect on Canadian aggregate demand is clearly negative. And this decrease in demand--if it persisted--would likely lead to undesirable downward pressure on inflation. All other things being equal, this would require monetary policy to be more stimulative than it otherwise would have been. I hope that this helps to clarify why these two different types of exchange rate movement have different implications for monetary policy. However, I don't want anyone to think that we at the Bank have a mechanical or formulaic approach to dealing with exchange rate movements. The truth is exactly the opposite. Analyzing foreign exchange movements and determining the appropriate monetary policy response is a complicated business. Consider the sharp appreciation of the Canadian dollar against the U.S. dollar over the past couple of years. Which type of movement drove this appreciation? How much of this movement was related to stronger demand for Canadian goods and services, and how much was related to widespread weakness in the U.S. dollar? As we noted in our last month, both types of exchange rate movement seem to have been at play over the past year. However, their relative importance appears to have shifted over this period. And that made it difficult to determine the appropriate monetary policy response. Looking at the economic data at the beginning of 2004, we saw that net exports had made a significant negative contribution to Canadian economic growth in 2003. We were concerned that, on balance, much of the exchange rate appreciation in 2003 was of the Type Two variety. This assessment was one of the factors that led the Bank to lower interest rates in early 2004. However, by late last summer and early last autumn, we had seen strong commodity prices and strong world demand. And net exports had made a solid, positive contribution to Canadian growth in the first half of 2004--a typical Type One effect. With our economy approaching its capacity limits, we raised interest rates in order to reduce the amount of monetary stimulus in the economy. But towards the end of 2004, the balance of Type One and Type Two forces appeared to shift again, with Type Two dominating. The U.S. dollar weakened against all the major floating currencies, and the Canadian dollar rose to a 13-year high of about 85 1/2 cents (US). This occurred despite the fact that world commodity prices had declined somewhat and the outlook for the global economy had weakened. The Bank's target overnight rate was therefore left unchanged at the fixed announcement dates in Each monetary policy decision that we make is complicated by uncertainty about the persistence of exchange rate changes and about the length of time it takes for both exchange rate and monetary policy movements to influence the economy. This has been one of the Bank's major challenges in the recent conduct of monetary policy. It's one thing to observe a movement in the exchange rate. It's quite another to determine its implications for aggregate demand and, hence, for monetary policy. We continue to struggle with the same complications today as we chart a path for monetary policy. Canadian interest rates remain low by historical standards. Eventually, this considerable monetary stimulus will have to be reduced; that is, at some point, interest rates will have to rise. But as I said, the second type of exchange rate movement appears to have gained relative importance in recent months, which means that aggregate demand in Canada will be weaker than we had expected last autumn. That is why in our recent we slightly lowered our growth projection for 2005, to 2.8 per cent from 2.9 per cent. And it is why we said in the that: "...the pace of reduction in monetary stimulus is likely to be slower than envisioned in the October ." By slowing the pace at which we will reduce monetary stimulus, we will continue to provide support for domestic demand to offset the additional drag we expect from net exports. Let me conclude by reminding you of what I said at the beginning of my remarks today. The relationship between the exchange rate, the economy, and monetary policy is complex. And the effects of movements in the currency are spread out over time. You can't look at one day's or one week's performance of the Canadian dollar and pinpoint the reason behind the movement. There is no precise way to measure the relative importance of the two types of movement that I have described, or their likely persistence. So, in setting monetary policy, we at the Bank use an analytical framework based on historical evidence, assess a lot of current data and, even then, we must apply a lot of judgment to our analysis. And the analysis and the judgment can change over time as new information becomes available. Ultimately, the Bank of Canada's commitment to Canadians about monetary policy boils down to this: We will continue to work at maintaining a rough balance between demand and supply in the economy, in order to keep inflation low, stable, and predictable. And as we pursue this objective, we will continue to explain the reasons behind our policy actions, and our view of the outlook for inflation and for economic growth in Canada.

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Inflation Targeting: A Canadian Perspective

dodge

Governor of the Bank of Canada Good afternoon. Three years ago, when I last addressed this group, I spoke about the conduct of monetary policy in the presence of economic shocks. In those remarks, I made passing reference to the Bank of Canada's inflation-targeting framework. Today, I am happy to accept your invitation to return and talk in more depth about how we use inflation targeting as our monetary policy anchor. The invitation is timely, given that the Bank of Canada's inflationtargeting agreement with the Canadian government is up for renewal next year. At the Bank, we are always reflecting on our framework, deciding what works well and what we can improve. Against that backdrop, we have watched with interest the debate taking place here in the United States--both inside and outside the Federal Reserve--about whether that institution should join the ranks of inflation-targeting central banks. As part of that debate, the minutes of the February FOMC meeting show that my colleagues at the Fed had a discussion about the merits of inflation targeting last month. According to the minutes, arguments were made both for and against the adoption of an explicit inflation target. Those in favour spoke of how such a target can anchor inflation expectations, add clarity to monetary policy decision making, and help with communications. Those opposed said that the benefits of adopting a target were unlikely to be large, that adopting a target might bias or constrain policy, and that it might appear--and I stress the word "appear"--to be inconsistent with the Fed's dual mandate to promote price stability and maximum employment. Before I proceed with my remarks today, I want to make it absolutely clear that my purpose here is not to weigh in on the debate within the Federal Reserve. I would not presume to tell the Fed what it should or should not do. Rather, I want to talk about the Canadian experience with inflation targets. However, in doing so, I will address some of the arguments raised at the FOMC meeting that I just mentioned. I will begin by discussing the Bank of Canada's legislated mandate, and how inflation targeting helps us to meet the objectives of that mandate. I will then talk about some of the choices that we have made to establish and refine our particular framework. I'll discuss some of the benefits that we can attribute--at least in part--to inflation targeting. And I will conclude by touching on some of the issues still facing us as we look to the future. Let me start with the Bank of Cana da's legislated mandate. It is interesting to compare our mandate with the one spelled out in the Federal Reserve Act, given that the nature of the Fed's mandate is often cited as one reason why it should not adopt an explicit inflation target. The pieces of legislation that govern the Bank and the Fed do contain some clear differences. But in terms of the conduct of monetary policy, it is the similarities that are more striking. Our mandate is broadly set out in the preamble to the Bank of Canada Act. The preamble was drafted in 1934 and, of note, has not been substantively amended over the past 70 years. The preamble calls on us to "regulate credit and currency in the best interest of the nation." It goes on to say that the Bank should mitigate "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." By comparison, the most recent revision of the Federal Reserve Act calls on the Fed to maintain growth of credit and the money supply "commensurate with the economy's long-run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates." The Fed's mandate is a bit more specific than ours in that it states directly that monetary policy should aim at having the U.S. economy operate at full capacity. But the main point is that both central banks have references in their mandates to production, prices, and employment. Indeed, a key goal for all central banks is to conduct monetary policy so as to provide favourable conditions for maximum, sustainable long-run growth, while recognizing that monetary policy alone is not sufficient to bring about that growth. So the question is, What is the best way to operate monetary policy in order to provide the conditions for sustainable growth, bearing in mind the words in our mandate: "so far as may be possible within the scope of monetary action"? Over the years, central banks have tried various frameworks in attempting to answer this question. First, central banks tried fixing exchange rates to gold; most later tried fixing their exchange rates to those of other countries. Some central banks tried to target credit or the growth of monetary aggregates, while many relied solely on their own judgment. All of these frameworks have had their problems, which I won't go into today. But over time, what has become clear is that the best way for monetary policy to promote sustainable economic growth is to anchor expectations about the future purchasing power of money. What we have learned from the bitter experience of many countries--including Canada and the United States--is that when monetary policy chases short-term goals, mistakes are made, uncertainty is increased, and fluctuations in economic activity are aggravated. Focusing on domestic price stability--however that term is defined--is the best contribution monetary policy can make to economic stabilization and sustainable long-term growth. Indeed, as my predecessor Gordon Thiessen put it, "Focusing on price stability helps us to guard against the sort of systematic [policy] errors that often occurred when we tried to aim directly at output and At the end of the 1980s, the Bank of Canada faced the question of how to pursue price stability in a way that would allow it to accomplish three things: first, help to anchor expectations about the future purchasing power of money; second, give the Bank a guide for the conduct of policy; and third, help us to explain to markets, politicians, and the Canadian public what we are doing and what actions they could expect from their central bank. By 1991, the Bank and the Government of Canada had agreed that inflation targeting was the right framework for pursuing this objective. We considered targeting inflation as the best way to achieve high, sustainable growth of output and employment. To be clear, inflation targeting is not an end in itself. Rather, it is the best means of fulfilling our commitment to promote the economic and financial welfare of Let me now say a few words about some of the particular choices we have made over the years to shape our inflation-targeting framework. A central bank that wants to target inflation and run an independent monetary policy must allow its currency to float. As you know, a monetary authority cannot control both the domestic and external values of its currency. We have one instrument, so we can have only one target. Thus, with inflation as our target, we naturally operate with a floating currency. Once the Bank and the government agreed on the concept of inflation targeting, we needed to make some choices to put the concept into practice. Our goal of price stability came to be defined as low and stable inflation. Like many other central banks, we chose a target for the annual increase in the consumer price index (CPI). Initially, our focus was on inflation reduction. So it was announced that the target would decline gradually--from the 3 per cent midpoint of a 2 to 4 per cent target range at the end of 1992 to the 2 per cent midpoint of a 1 to 3 per cent range by the end of 1995. The target has remained there since. Let me take you through some of the key decisions that we made in 1991, and the rationale behind our choices, as we set out the details of our framework. First of all, why did we choose the CPI as our target? The key reasons were that it is widely understood and is the measure of inflation most familiar to Canadians. Choosing a well-known indicator as a target makes it easier to explain our actions and to be accountable to Canadians. However, movements in the prices of particularly volatile components of the CPI can cause the index to fluctuate sharply. So we use a measure of core inflation as an operational guide. This measure strips out the most volatile components and the effect of changes in indirect taxes on the rest of the index, giving us a better understanding of the trend of inflation. Second, why have a range? While we emphasize the 2 per cent target, we have a range--as many central banks do--because monetary policy operates with long and variable lags. If we tried to target inflation too precisely we could have "instrument instability;" in other words, we would be adjusting our policy interest rate sharply and frequently, which would lead to greater instability in the economy. Further, measured inflation itself can be volatile as specific prices adjust. But to be clear, the range does not represent a zone of indifference--we do aim to achieve the 2 per cent target. Third, given that we must always be forward looking as we conduct policy, what time frame would we choose to achieve our target? From the beginning, we said that if a demand shock pushed inflation away from the target, we would conduct policy so as to return inflation to target over a period of 18 to 24 months. This is because our research suggests that it takes 12 to 18 months for changes in interest rates to have most of their impact on output, and 18 to 24 months to have most of their impact on prices. Of course, there is always uncertainty about the lags involved, and I'll have more to say about this later on. To be sure, there will always be times when there are large swings in relative prices in the economy--energy prices being a good example. Under inflation targeting, the objective is not to try to offset or stifle these relative price movements. Our experience has been that with a clear inflation target and with well-anchored expectations, these types of relative price shocks have only a one-off effect on the price level, and do not feed into ongoing inflation. Before I leave this section, I want to emphasize two points about our inflation-targeting framework. The first is that we operate in a symmetric way, and we make it clear to everyone that we do so. By this, I mean that we worry just as much about inflation falling below target as we do about it rising above target. This is a tremendously important point. When the demand for goods and services pushes the Canadian economy against the limits of its capacity, and inflation is poised to rise above target, the Bank will raise interest rates to cool off the economy. Just as importantly, when the economy is operating below its production capacity, and inflation is poised to fall below target, the Bank will lower interest rates to stimulate growth. Whatever the direction of the demand shock, the Bank of Canada will respond appropriately. This symmetry is our answer to the charge that central banks target inflation at the expense of growth. On the contrary, paying close attention to signs of deviation from our target promotes timely action in response to both positive and negative demand shocks. This is how we can keep the economy operating near its full capacity and thus keep inflation low, stable, and predictable. The second point I want to stress is that having an inflation target as an anchor is very helpful in terms of the Bank's accountability. If inflation persistently deviates from the target, we are committed to explaining the reasons why this is so, what we will do to return it to target, and how long we expect the process to take. Now let me turn to our experience with inflation targeting. Just as Canada was a pioneer at having a floating exchange rate, we were also among the very first to adopt inflation targeting. And as in other countries that have done so, the result has been unambiguously positive. Indeed, as Claudio Borio put it, "no country embracing inflation targeting has regretted doing so." Back in 1991, Canada had several compelling reasons for moving to inflation targeting. Compared with today, inflation was still relatively high. Further, the Bank of Canada and the federal government wanted to minimize the possibility of a wage-price spiral developing in the wake of the introduction of the Goods and Services Tax. We recognized the importance of having both the general public and financial markets understand our actions. And as inflationary pressures built towards the end of the 1980s, we saw that the lack of a monetary anchor was leading to rising inflation expectations. As we look at Canada's record since 1991, in terms of inflation and economic growth, I can tell you that all of the benefits we had hoped would come from inflation targeting have, in fact, materialized. We expected that inflation would become more stable under a targeting framewor k--and it did so, sooner than we had anticipated. We expected that our credibility would increase and that inflation expectations would become well anchored under targeting--and this also happened. Indeed, short-term expectations quickly became anchored to our target, although longer-term expectations took a bit more time to fall in line. Together with marked improvements in Canada's fiscal position in the mid-1990s, our excellent track record on inflation added to our credibility. Private sector forecasts for inflation in Canada now average close to the 2 per cent target far into the future. We expected that setting out a clear paradigm for operating under inflation targeting would bring benefits--and it did. Internally, focusing on inflation brought increased discipline and clarity to our monetary policy deliberations. But more importantly, being transparent about our operational paradigm has allowed markets and analysts to better predict how we will react to different economic outcomes. Financial markets and analysts now pay more attention to their own evaluations of the prospects for the economy and inflation in assessing the future path of our policy interest rate. Appropriately, they do not have to rely on the wording of our communications for guidance. Empirical evidence shows that inflation targeting has been an unqualified success for Canada. Inflation has averaged very close to 2 per cent and has remained within the target range since we adopted our targets, with rare exceptions that were due mainly to large swings in the prices of oil or other commodities. Further, there is evidence that inflation targeting has been successful as a macroeconomic stabilizer, helping to smooth the peaks and valleys of the business cycle. Our symmetric approach to inflation targeting is crucial in this regard. Because we guard against both inflationary and deflationary pressures, businesses and individuals can make long-range economic plans with increased confidence. Scarce economic resources are no longer wasted trying to hedge against the threat of runaway inflation. And because our paradigm makes it clear that we guard against deflationary pressures, Canada has avoided any serious threat of deflation. Throughout all the shocks we have experienced, Canadian inflation expectations have remained remarkably well anchored on the 2 per cent target. At the time that we were considering the adoption of inflation targeting, we heard many of the same arguments against such a framework that we hear today in the United States. Some argued that inflation targeting could constrain our ability to act, or would take away our ability to apply our own judgment in the conduct of policy. Our experience has shown these concerns to be groundless. Let me illustrate with a couple of recent examples. In the immediate aftermath of the 9/11 terrorist attacks, we lowered interest rates quickly and decisively to underpin confidence, which could have been profoundly shaken by the attacks. When a major loss of confidence did not materialize over the next few months, we were able to reverse course and withdraw some of that monetary stimulus. Our inflation-targeting framework did not restrict our ability to act. Indeed, because our paradigm is clear, financial markets were able to understand why we made these rapid rate adjustments. Another example is our reaction to the continuing realignment of world currencies over the past two years. The Canadian economy has had to adjust to sharp movements, not just in the external value of our dollar, but also in the foreign demand for many of our goods and services. Inflation targeting gives the Bank an important guideline for dealing with the currency appreciation, allowing us to maintain our focus on macroeconomic stabilization at a time when various sectors of the economy are dealing with the exchange rate shock. Our paradigm has given us the flexibility to apply judgment in the face of considerable uncertainty over this period. Before I close, let me say a few words about the future of inflation targeting in Canada. As I noted at the beginning, our current agreement with the federal government is up for renewal in 2006. So it is useful to think about those elements of our framework that we would not want to change, and other areas where changes might be considered. From the central bank's point of view, the basic arrangement of aiming inflation at the 2 per cent midpoint of a 1 to 3 per cent target range has served us well, along with the use of the CPI as our target. The CPI may not be a perfect indicator of inflation, but it is the most readily recognized and understood measure, and so likely represents our best option for targeting. However, given the volatility inherent in the index, the Bank has emphasized a core inflation measure for operational purposes. I would expect that these elements of our framework will remain in place. But good public policy demands that we continue to do the necessary research to confirm that these remain the best options. Also, the Bank of Canada will continue to recognize the importance of communications and transparency to the conduct of monetary policy. Inflation targeting is a helpful tool for anchoring expectations, but its effectiveness is greatly enhanced when a central bank communicates well. And a symmetric approach to inflation targeting allows the bank to make a convincing case for its policy actions, even during difficult economic conditions. But I don't want to suggest that there aren't questions to be answered as we go forward. One question facing us now is whether 18 to 24 months is the appropriate time horizon for monetary policy to bring inflation back to target after various types of shocks. One type of shock that we have to consider is a major movement in asset prices. Do these types of movements in asset prices contain any information about future inflation beyond our typical policy horizon? And if so, what should we do about it? This is not to suggest in any way that we should try to target asset prices. Rather, the question is whether it would ever be appropriate to lengthen the time horizon for returning inflation to target. A similar question applies to exchange rate shocks. Globalization appears to have altered the way in which economies adjust to movements in exchange rates. This applies both to the adjustment of real economic activity to the shock, as well as the direct pass-through of exchange rate movements to prices. This raises the question of whether 18 to 24 months is too short a time horizon for monetary policy to deal with exchange rate shocks. On the other hand, the reduction in the persistence of inflation that we have seen under inflation targeting would suggest that it may instead be more appropriate to shorten the policy horizon. Given the success to date of handling shocks within an 18 to 24-month horizon, we should not change our framework lightly. But we need to think hard about the appropriate time horizon in dealing with various shocks as inflation targeting evolves in the future. Let me close by emphasizing a few key points. There is no doubt in my mind that inflation targeting is the right monetary policy framework for Canada. Through our symmetric approach of keeping inflation low, stable, and predictable, we have laid the groundwork for solid, sustainable growth in output and employment. In doing so, we fulfill our commitment to "promote the economic and financial welfare of Canada," as spelled out in the Bank of Canada Act. With inflation targeting, our policy is more focused, our communications are clearer, and Canada's inflation expectations are more solidly anchored. During a period when consumer price inflation is low and appears to be stable, it may be tempting to some to conclude that an inflation anchor is unnecessary. In my opinion, to reach this conclusion would be a huge mistake. On the contrary, it is particularly important at this time, in the face of large terms-of-trade movements and other shocks, that central banks have an anchor to keep monetary policy focused. From my perspective, inflation targeting is the best anchor we've seen. Of course, I'm not saying that inflation targeting is the end of monetary policy history. And, I love a good debate. So I hope that my remarks today may have helped to add some context to the ongoing discussions here in the United States. And I can tell you that we in Canada will continue to watch, with great interest, as the debate unfolds.

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Canada's Competitiveness: The Importance of Investing in Skills

dodge

Governor of the Bank of Canada Thank you, Michael, and good evening. I am honoured to be here with you to kick off this lecture series. Once again, I want to thank Humber College and the Canadian Foundation for Economic Education for this opportunity. It's a bit daunting to try to deliver a lecture this late in the evening. But the subject that I want to discuss tonight is one that should be of interest to all of us --the importance of investing in skills to improve productivity growth. As most of you know, this lecture series was announced by the CFEE at a dinner here in Toronto in November 2003. At the conclusion of my speech that evening, I said that, in an increasingly complex and competitive world, furthering our national economic welfare will depend importantly on the quality of our labour force. I also said that improving skills will require concerted efforts from all of us who are involved directly or indirectly in education: parents, educators, employers, community organizations, and policy-makers. It is this shared responsibility that I would like to emphasize this evening. I will begin with a brief discussion about some of the factors influencing Canada's productivity performance. Then, I will review some of the larger forces at work on the world economy and their implications as we strive to improve productivity. Finally, with these forces in mind, I will offer a few thoughts on how we can best develop Canada's human resources. What drives productivity growth? Productivity plays a critical role when it comes to our national standard of living. Productivity growth is the main element that contributes to continued improvements in real incomes and overall prosperity. Rising productivity lets businesses pay higher wages, while keeping costs down, employment high, and profits coming in. That's why economists like me spend a lot of time thinking about ways to improve the productivity of our economy. There are several factors that help to raise labour productivity--by which I mean the amount of goods and services produced per worker per hour. These factors include the education, training, and experience of the workers and the amount and type of equipment available to them. Productivity can also be raised through technological innovation, and through changes in organizational and management practices. All of these key determinants of productivity influence how "smartly" human and capital resources are used. And these determinants are, in turn, influenced by broader factors such as competition, openness to foreign trade and investment, macroeconomic policies, and the efficiency of financial markets. We all recognize that improving productivity is the key component to raising the standard of living of Canadians. From 1996 to 2002, output per hour worked grew at just over 2 per cent, on average, a little faster than our undistinguished performance of the previous quarter century. This provided some reason for optimism. But over the past two years--while economists, business leaders, and policy-makers have talked about the need to raise productivity--output per hour has been essentially flat. While we're talking the talk on productivity, we are not doing a good job of walking the walk. We have to do better. And over the next decade or two, we will be working to improve this country's productivity amid significant global economic change. This evening, I'll focus on three important and ongoing elements of this change: technological innovation, globalization, and demographic shifts. Then I'll discuss the implications of these trends for skills development. Technological change Let me start with technological change. It's difficult to untangle and measure the individual components that contribute to productivity growth. But we do know that one of the most important factors in recent years has been the adoption of new technologies. Key among these has been information and communication technology, or ICT. It is by no means the only area where transformative technological advances have been made, but it is the one on which I will focus tonight, for two reasons: first, because ICT offers a useful example of the sweep and the impact of technological change; and second, because it relates to the other two broad trends that I will discuss this evening. The productivity potential of new technology is only realized when companies and institutions reorganize their business and management practices to integrate the new technology. Our lacklustre productivity record suggests that Canadian firms and public sector institutions are moving too slowly to adopt these new technologies and business practices. Let us also remember that technology not only creates opportunities to change work within a firm, it also creates opportunities to change the nature of transactions across firms. Technological innovation lowers transactions costs and facilitates productivity improvements through increased specialization. Specialized firms can build expertise by developing specific skills and then trading that expertise with other firms that offer complementary advantages. Technological change is hastening the second trend that I want to discuss tonight--and that is globalization. Travelling or shipping goods around the world now takes hours, not days. Information and ideas are available simultaneously to anyone who has access to the Internet. Wireless technology has brought telecommunication to places where phone lines cannot reach. In short, technological advances have allowed markets to expand as never before. In many ways, technology is the enabler of many of the trends leading to globalization, by slashing the costs and the time it takes to reach across borders and continents. Today, we're all shopping in the same global village market. Consumers and businesses around the world have become the target customers of Canadian firms. At the same time, our firms are exposed to new sources of competition and new pressures to innovate. Perhaps the most preoccupying element of this trend towards globalization is the emergence of China as an economic powerhouse. And India is not far behind. When you consider that China and India account for 40 per cent of the world's population--and that their economies are growing at annual rates of 9 and 7 per cent, respectively--it is not hard to see why they have such an impact on the global economy. China and India are now major global competitors in labour-intensive industries. Increasingly, they're also flexing their muscles in skill-intensive industries. Asia's highly efficient production capacity is prompting a transformation of manufacturing and distribution processes around the world. And the skills-based software industry in India is transforming that sector globally. So we're seeing tremendous competitive pressure on industries that are the traditional mainstays of the Canadian economy in general and of Ontario in particular-- such as automobiles and parts, steel, and other manufacturing industries. We're also seeing competitive pressures transform Canada's high-tech sector, which has only recently emerged as an engine of growth. But the income and wealth created in China and India are increasing the ability of these countries to buy goods and services from abroad. So, their integration into the global economy represents both a competitive challenge and a tremendous opportunity. These emerging markets are just that--markets. China is already one of the world's largest importers. This growing demand can provide a real boost to the Canadian economy, if we gear up to meet the challenge. So, how do we meet those challenges? One way is to integrate low-cost components from other regions of the world into our own production processes, through direct investment or joint ventures. This can help to keep costs down and free up our resources to concentrate on those areas where we have a competitive advantage. Second, we can focus on activities that embrace and facilitate technological advances. I'm thinking of activities such as industrial design, marketing, customization, packaging, and high-quality, individualized service. Humber College and similar institutions are helping to develop and maintain the skilled labour force that Canada needs to be a global player in these activities. At the same time, we can't ignore the fact that refocusing activity will likely mean job displacement in certain sectors. There will be some activities, particularly those that are labour-intensive and lower-value-added, where Canadian firms will not be well placed to compete with lower-cost producers in Asia. Adjustment will require shifting resources into expanding, higher-value-added activities where Canadian firms can exploit the new opportunities presented by the changing world economy. By making these adjustments, we will be able to increase productivity and raise our standard of living over time. Demographic trends The third significant trend that Canada and other industrialized countries face is the aging of our populations. Right now, about one Canadian in eight is aged 65 years or older. By 2026, that ratio will be one in five. So, we can expect reduced growth in the labour force and a smaller, older workforce in proportion to our population. And let's remember that this aging of the workforce is taking place as Canada is shifting to a knowledge-based economy. Technology-intensive employers require increased emphasis on retraining and on continuous learning for all workers, including older ones. Studies have shown that older workers participate less than younger ones in job-related education and training. And those workers with less education or low literacy levels find it particularly difficult to adjust to the knowledge-based economy. They are at a higher risk of being laid off and have greater difficulty in finding new work. The good news is that we still have time to prepare for the demographic shift. We have several factors working in our favour. First, technological change and increased use of ICT mean that participation in the labour force can be more flexible-- through teleworking, part-time work, job-sharing, off-site consulting, and other innovations. Second, older Canadians are, on average, healthier than in previous generations, and could stay in the labour force longer. Third, the nature of many jobs has changed. There are more skills-based jobs, but they are often less physically intensive and therefore can be done by older workers. Fourth, since the baby boomers are better educated than the current cohort of retiring workers, they may find it easier to adapt to changing work environments. All of these factors mean that the aging of our population over the next two decades need not have as serious an effect on economic growth as some fear. But we will need to increase productivity and to prepare our workforce and our economy for the demographic realities ahead. A focus on skilled labour This leads naturally to the subject that I will discuss in the remainder of my remarks tonight. These three global trends--technological change, globalization, and demographic shifts--must be central to our thinking as we prepare our workforce and our economy for the challenges that we face. So, in light of these trends, how do we best develop our labour force to boost our productivity? As I said at the beginning, the key to achieving these goals lies in coordinated effort. Skills development is a shared responsibility of business, academic institutions, the public sector, workers, and students. We need a system of incentives for continuous learning and upgrading of skills, and an infrastructure that delivers the training. This has always been important. But, as I mentioned earlier, it will be particularly important in the next two decades, as labour force growth in Canada slows. This system of incentives must benefit both workers and firms. If companies don't see the payoff from training and skills development for their workers, they won't make the investments. If workers don't see what's in it for them, they won't devote the time and energy to improve their skills. The first step to improving skills is to build an excellent infrastructure for early childhood development, feeding into a school system that effectively teaches basic skills. For Canada to generate productivity gains in a world market that's embracing technological change, provincial education systems must continue to boost literacy and numeracy rates among students. There's no longer such a thing as an unskilled job. The workers of today and tomorrow need to know how to learn, so that they can continuously improve their skills after they leave school. If we find more innovative ways to keep students engaged in their education, they will leave school with the enthusiasm they need to continue learning throughout their career. For some students, especially boys, school can feel like incarceration. One reason why drop-out rates are high is that some students don't see the connection between what they're being taught in school and what they want to do when they leave school. In order to be motivated to learn math, language, or science, students need to understand that this knowledge is relevant to the careers they want--that these courses are the foundation on which they will build their skills and interests. No one who learns a musical instrument practices scales so that they can be really good at playing scales. They practice scales so that they can play the songs they like. And students need to see firsthand the opportunities that will open up for them by studying hard and staying in school. Colleges, and the industries that support them, play a key role in providing that motivation, through programs that give high school students a first-hand look at the career options ahead. The flip side of the aging population that I discussed a minute ago is relatively smaller cohorts of young people. But that doesn't mean that we can stop focusing on the problems we face in preparing these young people for the workforce. Indeed, the fact that we have smaller cohorts means that we must do better--we can't afford to squander the potential of these young people. Once they have finished high school, they need to learn the skills that will help them to become productive workers in the expanding sectors of the economy. I'm in the right place to be talking about this, because Humber College has an exemplary record of training in areas such as design, merchandising, high-end services, and product innovation. Of course, it will always be critical that Canada stay on the leading edge of advanced research and theory. But pure research always needs to be complemented by the ability to commercialize, customize, and market the products that result. Service industries will also require increasing numbers of skilled workers. Older people buy relatively more services as a percentage of their overall consumption. The health care sector, for example, will require more medical technicians, therapists, nurse practitioners, and home care workers to meet growing demand. And as our population ages, the demand for leisure and travel services is increasing. The hospitality and tourism sectors can differentiate Canada from other destinations by delivering the exemplary service that only well-trained workers can provide. In order to learn relevant skills, students should be trained to use the latest tools and production methods employed by the sector for which they' re training. This means innovative partnerships between educational institutions and industry, to give students access to equipment and methods that are actually being used by leading-edge businesses. It means embracing the classic notion of apprenticeship to help make education and training as efficient and as relevant as possible. One more word on apprenticeships. We need to focus on creating a new generation of skilled craftspeople to replace the generation that is retiring. This is not a new problem. I was writing papers about it in the early 1970s, and it still hasn't been resolved. Existing shortages in some skilled trades are likely to worsen, particularly in those trades where Canada used to rely on imported skills to meet domestic demand. The time to train this new generation is now, so that they can gain from the experience of the older generation while learning the latest techniques. I've spoken at length about our education system. But, as we improve the training of young workers, demographics will demand that we also make better use of older workers over the next couple of decades. And that requires continued and innovative on-the-job training. Employers may be reluctant to invest in training older individuals because of the shorter period in which to recoup training costs and because of a perception that older workers are less "trainable." These are misperceptions. First, because of rapidly changing technology, the payoff period for any training has become shorter and the need for the continuous upgrading of skills greater. Second, research suggests that successful training depends on the design of the training program, not on the age of the trainee. We should help older workers to continue to get the skills they need to remain in the workforce--should they wish to do so. I've said that improving the skills of Canada's workers is a shared responsibility. So let me say a word about the role of the public sector. Boosting productivity requires microeconomic policies that encourage innovation in Canada's private and public sectors. As I mentioned earlier, sometimes this innovation results in the displacement of workers. Public policy should assist those workers to upgrade their skills--not just when they lose their jobs, but during their entire working life. That requires the right mix of policy incentives for individuals and employers to continue to invest in training. And it must be a continuing process, not just a remedial one. Ladies and gentlemen, I don't for a minute believe that these are easy tasks. But the more flexible and efficient we can make our labour force, the better prepared we will be to improve our productivity and to increase the real incomes of Canadians in the years ahead. So let me conclude with a challenge. I began my remarks by talking about the importance of productivity in our efforts to assure rising incomes and economic wellbeing. And just as we need to improve the productivity of our factories and enterprises, we also need to improve the productivity of our training and education system. So I challenge Humber College and other educational institutions to constantly evaluate and improve the methods they are using to develop the skills of Canada's workforce. And I challenge subsequent lecturers in this series to come up with new ideas to help them achieve this goal. Creating the world's most innovative framework for education and training is not a simple task. But it's an extraordinarily important one. Because the more innovative we can be in skills development, the more innovative we will be as a nation. And that is the best way to promote sustained, longterm economic prosperity for Canadians.

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Release of the

dodge

This morning, we released our April Monetary Policy Report. In the report, we said that the global economy has been unfolding largely as expected, and the outlook for the Canadian economy is essentially unchanged from that in January's Monetary Policy Report Update. There is increasing evidence that the Canadian economy is adjusting to major global developments, including the realignment of currencies and higher commodity prices. The Bank expects Canada's economy to grow by about 2 1/2 per cent in 2005 and 3 1/4 per cent in 2006, with growth this year and next coming primarily from strength in domestic demand. To continue to support aggregate demand, we decided to leave the target for the overnight rate unchanged at 2.5 per cent on 12 April. The Bank continues to judge that the economy is operating slightly below its production capacity, and we expect that it will move back to full capacity in the second half of 2006. Core inflation is expected to return to 2 per cent around the end of 2006. Based on the scenario implied by oil-price futures, total CPI inflation is projected to remain slightly above 2 per cent this year, and to move slightly below 2 per cent in the second half of 2006. In line with this outlook for growth and inflation, a reduction of monetary stimulus will be required over time. This outlook is subject to both upside and downside risks and to uncertainties. The risks include the pace of expansion in Asia and the prices of oil and non-energy commodities. A further risk relates to the resolution of global current account imbalances. Should these imbalances persist, the risk of a disorderly correction would grow over time. Most of the uncertainties with respect to the Canadian outlook relate to how the economy is adjusting to the relative price changes associated with major global developments. Monetary policy continues to facilitate the adjustment process by aiming to keep inflation at the 2 per cent target and the economy operating near its production capacity.

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How Canada is Adjusting to Global Economic Forces

dodge

Governor of the Bank of Canada The Bank of Canada has been examining the issue of how the Canadian economy adjusts to movements in the exchange rate for a long time. Canada's economy is very open, so we always need to understand how exchange rate movements are affecting real economic activity and, in turn, what the implications are for monetary policy. And with a 25 per cent appreciation of the Canadian dollar over the past couple of years, this has been a major preoccupation. Of course, there's much more to the story than just the exchange rate. Powerful forces have been shaping the global economy. These include the emergence of the economic powerhouses of China and India, and large and growing financial imbalances in the United States and Asia. As a result, we have seen large movements in relative prices, and not just the realignment of exchange rates. We have seen firming prices for non-energy commodities, rising oil prices, flat or falling prices for many consumer goods, and dramatic reductions in the prices of communications services and computer equipment. Today, I want to talk about the kinds of adjustments that the Canadian economy is making in response to these forces. I will start with a brief review of how our monetary policy operates and how it helps with the adjustment process. I'll spend a few minutes talking about how the Bank takes exchange rate movements into account as it conducts monetary policy. Then, I will discuss the ways in which the real economy is adjusting to movements in the exchange rate and other global forces. Finally, I will recap the projections for the Canadian economy contained in the . Let me begin with a few words about our monetary policy framework. The Bank of Canada Act calls on us to "mitigate 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 do this by trying to foster an environment of low, stable, and predictable inflation. In particular, we aim to keep the annual rate of consumer price inflation at the 2 per cent midpoint of a 1 to 3 per cent target range. This is the best contribution that we can make to achieving high, sustainable growth of output and employment. To be clear, inflation targeting is not an end in itself. Rather, it is the best means of fulfilling our commitment to promote the economic and financial welfare of Canadians. We pursue this objective by trying to keep the economy operating at full capacity; that is, we aim for a balance between total demand and supply in the economy. When the demand for goods and services pushes the Canadian economy against the limits of its capacity, and inflation is poised to rise above the target, the Bank will raise interest rates to cool off the economy. And when the economy is operating below its production capacity, and inflation is poised to fall below the target, the Bank will lower interest rates to stimulate growth. So, by maintaining low and stable inflation, monetary policy promotes greater stability in economic output. A flexible exchange rate is an important part of our monetary policy framework. I hasten to add that we do not have a targe t or preferred level for the Canadian dollar. I'll come back to the topic of the exchange rate in just a moment. But first let me talk about how our monetary policy helps the economy to adjust to the powerful economic forces we see today. To begin with, low and stable inflation allows businesses and consumers to better read price signals in markets, which helps them to make better long-term decisions in the face of major economic developments. A second way that monetary policy helps with the adjustment process comes from our strategy of keeping total supply and demand in balance. In these circumstances, economic resources that are released by shrinking sectors, where demand is weak, can be absorbed by expanding sectors, where demand is strong. Of course, adjustment is never simple or without pain, especially at the personal level. But from a macroeconomic point of view, adjustment can take place with less social and economic cost when inflation expectations are well anchored and the economy is operating close to its potential. Having a floating exchange rate is a third way in which our monetary policy framework helps with the adjustment process. Let me explain how. Changes in global demand for a country's goods and services tend to bring about movements in that country's currency. The resulting exchange rate movements help to keep balance in the economy by offsetting the impact of the change in demand. For example, rising global demand for Canadian goods and services tends to lead to a stronger Canadian dollar. The stronger currency, in turn, tends to restrain exports and to encourage imports. By restraining the demand for Canadian-produced goods and services, the floating exchange rate helps to keep total supply and demand in balance. Similarly, when there is falling global demand for Canadian-produced goods and services, the floating exchange rate will encourage demand for these goods and services, again helping to keep total supply and demand in balance. This brings me to my next subject, which is how we at the Bank of Canada view movements in the exchange rate. As I said earlier, we do not have a target or a preferred level for the Canadian dollar. But this does not mean that the value of the currency is unimportant--far from it. The exchange rate is something that we at the Bank are always watching closely, looking for the valuable information that helps us to better interpret and predict the strength of total demand for Canadian goods and services. The way that we take the exchange rate into account as we conduct monetary policy is complicated. This is because the exchange rate can move for different reasons. Sometimes, movements in the exchange rate reflect changes in the demand for a country's goods and services. But sometimes, they do not. This distinction is important, because the two types of movements have different implications for demand in the economy and, hence, for monetary policy. Indeed, the reason behind a movement in the Canadian dollar can be just as important for monetary policy as the movement itself. Let me take a couple of minutes to explain. First, consider the type of currency movement that reflects changes in foreign demand. In 2003 and much of 2004, we saw a strong increase in the value of the Canadian dollar. This reflected, at least in part, the strong demand for Canadian exports and a sharp rise in the global prices of many of these exports, particularly commodities. The stronger Canadian dollar, in turn, encouraged imports and discouraged exports. This is an example of how the appreciation of the Canadian dollar can work to dampen an initial increase in aggregate demand. Were this dampening effect on aggregate demand to exactly offset the initial, direct increase in demand, all other things being equal, there would be no need for a monetary policy response. Now, consider the other type of exchange rate movement, which does not reflect changes in demand for a country's goods and services. Instead, it can reflect changes in foreign demand for that country's financial assets or changes in domestic demand for foreign financial assets. For example, during the past two years, investors have become more concerned about the large and growing U.S. current account deficit which, according to the Bureau of Economic Analysis, hit a remarkable US$666 billion, or 5.6 per cent of GDP, in 2004. And so we have seen the U.S. dollar depreciate against many major currencies, including the Canadian dollar. In this example, the stronger Canadian dollar leads to a decline in net exports, just as in the previous example. But in the absence of any initial increase in demand to be offset, the overall effect on Canadian aggregate demand would clearly be negative. And this decrease in demand--if it were to persist--would generate downward pressure on Canadian prices and employment that could push inflation below our target. All other things being equal, this would require monetary policy to be more stimulative than it otherwise would have been. To be clear, I don't want you to think that we at the Bank have a mechanical or formulaic approach to dealing with exchange rate movements. The truth is exactly the opposite. Analyzing foreign exchange movements and determining the appropriate monetary policy response is a complicated business. When we look at the movement of the Canadian dollar against the U.S. dollar over the past couple of years, it is clear that the upward movement during this period has been driven by both stronger demand for Canadian goods and services and by widespread weakness in the U.S. dollar. But there have been times during this period when the first factor appears to have been the strongest influence, and at other times, it appears that the second factor dominated. Now that I have talked about how the Bank of Canada deals with exchange rate movements, let me turn to how the real economy is adjusting to global economic developments and to the large relative price movements associated with them. It is interesting to compare the experience of the past two years with that in the period from 1997 to 2002. From the beginning of 1997 to the end of 2001, falling commodity prices led to a decline of more than 6 per cent in Canada's terms of trade -- the ratio of the prices Canadians receive for their exports to the prices Canadians pay for their imports. At the same time, "irrational exuberance" about the prospects for the U.S. economy led to heavy financial flows into the United States, and this helped to drive up the value of the U.S. dollar relative to other currencies. The Canadian dollar fell from just ending that year at about 63.4 cents U.S. During this time, the cost of labour relative to capital goods declined in Canada, because most capital goods are imported and priced in U.S. dollars, while labour is paid in Canadian dollars. Businesses reacted appropriately to these price signals by increasing their production of services and of those manufactured goods that require relatively more labour and less machinery and equipment. What we have seen over the past couple of years is, in many ways, a mirror image of the 1997-2002 period. Commodity prices have risen, and our terms of trade improved by more than 16 per cent from the fourth quarter of 2001 to the fourth quarter of 2004. The cost of labour has increased relative to the cost of capital goods. Again, Canadian firms are responding to the price signals. We are currently seeing large increases in investment spending in oil and gas extraction, other mining activity, and wood-product manufacturing. Firms have been motivated both by high prices for their products and by the expectation that these high prices will persist. We are also seeing rising investment spending in sectors with low exposure to international trade, such as electric power generation, finance and insurance, and information and cultural industries. In these cases, firms are reacting to recent substantial gains in Canadian domestic demand. For both of these groups, a crucial point to note is that a large part of the planned investment is motivated by the desire to increase production capacity. But the story is somewhat different for those sectors that are highly exposed to international trade , but where the prices of their products are not rising. Here, I am referring to sectors such as auto parts, textiles, and clothing manufacturing. Firms in these sectors are feeling the pressure of the higher Canadian dollar and are also facing increased competition from places such as China and India. The good news is that there is evidence that many of these firms are making adjustments in the face of adversity. Investment spending for these firms is being channelled towards increasing productivity and reducing costs, not increasing capacity. Because much of the productivity-enhancing machinery and equipment is produced abroad and priced in U.S. dollars, the appreciation of the Canadian dollar has lowered the cost of this machinery and equipment relative to that of labour. Other firms are using different strategies to adjust to the stronger Canadian dollar and to increased competition from abroad. A growing number of firms are looking to cut costs by importing more inputs. Others are phasing out production of goods and services with low profit margins and concentrating on those that yield higher returns. And of course, all of these adjustments have implications for the Canadian labour market. Overall job growth has been strong, but there have been important sectoral differences. We have seen job gains in commodity-producing sectors and in those that have low exposure to foreign competition. However, employment has fallen in a number of manufacturing sectors. This reflects, at least partly, the fact that some firms are now substituting capital for labour in order to reduce costs, which is the opposite of the situation we saw in the late 1990s and at the beginning of this decade. Before I conclude, let me quickly review the projections for the Canadian economy that we set out in our yesterday. The global economy has been unfolding largely as expected, and the prospects for continued robust growth are quite favourable, especially over the near term. The outlook for the Canadian economy through to the end of 2006 is essentially unchanged from that in our January . Our base-case projection calls for annualized growth of about 2 1/2 per cent in the first half of 2005 and 3 per cent in the second half. Growth of about 3 1/2 per cent is expected through the four quarters of 2006, consistent with closing the output gap in the second half of next year. To express it in annua l average terms, growth in 2005 is projected to be about 2 1/2 per cent, down slightly from the January , while the projection for 2006 is little changed at about 3 1/4 per cent. With the economy expected to return to full production capacity in the second half of 2006, core inflation should move back to 2 per cent around the end of next year. Based on the scenario implied by oil-price futures, total CPI inflation is expected to remain above the 2 per cent target for some time, before moving slightly below 2 per cent in the second half of 2006. In line with this outlook, a reduction of monetary stimulus will be required over time. However, I want to stress again that the Bank is not committed to any particular interest rate path or timetable. Let me now conclude. As I noted at the beginning, there are powerful global economic forces at work, and economies everywhere need to make adjustments. In Canada, businesses are, indeed, making adjustments to meet these challenges and to take advantage of emerging opportunities. At the Bank of Canada, we will continue to monitor these global forces closely and to assess their impact. We will continue to conduct monetary policy with the aim of keeping inflation close to target and thus keeping the economy operating at its full potential. In this way, we will do our part to facilitate the adjustments that Canadian businesses are making to changes in the global economy.

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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 this committee twice a year, following the release of our . These meetings help us keep Members of Parliament and, through you, all Canadians informed about the Bank's views on the economy, and about the objective of monetary policy and the actions we take to achieve it. Last Thursday, we released our April . In the report, we said that the global economy has been unfolding largely as expected, and the outlook for the Canadian economy is essentially unchanged from that in January's . The Canadian economy continues to adjust to global economic developments. This was also an important theme last October when Paul and I appeared before this Committee. These developments include the realignment of currencies in response to global imbalances, the higher prices of both energy and non-energy commodities, and growing competition from emerging-market economies. In Canada, we are seeing more evidence of sectoral adjustments to these global developments. Many Canadian commodity-producing sectors are expanding. However, firms in some other sectors that are exposed to international trade are facing pressure from the appreciation of the Canadian dollar and from foreign competition. On balance, net exports have been a drag on the economy. But with robust domestic demand, some sectors--such as retail, wholesale, and housing--have been growing strongly. The Bank expects Canada's economy to grow by about 2 1/2 per cent in 2005 and 3 1/4 per cent in 2006, with growth this year and next coming primarily from strength in domestic demand. To continue to support aggregate demand, we decided to leave the target for the overnight rate unchanged at 2.5 per cent on 12 April. The Bank continues to judge that the economy is operating slightly below its production capacity, and we expect that it will move back to full capacity in the second half of 2006. Core inflation is projected to return to 2 per cent around the end of 2006. Based on the scenario implied by oil-price futures, total CPI inflation is expected to remain slightly above 2 per cent this year, and to move slightly below 2 per cent in the second half of 2006. In line with this outlook for growth and inflation, a reduction of monetary stimulus will be required over time. This outlook is subject to both upside and downside risks and to uncertainties. The risks include the pace of expansion in Asia and the prices of oil and non-energy commodities. A further risk relates to the resolution of global current account imbalances. Should these imbalances persist, the risk of a disorderly correction would grow over time. Most of the uncertainties with respect to the Canadian outlook relate to how the economy is adjusting to the relative price changes associated with major global developments. Monetary policy continues to facilitate the adjustment process by aiming to keep inflation at the 2 per cent target and the economy operating near its production capacity. Mr. Chairman, Paul and I now will be happy to answer the committee's questions.

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

dodge

Good afternoon, 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. Last Thursday, we released our April . In the report, we said that the global economy has been unfolding largely as expected, and the outlook for the Canadian economy is essentially unchanged from that in January's . The Canadian economy continues to adjust to global economic developments. These developments include the realignment of currencies in response to global imbalances, the higher prices of both energy and non-energy commodities, and growing competition from emerging-market economies. In Canada, we are seeing more evidence of sectoral adjustments to these global developments. Many Canadian commodity-producing sectors are expanding. However, firms in some other sectors that are exposed to international trade are facing pressure from the appreciation of the Canadian dollar and from foreign competition. On balance, net exports have been a drag on the economy. But with robust domestic demand, some sectors--such as retail, wholesale, and housing--have been growing strongly. The Bank expects Canada's economy to grow by about 2 1/2 per cent in 2005 and 3 1/4 per cent in 2006, with growth this year and next coming primarily from strength in domestic demand. To continue to support aggregate demand, we decided to leave the target for the overnight rate unchanged at 2.5 per cent on 12 April. The Bank continues to judge that the economy is operating slightly below its production capacity, and we expect that it will move back to full capacity in the second half of 2006. Core inflation is projected to return to 2 per cent around the end of 2006. Based on the scenario implied by oil-price futures, total CPI inflation is expected to remain slightly above 2 per cent this year, and to move slightly below 2 per cent in the second half of 2006. In line with this outlook for growth and inflation, a reduction of monetary stimulus will be required over time. This outlook is subject to both upside and downside risks and to uncertainties. The risks include the pace of expansion in Asia and the prices of oil and non-energy commodities. A further risk relates to the resolution of global current account imbalances. Should these imbalances persist, the risk of a disorderly correction would grow over time. Most of the uncertainties with respect to the Canadian outlook relate to how the economy is adjusting to the relative price changes associated with major global developments. Monetary policy continues to facilitate the adjustment process by aiming to keep inflation at the 2 per cent target and the economy operating near its production capacity. Mr. Chairman, Paul and I now will be happy to answer the committee's questions.

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The Canadian Economy: Adjusting to Global Economic Forces

dodge

Governor of the Bank of Canada to the Ottawa Chamber of Commerce Good morning. It's a pleasure to be here. I'm always glad to deliver a speech in Ottawa and to get a chance to play before the hometown crowd. But the opportunity is especially welcome this year, because this is an anniversary year for both the City of Ottawa and the Bank of Canada. The year 2005 marks the 150th anniversary of the establishment of Ottawa as a city. On 1 January 1855, the logging community of Bytown was formally incorporated as a city and adopted Ottawa as its new name. This year is also the 70th anniversary of the Bank of Canada. The Bank opened its doors on 11 March 1935. Both the City of Ottawa and the Bank of Canada have evolved and grown since their early days. But at the Bank, one thing that has not changed is our commitment to promoting the economic and financial welfare of Canada. Our work at the Bank of Canada breaks down into four main functions. Let me briefly review them. First, the Bank issues and distributes Canada's paper currency and protects it from counterfeiting. Last year we issued new $100, $50, and $20 bank notes with enhanced security features. We are adding these security features to an upgraded $10 note, which will begin circulating on 18 May. The Bank of Canada's second function is to act as the federal government's banker, managing government funds and the public debt. Third, the Bank promotes the safety and efficiency of Canada's financial system. It provides banking services to commercial banks and oversees the systems that financial institutions use to transfer funds and settle their accounts. Finally, the Bank of Canada conducts monetary policy in order to preserve the confidence of Canadians in the value of their money by controlling inflation. In this way, we contribute to the long-term stability and strength of the Canadian economy. I will spend most of my time this morning discussing this last function-- monetary policy. The Bank of Canada Act calls on us 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 do this by trying to keep inflation low, stable, and predictable. Specifically, we aim to keep the annual rate of consumer price inflation at the 2 per cent midpoint of a 1 to 3 per cent target range. We pursue this objective by trying to keep the economy operating at full capacity; that is, we aim for a balance between total demand and supply in the economy. Simply speaking, if the demand for goods and services is pushing the Canadian economy against the limits of its capacity, and if inflation is poised to rise above the target, the Bank would raise its official policy interest rate. This, in tur n, would push up other interest rates and help to cool off the economy. Conversely, if the economy is operating below its production capacity, and inflation is poised to fall below the target, the Bank would lower its target rate, to help bring down interest rates and stimulate growth. So, by maintaining low and stable inflation, monetary policy promotes greater stability in economic output, too. A flexible exchange rate is a critical part of our monetary policy framework. We do not have a target or preferred exchange rate for the Canadian dollar. But it is an important relative price in our economy. A floating currency helps us to achieve our inflation target and can act as a shock absorber to cushion our economy from external shocks. Now, let me say a few words about the economic environment in which we're conducting monetary policy. There are powerful forces at work in the global economy, including growing competition from emerging-market economies, such as China and India, and large and growing financial imbalances in the United States and Asia. The growth of emerging-market economies is driving up demand for commodities, and that is pushing up world prices for oil and many non-energy commodities. Meanwhile, productivity improvements in some countries and a competitive world environment are lowering the prices for some consumer goods, communications services, and computer equipment. All of these forces are causing significant movement in the exchange rates of key currencies. They have also contributed to the sharp appreciation of the Canadian dollar against the U.S. dollar over the past couple of years. Some of the adjustments we're now seeing in the Canadian economy are in direct response to these forces. Our monetary policy is helping these adjustments by aiming to support continued high levels of domestic demand. In our most recent , released in April, we projected that domestic demand will grow by almost 4 per cent in 2005. This will offset softer foreign demand and the weaker contribution that exports are making to economic growth this year. This is important in the context of the Ottawa region, and I'll return to that in a moment. I mentioned earlier that monetary policy works to control inflation. Low and stable inflation allows businesses and consumers to better read price signals in markets, which helps them to make better long-term decisions in the face of major economic developments. These signals prompt sectors that are shrinking because of weak demand to release resources that can be absorbed by expanding sectors, where demand is strong. Of course, adjustment is never simple or without pain. Individuals may have to retrain or relocate, and expanding businesses may require time to put the necessary capital equipment in place. But from a macroeconomic point of view, adjustment can take place with less social and economic cost when inflation expectations are well anchored, the economy is operating close to its potential, and a floating exchange rate is helping to absorb external shocks. Let's now explore ways in which Canada's economy is responding to global economic developments. Over the past couple of years, commodity prices have risen dramatically. Our terms of trade--that is, the ratio of the prices that Canadians receive for their exports to the prices that Canadians pay for their imports--have improved by more than 16 per cent since late 2001. In response to these higher prices and stronger demand, we've seen stronger investment spending in oil and gas extraction, mining activity, and wood-product manufacturing. We are also seeing rising investment spending in sectors with low exposure to international trade, such as electric power generation, finance and insurance, and information and cultural industries. In these cases, firms are reacting to strong growth in Canadian domestic demand. I should add that the increased activity in the construction sector reflects increases in both domestic and foreign demand. But there are other sectors that are highly exposed to international trade where the prices of products are not rising. Here, I am referring to goods-producing sectors such as auto parts, textiles, and clothing manufacturing, as well as service sectors such as tourism. Firms in these industries are feeling the pressure of the higher Canadian dollar, and they are also facing increased competition from other regions of the world. The good news is that many Canadian firms are making adjustments. Investment spending is being channelled towards increased specialization, higher productivity, and lower costs. In the goods-producing sector, where much of the productivity-enhancing machinery and equipment is produced abroad and priced in U.S. dollars, the stronger Canadian dollar has substantially lowered the cost of this machinery and equipment and has encouraged firms to buy tools that boost their productivity. In the services sector, stiffer competition is encouraging firms to increase their specialization and offer more value-added, customized services. Other adjustments are also taking place. A growing number of firms are looking to cut costs by importing more inputs. We've certainly seen this type of adjustment taking place among the manufacturers of telecommunications equipment. Other firms are phasing out the production of goods and services with low profit margins and concentrating on those that yield higher returns. Monetary policy is working to support this adjustment process by maintaining strong growth in domestic demand. Low interest rates help encourage consumer and business spending to keep the economy operating close to its production potential. This is important nationally, but strong consumer and business demand will be particularly important to Ottawa this year and next, as growth in the public administration sector is likely to slow. While we at the Bank don't conduct detailed analysis at the municipal level, our general analysis suggests that growth in manufacturing can be expected to moderate, as the higher Canadian dollar dampens demand for made-inCanada products-- including technology products from Ottawa. Like the tourism industry nationally, Ottawa's tourism and hospitality sector is also facing increased competitive pressure from the higher Canadian dollar. On the other hand, continued strong business and consumer demand can be expected to provide support for Ottawa's business services, software, and retail sectors. Before I conclude, let me say a few words about the financial system and the Bank of Canada's role in promoting its efficiency. As I have said before, an efficient financial system is critical to maintaining Canada's international competitiveness and long-term economic health. An efficient financial system is one that helps to allocate scarce economic resources to the most productive uses, in a cost-effective way. The ultimate goal is to have Canada's financial institutions and markets match investors and their savings with appropriate, productive investments. In other speeches, I have talked about ways to encourage competition, transparency, and efficiency in Canada's financial markets and institutions. I won't review these discussions today, but I do want to repeat that it is critical that Canada makes headway on these issues. If Canadians want sustainable economic growth and prosperity, our financial system must function as efficiently as possible. One initiative in this area is benefiting from the attention of Jim Watson, Minister of Consumer and Business Services, and the Government of Ontario, and that is the Uniform Securities Transfer Act. The efficiency of our financial markets would be improved if provincial and territorial governments would proceed with legislation to replace the current patchwork of legal rules in this area and to provide a sounder legal basis for the holding and transfer of rights in securities that are held in book-entry form. This is just one example of encouraging initiatives that are under way. At the Bank of Canada , we will continue to contribute to these efforts by conducting research and promoting discussion on ways to improve the functioning of our financial institutions and markets and to enhance the safety and soundness of Canada's financial system. We share this research with regulators, market participants, and the public. Our , published twice a year, is part of that effort. Let me now conclude. As I noted at the beginning, there are powerful global economic forces at work, and economies everywhere need to adjust. Businesses in Ottawa, and in the rest of Canada, are making adjustments to meet these challenges and to take advantage of emerging opportunities. At the Bank of Canada, we will continue to monitor these global forces closely and to assess their impact. We will continue to conduct monetary policy with the aim of keeping inflation close to our target and the economy operating at its full potential. We will maintain our efforts to promote a safe and efficient financial system. And, as always, we will work to enhance the confidence of Canadians in the value of their money and the stability of their economy. In this way, we will do our part to facilitate the adjustments that the Canadian economy is making to changes in the global economy.

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70 Years of Central Banking in Canada

dodge

Governor of the Bank of Canada It gives me great pleasure to be here today with you, and to chair this special conference session celebrating the 70th anniversary of the Bank of Canada. The Bank opened its doors on 11 March 1935, at the height of the Great Depression, and immediately faced enormous challenges. In meeting those challenges, the new Bank of Canada drew on the experience of other, established central banks. It received valuable guidance in functions such as the issuance of bank notes, managing foreign exchange reserves, and promoting financial stability. However, such guidance did not prove to be much of an advantage in what has become the main function of the Bank of Canada--monetary policy. Up to the time that the Bank was founded, monetary policy had been subject to the tight discipline of the gold standard--a topic that Angela Redish has explored in her work. That discipline severely limited the authorities' room to manoeuvre. The notion that countries, acting through their central banks, might actually try to stabilize macroeconomic activity within their borders is a relatively new one. As a consequence, over the past 70 years, the Bank of Canada and other central banks have had to learn by doing--by experimenting and gradually refining the art and science of monetary policy implementation. We have received a great deal of help in this effort from the academic community, including the people here today. But it has not been an easy exercise--nor is it finished. Monetary policy is still very much a work in progress. Let me now briefly review some of the significant changes in monetary policy that have taken place over the past 70 years. The Preamble to the Bank of Canada Act states that ...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. Seventy years later, this is still an accurate description of our goal. However, the Act does not provide any practical guidance as to how this objective should be pursued. Through the late 1930s and the early post-war period, the main concern of the central bank was to try to eliminate, and then to avoid a return to, the deflation and high unemployment of the Depression years. The government shared this preoccupation, as evidenced by the 1945 federal White Paper on Employment and Income. Things started to change in the late 1950s and early 1960s, when economists led authorities to believe that there was a permanent trade-off between a little bit more inflation and a little bit less unemployment. All authorities had to do, it was believed, was pick their preferred point on a downward-sloping Phillips curve. But the bitter inflationary experiences of the 1970s and a belated recognition that the Phillips curve might be vertical in the longer run--if not slightly upward sloping--eventually led to an increased focus on price stability as the goal for monetary policy. We began to appreciate what Olivier Blanchard calls the "divine coincidence"--that is, the realization that aggregate demand-supply equilibrium and price stability are complementary objectives. We've realized that a low, stable, and predictable inflation rate is probably the best contribution a central bank can make to the economic welfare of the nation. Since inflation was viewed as being "everywhere and always a monetary phenomenon," monetary aggregates were used as intermediate targets. But eventually, they proved to be an ineffective anchor. As Gerald Bouey said, we didn't abandon monetary aggregates, they abandoned us. And so, at the beginning of the 1990s, in the search for a new policy anchor, central banks started to focus directly on inflation, either through implicit or explicit inflation targets. The instruments that we have used for the transmission of monetary policy have also changed over the years. In the first 35 years of the Bank's existence, we relied on a "belt and braces" approach to policy execution, in the belief that credit was fungible and that every possible financial avenue had to be covered. The result was a complex mix of primary and secondary liquidity requirements, interest rate ceilings, quantitative limits, outright restrictions and prohibitions, foreign exchange market intervention, and--when all else failed--a healthy dose of moral suasion. Attempts to describe the conduct of monetary policy turned into a bewildering stream of arcane details that left listeners confused or--it was sometimes hoped--in awe of the economic alchemists who plied this mysterious craft. This started to change in the 1960s, particularly following the Royal Commission on be hard to overestimate the impact of this analysis, and the sea change in official thinking that was initiated by the Porter Commission. The Commission's revolutionary analysis threw out the old reliance on extensive control over the financial system. As a result, Canadian officials were among the first to understand that reserve requirements and various other controls are actually inimical to the efficient operation of the financial system. The government gradually abandoned these controls in its regulation of financial institutions, and so did the Bank in its implementation of monetary policy. Today, the Bank simply announces its target overnight rate, and the market does the rest--a form of virtual, yet effective, control, back-stopped by the Bank's ability to borrow and lend near-infinite amounts of liquidity. After decades of research, and trial and error, we have reduced the conduct of monetary policy to its essential elements--perhaps a form of alchemy, after all! From there, the next logical step was to make the conduct of monetary policy more transparent and accountable. In the past, central banking had often been cloaked in deliberate secrecy, relying on the element of surprise for its presumed effectiveness. Governance and accountability were not considered important. Communications and reporting were limited to an annual report and a few public addresses. Now, following on the work of John Chant--albeit with a significant lag--we have a clear, highly transparent paradigm for the conduct of monetary policy, and the Bank can be held accountable for its performance. Effective communication is an essential part of that transparency. Finally, let me talk about the role of the exchange rate in monetary policy. Canada moved to a flexible exchange rate in 1950 and again in 1970--well before most other countries. Although this gave Canada monetary policy independence, a flexible exchange rate alone does not provide a "coherent monetary order," as David Laidler has noted. The monetary policy framework still requires a nominal anchor to help guide decisions and expectations. As I've said before, the Bank searched for that anchor throughout the 1970s and the 1980s. The outcome of that search was our eventual adoption of inflation targets in 1991. And this anchor has exceeded our most optimistic expectations. This isn't to say that we have reached the end of monetary policy history. The Bank of Canada and other central banks are constantly looking for improvements. The inflationtargeting framework that the Bank and the government put in place 14 years ago has performed well. It is up for renewal in 2006, and we are now in the process of assessing both its past performance and possible refinements for the future. As in the past, we are drawing on the work of researchers both outside and inside the Bank. A long tradition of successful modelling and analysis underlies our work, going back to people such as John Helliwell, who put the Bank on the frontier of macromodelling in the late 1960s with initiatives like RDX. This research and external networking continues and was evident in the conference that the Bank hosted last month As we move forward and add to the Bank's proud history, it is always useful to look back. Special occasions, such as this 70th anniversary, are valuable opportunities to reflect on the work of those who have preceded us. I look forward to the presentations of our four distinguished panellists--John Chant, John Helliwell, David Laidler, and Angela Redish--all of whom have served as special advisers to the Bank. I want to thank them for the contribution they made while at the Bank, and for their continued efforts in advancing the practice of monetary policy in Canada. They will each speak for about 15 minutes. After that, I will open up the proceedings for questions and comments.

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Reflections on the International Economic and Monetary Order

dodge

Governor of the Bank of Canada to la Conference de Montre al Today, I want to talk about an issue that is central to the prospects for the world economy--the management of large, global economic imbalances that have become the subject of increasing concern among market participants and policy-makers around the world. I am referring, of course, to the persistent and growing current account deficit in the United States that is mirrored by large current account surpluses elsewhere, especially in Asia. Up to now, world capital markets have been managing the se imbalances in a reasonably smooth way. In the short term, it is reasonable to expect that they will continue to do so. But over the medium term, imbalances of this magnitude are not sustainable. At some point, they will have to be resolved. Why? For one thing, a country's external indebtedness cannot keep growing indefinitely as a share of its GDP. Eventually, investors will begin to balk at increasing their exposure to that country, even if it is a reserve-currency country, such as the United States. For another thing, the buildup of foreign exchange reserves by Asian countries will, eventually, feed into domestic monetary expansion and lead to higher inflation. These imbalances will ultimately be resolved, either in an orderly, or in an abrupt, disorderly way. The question is, are current economic policies and today's international monetary order likely to facilitate an orderly resolution of the imbalances? If not, what changes are needed to reduce the risk of an abrupt, disorderly adjustment? Before we discuss solutions and prescriptions, let me talk briefly about the nature and origins of the current global imbalances. In essence, these imbalances reflect the international financial flows associated with saving-investment mismatches. Specifically, over the past decade or so, we have seen many countries outside the United States increase their saving by a very large amount, while at the same time, the United States has reduced its saving and has become increasingly reliant on foreign borrowing. The origins of the increased saving outside the United States are many and varied. Following the Asian crisis of 1997-98, many countries in that region built up large foreign exchange reserves to guard against having to rely on international assistance in any future crisis. Even countries that avoided the worst effects of the Asian crisis--China, for example--increased their net savings by building up reserves. But more importantly, policies to encourage export-led growth in many Asian economies have exacerbated the situation. Some countries have actively tried to prevent an appreciation of their currencies by intervening in the foreign exchange market. In doing so, not only are they increasing the imbalances, they are also seen by some to be securing an unfair trade advantage and shifting the burden of global adjustment onto others. Of course, savings have also increased outside Asia. In Germany, for example, two factors have led to a large increase in saving in recent years: the conclusion of the reconstruction effort following the 1989 reunification and efforts to fix the German public pension system. Certain oil-exporting countries, including Russia, have also started to generate large net savings. And some developing economies, such as Brazil, have moved from being rather large net borrowers to being net savers today. Inside the United States, there has been a sharp decrease in national saving. The high expected returns in equity markets in the late 1990s led to large capital flows into the United States. The significant capital gains--first on equities in the late 1990s and then on housing in this decade--led to a net decline in household saving out of current income. Furthermore, the low interest rates after 2001, and importantly, the shift in the U.S. fiscal position after 2000, have contributed to growing net dissaving in the United States. As a result, the U.S. current account deficit--which represents the amount of net dissaving going on in the United States--now stands at about 6 per cent of GDP. So you might ask, why should policy-makers worry about the resolution of these imbalances? After all, there should be a process that works through world financial markets to allow savers in one country to lend to borrowers in another. Such a process supports higher global growth, since countries with surplus savings can invest them in countries that do not save enough internally. Within national borders, regional savings-investment imbalances emerge all the time. And we don't normally worry about them because there are effective market-based mechanisms in place that work to resolve them. Relative wages and prices change, as do relative returns on capital. This causes a movement in the real exchange rate between regions, which then provides an equilibrating mechanism. The ability of labour to move within a country helps to promote an orderly adjustment process. But there are reasons to worry about imbalances in a global context. To begin with, market-based means of resolving international imbalances are somewhat less effective and potentially more disruptive. This is because there is less labour mobility across international borders, and so larger movements in relative wages and prices are needed in order for them to act as an equilibrating mechanism. Further, certain national and international policies, as well as interventions in the foreign exchange market, have been inhibiting the necessary relative wage and price movements. Indeed, some of these policies are making the situation worse. And so the concern is that the longer the se imbalances remain unresolved, the greater the chances that the ultimate resolution will be disorderly. Equally troubling, there is a greater chance of protectionist measures that can seriously damage the global economy. Let's look a bit more closely at some of the key impediments to the resolution of imbalances. Some of these impediments are national policies, while others relate to the international monetary order. Let me talk about national policies first. Many of these impediments have been identified in discussions at the G-7 over the past couple of years. It is clear that, to date, there has not been enough progress on structural reforms. This lack of progress is somewhat frustrating, given that there is a reasonable consensus on what should be done domestically in all countries. First, microeconomic policies should allow markets for both goods and labour to function as well as possible and with a maximum degree of flexibility. Almost every country, including Canada, talks a good line about this, but action has been rather slow everywhere. Second, strong policies must encourage the creation and maintenance of a sound financial system that can efficiently allocate domestic and foreign savings. Progress here, although slow, is taking place. The work of the Financial Stability Forum, and the contributions in this area from the Bank for International Settlements, have been helpful. But much remains to be done. Third, all countries must pursue fiscal policies aimed at producing a sustainable public debt-to-GDP ratio. Where structural fiscal balance is absent, it should be achieved; where it is present, it should be maintained. There are some real problems on this front in the United States, in Europe, in Japan, and in some developing countries. A multiple-front approach like this, that works to remove the impediments arising from existing national policies, would certainly go a long way towards allowing market-based mechanisms to resolve global imbalances in an orderly way. However, I doubt that this approach by itself would do the whole job, if real exchange rates are not allowed to adjust in a timely manner. Movements in real exchange rates can come from changes in nominal exchange rates, changes in relative wages and prices, or a combination of the two. But when the nominal exchange rate is fixed, the only way to bring about adjustments in the real exchange rate is through large movements in relative wages and prices. Theoretically, this is feasible--but only if wages and prices are highly flexible both upwards and downwards. But this high degree of flexibility is practically non-existent. And so, when exchange rates are fixed, global economic adjustment can still take place, but it comes at a high cost--through shrinking output and rising unemployment in countries with current account deficits and through very high inflation in countries with current account surpluses. While this adjustment is costly, it does work, provided countries that are fixing their currencies through foreign exchange intervention are not offsetting the monetary consequences of this by "sterilizing" the intervention. This is an important point. When intervention is sterilized, this temporarily prevents the movements in wages and prices needed to bring about the necessary economic adjustment. In these cases, adjustment is postponed--in both surplus and deficit countries. But the adjustment and its costs are only delayed, they are not avoided. Indeed, the costs typically end up being larger than they would otherwise be, precisely because they have been delayed. The only way to truly minimize the costs of adjustment is to allow nominal exchange rates to move around. The ability of a flexible exchange rate to help with economic adjustment was a major factor behind Canada's decision to float its currency in 1950. By the end of the 1990s, most industrialized economies and a number of emerging-market economies had done the same. Other economies, particularly in Asia, have opted for a fixed exchange rate regime. However, some of these countries, by sterilizing their foreign exchange intervention, have rejected the adjustment mechanisms that should go along with such a regime. By sterilizing, not only are they accumulating even larger foreign exchange reserves, more importantly, they are undermining the efficienc y of their own domestic economies and interfering with the resolution of imbalances. So there are impediments in Europe, the United States, and Asia that are all getting in the way of a timely and orderly resolution. Because of this, global imbalances are growing, and this is increasing the risk of a disorderly correction at some point down the road. In addition, the longer the adjustment is delayed, the greater the risk that industrialized nations will take protectionist measures against emerging-market economies that are perceived as not playing by the rules. So, what are the policy prescriptions that hold the greatest probability of bringing about an orderly resolution of the imbalances? Put simply, what should be the "rules of the game?" I've already spoken about the consensus that exists on the need for action domestically. What I want to do now is talk about what would be helpful on the international front. To begin with, we certainly need to preserve and increase the potential for goods and services to move freely across national borders. This means further enhancement of the rules of free trade through the Doha round and a strengthening of the World Trade Organization (WTO) to ensure proper compliance with the rules. This effort, as you know, is going on rather more slowly than we would have hoped three years ago, and my sense is that the prospects for substantial improvement are not as good as we thought they might be. However, keep in mind that the last round took 10 years to complete. So, it is important to keep moving forward and to support the WTO in its enforcement of proper compliance with the rules. Of course, free trade needs the support of well-functioning capital markets, as well as exchange rate regimes that allow market-equilibrating forces to play a greater role in the adjustment process. Just as the WTO provides critical support for trade, there is also a need for an effective organization to support the international monetary system. Under Bretton Woods, this role was given to the International Monetary Fund (IMF). But world financial conditions have evolved dramatically, while in many respects, the IMF remains the same institution that was created in 1944 for an era of fixed exchange rates. To be clear, the basic mandate of the Fund--the promotion of an international order that fosters economic growth and investment--remains relevant and important. And the Fund's main responsibilities--surveillance, lending, and helping member nations to develop their financial infrastructure and efficient product and labour markets--are the right ones. But the IMF could, and should, be doing its job more effectively. The IMF must evolve to take account of today's realities. Essentially, change is needed in four areas. First, we must recognize that the Fund has little direct ability to affect the policies of non-borrowing members. Consequently, its ability to influence discussions of important global issues, such as external imbalances, hinges on the quality of its economic and financial surveillance, its advice, and its ability to communicate its message. The IMF should focus its surveillance on systemic issues that can affect global financial stability--an area where the Fund's particular expertise gives it a strong comparative advantage over other institutions. This surveillance must be seen to be independent of national authorities-- and independent of the IMF's lending activities. The Fund's analytic and surveillance functions must be strengthened and must not be subservient to its lending function. Second, in a world of freely flowing private capital, we must rely on market-based mechanisms to resolve financial crises, if and when they occur. While the Fund has a continuing role to play in providing liquidity assistance to members in financial distress, there are limits to such assistance--the IMF does not, cannot, and should not have endless reserves. Third, to help guide market expectations regarding the scale of official assistance, we must be very clear that extraordinary Fund lending is just that--extraordinary. If market players cannot judge whether or not the Fund will intervene, and at what amount, they are unable to make appropriate credit decisions. Without clarity on the rules governing access to Fund resources, we leave ourselves open to delays in resolving crises and to moral hazard. These rules must also be as free as possible from political considerations and must allow funds to be used for liquidity assistance only. The provision of additional loans to insolvent countries helps neither the borrower nor other creditors. In this regard, the Fund must improve its ability to distinguish between cases of illiquidity and insolvency. Finally, and very importantly, the IMF must be more effective in its role as a forum where global economic issues are discussed and solutions are found. The Fund should be considered as the place where national authorities can gather around the same table for a frank exchange about policy issues common to all. The Fund must be imbued with the same cooperative spirit seen at the OECD during the 1960s and 1970s as it helped to build a liberal economic order and framework for freer trade. But it's difficult to discuss problems and find solutions if key players don't feel that they are adequately represented. There is a crucial need to build an international financial institution that is seen as meeting the needs of all members. A good start would be to re-examine the representation of Asian and other emerging-market economies, and the implications for their quotas and voting power on the IMF's Board. A larger stake by Asian members in the IMF also implies greater responsibility on their part for the success of the Fund as guardian of the international monetary and financial systems. Indeed, by taking greater responsibility, Asian nations would affirm their commitment to the Fund's important objectives. Moreover, by being able to draw more on the strengths of the Asian economies, the IMF would be in a better position to do its job properly. I truly hope that such an institution--one that makes progress in these four areas--will emerge from the strategic review of the IMF that is currently underway. The creation of a global institution for the twenty-first century is tremendously important, not just for Canada, but for all nations. If we can get it right, a more effective IMF would be helpful in the worldwide effort to resolve global imbalances in an orderly way. But a global institution can't do it all by itself. Policy-makers around the world need to make sure that they are part of the solution and not part of the pr oblem. All countries must recognize that it is doubly important to pursue the sound domestic policies that I mentioned--the promotion of flexible markets, the creation and maintenance of a sound financial system, and the pursuit of sound fiscal and monetary policies. Clearly, following these policies is in each country's own domestic interest. But the benefits would flow beyond national borders. If we all follow appropriate policies, then market mechanisms can defuse the danger posed by global imbalances. And that is an outcome that is in everyone's interest.

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Monetary Policy and the Exchange Rate in Canada

dodge

Governor of the Bank of Canada It is an honour to be in Beijing and to have the opportunity to speak to you. My purpose today is to talk about what I know best--the conduct of monetary policy in Canada. I want to discuss Canada's experiences--both positive and negative-- in moving from a fixed to a floating exchange rate regime, and our subsequent search for a monetary policy anchor. In doing so, I hope that I can provide some insights that may prove useful as China makes its own important decisions about its exchange rate and monetary policy regimes. Canada's experience is interesting and potentially insightful for two important reasons. First, Canada has more experience with a flexible exchange rate than almost any other country. The Canadian dollar has floated for all but eight years since 1950. Canada is also one of the few countries to have moved, twice, from a fixed to a flexible currency without either an economic crisis or a rapid depreciation of its currency. A second reason why Canada's experience may be relevant is that the Bank of Canada has had considerable experience in conducting monetary policy independently and in controlling inflation through a system of inflation targets. In 1991, Canada became the second country to introduce inflation targets. I'm pleased to say that this monetary policy framework--with inflation targets and a flexible exchange rate--has proven to be very successful in delivering high, sustainable levels of output and employment in an environment of low and stable inflation. So, let me talk first about our experiences of moving from a fixed to a floating exchange rate. As I just mentioned, Canada did this twice during the postwar period. The first time was in 1950, and the second was in 1970, following an eight-year period during the 1960s when we again fixed our currency to the U.S. dollar. In both cases, our decision to float was driven by the desire of the Canadian authorities to do what was best for our own economy. We felt that trying to keep the exchange rate fixed at a time of large capital inflows would have had two serious domestic consequences. First of all, it would have generated large inflationary pressures in Canada. Second, and just as important, it could have created a "boom-bust" economic cycle. But Canada's decision to float in 1950 was not an easy one to make, particularly because we had been very active in the founding of the Bretton Woods institutions and the global fixed-rate system. Canada had struggled to stay within this system during the late 1940s. But by 1950, sharply higher commodity prices and strong capital inflows into our resource sector led to upward pressure on the Canadian dollar. In addition, there were speculative short-term capital inflows, which added to the upward pressure on the currency. To maintain the fixed exchange rate, the Canadian authorities first intervened on a massive scale. Foreign exchange reserves rose by 40 per cent in less than three months, and the money supply grew rapidly at a time when the domestic economy was already operating at capacity. Given the desire to both maintain stable domestic prices and to avoid an economic boom that could lead to a bust later on, Canadian authorities felt that they had two options. One was to revalue the Canadian dollar; the other was to let the Canadian dollar float. The IMF strongly favoured a revaluation--but to what level? It was impossible to know exactly what the correct level for the currency should be. So Canada chose to float the dollar. We allowed the market to set its own level for the currency, with the intention of re-fixing the Canadian dollar at a new level later on. What was surprising was just how quickly the speculative flows eased once we floated our currency. As it turned out, the Canadian dollar appreciated by just 5 per cent during the following three months. While the IMF was very critical of Canada's decision to float, it accepted our action on the condition that this move would be temporary. The IMF expected Canada to return to the Bretton Woods system as soon as a new equilibrium rate for the Canadian dollar was found. But the flexible exchange rate worked better than almost all observers had expected, and the "temporary period" lasted for 12 years. With the exchange rate allowed to float freely, the Bank of Canada was able to direct monetary policy to the needs of the Canadian economy. We were able to deal with the inflationary threat posed by rapid economic growth and strong investment flows. With the appreciation of the Canadian dollar and with the end of the speculative flows, inflation came down from more than 10 per cent in 1950 to under 3 per cent by Like most other countries at the time, Canada had extensive foreign exchange controls in place when it floated the Canadian dollar. But with growing confidence in the functioning of currency markets, capital controls were essentially eliminated in 1951, well before this occurred in most other countries. Moreover, the elimination of controls and the move to a flexible exchange rate facilitated the development of our domestic financial markets. And this, along with the floating exchange rate, helped the economy to make the necessary adjustments at a time when large numbers of Canadians were leaving farms and moving into the cities. Now let's look at 1970, the second time we floated our currency. Canada's reasons for floating then were similar to those in 1950; that is, there was upward pressure on the Canadian dollar and a rapid buildup of international reserves. This pressure came from high commodity prices, renewed capital inflows, and strong foreign demand for Canadian goods--demand associated with a strong global economy and very loose fiscal policy in the United States. These pressures again led to concerns that an inflationary buildup in Canada could lead to a boom-bust economic cycle. And once again, there were fears of speculative short-term inflows that would make the problem worse. The authorities looked at a number of alternatives, including the setting of a new higher value for the Canadian dollar against the U.S. dollar and a revaluation with a wide band. But these options were rejected because they might have invited further speculative pressures. It was clear that the least risky option for Canada was to return to a floating currency. The floating exchange rate again proved to be useful, because it eased the immediate inflationary pressures. But at the time, we did not understand that a flexible exchange rate alone does not provide a complete mone tary policy framework. What was missing was a nominal anchor. What I mean by the term "nominal anchor" is a clear target for monetary policy, a way to give people confidence that policy is on track, and a way to tie down or "anchor" expectations of future inflation. The Bank of Canada searched for such an anchor throughout the 1970s and 1980s. The outcome of that search was our eventual adoption of inflation targets. In February 1991, the Bank and the federal government announced a series of inflation-reduction targets. The authorities saw explicit inflation targets, with a clear time frame to achieve them, as a way to shape inflation expectations. This would make it easier to reduce inflation and, at the same time, make the central bank accountable for its actions. The inflation-control agreement has been extended three times, and since 1995 it has called for the Bank to aim to keep inflation at 2 per cent, the midpoint of a 1 to 3 per cent target range. Let me stress a few points about our inflation-targeting system. First, our commitment to inflation control is the best way that the Bank of Canada can contribute to high sustainable growth of output and employment. In other words, inflation targeting is a means to an end, not an end in itself. The second key point is that we operate in a symmetric way. We care just as much about inflation falling below target as we do about inflation rising above target. If demand for goods and services pushes the Canadian economy against the limits of its capacity, and inflation is poised to rise above the target, the Bank will raise interest rates to cool off the economy. And when the economy is operating below its production capacity, and inflation is poised to fall below the target, the Bank will lower interest rates to stimulate growth. Finally, inflation targeting is very important in terms of the Bank's accountability to the Canadian public. If inflation persistently deviates from the target, we must explain why this has happened, what we intend to do to bring inflation back on track, and how long we expect the process to take. With the adoption of inflation targets, we have gained all the expected benefits, and even gained some that we weren't expecting! Let me list some of them. Inflation has become more stable, averaging very close to 2 per cent, and private sector inflation expectations have become well anchored. Importantly, our symmetric approach has also worked as an economic stabilizer, helping to smooth the peaks and valleys of the business cycle. Businesses and individuals can make long-term economic plans with increased confidence about the future. And scarce economic resources are no longer wasted in efforts to hedge against the threat of either high inflation or deflation. Moreover, with inf lationary expectations well anchored, we have found that movements in the exchange rate have much less impact on inflation than in the past. This is because markets know that the central bank is committed to protecting the domestic value of the Canadian dollar. Because we have a clear objective, and because we explain publicly how we plan to meet that objective, financial markets can now better predict how the Bank will react to different circumstances. At the same time, inflation targeting has brought increased discipline and clarity to policy deliberations inside the Bank. Let me make two more points about our inflation-targeting framework. First, our experience with inflation targets has also allowed us to see the importance of having an anchor for fiscal policy. After the adoption of inflation targets in 1991, shortterm inflation expectations came down quickly. But long-term expectations adjusted much more slowly, for a couple of reasons. It took some time for the Bank to earn its credibility. But more importantly, the federal government also needed to address its fiscal problems. Indeed, the Bank of Canada found that it could not be as accommodative as it wanted to be in its monetary policy during the first half of the 1990s because of the difficult fiscal position at that time. But by the middle of the 1990s, the government committed to ending a series of budget deficits and to putting Canada's public debt-toGDP ratio on a sustainable, downward track. With that commitment, Canada finally had anchors for both its monetary and fiscal policies. This now allows us to gear monetary policy more directly to our domestic economic conditions. The other point I want to make is that with these two policy anchors in place, the floating exchange rate can work more effectively for the Canadian economy. It performs a very important function by helping the economy adjust to changing conditions. Movements in the exchange rate send appropriate signals to businesses and consumers, helping the economy to adjust to changing circumstances. To take a recent example, when there is increasing world demand for Canadian goods and services, this tends to lead to a stronger Canadian dollar. The stronger dollar, in turn, tends to restrain exports and to encourage imports. In doing so, the floating exchange rate helps to maintain a balance between total supply and demand in the economy and that helps keep inflation under control. This process also works in reverse. The point I want to emphasize here is that with these policy anchors in place, a floating exchange rate can be a tremendous asset for an economy by helping to keep total supply and demand in balance. In closing, let me say again that Canada has been a pioneer both in having a floating exchange rate and in operating with inflation targets. As a consequence, we have a lot of experience that may be of use to others who are contemplating changes to their monetary policy framework. Canada's long experience with flexible exchange rates has been very favourable, and a floating exchange rate continues to be a key part of our monetary policy framework. But our experience has also taught us that a flexible exchange rate on its own is not enough. A country also needs a domestic anchor for its monetary policy. After trying a number of different approaches, we have now settled on a monetary policy framework based on inflation targeting and a floating exchange rate. This framework helps the economy handle both external and internal shocks. These policies, together with a fiscal policy based on keeping our public debt-to-GDP ratio on a sustainable downward track, have helped to stabilize output and employment at a high level. At the same time, they have delivered low and stable inflation. Finally, let me say that the recent transformation of the Chinese economy has been nothing short of remarkable. The Chinese authorities and the Chinese people should be congratulated for their efforts to raise living standards and to become a dynamic part of the global economy. But there remains much work to do. So, I hope that my description of Canada's struggle to develop the appropriate policy framework for our country will yield some insights that may prove useful as China makes its own decisions about its own policies.

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How the Canadian Economy Is Adjusting to Global Forces

dodge

Governor of the Bank of Canada to the Canadian Chamber of Commerce in Japan I am happy to have the opportunity to be back here in Tokyo, and to address this group. No matter where you are in the global economy these days, everyone is talking about the same powerful, economic forces. We are all aware of the large and growing financial imbalances in the United States and in Asia. Rapid growth in emerging-market economies is driving up demand for commodities, and that has pushed up world prices for oil and many non-energy commodities. Meanwhile, productivity improvements in some countries and a competitive world environment are lowering the prices for some consumer goods, communications services, and computer equipment. All of these forces are causing significant movement in the exchange rates of key currencies, including a sharp appreciation of the Canadian dollar against the U.S. dollar over the past couple of years. In short, these are challenging economic times, not just in Canada and Japan, but throughout the world. Today, I'd like to raise two issues. I'll talk first about how the Canadian economy has been adjusting in the face of these forces--an adjustment that is being facilitated by the Bank of Canada's monetary policy framework. Then, I'll talk briefly about what needs to be done internationally to help bring about an orderly resolution of global imbalances. So let me begin with the Canadian economy. I should set the scene by saying just a few words about how the Bank of Canada conducts monetary policy. The Bank of Canada Act calls on 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 way we do this is by trying to keep inflation low, stable, and predictable. Specifically, we aim to keep the annual rate of consumer price inflation at the 2 per cent midpoint of a 1 to 3 per cent target range. In order to keep inflation at the target, we try to keep the economy operating at full capacity. By this, I mean that we aim for a balance between total demand and supply in the economy. Simply speaking, if the demand for goods and services is pushing the Canadian economy against the limits of its capacity, and if inflation is poised to rise above the target, the Bank would raise its key policy interest rate. This, in turn, would push up other interest rates and help to cool off demand. Conversely, if the economy is operating below its production capacity, and inflation is poised to fall below the target, the Bank would lower its key policy rate, to help stimulate demand. So, by maintaining low and stable inflation, monetary policy also promotes greater stability in economic output. I should add that since Canada adopted its inflation-targeting system in 1991, our track record has been excellent. Inflation has averaged very close to 2 per cent and has remained within the target range, with rare exceptions that were due mainly to large swings in the prices of oil and natural gas. And we have seen evidence that our symmetric approach to inflation targeting has helped to smooth the peaks and valleys of the business cycle. I should also add that a flexible exchange rate is a critical part of our monetary policy framework. We do not have a target or preferred exchange rate for the Canadian dollar. But it is an important relative price in our economy. A floating currency helps us to achieve our inflation target and can act as a shock absorber to cushion our economy from the effects of events both inside and outside Canada. I'll say a bit more about this in a few moments. With that as background, let's now look at the ways in which Canada's economy is responding to global economic developments. As I mentioned, the Canadian dollar has appreciated sharply and commodity prices have risen dramatically over the past couple of years, though both have been relatively stable in recent months. Canada's terms of trade--that is, the ratio of the prices that Canadians receive for their exports to the prices that they pay for their imports--have improved by about 15 per cent since late 2001, generating higher real incomes and stronger domestic demand in Canada. How has the Canadian economy reacted to these higher prices and , we noted that we have seen increased business investment spending in oil and gas extraction, other mining activity, and wood-product manufacturing. We are also seeing rising investment in sectors that are not very exposed to international trade, such as electric power generation, finance and insurance, and information and cultural industries. In these cases, firms are reacting to strong growth in Canadian domestic demand. As well, we've had very strong investment in residential housing. But there are other sectors, highly exposed to international trade , where prices are either not rising or are rising very slowly. Here, I am referring to goodsproducing sectors such as auto parts, textiles, and clothing manufacturing, as well as service sectors such as tourism. Firms in these industries are feeling the pressure of the higher Canadian dollar, and they are also facing increased competition from other regions of the world. The good news is that many Canadian firms are making adjustments. Investment spending is being directed towards increased specialization, higher productivity, and lower costs. Since much of the productivity-enhancing machinery and equipment is priced in U.S. dollars, the stronger Canadian dollar has made it easier for firms to buy tools that boost their productivity. Stiffer competition is encouraging firms to increase their specialization and offer more value-added, customized services. Other adjustments are also taking place. A growing number of firms are looking to cut costs by importing more inputs. We've certainly seen this type of adjustment taking place among the manufacturers of telecommunications equipment. Other firms are phasing out the production of goods and services with low profit margins and concentrating on those that yield higher returns. Looking at the economy as a whole, we can see that growth will come primarily from domestic demand this year and next, as the past appreciation of the Canadian dollar continues to restrain net exports. As we noted in our last , we expect the Canadian economy to move back to its production capacity in the second half of 2006. But of course, our outlook remains subject to both upside and downside risks. These are related largely to the global developments and associated relative price changes that I have already mentioned, and the way that the Canadian economy is adjusting to these factors. How is the Bank of Canada contributing to the adjustment process? At this point in time, monetary policy is aiming to maintain strong growth in domestic demand. Low interest rates help encourage consumer and business spending, which in turn helps keep the economy operating close to its production potential. This is an important point in terms of the adjustment process. Because we keep inflation low and stable, businesses and consumers are better able to read price signals in markets, and this helps them to make better long-term decisions in the face of major economic developments. These price signals prompt sectors that are shrinking because of weak demand to release resources that can be absorbed by expanding sectors, where demand is strong. Of course, adjustment takes time, and is never simple or without pain. Individuals may have to retrain or relocate, and expanding businesses may require time to put the necessary capital equipment in place to increase productivity. And of course, some firms will go out of business and some people will be unemployed for a period of time. But from a macroeconomic point of view, adjustment can take place with less social and economic cost overall when inflation expectations are well anchored, the economy is operating close to its potential, and a floating exchange rate is helping to absorb external shocks. That's a quick look at how the Canadian economy is adjusting to global forces. Our flexible exchange rate is helping to bring about movements in the real exchange rate, which is what matters in terms of the adjustment process. But this is not the case in all countries. Where the nominal exchange rate is fixed, the only way to bring about adjustments in the real exchange rate is through large movements in relative wages and prices. This is theoretically possible if wages and prices are highly flexible, both upwards and downwards. But in practice, wages and prices aren't that flexible. And so when exchange rates are fixed, adjustment can still take place, but it comes at a high cost--through shrinking output and rising unemployment in countries with current account deficits, and eventually through very high inflation in countries with current account surpluses. While this adjustment is costly, it does work, provided countries that are fixing their currencies through foreign exchange intervention are not offsetting the monetary consequences of this by "sterilizing" the intervention. This is an important point. When intervention is sterilized, this temporarily prevents the movements in wages and prices needed to bring about the necessary economic adjustment. In these cases, economic adjustment is postponed--in both surplus and deficit countries. But the adjustment and its costs are only delayed, they are not avoided. Indeed, the costs typically end up being larger than they would otherwise be, precisely because they have been delayed. The only way to truly minimize the costs of adjustment is to allow nominal exchange rates to move around. For decades, Canada has benefited from having a flexible exchange rate that can help bring about economic adjustments. By the end of the 1990s, most industrialized economies and a number of emerging-market economies had also realized the benefits of having a floating currency. But other economies, particularly but not exclusively here in Asia, have opted for a fixed exchange rate regime. And unfortunately, some have rejected the adjustment mechanisms that should go along with such a regime. By sterilizing their interventions, they are accumulating even larger foreign exchange reserves. But more importantly, they are undermining the efficiency of their own domestic economy, and interfering with the resolution of imbalances. Because of this and other impediments, global imbalances are growing, and this is increasing the risk of a disorderly correction at some point down the road. Furthermore, the longer the adjustment is delayed, the greater the risk that industrialized nations will take protectionist measures against emerging-market economies that are perceived as not playing by the rules. And this may be the greatest threat to the global economy--a rise in protectionism which could choke off the growth of international trade that has led to rising incomes around the world. So what is to be done? The adoption of appropriate exchange rate regimes is an important start. But this is only one element of a policy framework that will facilitate adjustment and promote the resolution of global imbalances. First, we all must recognize the legitimate role of the WTO as arbiter of international trade, and resist calls for protectionist measures in our own economies--measures that will ultimately hurt us all. Second, we all must enhance the flexibility of our domestic markets. Third, we all must create and maintain a sound financial system. Finally, we all must follow appropriate fiscal and monetary policies. We know what needs to be done to help our economies adjust to global economic forces. We all talk a good line about these policies, but action has been slow. If we can get on with the job, not only will we help ourselves, we will also improve the long-term prospects for the global economy. And that is an outcome that's in everyone's interest.

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canada

Adjusting to Change

dodge

Governor of the Bank of Canada to the Winnipeg Chamber of Commerce Good afternoon. I'm glad to be back in Winnipeg. The last time I delivered a speech here was in January 2002. A lot has changed since then-in this city and in the Canadian economy. At that time, our economy was recovering from a worldwide economic slowdown and from the impact of the September 2001 terrorist attacks in the United States. Today, we face more-intense international competition, but we also face new opportunities, as expanding economies become important markets for our products. Like the rest of Canada, Winnipeg and Manitoba are feeling the impact of these international changes. Change is the central theme of my remarks today. First, I will talk about some of the changes that have taken place at the Bank of Canada over its 70-year history. Then, I'll talk about some of the changes that are currently taking place in the global economy, as well as how we see our economy--across Canada and right here in Manitoba --adjusting to these changes. Changes at the Bank of Canada This year marks the 70th anniversary of the Bank of Canada. The Bank opened its doors on 11 March 1935, at a time when the Canadian economy was reeling from the effects of a Prairie drought and a worldwide Depression. In its early days, much of the Bank's work was focused on trying to cushion the economy from the effects of high unemployment and falling prices, and replacing bank notes from different issuers with Bank of Canada notes. Almost every aspect of the Bank's work has changed since that time. But today I'll focus on the changes that have take n place in the conduct of monetary policy. By the late 1950s, the Bank's monetary policy and the federal government's fiscal policy were trying to find a balance between controlling inflationary pressures in the economy and encouraging high levels of employment. The economic boom of the 1960s and the bitter inflationary experiences of the 1970s eventually led to an increased focus on price stability as the goal for monetary policy. We developed a better appreciation that keeping inflation low, stable, and predictable is the best contribution a central bank can make to the economic welfare of a nation. During those decades, we learned some key lessons. The first is that a floating exchange rate is a tremendous asset in helping an economy adjust to changes, particularly an economy as open as ours. A floating currency gives a country the flexibility it needs to adjust to economic forces that originate from inside and outside its borders. The second lesson we learned is that, for monetary policy to be successful in controlling inflation, a floating exchange rate is not enough. An "anchor" for monetary policy is also needed. Canada first floated its dollar in 1950, but returned to a fixed exchange rate for eight years during the 1960s. After the decision to float the dollar again in 1970, the Bank spent the 1970s and 1980s searching for an appropriate monetary policy anchor. By this, I mean a clear target for monetary policy, a way to help policymakers keep policy on track, and a way to tie down or "anchor" expectations about future inflation. The outcome of that search was the eventual adoption of inflation targets as the anchor for Canadian monetary policy. In February 1991, the Bank and the federal government announced an agreement on a series of inflation-reduction targets. This agreement has been extended three times, and since 1995, it has called for the Bank to keep inflation at 2 per cent, the midpoint of a 1 to 3 per cent target range. This inflation-targeting system, supported by a floating exchange rate, has done more than keep inflation low--it has delivered strong and sustained growth in output and employment in Canada. Let me quickly stress that our inflation-targeting framework operates in a symmetric way--we care just as much about inflation falling below target as we do about inflation rising above target. If demand for goods and services pushes the Canadian economy against the limits of its capacity, and inflation is poised to rise above the target, the Bank will raise interest rates to cool off the economy. And when the economy is operating below its production capacity, and inflation is poised to fall below the target, the Bank will lower interest rates to stimulate growth. This symmetric approach helps the Canadian economy adjust to changing circumstances, while maintaining strong, sustained growth in output and employment. The Bank's commitment to the idea of transparency is another way in which our monetary policy has evolved. There was a time when central bankers kept their actions and thoughts shrouded in secrecy, convinced that their policy would be more effective if implemented with an element of surprise. Times have changed, and best practices in monetary policy have evolved. We have found that monetary policy is more effective when people understand what we are doing and why. That's why we communicate regularly with parliamentarians, with markets, and with the public. We do this through our regular and to those reports. We do this through press releases on fixed announcement dates for interest rate decisions, eight times a year. And we do this through public speaking engagements with audiences across the country. Our methods of communication also continue to change. Today, we use more tools and more technologies to reach Canadians and explain our work. For example, the audio portion of this speech is being broadcast live on the Internet. And we have just completed a redevelopment of the Bank's website. Since its creation in 1995, our website has been central to our efforts to conduct the Bank's business in an open and transparent manner. The site is visited over 180,000 times a week. In 2003, it was named Kingdom. We wanted to make the site even better, and so on Monday we launched a new version. It features an attractive graphic redesign, improved navigation, and a lot of new content. I encourage you to visit our new site at www.bankofcanada.ca , and we welcome your comments. So that's a quick look at some of the ways that the Bank has changed in 70 years. I'll spend the remainder of my time today discussing some of the major changes afoot in the global economy and how the Canadian economy is adjusting to these developments. I've just returned to Canada from meetings with central bankers in China and Japan. I have also attended meetings in Switzerland, the United States, and Morocco over the past month. And in two weeks, I will head to the United Kingdom. In these countries, and in almost every other nation, people are being affected by the same powerful forces--growing competition from emerging-market economies, such as China and India, and large and growing financial imbalances in the United States and Asia. The growth of emerging-market economies has driven up demand for commodities, and that has pushed up the world prices for oil and many other commodities that we produce in Canada. Meanwhile, the more competitive world environment and productivity improvements in some countries are lowering the prices for a number of consumer goods, communications services, and computer equipment. All of these forces are causing significant exchange rate movements, including a sharp appreciation of the Canadian dollar against the U.S. dollar over the past couple of years. Higher prices for many commodities produced in Canada means that our terms of trade--that is, the ratio of the prices that Canadians receive for their exports to the prices that they pay for their imports--have improved by about 14 per cent since late 2001. This has contributed importantly to higher real incomes and stronger domestic demand. How has the Canadian economy been adjusting to these various economic , published in April, we noted that we have seen increased business investment spending in oil and gas extraction, in other mining activity, and in wood-product manufacturing. These sectors are benefiting from higher world prices for their products. We are also seeing rising investment in sectors that are not very exposed to international trade, such as electric power generation, finance and insurance, and information and cultural industries. In these latter cases, firms are reacting to strong growth in domestic demand. We've also had very strong investment in housing. But in other sectors that are highly exposed to international trade, prices are either falling or are rising very slowly. Here, I am referring to goods-producing sectors, such as auto parts, furniture, and clothing manufacturing, as well as service sectors such as tourism. Firms in these industries are feeling the pressure of the higher Canadian dollar, and they are also facing increased competition from other regions of the world. The good news is that many Canadian firms are making the necessary adjustments. Investment spending is being directed towards increased specialization, higher productivity, and lower costs. Since much of the productivity-enhancing machinery and equipment is priced in U.S. dollars, the stronger Canadian dollar has made it easier for firms to invest in equipment that boosts productivity. Stiffer competition is also encouraging firms to seek new markets, increase their specialization, and offer more value-added, customized services. Other adjustments are also taking place. A growing number of firms are looking to cut costs by importing more inputs. We've certainly seen this type of adjustment taking place among manufacturers of telecommunications equipment. Other firms are phasing out the production of goods and services with low profit margins and concentrating on those that yield higher returns. Through its monetary policy, the Bank is helping these adjustments by supporting domestic demand. In our April , we projected that domestic demand would grow by almost 4 per cent in 2005. According to recently released data, it grew by slightly more than expected during the first quarter of the year. So we continue to see evidence that strong domestic demand is offsetting the smaller contribution that net exports are making to economic growth. On 14 July, we will publish our , which will contain our latest views on the Canadian economy. The Bank is in the process of gathering and analyzing the full set of information on the global and the Canadian economies that will feed into our next interest rate decision, and into the On our last policy-announcement date in May, we decided to maintain the target for the overnight interest rate at 2 1/2 per cent. At that time, we indicated that global and Canadian economic developments had been unfolding broadly in line with our expectations and that our outlook for the Canadian economy through to the end of 2006 was unchanged from the one we presented in our April . The analysis contained in that is still relevant. So is our statement that, in line with this outlook for growth and inflation, a reduction of monetary stimulus--that is, an increase in our key policy rate--will be required over time. Now, let me say a few words about the economic prospects for Manitoba. The provincial economy grew by an estimated 2.3 per cent last year, up from 1.5 per cent in 2003. Like the rest of Canada, Manitoba will rely heavily on domestic spending as an engine of growth in 2005. Private sector forecasters are expecting output growth of about 2.7 per cent this year, largely as a result of strong consumption and investment. Exports should also continue to grow, albeit at a slower pace than in 2004. This projection assumes that agricultural production will increase in 2005. It is too early to predict the impact of the recent floods that have ruined many fields in the province. Diversification in Manitoba's economy has been helpful. This province's economy is one of the most diversified in Canada --with a good mix of goods-producing and service industries, resources and manufacturing, traditional and new technology. And there is growing diversity and innovation within industries, such as pharmaceuticals, furniture manufacturing, and the transportation-equipment sector. The broadening of Manitoba's economic base has provided stability to the economy and has kept the province's unemployment rate well below the national average. Manitoba has also been helped by continued fiscal prudence. Change is rarely made without difficulty, even when we know that the change is for the better. This is certainly true of adjustments in response to the global economic realities of today. In some cases, industries are being forced to rethink the way they do business. Some firms will close, and some jobs will be lost. This type of adjustment is never easy. But economic change creates new opportunities. And in cities like Winnipeg, and all across Canada, individuals, businesses, industries, and public sector institutions are making the adjustments that will help them improve their competitiveness and seize new opportunities. These efforts also make the Canadian economy stronger and more resilient. That is the best way to prepare ourselves and our economy for whatever changes the future may bring.

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canada

The International Monetary Order and the Canadian Economy

dodge

Governor of the Bank of Canada As business people with ties to Canada and the United Kingdom, you are keenly interested in the economic prospects of both countries. When we look closely at our economies, it is striking how much they have in common in terms of policies and outlook. The United Kingdom may have roughly twice the population of Canada, but our economies share some very important characteristics. Both are relatively small compared with our respective neighbours--the euro zone and the United States. From a macroeconomic perspective, we both operate with an inflation-targeting regime, backed by a flexible currency. We have had a record of sound fiscal policy, certainly in comparison with our large neighbours. We are relatively open economies and depend greatly on international trade for economic growth. This means that global developments are central to our own domestic economic performance. So I will begin my remarks today by talking about international issues--particularly global economic imbalances--before discussing how the Canadian economy is adjusting to international events. When I say "global imbalances," I am referring to the persistent and growing current account deficit in the United States that is mirrored by large current account surpluses elsewhere, especially in Asia. While Canada and the United Kingdom have not contributed in a major way to the creation of these imbalances, we will be part of the solution, whatever that solution turns out to be. And given our dependence on international trade and global financial stability for economic growth, we both have a major stake in seeing that global imbalances are resolved in an orderly way. These imbalances reflect the financial flows associated with mismatches in savings and investment on a global scale. Since the latter part of the 1990s, many economies outside the United States have increased their national savings by a very large amount for various reasons. At the same time, the United States has reduced its savings and has become increasingly reliant on foreign borrowing. Why should we care about global imbalances? After all, isn't it a good thing that markets allow investors in Asia and elsewhere to fill the savings gap in the United States? In theory, yes. But there are three concerns with the current situation. First, these financial flows are not sustainable indefinitely, and there are risks that markets could adjust in an abrupt way. Second, it seems clear that the excess savings in Asia could be put to better use in Asia itself. And third, there is concern that imbalances are contributing to rising protectionist sentiment. So how can we achieve an orderly resolution of these imbalances? Within domestic economies, savings flow across sectors and regions without much risk of disruption, because market-based mechanisms--such as changes in relative wages, prices, and returns on capital--are allowed to work. These market-based mechanisms should also be allowed to work internationally. Unfortunately, a number of inappropriate national policies are preventing these mechanisms from working effectively, and so imbalances are growing unchecked. We know that U.S. external indebtedness--even with that country's reserve-currency status--cannot keep growing indefinitely as a share of its GDP. Eventually, investors will balk at increasing their exposure to the United States. Should that occur suddenly, we could see economic growth plummet and world financial markets become disorderly, threatening global financial stability. Global imbalances are a global problem, and we need to think about them collectively. There is no simple solution to these saving-investment mismatches. But we must deal with the fact that the amount that citizens and businesses in the euro zone and much of Asia currently want to save exceeds the amount that firms there want to invest. And with current policies, this situation may persist for some time. As well, most oil-exporting countries are now generating large net savings. At the same time, desired investment in the United States exceeds desired national savings by a considerable amount, although it is not certain that this situation will persist. Thus, as we look out over the next decade or so, there is a risk that we will find ourselves in a situation of global excess supply. This could happen if policy-makers fail to take appropriate measures, and the risk will increase if policy-makers resort to protectionism. Should these risks materialize, the global economy would then be headed for a period of very slow growth, perhaps punctuated by periods of outright recession. I hasten to add that this is not a prediction on my part. I am only saying that such an outcome would be the consequence of inappropriate policies in many economies. And this outcome would hurt us all--including Canada and the United Kingdom--even if in our own case we are following appropriate policies. So it is clearly in everyone's interest to discuss these issues, not only domestically, but most importantly in international forums, such as the Ironically enough, the key to changing global savings and investment flows rests with each country doing what is right for itself. If all countries followed a framework of appropriate domestic policies, this would go a long way towards defusing the danger posed by global imbalances. These policies go well beyond the responsibilities of a central banker. But I am raising them because it is important that they be discussed more broadly. So let me take a few minutes to review some of these policies. I'll start with issues outside of central banking before turning to monetary policy. The way to ensure that global demand continues to grow over time is for all policy-makers to follow frameworks that give households the confidence to spend and businesses the confidence to invest. Let's look at how this applies to fiscal policy. There is a clear need for countries to pursue a fiscal policy aimed at producing a sustainable ratio of public debt to GDP. Such a policy gives businesses and consumers confidence that the value of their money will not be eroded over time, either by high inflation or by excessive rates of taxation. Where a sustainable public debt-to-GDP ratio is now absent, it should be achieved; where it is present, it should be maintained. Clearly, fiscal consolidation is in the best interest of the U.S. economy and would also be helpful in resolving global imbalances. More generally, sound fiscal policies help support investor and household confidence in all economies. The second point is that authorities everywhere need to ensure that domestic policies are promoting well-functioning markets for goods , services, capital, and labour. In particular, labour markets need to be flexible enough to facilitate the movement of workers from sector to sector as the economy adjusts to events. This is especially true in the euro zone, where rigid labour markets have been undermining confidence. Businesses hesitate to hire when labour market rules are so restrictive, and households lack the confidence to spend when unemployment rates are so high. By promoting domestic flexibility, policy-makers everywhere could support confidence and boost growth. This would be good for national economies, and it would also help to resolve global imbalances. There is also a need for policy-makers to recognize the positive role played by a well-functioning social safety net. Here, I am referring to unemployment insurance, public health care, and public pension systems. The benefits of a well-functioning safety net should not be underestimated. Consider the countries of emerging Asia, where such systems are lacking. Because there is no social safety net, citizens in those countries need very high levels of savings to mitigate the risk of job loss and illness, and to provide for the years after they leave the workforce. A well-functioning social safety net pools risk, so that citizens can have increased confidence about the future and reduce their need for precautionary savings. Boosting consumption in Asia would certainly help with the resolution of imbalances. Of course, the key to a well-functioning safety net is that it actually functions well. We have seen examples where safety nets become so unwieldy that they act as a hindrance, holding back prospects for growth. Certain Asian economies also face the particular challenge of ensuring that the benefits of increased growth and higher incomes are spread more widely throughout the economy. I'll return to this point in a moment. Authorities everywhere also need to follow policies that help a country's financial system work well. This is critical if the financial system is to carry out its vital role of helping to match savings with productive investments. The financial system can also support confidence by giving households appropriate access to credit. So it is essential that emerging-market economies have sound and efficient banking systems. The Asian crisis of 1997-98 illustrated this point clearly. International institutions, such as the Financial Stability Forum, have been working on this issue. While a number of emerging-market economies still have some distance to go, I am happy to say that we have seen some progress in many countries over the past few years. Finally, appropriate monetary policy is very important. It can help instill confidence among consumers and businesses alike. Canada's monetary policy is anchored by an inflation-targeting system--a system that has also been adopted by the Bank of England. The Bank of Canada aims to keep inflation at 2 per cent, the midpoint of a 1 to 3 per cent range. Under this regime, not only has inflation in Canada remained near the target in recent years, but inflation expectations are now anchored near 2 per cent. As a result, market signals can be sent and received more clearly, and Canadian businesses and consumers are more confident about the future value of their money. A critical feature of our inflation-targeting system is that we operate symmetrically around our target. This means that we care just as much about inflation falling below target as we do about inflation rising above it. This symmetric approach helps keep the Canadian economy near its production potential, thus encouraging strong, sustained growth in output and employment. I'm not arguing that all countries should copy every detail of our inflation-targeting regime. But it is important that central banks follow policies that anchor inflation expectations and thus prevent a buildup of deflationary as well inflationary pressures. As I mentioned before, both Canada and the United Kingdom operate with a flexible exchange rate. Much has been said recently about floating exchange rates in relation to certain Asian economies--China in particular--and global imbalances. The policies of some Asian economies to encourage export-led growth, including the fixing of their exchange rates to the U.S. dollar, have caused a buildup of large foreign exchange reserves, thus exacerbating global imbalances. It's important to point out that, in theory, there is nothing wrong with countries having fixed exchange rates. But in practice, there is a major problem. Through "sterilization," certain Asian countries--including China--have been trying to offset the domestic price effects of their foreign exchange intervention. This is inhibiting economic adjustment. At the Bank of Canada, we have argued that it is very much in China's own economic interest to float its currency. By having a flexible currency, China could gear its own monetary policy to its own domestic considerations. If the external value of the renminbi were allowed to rise, the global purchasing power of Chinese citizens would also rise. This, in turn, would help to spread the gains from integrating into the world trading order throughout Chinese society and would allow that country to boost its consumption, thus helping to resolve global imbalances. Floating exchange rates are not the whole answer to the problem of global imbalances, but they are an important part of the solution. As I just said, when countries offset the effects of intervention, they delay domestic economic adjustment. They also delay global adjustment. Just as worrying, such intervention is provoking threats in certain political quarters of protectionist measures. Such wrong-headed measures could choke off the growth of international trade that has led to rising incomes worldwide. And so it is very important that all countries work to protect and enhance the free flow of goods and services by pushing the Doha round of trade talks to a successful conclusion, and by strengthening the World Trade Organization to ensure proper compliance with the rules of trade. All of us need to support these efforts and to be vocal in resisting calls for protectionism. In addition, it is critical that we get on with the job of building an international crucial role to play in this regard. This issue is extraordinarily important, and I spoke at length on this topic in a speech I gave last month in Montreal. You can find that speech on the Bank of Canada's website. Against that backdrop, what specific policies are needed to help the Canadian economy adjust to global developments? While imbalances pose risks ahead, recent economic growth in the global economy has been quite strong, led by the United States and China. This growth has increased the world prices of oil and of many other commodities that we produce in Canada. As a result, there has been a marked improvement in our terms of trade--that is, the ratio of the prices that we receive for our exports to the prices we pay for our imports. This improvement has helped to raise real incomes and stimulate domestic demand in Canada. We have also been importantly affected by the sharp appreciation of the Canadian dollar against the U.S. dollar over the past couple of years--an appreciation that has had a major impact in many sectors. The Canadian economy has been adjusting to these economic forces. We have seen increased business investment spending in sectors that are benefiting from higher world prices. We are also seeing rising investment in sectors that are not very exposed to international trade, as such firms react to strong growth in domestic demand. And we've had very strong investment in housing. But in other sectors that are highly exposed to international trade, mainly goods-produc ing sectors, prices are either falling or rising very slowly. Firms in these industries are feeling the pressure of the higher Canadian dollar, and they are also facing increased competition from other regions of the world. The good news is that many Canadian firms are making the necessary adjustments. Investment spending is being directed towards increased specialization, higher productivity, and lower costs. Since much of the productivity-enhancing machinery and equipment is priced in U.S. dollars, the stronger Canadian dollar has made it easier for firms to make investments. A growing number of firms are looking to cut costs by importing more inputs, particularly from Asia. Other firms are phasing out production lines with low profit margins. Through its monetary policy, the Bank of Canada is helping these adjustments by keeping inflation low, stable, and predictable, and by aiming to keep the economy operating close to its production potential. With the recent sharp appreciation of the Cana dian dollar, net exports have been acting as a drag on economic growth. So growth has been driven by domestic demand, supported by monetary stimulus. In our April , we projected that final domestic demand would grow by almost 4 per cent in 2005. According to recently released data, it grew by more than expected during the first quarter of the year. So we continue to see evidence that strong domestic demand is offsetting the weakness in net exports. On 14 July, we will publish our , in which we will spell out our latest views on the Canadian economy. The Bank is now in the process of gathering and analyzing the full set of information on the global and the Canadian economies that will feed into our next interest rate decision, and into the . On our last policy announcement date in May, we decided to keep the target for the overnight rate at 2 1/2 per cent. At that time, we indicated that global and Canadian economic developments had been unfolding broadly in line with our expectations and that our outlook for the Canadian economy through to the end of 2006 was unchanged from the one presented in our . The analysis in that is still relevant. So is our statement that, in line with this outlook for growth and inflation, a reduction of monetary stimulus--that is, an increase in our key policy interest rate--will be required over time. Let me conclude. On the one hand, I'm bringing you a hopeful message: Canada's economy, backed by a sound policy framework, is adjusting to forces at work in the global economy. This adjustment is not painless, but it is taking place, leaving Canada well placed to thrive in the years ahead. On the other hand, I want to leave you with a caution against complacency. We are all part of the global economy and, as such, we can do little to shield ourselves from a major economic disruption, such as a disorderly resolution of global imbalances. Collective action is needed now to minimize the chances of a major crisis down the road. The task won't be easy, but it is up to policy-makers--whether they gather at the Bank for International Settlements in Basel, at the IMF in Washington, or around the G-7 table at Gleneagles in a few days --to work towards an environment that will support sustained economic growth worldwide.

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canada

Release of the

dodge

Today, we released the July to our April . The reviews economic and financial trends in the context of Canada's inflation-control strategy. Global and Canadian economic developments have been unfolding broadly as expected, and the Bank's outlook for output and inflation in Canada through to the end of 2006 is little changed from the scenario outlined in the April . Strong growth in final domestic demand in Canada continues to offset the drag from net exports. Further progress has been made across sectors of the Canadian economy in adjusting to global developments, and the economy is operating close to its production capacity. The Bank expects Canada's economy to grow by about 2.7 per cent in 2005 and 3.3 per cent in 2006. With the economy projected to continue to operate near capacity, and with inflation expectations firmly anchored, inflation is expected to return to 2 per cent by the end of 2006. To support aggregate demand, the Bank has held the target for the overnight rate unchanged at 2 1/2 per cent since October 2004. However, in line with the Bank's outlook for growth and inflation, some reduction in the amount of monetary stimulus will be required in the near term to keep aggregate demand and supply in balance and inflation on target. The risks to the outlook through 2006 relate primarily to the future path of prices for oil and non-energy commodities, the pace of growth in China, and the ongoing adjustment of the Canadian economy to global developments. These risks appear to be balanced. Over the medium term, however, there is increasing risk that the correction of global current account imbalances could involve a period of weakness in world aggregate demand.

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canada

The Evolution and Resolution of Global Imbalances

dodge

Governor of the Bank of Canada Good morning. I am happy to be back at Spruce Meadows, and to Our host, Ron Southern, has asked us to be at once "integrative, comprehensive, anticipatory, and apolitical." This is a tall order, but I will do my best to oblige. Today, I will talk about two types of global economic imbalances. The first relates to the way that savings and investment are being distributed across countries in an increasingly uneven way. The second is the possibility that, over the next couple of decades, the global economy might face a protracted period in which desired savings exceed planned investment, partly because of demographic trends. If economic policy-makers do not take appropriate measures quickly enough, there is even a risk--albeit a small one-- that the world economy could end up with the classic dilemma--first spelled out by John Maynard Keynes--of widespread demand deficiency and a persistent deflationary gap. But before talking about this longer-term risk, let me focus on the savings-investment imbalances that currently exist across different regions of the global economy. The United States faces a large and growing current account deficit, which reflects an excess of investment spending relative to domestic savings. This is matched by growing current account surpluses in Asia, in oilexporting nations, and in some other economies around the world. Geographical imbalances are not necessarily a bad thing, nor are the large capital flows that they generate. Indeed, there should be a process that works through world financial markets to allow savers in one country to lend to borrowers in another. Such a process leads to higher global growth, since countries with surplus savings can invest them in countries that do not generate enough savings internally. However, when imbalances grow at an unsustainable pace, as appears to be the case at present, some form of correction must take place. If markets are allowed to operate without interference, imbalances can resolve themselves in a reasonably smooth manner. But in the absence of appropriately functioning market mechanisms, there is a greater risk that the correction will be abrupt and disorderly. Beyond disruption to financial markets, a disorderly correction might also lead governments to adopt wrong-headed protectionist measures, which would then exacerbate the damage to the global economy. But regardless of how these imbalances are resolved, it is clear that the resolution will require greater net national savings in the United States. Investment in the U.S. economy will need more financing from domestic sources--be it from the household, business, or government sectors--and less from foreign sources. This implies an increase in net U.S. exports and a decrease in net exports elsewhere in the world, as well as an increase in domestic demand in other countries. Exchange rate movements have an important role to play in this regard, because they can help redirect international trade and investment flows. In this context, efforts by some countries to slow or prevent required adjustments by pegging exchange rates are, in the end, counterproductive. I know that Governors Zhou and Noyer fully understand that, by frustrating market mechanisms, such policies raise the risk of a much larger and more disorderly correction in the future, as well as an outbreak of protectionism. But we should not look to exchange rate movements alone to resolve the existing global imbalances. Within the United States, higher interest rates can be expected to lead to increased savings. Authorities could also encourage greater national savings with a tighter fiscal policy. And they could implement structural reforms to encourage national savings through taxation, social security premiums, and other measures. But if the United States alone were to act to resolve its imbalance by taking the steps I've just described, it would leave the global economy with much weaker aggregate demand. And so a number of other countries must focus on stimulating domestic demand. This task is made more urgent by the fact that the global economy is currently operating somewhat below capacity. The fact that inflationary pressures are absent globally is evidence of this. So, how can we stimulate domestic demand outside the United States? Clearly, monetary authorities bear most of the responsibility for stabilizing domestic output in the short run and moving their own economies towards full production capacity. But monetary policy may not be as effective as it could be, if there are problems with an economy's structural or fiscal policies. Thus, the appropriate policy prescription depends on each country's circumstances. Structural reforms to remove market rigidities are important for most of us. Many need to improve or develop their financial system so that savings can be more effectively channeled into investment and households can have improved access to credit. For some, the development of social safety nets would be helpful, so citizens don't feel the need to hold excessive precautionary savings. And for a few, more stimulative fiscal policy would be helpful. I'll have more to say about these policies in a few minutes, since they are also critical for the good performance of the global economy in the long run. But first, I want to discuss the second type of imbalance that I mentioned at the beginning: the challenges that will be posed by evolving economic and demographic realities. As I see it, if countries do not have the appropriate structural policies in place, there is a risk of a prolonged deficiency in global demand in the future. Let me now expand on this risk by highlighting two trends that will be important over the next decade or two. First, we can expect that Asia's share of the world economy will continue to grow. For various reasons, Asian nations have traditionally had a higher rate of savings than other economies. And so, all other things being equal, we can expect that global desired savings will rise. But all other things are not equal. The second trend that we can expect is higher desired savings in most OECD economies as the baby-boom generation prepares for retirement. Taken together, these two trends can certainly be expected to lead to a higher level of global desired savings. So it is critical for policy-makers to act now, so there can be an increase in demand and investment to compensate for the increase in desired savings. How policy-makers handle the events of the next 10 to 20 years will be critical in preparing the global economy for the period from roughly 2020 on, when the proportion of the working-age population will start to decline in many countries. Canada will likely be in this position within 15 years. While demographic trends in the United States will likely be less challenging, in many OECD countries, the old-age dependency ratio is poised to rise sharply. According to a study by the European Commission, by 2025 the European Union will go from a ratio of roughly four working-age persons for every senior citizen to a ratio of 3 to 1. Indeed, without radical changes in fertility rates, life expectancies, or migration patterns, populations in many parts of the world will start declining, even as the world's total population continues to climb. According to the United Nations, the population of the EU could start to decline by 2025, with China expected to follow by 2050. Indeed, just this year, Japan reported a drop in its male population, and the number of deaths in that country began to exceed the number of births. But for most OECD countries, the era of declining labour forces and population is still at least a couple of decades away. Before we get there, we will first go through a period when desired savings are likely to rise. Workers in many countries can be expected to try to increase their savings for retirement. This can be accomplished for a short period through rising prices of assets, such as houses. But over the next couple of decades, this increased saving will have to come out of current income, and this means slower growth in consumer spending. At the same time, governments--faced with the need to prepare for future increases in public spending on an aging population--will also have to slow the rate of increase in current spending. To deal with this expected slower growth in domestic demand, we would typically expect monetary policy in an open economy to encourage or "crowd in" foreign demand with higher exports. But the world as a whole is one large closed economy--we can't export to another planet! If savings increase in one part of the world, offsetting increases in domestic demand will be needed elsewhere to keep global demand in line with global supply. So, since we can't export to another planet, what can policy-makers do to support the three remaining components of demand--private consumption, government spending, and investment? In terms of investment, a key point to remember is that investment requires an expectation that future profits will more than compensate for the cost of capital. Of course, changes in financial conditions play an important role in spurring investment, since real interest rates should decline to the point where desired investment matches desired savings. But, if the desire to save is too strong, and if it is spread throughout the global economy, it could happen that real interest rates would not be able to fall sufficiently to match desired savings with investment. With global inflation and interest rates already low, it could be argued that, when the expected increase in desired savings materializes, there will be a risk that global nominal interest rates would hit zero before real interest rates had fallen sufficiently to restore the balance between desired investment and savings. Let me stress that this is not a prediction on my part. I am only saying that, if there is no increase in global demand to offset the expected increase in desired savings, it may be difficult for monetary policy to effectively fulfill its role as the main short-run economic stabilizer in the years ahead. what should policy-makers be doing now to help us avoid a Keynesian deflationary gap in the future? As it turns out, most of the policy prescriptions that I spoke about earlier in the context of the resolution of today's imbalances would also address potential problems further ahead. Let me now return to those policies and talk about them in a bit more detail. First, one might look to governments to provide an expansionary fiscal policy. In a few economies, there is clearly room for fiscal policy to become more stimulative in order to boost investment and demand. Certainly, the economies of emerging Asia have the scope to support demand with fiscal policy. But in North America, Europe, and Japan the scope for fiscal policy to spur demand appears to be very limited, given current debt levels in most of these countries and the increasing demands that aging populations will place on the government sector. The strain on the public purse to meet the needs of our aging populations will be enormous. The situation will be more serious in those countries that have not yet taken steps to ensure that their public pension systems will be able to handle the retirement of the baby-boom generation. Unless the ratios of public debt-to-GDP are reduced before this strain is felt, governments in many countries will face the difficult task of reducing services or raising taxes, or both. In any event, public debt in some countries may have already become so large that additional fiscal stimulus might actually be counterproductive. Households, anxious about future tax liabilities or the viability of public pensions, might cut back on consumption. This could offset the positive effects of the easier policy stance. But if there is any scope at all for effective fiscal action, I would argue that the emphasis should be on improving the economic infrastructure in a way that can support the production capacity of the economy while, at the same time, helping to meet rising social needs as the working population begins to decline. This might include additional money for education and training, which by adding to human capital, would help maintain the production capacity of the world economy. But if there is one thing that all governments can do to stimulate demand, it is to have appropriate structural policies, and I stress the word "appropriate." Structural policies that promote economic flexibility are important in all circumstances. We all need to take steps to improve the flexibility of our labour markets and, in particular, to make sure that older workers who want to remain in the workforce are not discouraged from doing so. We also need to recognize that well-functioning credit markets are extremely important, so that households can borrow against future income, and businesses are able to make investments for the future. The improvement of labour and financial market policies is particularly important in Europe. In emerging Asia, improving income-security policies is essential in order to reduce the need for households to build up large amounts of precautionary savings. As well, stronger, more efficient domestic financial systems could go a long way towards raising confidence and promoting increased spending. By effectively pooling resources, stronger financial institutions and markets in Asia would help individuals become less risk-averse. Households would be more readily able to borrow against future income, and businesses would have more appropriate access to credit in order to finance investments. In closing, let me stress a few key points. I'm not saying that a disorderly correction to global imbalances is certain to happen. Nor am I saying that the global economy is inevitably headed for a deflationary shortfall in demand. What I am saying is that, as prudent policy-makers, we must not rely on good fortune to help us muddle through. We need to get going on these policy issues now, before it is too late to take remedial action. In particular, we need to make sure that our structural policies encourage maximum economic flexibility and that they do not impede investment and growth. We need to make sure that we will have the fiscal flexibility to handle the demographic challenges of the future. And we must continue to conduct monetary policy with the aim of keeping inflation low, stable, and predictable, to maximize the chances that our economies will operate at full capacity. We must act now to meet the challenges of today, and of the future, for the benefit of all our citizens.

r050922a_BOC

canada

Financial System Efficiency: Getting the Regulatory Framework Right

dodge

Governor of the Bank of Canada I am happy to have the opportunity today to follow up on a speech I gave here in Toronto last December. In that speech, I talked about the need for Canada to improve its financial system efficiency. Today, I want to focus my remarks on how regulation can, and must, contribute to that important goal. When I talk about an efficient financial system, I mean a system that helps to allocate scarce economic resources to the most productive uses. By making our financial system more efficient, we can help generate sustained economic growth and prosperity. The Bank of Canada has been contributing to the goal of an efficient financial system in a number of ways. The Bank's monetary policy aims to keep inflation low, stable, and predictable. By doing so, we enhance Canadians' confidence in the value of their money, thus reducing the need for people to spend resources either anticipating or coping with inflation. We also contribute to efficiency through our role as overseer of major payments, securities, and foreign exchange clearing and settlement systems, and by providing liquidity in times of financial stress. By reducing risks to the safety and stability of the financial system, we increase certainty about the robustness of the system, thus supporting efficiency. Our semi-annual promotes awareness of financial system issues, looks at developments and trends in the system, and addresses issues that affect its safety, soundness, and efficiency. As well, the Bank works actively with market participants and regulators to develop and promote an efficient financial system. And we conduct research that helps inform the decisions of policymakers in terms of promoting this goal. Today, what I want to talk about is how policy-makers can support efficiency by getting the regulatory framework right. I will start with some brief remarks about regulation in general. I'll then discuss how our regulatory framework can support financial system efficiency, and how we can best make sure that our framework is an effective one. I'll conclude with a look at some current issues in financial system regulation and the various ways in which the Bank is involved in them. Let me start with a basic premise. For any market economy to operate efficiently and achieve an optimal allocation of resources, there needs to be a solid legal and regulatory framework. Basic legal concepts, such as property rights, the rule of law, and the honouring of contracts, must be in place in order for market forces to work and to generate wealth. Once this is done, policy-makers have a number of overlapping motivations for further regulation. I'll spend much of my time today talking about the promotion of efficiency. But regulators also act to improve the safety and stability of the financial system, and to protect investors and savers. Let me set out three principles that policy-makers should apply in deciding when regulation is appropriate. First, regulation is appropriate to correct a market failure or, to put it in economic jargon, to deal with "externalities." The second principle is that regulation must be effective. Even when a market failure is recognized, regulators should act only if there is a reasonable chance that they will actually address the failure in question. The third principle is that the benefits of a particular regulation must be greater than the costs it imposes. In trying to solve one problem, regulators must avoid causing even greater problems. With these principles in mind, let me now describe three ways in which regulators can enhance the efficiency of the financial system. The first is to promote competition in domestic and international markets. Competition unleashes the forces that drive financial institutions and markets to become more innovative and efficient. That doesn't mean that regulators should "just get out of the way." Appropriate regulation can enhance competition. For example, an important goal of the Competition Bureau is to prevent firms from unfairly restricting competition. Canada became a world leader in promoting competition in financial markets when it adopted many of the recommendations of the Porter Commission of the 1960s. At a time when policy-makers worldwide favoured extensive government controls on economic activity, particularly within the financial system, Porter broke new ground by coming out strongly in favour of enhancing efficiency through the promotion of competition and freer markets. Competition is enhanced by expanding the scope of a given market. One way to do this is to have our markets and institutions compete with those in other countries and to have foreign enterprises compete in our markets. Therefore, regulation needs to take international considerations and developments into account. I'll have more to say on this point in a few minutes. For now, the point I want to stress is that competition leads to greater efficiency. A second way that good financial system regulation can promote efficiency is by working to that sometimes occur, and that can lead to market failures and a suboptimal allocation of funds. Most often, these failures arise when there are significant differences in the quantity or quality of relevant information available to market participants. Regulation should be designed so that investors are able to adequately gauge the risks and potential returns of an investment. To be clear, I'm not saying that the goal of regulation should be full disclosure of all information. Rather, the aim should be to reduce information asymmetries to the point that the benefits of disclosure still outweigh the costs of compliance. In that way, regulation can lead to a more efficient financial system. The third way that financial system regulation can support efficiency is to promote overall financial stability , which essentially means limiting systemic risk. The idea that regulation can support efficiency at the same time as it promotes stability may strike some as counterintuitive. But these objectives are not mutually exclusive. If the regulation is carried out in the right way, enhancing stability can lead to increased efficiency through the saving of resources that would otherwise be dedicated to guarding against systemic risk. Let me elaborate. I noted earlier that the Bank's monetary policy supports efficiency by increasing certainty about the future value of money. This reduces the need for Canadians to spend resources on activities intended to protect them from inflation. Similarly, enhancing the safety of the financial system reduces the need for Canadians to unnecessarily spend resources to guard against the risk of a financial crisis. Policy-makers are more likely to successfully promote both stability and efficiency if they bring market players into the picture when addressing a particular issue. systemic risk can be mitigated in the most efficient way. The LVTS processes Canada's large-value or time-critical payments. It gives participants the certainty that once a payment has been processed, the transaction will settle on the same day, regardless of what might later happen to any of the participants. This certainty enhances efficiency on its own. But, in addition, the design of the LVTS minimizes the amount of collateral that each institution needs to pledge to the system, compared with the gross settlement systems used in other countries. This reduction in collateral frees up resources that can then be put to more efficient uses elsewhere. That's a look at three ways in which a sound regulatory framework can improve the efficiency of the financial system--by promoting competition, by reducing information asymmetries where practical, and by reducing systemic risk. But to further our goal of improving efficiency, it is also important that our regulatory framework be effective. What makes a framework effective? I would highlight three factors. First, our regulations should provide incentives that encourage markets to reinforce and reward the right behaviour. These incentives should be sufficient to motivate market participants without the constant intervention of regulators or the imposition of detailed rules that dictate to firms not just what must be done, but how it must be done. The right incentives can help regulators achieve their goals without imposing process costs that outweigh the benefits of the regulation. Second, to achieve an effective regulatory framework, we need to take international developments into account. Countries can gain a comparative advantage by developing a superior regulatory framework. For our financial markets and institutions to be internationally competitive, our regulator y framework needs to be--and needs to be seen to be --as good as, if not better, than that of other countries. But at the same time, Canadian rules and their application should be tailored to our domestic needs and should reflect domestic realities. This tension between domestic and international considerations leads to some challenges for Canadian policymakers. A case in point is the Sarbanes-Oxley law. Canadian policy-makers embrace the general principles behind this legislation in terms of promoting good governance and financial practices. But the extreme level of detail in the application of its rules, as well as its focus on process instead of outcomes, creates costs for many of our firms that likely exceed the benefits to the system. Large Canadian corporations that want access to U.S. capital markets have no choice--they must follow both the spirit and the letter of Sarbanes-Oxley. But Canadian regulators are right to take a made-in-Canada approach that accommodates the needs of Canadian issuers and investors. Let me be clear. The goal is not to mimic U.S. regulations, despite that market's size and proximity. The principles behind our regulations must be as good as, or better than, those of other countries. But we must apply those principles in a way that develops a comparative advantage for our firms and our markets. Finally, and very importantly, an effective regulatory framework is one where the rules are enforced and are perceived to be enforced. Even the most coherent and efficient regulatory framework won't be effective unless it is followed. Participants must be appropriately monitored. And when the rules are broken, offenders must be prosecuted, and adequate penalties must be strictly applied. A framework with strong monitoring, prosecution, and application of penalties provides the incentives for firms to follow the rules, and this adds to the framework's credibility. When everyone is playing by the rules--and everyone is confident that others have the incentives to do the same-- then markets operate with greater efficiency. I've said before that regulation should be designed to enhance confidence and support trust in markets and institutions. Let me talk about one issue as an example. Canadian-listed firms can sometimes have a lower market valuation than similar firms listed in the United States. Why? Bank of Canada research has pointed to concerns about governance as a possible cause. And one of the main concerns appears to be a perception that Canadian enforcement of insider-trading laws is not as strong as it could be. We are continuing our research to better understand the root of this perception. The key point here is that to improve the effectiveness of our regulatory framework, investors must have confidence that they will be treated fairly. To repeat: we must have, and be perceived to have, proper enforcement in Canada. That's a look at how a sound regulatory framework can improve the efficiency of the financial system. Now let's turn to some current issues, a number of which the Bank of Canada has some involvement in. The Bank has been active in terms of research and commentary on developments aimed at improving efficiency. We have worked alongside the private sector to improve the safety and efficiency of clearing, payment, and settlement systems. For example, we've recently worked with various groups to make sure that participants are continuing to pursue more robust business-continuity plans, especially from a systemwide perspective. By increasing the degree of certainty that critical systems will be operational in times of disruption, the development of appropriate business-continuity plans can improve the overall efficiency of the financial system. With respect to fixed-income markets, the Bank is also playing a role in helping to develop regulations regarding transparency and alternative trading systems. We are promoting innovations such as electronic trading systems, because they provide opportunities to reduce transactions costs and increase transparency to appropriate levels. This will increase liquidity and lead to better-functioning markets. And through our research, our commentary, and, in some cases, our direct involvement, we contribute to the design of rules and codes of conduct that improve the functioning of both fixedincome and foreign exchange markets. Of course, one ongoing issue in the financial system is the question of consolidation among financial institutions. In my speech here in Toronto last December, I noted that Canada is facing a difficult policy challenge as we try to keep up with other countries that have enthusiastically adopted the competition-based regulatory philosophy espoused by the Porter Commission. We need to strive for a policy framework that continues to provide incentives for innovation and efficiency by encouraging competition. At the same time, we need to consider how to allow our financial institutions the scope to improve efficiency through economies of scale. Recent research at the Bank of Canada that examined economies of scale in banking concluded that there could be untapped efficiency gains for Canadian financial institutions. The benefits from these efficiency gains could flow across the economy, through lower-cost business and retail lending. But there are other relevant public policy questions here as well, including foreign ownership and concerns about the concentration of market power among very few players. Striking a balance between these interests is not a simple task. But in terms of competition, we should keep in mind that the level of competition can be maintained or enhanced by new entrants in the marketplace or by the threat of new entrants. Another issue that is being hotly debated relates to the ideal structure for securities regulators in Canada. What I said about this issue last year remains true today. Efficiency dictates that Canada should have uniform securities laws and regulations based on principles that apply to everyone. But the question is how to apply these rules in a tiered way to take into account the differing needs of issuers. For example, one tier could apply to large, complex firms that want access to international capital markets. Rules for these firms would be similar to those that are applied in New York or London. At the other end of the spectrum, another tier could apply to small, speculative resource firms that have historically relied on Canadian equity markets for financing. A third tier in the middle could apply to the bulk of Canadian "mid-cap" firms, which choose to access only Canadian capital markets, and which very often are smaller and less complex than U.S. These different tiers of firms exist in all major provincial jurisdictions. And investors in every jurisdiction have similar needs. So the key point is that, while the application of rules needs to take into account the size and complexity of firms, there is no need for different rules to be applied based on the province or territory of the issuer or investor. In closing, let me say that I hope you've found my comments to be topical. Many important decisions about our regulatory framework are currently being considered, and these will profoundly affect the Canadian economy. In making those decisions, it is very important that policy-makers keep in mind the goal of efficiency. They can support this goal by promoting competition, by correcting market imperfections where practical, and by promoting financial stability through reduced systemic risk. But it is even more important to remember why the goal of efficiency must be followed. Ultimately, policy-makers must strive to provide the best possible environment for achieving optimal allocation of economic resources. This is how policymakers and regulators of the financial system can best serve the public and contribute to sustainable economic growth and prosperity in Canada.

r051020a_BOC

canada

Release of the

dodge

This morning, we released our October . In the report, we said that the global and Canadian economies have continued to grow at a solid pace, and our economy now appears to be operating at full production capacity. Past and recent movements in energy prices and in the exchange rate for the Canadian dollar, along with competitive pressures from China and other newly industrialized economies, are giving rise to significant ongoing adjustments in the Canadian economy. Given these adjustments and the slow growth of productivity in recent years, the Bank has slightly reduced its estimate of potential output growth for 2005 and 2006. The Bank projects that the economy will grow in line with production potential through 2007, with growth averaging 2.8 per cent this year, 2.9 per cent in 2006, and 3.0 per cent in 2007. With the economy operating at capacity and with higher energy prices, pressures on consumer prices are somewhat stronger than they were at the time of the July . Assuming energy prices evolve in line with currently prevailing futures prices, CPI inflation is projected to average near 3 per cent through the middle of 2006, before returning to the 2 per cent target in the second half of next year. Core inflation should remain below 2 per cent in coming months, returning to 2 per cent by mid-2006. The Bank raised its key policy interest rate to 3 per cent on 18 October. In line with our outlook, some further reduction of monetary stimulus will be required to maintain a balance between aggregate supply and demand over the next four to six quarters, and to keep inflation on target. Short-term risks to this projection appear to be balanced. But as we look further out to 2007 and beyond, we see increasing risks that the unwinding of global economic imbalances could involve a period of weak world economic growth. The Bank will continue to assess the adjustments and underlying trends in the Canadian economy, as well as the balance of risks, as it conducts monetary policy to keep inflation on target over the medium term.

r051025a_BOC

canada

RCMP management retreat

dodge

Governor of the Bank of Canada to the RCMP management retreat Thank you, and good evening. When Commissioner Zaccardelli asked me to speak at this retreat, I was glad to accept. In fact, I'm honoured to be part of this inception of the It's not surprising that the Bank of Canada is interested in promoting economic integrity. After all, the Bank of Canada Act mandates us, as far as possible within the scope of monetary policy action, to "promote the economic and financial welfare of Canada." We are committed to promoting the economic well-being of this country and its citizens. We do this through our monetary policy, through our role as the federal government's banker, and through the issuance of Canada's paper currency. And we constantly work to promote confidence in a sound, safe financial system. A few years ago, your Commissioner coined the phrase "Safe Homes, Safe Communities". Your new strategic priority adds a third element to this phrase--"A Safe More than ever before, the law-enforcement community has a critical role to play in strengthening and preserving the security and economic interests of Canada. Now more than ever, the Bank of Canada, the RCMP, and other police agencies across Canada are working together to achieve this goal. Good policing is economic policing A focus on promoting a safe economy is not new for the RCMP and other police agencies. It is part of everyday policing--providing a safe place for citizens to live and work. But what do we mean by safety in our economy? For those of us involved in the nation's finances, it means preventing activities that undermine Canadians' confidence in their economy. It means fighting against the counterfeiting of currency and goods, credit card fraud, identity theft, money laundering, and so on. And it means preventing the erosion of confidence in our financial markets. Public companies need capital to invest and create jobs. Governments need capital to build infrastructure. Investors provide capital on the expectation that it will be put to good use and yield good returns. In turn, investors rely on these returns to finance their own needs, their homes, their retirement, and the education of their children. All of this activity will not take place unless the players are confident that they will be treated fairly, and that they operate on a level playing field. We know that all investments are subject to some risk of loss--that is the nature of markets. Properly-functioning financial markets price investments according to their degree of risk and their economic merit. But these markets can only function properly, and price appropriately, if the information on which they function is correct. If there is misinformation and deception--or the suspicion of fraud--markets cannot work efficiently. Let me explain further. When there is fraud, the market is operating on incorrect information. Clearly, that can result in private losses for individual investors who acted on the wrong information. But it can also cause a general loss in confidence--a loss which affects the economy as a whole. In the absence of trust that information is correct, the market cannot function, and society as a whole is the poorer for it. That's why we have accounting standards, securities regulations, and laws prohibiting economic crime. There are significant social benefits of a properly functioning market. And there are severe social costs of a market that functions poorly. Economic crime erodes the faith of Canadian and foreign investors in the integrity of our financial systems, our currency, our governments, our businesses, and our products. These crimes undermine the financial health and reputation of our country. They are far from victimless. Ultimately, we are all victims of these crimes, as they erode confidence in the financial system. And it takes a long time and a lot of effort and investment to reestablish public confidence once it is lost. That's why we have to view economic crime as every bit as serious as certain crimes of violence. It is true that fraud is less physically dangerous than an armed robbery. But its social damage is every bit as severe. Both types of crime undermine the trust that people have in their society. That's why a computer hacker who steals from a company is just as much a criminal as a bank robber who steals from a bank branch. And an illegal inside trader that has hijacked a million dollars from the pockets of investors is no less a criminal than the thief who commits an armed robbery. In all of these cases, the specific loss of property is exacerbated by a more widespread loss of confidence. Let's look at an example that's closer to home for the Bank of Canada--paper currency, our one tangible product. When an individual gets stuck with a fake bill, the amount he or she loses may be very small. But again, it is the aggregate impact that matters. Cash transactions still account for a large percentage of our economy, and the use of cash continues to grow every year. If people lose faith in their currency, the economic and social costs are immense. The impact of the Windsor $100 counterfeits a few years back is a lasting reminder of those costs. Maintaining the public's trust in Canada's paper money is a job that the Bank takes very seriously. Many police agencies are already working, either implicitly or explicitly, to protect economic integrity. You've been fighting the economic components of conventional crime--such as the laundering of the proceeds from drug sales--as well as economic crime itself--such as fraud, counterfeiting, and computer hacking. By improving your ability to fight these specific economic crimes, you improve your ability to fight all crime. In matters of personal and public safety, police organizations have known for a long time that enforcement cannot be effective without active cooperation from citizens and communities. Enforcement alone is not sufficient to improve safety in our homes and in our streets. Prevention, education, and community initiatives all have their role to play. Police officers also rely on the help of a broad range of complementary experts: psychologists, lawyers, community workers, public health officers, and so on. That spirit of cooperation is just as vital when it comes to protecting economic integrity. No one policing agency can fight alone against terrorist financing, money laundering, counterfeiting, or financial market fraud. This has become especially true in recent years, because of the growing sophistication of financial instruments and trading technologies. It's now much easier to hide one's own identity, or to steal someone else's, using Internet and other anonymous networks. And it's easier to confuse people with ever more complex financial schemes. The good news is that we've already seen how effective the police can be when they mount a sustained and coordinated effort to reduce these types of crime. Integrated Proceeds of Crime Teams have made it increasingly difficult for criminals to profit from their illegal activities. The launch of the Integrated Market Enforcement Teams in 2002 has helped boost public confidence in our capital markets. These are still early days, but the work of these teams is being noticed. The Bank is solidly behind this integrated approach to enforcing laws against economic crime. Special teams have the skills and resources needed to conduct complex investigations leading to the successful prosecution of these so-called "professional a result of this initiative, it appears that we may soon have specialized Integrated Counterfeit Enforcement Teams (ICETs) in place, to fight the serious threat posed by currency counterfeiting. Be assured that my colleagues and I applaud and strongly support these vital efforts. However, I know how difficult it is to generate support and funding for these new initiatives. I understand how frustrating it must be to investigate these complicated crimes without adequate and skilled resources or support. And I understand the frustration of police who spend time and resources investigating these offences, only to see the criminals walk away with little punishment because the social costs of their crimes aren't always fully recognized. That's why the Bank is working with the law enforcement community on training materials and legal tools to help prosecutors present their cases more effectively. Further progress will require a coordinated effort and a multidisciplinary approach. Vocal championship by leaders from the public and private sectors is needed if Canadians and their governments are to appreciate and support investment in specialized enforcement teams and more effective prosecutions and sentencing. As Governor of Canada's central bank, it is my responsibility and my intention to do all that I can to increase awareness of the importance of protecting economic integrity. That is why the Bank has been, and continues to be, committed to partnering with law-enforcement authorities and other participants in the legal system. Challenges in protecting economic integrity You and the Bank of Canada share a compelling objective: Making Canada a safe place to earn a living, to do business, and to invest. So, what challenges do we face in this Canada has a strong financial system, low and stable inflation, and a healthy economy. Our regulatory and governance structures are sound, and they are evolving to meet the challenges of new technology. So are Canada's bank notes--they now contain some of the best security features in the world But there is evidence that Canada is at risk of becoming a safe haven for opportunistic criminals who deal in white collar crime. This may be because we have lacked an adequately resourced enforcement regime and strong sentencing precedents. It may also be because there is a perception that our markets may not be as safe as they should be, and a perception that our enforcement is not as tough as it ought to be. So we're battling on two fronts: we need to thwart these opportunistic criminals, and we must be seen to be doing so. Another challenge is also a traditional strength of Canada's economy, and that is its openness. This openness has helped us to become one of the world's great trading nations, and a model of multiculturalism. Canada is seen as an attractive place for people to live, to invest, to do business, and to trade with. But, as I've said, this open economy makes us a target for international economic criminals. That's why we need more effective public and private sector governance and sound regulatory and enforcement practices to nurture strong businesses and sound financial systems. A third challenge is the need to ensure that our laws are current and that the judiciary is well-informed. The mere detection of crime--not to speak of its prosecution--is now a very sophisticated activity. It requires accountants, actuaries, commercial lawyers, financial specialists, and computer experts. Most importantly, it needs skilled investigators who are able to collect, analyze, and assemble complex evidence. And it requires informed prosecutors who are able to effectively marshal this evidence in the courtroom. To meet these three challenges, we need to continue to work efficiently together--across specialties and institutions. No single institution can gather and manage all the experts who have to cooperate in this new environment. Police know their role in fighting economic crime. But manufacturers, issuers of highvalue instruments (such as currency, securities, and passports), and financial institutions also have key roles to play. We must make our products and services as secure as possible. And we must do this while remaining profitable or, in the case of public sector institutions, cost effective. Now more than ever, this entails considerable expenditure to create and deploy highly sophisticated, reliable, and easy-to-use products and services. Our new series of bank notes is a good example of the effort that we are making in this regard. As organizations make these investments, they must put even greater emphasis on security, quality, and service. They must be audited and supervised to the highest standards. Regulators, overseers, users, boards of directors, the legal community, and the general public all have a stake in the outcome. Tracking down the bad guys and collecting the evidence is the responsibility of the RCMP and other law enforcement agencies. Bringing a strong case to court for the Crown rests with the prosecutors. By working together, we can hope for sentencing that reflects the importance of the crime. But achieving that goal requires active collaboration. That is easy to say, but devilishly tough to achieve. Knowledge sharing is difficult even within a homogeneous organization. Sharing information and expertise across separate and independent organizations is even harder. But it is critical if we are to succeed. The RCMP's creation of the strategic priority of Economic Integrity is a tremendous step towards achieving that goal, for two reasons. First, this initiative is the vehicle by which your internal resources can be mobilized. The IMETs are an excellent example of this and I'm confident that the ICETs will be, too. Second, this initiative will become the conduit for sharing knowledge, information, and resources with other partners, including the Bank of Canada. Through a well-organized partnership, we can succeed in our goal of enhancing and preserving the economic integrity of our country. On behalf of the Bank of Canada--and I'm sure that I speak for securities commissions and other market regulators on this--let me say that we appreciate your efforts, and that you have our full and enthusiastic support. Everybody in this room is committed to making Canadians secure, in their homes, in their communities, and in their business and working lives. As we do so, it is imperative that we continually remind ourselves that crime extends beyond the physical. Economic crime is harder to investigate and to prosecute. But it is every bit as damaging to the well-being of Canadians, and it is just as important to fight it with all of our effort. That's why I applaud your decision to make economic integrity a strategic priority. And I renew the Bank of Canada's commitment to work together with the RCMP and all enforcement agencies to help make the Canadian economy a safer place for investors, for businesses, and for all of our fellow citizens.

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

dodge

Good afternoon, Mr. Chairman and members of the Committee. We appreciate the opportunity to meet with this committee 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 objective of monetary policy and the actions we take to achieve it. When Paul and I appeared before this Committee last April, we said that the economy appeared to be operating slightly below its production capacity, and that we expected it to move back to full capacity in the second half of 2006. In our October , which we published last Thursday, we said that economic growth in the first half of the year was somewhat stronger than we had previously expected. Indeed, the global and Canadian economies have continued to grow at a solid pace, and our economy now appears to be operating at full production capacity. Past and recent movements in energy prices and in the exchange rate for the Canadian dollar, along with competitive pressures from China and other newly industrialized economies, are giving rise to significant ongoing adjustments in the Canadian economy. Given these adjustments and the slow growth of productivity in recent years, the Bank has slightly reduced its estimate of potential output growth for 2005 and 2006. The Bank projects that the economy will grow in line with production potential through 2007, with growth averaging 2.8 per cent this year, 2.9 per cent in 2006, and 3.0 per cent in 2007. With the economy operating at capacity and with higher energy prices, pressures on consumer prices are somewhat stronger than they were at the time of the July . Assuming energy prices evolve in line with currently prevailing futures prices, CPI inflation is projected to average near 3 per cent through the middle of 2006, before returning to the 2 per cent target in the second half of next year. Core inflation should remain below 2 per cent in coming months, returning to 2 per cent by mid-2006. The Bank raised its key policy interest rate to 3 per cent on 18 October. In line with our outlook, some further reduction of monetary stimulus will be required to maintain a balance between aggregate supply and demand over the next four to six quarters, and to keep inflation on target. Short-term risks to this projection appear to be balanced. But as we look further out to 2007 and beyond, we see increasing risks that the unwinding of global economic imbalances could involve a period of weak world economic growth. The Bank will continue to assess the adjustments and underlying trends in the Canadian economy, as well as the balance of risks, as it conducts monetary policy to keep inflation on target over the medium term. Mr. Chairman, Paul and I will now be happy to answer your questions.

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International symposium of the Banque de France

dodge

Governor of the Bank of Canada at the International Symposium of the Banque de France Thank you, Mr. Chairman. My remarks today will focus on how countries and economies can best weather economic shocks and imbalances, and seize the opportunities that globalization brings. As globalization intensifies, more and more regions are realizing the benefits of open trade and capital account liberalization. But with increased globalization also comes increased exposure to shocks originating outside each country's borders. Open economies will always be buffeted by shocks from abroad. But increased globalization of the financial system also means that imbalances can build and persist for long periods. Provided that market mechanisms are allowed to work, these imbalances will be selfcorrecting over time. However, when policies are followed that prevent market mechanisms from bringing about a smooth adjustment, the risk of a disorderly correction grows. Experience has taught us that in this environment where shocks are common and where imbalances may build, the key to surviving--and thriving--is to be flexible. And flexibility comes from markets that work. Our domestic markets for goods, services, labour, and capital all need to allocate resources efficiently. We need to establish frameworks that let our markets and our economies function as efficiently as possible. In this way, we can increase living standards over time for citizens in all countries. Of course, it is easy for us as economists and central bankers to say this. But it is much less easy to build the political consensus that lets governments put in place and maintain the policies that give our economies the flexibility to adjust. Part of our job as central bankers is to provide the analysis that helps to achieve that consensus. Let me briefly outline what I believe are the five critical elements that create an environment of economic flexibility. policy The first critical element is monetary policy. Experience around the world has taught us that the best contribution that monetary policy can make to the flexibility and enduring health of an economy is to anchor long-term inflation expectations. In Canada, we target inflation at the 2 per cent midpoint of a 1 to 3 per cent range--a system that we believe has been effective as a macroeconomic stabilizer. But whether or not a central bank adopts explicit inflation targets, keeping inflation low is the best means that we have as central bankers to facilitate sustainable growth in output and employment. A second critical element of flexibility, and an important part of any monetary policy approach, is the exchange rate regime chosen. For Canada, since our focus is on a target for domestic inflation, this, of necessity, means a floating exchange rate--a regime with which we have had more experience than almost any other country. Our floating exchange rate acts as a shock absorber, sending important price signals to businesses and consumers, and helping our economy adjust to swings in world demand and prices. Of course, real exchange rates will always adjust to reflect changing economic circumstances. But having this adjustment take place through movements in the nominal exchange rate is quicker and less painful than through general inflation or deflation. That is why efforts by some countries to slow or prevent required adjustments in their economy by pegging exchange rates may, in the end, be counterproductive. The third element of macroeconomic policy that is important for promoting sustained growth and flexibility is prudent fiscal policy. While needs will vary depending on circumstances, government budgets should be sustainable, with a view to achieving longer-run budget balance. Persistent deficits undermine confidence in the ability of governments to meet their obligations. They increase borrowing costs, and can place undue strain on the financial sector that may be forced to finance these deficits. In a few economies, there may be room for fiscal policy to become more stimulative in order to boost investment and demand. Some emerging-market economies in Asia with low public-debt-to-GDP ratios have the scope to support demand with fiscal policy. But in North America, Europe, and Japan the scope for fiscal policy to spur demand appears to be very limited, given current debt levels in most of these countries and the increasing demands that aging populations will place on the government sector. Unless the ratios of public debt to GDP are reduced before the strain of an aging population is felt, governments in many countries will face the difficult task of reducing services or raising taxes, or both. Within the context of prudent fiscal policy, the emphasis should be on improving the economic infrastructure in a way that can support the production capacity of the economy while, at the same time, helping to meet rising social needs as the working population begins to decline. This leads me to a fourth element that is critical to flexibility: and that is, appropriate microeconomic structural policies, and I stress the word "appropriate." We all need to take steps to improve the flexibility of our labour markets. Long-term demographic trends demand, for example, that we find ways to allow older workers to remain in the workforce, if they wish to do so. The G-7 finance ministers have been saying these things since their meetings in Boca Raton, Florida in February 2004, but much remains to be done. For some countries, the development of social safety nets, such as better public pension and health care plans, would be helpful, so that citizens would not feel the need to hold excessive precautionary savings. While we as central bankers recognize the critical importance of building efficient markets for goods, services, and labour, the policies to achieve these goals are not the purview of central banks. However, improving the efficiency of financial markets does lie within our purview, and it is the fifth critical element to promoting flexibility. So I will conclude with a few words on this subject. I know that all of us in this room recognize that efficient domestic financial systems can go a long way to enhancing an economy's flexibility. Well-functioning markets are critical for the appropriate allocation of capital for investment. They are equally critical for households, allowing younger members of society to borrow against future earnings and older individuals to save for their retirement. And, of course, efficient domestic markets interact effectively with international markets. The financial crises of the past decade in emerging-market economies have taught us that a resilient national financial system requires three things: a well-developed system of prudential regulation; policies that encourage competition between financial market players; and oversight of market conduct that enhances transparency and efficiency. Prudential regulation, in its broadest sense, works to get banks and other financial institutions to recognize, and make provisions for, the risks they are taking. It also works at the systemic level, so that authorities can gather information, align incentives, and take appropriate corrective measures to head off threats to systemic stability. The goal of effective competition policy is to promote maximum efficiency and innovation in financial markets. Within the scope of our powers as central bankers, it is important that we do what we can to enhance competition between institutions--both domestic and foreign--in our markets. Finally, we have learned through bitter experience that transparency is a general prerequisite for well-functioning debt and equity markets. Appropriate oversight of market conduct is essential. As central bankers, we need to encourage regulators to take appropriate--and I emphasize the word 'appropriate,' not 'over-zealous'--actions in this regard. In all cases, the focus should be on continuously striving to improve the efficiency of the financial system. This is a challenge that we in Canada also face, as we review the structure of our banking system and the efficacy of our capital markets. Over the course of this conference, we have heard some cogent and useful ideas. Throughout the rest of these proceedings, I know we'll hear more. Some of the world's best economic minds are focused on the implications of, and policy responses to, globalization. As we struggle to understand and to adjust to our changing world, it is important to remember that our past failures are usually the result of our inability--or unwillingness-- to get the basics right. As Voltaire said, "il faut cultiver notre jardin" with sound monetary, fiscal, and structural policies, and with well-functioning financial markets. If we get the domestic fundamentals right, we all stand a better chance of managing sudden swings in capital flows and the inevitable shocks that will remain a reality in our globalized economy.

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Economic and Financial Efficiency: The Importance of Pension Plans

dodge

Governor of the Bank of Canada Over the past year, I have spoken a number of times on the topic of efficiency, and why it is so important for Canadian policy-makers to keep in mind the goal of an efficient financial system. Today, I want to talk about Canada's system of pension plans and how they contribute to the efficiency of financial markets and of the economy as a whole. Before I talk specifically about pensions, let me begin with a few words about financial system efficiency in general. What exactly do I mean by efficiency? An efficient financial system is one that helps to allocate scarce economic resources to the most productive uses, in the most effective way. An efficient financial system reduces the misallocation or waste of economic resources. This is important because, by making our financial system as efficient as possible, we maximize our chances of generating sustained economic growth and prosperity. At the Bank of Canada, we contribute to the goal of an efficient financial system in various ways. Our monetary policy aims to keep inflation low, stable, and predictable. By doing so, we enhance the confidence of Canadians in the value of their money, thus reducing their need to spend resources either anticipating or coping with inflation. We also contribute to efficiency through our role as overseer of major payments, securities, and foreign exchange clearing and settlement systems, and by providing liquidity in times of financial stress. By reducing risks to the safety and stability of the financial system, we increase certainty about the robustness of the system, which also supports efficiency. Our semi-annual promotes awareness of financial system issues. As well, the Bank works actively with financial market participants and regulators to develop and promote efficiency. And we conduct research that helps inform the decisions of policy-makers in terms of promoting this goal. In previous speeches, I've spoken about the need to support the efficiency of our financial institutions. Canadian policy-makers need to develop a framework that continues to provide incentives for innovation and efficiency by encouraging competition. At the same time, Canadian financial institutions may be able to find efficiency gains through economies of scale, which could flow across the economy in the form of lower-cost business and retail lending. However, other relevant public policy questions include foreign ownership and concerns about the concentration of market power among very few players. Striking a balance between all these interests is not a simple task. But we should keep in mind that the level of competition can be maintained or enhanced by new entrants into the marketplace or by the threat of new entrants. I've also spoken about the need to promote efficiency in the regulation of securities markets. Efficiency dictates that Canada should have uniform securities laws and regulations based on principles that apply to everyone. The question is how to apply these laws and regulations in a tiered way to take into account the differing needs of issuers. All major provincial jurisdictions deal with issuers that vary greatly in terms of size and complexity--whether issuers are large, complex firms that want access to international capital markets, "mid-cap" firms that choose to access only Canadian capital markets, or small speculative resource firms that have historically relied on Canadian equity markets for financing. And the needs of investors are similar from one jurisdiction to another. So while the application of rules needs to take into account the size and complexity of firms, there is no need for different rules based solely on the province or territory of the issuer or investor. Today, I want to bring Canada's pension system into the picture. Obviously, the health of the pension system is extremely important from the perspective of the people who rely on it for their retirement income. It is also important from the perspective of economic and financial market efficiency. A report to G-10 deputies published in September emphasized that pension funds have already become the largest institutional investor class among G-10 countries. It also noted that retirement savings and the related capital flows will have an increasingly important influence on financial markets. Here in Canada, policy-makers need to think about how our pension system can contribute to efficiency. There is a need for long-term investment in critical infrastructure to support Canada's future production capacity. And there are pools of pension capital that, given their very long-term investment horizon, can be invested in this manner. I will come back to this issue in a future speech. But in the balance of my remarks today, I want to look at the pension system itself and discuss the incentives under which these large pools of capital operate. We must allow these pools to be accumulated and invested so that they not only maximize returns to support future pensioners, but also maximize the future growth of the economy's production capacity. There are essentially three pillars that make up Canada's pension system. pension plans. Statistics Canada data show that through the 1990s, income from the third pillar grew in importance, rising from 18 per cent to close to 30 per cent of retirement income. By comparison, income from the first pillar--the OAS/GIS--edged down from 30 per cent to 27 per cent during that decade, while income from the CPP/QPP rose from about 16 per cent to about 20 per cent. Returns on other personal investments made up most of the balance of retirement income. Of these sources of pension income, the OAS/GIS is not relevant to this discussion, since it is funded out of current federal government revenues and is not backed by a pool of dedicated assets. The other pillars are composed of three pools of capital with combined assets of more than $1 trillion at the end of 2003. Expressed in very rough percentages, the CPP/QPP pool was the smallest, with less than 10 per cent of the total, while assets held in RRSPs accounted for about 35 per cent. By far the largest pool was employer-sponsored pension plans, at about 55 per cent of the total. In virtually all cases, employer-sponsored pensions take the form of either defined-benefit or defined-contribution plans. A defined-benefit pension plan promises a guaranteed, fixed stream of retirement income. The pension is based on the employee's work history and is often expressed as a percentage of the employee's salary. In contrast, pension benefits from a defined-contribution plan are not pre-determined. They depend on the actual amount of contributions made on behalf of the individual employee and on the actual rate of return realized on those contributions. An efficient financial system distributes various risks to those who are best able to bear them. And the efficiency of these three pools of capital largely boils down to how they handle two principal types of risk. The first of these is return risk. This refers to the fact that the value of the pension that can be purchased at the time of a person's retirement depends largely on the conditions that exist just at the point of retirement. This risk is handled in different ways by different types of pension plans. For example, a defined-benefit pension plan mitigates this risk by pooling the assets of all contributors. This pooling helps to protect the ability of a sponsor of a defined-benefit plan to pay the pensions of all plan members, even those who retire one day after a stock market crash, or at a time when the return on long-term bonds is particularly low. The other type of risk is longevity risk. In a defined-benefit pension plan, this risk is transferred to the sponsor of the plan--usually the employer--who is responsible for making up any shortfall that could arise from pensioners living longer on average than expected. By pooling these risks, pension funds generate important benefits in terms of economic efficiency. By transferring risk from individuals to collectives, pension funds help achieve a more efficient allocation of savings. Pension funds--particularly the very large ones--tend to have sophisticated asset managers. These large funds have the incentive and the ability to invest pools of contributions across appropriately varied asset classes. Further, they invest over very long time horizons, so they can finance large investment projects at competitive rates of return. All of this contributes significantly to economic efficiency by transferring risk to those investors that are best able to bear it. Let's now turn to the three large pools of capital in Canada's pension system, and consider their implications for the efficiency of financial markets and for the economy as a whole. First, let me talk about the CPP and the QPP. While these plans are not fully funded, as private pension plans must be, many of the principles of the CPP and QPP are the same as those used by well-structured defined-benefit pensions. The benefits are linked to the earnings history of each member. The assets of the plans are managed by the Canada Pension Plan Investment Board and the Caisse de depot et placement du Quebec, with the aim of maximizing their long-run returns. Contributions are invested broadly, thus supporting the efficiency of financial markets and of the economy as a whole. Now let's turn to private pension plans and look first at individual and group tax-deferred RRSPs. This component of Canadians' retirement income has many of the same characteristics as a defined-contribution pension. By deferring taxes, RRSPs provide an appropriate incentive for saving. In recent years, just under one-third of taxpayers have contributed to their RRSP in any given year, and close to two-thirds of Canadians who filed a tax return contributed to a plan between 1993 and 2001. The increasing use of RRSPs has encouraged the development of financial products that allow individuals to diversify their risk. Of course, this source of income is subject to return risk, since an individual's portfolio could fall sharply in value just before planned retirement. has shown that individuals tend to be risk averse in terms of the assets they hold in individual retirement accounts, and in terms of how they allocate assets in defined-contribution pension plans when they have the opportunity to do so. Individuals tend to invest too much in investment-grade bonds, money market instruments, and large-cap equities relative to the portfolio that would maximize their expected pension. And, understandably, the older they get, the more risk averse they become. So the proportion of the pool of savings from individual and group RRSPs and from other defined-contribution plans that is allocated to riskier, less-liquid and longer-dated assets is likely to be quite small compared with that of defined-benefit plans. This difference in the risk appetite of individual savers with RRSPs and that of the sponsors of defined-benefit plans has an important effect on the functioning of Canadian capital markets. I'll come back to that point in a moment. Now let's look at the third pool of capital--employer-sponsored pensions. I want to spend a bit more time discussing these plans because there are policy concerns here that need to be addressed with some urgency. For decades, the vast majority of this pool--in terms of assets--has been held in defined-benefit plans. These plans can be attractive to individuals because they mitigate longevity risk and return risk. Defined-benefit plans also have important positive attributes for efficiency. I mentioned earlier the way in which defined-benefit plans support economic efficiency by allowing for a better allocation of savings. But there are also efficiency gains for financial markets. The managers of defined-benefit pension plans have both the ability and desire to invest in the kinds of assets that the average individual investor might not normally consider. Pension managers have superior knowledge of financial markets and of the associated risks that makes them willing to invest in alternative asset classes and to engage in arbitrage between markets. All of these activities make financial markets more complete and, so, enhance their efficiency. The size and sophistication of pension plans also lead them to be actively interested in good corporate governance, thus contributing to market discipline, which supports overall market efficiency. In recent years, defined-benefit pension plans have been in decline. The number of Canadians covered by defined-benefit plans has fallen by roughly 5 per cent since 1992. While the large majority of employer-sponsored plans are still of the definedbenefit variety, defined-contribution plans have grown significantly. We have seen many employers either collapse their defined-benefit plans or restrict new entrants into the plans. We have also seen increasing deficits in many defined-benefit pension plans. While part of the decline in defined-benefit plans comes from developments in the economy and the labour force, part is also due to the incentives under which these plans operate. Let me elaborate. Defined-benefit plans should operate so that the expected value of all benefits to be paid out equals the expected value of all contributions plus the expected returns on investments. But when the actual value of one of these variables differs from the expected value, the sponsor of the plan takes on responsibility for making up any difference. What would make a sponsor accept this responsibility? One reason would be if sponsors could mitigate the risk of worse-than-expected outcomes by being allowed to benefit from better-than-expected outcomes. But while there is no question that the sponsor is responsible for any deficit in the plan, it is not at all clear that the sponsor benefits from any surplus that may be generated. The question of who "owns" a surplus in a defined-benefit plan has been before many different courts at different levels and in different jurisdictions in recent years. While the precise answer depends on the specific wording of the rules of any given pension plan, in general, provincial and federal pension law has evolved so that employees have increasingly been given rights to pension surpluses, even though employees typically bear none of the responsibility for any deficit. A further distortion of incentives arises in those cases where the pension plan contributions are held in trust and administered by a trustee. Currently, most pension plan trusts are set up so that the employees are beneficiaries of the trust. Beginning in the 1980s, successive court decisions have established that sponsoring firms may gain exclusive access to a surplus in a pension plan trust only if the trust is set up in such a way as to permit the sponsoring firm to gain exclusive access. If defined-benefit plans are to survive, grow, and provide a source of funding for long-term, riskier assets, it is important that Canadian policy-makers consider taking steps to rebalance the incentives for sponsors to operate defined-benefit plans. Let me mention a few of the things that could be done. First, the provincial and federal governments need to make appropriate adjustments to their pension laws so that the sponsors of defined-benefit pension plans are responsible for all residual risks to the pension plan--both outcomes that lead to deficits and outcomes that lead to surpluses. Let me be clear. I am not saying that firms should be given unambiguous sole ownership of pension surpluses, but rather that sponsors should have that ownership. There are a handful of pension funds--such as the Ontario Teachers' Pension Plan--where both the employer and employees are joint sponsors, and share ownership of any surpluses, as well as responsibility for any deficits. The second step would be to consider rebalancing the tax treatment of employer contributions. Currently, in most circumstances, employers are not allowed to deduct contributions to a defined-benefit pension plan if the going-concern valuation of the plan is more than 110 per cent of expected future liabilities. This has certainly added to the bias against sponsors allowing surpluses to build up in their pension plans. Third, there are issues with Canadian accounting standards for pensions in terms of valuation that have been posing challenges since they were adopted in 1999. For one thing, changes in the annual discount rate used to value pension liabilities can result in large swings in the amount reported as pension expenses. For another thing, periodic actuarial valuations of defined-benefit plans also flow through firms' income statements. Both of these issues lead to volatility in reported earnings, which investors do not like. So, accounting standards have become another reason for employers to avoid definedbenefit pension plans. I have just listed three of the most serious problems facing sponsors of defined-benefit pension plans. Of course, there are other issues as well. Nevertheless, addressing these three issues would be helpful in getting the incentives right, so that defined-benefit plans can remain actuarially sound. This would significantly reduce the risk that pension contributions would be insufficient to cover future liabilities should sponsor firms go bankrupt. That said, sponsor bankruptcy remains a risk for members of private sector plans, and some form of risk-sharing arrangement is desirable. There are a number of options as to how to pool this risk, including encouraging the creation of plans sponsored by multiple employers. However, I would argue against the use of pension benefit guarantee funds, since they significantly raise the risk of "moral hazard," and further increase the bias against employers sponsoring defined-benefit plans. Let me conclude. Canada's pension plan system is crucial to our future, not only because it will sustain us in our retirement, but also because it supports the efficiency of our financial markets and our overall economy in important ways. Defined- contribution and defined-benefit pension plans, RRSPs, and the CPP and QPP all have a role to play. But as we have seen, one important part of our pension system--definedbenefit plans--has been in relative decline. This relative decline represents a transfer of return risk and longevity risk to individuals, who are less able to bear or manage them. This transfer has a negative impact on overall economic efficiency and could ultimately represent a significant threat to the ability of pension funds to finance the long-term investments that will maximize our economy's future potential growth. The task of establishing proper incentives is a difficult one, and I have touched on only some of the issues today. But policy-makers cannot avoid these difficult issues, and the stakes are too high for us to get it wrong. For the sake of efficiency and for the future health of our economy, we must get the analysis right, and then we must

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Inflation Targeting in Canada: Design, Lessons, and Challenges

dodge

Governor of the Bank of Canada to a Conference on the occasion of the anniversary of the Banco de Mexico Today, I want to share with all of you Canada's perspective on the design of an inflation-targeting system, some of the lessons we have learned over almost 15 years of experience with explicit inflation targets, and some of the challenges that remain. This topic is timely, because the Bank of Canada's inflation-targeting agreement with the Canadian government is up for renewal next year, and I am pleased to note that, earlier today, the Government announced its intention to renew our agreement for another five years. At the Bank, we are always reflecting on our framework; deciding what works well and what we can improve. My intention today is to spend relatively less time on history and, as is fitting for central bankers, to be more forward looking in terms of the issues that we continue to face as we refine our inflation-targeting regime. Canada's history with inflation targeting began in 1991 with an agreement between the Bank of Canada and the federal government that set out a series of targets for reducing inflation. This agreement has since been renewed three times. And since the end of 1995, our target for the annual rate of total consumer price inflation has been the 2 per cent midpoint of a 1 to 3 per cent range. Let me emphasize four points about our framework. First, the Bank of Canada and the Government of Canada have agreed that the best contribution that monetary policy can make to sustained economic growth and high employment over the medium term is to keep inflation low, stable, and predictable. Inflation targeting is viewed not as an end in itself, but as a means to achieving solid growth in output and employment. The second point is that we operate in a symmetric way, and we make it clear to Canadians that we do so. We are just as concerned about inflation coming in below or above target. So our framework helps us to avoid both deflation and high inflation. When a shock--positive or negative--hits the economy, the Bank of Canada will respond accordingly. Paying close attention to signs that inflation is moving away from the target promotes timely action in response to shocks. The third point I want to stress is that having an inflation target as an anchor is very helpful in terms of the Bank's accountability. If inflation persistently deviates from the target, we are committed to explaining the reasons, what we will do to return it to target, and how long we expect the process to take. Finally, inflation targeting has helped the Bank in its efforts to make its monetary policy more transparent. This is important, as we have found that monetary policy is more effective when people and markets understand what we are doing and why. We have also learned that effective communication is a crucial part of a successful monetary policy framework. Now let me quickly turn to our record with inflation targeting. As we look at inflation and economic growth in Canada since 1991, it is quite clear that the benefits we had hoped would come from inflation targeting have, in fact, materialized. We expected inflation to become more stable under a targeting framework--and it did so, sooner than we had anticipated. We expected our credibility to increase and inflation expectations to become well anchored under targeting--and this has also happened. Indeed, short-term expectations quickly became anchored to our target, although longerterm expectations took a bit more time to fall in line. Since we settled on a 2 per cent target for inflation at the end of 1995, actual inflation has averaged very close to 2 per cent. And it has remained within the 1 to 3 per cent target range, with only rare exceptions. Our experience has been that, with a clear inflation target and with well-anchored expectations, large relative price movements have only a one-time effect on the general price level and do not feed into ongoing inflation. We also thought that inflation targeting would help the economy to avoid the exaggerated "boom-bust" cycles of previous decades--and it has. The business cycle is still with us, but output volatility has diminished. By maintaining inflation close to the target, monetary policy helps to keep the economy operating near its potential. In this way, inflation targeting has also been successful as a macroeconomic stabilizer. Finally, and very importantly, our transparent framework has allowed markets and analysts to better predict how we will react to different economic outcomes. I would add that within the Bank, too, focusing on inflation brought increased discipline and clarity to our monetary policy deliberations. Let me now turn to the future of inflation targeting in Canada and some of the issues we are currently looking at. As I said at the beginning, our agreement with the federal government is up for renewal in 2006. So it is a good time to think about those elements of our framework that we would not want to change and other areas where changes might be considered. First of all, I can tell you that we are unlikely to change the choice of the total consumer price index (CPI) as our target. The CPI may not be a perfect measure of inflation, but it is widely understood, and it is the measure of inflation most familiar to Canadians. Choosing a well-known indicator as a target makes it easier to explain our actions and to be accountable. However, as you know, short-run movements in the total CPI are often caused by fluctuations in the prices of particularly volatile components of the index. Since the effects of monetary policy actions on inflation are spread over longer periods of time, it makes no sense to respond to very short-run fluctuations in the CPI that will have disappeared by the time those actions take effect. This is why we are likely to continue to operate with a point target within a range. While we emphasize the 2 per cent point target, we also have a target band of 1 to 3 per cent, partly to take into account the inherent volatility in the prices of some of the components of the CPI basket, and partly because monetary policy operates with long and variable lags. Trying to move too quickly back to target could lead to instability in our operational instrument, which would then lead to greater output instability. Furthermore, measured inflation can itself be volatile as specific prices adjust. And so the range provides a measure of the normal variation in inflation that Canadians can expect to see. But, to be clear, the range does not represent a zone of indifference--we do, in fact, aim at the 2 per cent target. There are, however, questions about our framework that we continue to explore. We examined many of these at a conference hosted by the Bank of Canada earlier this year. Let me go into some of them in a bit more detail. First of all, is 2 per cent the right target? When we last renewed the inflation agreement in 2001, we looked closely at this issue. At the time, our research could not convincingly demonstrate that the benefits of moving to a lower target would outweigh the costs. More recent research, while still inconclusive, provided a little more support for a lower target. Of course, we continue to look at this question, but the evidence will have to be quite compelling before we would change our target. Another issue that we continue to examine is whether we should target the price level rather than the inflation rate. While, in theory, there are benefits to having greater certainty about the price level over the longer term, analytically and empirically it has not been possible to provide a conclusive assessment of the costs and benefits of switching from targeting inflation to targeting the price level. While there are concerns that if we target the price level over too short a period of time there could be increased output volatility, recent research suggests that a price-level target could, in fact, help to stabilize output. We are still working at building better methods to examine these questions, and we will continue to look at new evidence as it becomes available. As I mentioned earlier, Canada's inflation rate has averaged very close to our target. Had the inflation rate been consistently and exactly 2 per cent over the 10 years since we settled on that figure as our target, the total CPI level would have grown from 102.8 in December 1994 to 127.4 in September of this year. The actual price level for that month was 129.1--a minimal difference. But it is conceivable that at the time of a subsequent renewal of our inflation-targeting agreement, the price level might have diverged quite significantly from where it would have been had we always hit the 2 per cent target exactly. So it might be worthwhile to explore an idea that is a variation on price-level targeting. Such an idea would involve a pre-announced policy whereby the inflation target would be adjusted to redress any previous drift in the price level relative to the 2 per cent target. This is a theoretical question that needs further study, and my discussion today barely scratches the surface. But the goal of such a system would be to bring the CPI to a level that would represent 2 per cent inflation, on average, over a very long period. We are also looking at other issues related to the way the Bank should react to various kinds of shocks, and whether we should adjust the existing 18- to 24-month time frame for bringing inflation back to the target. After 15 years of experience, it is worth considering whether this time frame is still appropriate for reacting to every type of shock. One type of shock that we have to consider is a major movement in asset prices. There is little evidence in the literature that central banks should respond directly to asset prices. For example, research presented at a recent Bank of Canada conference suggests that the gains--in terms of reduced output and inflation volatility--that come from reacting directly to equity prices are, at best, very small. Several open questions remain concerning asset-price movements and monetary policy, and research here is a priority for the Bank. In particular, we are looking for answers to these questions: Are there ways in which asset prices can give central banks reliable information about price pressures beyond the policy horizon? If so, what should be done about it? Would it ever be appropriate to lengthen the time horizon for returning inflation to the target in the face of certain asset-price shocks? Similar questions about lengthening the time horizon for monetary policy may apply to exchange rate shocks. Globalization appears to have changed the way in which economies adjust to movements in exchange rates. Here, I am referring both to the adjustment of real economic activity, as well as to the slower direct pass-through of exchange rate movements to prices. But there are also reasons to consider shortening our time horizon. For example, we have seen evidence that inflation has become less persistent under inflation targeting, because we have successfully established a clear anchor for inflation expectations. So, a shorter time horizon may be appropriate when dealing with demand shocks. Given the success we have had to date in dealing with various shocks within an 18- to 24-month horizon, we should not change that horizon lightly. But as inflation targeting evolves, it is clear that we need to think hard about the appropriate time horizon, as well as about some of the other issues I discussed today. I want to conclude by emphasizing a few key points. Despite a successful track record, I am not claiming that we have reached the end of monetary policy history. There is always room for improvements in our inflation-targeting regime. But despite the issues I've raised, there is no doubt in my mind that, fundamentally, inflation targeting is the right monetary policy framework for Canada. Through our symmetric approach of keeping inflation low, stable, and predictable, we have laid the groundwork for solid, sustainable growth in output and employment. With inflation targeting, our policy is more focused, our communications are clearer, and inflation expectations are more solidly anchored. It is particularly important at this time, when we are facing large movements in relative prices and in the terms of trade, that central banks have an anchor to keep monetary policy focused. From my perspective, inflation targeting is the best anchor we've seen.

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Investing in Productivity

dodge

Governor of the Bank of Canada Today I want to discuss the importance of efficiency in Canada's economy. Specifically, I'll focus on some of the elements that contribute to productivity growth in Canada--a subject that I've addressed before and that you've been hearing a lot about lately. Let me start by explaining what we mean when we talk about productivity. Measures of productivity tell us how much output we produce from the use of tangible inputs--such as skilled workers and capital equipment--and intangible inputs--such as technological advances and managerial and entrepreneurial know-how. Productivity rises over time as we boost output by finding new and more efficient ways to use these inputs. When measuring productivity, economists often prefer to use a measure called total factor productivity , which includes all these inputs--capital, labour, innovation, and know-how. In practice, however, it is very difficult to measure total factor productivity. That's why analysts usually focus on the more commonly used and better-understood measure, labour productivity. This measure tells us how much output is produced per worker or per hour worked. Labour productivity has the added advantage of being closer to measures of standards of living and more directly comparable across countries. Of course, labour productivity is affected by experience and education, by the amount of capital equipment (notably machinery and equipment) that is available to workers, and by innovation and know-how. We care about productivity because it is critical to our national standard of living. There are other factors that affect our living standards--changes in our terms of trade and in employment-to-population ratios, for instance--but productivity growth is the main contributor to sustained improvements in real incomes and rising standards of living over the long term. But productivity growth in Canada, measured as real gross domestic product per hour worked, has averaged less than 1 per cent per year so far in this century. Frankly, we must do better. But what does "doing better" actually mean? First, it means increasing the amount and the quality of physical capital per worker--giving employees better tools to work with. It also means allocating resources more efficiently and being more innovative. In my remarks today, I'm going to focus on the two latter elements--efficient allocation and innovation. I'll start with efficient allocation. At any point in time, we allocate resources among competing uses, always trying to use the resources we have as efficiently as possible. The goal is to move to the point where, given current production practices and knowledge, we are getting the absolute most out of the labour and capital resources at our disposal. The second element of productivity is innovation. This means generating new knowledge, improving technology, and enhancing both the processes and the organization of production. To take advantage of innovation, we also need to upgrade the skills of our labour force and, in some cases, change our business and managerial practices. Innovation and skills enhancement, when combined, lead to continuing growth of output per unit of input. For long-term improvements in productivity, we need both innovation and more efficient allocation. And so enterprises, sectors, and governments must follow the practices and policies that not only will allocate resources more efficiently, but also provide the framework to encourage innovation. When we talk about encouraging innovation, we're talking about two things. First, there are the incentives to encourage product innovations. These include the encouragement of that's done at universities, research institutes, and knowledge-intensive companies. But just as important, although sometimes overlooked, are the research and development that lead to incremental improvements in the design and performance of existing products. This kind of innovation requires investment. In Canada, we make quite large public investments in research through our public institutions. Research spending by Canadian companies and private sector institutions, on the other hand, tends to lag that of other countries. But dollar amounts don't tell the whole story. Research success depends not only on the amount that you invest, but also on how efficiently you invest it. That's why it is hard to judge the innovative capacity of an economy or an enterprise by the raw dollars that it computer industry average would come as a surprise to anyone who has a new iPod on his or her Christmas list. Others are probably in a better position than me to offer advice on ways to get more bang for your research buck, but this will be an important part of future discussions on productivity. The second type of incentive to encourage innovation relates to improving the processes used by an organization. For example, how can an organization use new technology to restructure its business and managerial practices? And what incentives drive that restructuring? Well, the most obvious incentives are the need to maintain a competitive edge, the desire for profit, and the fear of going bankrupt. That is why economies that have intense competition in domestic markets--from both domestic and foreign firms-- are the most innovative. Indeed, competition encourages both product and process innovation. But innovation means taking risks. Enterprises must also be given the incentives to take those risks. And they should be rewarded by the market when they do so. Among other things, this requires a financial system that appropriately prices the risks and potential returns being taken on by investors. Finally, we know that innovation is not a government-driven process: It occurs on the shop floor, in the start-up's laboratory, and in the minds of entrepreneurs. In our businesses and public sector institutions, we need to develop a culture that encourages both the "eureka!" moments and the incremental improvements that come from the incentive to stay just one step ahead of the competition. Let me now talk about improving productivity through more efficient allocation of resources. Some of the policies that promote better resource allocation are the same ones that encourage innovation. Let me mention four elements that are critical. First, we need an appropriate legal framework of property rights, including intellectual property and contract law. This framework must also include suitable penalties for those who break these laws, breach the public trust, or commit fraud. Second, labour markets must operate efficiently, encouraging the flow of resources from less-productive to more-productive uses, and from shrinking sectors to growing ones. This flexibility is encouraged through appropriate labour market policies, education, and training. I won't say more about this--recent research by the International Monetary Fund and the Organisation for Economic Co-operation and Development explores this issue thoroughly. The third critical element is a financial system that operates efficiently, helping to allocate scarce economic resources to the most productive uses, in the most effective way. In previous speeches, I spoke about the importance of a well-functioning financial system and about the need to support the efficiency of our financial institutions. I also spoke about the need to promote efficiency in the regulation of securities markets and about the role that Canada's pension system can play. The fourth key element is the construction and operation of the physical infrastructure that we need for economic growth and development. I will focus the remainder of my remarks on this area. This critical infrastructure includes public assets, such as highways, public transit and transportation facilities, power, waterworks and waste water, schools, hospitals, and other facilities. It also includes private infrastructure, such as pipelines, rail, and telecommunications networks. To illustrate why infrastructure is an important means of encouraging more efficient resource allocation, let me offer a few examples. Canada is envied around the world for its wealth of natural resources. But getting these natural resources to market has always relied on railways, pipelines, ports, and other transportation infrastructure. Similarly, Canada's world-renowned telecommunications sector has grown out of huge investments in this country's land-based and satellite infrastructure. The clusters of industrial, manufacturing, and technology companies located in our major centres are there because our cities function well, with quality water, sewer, transportation, and municipal and social services. These companies employ Canadians who were educated and trained by our public schools, colleges, and universities. And these companies are funded by individuals who are willing to invest their savings through a financial system that they trust. Clearly, infrastructure plays a key role in creating an efficient, productive economy. But today, there are clear signs of a public infrastructure deficit in Canada. And there is a growing concern that this deficit could harm Canada's productivity growth and standard of living, unless we take steps to correct it. Estimates of the magnitude of this deficit vary considerably. But it is generally acknowledged that the gap will not be reduced solely through government financing. No single means of development always creates the right infrastructure, so it will take a number of different solutions. Through our history, we have used various methods. We have seen private infrastructure development, encouraged by governments through land grants, monopoly rights, subsidies, and so on. In these examples, the private sector takes on the risk of financing the infrastructure, with the promise of profits down the road. Perhaps the most well known example of this type of infrastructure development is We have also seen purely public infrastructure building, in which the government or its agencies build and operate the infrastructure. An obvious example is Canada's network of highways and roads. Some infrastructure has been built and operated entirely by private companies, under the umbrella of a legal framework that helps to protect their investment and of a regulatory structure that helps to protect the consumer. Cable television is an example of this type. employ a mix of public and private funding, with the operation and maintenance of the infrastructure performed by a private enterprise on behalf of the government. The most familiar example of a PPP is the Confederation Bridge between New Brunswick and Prince Edward Island. But there are still relatively few existing PPPs in Canada. Other countries, such as the United Kingdom and Australia, offer many examples of successful PPP infrastructure. Unlike most jurisdictions in Canada, these other countries already have a well-developed legal and regulatory framework for PPP investments. Each of these methods has advantages, but also problems. In the final analysis, it is all a question of incentives. For example, when infrastructure projects are solely publicly funded, the usual incentives to build and operate efficiently--the incentives to avoid bankruptcy and to make a profit--are not the driving motive behind the investment. The most efficient and timely allocation of resources for infrastructure occurs when the incentives are right. And that framework of incentives usually includes some expectation of profit. This applies equally to decisions on what to build and to decisions regarding how to operate the infrastructure once it is in place. The hardest incentive to get right is that of proper pricing. A lack of pricing that appropriately reflects demand and supply conditions may be one reason why there have been relatively few PPP infrastructure projects in Canada. It is particularly important to improve pricing mechanisms for services that are provided through public infrastructure. Governments have often been unwilling to price-to-market infrastructure-based services. As a result, shortages are managed through non-price rationing, such as rolling electricity blackouts, highway congestion, or waiting lists for government documents or services. And occasionally, we get the opposite problem--an over-build of infrastructure that cannot be justified by demand. New technologies, such as transponders on vehicles to monitor road use, and meters that allow peak-hour pricing of electricity, provide new opportunities to gauge demand for these services, and to price them accordingly. Another key incentive with respect to infrastructure investment is the incentive to manage risk. Private financing of infrastructure through the markets tends to lead to better assessment of the risks of the investment, because financial markets are better able to measure and price risk. This is not to say that we should expect the private sector to shoulder all the inherent risks of major infrastructure investments without any public sharing of those risks. But financing through markets provides a mechanism by which we can better assess the economic merits of an investment. These are some of the complex issues facing us as we try to eliminate Canada's infrastructure deficit. The timing is right to make these investments. During the early 1990s, governments had to deal with large fiscal deficits and they simply did not have the cash to invest in building infrastructure. That is not the case today. Further, over the next couple of decades as our population ages, more Canadians will be saving for their retirement. This added saving will boost an already growing demand for long-term financial assets. Pension and endowment funds are now allocating an increasing share of their portfolio assets to infrastructure investments, in an attempt to increase returns and better manage risk through portfolio diversification. These funds are increasingly looking for longerterm assets that provide a better match to their liabilities. So far, much of this investment has gone to projects in other countries. This is partly because the domestic markets for PPP in these other countries are more developed than ours. In Canada, we currently see three conditions that present us with a vital opportunity. We have governments that are committed to investing in infrastructure, a private market with an appetite for longer-term financial assets, and a pent-up need for those investments in Canada. If we get this right, we can enhance Canada's productivity in two ways. First, the improved infrastructure can help to boost the productive capacity of the private sector and help to achieve more efficient resource allocation. Second, better infrastructure is a key component in attracting the companies and the people who spearhead continuous innovation. The Bank of Canada's mandate is to promote the economic and financial well-being of this country. We know that an efficient and innovative economy is critical if we are to achieve sustainable growth and prosperity for Canadians. That is why, in past speeches, I have focused on the need to have efficient financial institutions and markets. The right infrastructure is also key to promoting efficiency. And PPP is a practical way to match the demand of savers for long-term assets with the economy's need to build critical infrastructure. It is also a way to promote the efficient operation of that infrastructure. That is why I have chosen to focus on this issue today. I know that over the course of this conference, we'll hear some innovative ideas on how to achieve these goals. Your deliberations are important. The right infrastructure can support and encourage initiatives to increase productivity. Finding innovative and reliable ways to fund this country's current and future infrastructure requirements is a key element of any effort to improve Canada's productivity and raise living standards for

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Our Approach to Monetary Policy: Inflation Targeting

dodge

Governor of the Bank of Canada to the Regina Chamber of Commerce I am happy to have the opportunity to speak in Regina during Saskatchewan's centennial year. Throughout 2005, the people of Saskatchewan have been celebrating the many remarkable contributions that this province and its citizens have made to Canada. Gerald Bouey and Gordon Thiessen, two of my predecessors as Governor, are examples of individuals with deep Saskatchewan roots who have made great contributions to the Bank and to our country. As this province turns 100, you can be proud not only of your history, but also of your modern, increasingly diversified economy that positions Saskatchewan for success in the future. This year also marks the 70th anniversary of the creation of the Bank of Canada, and we too have taken the time to celebrate our contributions to Canada. At such times, while it is appropriate to look back and celebrate history and accomplishments, it is also a good opportunity to look forward and think about where we are headed. In this spirit, I'd like to talk to you today about one of our main responsibilities; that is, the conduct of monetary policy. I want to recount a bit of the Bank's history and talk about how we developed our current framework for conducting monetary policy. At the Bank of Canada, we strongly believe that targeting inflation is the best way for us to fulfill our mandate to Canadians. I also want to look forward a bit, and talk about the future of inflation targeting, as we prepare to renew our inflation-targeting agreement with the federal government next year. Let me begin with a brief discussion of the Bank's legislative mandate. The preamble to the Bank of Canada Act instructs us to "regulate credit and currency in the best interest of the nation." It goes on to say that the Bank should mitigate "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 . . . promote the economic and financial welfare of Canada." So the question is, How can the Bank best provide the conditions for sustainable economic growth, bearing in mind the words in our mandate: "so far as may be possible within the scope of monetary action"? Over time, it has become clear that the best way for monetary policy to promote sustainable economic growth is to anchor expectations about the future purchasing power of money. In other words, it is important for Canadians to have confidence that the value of their money will not be eroded over time. Focusing on domestic price stability is the best contribution that monetary policy can make to economic stability and sustainable long-term growth. After the bitter inflationary experiences of the 1970s, it became clear that central banks needed to focus on achieving low inflation. But monetary authorities around the world were struggling to figure out how best to do this. At the Bank of Canada, we were trying to determine how to achieve price stability in a way that would allow us to accomplish three things: first, as I just said, we wanted to anchor Canadians' expectations about the future purchasing power of their money; second, we wanted an operational framework for the conduct of monetary policy; and third, we wanted an approach that would help markets, politicians, and the Canadian public to understand what we were doing, and what actions they could expect from us. Throughout the 1980s, we at the Bank worked to come up with such an approach. By 1991, we had decided that targeting inflation was the best way to achieve high, sustainable growth in output and employment. And so the Bank and the Government of Canada agreed on a series of explicit targets for inflation. To be clear, however, inflation targeting is not an end in itself. Rather, as I said, it is the best means of fulfilling our commitment to promote the economic and financial welfare of Canadians. Once the Bank and the government agreed on the concept of inflation targeting, we needed to make some choices to put the concept into practice. Like many other central banks, we chose a target for the annual rate of inflation. Initially, our focus was on reducing the rate of inflation, which was running at more than 5 per cent annually in 1991. The target was set to bring inflation down gradually--first, to the 3 per cent midpoint of a 2 to 4 per cent target range by the end of 1992, and then to the 2 per cent midpoint of a 1 to 3 per cent range by the end of 1995. The target has remained there since then. Let me take you through some of the other key decisions that we made in 1991, and the rationale behind our choices, as we set out the details of our framework. First of all, why did we choose the consumer price index (CPI) as our measure of inflation? The key reason is that the CPI is the measure of inflation most familiar and relevant to Canadians. Choosing a well-known indicator as a target makes it easier to explain our actions and to be accountable. Second, why do we have a range? This is because there are some components of the CPI--such as some energy and food items--whose prices tend to move a lot, both up and down. These movements can cause large fluctuations in the index. If we tried to target inflation too precisely, we would then be adjusting our policy interest rate sharply and frequently, which would lead to greater instability in the economy. Having a range reflects the inherent volatility of the CPI. But to be clear, the range is not a zone of indifference--we do aim to achieve the 2 per cent target. Another concern is that this volatility can obscure the underlying trend of inflation. So for operational purposes, we use a measure of core inflation. This measure strips out eight of the most volatile components of the CPI and the effect of changes in indirect taxes on the rest of the items. In this way, core inflation provides a better forward-looking indicator of the trend of inflation. Finally, since today's monetary policy actions only affect future inflation, we needed to choose a time frame in which to achieve our target. From the beginning, we said that if inflation was pushed off target, we would conduct monetary policy so as to return inflation to target over a period of 18 to 24 months. This is because research has suggested that historically it takes 12 to 18 months for changes in interest rates to have most of their impact on output, and 18 to 24 months to have most of their impact on prices. Of course, there is always uncertainty about the lags involved, and I'll have more to say about this later on. Before I move on, I want to emphasize three points about our inflationtargeting framework. The first is that we operate in a symmetric way, and we make it clear to everyone that we do so. By this, I mean that we worry just as much about inflation falling below target as we do about it rising above target. When the demand for goods and services pushes the Canadian economy against the limits of its capacity, and inflation is poised to rise above target, the Bank will raise interest rates to cool off the economy. And when the economy is operating below its production capacity, and inflation is poised to fall below target, the Bank will lower interest rates to stimulate growth. Paying close attention to signs that inflation is moving away from our target--in either direction--promotes timely action. This is how we keep the economy operating near its full capacity and thus keep inflation low, stable, and predictable. The second point I want to stress is that having an inflation target as an anchor is very helpful in terms of the Bank's accountability. If inflation persistently deviates from the target, we are committed to explaining the reasons why, what we will do to return it to target, and how long we expect the process to take. The third point is that any central bank that runs an independent monetary policy and targets inflation must allow its currency to float. It is simply not possible for a central bank to successfully control both the domestic and external values of its currency at the same time. We have only one instrument--our policy interest rate--so we can have only one target. Thus, with inflation as our target, we naturally operate with a floating currency. Now, let me quickly review our record with inflation targeting. As we look at inflation and economic growth in Canada since 1991, it is quite clear that the benefits we had hoped would come from inflation targeting have, in fact, materialized. We expected inflation to become more stable--and it did so, sooner than we had anticipated. Since settling on the 2 per cent target for inflation at the end of 1995, actual inflation has averaged very close to 2 per cent. And it has remained within the 1 to 3 per cent target range, with only rare exceptions. We expected our credibility to increase and inflation expectations to become well anchored--and this has also happened. We also thought that inflation targeting would help the economy to avoid the exaggerated "boom-bust" cycles of previous decades--and it has. The business cycle is still with us, but economic volatility has diminished. By keeping inflation close to the target, monetary policy has helped to keep the economy operating near its potential. Finally, and very importantly, our transparent framework has allowed markets and analysts to better predict how we will react to different economic outcomes. Within the Bank, too, focusing on inflation has brought increased discipline and clarity to our monetary policy decision process. Canada was the second country after New Zealand to adopt explicit inflation targets. But over the past decade and a half, about 20 other central banks have also adopted this framework. Some, like the central banks of the United Kingdom and Sweden, are from advanced, industrialized economies. Others, such as the central banks of Chile and Brazil, are from emerging-market economies. In every case, inflation targeting has been a success: inflation rates have been reduced, and central banks have generally been able to hit their targets. Inflation has become less persistent where inflation targeting is practiced, and it is reasonable to assume that well-anchored inflation expectations are a good part of the reason why. Given this success, it seems likely that other countries will join the ranks of inflation targeters in coming years--indeed, just last week the central bank of Turkey announced that it will move to formal inflation targeting next year. Inflation targeting is also being discussed in the United States where Ben Bernanke, Alan Greenspan's designated successor at the Federal Reserve, has been an enthusiastic proponent. However, some have argued that inflation targeting is too limiting an approach, and that it can constrain a central bank's ability to act or to apply judgment in the case of extraordinary events. But this has not been our experience in Canada. For example, in the immediate aftermath of the 9/11 terrorist attacks, we lowered interest rates quickly and decisively to underpin confidence. When a major loss of confidence did not materialize, we were able to reverse course in fairly short order and withdraw some of that monetary stimulus. Our inflation-targeting framework did not restrict our ability to act. Indeed, because our framework is transparent, financial markets were able to appreciate why we made these rapid rate adjustments. The Bank of Canada focuses on inflation at the national level. This can lead to suggestions that some of Canada's regions may not have the appropriate policy for their particular circumstances. We hear these comments more often during times such as these, when economic prospects and growth rates vary from sector to sector and-- because of the geographic concentration of sectors in Canada--also from region to region. These comments reflect a fairly common misunderstanding about monetary policy. Remember that in any market economy, adjustments are always taking place. Markets and prices send clear signals that indicate how economic resources should be allocated, shifting resources to rapidly growing sectors from slower-growing ones. Because our monetary policy targets inflation for the country as a whole, it does not try to mask these important price signals--nor should it. To do so would impede the adjustment process and, ultimately, lead to lower economic growth. But this does not mean that we ignore what is happening on a regional basis--far from it. Indeed, the information we receive from our five regional offices, and from our , is an important input to our monetary policy deliberations. Our job is to add up what is going on across the country and to conduct monetary policy so that we achieve our inflation target for the country as a whole. Despite our success to date with inflation targeting, I shouldn't leave you with the impression that this somehow represents the end of monetary policy history. Prudent policy-makers should always be striving to find better ways of getting things done. As I said at the beginning, our agreement with the federal government is up for renewal next year. So at the Bank, we have been busy thinking about those elements of our framework that we would not want to change , as well as others where changes might be considered. From the Bank's point of view, the basic arrangement of aiming inflation at the 2 per cent midpoint of a 1 to 3 per cent target range has served Canadians well, along with the use of the total CPI as the target, and a measure of core inflation for operational purposes. The Bank will also continue to recognize the importance of communications and transparency. Inflation targeting does a good job of anchoring expectations, but it works better when a central bank communicates well. I expect that these basic elements of our framework will remain in place. This is not to say that we haven't examined these elements. Indeed, we have asked ourselves if 2 per cent is the right target. When we last renewed the inflationtargeting agreement in 2001, we looked closely at this issue. At the time, our research could not convincingly demonstrate that the benefits of moving to a lower target would outweigh the costs. More recent research, while still inconclusive, provided a little more support for a lower target. Of course, we will continue to look at this question, but the evidence would have to be quite compelling before the target would be changed. Another issue that we continue to examine is whether we should target the actual level of prices rather than the inflation rate . Let me explain what I mean. Had the annual rate of inflation been exactly 2 per cent since 1995, when we settled on that figure as our target, the consumer price index would have risen from a level of 102.8 in December 1994 to 127.6 in October of this year. The actual price level for October was 128.5--a minimal difference, as it turns out. But in the future, it is possible that we could get a series of shocks that moved inflation predominantly in one direction, either up or down. And so, the price level could move significantly away from where it would have been if we had hit the 2 per cent target exactly over a period of years. Under price-level targeting, monetary policy would be set so as to offset those deviations from the desired price level. But under inflation targeting, those past price-level movements are essentially forgotten; they would not change the conduct of policy going forward. Economic theory tells us that, over the longer term, having certainty about the future price level would yield somewhat greater benefits than just having certainty about the future rate of inflation. But to date, it has not been possible to conclusively measure the costs and benefits of targeting the price level versus targeting the inflation rate. We are still working at building better analytical tools and methods to examine these questions, and we will continue to look at new evidence as it becomes available down the road. Another issue that we are looking at is the appropriate time frame for returning inflation to target following various kinds of shocks. As I said before, we now conduct monetary policy with the goal of bringing inflation to target within an 18- to 24-month time frame. But there are questions as to whether this time frame is appropriate for every type of unexpected development that could affect inflation. There could be reasons to look at adjusting the time frame in response to inflationary pressures from major movements in asset prices--be they real estate, equity prices, or the exchange rate. Given the success we have had to date in dealing with various shocks within an 18- to 24-month horizon, we should not change that horizon lightly. But as inflation targeting and the global economy evolve, we will need to continue considering the appropriate time horizon and some of the other issues I discussed today. The Bank of Canada remains committed to conducting and encouraging research in these and other important areas. I want to conclude by emphasizing a few key points. Despite the issues I've just raised, the economic record of the past 15 years shows that inflation targeting has served Canada well. The Bank's symmetric approach of keeping inflation low, stable, and predictable has laid the groundwork for solid, sustainable growth in output and employment. With inflation targeting, monetary policy is more focused, our communications are clearer, and inflation expectations are more solidly anchored. As we look forward, it is important that we maintain an anchor to keep monetary policy focused. From my perspective, inflation targeting is the best anchor we've seen.

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Canada's Monetary Policy Framework: Dealing with Global Economic Change

kennedy

It's a pleasure to be in Montreal and to be speaking to the International Finance Club. I'd like to take this opportunity to discuss the Bank of Canada's monetary policy framework--what it is, and how it works to promote strong economic growth and facilitate adjustment to economic change. You are an ideal audience for these remarks. Your expertise in international finance gives you a clear view of how quickly national economies and financial markets around the world are changing. And you know that in a global economy, Canada's economic well-being depends on how effectively it responds to these developments. The constant economic change that we've been experiencing makes it critical for the central bank to stand on a firm foundation as it works to enhance the country's economic strength. The Bank of Canada's monetary policy framework is such a foundation. In a moment, I'll outline how this framework works to mitigate the effects of shocks, facilitate the adjustment process, and promote sound economic performance. But first, let me discuss some of the major global forces that have been affecting the Canadian economy. In recent years, a strong global economic expansion has contributed significantly to a sharp rise in the prices of energy and some other commodities. With energy and other commodities accounting for about 45 per cent of our total exports (and some 13 per cent of all value-added economic activity), these relative price movements have led to a substantial improvement in our terms of trade. By this I mean that the prices we receive for our exports have been rising faster than the prices we pay for the goods and services that we import. Together with downward pressure on the U.S. dollar because of that country's very large current account deficit, these improved terms of trade have led to a sharp appreciation of the Canadian dollar. Since the beginning of 2003, our dollar has appreciated by about one third against the U.S. dollar, as well as against a trade-weighted basket of currencies. As a result, the cost of many imported goods, including--importantly--machinery and equipment, has fallen. At the same time, Canada has experienced increased competition from the rapidly growing economies of Asia, especially China. But we have also been presented with new opportunities to expand trade with these countries and to tap lower-cost supplies. These global developments, while clearly yielding benefits for Canada, have also necessitated adjustments involving significant shifts among economic sectors, and thus shifts in employment, but also new opportunities for growth. Higher prices for energy and other commodities, the appreciation of the Canadian dollar, the opening of new markets, and lower import costs have implications for firms and individuals across Canada. I'll return to this point later. But first, I'd like to talk about what these developments mean for the Bank of Canada and for the conduct of monetary policy. Under the Bank of Canada Act, the Bank is required to mitigate "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." To achieve this goal, we need a clear, effective policy framework, one that gives Canadians confidence in the value of their money and contributes to strong economic performance and a sound financial system. The two key components of our monetary policy framework are an inflation target and a floating exchange rate. These components work hand in hand, and indeed reinforce each other, to facilitate adjustment to economic developments. Let me elaborate. To achieve the inflation target of 2 per cent, the Bank aims to maintain a balance between the aggregate demand for and supply of goods and services. When aggregate supply and demand are in balance, the economy can operate at its full potential, and inflation stays low. The Bank aims to achieve this balance by raising interest rates when aggregate demand pushes the economy against the limits of its capacity and, in a symmetric fashion, by lowering interest rates when demand weakens. Inflation control facilitates adjustment to economic developments in two ways. First, when inflation stays close to the 2 per cent target, expectations about future inflation become anchored. Firms and individuals can then read price signals more clearly and thus make sound long-term economic decisions, which is especially important during times of rapid change. Second, when aggregate supply and demand are in balance, and inflation is contained, economic resources can be more effectively reallocated from sectors where demand is relatively weak to sectors where demand is relatively strong. This is especially important at times, like the present, when there are large movements in relative prices and changes in the terms of trade. So far, I have focused on the inflation target. The other key component of Canada's monetary policy framework is a flexible exchange rate. The Bank of Canada does not have a target or a preferred level for the Canadian dollar. But we do monitor the exchange rate closely, and we look for information that can be gleaned from movements in the currency to help us interpret and assess the implications for aggregate demand in Canada. Together with the inflation target, the flexible exchange rate works to facilitate economic adjustment. How? Put simply, movements in the exchange rate send appropriate signals to businesses, helping them to allocate capital and labour to the most efficient uses. Now, in formulating monetary policy, we at the Bank need to understand the underlying reasons for a currency movement. Understanding these reasons allows us to estimate the net effect of the currency movement on aggregate demand and, in this way, to make appropriate monetary policy decisions. We've discussed this subject in past speeches and, more recently, in the Autumn 2005 . So I will be brief today. In principle, there are two types of exchange rate movement: "Type One," those that stem from changes in the demand for Canadian goods and services, and "Type Two," those that do not. An example of a Type One movement relates to the strengthening global economy, which, as noted, has led to a substantial increase in world commodity prices and to strong foreign demand for Canadian products, especially raw materials. This development represents a direct increase in Canadian aggregate demand. The associated appreciation of the Canadian dollar has dampened the increase in demand and helped to facilitate the adjustment of the Canadian economy by encouraging a shift in activity towards Canada's commodity-exporting sector. To the extent that the dampening effect on demand exactly offsets the direct increase in demand, there would be no need for a policy response. A Type Two exchange rate movement does reflect a change in the aggregate demand for Canadian goods and services. Instead, it may reflect a rebalancing of portfolios, that is, a change in foreign demand for Canadian financial assets or a change in Canadian demand for foreign financial assets. However, the exchange rate movement itself has an impact on the demand for Canadian goods and services. When this movement persists, other things being equal, there would be a need for an offsetting change in monetary policy. A good example of a Type Two exchange rate movement was the appreciation of the U.S. dollar in the late 1990s when global investors, influenced by what they saw as robust prospects for the American economy, sought U.S. financial assets. In 2003-04, of course, we saw the reverse flow: investors became concerned about the large U.S. fiscal and current account deficits, foreign demand for U.S. financial assets declined, and the U.S. dollar, on balance, fell against many major currencies, including the Canadian dollar. It can be very difficult to determine whether, at a given moment, Type One or Type Two forces are driving the exchange rate. More often than not, shocks of different kinds occur at the same time, posing a challenge for the Bank in terms of determining the implications for monetary policy. It's interesting to compare the exchange rate movements over the past few years, and their effects on Canada, with those during the Asian economic and financial crisis of 1997-98. Because of that crisis, Asian demand, which had accounted for a relatively large share of the growth of world demand for many commodities, weakened considerably. Prices of key commodities produced by Canada fell, and the growth of Canadian aggregate demand was adversely affected. At the same time, and mainly because of the downturn in world commodity prices, the Canadian dollar depreciated against the U.S. dollar. This depreciation, together with a strong U.S. economy, partly offset the negative effects of the Asian crisis on Canadian aggregate demand. The current situation, which in terms of commodities is the inverse of the one during the Asian crisis, demonstrates the effectiveness and flexibility of the Bank's monetary policy framework. While the particulars of today's situation are different, the monetary policy framework continues to support appropriate adjustments. Adjustment to economic change is never easy, either for businesses or individuals. Over the past three years, changes in relative prices, including the appreciation of the Canadian dollar, have contributed to a reallocation of labour and capital from the production of non-commodity tradable goods to the production of commodities. As I mentioned earlier, given the importance of commodities to our economy, and given the improvement in our terms of trade, there have been real economic benefits for Canada as a whole. The flexibility and diversity of the Canadian economy are also helping to facilitate adjustment to global economic developments. Over the past three years, we have seen strong growth in capital spending in commodity-producing industries, as well as substantial gains in both capital spending and in employment in sectors with low exposure to international trade. Capital spending has also increased, although at a more moderate pace, in non-commodity manufacturing industries with a high exposure to international trade. Here in Quebec, and in central Canada more generally, the strong Canadian dollar and increased energy costs have posed a significant challenge to manufacturers and service providers facing international competition. The Bank closely follows developments in all sectors of the economy, partly through its quarterly conducted by its regional offices, including the one here in Montreal. For Canada as a whole, including Quebec, exports have continued to grow, despite the higher Canadian dollar. And investment in machinery and equipment suggests that a good number of firms are taking advantage of the stronger exchange rate to improve their productivity and enhance their competitiveness. And, of course, healthy final domestic demand, underpinned by rising incomes and relatively low interest rates, has continued to support economic growth in Canada during this period of significant economic adjustment. But the adjustment process is not over. We continue to experience changes in the prices of commodities relative to other products, in the exchange rate, and in the world demand for Canadian goods and services. Energy prices, in particular, have surged over the past year, and the associated effects are still working their way through our economy. Increased competition from abroad and structural changes in demand are other important economic forces at play that also require adjustment. I'd like to conclude by summarizing my key messages. Recent years have been marked by significant global economic change. A rise in the prices of commodities relative to those of other goods that we in Canada produce, the appreciation of our currency, increased international competition, and the rapidly growing emerging-market economies of Asia present challenges and opportunities for Canadian businesses and individuals. Adjusting to these developments is difficult but necessary. The adjustments that have already taken place suggest that Canadians are responding effectively to the challenge. For its part, the Bank of Canada will continue to help facilitate adjustment by conducting monetary policy with a view to keeping the economy operating at its potential and inflation close to the target. We will be closely monitoring economic developments and assessing their impact. The monetary policy framework--the inflation target working in concert with a floating exchange rate--will continue to be fundamental in facilitating the adjustments that businesses and individuals are making to deal with changes in the global economy. The Bank is constantly working to improve its research and analysis, as well as its conduct of monetary policy. But we remain confident that our monetary policy framework will continue to provide the firm foundation needed as we work to help Canada deal effectively with global economic change.

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Release of the

dodge

Today, we released the to our October . The reviews economic and financial trends in the context of Canada's inflation-control strategy. The Canadian and world economies are evolving essentially in line with the Bank's expectations, and the outlook for growth and inflation in Canada is similar to that in the October . Canada's economy continues to adjust to global developments and to the associated changes in relative prices. The Bank continues to judge that the Canadian economy is operating at its production capacity and will grow roughly in line with its production potential through 2007. Annual GDP growth is expected to be 3.1 per cent this year and 2.9 per cent in 2007, with strong growth in domestic demand and further gains in exports. Total CPI inflation, which was 2.3 per cent in the fourth quarter of 2005, will continue to be affected by the prices of crude oil and natural gas. The Bank projects that total inflation will be about 2.5 per cent in the first half of 2006, easing to 2 per cent by the first half of 2007. Core inflation, which was 1.6 per cent in the fourth quarter of 2005, should also return to 2 per cent by the first half of next year. Risks to the Bank's projection remain balanced for 2006. Through 2007 and beyond, risks are tilted to the downside, as the unwinding of global imbalances could involve a slowdown in world economic activity. In line with the Bank's base-case projection and current assessment of risks, some modest further increase in the policy interest rate would be required to keep aggregate supply and demand in balance and inflation on target over the medium term.

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Global Economic Trends: Implications for Canada

jenkins

Thank you for the opportunity to speak to you today--I am delighted to be here. I would also like to thank Gilles Lepage, the Bank's director from New Brunswick, for joining me. Wherever one lives in Canada these days, one cannot help but be aware that the world around us has been changing rapidly. Because Canada is so open to world trade and finance, we need to understand these changes so that we can manage our economy appropriately and take advantage of new opportunities. World economic growth has been remarkably strong over the past three years, averaging close to 4 1/4 per cent, and it is expected to stay around 4 per cent this year and next. But despite this solid overall performance, several interconnected global trends pose major challenges for the Canadian and New Brunswick economies. First, we have been witnessing large and growing global imbalances. Most important for Canada, the United States is running a very large deficit on its external current account (that is, the balance of trade in goods, services, and investment income with the rest of the world). The flip side of this deficit shows up primarily in Asia, where there are large current account surpluses and a massive accumulation of foreign exchange reserves. Second, we are seeing the emergence of China and India as economic powerhouses and formidable global competitors. Third, there is a divergence in economic performance across world regions, with North America and the emerging economies of Asia outperforming Europe and Japan. What are the implications of these trends for Canada and for New Brunswick? This is what I would like to discuss today. Let me begin by reviewing these global trends in greater detail. The U.S. current account deficit has widened--by about US$300 billion since 2002--to US$785 billion, or 6 1/2 per cent of that country's gross domestic product (GDP). And the level of U.S. indebtedness to the rest of the world has more than doubled over the past five years to more than 25 per cent of its GDP. Asia has been the primary source of foreign savings flowing into the United States. Moreover, Asian countries have accumulated over US$2 trillion in foreign exchange reserves, with China alone holding US$820 billion at the end of 2005. One factor contributing to this buildup of reserves is that some of these countries, most notably China, have been operating with fixed or tightly managed exchange rates (vis-a-vis the U.S. dollar) that are widely considered to be undervalued. These large imbalances are not sustainable over the longer run. No country, even one as big as the United States, can keep increasing its external indebtedness as a share of its GDP. Ultimately, these imbalances will have to be resolved. But this won't be simple. First, resolving the imbalances is not a short-term issue--it will take time. Second, what is needed is multi-faceted international policy action. Part of the solution involves an increase in U.S. national savings. But higher U.S. savings means lower U.S. consumption, which would likely mean lower Canadian exports to the United States. To avoid the dampening effect that lower U.S. spending could have on overall global demand, other industrialized countries need to adopt policies that promote stronger domestic demand. But this won't be enough. When significant global imbalances last emerged, in the mid-1980s, they largely occurred among the industrialized economies. That is not the case today. As I said before, major new players have appeared on the global scene. I'm referring primarily to the emerging economies of Asia. So, the resolution of today's imbalances requires that these countries, too, contribute through stronger growth in domestic demand rather than exports. But this shift towards greater domestic demand growth in Asia will not come about smoothly if those countries currently operating under fixed or tightly managed exchange rates do not begin to promote greater nominal exchange rate flexibility. If this does not happen, there is a risk that countries with floating exchange rates, like Canada, may have to bear more than their fair share of the burden of resolving the imbalances. There is also a risk that protectionist measures could be taken worldwide, hurting all trading nations, including Canada. For these reasons, the Bank of Canada has been on the side of the debate that advocates greater exchange rate flexibility for China and other Asian countries. But equally importantly, we have also argued that greater exchange rate flexibility in those countries will, in fact, best serve their needs, in terms of promoting sustained economic growth through stronger domestic demand and an efficient allocation of resources. Now, what about the more general issue of the integration of Asia, and particularly China, into the world economy? China's rising prominence in world trade has been partly a reflection of its increasing importance as an assembly platform for a broad range of exports. China's exports in the 1980s and early 1990s were concentrated in clothing, footwear, and other light manufactured goods. More recently, its share of world exports has increased in nearly all categories, with rapid growth in areas such as office machinery and telecommunications, furniture, textiles, travel goods, and industrial supplies. The increasing sophistication of Chinese exports means growing competition for Canadian products, both at home and in world markets. But we should not forget that the emergence of China and India as major economic players also offers Canadian firms the opportunity to profit by expanding into these huge export markets and by tapping into cheaper sources of supplies. Let me now elaborate a bit on the implications of these global trends for Canada. The rise of China and other newly industrialized countries to economic prominence, and the need to resolve the existing large global imbalances, have triggered sizable movements in key relative prices that are particularly relevant for Canada. I am referring specifically to the dramatic rise in the world prices for raw materials and energy, and to the marked appreciation of the Canadian dollar since 2002. When prices for energy and non-energy commodities rise relative to the prices of other goods that Canada produces, it is a signal that economic resources need to be shifted into the production of commodities. That's one implication. Another implication, given Canada's strength in commodity production, is higher real incomes for Canadians. As those incomes feed into stronger demand, the benefits extend to the sectors of our economy that are less exposed to global forces, such as housing and various services. But, of course, that's only part of the story. The other part is that large segments of the manufacturing sector, because of their exposure to growing competition from Asia and because of the higher Canadian dollar, will expand less rapidly relative to other sectors. As this process unfolds, labour and capital are reallocated across economic sectors. A quick look back at the Asian financial crisis of 1997-98 might help to put this current challenge in perspective. What we went through then is essentially the reverse of the current situation. At that time, world commodity prices plummeted, the Canadian dollar depreciated sharply and, in response to these price signals, production resources moved out of commodities into manufacturing. And so we saw a period of exceptionally strong growth in output, exports, and employment in the manufacturing sector. How are sectoral developments affecting regional economic growth in the current environment? Because of the differing industrial bases of Canadian regions, the effects of the recent sharp movements in relative prices are playing out differently across the country. The energy-producing provinces of Western Canada are certainly benefiting from higher prices for raw materials and from surging oil and gas revenues. The result is increased profits and investment, strong growth in output and employment, and fiscal surpluses. But the sudden rapid economic expansion is straining the region's infrastructure. And it is creating labour shortages, not just in the energy sector but also in mining, manufacturing, and construction--all of which are competing for the same pool of labour, especially skilled labour. Certain professions (notably accountants, engineers, and project managers) are also in short supply. Other parts of Canada with a significant resource-production base, including New Brunswick and Atlantic Canada more generally, are also benefiting from high commodity prices. For example, the construction this spring of a liquid natural gas (LNG) plant, right here in Saint John, has been spurred by high demand and prices for energy. As the largest producer of zinc and lead in Canada, this province is also benefiting from surging prices for these minerals. But in Central Canada and in those parts of New Brunswick where there is a concentration of manufacturing activity, overall economic performance has not been as strong. Since manufacturers export a good part of their production, the appreciation of the Canadian dollar and rising energy costs have reduced their competitiveness. Reduced profitability and declining employment in the manufacturing sector are a reflection of this. Several traditional industries, such as the fishery and forestry, have also been affected because of increased global competition, low selling prices, and the higher Canadian dollar. But it is important to note that, at the same time, there has been relatively broad-based strength across Canada in those sectors that are catering to robust domestic demand. For many firms and individuals, adapting to global change has been difficult and, in some cases, painful. All of us understand the challenges they face. Encouragingly, evidence from the Bank's quarterly surveys confirms that across Canada businesses have been responding to the new global economic realities. Some have chosen to import more inputs and finished goods from lower-cost suppliers in Asia. Others have moved away from products and markets with low profitability towards those that are likely to yield higher profit margins. And firms have been investing in machinery and equipment to increase their productivity. Moreover, our latest suggests that companies continue to be positive about the economic outlook, and that investment and hiring intentions remain firm across regions and sectors. But what about macroeconomic policies--how can they contribute to the adjustment process? Monetary policy, which is the responsibility of the Bank of Canada, is in nature and scope. This means that we need to look at what is happening across Canada, add it all up, and gear monetary policy to the needs of the entire country. In this sense, the best contribution that monetary policy can make to the adjustment is by aiming to keep inflation at 2 per cent and the national economy operating close to its production capacity over the medium term. When inflation is low and stable, businesses can read price signals more clearly, which helps them to make sound economic decisions. This is particularly important during times of rapid change, such as at present. And when the economy is operating at capacity, production resources can be reallocated more effectively from sectors where demand is weak to those where demand is relatively strong. Prudent federal and provincial fiscal policies, focused on keeping government budgets sustainable and balanced over the longer run, are also important to preserve investor confidence in Canada and to help keep interest rates relatively low and stable. All in all, sound monetary and fiscal policies go hand in hand in providing a stable macroeconomic environment that can facilitate the required adjustments. Let me now summarize the Bank's latest outlook for the economy and inflation, which we discuss in greater detail in our January that we published last week. In the , we note that the Canadian and world economies have been evolving in line with our expectations and that the outlook for growth and inflation in Canada is similar to that in our October . We also point out that the Canadian economy continues to adjust to global developments and to the associated changes in relative prices. As I said at the beginning, world economic growth will remain robust--around 4 per cent this year and next. Against this backdrop, our assessment is that the Canadian economy as a whole is currently operating at its production capacity. And we expect it to keep on growing roughly in line with its production potential through 2007. Specifically, we project annual average growth of 3.1 per cent this year and 2.9 per cent in 2007. For New Brunswick, we are looking for a slight pickup in growth in 2006-07--to about 2 3/4 per cent from 2 1/2 per cent in 2005--mainly boosted by investment projects such as the LNG facility I mentioned earlier. Total CPI inflation for all of Canada, which was at 2.3 per cent in the fourth quarter of 2005, will continue to reflect changes in the prices of crude oil and natural gas. But it should return to the 2 per cent target by the first half of 2007. So should core inflation which, in the closing months of 2005, was at 1.6 per cent. As always, there are both upside and downside risks to our projections. For 2006, the risks relate to the world economic outlook and the adjustment of our economy to global developments. These risks appear to be balanced. But through 2007 and beyond, the risks are tilted to the downside as the unwinding of global imbalances could involve a slowdown in world economic activity. With our economy operating at capacity and expected to grow roughly at potential through the projection period, on 24 January we raised the policy interest rate by another 25 basis points to 3 1/2 per cent. And we indicated that, in line with our base-case projection and current assessment of risks, some modest further increase in the policy interest rate would be required to keep aggregate supply and demand in balance and inflation on target over the medium term. Let me conclude by summarizing my key points. First, because our economy is very open to world trade and finance, we need to recognize today's global economic realities and to have the flexibility to adjust accordingly. Second, sound economic policies have a critical role to play in facilitating the necessary adjustments. Such policies include, importantly, a monetary policy aimed at keeping inflation low, stable, and predictable--to which the Bank of Canada is fully committed. Third, based on our history, there is every reason to believe that Canadian businesses and workers will rise to the current challenges and make the necessary adjustments to take advantage of the opportunities presented by an evolving and expanding global economy.

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Global Imbalances and the Canadian Economy

dodge

Canada and Barbados may not have much in common in terms of climate, but we both have very open economies. So we both rely on good economic performance globally for good performance domestically. Recently, the global economy has been delivering that performance, and is expected to record real growth of about 4 per cent or better through 2007. It would be nice to think that this solid growth could endure forever. However, we all know that the global economy is subject to a number of risks, and policy-makers in international forums spend a lot of time thinking about how best to handle those risks. Most recently, discussions have focused on two major issues that are partly related to the rise to prominence of China and other Asian economies. One is that world oil markets remain very tight, and a further increase in oil prices remains a possibility. The other issue relates to the global economic and financial imbalances that we now see, and the way in which they will be resolved. Today, I want to spend some time discussing these imbalances and how they might be resolved. Then I'll say a few words about the state of the Canadian economy before turning to you for questions and discussion. I should start with a definition. When I say "global imbalances," I am referring to the large and persistent current account deficit in the United States that is mirrored by large current account surpluses elsewhere, especially in Asia and in many oil-exporting countries. Given that Canada and Barbados depend on international trade and global financial stability for economic growth, we both have a major stake in seeing that global imbalances are resolved in an orderly way. There has been much written and spoken commentary on the causes of these imbalances. But at the Bank of Canada, we see them as reflecting the financial flows associated with mismatches in savings and investment within major regions of the global economy. Since the latter part of the 1990s, many economies outside the United States have, for various reasons, increased their national savings by a very large amount. At the same time, the United States has reduced its savings and has become increasingly reliant on foreign borrowing. Is this a problem? So far, no. Global financial markets--in which many of you are involved--have done a good job of matching international savings flows with investment opportunities. International capital flows are the lifeblood of the global economy. However, the sheer size of these financial flows into the United States is not sustainable indefinitely. We know that U.S. external indebtedness--even with that country's reserve-currency status--cannot keep growing forever. This is especially so given that this borrowing is being used mainly to finance current consumption. We also know that in many places outside the United States--particularly in Asia and in many oil-exporting countries--households currently want to save more than businesses want to invest. At the same time, desired national savings in the United States are not sufficient to meet desired investment, although it is not certain that this situation will persist. Eventually, domestic savings in the United States will have to increase. Should that occur suddenly, we could see global economic growth slow sharply, unless there was corresponding growth in domestic demand outside the United States. Such a slowdown in growth, in turn, raises the risk that policy-makers might resort to protectionism. In that event, a period of very slow growth could, perhaps, be punctuated by periods of outright recession. I hasten to add that this is a prediction on my part. I am only saying that such an outcome could be the consequence of inappropriate policies in many economies. And this outcome would hurt all countries, including those that are following appropriate policies. Global imbalances are a global problem, and we need to think about them collectively. So how can we achieve their orderly resolution? Let me spend a few minutes talking about what is needed, both domestically and internationally, to help resolve the imbalances. One of the keys to changing the flows of global savings and investment is for each country to follow policies that have the best chance of achieving sustained growth in the medium term. The best way to ensure that global demand continues to grow over time is for policy-makers to provide an environment that gives households the confidence to spend and businesses the confidence to invest. If all countries were to follow appropriate domestic policies, this would go a long way towards defusing the danger posed by global imbalances. Specifically, in terms of fiscal policy, there is a clear need for countries to focus on having a sustainable ratio of public debt to GDP. This would give confidence to businesses and consumers that the value of their money will not be eroded over time, either by high inflation or by excessive taxation. Where a sustainable public debt-to-GDP ratio is now absent, it should be achieved; where it is present, it should be maintained. The second point is that authorities everywhere need to ensure that domestic policies are promoting well-functioning markets for goods, services, capital, and labour. In particular, labour markets need to be flexible enough to facilitate the movement of workers from sector to sector as the economy adjusts to events. By promoting domestic flexibility, policy-makers in all countries could support confidence and boost growth. This would be good for national economies, and it would also help to resolve global imbalances. There is also a need for policy-makers to recognize the positive role played by a well-functioning social safety net. Here, I am referring to unemployment insurance, public health care, and public pension systems. Consider the countries of emerging Asia, where such systems are lacking. Citizens in those countries need very high levels of savings to mitigate the risk of job loss and illness, and to provide for the years after they leave the workforce. An effective and efficient social safety net pools risk, so that citizens can have increased confidence about the future and reduce their need for precautionary savings. I know that the Chinese authorities that we at the Bank deal with are well aware of the need to create a well-functioning social safety net. Authorities everywhere also need to follow policies that help a country's financial system to work well. This is critical if the financial system is to carry out its vital role of helping to match savings with productive investments. The financial system can also support confidence by giving households and businesses appropriate access to credit. I know all of you in this room are well aware of the importance of a well-functioning financial system, so I don't need to belabour the point. But I would add that, in terms of supporting confidence, appropriate monetary policy is also critical. It is important that central banks follow policies that anchor inflation expectations and thus promote confidence in the future value of money. Having spoken about what policy-makers can do domestically, let me now turn to international issues. Essentially, the global economy needs a commitment by all countries to a renewed international monetary order, and a willingness to play by accepted rules within this order. Let me explain what I mean. Around the end of World War II, the developed countries came together and reached a series of agreements. They agreed to establish a monetary order based on fixed exchange rates, together with a process to realign exchange rates in the event of fundamental imbalances. Important institutions, such as the International Monetary Fund, the World Bank, and the General Agreement on Tariffs and Trade, were also established. But since the 1970s, many economies have adopted flexible exchange rate regimes. In general, these regimes have been able to coexist with fixed exchange rate regimes, and to do so relatively well in a world of open capital markets. However, the success of this coexistence has depended on countries following "the rules of the game" appropriate to the exchange rate regime they have chosen. What do I mean by "the rules of the game"? For countries with a flexible exchange rate, this means that authorities should actually let their currency float freely. And for countries with a fixed exchange rate, this means that authorities need to run appropriate policies in order for the fixed exchange rate to be sustainable. In particular, countries with a fixed exchange rate and a current account surplus should not "sterilize" the foreign exchange interventions required to fix the value of their currency. By "sterilize," I mean offsetting the effect of interventions on the domestic money supply. Recently, problems have arisen from countries not playing by the rules of the game. Certain Asian economies have been stifling the inflationary effects of their interventions and, in the process, building up massive amounts of foreign reserves. When countries offset the effects of intervention, they delay domestic economic adjustment. They also delay global adjustment. Just as worrying is the fact that such intervention is provoking threats of protectionist measures in certain political quarters. Such wrong-headed measures could choke off the growth of international trade that has led to rising incomes worldwide. What is needed today is a renewal of the international monetary order and of the spirit of international co-operation that led to the original agreements. The global economy has changed enormously since the end of World War II. But the danger posed by global imbalances is a clear reminder that there is still a need for a coherent international monetary order--and a need for countries to play by the rules. In this context, it is also very important that all countries work to protect and enhance the free flow of goods and services by finding a way to break the stalemate at the Doha round of trade talks and by strengthening the World Trade Organization. We all need to support these efforts and to be vocal in resisting calls for protectionism. Having set out this global context, let me now turn to how Canada fits into the picture. As I said at the outset, like Barbados, Canada has a very open economy, so how we deal with the current challenges is crucial to our economic health. We have been following policies that allow the Canadian economy to adjust to global developments. Let me say a few words here about my own area, which is monetary policy. Canada's monetary policy consists of an inflation-targeting system, backed by a freely floating exchange rate. We aim to keep inflation at 2 per cent, the midpoint of a 1 to 3 per cent target range. Under this regime, not only has inflation in Canada remained near the target in recent years, but inflation expectations are now anchored near 2 per cent. As a result, market signals are sent and received more clearly, and Canadian businesses and consumers are more confident about the future value of their money. A critical feature of our inflation-targeting system is that we operate around our target. This means that we care just as much about inflation falling below target as we do about inflation rising above it. This symmetric approach helps keep the Canadian economy near its production potential, thus encouraging strong, sustained growth in output and employment. Another feature of our monetary policy is that we aim to be transparent. At the Bank of Canada, we believe that monetary policy is more effective when people understand what we are doing and why we are doing it. We publish regular reports and updates about our monetary policy. In the most recent , published on 26 January, we noted that the Canadian economy continues to adjust to global developments and to the associated changes in relative prices. As I said at the beginning, global economic growth is expected to remain robust--around 4 per cent this year and next. Against this backdrop, we continue to judge that the Canadian economy as a whole is currently operating at its production capacity. And we expect it to keep on growing roughly in line with its production potential through 2007. Specifically, we project annual average growth of 3.1 per cent this year and 2.9 per cent in 2007. Total consumer price inflation, which was at 2.3 per cent in the fourth quarter of 2005, has been and will continue to be affected by changes in the prices of crude oil and natural gas. Assuming that energy prices evolve in line with the prices reflected in futures markets, we expect total inflation to return to the 2 per cent target by the first half of 2007. The same is true of core inflation which, in the closing months of 2005, was at 1.6 per cent. With the Canadian economy operating at capacity and expected to grow at potential through the projection period, on 24 January we raised our policy interest rate by 25 basis points, bringing it to 3 1/2 per cent. And we indicated that, in line with our base-case projection and our current assessment of risks, some modest further increase in the policy interest rate would be needed to keep aggregate supply and demand in balance and inflation on target over the medium term. It is important to keep in mind that there are, as always, both upside and downside risks to our projections. For 2006, these risks appear to be balanced. But through 2007 and beyond, the risks are tilted to the downside because, as I have said, the unwinding of global imbalances could involve a slowdown in world economic activity. Let me conclude. Global imbalances are a global problem, and their resolution requires a global effort. Every country has a role to play in this effort. And while the specific policy measures will vary from country to country, there are common principles that policy-makers everywhere should follow. These include the adoption of appropriate fiscal policies, the promotion of well-functioning labour and product markets, the provision of a well-functioning social safety net, policies that allow for an efficient and sound financial system, and a monetary policy focused on low, stable, and predictable inflation. We also need a commitment by all countries to a renewed international monetary order and a willingness to play by the rules of the game. This does not represent a new prescription for global economic health. But the need for urgent action has increased. Imbalances are persisting, and if they aren't resolved in an orderly way, we face the threat of great disruption. That is particularly true for countries with very open economies such as Canada and Barbados. An orderly resolution of imbalances is in all of our interests.

r060309a_BOC

canada

Renewing the IMF: Some Lessons from Modern Central Banking

macklem

Philadelphia, and I'm grateful for the opportunity to speak to the Global Interdependence Center. Your group aims to foster dialogue "on the challenges and opportunities arising from our increasingly interdependent global civilization." The globalized economy has indeed generated tremendous opportunities to create wealth and to raise living standards. But as opportunities have arisen, so too have challenges. As economies have become more interconnected through trade and financial flows in a truly global marketplace, economic developments in one location can quickly have repercussions on the other side of the globe. In 1997, what began as a currency devaluation in Thailand became a crisis with repercussions not just in Asia, but in countries as far away as Russia, Brazil, and Canada. So, the challenge we face is to find the best ways to reap the economic benefits of globalization while minimizing the risks of disruption. Today, I'd like to discuss how the International Monetary Fund (IMF) can do its part to meet this challenge. The IMF was created some 60 years ago to oversee the global monetary system in an era of fixed exchange rates. But the world has changed dramatically in 60 years. Most major currencies have been allowed to float. Financial markets are much larger, much more sophisticated, and vastly more integrated than they were 20 years ago, let alone in the 1940s. Trade has expanded enormously, and major new players have entered the global trading network. The IMF has responded to new challenges with professionalism. It's taken on new responsibilities and developed new expertise. Yet concerns have arisen that the Fund has not kept pace with the changes in the global economy. After 60 years, it's time to take a fundamental look at the role of the Fund in the global economy. Under Managing Director Rodrigo de Rato, the IMF has launched a strategic review of its role and activities. This is the opportunity to consider what kind of a Fund we need to meet the challenges of the global economy in the 21st century. But to do this right, we must be ambitious. I'm also pleased to be part of your "Central Banking Series" of speakers, because central banks can bring a valuable perspective to the discussion. Central banks have a large stake in a sound international monetary order, and thus have a profound interest in the IMF. And central banks have had to adapt to the same forces in the global economy that have affected the IMF: the collapse of fixed exchange rates, the expansion of private capital flows, the evolution of financial markets, and so on. What I propose to do today is discuss how the Bank of Canada and other central banks have evolved in response to these changing circumstances. Then I'll outline how the lessons central banks have learned can be distilled into four key principles. I'll conclude by offering some thoughts on how these same principles could prove useful as we consider the IMF of the future. For good reasons, Canada returned to a floating exchange rate in 1970. With the collapse of the Bretton Woods system of fixed exchange rates shortly thereafter, other major industrialized countries followed Canada's lead. Unfortunately, the Bank of Canada, like many other central banks, did not take full advantage of the monetary independence that comes with having a flexible exchange rate. Without the anchor of a fixed exchange rate, and with no other monetary anchor in its place, Canada, like many other countries, suffered the effects of high inflation in the 1970s. Inflation reduced the ability of the price system to allocate economic resources efficiently; savings and investment decisions were distorted; and the economy went through boom and bust cycles. Central banks, including the Bank of Canada, struggled with this problem, and from this bitter experience came a search for the right anchor. We, and others, experimented with monetary aggregates as intermediate targets. But deregulation and financial innovation weakened the reliability of money measures, and the relationship between money growth and inflation proved to be unstable. By the end of the 1980s, it became clear that price stability should be the Bank of Canada's pre-eminent objective, and that we should aim more directly at achieving it. In 1991, Canada took the bold step of formalizing this objective with an explicit inflation target. Our inflation-target objective, which is established jointly with the Government of Canada, aims to keep inflation at the 2 per cent midpoint of a 1 to 3 per cent target range. The target has proven to be a very effective anchor. Inflation has been low and stable, and we've experienced solid growth in output and employment. Canada was the second major country to adopt an inflation target. Today more than 20 countries have such targets. In other words, there's a good deal of international experience with inflation targeting. As in Canada, this experience has been very positive: inflation targeting, working in tandem with a floating exchange rate, has generally resulted in low inflation and sustained economic growth. Stepping back, and looking beyond these positive results, we can distinguish four key characteristics of a credible and effective monetary policy framework: clear objectives and effective tools; legitimacy; the effective use of markets; and transparency and accountability. Let me say a few words about each of these in turn. . The Bank of Canada's monetary policy has one clear objective--to keep inflation at 2 per cent. And it has one instrument with which to get the job done--the target for the overnight interest rate. . The inflation target is not just the Bank of Canada's target, but also the government's. This adds legitimacy to the monetary policy objective, thereby strengthening it. But legitimacy also comes from our experience of low inflation and good economic outcomes, with the result that there is now broad support among Canadians for anchoring monetary policy to a low inflation target. Third, monetary policy works best when it is . We learned some valuable lessons in the 1970s. We learned that direct controls on wages and prices do not work beyond the short run, and that they introduce a myriad of distortions, which reduce market efficiency. We also learned that direct controls on credit expansion are difficult to calibrate and enforce. They also reduce the efficiency of the financial system as it allocates resources in the economy. Today, monetary policy is implemented entirely through financial markets. By controlling the overnight interest rate, monetary policy influences interest rates along the yield curve, as well as other asset prices. These, in turn, influence spending, and, ultimately, inflation. We have found that the transmission of monetary policy works most effectively when the central bank implements policy through markets, when it maintains a credible policy goal, and when it communicates its objectives and actions clearly. This leads me naturally to the fourth characteristic-- . One of the most important things we have learned with inflation targeting is that monetary policy works best when it is well understood. The explicit inflation target is the centrepiece of our communications on monetary policy--it helps to anchor inflation expectations, and it makes it easier for us to explain our actions, and for people to judge our performance. It provides a strong incentive for us to meet the objective and to be accountable. Taken together, these are the characteristics of effective, modern central banking. But I think that one can go further and say that these characteristics are useful that apply to the broader realm of public policy making. Let me now turn to the topic of IMF renewal, and talk about how these same principles can be applied to the task at hand. The place to start is for achieving those objectives. The IMF's first Article of Agreement states that it should "promote international monetary co-operation through a permanent institution which provides the machinery for consultation and collaboration on international monetary problems." In the globalized, market economy of the 21st century, what this really means is the . I hope that there's a broad consensus that this should be the objective of the IMF. I view the challenge facing the Fund as being how best to fulfill this objective. The main tool is surveillance. But surveillance needs to be more effective. This means two things. First, surveillance should be more multilateral, putting greater emphasis on the linkages between members, the spillover of one country's policy choices on other countries, and the joint risks that this implies. The reality is that in an increasingly globalized economy, our understanding of these linkages and spillovers is not as good as it should be. The Fund staff is an enormously talented group of men and women. We have to ensure that they undertake the research and analysis needed to understand the changing nature of global linkages. But understanding these linkages is not enough. We need a forum where risks are debated openly, frankly, and comprehensively by national policy-makers. In turn, this implies less emphasis on bilateral communication between the IMF and a given country and more multilateral discussions among countries, supported by the IMF. Making surveillance more effective also means strengthening the analysis of the linkages between the financial sector and the real economy. In recent years, the Fund has devoted considerable energy to developing sound standards and codes for assessing the financial infrastructure of its member countries. This financial sector surveillance needs to be better integrated into IMF country reviews. This will allow potential risks to be identified earlier so that authorities can address any problems, rather than calling on the Fund for financial assistance in the midst of a crisis. Achieving this integration may require re-thinking the Fund's internal structure to ensure that all facets of its work feed effectively into its surveillance and provide sound analysis of the interaction of economic and financial developments and risks, both within and between countries. Let me now turn to the second key principle-- . The Fund's effectiveness, and hence its ability to promote global financial stability, is what ultimately gives it legitimacy and credibility. At the same time, its effectiveness depends on its legitimacy as a truly global institution, and on a shared sense of trust and responsibility among its members. Global issues can't be effectively addressed if key players feel that they don't have an adequate voice as IMF members. In this respect, it is clear that important aspects of the Fund's governance arrangements have not kept pace with changes in the global economy. In particular, quotas and voting power at the Fund need to better reflect the growing power of Asian and other emerging-market economies. The issue of quota and voting power is complex and will persist for years to come, since Asia is likely to continue to grow faster than other major regions. This suggests the need for a comprehensive solution, and we should work towards this end. But we also need to be pragmatic. We need to make concrete progress on the quota issue in the short term to show that members are serious about aligning the representation of Asian members with their economic weight. Of course, with a larger voice comes greater responsibility. So let's be clear: a larger stake for Asian members implies that they should be prepared to shoulder their fair share of the responsibility for promoting global financial stability as part of the international monetary order. This brings me to the third principle-- . As I have already highlighted, the role of the Fund in the 21st century should be to promote financial stability by supporting a market-based international monetary order. This means that the IMF must work to ensure that the international financial infrastructure is sound, that countries pursue sustainable policies, and that incentives encourage the appropriate pricing of risk and the efficient allocation of resources. It also means that the IMF should play a more active role in establishing the "rules of the game," clear rules that support a market-based international monetary order. Consider exchange rates, for example. Tim Adams, the U.S. Treasury's Under Secretary for International Affairs, recently called on the IMF to demonstrate "strong leadership on multilateral exchange rate surveillance." Specifically, he called on the IMF to "improve its tools and advocacy to persuade countries to exit unsustainable exchange regimes early on, rather than waiting for perfect circumstances that never come." More broadly, I would suggest that the IMF needs to bring pressure to bear on national public policies that thwart adjustment. Delaying adjustment does not make the need for adjustment go away. It simply increases the risk that the adjustment--when it comes--will be abrupt and disorderly. A highly visible example of this risk is the issue of "global imbalances," which is shorthand for the large U.S. current account deficit that is mirrored by large surpluses in Asia and, increasingly, in major oil-exporting countries. If these imbalances are to be resolved in a way that is consistent with maximizing global growth, significant adjustments are required. Markets can lead these adjustments, but they need to be allowed to work effectively. This means letting real exchange rates adjust in countries with large current account surpluses, like China; reducing unsustainable fiscal deficits in the United States; and making labour markets more flexible in Europe. The IMF should play a lead role in bringing the right players together, facilitating discussion, and relying on markets to achieve the necessary adjustments. Markets should also play a greater role in crisis resolution. The Fund has been accused of doing too much "exceptional lending." Indeed, in some cases, this lending has delayed the needed actions and adjustments. Essentially, both sovereign borrowers and creditors wait to see if the Fund will put new money on the table. Strict implementation of exceptional access limits--that is, clear rules of the game for the Fund's own activities--would reduce the uncertainty associated with Fund lending and create incentives for creditors and lenders to negotiate when negative economic shocks render debt levels unsustainable. The Fund could facilitate these negotiations by offering its good offices to promote a timely, orderly restructuring of private claims. The Fund's effectiveness in this capacity depends critically, however, on its perceived independence. It will not be viewed as a disinterested adjudicator if it is also a major creditor. The Fund can reduce some of the uncertainty that impedes debt restructurings by providing independent analysis of the future growth prospects of the country concerned, advice on possible adjustment measures, and an assessment of the global economic and financial outlook. With this information at hand, creditors and debtors can then seek market-based solutions. The fourth and final characteristic is . I said earlier that the Fund needs to be clear about its main objectives and its policy framework. The IMF must also ensure that clear lines of responsibility within the organization support the framework. And it must be transparent about the reasons for its decisions. In other words, the Fund needs a governance structure that helps it achieve its goals and holds individuals accountable. Currently, decision-making responsibilities are divided among the Board of Governors, the Executive Board of Directors, and the Managing Director and staff. But the division of responsibilities among these groups is not, in practice, always clearly defined. Accountability is dispersed, and decision-making lacks transparency. The IMF would be more effective if the Executive Board focused on setting strategic direction, as well as ensuring that policies are sound and that objectives are met. The Managing Director would then be responsible for policy implementation, and be accountable to the Board. This framework would help to ensure that the responsibility for policy formulation and implementation was clear and borne appropriately by the members of the Board and the Managing Director, respectively. Toward this end, Bank of England Governor Mervyn King has recently suggested establishing a non-resident Executive Board that meets periodically, rather than almost continuously, and that focuses on strategic direction and oversight. Accountability and transparency of the Board's decision-making would also be enhanced with more frequent and more timely reporting. Finally, and very importantly, surveillance and analysis must be, and seen to be, independent of political influence. I'd like to conclude by underscoring a key point. The progress made by central banks in furthering the economic well-being of their citizens has largely been the result of determining the most appropriate objective--low and stable inflation--and determining how best to achieve it in a transparent and accountable fashion. For many central banks, this has meant inflation targeting. I've suggested that there are lessons here for the International Monetary Fund. A more effective IMF really does matter. In a world of floating exchange rates, large private capital flows, and liberalized trade, we need an effective forum in which the issues that shape the global economy can be discussed with candour and good will, and in which problems can be resolved. The IMF that forum. But it needs to become more legitimate, that is, more representative of an international economic community where all members share responsibility for promoting the common good of international financial stability. The IMF needs to operate with clear objectives; effective, market-based tools to achieve these objectives; and a governance framework that supports sound decision-making and accountability. The need for change is pressing. As the risks associated with global imbalances grow in importance, the IMF will be tested. I very much hope that a significantly more effective institution will emerge from the strategic review currently under way. If we can get it right, a more effective IMF will be central to maximizing the benefits of globalization. Indeed, the renewal of the International Monetary Fund is tremendously important, not just for Americans and Canadians, but for all nations in this increasingly interdependent world.

r060329a_BOC

canada

Global Imbalances: Why Worry? What to Do?

dodge

Today, I am going to discuss global current account imbalances--why we should worry about them, and what we can do to encourage their resolution. I will talk about the need to develop an international monetary system that supports market-based solutions to global imbalances and removes existing impediments to these market-based solutions. Before I discuss why we need to worry about global current account imbalances, let me first explain what I mean by "global imbalances." I am referring to the persistent and growing current account deficit in the United States, mirrored by large and growing current account surpluses elsewhere, especially in Asia. These imbalances reflect the financial flows associated with mismatches in savings and investment on a global scale. Since the late 1990s, many economies outside the United States have increased their net national savings. At the same time, the United States has further reduced its net national savings and has relied more heavily on foreign borrowing. Geographical imbalances are not a bad thing nor are the capital flows that they generate. Indeed, there should be a process that works through world markets to allow savers in one country to lend to borrowers in another. Such a process leads to higher global economic growth, since countries with surplus savings can invest them in countries that do not generate enough savings internally. In an ideal world, markets for goods, services, and capital function efficiently. Funds flow from areas with excess savings to areas with excess investment opportunities. In this ideal world, domestic labour markets operate without any barriers to the movements of workers. And there are no restrictions on the trade of goods and services or on the flow of capital across borders. Under these perfect circumstances, as economies evolve, we would expect to see shifts in the flows of savings into regions where investment opportunities are particularly strong and where markets are offering favourable returns. These flows would generate periods of current account surpluses or deficits, but these would not be a cause for worry, since adjustment mechanisms in the market would resolve them. And since our world economy is a closed one--Mars missions notwithstanding, we still don't export to other planets--we would see savings increase in one part of the world to offset increases in domestic demand elsewhere. In this ideal world where markets operate efficiently, without distorting policy interventions, imbalances can resolve themselves in a smooth and orderly manner. But we don't live in an ideal world. Domestic labour markets in Europe and Asia are not very flexible, and reallocation of labour resources is difficult. Domestic fiscal and social policies often stifle investment and encourage excessive savings in some parts of the world and overstimulate consumption in others. And there are still persistent impediments to the free flow of goods and services across borders. Meanwhile, some domestic banking sectors and capital markets continue to operate under rigid and inefficient regulations. And some important economies, particularly in Asia, are maintaining undervalued exchange rates through exchange market interventions and capital controls. In the process, they are accumulating excessive reserves. Because of these issues--inflexible labour markets, inappropriate fiscal policies, barriers to open trade, and dysfunctional capital markets--market-equilibrating mechanisms are not being allowed to work as they should. And so there are risks that these current account imbalances will persist until they are resolved in a disorderly way. Let me spend a few minutes outlining these risks. The first risk is that private and public savings in the United States will rise and that spending will decline without a compensating increase in demand in the rest of the world. If that drop in U.S. demand is not matched by higher demand in other countries, the global economy could slide into a phase of very slow growth, perhaps punctuated by periods of outright recession. A second risk is that investors could dramatically reduce their exposure to the United States, which could cause major disruption in world financial markets. Instability in the financial sector could spill over into trade in goods and services, leading to an even more dramatic decline in demand and output. A third risk is that these events might also prompt governments to adopt wrong-headed protectionist measures, which would exacerbate the damage to the global economy. Economic theory and history tell us that external indebtedness cannot keep growing indefinitely as a share of a country's GDP--even for a country like the United States with its reserve-currency status. There is no compelling reason to believe that historical and fundamental economic and financial constraints do not apply to the world economy today. There is no reason to believe that this time is different. There is every reason to believe that a market adjustment to these imbalances will take place. If this adjustment is disorderly, it would affect the economy through a sudden drop in demand and prices and a resulting decline in economic output. It could also cause a painful correction in capital markets and exchange rates. In a worst case scenario, it could do both. That is why we worry about the risks from current account imbalances, and why the Bank of Canada has been focusing on the implications of these risks. Policy-makers around the world have a responsibility to facilitate adjustments in a way that keeps the global economy growing at potential and mitigates the impact of these risks. Our job is to provide a framework that helps market forces promote an orderly adjustment. So what can we collectively do to help prevent a disorderly adjustment? What insurance can economic and financial policy-makers take against these risks? I said earlier that the resolution of global imbalances will require market-based solutions. In many cases, building the right framework will involve eliminating some of the policies that inhibit markets from resolving these imbalances. This was the theme of the G-7 discussions at Boca Raton two years ago. Let me briefly look back at what we called for in our statement following those meetings. Then I'll review what progress has been made. Central bankers and finance ministers emerged from the Boca Raton meetings with a list of policy initiatives that are key to addressing global current account imbalances. This list included five priorities: first, microeconomic policies that increase flexibility and raise productivity growth and employment; second, the development of well-functioning domestic capital and financial markets; third, resumption of the Doha round of multilateral trade negotiations; fourth, sound fiscal policies; and fifth, flexible exchange rates that reflect economic fundamentals and promote smooth adjustments. To deal with global current account imbalances in an orderly and efficient way that supports continued growth, we have to make progress on all five of these policy fronts. It simply won't do for countries to pick one or two of these policy priorities and ignore the others. And we can't delude ourselves into thinking that economic imbalances will be resolved in an orderly way through exchange rate adjustments alone. Progress has to be extensive, international, and simultaneous. Let's review our collective progress on these priorities in the two years since our meetings in Boca Raton. I'll start with domestic microeconomic policies. Domestic reform is important because if each country works to get its own house in order, we increase the odds of doing the same on an international scale. In well-functioning domestic economies, savings flow across sectors and regions without much risk of disruption, because market-based mechanisms--such as changes in relative wages and prices--are allowed to work. Authorities everywhere need domestic policies that promote well-functioning markets for goods, services, capital, and labour. In particular, labour markets need to be flexible enough to facilitate the movement of workers from sector to sector as the economy adjusts to events. If they are not, confidence is undermined: businesses hesitate to hire when labour market rules are restrictive, and households lack the confidence to spend when unemployment rates are high. By promoting domestic flexibility, policy-makers everywhere could support confidence and boost growth. This would be good for national economies, and it would also help to resolve global imbalances over time, provided that macroeconomic policies can smooth demand in the short run. Since Boca Raton, we have seen some efforts to increase flexibility in some regions, but progress has been minimal. This is understandable because, politically, measures to increase the flexibility of labour markets can be very difficult. But labour market rigidities, particularly in Europe and Japan, remain significant barriers to adjustment. The second policy priority is the development of domestic capital and financial markets. The goal is to have markets that are not distorted by capital controls and other interventionist policies. It is important that Asian policy-makers let their domestic financial systems do their job. We must acknowledge the difficulty and the time that this will take. And we should acknowledge that progress has been made in the banking and financial systems of several countries since the Asian crisis of 1997-98. But even with that progress, it will still be some time before markets in that region are functioning at their optimal efficiency. And it will be some time before households in Asia have sufficient and appropriate incentives to reduce savings and increase their consumption. This is not just an Asian problem. Europe, too, has a long way to go before it can establish a single euro capital market, let alone one that is open beyond the boundaries of that region. And I note, with some dismay, the rising economic nationalism with respect to foreign direct investment, not just in Asia and Europe, but in the United States as well. The third priority we outlined in Boca Raton was resumption of the Doha round of multilateral trade negotiations. It is critical that all countries work to protect and enhance the free flow of goods and services by pushing the Doha round to a successful conclusion and by strengthening the World Trade Organization to ensure proper compliance with the rules of trade. All of us need to be vocal in resisting calls for protectionism. Yet, two years after Boca Raton, progress on trade appears to be stalled. Protectionism is a real and rising threat, and we see mounting restrictions on the flow of capital. Instead of more openness in trade and investment, we see signs of increasing insularity. Our fourth priority was sound fiscal policy over the medium term. Countries should pursue policies that promote sustainable levels of household and government consumption and a low ratio of public debt to GDP. And while we didn't discuss monetary policy goals in the Boca Raton communique, we all recognize that prudent fiscal policy works best when it is combined with monetary policy that promotes low and stable inflation. Such policies give businesses and consumers confidence that the value of their money will not be eroded over time by high inflation or excessive rates of taxation. Sound fiscal and monetary policies are needed in the United States, Europe, and Japan to support investor and household confidence. Fiscal consolidation in the United States would also be helpful in resolving global imbalances. The fifth priority is a policy of more flexible exchange rates that reflect economic fundamentals and promote smooth adjustments. Given the fact that labour markets are still fairly inflexible and that wages and prices are slow to absorb shocks, a floating exchange rate is an important adjustment mechanism for many economies, including Canada's. A market-based exchange rate can be a useful "shock absorber," helping the economy to react to external swings in demand more efficiently than a fixed exchange rate. Some Asian economies have pursued an export-led growth strategy by fixing the value of their currencies to the U.S. dollar through persistent, sterilized, foreign exchange market intervention. This has resulted in an accumulation of excessive foreign exchange reserves and has exacerbated global imbalances. In theory, there is nothing wrong with countries having fixed nominal exchange rates. But in practice, this leads to major problems, because real rates do have to adjust to external shocks. The first problem is that under a fixed rate regime, the economy must adjust to these shocks through sharp changes in domestic prices. This means that countries with current account surpluses should experience high rates of domestic credit expansion, leading to high inflation. But when authorities use sterilization policies to try to offset the domestic price effects of their foreign exchange intervention, they delay both domestic and global economic adjustment. Such intervention also provokes threats of protectionist measures, which could choke off the growth of international trade that has led to rising incomes worldwide. It was these kinds of "beggar-thy-neighbour" policies that we were seeking to avoid 60 years ago, when developed countries came together for the United Nations Monetary and Financial Conference at Bretton Woods, New Hampshire. Increasing exchange rate flexibility is perhaps the most important of the five policy priorities that I have outlined today. But as I said before, the orderly resolution of global imbalances will require progress on all five policy fronts. The reward for such reform is better access to a growing world market. The gains for the citizens of emerging-market countries are more flexible economies, higher real incomes, and better living standards. These and other reforms to resolve global imbalances can be achieved more easily if we also reform the financial institutions that oversee the world economy. I mentioned the Bretton Woods conference 60 years ago that created an international monetary order to help repair the damage of the Great Depression and the Second World War. Today, we must get on with the job of building an international monetary order for the 21st century--one that encourages market-based solutions to global imbalances. To achieve these solutions, we need a framework that can manage a world where open economies interact with economies whose markets are not yet allowed to operate freely. We must accommodate the fact that some systemically important economies, including China, still prefer the stability of a fixed or quasi-fixed exchange rate regime. We need rules that will allow market signals to come through and market forces to work during what could be a lengthy period of coexisting fixed and floating exchange rate systems. To build that framework and develop these rules, we need an international table around which we can all gather, and an institution to manage the development and the continued success of that framework. That institution should be the International Monetary Fund, but an IMF that is revitalized and is more representative of the global economy in the 21st century. A renewed IMF could use its surveillance to be more forthright in terms of the policy outcomes that are implied by different regimes. It could and should be the umpire for the world economic order, unafraid to call out countries that aren't playing by the rules. It could provide the support for the market to work at peak efficiency, monitor risks, provide necessary early warnings, and help to correct vulnerabilities before they become crises. In short, a renewed IMF could help us move towards a well-functioning, market-based international financial system in which markets would provide incentives that would lead to an orderly resolution of global imbalances. I'll have more to say on this tomorrow in a lecture at Princeton University. Let me conclude. We are all part of the global economy. A major economic disruption, such as a disorderly resolution of global imbalances, will affect every country. Collective action is needed now to minimize the chances of such a disruption. Domestically, policy-makers need to promote well-functioning markets for goods, services, capital, and labour. Internationally, policy-makers need to develop a framework that allows an orderly, market-based unwinding of global imbalances. It is not realistic to suggest that overnight we can build the ideal market that I described at the beginning of my remarks. We don't need to create a perfect world. But we do need to make progress--real progress on better-functioning financial markets, more flexible currency regimes, more open international trade, and better fiscal and structural policies. Each country and each region has its work to do. Now is the time for all of us to get on with the job.

r060330a_BOC

canada

The Evolving International Monetary Order and the Need for an Evolving IMF

dodge

Yesterday, I was in New York City, where I had the opportunity to talk to the New York Association of Business Economics about global current account imbalances, and about the pressing need to allow market-based mechanisms to resolve these imbalances. Most of dealt with what policy-makers should do to allow market-based mechanisms to work. But at the end of my speech, I mentioned that there is also an important international aspect to this issue. The world needs an international institution to promote a new monetary order--a well-functioning, market-based global financial system. This will be the subject of my remarks today. used his column to pose an interesting question: If the International Monetary Fund did not exist, would we invent it? His answer, if I may oversimplify, was no, because today's world does not have the courage and vision to create powerful multilateral institutions. I'm not sure that I agree with his answer or with his reasoning for it. But I am sure that this is exactly the kind of fundamental question we need to be asking. Today, I'd like to take a slightly different approach to Wolf's question. Let me put it this way: If the IMF did not exist and we set out to create it from scratch, what would be its fundamental role in the global economy? What should an ideal IMF do, and what should it not do? Some might suggest that these very questions are being asked and answered right now within the IMF, in the context of the internal strategic review initiated by Managing Director Rodrigo de Rato. Mr. de Rato is to be commended for taking on this task. The Executive Board of the IMF will discuss the internal review next week. But it seems to me that the review, while important and useful, has been focused on finding better ways for the existing institution to do what it already does. I want to approach this issue from a more basic level and ask what is required for the IMF to evolve into the best possible institution, designed for the global economy of the 21st century. For that evolution to take place, the key shareholders of the institution need to show leadership and vision. To set the stage for my remarks today, I will briefly review how and why the current IMF came into being, and then I will consider how the global economy has evolved since the founding of the IMF. I will next elaborate on what I see as the fundamental role for the IMF in today's global economy, and then discuss the changes that would need to take place in order for the institution of today to evolve into the "ideal" IMF. I hope that my remarks will then lead to a vigorous discussion in the time remaining. So let me begin by going back 60 years to the original United Nations Monetary and Financial Conference at Bretton Woods, New Hampshire. The delegates--representing 45 nations--were nothing if not ambitious. They ended up creating two, almost three, international institutions. There was the International Bank for Reconstruction and Development--now known as the World Bank--charged with providing aid for the rebuilding of Europe. Delegates also came close to creating the International Trade Organization, which was to be dedicated to keeping protectionism in check and facilitating freer international trade in goods and services. This organization eventually came into being a couple of years later as the General Agreement on Tariffs and Trade, which subsequently morphed into the World Trade Organization. And, of course, the third institution was the International Monetary Fund. The IMF was meant to create an international monetary order that would allow trade to flourish again and post-war reconstruction to take place. The institution that these delegates created was very much a creature of its time, and its roles and responsibilities reflected the experience of the Great Depression. The great policy failure of the 1930s was the competitive "beggar-thy-neighbour" currency devaluations to which nations resorted. The Bretton Woods delegates sought to prevent countries from adopting such policies. The first of the Articles of Agreement that govern the IMF called on it "to promote international monetary co-operation through a permanent institution which provides the machinery for consultation and collaboration on international monetary problems." Exchange rates were to be fixed, and were to be adjusted only in the case of "fundamental disequilibrium." The delegates also correctly identified liberalized trade in goods and services and the development of economic specialization as crucial for the creation of wealth. Permeating the Bretton Woods conference was a vital sense of co-operation, identified as the "spirit of internationalism" by Raghuram Rajan, the current Director of the IMF's Research Department in a recent lecture. The Bretton Woods delegates were able to see how their own country's interest was clearly wrapped up in a collective interest. All represented nations understood that their own countries might sometimes need to shun politically expedient policies and, instead, "play by the rules of the game," thus promoting the common good of a well-functioning international monetary and financial order. Delegates also saw that the Fund could act as an impartial arbiter or umpire to call out countries that violated the rules by pursuing policies that impeded the free flow of goods and services. The prime focus of delegates was to encourage trade flows, rather than to rebuild or develop international capital markets. This is understandable when you recall that as a legacy of World War II, governments controlled international capital flows tightly, and private capital flows were a tiny fraction of what they are today. Capital controls were symptomatic of the enormous faith that delegates had in the power of the state to direct economic activity and to control economic variables, including the correct exchange rate values among the world's major currencies. The controls were also symptomatic of the fact that outside the United States, capital markets had either atrophied because of the war, or simply were not yet well developed. Because of the stresses brought on by the war, the allocation of capital was much more state directed than market directed. These controls stayed in place for some years after the war, persisting longer in Europe than they did in the United States or Canada. The Bretton Woods system of fixed exchange rates did not work all that smoothly, and its framework led to several crises along the way. During the quarter century that the system operated, Canada developed a reputation as the "bad boy" of the international financial system when we "temporarily" opted out of Bretton Woods in 1950. By that time, strong capital inflows into our resource sector, as well as sharply higher commodity prices, led to upward pressure on the Canadian dollar. In addition, there were speculative short-term capital inflows, which added to the pressure on the currency. To maintain the fixed exchange rate, Canadian authorities first intervened on a massive scale. Foreign exchange reserves rose by 40 per cent in less than three months, and the money supply grew rapidly at a time when the domestic economy was already operating at capacity. Ultimately, Canadian authorities decided that the best way to resolve these emerging imbalances was to let the Canadian dollar float. The alternative would have been higher inflation. One of the key lessons the Canadian authorities learned was that in an open economy, a market-based floating exchange rate was not at all incompatible with the goal of free international markets for goods and services. Indeed, we came to realize that allowing the relative price of the currency to be set in the market meant that we could concentrate on conducting monetary policy in our own best interest, rather than being preoccupied with aiming for balance in our external current account. In a rapidly changing global economy, it did not make sense to assume that the "correct" exchange rate could ever be known in advance. And even if the correct exchange rate could be identified at a point in time, the economic situation would soon change, and the level of the pegged exchange rate would no longer be appropriate. A market-based exchange rate proved to be useful as a "shock absorber," helping the economy react to shocks more efficiently than a fixed exchange rate. In 1971, the Bretton Woods system collapsed. Domestic capital markets in many countries had been restored and modernized. As well, there was recognition by some major industrialized economies that the Bretton Woods paradigm wasn't working. But the alternative was not yet clear. Just as central banks around the world spent much of the 1970s and 1980s searching for a monetary policy anchor, much time was spent searching for a new framework for the international financial system. By the 1990s, policy-makers--particularly in the OECD countries--started to come around to the idea that a framework of market-based policies was best both for national economies and for the global economy. This shift in paradigm, from the distrust of markets to the primacy of markets, set the stage for the rise of economic globalization. If we held a new Bretton Woods Conference today, it is clear that delegates would design a different IMF, because both attitudes and circumstances are fundamentally different than they were at the end of World War II. International trade flows now constitute a much greater share of most countries' GDP. The transfers of goods, services, and technology, and the existence of supply chains across national borders, have brought enormous benefits in terms of growth and efficiency. As well, financial markets have become vastly larger and deeper--in economists' words, more complete. Private capital flows are now dominant, dwarfing the size of official flows. Today, we need an international monetary order that does more than just facilitate trade. We need a system predicated on the idea that markets--not just for goods and services but also for capital--need to be free and open. And so let me now go back to my original question: What should the fundamental role of the IMF be in today's economy? The answer is that the role of the IMF must be . By "well-functioning," I mean a financial system that is both efficient and stable, so that markets can do their job in allocating savings to investments through the pricing of capital, and in smoothing economic adjustments through movements in relative prices. Sixty years after the original Bretton Woods conference, now is the time for policy-makers to agree once again on the fundamental objective of the IMF. We need to agree that its role should be to promote a well-functioning, market-based, international financial system. We need to agree that the IMF should be the forum where we as shareholders collectively develop the appropriate framework--the rules of the game--to support the international financial system. And we need to agree that the IMF should be an independent, impartial umpire, ready to call out countries that are breaking the rules by imposing policies that distort trade flows, or policies that inhibit capital flows unnecessarily. What does this mean in concrete terms? Before getting into detail, there is a complication that we need to deal with. We live in a world where all industrialized economies now profess to accept the market-based paradigm for the international financial system. But today's global economy consists of more than just the industrialized economies. There are emerging-market countries that are systemically important. These countries, particularly China, have the clout to influence the entire world economy. So, in developing the appropriate framework for the international financial system, in setting out the rules of the game, we need to make sure that everyone is at the table. We also need to recognize that some emerging-market countries are, and have, just that: markets that are emerging. And so while the principle of a market-based international financial system should be accepted by all, we need to recognize that some economies are in transition, and that until their markets fully develop, the rules of the game need to take this into account. For example, the removal of capital controls needs to be done with proper sequencing. So, if we were to create the IMF from scratch today, we would want it to have as its ultimate objective the promotion of a well-functioning, market-based international financial system. But how should we turn that objective into concrete action? What would this ideal IMF actually do? How would it operate? And how would that differ from what the IMF does now? I will discuss four related issues here: surveillance, lending, representation, and governance. First, let me talk about how surveillance can support a market-based international financial system. There are several points to be made here. It is absolutely critical that surveillance take into account the growing interdependence of the global economy in order to maintain the stability of the international financial system. When policy errors in one country can lead to a financial crisis halfway around the world, we need to better understand the linkages between countries. Therefore, the IMF should use its surveillance, not just nationally but internationally, to identify externalities and potential policy spillovers. This would be invaluable in helping policy-makers to understand the implications of their actions. I am pleased to see that there has been progress in this area. Indeed, IMF staff have been working to develop GEM--the Global Economic Model--that can help to model spillover effects in the global economy. This work is tremendously valuable in that it provides authorities with a broader, multilateral perspective on their own policies. Policy-makers can see how their actions affect the global economy and, in turn, how these global repercussions will be felt back at home. This is a good start. But it is critical that greater emphasis be placed on this type of work in the future, to help us better identify spillovers. A few minutes ago, I said that the IMF should be the forum where shareholders gather to collectively develop the appropriate rules of the game. I also said that it should be an independent, impartial umpire, ready to call out countries that break the rules. In other words, the IMF should have a function and an function. IMF surveillance can, and must, do a better job of supporting both of these functions. Let me start with the so-called umpire role. This is one area where the IMF has consistently fallen short of the mark. Too often, surveillance has shied away from the "ruthless truth-telling" that Keynes--one of the main architects of Bretton Woods--called for. Instead of making the tough calls about the rules of the game, the IMF has sat in the umpire's chair and simply asked the players whether they thought that their shot was in or out. This needs to change. The IMF needs to be able to make calls impartially about whether countries are playing by market-based rules of the game. This would help policy-makers sitting around the table to decide what actions should come next. It would also help the market to apply the appropriate discipline to a country not playing by the rules. Like any good umpire, the IMF should apply the same judgment to players in the global economy. Much has been said about the way China and other countries continue to operate with a fixed exchange rate. I have previously argued that while greater exchange rate flexibility would be good for China, its citizens, and the global economy, the Chinese authorities must be allowed to choose the exchange rate regime they feel is best for them. But what the authorities should not do is frustrate market forces by thwarting the adjustment of real exchange rates through sterilization of their foreign exchange interventions. By "sterilization," I mean offsetting the effect of those interventions on the domestic money supply. Last month, U.S. Treasury Undersecretary Tim Adams called on the IMF to put more emphasis on exchange rates in its surveillance activities. I certainly agree that the IMF needs to put greater emphasis on the interdependencies in the system, and exchange rates are clearly a part of those interdependencies. But we have also seen examples of industrialized economies choosing to break the rules of the game. As I said yesterday in New York in the context of global imbalances, we now see examples of industrialized countries following policies that impede market forces--for example, restrictive labour policies in Europe. We have also seen unsustainable fiscal policies here in the United States. In Canada, we still have restrictions on foreign ownership of firms in certain sectors. And recently, we have seen legislators in the United States and Europe propose new restrictions on foreign investment flows. Again, the IMF as umpire should not shy away from making tough calls whenever they see the rules being violated, be it with respect to trade, capital flows, or other policies that distort financial markets. Making these calls loudly and forcefully could, as I said, help IMF members apply pressure for policy reform, and could certainly help the market to apply its own pressure, thus maximizing the chances that welfare-enhancing, market-based policies would be adopted. In a world where stability can be easily threatened by capital flows, we need to have a better sense of national balance sheets, a point that Bank of England Governor Mervyn King recently made. Surveillance needs to answer questions such as: What is a country's net foreign asset position? How is it being financed? What are the currency and maturity mismatches? The goal is to better integrate financial sector surveillance into country reviews so that potential risks are identified earlier. This would also help the IMF in its secretariat role, allow national authorities to address problems early on, and give capital markets more information to help them price risk appropriately. Earlier, I spoke about the need for capital markets in emerging-market economies to fully emerge. Ultimately, we hope that all countries will develop capital markets and the infrastructure to allow them access to global private investment flows. But in the transition period, we need to bear in mind that these markets work imperfectly at best, and are susceptible to overshooting and sudden reversals of capital flows. The IMF, therefore, has a role to play in furthering financial market development through its surveillance, through its advice and technical assistance, and through appropriately structured lending activities. I'll return to this point in a minute. Let me make one more point about surveillance. We all know that markets work less efficiently, and can even fail, in the absence of the right policy framework. Markets can fail when they are impeded by information asymmetries or by a lack of proper transparency. The IMF has an important role here in helping to support markets so they can work at peak efficiency. The talented staff of the IMF certainly have a long history of expertise in this area from years of conducting surveillance, and this expertise should be used to maximum potential. Currently, it is not. The IMF could be a key supplier of an important public good: reliable information on, and judgment about, the performance of national economies. In addition, as I said, the IMF has a very important role to play in providing analysis of spillovers and interdependencies. The IMF has taken a good step in this direction through its Financial Sector Assessment Program and its Reports on the Observance of Standards and Codes. But it needs to do more--not to duplicate what markets provide, but to supplement it. Having discussed surveillance, I will now turn to the second issue, which is lending. In a world where countries have unprecedented access to international capital flows, and where those who have borrowed from the IMF are doing everything they can to repay their loans early, some have argued that an ideal IMF should do no lending whatsoever. I certainly agree that the prime purpose of the IMF is to make loans. In particular, long-term lending for development clearly falls outside of its mandate. Until such time as all countries can develop their own capital markets, it is the World Bank that should play this role, just as the European Bank for Reconstruction and Development recently helped many Eastern European countries make the transition to market economies. However, as I mentioned earlier, a number of emerging markets do not have robust financial systems. And so there may still be a role for the IMF to maintain stability by providing temporary liquidity in extreme cases. But this very limited lending must take place only when it can be shown that the borrower is illiquid but not insolvent. And I would stress that there must be clear rules as to when this liquidity can be accessed, as well as clear lending limits that are known by all parties in advance. In terms of "emergency" lending, it would be far preferable to have the IMF focus on helping countries avoid problems in the first place, rather than lending funds to help them resolve balance-of-payments problems. The IMF could best support a market-based international financial system by working with countries to put mechanisms in place that help resolve problems before they turn into crises. In this regard, the institution has taken some steps in the right direction by stressing the use of collective-action clauses and encouraging parties to adhere to basic principles during debt restructurings. By restricting its lending role, the IMF can make a much greater contribution to a market-based financial system. Too often in recent years, Fund lending has impeded the very same market-based adjustments that the IMF should be encouraging. There are three important points to be made here. First, a lack of clear rules about when the IMF would lend--and in what amounts--has caused uncertainty and unnecessary delay, thus making the timely and efficient resolution of crises more difficult. Second, there is nothing inherently wrong with the IMF providing financing which, if it occurred in the private sector, would be called "debtor in possession" financing. In those circumstances, the IMF can expect to be treated as a "preferred creditor," standing at the head of the line with respect to subsequent debt servicing. However, as in the private sector, this should only occur when this action would preserve or increase the value of outstanding claims. This brings me to my third point. Too often in the past, assistance was provided to countries that were assumed to be suffering only from temporary illiquidity, but which later proved to be insolvent. IMF lending in these cases simply added to an already unsustainable debt burden, placing additional costs on both debtors and creditors. As I said before, emerging-market economies may occasionally face problems for which timely financial assistance from the Fund would help. But this lending needs to be clearly delineated and constrained if it is to do more good than harm. All of this is to say that we need a fundamental review of the IMF's lending activities. Lending should not be the major focus of the IMF's mandate. Instead, it should play only a supporting role. Next, let me talk about representation. For the IMF to successfully promote a well-functioning, market-based international financial system, it must be an effective forum, where global economic issues are discussed and solutions are found. The IMF should be place where national authorities gather around the table for a frank exchange on policy issues common to all. We need to rekindle the "spirit of internationalism" seen at Bretton Woods 60 years ago, and also seen at the OECD during the 1960s and 1970s, as that organization did its part to build a liberal economic order and a framework for freer trade. But it is difficult to build a shared sense of trust and responsibility if key players feel that they don't have an adequate voice. In this respect, it is clear that the IMF needs to give a larger voice to China and some other emerging-market economies, as they become more systemically important. But as my colleague at the Bank of Canada, Deputy Governor Tiff Macklem, said recently, "with a larger voice comes greater responsibility." Membership in the IMF carries with it a responsibility for supporting the goals of the institution. Members must have a shared understanding of how the international financial system should function, and of the IMF's role in supporting that system. So it seems to me that there really is no point for countries to demand, and receive, greater quota and voting power unless they believe in, and actively support, a market-based international financial system. It is absolutely true that Asian nations need to have greater quota and voting power to make the institution more legitimate in their eyes. But this should happen only if it will lead to an increased willingness among all countries to respect the rules of the game that are developed. Having discussed surveillance, lending, and representation, the final issue I want to talk about is governance. Good governance begins with clear objectives. So, after establishing the IMF's fundamental objectives, the institution must improve its governance structures. The IMF must ensure that it has clear lines of responsibility internally, and that it is transparent with respect to the reasons for its decisions. In other words, the IMF needs a governance structure that helps it achieve its goals and that holds its officials accountable. Currently, decision-making responsibilities are divided among the Board of Governors, the Executive Board, and the Managing Director and staff. But in practice, the division of responsibilities among these groups is not always clearly defined. Accountability is dispersed, and decision making lacks transparency. The IMF would be more effective if the Executive Board focused on setting strategic direction, and ensured that policies are sound and that objectives are met, rather than focusing on the day-to-day business of the institution. The Managing Director would be accountable for the secretariat and surveillance functions and be responsible for policy implementation. This framework would help to clarify that the responsibility for policy formulation rests with the Executive Board, and that the responsibility for implementation rests with the Managing Director. Towards this end, Mervyn King recently suggested establishing a non-resident Executive Board that meets periodically, rather than almost continuously, and that focuses on strategic direction and oversight. This suggestion certainly merits consideration. We also need to consider how to enhance the vital role of the IMFC--the International Monetary and Financial Committee--within the institution. As well, we should think about whether there could be some useful role for various working committees to deal with specific issues as they arise. Ladies and gentlemen, let me conclude. I've argued today that there is a role for the IMF in today's global economy. We need an institution to promote a market-based international financial system that works efficiently and is stable. This ideal IMF would have a sharper focus and a more international aspect to its surveillance, with clear rules governing a greatly reduced lending role. It would also be more representative than the current IMF, and would have an overhauled governance structure. The prescription I have outlined today may sound radical. But we cannot afford to be put off by the size of the task. Progress may come only over time, but it does need to happen. The first and most important step on the path is to have all players in the global economy agree on the fundamental objective of the IMF. As IMF members gather next month in Washington for the institution's spring meetings, my great hope is that we will have a real discussion of these fundamental issues. Let me close by recalling Martin Wolf's column in the . Ultimately, Wolf agreed that the world needs to create a tough and independent IMF. But Wolf said it could not be done. It is up to us to prove him wrong. It is up to us to show that we do have the courage and the vision to build this important institution.

r060404a_BOC

canada

The Conduct of Monetary Policy: Dealing with Changes in the Terms of Trade

duguay

Good evening. I'm delighted to be here in Kelowna, in the beautiful Okanagan Valley. It's good to be back in a classroom, speaking to business and economics students. For those of you who want to work in finance or the wider world of business, it is particularly important that you have a solid grasp of economic issues and that you understand how monetary policy contributes to the economic and financial well-being of Canadians. And as you will find out, economics is a way of thinking, one that combines logic and pragmatism. The more you know about basic economic concepts, the better you'll perform in whatever career you choose. What I would like to do in the next 20 to 30 minutes is explain how monetary policy helps the economy adjust to important shocks that occur from time to time, including sharp movements in our terms of trade. I will start with the objective of monetary policy. Then I'll describe how monetary policy works and where the exchange rate fits in. I will then explain what we mean by "terms-of-trade" shocks and show how Canada's monetary policy framework helps to facilitate the adjustment to these shocks. I'll leave plenty of time at the end of my remarks for questions. Let me start with the objective of monetary policy. The ultimate goal of Canadian monetary policy is to help our economy achieve its maximum sustainable growth, and thus contribute to rising living standards for Canadians. The best way to achieve this goal, we've learned from experience, is to keep inflation low, stable, and predictable. Inflation, as measured by the annual rate of increase in the consumer price index (CPI), has been running at about 2 per cent for more than a decade now. But in the 1970s and 80s, the rate of price increases was a good deal higher, spiking twice to well over 10 per cent ( ). I doubt that many of you here tonight remember those days of high and variable inflation. High inflation exacted a heavy toll on Canadians. Borrowers faced high and volatile interest rates. Incomes and savings were eroded by rising prices. Speculation was rampant. And the economic booms that led to rising inflation ended up in recessions. One of the things we learned from this bitter experience is that high inflation injects additional uncertainty into decision making. In a market economy, prices contain valuable information. When the price of a product is rising relative to other products, it's a signal that that particular product is becoming scarcer. Producers are then encouraged to increase its supply, while consumers are encouraged to economize on its use, thus alleviating the scarcity. Conversely, a drop in the price of a product is a signal that it is becoming more abundant. When this happens, firms are led to reduce their supplies of the product, and consumers are encouraged to increase their demand for it. But when inflation is high and variable, buyers and sellers are never quite sure what a price increase means. Is it a sign that a specific good is becoming scarcer, or is it just a sign of more widespread inflation? This uncertainty means that prices no longer convey as much useful information, and, as a result, people find it difficult to make sound decisions about production and investment. They focus on trying to protect themselves against the effects of inflation. Investors won't commit their resources for lengthy periods; labour negotiations become more acrimonious; and the overall economy is not as productive as it could be. Indeed, with the erosion of confidence in money comes an erosion of confidence in the fairness of markets. As former Bank of Canada Governor Gerald Bouey aptly put it in his 1981 Annual Report, "inflation melts the glue that holds free societies together." The lesson we (and other central banks) have learned in the past 30 years is that low and stable inflation is the best contribution that monetary policy can make to a strong economy. Since 1991, the Bank of Canada has conducted monetary policy with an explicit numeric target for inflation, a target that is set jointly with the Government of Canada. Since 1995, the inflation target has been the 2 per cent midpoint of a 1 to 3 per cent range. It was last renewed 5 years ago, and is coming up for renewal this year. Having a clear objective has increased the Bank of Canada's accountability to Canadians. It has made it easier for the Bank to explain its actions and easier for people to judge how the Bank is doing in meeting its objective. Once Canadians believed that the Bank would take action to meet the target--as we have done for some 15 years--they came to that inflation would remain low and stable. This expectation helped people make economic decisions that are aligned with the objective of monetary policy. And this facilitates the achievement of that objective. Since the adoption of the target, inflation has been pretty close to 2 per cent. And this stable, low-inflation environment has produced steadier economic growth, as well as lower and more stable interest rates, than was the case when inflation was high and variable ( Now that I have described the objective of monetary policy, let me turn to how we go about achieving it. I will start with what we call the "monetary policy transmission mechanism," which traces how monetary policy actions work their way through the economy ( The Bank of Canada has only one tool at its disposal for carrying out monetary policy--its direct influence on the . The overnight rate is the interest rate at which financial institutions borrow and lend one-day (or overnight) funds among themselves. The Bank has a direct influence on that rate because it controls the total amount of funds (settlement balances) available to these institutions. The Bank sets the target for the overnight rate eight times a year on a pre-announced schedule. That schedule reduces uncertainty in financial markets about the timing of policy actions and helps direct attention to the medium-term perspective of monetary policy. The decisions are made by the Bank's Governing Council--that is the Governor and five Deputy Governors--based on consensus. They are informed by a thorough analysis, provided by Bank staff, of current and prospective economic and financial developments. Changes in the target for the overnight rate spread to other interest rates, which then affect borrowing and spending decisions, and thus the overall level of demand for goods and services--what we call . Imbalances between aggregate demand and the economy's capacity to supply goods and services (referred to as the output gap) set off changes in inflation. That's a quick sketch of the transmission mechanism, and I would encourage you to look up a fuller description on our web site at: www.bankofcanada.ca/en/monetary_mod/index.html. My key point here is that the whole process takes time. Monetary policy actions take 12 to 18 months to have most of their effects on total spending, and another 3 to 6 months to have most of their effects on inflation. This means that the Bank of Canada has to be forward-looking, taking actions based on projections of future pressures on inflation. Monetary policy aims to keep inflation low and stable by keeping overall demand in line with supply. When demand is projected to rise beyond the economy's ability to meet that demand, threatening to push inflation above target, the Bank will act to dampen some of that demand by raising interest rates. Conversely, when demand is weak, threatening to take inflation below target, the Bank will lower interest rates to stimulate demand. This symmetric, forward-looking approach to monetary policy has a stabilizing influence on the economy, thus helping to prevent costly boom-and-bust cycles. If we waited for inflation to increase or decrease before tightening or loosening monetary policy, we would be too late, and there would be a risk that the economy would be less stable. Except for a brief period from 1962 to 1970, when the exchange rate was fixed, Canada has had a floating exchange rate since 1950. Today, the Canadian dollar is worth about 86 U.S. cents. Four years ago, it was worth 63 U.S. cents ( Our flexible exchange rate regime is an essential ingredient of our inflation-targeting system. It allows us to follow an independent monetary policy, suited to our own economic circumstances, which would not be possible if we had to set monetary policy with the objective of maintaining a fixed exchange rate for the Canadian dollar. At the same time, inflation targeting means that our floating exchange rate acts as a "shock absorber," helping our economy adjust to changes with less pain and less disruption than if the exchange rate was fixed. So, we do not have a target for the external value of the Canadian dollar. With only one instrument--the target for the overnight rate--to carry out monetary policy, we couldn't hit two targets, one for inflation and one for the exchange rate. But saying that we do not have a target for the exchange rate doesn't mean that we ignore it. On the contrary, we monitor the exchange rate closely to assess the effects of currency movements on aggregate demand for Canadian goods and services, and the consequences for future inflation. The fact is that the exchange rate is an important price in the Canadian economy. It directly affects the Canadian dollar price of everything we import and export, thus sending strong price signals to businesses and consumers. As an open economy and a major producer of commodities, Canada is very much affected by swings in the world demand for, and prices of, our products. Such swings cause our terms of trade--that is, the prices we get for our exports relative to the prices we pay for our imports--to move around a great deal. When the prices of the products we sell on world markets rise relative to the prices of those we buy from abroad, our terms of trade are improving--and we are getting richer. When the prices of our exports fall relative to those of our imports, our terms of trade deteriorate--and we are getting poorer. So, improving terms of trade are favourable for a country. They result in gains in labour income, in corporate profits, and in government revenues. But changes in our terms of trade--whether in a favourable or unfavourable direction--can cause stress and dislocations. They can involve significant shifts in production and employment among sectors of the economy. That means loss of jobs in some industries and growth in others. In economic terms, it triggers a shift of resources from less profitable to more profitable sectors. Thus, while the adjustments can be difficult, they are vital to our economic prosperity. To make the most of our opportunities as a trading nation, we need to adjust to changing global economic circumstances. The key point I would like to emphasize here is that our low-inflation target and our flexible exchange rate help facilitate the necessary adjustments. Of course, by its very nature, monetary policy is national in scope, and while its effects are far-reaching, it cannot address the specific needs of a sector or region. It can only address the needs of the nation as a whole. Canada's terms of trade have moved around significantly over the past decade ( ). To illustrate my point, I'd like to focus on one episode when they were weakening and one when they were improving. I'll describe the nature of the shock in each case, and explain the role of our monetary policy framework, in particular, the role of the exchange rate, in facilitating the adjustment process. The first episode occurred in 1997-98, when a financial crisis that started in Thailand spread to Indonesia, South Korea, and other countries. Asian demand, which had accounted for a relatively large share of growing world demand for commodities, weakened considerably. As a result, prices of key commodities produced by Canada fell, and our terms of trade weakened. Reflecting the downturn in world commodity prices, the Canadian dollar depreciated against the U.S. dollar. The depreciation helped to mitigate the negative shock for commodity producers. And, more importantly, it encouraged the manufacturing sector to expand and absorb the resources--labour and capital--that were released from the commodity-producing sector. Thus, the depreciation of our currency helped to offset the negative effects of the Asian crisis on aggregate demand for Canadian goods and services and thus pre-empted downward pressures on prices and wages. In this way, the flexible exchange rate acted as a shock absorber to mitigate the effects of the weakening terms of trade on the overall level of economic activity, while encouraging economic adjustment. Let me now turn to the second episode. In the past three to four years, Canada's terms of trade have improved sharply. The basic story has been one of strong global economic growth, leading to a surge in world demand and prices for oil and gas, lumber, metals, and other primary commodities. The resulting rise in Canadian incomes has also boosted demand by Canadian households and businesses. Over this period, the Canadian dollar has appreciated by more than 30 per cent against the U.S. greenback, and indeed significantly against many other currencies. This stronger Canadian dollar has dampened the positive shock for commodity producers and made manufacturing less competitive. As a result, resources have been reallocated from the manufacturing sector to the commodity and services sectors. This adjustment has helped keep overall supply and demand in balance and inflation pressures in check. In this sense, the past four years have been the reverse of the situation in 1997-98. Once again, the flexible exchange rate has helped to stabilize the economy and to encourage adjustment--this time in the context of strengthening terms of trade. It's useful to compare these two recent terms-of-trade shocks--which occurred when monetary policy was anchored by an inflation target--with an earlier shock when monetary policy was not conducted with an explicit target. During 1997-98, when our terms of trade were weakening, CPI inflation averaged 1.3 per cent. Since the beginning of 2003, when our terms of trade have been strengthening, inflation has averaged 2.6 per cent. Thus, during both of these recent episodes, inflation has remained relatively close to target. This is in sharp contrast to the 1972-74 period, when Canadian terms of trade improved dramatically as a result of steep increases in energy and other commodity prices ( ). Inflation rose sharply, spiking to more than 12 per cent in late 1974. Inflation remained high and variable for quite some time after that, causing severe economic disruptions, and great difficulty for people living on fixed incomes. Clearly, the monetary policy framework at the time was not robust enough to contain the inflationary consequences of rising energy and raw material prices and strong demand for commodities. The comparison of these episodes illustrates how the two key elements of our current monetary policy framework--the inflation-control target and the flexible exchange rate--work together to facilitate the adjustment to terms-of-trade shocks. To summarize: sharp changes in the terms of trade necessitate a reallocation of economic resources. That adjustment process, while always a challenge, and sometimes painful, can be helped a great deal by a coherent monetary policy framework. Of course, monetary policy is only one part--albeit an important part--of the adjustment process. Also of great help in facilitating economic adjustment to terms-of-trade shocks are the ingenuity of Canadian business people, the diversity and resilience of the Canadian economy, and the flexibility of labour and product markets. Over the past three years, we've seen strong growth in capital spending in commodity-producing industries, as well as substantial gains in both capital spending and employment in sectors with low exposure to international trade. Exports have continued to grow, despite the higher Canadian dollar. And a surge in investment in machinery and equipment suggests that firms are, in fact, taking advantage of the stronger exchange rate (which reduces the cost of imported machinery and equipment in Canadian dollar terms) to improve their productivity and enhance their competitiveness. There is also evidence that Canadians are more mobile, making the best of work opportunities in strong growth areas such as the Athabasca tar sands. Indeed, it has recently been reported that Air Canada is introducing an "Oil Express" pass to facilitate the movement of labour between Eastern Canada and Fort McMurray, Alberta. And strong economic activity in Alberta is not only drawing in migrant labour from other provinces; it is also generating large orders for goods and services produced elsewhere in Canada. Here in British Columbia, there has been solid growth in output in the construction, mining, transportation, and the services sectors. Indeed, B.C. now enjoys its lowest recorded unemployment rate. A Vancouver firm recently signed the largest licensing deal in Canada's biotech history. In B.C. and across Canada, workers and investors have been quick to seize the new opportunities presented by the improvement in our terms of trade. The global economic environment has been particularly favourable to Canada in the past few years, and our economy has adjusted remarkably well to large changes in relative prices, including the marked appreciation of the Canadian dollar. , we concluded that the Canadian economy was operating at its production capacity and we projected that it would grow roughly in line with capacity through 2007. We expected CPI inflation to stay slightly above the 2 per cent target in the first half of this year and to ease to 2 per cent by the first half of next year. Core inflation--a measure of the underlying trend in prices that excludes eight of the most volatile components of the CPI, and which has been slightly below 2 per cent in the past two years--was also projected to return to 2 per cent by the first half of next year. also indicated that the risks to the Bank's projection were balanced for 2006, but tilted to the downside through 2007 and beyond. These downside risks relate to the possibility that the unwinding of large global current account imbalances could involve a slowdown in the world economy. (By global imbalances, I mean the large current account deficit in the United States, mirrored by large current account surpluses in other countries.) Consistent with this view, at the time of our last policy decision on 7 March, we indicated that some modest further increase in the policy interest rate may be required to keep aggregate supply and demand in balance and inflation on target over the medium term. We are now well into the preparation of our spring , which will be released on 27 April. If anything, the global economy may be a touch stronger in 2006 because of improved growth prospects for Japan and Europe. In our upcoming , we will provide a full analysis of economic developments, trends, and risks to the outlook. Let me conclude. In a constantly changing and increasingly globalized world economy, the Canadian economy will continue to be buffeted by various shocks. Our monetary policy framework--the inflation target working in concert with a floating exchange rate--will continue to play an important role in mitigating the effects of shocks, and in helping to facilitate the needed economic adjustments by ensuring that the price system sends the right signals. And of course, the ingenuity and adaptability of Canadian workers and business people will remain critical to increasing our standards of living. This is an exciting time to be in post-secondary education, preparing for a career in Canada. Employment prospects are very good, and they will undoubtedly improve as the baby boomers retire. I talked about the inevitability of economic shocks and of the adjustments that these shocks necessitate. You will find that your studies will help you to prepare for, and to take advantage of, rapid changes in our economy. I wish you all well in your studies.

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Release of the

dodge

Today, we released the April (MPR), which discusses current economic and financial trends in the context of Canada's inflation-control strategy. The Canadian economy continues to grow at a solid pace, supported by robust global growth, firm commodity prices, and strong domestic demand. At the same time, global competition and the past appreciation of the Canadian dollar continue to pose challenges for a number of sectors. All factors considered, the Canadian economy is judged to be operating at, or just above, its production capacity. The Bank projects economic growth of 3.1 per cent in 2006, 3.0 per cent in 2007, and 2.9 per cent in 2008. Total CPI inflation will continue to be volatile and affected by developments in the markets for crude oil and natural gas. The Bank projects that the total CPI will average close to 2 per cent in 2007 and 2008 (excluding the effect of any changes in the GST). Core inflation is projected to rise to 2 per cent in the second half of this year and remain there through the end of 2008. There are both upside and downside risks to the Bank's outlook for growth and inflation. The Bank judges that these risks are roughly balanced, with a small tilt to the downside later in the projection period. On 25 April, the Bank raised its target for the overnight rate to 4.0 per cent. In line with the Bank's base-case projection and current assessment of risks, some modest further increase in the policy interest rate may be required to keep aggregate supply and demand in balance and inflation on target over the medium term. The Bank will closely monitor evolving developments in the Canadian economy in light of the cumulative increase in the policy interest rate since last September.

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

dodge

Good afternoon, Mr. Chairman and members of the Committee. We appreciate the opportunity to meet with this Committee 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 objective of monetary policy and the actions we take to achieve it. When Paul and I appeared before this Committee last October, we said that the global and Canadian economies were continuing to grow at a solid pace, that our economy appeared to be operating at full production capacity, and that it would remain at capacity in 2006 and 2007. Total and core inflation were projected to average close to 2 per cent, beginning in the second half of this year. This projection assumed oil prices at roughly US$64 per barrel, a level then indicated by futures prices. Our projection also assumed stable commodity prices, government spending that was growing roughly in line with revenues, and a Canadian dollar continuing to trade in a range of 85 to 87 cents U.S. ), we say that the global economy has shown a little more momentum than had been anticipated: oil prices have been roughly US$10 per barrel higher than assumed; metals prices have risen significantly; and the Canadian dollar had been trading in a range of 85 1/2 to 88 1/2 cents U.S. In our , the Bank projects economic growth of 3.1 per cent in 2006, 3.0 per cent in 2007, and 2.9 per cent in 2008. Total CPI inflation will continue to be volatile and affected by developments in the markets for crude oil and natural gas, and will average close to 2 per cent in 2007 and 2008 (excluding the effect of any changes in the GST). Core inflation is projected to rise to 2 per cent in the second half of this year and remain there through to the end of 2008. This projection is based on three key assumptions: first, that energy prices will remain roughly as indicated by futures prices; second, that Canadian governments will continue to run budgets that are roughly in balance; and third, that the orderly resolution of global imbalances will involve a gradual depreciation of the U.S. real effective exchange rate. A small fraction of this depreciation will be against the Canadian dollar and will occur late in the projection period. There are both upside and downside risks to the Bank's projection for growth and inflation. The Bank judges that these risks are roughly balanced, with a small tilt to the downside later in the projection period, related to a possible disorderly correction of global imbalances. We consider this risk to be slightly smaller than previously judged, given the tentative signs of policy adjustments in some countries and of rotation in global demand. In line with the Bank's outlook for the Canadian economy and its current assessment of risks, some modest further increase in the policy interest rate may be required to keep aggregate supply and demand in balance and inflation on target over the medium term. We will closely monitor evolving economic developments in the Canadian economy in light of the cumulative increase in the policy interest rate since last September. Mr. Chairman, I want to emphasize that what we have laid out in our April is a projection for growth and inflation based on the assumptions that I have noted above. We publish our projection so that Canadians and financial markets know the basis against which the Bank judges all new economic developments. When we set our policy interest rate eight times a year, we assess all available information on the global and Canadian economies relative to our base-case projection and then make our monetary policy decisions.

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The Crucial Contribution of the Financial System and Monetary Policy to Economic Development

longworth

The panellists in the preceding workshop challenged us economists to be more lucid and convincing. I will do my best not to disappoint you with my speech today, especially since I am genuinely grateful for this opportunity to address a subject as interesting as the topic of this conference. Over the past few days, you have examined some of the broad trends that have been observed in finance, as well as their implications for economic development. These are matters of great public importance. I shall begin with a brief overview of what research has taught us regarding the contribution of the financial system to economic growth. Then I will discuss the particular role played by efficiency and regulation in the good functioning of markets, and draw on these theoretical elements to assess Canada's successes and how we can better rise to the challenges that await us. In the second part of my speech, I will look at the specific contribution of monetary policy to economic development. These two parts of my presentation are closely linked since, as you know, the Bank of Canada uses financial markets as a channel for the transmission of monetary policy--which also strives to promote the well-being of Canadians. Many analysts have examined the relationship between the financial system and economic development. They have uncovered some interesting facts regarding the characteristics of the financial system--characteristics that contribute to the best possible allocation of savings to productive investments, which are themselves engines of economic growth. We know that in some countries, particularly those of continental Europe, a large part of the allocation of capital is provided by the banks, but that elsewhere, such as in North America, this task is performed primarily by financial markets. Now, we have learned from the research that a country's economic growth does not depend on any specific structure of the financial system. And yet, if not the structure, then what are the factors of success? A more in-depth analysis sheds some light on the breadth and quality of financial services. The central issue is not to understand whether markets should replace intermediation by banks, but rather how banks and markets complement each other. As to the size of the financial sector, research reveals that it has a straightforward link with economic growth. Historically, we note that the share of this sector in the Canadian economy has expanded from 10 per cent of GDP after the Second World War to nearly 20 per cent today. The financial industry is also one of the most productive in Canada, if we consider its relatively modest share in total employment--barely 6 per cent. A recent study by the OECD emphasizes the quality of regulation of the financial system as a factor of economic growth. Its main conclusion is that ". . .regulatory settings that maintain excessively high barriers to competition in banking, or that provide too little protection for investors in securities markets, hamper the development of financial systems, resulting in weaker economic growth." Thus, a balance must be struck between competition and the protection of investors. This is of particular importance for firms that are growing rapidly and that depend on injections of outside capital, such as those specialized in information technology and biotechnology. This suggests that the quality of the financial sector is reflected in the industrial structure of an economy, and not only in its growth rate. At the Bank of Canada, we have devoted considerable effort to promoting the efficiency and stability of the financial system. When speaking of the financial system, we are referring not exclusively to banks and markets, but rather to all financial institutions, their legal and regulatory framework, and their infrastructures, such as the payment, clearing, and settlement systems. We say that a financial system is functioning well when two conditions are met. First, agents have access to the information they need to allocate capital to the most productive investment projects. Second, risk is managed in such a way that it is assumed by those who are most prepared to do so. This type of financial system also contributes to reducing volatility in consumption and investment. It buffers the real economy from harmful shocks, making growth less volatile. Asymmetries in the information available to lenders and borrowers are an example of frictions that undercut efficiency. Typically, the borrower has better information on the value and the risks associated with an investment project. Other examples of frictions are operational inefficiencies resulting from relatively weak competition among suppliers of financial services or from market distortions caused by poorly designed regulation. If we want to bolster economic growth, we need to expose and correct these inefficiencies. However, before sketching out a solution, it may be wise to recall the basic principles of sound regulation. Let us begin with a basic axiom. Operational efficiency and the optimal allocation of resources in a market economy rely on a solid legal and regulatory framework. Fundamental legal principles, such as property rights, the rule of law, and respect for contracts, must be in place for market forces to play their role and create wealth. Therefore, before a government agency considers imposing a new regulation, three tests must be passed: ensure that the regulation is targeted at correcting market failure; ascertain that the proposed solution is effective; and see to it that the cure isn't worse than the disease. While satisfying these conditions, regulators can increase the efficiency of the financial system by acting on three complementary paths. The first is to foster competition in domestic and international markets. Competition stimulates innovation and efficiency. That does not mean, however, that authorities should simply get out of the way of market operators. Regulators can also promote efficiency by--and this is the second path--reducing informational asymmetries through the adoption of certain transparency requirements. Here, it is important to focus not only on the quantity of the information revealed, but also on its relevance, which, in turn, depends on the specific nature of the market and the preponderance of benefits over costs. For example, the optimal degree of transparency could differ between the bond and the stock markets. Finally, efficiency is bolstered by promoting financial stability in general. When well-designed rules give rise to systemic stability, resources are freed up that can then be devoted to more productive ends. To a large extent, this is the purpose of the international standards in Basel II, which sets banks' regulatory capital requirements as a function of the individual risks assumed. The current Basel I standards are not that sophisticated. Now that we have established the principles for the well functioning of the financial system on the basis of research and of some elements of the theory, we can take a look at the Canadian record. To gain a broader perspective, let us step back in time to the Porter Commission. In 1964, this Royal Commission on Banking and Finance recommended increasing competition, liberalizing markets, and creating a regulatory framework conducive to greater efficiency. These proposals may seem mundane today, but in postwar Canada the government retained a considerable presence in the economy and so they were quite avant-garde. The Royal Commission won the day, and Canada radically amended some of its laws. The banks reacted to the new competitive environment by innovating and improving their efficiency. Canadian institutions became global leaders while foreign banks lagged, bound by more restrictive and less efficient regulatory regimes. For a full 30 years, Canada maintained its lead on the world stage. Recall that subsequent revisions to the law allowed greater competition between traditional pillars of finance, i.e., banking, insurance, brokerage, and trusts, thus driving down costs and increasing efficiency. Over the course of the past decade, efforts have focused on improving prudential regulation, which seeks to stabilize institutions and the financial system as a whole. In 1987, the federal government created the Office of the Superintendent of Financial Institutions and the Financial Institutions Supervisory Committee. The purpose of the latter is to facilitate the exchange of information between various federal bodies involved with financial stability, including the Bank of Canada. At the Bank, one of our less well-known mandates is to oversee payments infrastructures, especially the Large Value Transfer System. The LVTS is an electronic system launched in 1999 and operated by the Canadian Payments Association. It meets or exceeds the highest international standards in matters of risk management, and does so at a fraction of the cost. Experience has shown that a solid and comprehensive infrastructure contributes greatly to the robustness of a financial system. Allow me to take advantage of this occasion to draw your attention to another less-recognized contribution of the Bank: its . In it, the Bank presents its current analysis of systemic risks, along with articles that tap into the wealth of research that we conduct into financial markets. In other matters, the restructuring of Canadian stock exchanges at the end of the 1990s allowed specialization and solidified our market position. Since that time, the Montreal and Toronto stock exchanges, and the TSX Venture Exchange have experienced remarkable expansion. It remains to be seen how the inchoate movement to consolidate markets elsewhere in the world will affect us here, and the new challenges it will pose to Canadian stock exchanges. Also, even though North American financial markets are more integrated than ever before, their regulation has not always kept pace, and non-tariff barriers, which one would have expected to disappear in an era of free trade, persist. In particular, I am thinking of the constraints imposed on small U.S. investors wishing to buy Canadian stock. All in all, even though the Canadian financial system has continued to develop since the Porter report, it is clear that a number of countries have now caught up to us, and some might even say that they have surpassed us. The competitive capacity of the Canadian economy depends largely on the ability of its financial sector to compete on the world stage. Canada needs to follow best practices in regulation. But this does not mean blindly importing any and all flavours of the month in terms of innovations, not even those originating with its principal trading partner. A telling example will allow me to illustrate several principles. Enron, along with a number of other similar scandals, drove the U.S. Congress to rush into legislating the Sarbanes-Oxley Act (SOX). This law regarding corporate governance reflects some sound principles, and several equivalent provisions have been enacted in Canada. However, after careful consideration, Canadian Securities Administrators recently opted not to require external audits of the internal controls of publicly traded companies, as under SOX. Of course, large Canadian corporations that draw on U.S. capital will continue to comply with this law, but Canadian companies with more modest capitalizations--which, we should recall, are considerably smaller than their U.S. equivalents--will not have to bear this very heavy burden. What conclusions can we draw from all of this? That it is essential that the Canadian regulatory framework be guided by principles that are at least as good as, if not better than, those of other countries. However, our rules, and their implementation, must be adapted to domestic requirements and reflect the diversity in size and complexity of our publicly traded companies. So "yes!" to regulatory requirements that vary with size, but "no!" to regulatory requirements that vary by province. At this time, I would like to welcome and encourage the harmonization efforts that are ongoing among provincial securities commissions, including Quebec's Autorite des marches financiers. Enron gave rise to the adoption of Sarbanes-Oxley in the United States. On a smaller scale, the Portus, Norshield, and Norbourg affairs force us to look at ways to strengthen the application of the law in Canada. I do not deny the need to foster the development of a culture of compliance and the implementation of appropriate internal controls within financial institutions. Unfortunately, this is not always enough. Some research suggests than insider trading is not prosecuted with the same vigour here as in the United States, tainting the reputation of Canadian financial markets. It can even be argued that this less- than-stellar reputation results in higher financing costs for our firms. Thus, it is necessary that the behaviour of market operators be monitored and that violators be prosecuted and appropriately punished. A regulatory framework that ensures strict application of the law and that punishes dishonest players will reinforce the credibility of markets and investor confidence. Rising to this challenge will involve complementary and sustained action by several bodies at both levels of government: securities commissions, police forces, prosecutors, and the courts. It will also require that all stakeholders develop a solid expertise. Integrated Market Enforcement Teams (IMETs), which unite various law-enforcement forces, are a step in the right direction. However, we must push for greater co-operation, since only in that way will we be able to mobilize the complementary expertise of all participants. The Canadian economy faces stiff international competition. To continue to prosper, it must be able to count on the support of an efficient financial system under a modern regulatory framework. The Porter Commission provides good advice for legislators and regulators: The future of our financial system remains ever and always dependent on competition and innovation. What is the role of monetary policy in all of this? In a narrow sense, monetary policy is a user of the financial system. It targets the overnight rate, but relies on efficient markets to transmit its impact throughout the economy. This explains the strong interest of the Bank of Canada in the issues that I have discussed earlier. At the same time, solid monetary policy reduces costs and volatility in credit markets. It's a matter of give and take, so to speak. More generally, we can further assert that good monetary policy, like an efficient financial system, yields considerable benefits to a country's economy. We observe a positive feedback mechanism. In short, the Bank of Canada believes that by keeping inflation low, stable, and predictable, it maximizes its contribution to the well-being of Canadians. Let us look at that in greater detail. The adoption of an inflation-targeting regime in 1991 stabilized inflation at approximately 2 per cent and provided an anchor for medium- and long-term expectations. Together with the restoration of fiscal health, this stability permitted a decline in both the level and the volatility of interest rates. Over the past 15 years or so, we have all witnessed a sharp drop in short- and long-term interest rates, at times to levels lower than U.S. rates--which in the past would have been unthinkable. However, what is less obvious is the decline in volatility: The standard deviation of the variability of 10-year rates has fallen by half since the early 1990s, to below U.S. levels. These results have certainly benefited Canadian borrowers and, by extension, investments. The reduced uncertainty of all economic agents has paved the way for loans with longer terms to maturity. The ratio of long-term debt to total business debt has risen from 45 per cent in 1981 to over 70 per cent. Also, the benefits extend far beyond financial markets. For example, the duration of union contracts has increased, with typical maturities having risen from approximately 25 months at the end of the 1970s to nearly 40 months in recent years. The manner in which monetary policy responds to fluctuations in the business cycle also promotes greater stability in the economy, which then runs closer to its full capacity. For example, if a negative demand shock drives inflation below the 2 per cent target, interest rates are cut or held at lower levels than they would otherwise be, so as to bring economic activity back to production potential. Naturally, the Bank's actions are symmetric, and interest rates will typically rise when an overheating economy threatens to drive inflation above target. Having a credible monetary policy also makes it possible to abstain from reacting to most relative price shocks. For example, if a sudden jump in the world price of oil translates into a greater-than-expected rise in the CPI, the fact that we are focusing on inflation 18 to 24 months down the road means that we can ignore this effect, since it will likely have no impact on inflation expectations. Finally, monetary policy facilitates the structural adjustments required of the Canadian economy in two ways. First, high and variable inflation masks the strong economic signals conveyed by changes in relative prices. With inflation under control in Canada, firms and individuals are better able to understand what rising energy prices and the appreciating Canadian dollar mean for them, and in this way, they can make better informed decisions. Second, resources released by sunset industries can more easily migrate to growth sectors when the economy is running at full capacity. This is our monetary policy strategy for the current period of significant change. Fortunately, the adjustment seems to be unfolding relatively smoothly, despite the real difficulties encountered by some firms and their employees. Let me conclude. I hope that my remarks today have helped to emphasize that behind the abstract concept of financial system efficiency lies a very important factor for the competitiveness of the Canadian economy. What can be done to improve things? I submit to you that our financial system does not need a comprehensive, dramatic reform. There is, however, a genuine need for tenacious efforts from all financial system participants to bring about a long series of ongoing improvements--especially in the area of enforcement, competition, and innovation. As good economists, we at the Bank of Canada will continue to advocate efficiency. And, as for monetary policy, rest assured that control of inflation will help markets function as efficiently as possible. All of these efforts will strengthen our economy and its ability to generate a high standard of living for our fellow citizens.

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Opening Statement before the House of Commons Standing Committee on Industry, Science and Technology

dodge

Good morning, Mr. Chairman and members of the Committee. It is an honour to be invited to appear before you and to help you in your examination of the challenges facing Canada's manufacturing sector. As far as I am aware, this is the first time that a Governor or Senior Deputy Governor of the Bank of Canada has appeared before this committee. So I thought it would be appropriate to begin with a very brief description of the framework in which the Bank conducts monetary policy. Then I will talk about the global forces that are posing challenges for our manufacturing sector, and what they imply for the economy as a whole. Finally, I will share with you some of the evidence we have gathered about how Canadian manufacturers are adjusting to these challenges. The Bank of Canada Act calls on us to "mitigate ... 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." Over time, it has become clear that the best way for us to fulfill this mandate is to keep inflation low, stable, and predictable. Specifically, we aim to keep the annual rate of consumer price inflation at the 2 per cent midpoint of a 1 to 3 per cent target range. To keep inflation on target, we try to keep the economy operating at its full capacity. By this, I mean that we aim for a balance between total demand and total supply in the economy. Simply speaking, if strong demand for Canadian goods and services were pushing the economy as a whole against the limits of its capacity, and if inflation were poised to rise above the target, the Bank would raise its key policy interest rate. This, in turn, would push up other interest rates and help to cool off demand, thus keeping supply and demand in balance and inflation on target. On the other hand, if the economy as a whole were operating below its production capacity, and inflation were poised to fall below the target, the Bank would lower its key policy rate to help stimulate demand. By maintaining low and stable inflation, monetary policy helps to keep the economy operating at full capacity and promotes greater stability in economic output. This point is crucial in helping the economy adjust to global economic forces. A key element of our monetary policy framework is the floating exchange rate. Let me be clear: we do not have a target or preferred exchange rate for the Canadian dollar. But it is an important relative price in our economy. In terms of the Bank's monetary policy, exchange rate movements give us information about economic developments that may be having a direct impact on demand in the Canadian economy. And the movements themselves have their own effect on demand, by changing relative prices for Canadian goods and services and by shifting demand between domestic and foreign products. The challenge for the Bank is to evaluate these movements, together with other data, and set a course for monetary policy that works to keep demand and supply in balance and inflation on target. When the Canadian dollar rises or falls, we try to determine how much of that movement is due to changes in world demand for our goods and services, and how much is due to other unrelated factors. It is important that we understand the causes of exchange rate movements, because the implications for the economy--and the appropriate monetary policy response--depend on the cause of the change. We set out a fairly detailed explanation of this in our January 2005 , which is included in your package. That's a very quick look at our framework. Now, let me apply that framework to our current situation. I am sure that the members of the committee are well aware of the global forces that are affecting not just Canadian manufacturers, but the entire economy. In the past few years, we have had extraordinarily strong global economic growth. There has also been an unusually high amount of liquidity in the global economy, which central banks are now in the process of removing. Meanwhile, we have seen a persistent and growing current account deficit in the United States, mirrored by large and growing current account surpluses elsewhere, especially in Asia and among many oil-exporting countries. These imbalances reflect the financial flows associated with mismatches in savings and investment on a global scale. We have also seen the emergence of China and India as economic powerhouses. The strong growth in these countries and other emerging-market economies has led to sharply higher prices for many of the products that Canada produces. At the same time, intense competition from manufacturers around the world has led to lower prices for many consumer durable and semi-durable goods. All of this has resulted in an improvement in our terms of trade and higher incomes for Canadians--particularly for producers of commodities, metal products, energy products, building materials, and machinery. We have also seen a rapid rise in the external value of the Canadian dollar. This increase largely, though not entirely, reflects stronger global demand for Canadian goods and services. Against this backdrop, Canadian manufacturers have been getting more efficient. Indeed, we have seen a tremendous rebound in manufacturing productivity--output has increased even while the number of jobs has been reduced. This has been very difficult for many workers in the manufacturing sector who have lost jobs as a result of these changes. We all recognize this. But we must also recognize that this reflects, in part, the fact that many firms are taking advantage of the strong Canadian dollar to invest in machinery and equipment in order to improve their productivity. These productivity gains bode well for the future--improved efficiency helps to improve our international competitiveness and our ability to adapt to shocks and to shifting trends in the global economy. Indeed, we see businesses across the country working hard to adjust to an increasingly competitive environment. We have been tracking this adjustment through our regular communication with business groups, manufacturers, and exporters, as well as through the Bank's . You will find a copy of our spring in your package. Our surveys have highlighted three areas that are posing problems for manufacturers--labour shortages, the appreciation of the Canadian dollar, and competition from Asia. Let me say a few words about each of these areas. Our surveys have shown that the key problem for some manufacturers, like firms in other sectors, has been a shortage of skilled labour. But despite the difficulty in attracting skilled labour, our most recent survey showed that hiring intentions remain strong across most sectors and all regions. Many of the workers who will be hired to alleviate labour shortages in expanding sectors are those who are being released from sectors that are growing less rapidly. Since 2003, when the Canadian dollar began to appreciate, we have regularly asked businesses how they have been adjusting to the appreciation of the Canadian dollar. Roughly half of the firms surveyed say they have been adversely affected by the rise in the Canadian dollar. Most of these are firms that are highly exposed to international trade--including manufacturing. Finally, many firms that we surveyed also say that they have felt the effects of increased competition from Asia, in addition to significant increases in their input costs, particularly higher energy costs. In response to these three challenges, many firms have undertaken a profound restructuring of their businesses. Indeed, some 80 per cent of manufacturers surveyed reported changing their operations. Many firms are repositioning themselves to specialize in higher value-added production. Some have abandoned labour-intensive mass production in favour of small lots and customized products. Many are improving the quality of their products and services. Others have transferred labour-intensive production offshore, but have kept and developed their high-skilled operations in Canada. Let me make one last very important point. From our discussions and our analysis of the data, it is clear that manufacturing is not a monolithic sector. There is no single strategy that will work for every manufacturer, because every business is unique. Some manufacturers face sector-specific challenges. Others, such as those producing machinery and equipment, are facing booming demand. But while each business is unique, most of them are looking for ways to adapt to, and thrive in, these challenging times. Paul and I will now be happy to answer your questions.

r060608a_BOC

canada

Floating Dollar, Anchored Inflation: The Role of the Exchange Rate in Canada's Monetary Policy Framework

macklem

The first thing I'd like to say is . . . Happy Birthday! And many, many more. Two hundred and fifty-three years of hard work and civic pride have made Lunenburg the beautiful and historically rich place it is today. I'm very pleased to be here with you on this occasion. I'm happy to have been invited by the Board of Trade to speak about the role of the exchange rate in Canada's monetary policy framework. The Canadian dollar is very much in the news these days. And so I want to put exchange rate movements into context, and Nova Scotia is a good place to do that. With a commercial history that goes back centuries, Nova Scotians have a long experience with trade and currencies. From the early 1700s, when they were alleged to possess, and I quote, "a canniness in trade that staggered even the Scotch," ) to the energy and agri-food exports of today, Nova Scotians have always been outward-looking, engaged in trade, and thus interested in the value of currencies. Over the next 20 minutes, I'd like to explain the role of the flexible exchange rate in our economy. I'll start by providing a useful backdrop--the Bank of Canada's monetary policy framework. Next, I'll take a close look at the flexible exchange rate, and discuss how the Bank considers currency movements in its monetary policy decisions. I'll then comment on the recent appreciation of the Canadian dollar, and conclude by discussing the challenges that the rapid appreciation of our currency is posing. At the end of my remarks, there will be time for comments and questions. The ultimate goal of the Bank of Canada is to promote the economic and financial welfare of Canadians. To achieve this goal, we need a clear, effective policy framework. The two key components of the Bank's monetary policy framework are an "anchor," the inflation target, and a "float," the flexible exchange rate. Living by the ocean, you know better than I that a good mooring is one that keeps a boat in place, yet allows some give and take for the wind and the tide. And so it is for our framework. We need an inflation target to anchor our policy with a clear objective. We also need the flexible exchange rate to pass on valuable price signals and to absorb some of the ups and downs of the global economy. The two components work hand in hand and reinforce each other to promote the economic well-being of the nation. Let me elaborate first on the "anchor," the inflation target. Out of the bitter experience of the 1970s and early 1980s, we learned that the best contribution that monetary policy can make to the welfare of Canadians is to keep inflation low and stable. In 1991, the Bank and the Government of Canada formalized this commitment to low inflation by announcing an explicit inflation target. Since 1995, the target has been the 2 per cent midpoint of a 1 to 3 per cent inflation control range. The inflation target has proven to be very effective--indeed, it has been the most successful regime in Canadian monetary policy history. Inflation has been low and stable, and we've experienced solid growth and less volatility in output and employment. To keep inflation at 2 per cent, the Bank tries to maintain a balance between the overall (or aggregate) demand for, and supply of, goods and services. When aggregate demand and supply are in balance, the economy can operate at its full production capacity, and inflation is stable. To achieve this balance, the Bank raises interest rates when aggregate demand pushes the economy above its sustainable production capacity, causing price pressures to build and inflation to rise above the target. And, in a symmetric fashion, the Bank lowers interest rates when unused capacity puts downward pressure on inflation, pushing it below the target. Inflation control contributes to better economic performance in several ways, but let me highlight two of them. First, low and stable inflation enables firms and individuals to have confidence in the value of money and to read price signals clearly, helping them to make sound long-term economic decisions. Second, when inflation is contained, and the economy is running close to capacity, we can deal more effectively with economic shocks. Resources can more easily be reallocated from sectors where demand is relatively weak to sectors where demand is relatively strong. This is especially important at times, like now, when there are large movements in relative prices--that is, in the prices of some goods, such as energy products, relative to other prices. Meeting the inflation target helps to anchor expectations of inflation, and that in itself helps to keep inflation low and the economy relatively stable. Also, and importantly, the explicit goal of the inflation target acts as an anchor in our decision-making process at the Bank of Canada. Let me now turn to the other key component of Canada's monetary policy framework--the "float"--the flexible exchange rate. Let's start with a basic question: Why allow the dollar to float? The fundamental reason is that a flexible currency allows us to follow an independent monetary policy, a policy suited to our own economic circumstances. We wouldn't be able to address the particulars of the Canadian economy if we set monetary policy with the goal of maintaining a fixed exchange rate. With just one instrument to carry out monetary policy, we can have only one target--and we target inflation. But there's another important reason for having a flexible exchange rate. Just as a properly moored ship has some play in the mooring lines to absorb changes in the wind and the tide, the floating dollar helps the economy to absorb shocks--especially external shocks that affect our economy differently than the economies of our major trading partners. That is, it helps us adjust to shifting currents in the global economy. It's useful to think of the exchange rate as a , a price that provides a good deal of useful information. Movements in the exchange rate send signals to businesses and consumers, signals that help the economy adjust to changing circumstances. But just because the Bank of Canada does not have a target for the Canadian dollar does mean that we ignore the exchange rate. Far from it. For any significant currency movement, we try to assess the implications for aggregate demand in Canada, and thus the implications for monetary policy. And, as part of this analysis, we try to determine the factors driving a given movement. Let me expand on this. The Canadian dollar can rise or fall for a number of reasons. But, in principle, we can divide exchange rate movements into two categories--Type One and Type Two. Type One exchange rate movements reflect changes in the aggregate demand for Canadian goods and services. Type Two movements reflect other factors. The key point is that these two types of currency movement have different implications for monetary policy. In general, there's less of a need for monetary policy to respond to a Type One movement than to a Type Two movement. But just to make life interesting for central bankers, types of movement may occur at the same time. Interpreting currency movements is not a science; it requires judgment. In Canada, Type One currency movements often relate to the health of the global economy, which in turn is reflected in the foreign demand for, and world prices of, the commodities we produce in this country. When global demand is strong, and world commodity prices rise, the value of the goods that Canada exports increases, and this tends to cause the Canadian dollar to appreciate. This appreciation provides an offsetting force, dampening foreign and domestic demand for Canadian-produced goods and services. To the extent that this dampening effect offsets the initial direct increase in demand, there's no need for a policy response. Aggregate demand and supply remain in balance, and inflation stays on target. A Type Two exchange rate movement is one that is triggered by a change in aggregate demand for Canadian goods and services. But, as you might expect, the currency movement affects the demand for Canadian goods and services, by making them more, or less, competitive relative to goods and services produced elsewhere. Other things being equal, this is a situation to which monetary policy needs to respond to keep aggregate demand and supply in balance, and inflation on target. Type Two exchange rate movements are more difficult to describe, both because they are best defined as anything that is not Type One, and because the distinction is not always as clear in practice as it is in theory. One example of a Type Two exchange rate movement is the "portfolio shock" that can arise when there is a sudden reassessment of risk by global investors, often in response to an economic crisis somewhere in the world. When this happens, there is a so-called "flight to quality." That is, investors move out of assets denominated in riskier currencies--typically those of highly indebted countries--and this can lead to a sharp depreciation of these currencies. To the extent that the depreciation reflects the pure portfolio effect that is due to "financial contagion," and not the result of a fall in demand for the goods and services produced by the country, it is a Type Two depreciation. In the first half of the 1990s, when inflation targeting was still very new in Canada, and our government debt was rising unsustainably, Canada was more susceptible to this kind of exchange rate movement. Another example of a Type Two force, this time in the opposite direction for the Canadian dollar, is the adjustment of the U.S. dollar against most major currencies, reflecting concerns about the U.S. current account deficit. I'd like to elaborate on this as I discuss the recent appreciation of the Canadian dollar. Since the beginning of 2003, the Canadian dollar has appreciated by about 40 per cent relative to the U.S. dollar, and by a lesser amount against a trade-weighted basket of the currencies of our major trading partners. This sharp appreciation appears to be largely the result of two factors: strong foreign demand for Canadian products, especially commodities, and broad-based weakness in the U.S. dollar. That is to say, both Type One and Type Two forces have been at play. Global economic growth has been strong over this period. Sustained strength in the U.S. economy, combined with tremendous growth in China and other parts of Asia, has led to a surge in world demand and prices for oil and gas, metals, and other commodities that Canada exports. In many respects, what we have been seeing since 2003 is the reverse of what happened as a result of the fallout of the Asian Crisis in the second half of the 1990s, when world growth weakened, commodity prices plunged, and the Canadian dollar dropped to a low of about 64 cents U.S. Indeed, our own research has long found a relationship, in the same direction, between non-energy commodity prices and the value of the Canadian dollar. And our more recent research suggests that, with the substantial growth in our net trade surplus in energy since the early 1990s, energy prices now appear to have an influence (also in the same direction) on the value of the Canadian dollar. So, with the boom in the prices of energy and non-energy commodities since 2003, we have seen a marked Type One appreciation of our currency. But this is not the whole story. Another factor driving the Canadian dollar higher since 2003 has been a broad-based weakening of the U.S. dollar. The American dollar has fallen against many currencies as a result of concerns about the large and growing U.S. current account deficit. This situation cannot be sustained indefinitely, and investors appear to believe that a depreciation of the U.S. dollar is needed to help resolve this aspect of the "global imbalances." This multilateral currency realignment also appears to be playing a role in the appreciation of the Canadian dollar. To the extent that the Type One appreciation is working to offset the underlying positive shock to the Canadian economy, there is less need for monetary policy to respond. But the Type Two appreciation is something that monetary policy would want to respond to in the form of a lower policy interest rate . Our assessment is that of the exchange rate appreciation since 2003 reflects strong global demand and higher commodity prices. At the same time, part of the Canadian dollar appreciation has been related to the multilateral depreciation of the U.S. dollar, and we have had to factor this Type Two force into our monetary policy decision making. Weighing all factors, the Bank of Canada has raised the policy interest rate from 2 1/2 per cent to 4 1/4 per cent, as unused capacity in the Canadian economy has been absorbed by strong foreign and domestic demand for Canadian goods and services. Our objective with these rate moves has been to keep the Canadian economy operating at its potential and inflation close to the 2 per cent target over the medium term. Policy interest rates in the United States, by comparison, have increased from 1 per cent to 5 per cent. As a result, while the Canadian and the U.S. economies both appear to be operating close to their full production capacity, interest rates in Canada are below those in the United States right across the yield curve. And, at longer maturities, the negative spreads with U.S. rates are historically large. As I said earlier, interpreting currency movements is difficult and requires judgment. The challenge is even more acute during periods of market volatility, such as we've seen in recent weeks. At this point, I'd like to make one thing very clear: for many individuals and firms, adjusting to exchange rate changes can be difficult--particularly when the currency moves as far and as quickly as it has in the past three years. While higher commodity prices benefit some firms, others are facing higher energy and non-energy input costs, and new competition from low-cost producers in China and elsewhere. For these firms, the higher value of the Canadian dollar is an added pressure. Some sectors, particularly manufacturing, tourism, the fishery, and forestry, are facing some very real challenges. And some firms, especially in the manufacturing sector, are struggling, and individuals have lost jobs. We are well aware of this, and recognize the stresses that come with such dislocation. It's important to point out that there's a good deal of diversity each sector of the economy. Not all commodity producers are benefiting from high commodity prices--firms in the paper products and agriculture sectors face difficulties. And some manufacturers, notably in machinery and equipment, and resource processing, are doing well. What we have been struck by, both in industry visits and in our analysis of the data, is how actively businesses have been responding to the challenges posed by a rapidly appreciating dollar. The Bank of Canada's most recent survey of Canadian businesses shows that about half of the firms surveyed have been adversely affected by the rising dollar, while about a quarter have been favourably affected. Those adversely affected have responded to the strengthening dollar by outsourcing labour-intensive production, specializing in higher value-added products, developing new products and entering new markets, and by improving productivity. Firms in Nova Scotia and across Canada are looking for ways to adapt to, and thrive in, these challenging times. The fact that they adjusting attests to the strength and resiliency of Canadian business, and to the skills and resourcefulness of our workers. For its part, the Bank of Canada will continue to support the adjustment process by keeping inflation low and stable and the economy operating close to capacity. This contribution is critical to the adjustment process because it enables sectors that are expanding to more readily absorb resources that are released by sectors under pressure. And our focus on inflation control ensures that Canadians can continue to have confidence in the value of their money. I'd like to conclude by emphasizing that the flexible exchange rate is an essential part of Canada's monetary policy framework. A floating currency absorbs shocks, passes on price signals, and--against a backdrop of low and stable inflation--facilitates adjustment to economic developments. This framework, of anchored inflation and a floating exchange rate, helps Canada to weather the sometimes stormy seas of the global economy. Whatever the economic circumstances, the Bank of Canada will continue to do its part by keeping inflation under control and the economy expanding in a sustainable fashion. For business, a floating currency brings both challenges and opportunities. I'm sure that Nova Scotians will continue to seize the opportunities, and, through investment, innovation, and marketing, rise to the challenges. I'd now be happy to respond to your comments and questions.

r060621a_BOC

canada

Global Economic Forces and the Need for Adjustment

dodge

Since the start of the millennium, developments in the global economy have led to important changes throughout the Canadian economy and to serious challenges for many sectors and regions. Because nobody can anticipate precisely how the world will unfold, the best we can do is to ensure that our economy is as flexible as possible. What I want to do today is look briefly at how the Canadian economy has adjusted so far and talk about what public policies--including monetary policy--can do to promote economic flexibility. Let me start by listing the main global developments since 2000. First, China and India have emerged as economic powerhouses. Second, global economic growth has been extraordinarily strong. Third, we have gone through a period marked by an unusually high amount of monetary stimulus, which central banks are now in the process of reducing. At the same time, we have seen a persistent and growing current account deficit in the United States, mirrored by large and growing current account surpluses elsewhere, especially in Asia and among many oil-exporting countries. These developments have had significant consequences for the Canadian economy. The strong global growth, especially in China, India, and the United States, has led to sharply higher prices for many of the primary commodities that Canada produces. The emergence of China and India has also led to intense competition for many manufacturers, as well as lower prices for various consumer durable and semi-durable goods. The higher prices for many of our exports, coupled with lower prices for imported goods, have led to an improvement in our terms of trade and rising incomes for Canadians--particularly for producers of commodities, including metals and energy products. In this environment, we have seen a rapid increase in the external value of the Canadian dollar. It is clear that we must all adjust to these developments and be ready to take advantage of the opportunities presented by the strong global economy. Of course, adjustment is easier said than done. And it is important to acknowledge that adjustment is often very difficult on a personal level. The adjustments over the past three years have been particularly difficult because of the speed and size of the movements in relative prices. This has been a double-edged sword. On the one hand, some firms are facing booming demand and have been unable to expand quickly enough, hindered by shortages of skilled labour, outdated machinery, and inadequate infrastructure. On the other hand, some firms have struggled to increase the value-added of the goods they produce in Canada in the face of falling prices and global competition. They have had to find ways to shift some activities offshore. This second type of difficulty has been more prevalent in traditional goods-producing industries such as clothing, textiles, and newsprint. In some cases, business owners and employees--who have invested decades of their lives in a particular firm or industry--are coming to terms with plant closures and the loss of jobs. None of this is easy. These difficulties have been plain to see in media reports and in official economic data. However, these same data also show increases in output in sectors such as wholesale trade and financial and business services, as well as manufacturing sectors such as pharmaceuticals and transportation equipment. Despite all the challenges, we are seeing businesses across the country being inventive in responding to the necessity of adjustment. We have been tracking this adjustment through our regular communications with business groups, manufacturers, and exporters, as well as through the Bank's . These surveys, conducted by staff in the Bank's regional offices, are available on our website, and I encourage you to look at them. Since 2003, when the Canadian dollar began to appreciate, they have told an encouraging story of how businesses have found ways to innovate and adjust to changing circumstances. But what role is there for public policies in this adjustment process? Above all, governments should not try to shield business from global forces, nor should they interfere with market signals. Which policies then can support market-based adjustment? At the macroeconomic level, monetary and fiscal policies can facilitate adjustment by promoting stable and sustainable long-term economic growth. I'll have more to say about the role of monetary policy in a moment. On the microeconomic side, let me mention a few areas where governments can act. The first has to do with infrastructure, and there are really two sides to that--human and physical. In terms of human infrastructure, there is a crucial role for government in promoting education and training. Ultimately, the strength of our economy depends on the skills of its workforce. Obviously, governments should make sure that everyone has the opportunity to receive a sound, basic education. And in the face of shortages of skilled labour, public policies should encourage the training and retraining of employees, so that they can move more easily into sectors that are expanding. But I would not stop there. There is much that we as employers can do to give our employees the opportunity to improve and develop their skills. In terms of physical infrastructure, public policies can support both public and private investment so that firms can become more productive. By infrastructure, I am referring not only to traditional projects such as roads, bridges, and pipelines, but also to assets such as the so-called "information superhighway." Having modern, reliable infrastructure in place allows businesses to invest with greater certainty, thus furthering the adjustment process. This may mean the use of private funds to develop public infrastructure projects, as I have mentioned in past speeches. And now is the time to encourage this type of investment, given our climate of low nominal interest rates, and the presence of large pension funds that are searching for these kinds of investment opportunities. The second area where governments can act has to do with policies to promote economic flexibility. Governments must see to it that rules and regulations are not hindering that flexibility. In terms of labour markets, we need to recognize that supporting workers does not mean propping up factories or industries that cannot compete in the global economy. Rather, it means removing barriers so that workers can make adjustments as easily and painlessly as possible. Rules and regulations should not prevent workers from shifting from sector to sector, province to province, or even region to region within a province. Too often, labour mobility is hindered because credentials are not recognized from one province to another. All of these barriers to labour mobility are unhelpful, not just to the economy, but to the workers themselves. The focus for policy must be how to encourage and support the mobility of our workforce. Third, we need policies that allow Canadian capital markets to work at peak efficiency. This will also provide business with flexibility to help them invest and expand, and so support the adjustment process. As I have said before, we need policies that do not impede efficiency in our financial institutions and markets, and at the same time encourage competition. This is crucial, not only because it allows firms to have appropriate access to capital, but also because financial services is a high value-added industry that makes a large contribution to employment and income, particularly here in Montreal. Those are three of the most important microeconomic policy considerations for the public sector in terms of supporting economic adjustment. On the macroeconomic side, governments should continue to aim for sustainable fiscal policies, with budgets in rough balance or in small surplus. But I want to spend a few minutes speaking about monetary policy and the role of the Bank of Canada. The Bank of Canada's monetary policy aims to preserve a climate of low, stable, and predictable inflation. This can help with the adjustment process in several ways. Such a climate minimizes the distortion of price signals that can lead to inappropriate investment choices. Low and stable inflation allows firms to undertake long-term investments with greater certainty. But crucially, low inflation also reduces the risk premium demanded by investors. This means that nominal long-term interest rates are kept low, which supports the investment that helps with the adjustment process. In addition, the Bank's monetary policy has a stabilizing function, which also facilitates adjustment. Let me explain. We keep inflation in check by trying to have the economy operate at full capacity, with aggregate supply and demand in balance. In doing so, we help the adjustment process because resources that are released by sectors under pressure can be more readily absorbed by sectors that are expanding. We see clear evidence of this process happening right now in Canada. Let me now say a few words about how our flexible exchange rate fits into our monetary policy framework. There are some who have called on the Bank to smooth out fluctuations in the Canadian dollar, or to slow its ascent. But we have one monetary policy instrument--our influence over interest rates--so we can have only one target. Canada has chosen low inflation as the target, because experience clearly shows that low inflation is the best contribution that monetary policy can make to economic health. We do have a target for the Canadian dollar. However, this does not mean that the Bank does not care about the impact of movements in the exchange rate on the Canadian economy. The truth is quite the opposite--the exchange rate plays an important role in our monetary policy deliberations. Exchange rate movements tell us something about economic developments that may be having a direct impact on the demand for Canadian goods and services. And the movements themselves have their own effect on aggregate demand, by changing relative prices and by shifting demand between domestic- and foreign-produced products. The challenge for the Bank is to evaluate these movements, together with other data, and to set a course for monetary policy that works to keep demand and supply in balance and inflation low and stable. In making this evaluation, we try to determine how much of a particular movement in the Canadian dollar is due to changes in world demand for our goods and services, and how much is due to other factors unrelated to the demand for Canadian goods and services. It is important that we understand the causes of exchange rate movements, because the implications for the economy, and the appropriate monetary policy response, depend on the cause of the change. Generally speaking, movements related to changes in demand for our goods and services would require little, if any, monetary policy response. This is because their impact on Canadian aggregate demand would serve to offset the initial direct changes in global demand for our goods and services. And this would help to keep overall supply and demand in balance. So what can we say about the appreciation of the Canadian dollar? Since 2003, most of the appreciation--but not all--appears to have been related to our improved terms of trade and the increased demand for Canadian goods and services. Some of the appreciation has also reflected the broad-based weakness of the U.S. dollar associated with global current account imbalances. My colleague, Tiff Macklem, spoke on this topic at some length a couple of weeks ago, and you can find his . Determining how much of each of these forces is behind the movement in the currency is an important, but very difficult, judgment that the Bank must make. This judgment is even more difficult during times of market volatility, such as we have seen since the Bank's last fixed announcement date on 24 May. During that time, a number of Canadian economic indicators have also been published. Some of these indicators have been stronger than expected, others have been weaker. But on balance, the projection we set out in our April appears to be reasonable. That is to say, we continue to expect economic growth roughly in line with the growth of potential output, and inflation to average close to the 2 per cent target in 2007 and 2008, excluding any temporary effects on inflation that will follow the forthcoming reduction in the Goods and Services Tax. As we said at our last fixed announcement date, we will continue to monitor all economic and financial developments in the global and domestic economies relative to the projection in the April . But it is important to remember that when it comes to setting monetary policy, the Bank always tries to develop a complete picture of the economy. We do not react unduly to any individual piece of information. Rather, we put all the pieces together to get to the underlying trends in the economy. And, as always, we will look at the complete economic picture as we lead up to our next decision date on 11 July, and we will present that complete picture in our two days later. Let me conclude. Powerful global economic forces have been affecting the Canadian economy and will continue to have an impact for the foreseeable future. Adjustment must take place. It hasn't been easy, and it hasn't been without pain. And adjustment won't be easy in the months and years ahead. But I'm encouraged to see that most firms are getting on with the job. I encourage you to persevere with these adjustments. For our part, we remain committed to keeping inflation low, stable, and predictable. That is the best contribution we can make to helping output and employment remain strong.

r060629a_BOC

canada

What Monetary Policy Can and Cannot Do

jenkins

I am very pleased to be here today. As Canada's central bank, we are committed to conduct monetary policy in a way that fosters confidence in the value of money. This is our primary responsibility. But the Bank has a number of other functions that are very important to economic life in Canada. We promote the safety and soundness of the financial system. We supply quality bank notes that are readily accepted without concerns about counterfeiting. We provide efficient and effective central banking and debt-management services. And, of course, we communicate our objectives openly and effectively as part of our commitment to be accountable for our actions. Today, I will focus on our main function--the conduct of monetary policy. Specifically, I want to talk about what monetary policy can do and, by implication, what it cannot do. This is a fairly broad mandate, with multiple policy objectives. So one can understand why people might think that monetary policy can do more than it really can. But why does the preamble say " " I believe that this is how the legislators meant to recognize the complexity of the economy and the fact that not all of the policy objectives in the preamble would be achievable through monetary policy action alone. As economists, we deal with this complexity by looking separately at different areas and aspects of the economy--industries, sectors, regions, various demand components such as consumption, investment, government spending, etc. Then we add up all this information to get a better overall picture before taking policy action that is appropriate for the economy as a whole. We can use a similar approach with the preamble--pulling apart its various pieces and focusing on them separately. So let me start with the stated objective of monetary policy, which is ". . . to regulate credit and currency in the best interest of the economic life of the nation . . . and generally to promote the economic and financial welfare of Canada." This means that the Bank should conduct monetary policy so as to provide conditions that will allow the economy to expand in line with its full production potential. By production potential I mean the highest level and growth rate of output that can be sustained over the long run without triggering inflation pressures. Over time, gains in employment and incomes that go with an economy operating at potential will lead to rising living standards, maximizing our national welfare. What are the key factors that determine potential output? Quantity and quality of labour are certainly among them, as are investment in physical capital (that is, machinery and equipment, buildings, and infrastructure), technological innovation, and managerial and entrepreneurial know-how. So, what role can monetary policy play here? The fact is that none of these factors are determined directly by monetary policy. But the Bank can make an important contribution by instilling confidence in the public, specifically about the future value of money. This is fundamental. And it is in fact what monetary policy can deliver on a consistent basis. Over the long haul, the single, most direct contribution that monetary policy can make to sound economic performance is by providing Canadians with confidence that their money will keep its purchasing power. When inflation is low and stable, and when we all trust that it will stay that way, market signals are sent and received more clearly. And this leads to a more efficient allocation of economic and financial resources, which in turn helps to achieve our economic potential, in terms of growth in output, employment, and incomes. So that's the long run. But what can monetary policy do in the short term to ". . . mitigate by its influence fluctuations in the general level of production, trade, prices and employment," as instructed in the preamble? Consistent with our mandate, we work to reduce short-term volatility in output and employment. We cannot, of course, hope to do away with the business cycle altogether. But at a minimum, we can conduct monetary policy so that the economic ups and downs are not exaggerated, and in fact smoothed out. Again, experience has taught us that a policy of low and stable inflation works best to stabilize the economy in the short run. How do we go about achieving a more stable economy through our focus on low and stable inflation? Theory tells us that we can provide confidence in the value of money in one of two ways. By fixing the value of our currency to that of a low-inflation country and letting domestic prices move around in response to shocks. Or, by controlling domestic inflation directly and allowing our currency to float. We cannot target both the exchange rate and inflation because monetary policy has only to work with--the policy interest rate. So realistically, it can aim only at . In Canada, we have chosen the second option--a policy framework that combines an explicit target for domestic inflation and a flexible exchange rate. This allows us to conduct an independent monetary policy that both provides confidence in the value of money and helps to stabilize the economy in response to shocks. Let me expand on this latter point. The Bank operates around an inflation target of 2 per cent--caring equally about inflation falling below or rising above that target. And so we take action to lower, or raise, our policy interest rate to bring inflation back up, or bring it down, to 2 per cent over the medium term. This symmetric approach to inflation control helps keep the economy expanding near its trend growth of potential. A floating exchange rate also contributes to stabilizing output around potential. As a very open economy and as major producers of commodities, we are very much affected by large swings in the world demand and the prices for our products. Such swings cause our terms of trade--the prices we get for our exports relative to the prices we pay for imported goods--to move around a lot. Because wages are sticky in the short run, a fixed exchange rate would force the economy to adjust to terms-of-trade shocks mainly through changes in output and employment--and the result would be exaggerated swings in economic activity. But an exchange rate that floats will absorb some of the movements in relative prices and, in this way, help the economy adjust with less overall fluctuation in output and employment. All told, the inflation target and our flexible exchange rate work well together--indeed reinforcing each other--to provide an effective stabilization mechanism for the economy. This pretty much covers what monetary policy can realistically do to support economic growth in the long run and to smooth out short-term fluctuations. Let me now give you a flavour of the specific concerns and problems monetary policy is often asked to address directly--and, for the most part, cannot. These no doubt will sound familiar as the Canadian economy has been going through a period of adjustment during which the challenges for many industries and their employees have become more intense than usual. Topping the list of concerns are exchange rate movements. Any significant upward or downward movement in the Canadian dollar is virtually guaranteed to bring forth pleas for central bank action to, at least, moderate the movement and lessen its effects on the economy. We went through this in 1997-98, when the Canadian dollar depreciated markedly in response to the decline in world demand and commodity prices. And since 2003, we have repeatedly been urged to deal with the reverse situation--that is, a sharp appreciation of our currency, primarily reflecting strong world demand and high prices for energy and other commodities. In response, we have stressed that movements in our currency are largely a of market forces at work in the world environment in which Canada operates. In other words, the changes that we have seen in recent years represent a global reality. We simply cannot wish them away. And they will continue, regardless of the level of our policy interest rate and regardless of whether we have a fixed or a floating exchange rate. Monetary policy cannot change the reality of these developments. Nor can it somehow eliminate the need for our economy to adjust to global forces and trends that are fundamental in nature. To be clear, this is emphatically not to say that, in setting policy, we won't take into account the effects that any adjustments related to global change--including the reallocation of resources across sectors--are likely to have on the production capacity of our economy. Nor does it say that monetary policy will not take into account any effects that global developments and relative price movements will have on aggregate demand for Canadian products. Indeed, before announcing our interest rate decisions eight times a year, we assess all of the factors that have implications for the balance of demand and supply in the economy, and thus for the conduct of monetary policy. Exchange rate movements among those factors. But I must clarify that the response of monetary policy to exchange rate movements depends on the reason for those movements. More importantly, it depends on the overall net effect that such movements and other developments are expected to have on aggregate demand in Canada. In general, there are two types of exchange rate movement. The first reflects a direct real change in the demand for Canadian products stemming from a strengthening (or weakening) of world economic activity and any associated changes in the prices of those products. The second type does not reflect a direct change in the demand for Canadian products. Instead, it may reflect a portfolio adjustment--in favour of, or away from, Canadian financial assets. Or it may be part of a broader realignment of major currencies that is required to resolve the global imbalances (by which I mean the persistent large U.S. current account deficit mirrored by large surpluses elsewhere, notably in Asia and in many oil-exporting countries). Let me now relate all this more closely to our recent experience in Canada, and explain how monetary policy can be expected to respond to these different types of currency movements. Consider the sharp appreciation of the Canadian dollar since 2003. This movement has largely reflected strong world demand and prices for our energy and non-energy commodities. In this case, the higher Canadian dollar has been working to dampen the initial increase in demand for our products and to encourage a rotation of economic activity towards commodities. To the extent that the dampening effect of the appreciation on aggregate demand exactly offsets the initial increase in demand, thereby keeping overall supply and demand in balance, there would be no need for monetary policy to respond. Now, consider an upward movement in the Canadian dollar that reflects financial market developments that have little to do with an increase in the demand for Canadian products. Movements reflecting a general weakness of the U.S. dollar against major floating currencies, related to the large global imbalances, are of this type. An appreciation of the Canadian dollar reflecting these factors would have a dampening effect on aggregate demand in Canada. So, if such a movement persisted, other things equal, there would be a need for offsetting monetary policy action. Of course, in practice, it is difficult to gauge precisely the relative importance of these two types of movements. Often, they may be concurrent, making it particularly challenging to sort out the implications for the economy and for monetary policy. I will now turn to another, not unrelated, issue that some Canadians expect us to address. And that is, the notable differences in performance we now see in certain sectors and regions of our economy. To put these trends in perspective, it is important to understand what drives them. The key factors at play here are the strong world demand and prices for energy and non-energy commodities, and the decline in the prices of many manufactured goods, but especially consumer goods, because of strong global competition. These developments and the differing economic circumstances across regions are the reason why some people argue for a monetary policy that is differentiated by region. The Bank's response is that all Canadian regions are part of the same currency union; so it is simply not possible to deliver different interest rates or exchange rates to different parts of the country. Monetary policy is in nature and scope, with each region having its in the aggregate economy. This means that our monetary policy actions have to be directed at balancing aggregate demand and supply in the economy as a whole in order to keep the national rate of inflation on target. Thus, monetary policy cannot be used to eliminate or to smooth out differential growth rates in specific sectors or regions. But even if this were possible, there is another good reason why monetary policy should remain focused on the aggregate economic picture. As I said before, the movements we now see in relative prices reflect changes in the global economy. Through these relative price movements, markets are essentially telling us that there has been a fundamental change in the type of products the rest of the world wants to buy from us. So, we have to adapt and shift production towards those goods and services most in demand. Monetary policy action (or indeed any other policy action) that would thwart those market signals and impede the adjustment process would not serve Canada well over the long run. Adjustment is never easy or painless. And the Bank fully appreciates the difficulties that Canadian companies, particularly manufacturers and their employees, are currently facing. Monetary policy can help the adjustment process by keeping inflation at 2 per cent and the national economy operating close to capacity. When inflation is low and stable, businesses can read price signals more clearly, which helps them to make informed, sound decisions. And when the economy is operating at capacity, production resources can be more effectively reallocated from sectors where demand is relatively weak to where demand is relatively strong. Let me now say a word about the economy. Since the Bank's last fixed announcement date on 24 May, a number of economic indicators have been published. Some of the new data have been stronger than expected, others have been weaker. But on balance, the economic projection we set out in our April appears to be reasonable. And as we said on 24 May, we will continue to monitor economic and financial developments in the global and Canadian economies relative to the projection in our April . But it is important to remember that, in setting monetary policy, we always try to develop a complete picture of the economy. This way, we do not unduly react to any single piece of information. In line with this, as we lead up to our next decision date of 11 July, we will be looking to put all of the pieces together into a complete picture. And we will present that picture in our two days later. This brings me to the end of my remarks. Let me then summarize my key points. Clarity about what monetary policy can, in fact, deliver is fundamental to our job as central bankers. Experience in Canada and around the world has taught us that preserving confidence in the value of money is the unique contribution that monetary policy can make to sustained economic performance and rising standards of living. Our commitment is to keep inflation low, stable, and predictable. This is the best way for monetary policy to help output and employment remain strong, and to facilitate the adjustment of our economy to global forces.

r060713a_BOC

canada

Release of the

dodge

Today, we released our July , which discusses current economic and financial trends in the context of Canada's inflation-control strategy. Overall, the Bank's outlook for growth and inflation in Canada is largely unchanged from that in its April . Growth in the first half of 2006 appears to have been a little stronger than projected, and the Canadian dollar has traded in a higher range than was envisaged in the April . The economy is currently judged to be operating just above its production capacity. Growth in 2007-08 is expected to be a little weaker than was anticipated in the April , owing primarily to the lagged effects of the higher Canadian dollar. With some anticipated moderation in U.S. growth, combined with past interest rate and exchange rate increases, the Canadian economy is projected to return to its production capacity by the end of 2008. The Bank projects economic growth of 3.2 per cent in 2006, 2.9 per cent in 2007, and 2.8 per cent in 2008. Total CPI inflation is expected to average just over 1 1/2 per cent from mid-2006 to mid-2007--with the reduction in the GST lowering the inflation rate by 0.6 percentage points over this period--and then return to the 2 per cent target and remain there through the projection period. Core inflation should also remain at about 2 per cent through to the end of 2008. There are important upside and downside risks to the Bank's projection. But the Bank continues to judge that these risks are roughly balanced, with a small tilt to the downside later in the projection period because of the possibility of a disorderly resolution of global imbalances. On 11 July, the Bank kept its target for the overnight rate unchanged at 4.25 per cent. The current level of this policy rate is judged, at this time, to be consistent with achieving the inflation target over the medium term. The Bank will continue to monitor global and domestic economic and financial developments, including adjustments in the Canadian economy, relative to its projection.

r060719a_BOC

canada

The Right Policies for Today's Global Economy

dodge

Canada and Chile both rely heavily on international trade and foreign investment for economic growth, and are both major producers of commodities. Because we share these attributes, we also share a keen interest in the health of the global economy. So, what I would like to do this morning is talk about how the global economy has unfolded and what we can expect to see in the future. In doing so, I'll talk about some of the major forces at work in the global economy and the key challenges that they pose. Then, I'd like to discuss the policies that will best help countries like ours to deal with these challenges, from both a domestic and an international perspective. Over the past few years, we have seen a strong expansion of the global economy. Indeed, the rate of expansion has exceeded the growth rate of global potential output. This strong growth has led to higher prices for many of the primary commodities that our two countries produce. In turn, this has meant an improvement in our terms of trade and rising national incomes. This global growth has been rooted primarily in the economic strength of the United States and emerging Asia. In the U.S. economy, growth has come from strong household demand, while net national savings have been negative. But in emerging Asia, household demand has been weak, while net national savings have been very high. These forces have contributed to the global current account imbalances that are now such a concern. To be clear, when I say "global imbalances," I am referring to the large and persistent U.S. current account deficit, which is mirrored by current account surpluses in Asia and in many oil-exporting countries. These imbalances have grown to the point where the United States needs to attract 70 per cent of the world's capital flows to finance its current account deficit--clearly an unsustainable situation. I'll have more to say about imbalances, and how they can be resolved, in just a moment. But first, I should mention another important consideration in today's global economic picture. Following events such as the Asian and Russian financial crises of the late 1990s and the bursting of the tech bubble earlier this decade, central banks around the world injected a lot of liquidity into the global economy. Clearly, this liquidity helped to encourage the strong growth of recent years. But now, central banks are in the process of removing some of it. The interest rate increases seen to date, and the prospects for more increases to come in some countries, have been associated with somewhat increased volatility in financial markets, as investors adjust their expectations about future growth. This withdrawal of liquidity is completely appropriate, given that the global economy is now likely not too far away from the limits of its capacity. Thus, it seems very likely that global growth will slow to a more sustainable pace. Ideally, this would take place in a relatively smooth way. But there are a number of risks surrounding this scenario, and there is a possibility that global growth will slow more sharply than desired, to the detriment of our two economies. The most important risk has to do with the way global imbalances are ultimately resolved. There are a couple of concerns here. First, in order to reduce its current account deficit to sustainable levels, the U.S. economy needs to reduce its domestic demand. But as I mentioned, U.S. demand has been a key support for the global economy. So it is crucial that other major players boost their domestic demand to pick up the slack. Specifically, it is important that China and the economies of emerging Asia take steps to reduce their savings by strengthening household demand. It is also important that demand in Europe and Japan continue to strengthen, to help global economic growth smoothly "rotate" away from the United States without global demand slowing too much or too quickly. It is crucial that financial markets remain confident that policy-makers are serious about putting the right policies in place to allow for an orderly resolution of imbalances. As long as they have this confidence, financial markets are likely to continue to function smoothly. But my main concern is that if we don't make more progress in implementing the right policies, then we run an increased risk of global financial instability. And such instability could then spill over into trade in goods and services, leading to a dramatic decline in global growth. So, what are the right policies? This will be the subject of the rest of my remarks. Let me begin by looking at this question from the perspective of domestic policies before turning to international issues. My counterpart at the , Vittorio Corbo, spoke at a conference on central banks and global imbalances last month in Spain. In his remarks, Governor Corbo discussed the need to have the right domestic policies in place to help deal with the resolution of imbalances. These policies include structural reform, fiscal policy, and monetary policy. Let me say a few words about each of these. Structural reform is a broad area with many priorities. But in general, we can say that policy-makers should aim to encourage efficiency and flexibility in their economies. This is particularly true in the financial sector, where it is vital that all countries work to strengthen their financial markets and institutions. The ultimate goal should be an efficient and stable financial system, so that scarce resources can be channelled into the most productive investments, and so that problems in the global economy are less likely to disrupt national economies. While both Canada and Chile have reasonably flexible economies, there is still much more to be done. In my own country, we continue to grapple with the need to make labour markets more flexible and to foster competition. We are also working to make financial markets as efficient as possible. As regards fiscal policy, the key for macroeconomic policy is to focus on the sustainability of public debt over the medium term. Canada has run a budgetary surplus at the federal government level for nine consecutive years. Because of this record, the federal government's public debt-to-GDP ratio has fallen from a peak of over 70 per cent to about 35 per cent now, and is on track to reach just 25 per cent in 2013-14. In Chile, the government has had great success since 2000 with its structural surplus rule. This policy has proven to be an effective stabilizer throughout the business cycle and has helped the country maintain an enviable debt position. A fiscal policy that delivers public debt sustainability is particularly useful in today's economic climate, because it gives governments the flexibility to respond to evolving circumstances. For Canada, this will become increasingly important given that we will be facing demographic pressures in the years ahead as our population ages. In terms of monetary policy, both the Bank of Canada and the were pioneers in adopting a policy of inflation targeting backed by a floating exchange rate. Both central banks agree that preserving confidence in the value of money is the best contribution that we can make to the economic and financial welfare of our countries. The inflation-targeting system has been enormously beneficial in providing an anchor for monetary policy. In both countries, the high and variable inflation rates of the 1980s have given way to low, stable, and predictable inflation, and inflation expectations are firmly anchored. We both approach the inflation target in a symmetrical way. This helps to smooth the ups and downs of the business cycle and, more generally, has led to stronger economic growth in the long term. How does inflation targeting help in the context of today's global economy? First of all, by reducing uncertainty about the future value of money, a climate of low and stable inflation maximizes the clarity of signals that are sent by prices. This helps businesses to make appropriate investments. Further, central banks pursue inflation targeting by adjusting interest rates with the goal of keeping total supply and demand in the economy in rough balance. In doing so, monetary policy can make it easier for resources to shift from sector to sector. This is particularly important in times such as these, when large swings in relative prices highlight the need for rapid adjustments in economic activity. One of these relative prices is the exchange rate. A flexible exchange rate is very useful because it helps the economy adjust to shocks, especially external shocks that affect different economies in different ways. But large movements in the exchange rate can pose difficulties for particular sectors. And it can be harder for policy-makers to keep following the right policies when some important economies are seen to be circumventing what could be called "the rules of the game." I'll come back to this point, and discuss the international financial system in just a moment. But first, let me say a few words about international trade. Our reliance on international trade means that both Chile and Canada have a particular interest in promoting the free flow of goods and services. All countries should be working to push the Doha round of multilateral trade negotiations to a successful conclusion and to strengthen the World Trade Organization in order to ensure proper compliance with the rules of trade. And policy-makers need to be vocal in resisting calls for protectionism. Unfortunately, progress on trade appears to be stalled, and protectionism is a real and rising threat. The calls for protectionist action are, perhaps, a natural by-product of today's globalized economy. As the world economy has developed, domestic firms have found themselves having to adjust to global forces much more quickly than in the past. With the globalization of markets has come intense competition in many sectors. Without question, this globalized economy has brought tremendous benefits to our citizens. But in the face of competition, policy-makers have heard calls to shield businesses or sectors from market forces. And in some cases, we have seen policies that try to prevent market-based economic adjustments, restrict foreign ownership in certain sectors, or restrict capital flows. These policies may have short-term appeal, but, in the long run, they are counterproductive. Instead, governments need to adopt the right policies--those that will encourage free and open markets and facilitate market-based economic adjustments. Indeed, the strong growth seen in Canada and Chile is clear evidence of the benefits that come from opening our economies to global competition. Central banks cannot do much directly to implement policies that encourage free and open markets and facilitate market-based economic adjustments. But central bankers do have a responsibility to advocate these policies. And we have a responsibility to work with each other in international settings to ensure that the world's financial system is conducive to the free flow of goods, services, and capital. We have a responsibility to ensure that systemically important countries are doing their part to support a well-functioning international financial system. This is why we in Canada have been pushing hard for a renewal and modernization of the International Monetary Fund. Just as the WTO is charged with promoting free and fair trade in goods and services, so should the IMF be the international organization dedicated to promoting a well-functioning, market-based international financial system. We need an IMF where all members commit to playing by the rules of the game--a set of guidelines for policies that best support a market-based international financial system. For the IMF to fulfill this role, we need to rekindle the spirit of internationalism that was evident 60 years ago when the Fund was first established. But it is difficult to build a shared sense of trust and responsibility if key players feel that they don't have an adequate voice. What Canada and others have been advocating is a multi-step approach to making the Fund more representative. First, at the annual meetings this year in Singapore, the Fund should move to grant an "ad hoc" increase in quota to the four key countries that are clearly underweight in terms of quota and voting power: China, South Korea, Mexico, and Turkey. Then, the Fund needs to move with some urgency to determine and implement a process for adjusting quotas in order to more systematically recognize the changing realities of the global economy. But how would a more representative IMF go about promoting a well-functioning international monetary system? Let me mention three issues. The first is to have countries commit themselves to following the rules of the game. What does this commitment mean in concrete terms? It means that members should commit to establishing frameworks for their monetary, fiscal, exchange rate, and financial sector policies that are coherent, consistent with maintaining internal balance, and that support an efficient and stable market-based international financial system. Further, their policies should facilitate adjustment to shocks and should aim to mitigate negative spillovers to other economies. I should be clear that following the rules of the game does not mean that a country must adhere to a narrow range of policy choices. The important principle is that all countries, whether they are OECD members or economies in transition, should share a commitment to a market-based international financial system. This means a commitment to strengthening domestic institutions and policy frameworks so that markets are allowed to work freely, and to eschewing policies that thwart market-based adjustments. This includes a commitment not to undertake sterilized foreign exchange intervention that impedes the adjustment of real exchange rates over the medium term. The second issue is IMF surveillance. The Fund should conduct bilateral surveillance that would assess how well each member is living up to its commitments. But there is also a clear need for the IMF to strengthen its surveillance of the global economy. The Fund is uniquely placed to perform this task. Essentially, multilateral surveillance should identify the key risks facing the global economy and the scope for policy actions--either by individual members or collectively--to mitigate these risks. If national policies are causing negative spillovers to other countries, this should be addressed through the surveillance process. And the Fund should be prepared to share its analysis of these spillovers with national authorities. The third issue is that the IMF must be more effective in its role as a forum where national authorities come together to discuss global financial and economic issues. The Fund should be considered as place where national authorities can gather around the same table for a frank exchange about common policy issues. The Fund must cultivate the same co-operative spirit seen at its inception and seen at the OECD in the 1960s and 1970s as that institution helped to build a liberal economic order and a framework for freer trade. Canada has called for this modernization of the IMF because it is clearly in our interest that there be an effective institution to promote a market-based international financial order. I believe that such an institution is in Chile's interest as well. Canada and Chile have benefited greatly from the strong global economic growth of recent years. But the global economy could suffer if policy actions are not taken to deal with global imbalances. In this context, I have spoken of domestic policies that are particularly important for countries such as ours: structural reforms to encourage economic efficiency and flexibility, a sustainable fiscal policy, and a monetary policy based on inflation targeting. By following these domestic policies, both Canada and Chile will be well placed to handle developments in the global economy, whatever those may be. But we also need to work together to shape that global economy. We need to support free trade in goods and services and to resist protectionism. And, as I said, we--together with other countries--need to make the international financial system as efficient and effective as possible. An important part of this effort will be to modernize the IMF. With strong domestic policy frameworks and a strengthened international financial system, Chileans and Canadians can look forward to continued strong economic growth in the years ahead.

r060720a_BOC

canada

The Right Policies for Today's Global Economy

dodge

Canada and Brazil both rely on international trade and foreign investment for economic growth, and both are major producers of commodities. Because we share these attributes, we also share a keen interest in the health of the global economy. So, what I would like to do today is talk about how the global economy has unfolded and what we can expect to see in the future. In doing so, I'll talk about some of the major forces at work in the global economy and the key challenges that they pose. Then, I'd like to discuss the policies that will best help countries like ours to deal with these challenges, from both a domestic and an international perspective. Over the past few years, we have seen a strong expansion of the global economy. Indeed, the rate of expansion has exceeded the growth rate of global potential output. This strong growth has led to higher prices for many of the primary commodities that our two countries produce. In turn, this has meant an improvement in our terms of trade and rising national incomes. This global growth has been rooted primarily in the economic strength of the United States and emerging Asia. In the U.S. economy, growth has come from strong household demand, while net national savings have been negative. But in emerging Asia, household demand has been weak, while net national savings have been very high. These forces have contributed to the global current account imbalances that are now such a concern. To be clear, when I say "global imbalances," I am referring to the large and persistent U.S. current account deficit, which is mirrored by current account surpluses in Asia and in many oil-exporting countries. These imbalances have grown to the point where the United States needs to attract 70 per cent of the world's capital flows to finance its current account deficit--clearly an unsustainable situation. I'll have more to say about imbalances, and how they can be resolved, in just a moment. But first, I should mention another important consideration in today's global economic picture. Following events such as the Asian and Russian financial crises of the late 1990s and the bursting of the tech bubble earlier this decade, central banks around the world injected a lot of liquidity into the global economy. Clearly, this liquidity helped to encourage the strong growth of recent years. But now, central banks are in the process of removing some of it. The interest rate increases seen to date, and the prospects for more increases to come in some countries, have been associated with somewhat increased volatility in financial markets, as investors adjust their expectations about future growth. This withdrawal of liquidity is completely appropriate, given that the global economy is now likely not too far away from the limits of its capacity. Thus, it seems very likely that global growth will slow to a more sustainable pace. Ideally, this would take place in a relatively smooth way. But there are a number of risks surrounding this scenario, and there is a possibility that global growth will slow more sharply than desired, to the detriment of our two economies. The most important risk has to do with the way global imbalances are ultimately resolved. There are a couple of concerns here. First, in order to reduce its current account deficit to sustainable levels, the U.S. economy needs to reduce its domestic demand. But as I mentioned, U.S. demand has been a key support for the global economy. So it is crucial that other major players boost their domestic demand to pick up the slack. Specifically, it is important that China and the economies of emerging Asia take steps to reduce their savings by strengthening household demand. It is also important that demand in Europe and Japan continue to strengthen, to help global economic growth smoothly "rotate" away from the United States without global demand slowing too much or too quickly. It is crucial that financial markets remain confident that policy-makers are serious about putting the right policies in place to allow for an orderly resolution of imbalances. As long as they have this confidence, financial markets are likely to continue to function smoothly. But my main concern is that if we don't make more progress in implementing the right policies, then we run an increased risk of global financial instability. And such instability could then spill over into trade in goods and services, leading to a dramatic decline in global growth. So, what are the right policies? This will be the subject of the rest of my remarks. Let me begin by looking at this question from the perspective of domestic policies, before turning to international issues. When I spoke to you two years ago, I talked about the importance of sound economic policies that facilitate change, and I referred to structural reform, fiscal policy, and monetary policy. The need to have sound policies in all these areas is even more acute today. Now, let me say a few words about each of these policies. Structural reform is a broad area with many priorities. But, in general, we can say that policy-makers should aim to encourage efficiency and flexibility in their economies. This is particularly true in the financial sector, where it is vital that all countries work to strengthen their financial markets and institutions. The ultimate goal should be an efficient and stable financial system, so that scarce resources can be channelled into the most productive investments, and so that problems in the global economy are less likely to disrupt national economies. As regards fiscal policy, the key for macroeconomic policy is to focus on the sustainability of public debt over the medium term. Canada has run a budgetary surplus at the federal government level for nine consecutive years. Because of this record, the federal government's public debt-to-GDP ratio has fallen from a peak of over 70 per cent to about 35 per cent now, and is on track to reach just 25 per cent in 2013-14. Brazil has also taken steps to stabilize its debt-to-GDP ratio and has taken advantage of recent favourable conditions to improve its public debt position. But the job is not complete; important challenges remain on the fiscal side. In terms of monetary policy, both the Bank of Canada and the follow a policy of inflation targeting backed by a floating exchange rate. Brazil came to inflation targeting a little later than Canada, but both countries have had success with this approach. Indeed, given the history of hyperinflation in Brazil, the current policy has been tremendously helpful in anchoring inflation expectations. How does inflation targeting help in the context of today's global economy? By reducing uncertainty about the future value of money, a climate of low and stable inflation allows the financial system to operate more effectively. This makes it easier for households to save and for businesses to borrow, so that they can make appropriate investments. Low and stable inflation also maximizes the clarity of signals that are sent by prices. Further, central banks pursue inflation targeting by adjusting interest rates with the goal of keeping total supply and demand in the economy in rough balance. In doing so, monetary policy can make it easier for resources to shift from sector to sector. This is particularly important in times such as these, when large swings in relative prices highlight the need for rapid adjustments in economic activity. One of these relative prices is the exchange rate. A flexible exchange rate is very useful because it helps the economy adjust to shocks, especially external shocks that affect different economies in different ways. But, as Canadians and Brazilians know, large movements in the exchange rate can pose difficulties. Brazil has continued to improve its macroeconomic and structural policies since I last spoke here in 2004. But economic growth is just now beginning to reflect these improvements, and it is important to stick with these policy reforms. To those who question the wisdom of maintaining these policies, I would point to Canada's history. We established inflation-reduction targets in 1991, and the first steps towards fiscal consolidation began a year later. But it was only in 1995 that our inflation target became 2 per cent, and large spending reductions began to take hold. It took a further three years for the payoff of improved economic performance to become apparent. But it did. Even in the face of some major shocks since the turn of the century, our economic performance has been much improved. So, the message I would bring to Brazil is that if you stay the course with the sound policies already adopted, and keep making progress where needed, you can be confident that the results will come in time. Why are these policies so important in today's climate? Essentially, they all give an economy the flexibility needed to handle various shocks. Nobody knows for sure how global imbalances will be resolved, so it is vital that our economies be prepared to adjust quickly. Structural reforms to enhance flexibility, a fiscal policy focused on debt sustainability, and a monetary policy of inflation targeting backed by a floating exchange rate, are all important in helping economic adjustment to take place--for the benefit of all. That's a look at some policy priorities on the domestic front. Let me now turn to a discussion of international policies, beginning with international trade. Our reliance on international trade means that we both have a particular interest in promoting the free flow of goods and services. All countries should be working to push the Doha round of multilateral trade negotiations to a successful conclusion and to strengthen the World Trade Organization in order to ensure proper compliance with the rules of trade. Our views may differ about how to get there, but Canada and Brazil would both greatly benefit from truly open international markets for all goods and services. So, policy-makers need to be vocal in resisting calls for protectionism. Unfortunately, progress on trade appears to be stalled, and protectionism is a real and rising threat. The calls for protectionist action are, perhaps, a natural by-product of today's globalized economy. As the world economy has developed, domestic firms have found themselves having to adjust to global forces much more quickly than in the past. With the globalization of markets has come intense competition in many sectors. Without question, this globalized economy has brought tremendous benefits to our citizens. But in the face of competition, policy-makers have heard calls to shield businesses or sectors from market forces. And in some cases, we have seen policies that try to prevent market-based economic adjustments, restrict foreign ownership in certain sectors, or restrict capital flows. These policies may have short-term appeal, but, in the long run, they are counterproductive. Instead, governments need to adopt the right policies--those that will encourage free and open markets and facilitate market-based economic adjustments. Indeed, the strong growth seen in Canada is clear evidence of the benefits that come from opening our economy to global competition. Central banks cannot do much directly to implement policies that encourage free and open markets and facilitate market-based economic adjustments. But central bankers do have a responsibility to advocate these policies. And we have a responsibility to work with each other in international settings to ensure that the world financial system is conducive to the free flow of goods, services, and capital. We have a responsibility to ensure that systemically important countries are doing their part to support a well-functioning international financial system. This is why we in Canada have been pushing hard for a renewal and modernization of the International Monetary Fund. Just as the WTO is charged with promoting free and fair trade in goods and services, so should the IMF be the international organization dedicated to promoting a well-functioning, market-based international financial system. We need an IMF where all members commit to playing by the rules of the game--a set of guidelines for policies that best support a market-based international financial system. For the IMF to fulfill this role, we need to rekindle the spirit of internationalism that was evident 60 years ago when the Fund was first established. But it is difficult to build a shared sense of trust and responsibility if key players feel that they don't have an adequate voice. What Canada and others have been advocating is a multi-step approach to making the Fund more representative. First, at the annual meetings this year in Singapore, the Fund should move to grant an "ad hoc" increase in quota to the four key countries that are clearly underweight in terms of quota and voting power: China, South Korea, Mexico, and Turkey. Then, the Fund needs to move with some urgency to determine and implement a process for adjusting quotas in order to more systematically recognize the changing realities of the global economy. But how would a more representative IMF go about promoting a well-functioning international monetary system? Let me mention three issues. The first is to have countries commit themselves to following the rules of the game. What does this commitment mean in concrete terms? It means that members should commit to establishing frameworks for their monetary, fiscal, exchange rate, and financial sector policies that are coherent, consistent with maintaining internal balance, and that support an efficient and stable market-based international financial system. Further, their policies should facilitate adjustment to shocks and should aim to mitigate negative spillovers to other economies. I should be clear that following the rules of the game does not mean that a country must adhere to a narrow range of policy choices. The important principle is that all countries should share a commitment to a market-based international financial system. This means a commitment to strengthening domestic institutions and policy frameworks so that markets are allowed to work freely, and to eschewing policies that thwart market-based adjustments. This includes a commitment not to undertake sterilized foreign exchange intervention that impedes the adjustment of real exchange rates over the medium term. The second issue is IMF surveillance. The Fund should conduct bilateral surveillance that would assess how well each member is living up to its commitments. But there is also a clear need for the IMF to strengthen its surveillance of the global economy. The Fund is uniquely placed to perform this task. Essentially, multilateral surveillance should identify the key risks facing the global economy and the scope for policy actions--either by individual members or collectively--to mitigate these risks. If national policies are causing negative spillovers to other countries, this should be addressed through the surveillance process. And the Fund should be prepared to share its analysis of these spillovers with national authorities. The third issue is that the IMF must be more effective in its role as a forum where national authorities come together to discuss global financial and economic issues. The Fund should be considered as place where national authorities can gather around the same table for a frank exchange about common policy issues. The Fund must cultivate the same co-operative spirit seen at its inception and seen at the OECD in the 1960s and 1970s as that institution helped to build a liberal economic order and a framework for freer trade. Canada has called for this modernization of the IMF because it is clearly in our interest that there be an effective institution to promote a market-based international financial order. I believe that such an institution is in Brazil's interest as well. Canada and Brazil have benefited greatly from the strong global economic growth of recent years. But the global economy could suffer if policy actions are not taken to deal with global imbalances. In this context, I have spoken of domestic policies that are particularly important for countries such as ours: structural reforms to encourage economic efficiency and flexibility, a sustainable fiscal policy, and a monetary policy based on inflation targeting. By following these domestic policies, both Canada and Brazil will be well placed to handle developments in the global economy, whatever those may be. But we also need to work together to shape that global economy. We need to support free trade in goods and services and to resist protectionism. And, as I said, we--together with other countries--need to make the international financial system as efficient and effective as possible. An important part of this effort will be to modernize the IMF. With strong domestic policy frameworks and a strengthened international financial system, Brazilians and Canadians can continue to benefit from the global economy in the years ahead.

r060828a_BOC

canada

Productivity, Terms of Trade, and Economic Adjustment

duguay

Good evening. It is a pleasure and an honour to speak to you this evening, at the start of a conference that has a long and distinguished tradition among Canadian business economists. I hope that my remarks will spur some fruitful discussion, and I look forward to your reflections tomorrow on Canada's "low-productivity conundrum." The Bank of Canada is keenly interested in productivity--for a number of reasons. Productivity gains are a key determinant of growth in potential output and, hence, of Canada's sustainable pace of non-inflationary economic expansion. Productivity also affects marginal costs, a key driver of prices. And productivity differences across sectors and across countries have implications for the real exchange rate. More generally, increasing productivity is fundamental to raising living standards and therefore deserves the attention of policy-makers, business people, and citizens. And it seems fair to say that productivity will become even more important as the Canadian population ages and as China, India, and other emerging-market countries increase their presence in the world economy. At the same time, it's important to realize that the expansion of trade with these countries provides new opportunities for increases in productivity and real income. I will touch on productivity in my remarks this evening, but I would like to focus on another issue that also has a direct bearing on our standard of living--namely, our terms of trade, that is, the prices we get for our exports relative to the prices we pay for our imports. When the prices of what we sell in world markets go up, or the prices of what we buy from the rest of the world go down, we are richer as a country. But changes in our terms of trade mean more than changes in real income and wealth. They also have significant implications for the allocation of resources within the economy. And our economic welfare depends, in large measure, on how well and how swiftly we adjust to such changes in economic circumstances. The past three and a half years have been marked by a significant improvement in Canada's terms of trade. This has also been a period of particularly intense adjustment. I want to talk about this adjustment process and the link to our standard of living. I will begin by drawing attention to the distinction that must be made, in an open economy, between real income and real output. I will then review the adjustment of the Canadian economy to the recent sharp rise in our terms of trade and suggest some general implications for productivity and potential output. After this, I'll say a few words about the Bank of Canada's new economic model, ToTEM, and conclude with some comments on the Bank's outlook for the Canadian economy. There is no doubt that advances in productivity underpin improvements in our standard of living. However, in an open economy, real income depends not only on the volume of output, but on the trading value of that output, that is, on the terms of trade. Moreover, domestic production is not the only source of income, and not all income from domestic production accrues to residents. The tendency to identify standard of living with real gross domestic product (GDP) per capita overlooks these important dimensions. In my view, a better indicator of the standard of living would be gross national product (GNP) per capita deflated by domestic demand prices. By focusing on GNP rather than GDP, this measure includes Canadians' earnings from abroad and excludes non-residents' income earned in Canada. By deflating GNP by the price index for domestic purchases rather than by the GDP deflator--the price of domestic output--it captures the terms-of-trade effect. It is instructive to compare this measure of real income with that of GDP per capita over the past 35 years ( ). While the two measures move broadly in sync for most of this extended period, they have diverged since 2003. Since then, and for the first time in 25 years, real income per capita has grown consistently faster than real output per capita. From 2002 to 2005, the average annual growth of real income per capita was 3.6 per cent, compared with growth in real output per capita of 1.7 per cent. This gain in real income reflects an improvement both in our terms of trade and in the balance on cross-border investment income. The substantial rise in real commodity prices since the beginning of 2003 and the reduced prices for imported consumer goods from emerging-market economies have resulted in a significant improvement in our terms of trade, and generated large gains in real income. These gains, which are reflected in higher prices for domestic output relative to those for domestic purchases, account for 1.6 percentage points of the 3.6 per cent annual growth in real income since 2002. In addition, current-dollar GNP has grown more rapidly than current-dollar GDP since 1999, as foreign investment income accruing to Canadians has risen more than Canadian investment income accruing to non-residents. This factor has contributed 0.3 percentage points to average annual growth in real income since 2002. It reflects both the decline in Canada's net international indebtedness--the result of a stream of current account surpluses in recent years--and the effect of a stronger Canadian dollar on the servicing of U.S.-dollar-denominated debt. The measure of real income advocated here--GNP divided by the domestic demand deflator--is more comprehensive, more intuitive, and easier to compute than the related concept of "command GDP," which has attracted some attention lately. Command GDP takes terms-of-trade changes into account by deflating current-dollar exports by the import price index ( ). It equals real income only when the trade balance and the current account balance are both at zero . To be sure, real GDP has other drawbacks as a measure of living standards, and these drawbacks apply equally to the measure of real income derived from GNP. For example, both are measures of gross, rather than net, output or income--they don't make allowance for depreciation of capital or degradation of the environment. Furthermore, they ignore non-marketed services produced by public infrastructure, and make no allowance for the distribution of income among Canadians. But the point I want to highlight this evening is that improved terms of trade and a strengthened net foreign investment position have resulted in a significant--and easily measured--increase in the real per capita income of Canadians in the aggregate, and thus in our standard of living. Of course, the income gains generated by an improvement in the terms of trade, particularly those associated with swings in commodity prices, may not be as durable as those generated by advances in productivity. But the income gains associated with declining import prices that come from the productivity gains achieved by our trading partners are no different than those generated by increases in domestic productivity. So, while accounting for the open-economy dimension doesn't diminish the importance of increased productivity to our standard of living, it does underscore that living standards are affected by a number of factors in addition to productivity gains, and that living standards benefit from increases in both domestic and foreign productivity. I should add that these inadequacies of real GDP as a measure of real income do not in any way diminish its relevance to monetary policy. From a monetary policy perspective, real income matters primarily as a driver of demand. But when it comes to assessing the pressures of demand on capacity--a key component of inflation dynamics--it is real GDP that matters. I would now like to turn to how Canada has fared in adjusting to the recent terms-of-trade shock. As I noted, the recent rise in Canada's terms of trade stems from two main sources: reduced prices for imports, especially from emerging-market countries such as China and India, and substantially higher prices for many of our commodity exports due to strong global demand, particularly from Asia. This improvement in our terms of trade may last for some time, if prices of commodities in futures markets are any indication. It has increased real wealth and income, and thus fuelled increased spending by consumers, governments, and businesses. A further outcome has been a rapid and substantial appreciation of the Canadian dollar against the U.S. dollar and, indeed, against many other currencies. The stronger Canadian dollar has tempered the pressure of increased domestic spending on aggregate demand by dampening net exports, thus helping to keep overall supply and demand in balance, and inflation pressures in check. At the aggregate level, then, the flexible exchange rate has been playing its classic role of "shock absorber." However, from a sectoral perspective, the sharp rise in the exchange rate has signalled the need for prompt adjustment. It has intensified the pressure on many manufacturers, who were already facing stiff competition from producers in emerging-market countries. It has reduced their export revenues and lowered the prices of competing imports, even as the prices of many raw material inputs were rising. Large, sustained changes in the terms of trade--whether in a favourable or unfavourable direction--can cause stress and dislocation. They can lead to significant shifts in production and employment among sectors of the economy, resulting in a loss of jobs in some industries and growth in others. In macroeconomic terms, terms-of-trade shocks trigger a shift of resources to activities generating higher income. From that perspective, postponing adjustment would mean forgoing the potential income gains that the reallocation of resources can bring. Adjustment is always difficult--but it is vital to our economic prosperity. Some observers regard the adjustment to the recent rise in Canada's terms of trade as a form of the "Dutch disease." But from a macroeconomic point of view, the reallocation of resources is a sign of health, not disease--it is the sign of a vibrant, dynamic economy adjusting to significant shifts in demand by putting resources to their most profitable use. To make the most of our opportunities as a trading nation, we need to adjust as quickly and effectively as possible to changes in global economic circumstances. There are indications that Canadians are doing just that. With profitability especially strong in the energy and mining sectors, as well as in most sectors with low exposure to international trade, businesses and investors have been quick to seize the new opportunities presented by the improvement in our terms of trade. We've seen strong growth in capital spending and employment in these sectors. A surge in investment in machinery and equipment across the economy suggests that firms are taking advantage of the stronger exchange rate (which reduces the cost of imported machinery and equipment) to improve their productivity and enhance their competitiveness. Many manufacturers are taking advantage of lower-cost imported inputs or shifting their focus to higher-value-added production. Labour is also adjusting to the terms-of-trade shock. The evidence shows that labour markets in Canada are relatively flexible, which helps the country adjust to labour-demand shocks. While employment has decreased markedly in manufacturing since 2004, it has grown strongly in non-farm primary industries, in construction, and in other sectors that are driven by the strength in domestic demand--for example, finance, insurance, real estate, and health and education services. These developments have involved a sharp increase in net migration of labour to Alberta from other parts of the country. Employment growth in Ontario and Quebec has moderated a bit, but still averaged a relatively robust 1.3 per cent from July 2004 to July 2006. Overall, the Canadian economy has been adjusting rather well, though not without pain, to a significant change in economic circumstances. However, the adjustment is not over yet, and challenges remain. There are still barriers to labour mobility and to interprovincial trade, and pressures are building on housing markets and infrastructure in regions of strong growth--most notably, Alberta. These are reflected in intensified labour shortages and differentiated pressures on wages and housing prices. Because governments receive a significant share of increased commodity-related revenues, they have the power to alleviate, but also to magnify, some of these pressures. Let me now turn to the implications of a terms-of-trade shock for labour productivity and for potential output. A change in the terms of trade can affect labour productivity through two main "channels": the exchange rate and the reallocation of resources across sectors. The currency appreciation associated with an improvement in the terms of trade lowers the relative price of imported physical capital, particularly machinery and equipment, and encourages the substitution of capital for labour, which should contribute to higher labour productivity over time, other things being equal. While the effect of the reallocation of resources on real income is always positive, its effect on aggregate labour productivity is less clear. For one thing, the rise in commodity prices can be expected to lower productivity in the primary sector, as higher-cost--that is, less-productive--activities become more profitable. On the other hand, the reallocation of capital and labour away from the production of manufactured goods toward the production of commodities should raise overall labour productivity, since labour productivity levels are higher in the more capital-intensive primary sector. As for the shift from tradables to non-tradables, no generalization is possible, since the non-tradable, services sector is very broad and very diverse, with some industries (like finance and wholesale trade) showing high productivity levels and others (like retail trade) showing much lower productivity levels. At any rate, these are long-run effects. In the short run, the adjustment process can be expected to exert a transitory drag on productivity growth. For instance, workers with skills tied to a particular industry may require retraining in order to become fully functional in areas of the economy that are expanding. Once in new jobs, it may take them some time to develop the firm-specific skills often associated with productivity gains. Furthermore, investment in new machinery and equipment may involve new technology, which may necessitate retraining or reorganization of the workplace before the full productivity gains materialize. Now, to the extent that a terms-of-trade shock affects productivity growth, there will also be an effect on the growth of potential output. If I were to generalize about the likely effects of the current terms-of-trade shock on potential output through productivity, I would say that we would expect to see an increase in the long run, but a possible dampening in the short run, owing to transitional dislocation costs. The gain over time would come primarily from the "capital deepening" that results from changes in the relative costs of labour and capital and from increased exploration in the primary sector. While closed mines can be re-opened fairly quickly, regulatory requirements and the time it takes to build infrastructure mean that it can take more than a decade for a new mine to go from exploration to production. Thus, the rise in potential output from this latter source will occur slowly. The Bank's interest in understanding how terms-of-trade movements play out in the economy is not new. For decades, the Bank of Canada has monitored the effect of swings in the terms of trade on real income and on the external value of the Canadian dollar. Over the years, we have built models to study how changes in the terms of trade and the subsequent economic adjustment affect the economy. But it is only recently that Bank staff have formally incorporated a separate commodity sector into our main projection model, ToTEM. In contrast to the Bank's previous model, which treated economic activity as a single aggregate, ToTEM--which stands for Terms of Trade Economic Model--makes explicit the distinction between raw materials or commodities, and manufactured goods. This distinction is crucial for two reasons. First, commodity production represents a sizable proportion, some 11 per cent, of Canadian GDP, and commodity exports account for nearly 45 per cent of the dollar value of our total exports. Second, the commodity sector and the manufacturing sector are characterized by different technologies and different competitive structures, which have important implications for the behaviour of inflation. For instance, the production of commodities is more capital-intensive and more price-inelastic than the production of other goods and services. Moreover, commodity prices are set in world markets, whereas manufactured goods are subject to product differentiation and to a greater degree of price-setting influence by firms. In ToTEM, the key driver of consumer prices is the marginal cost of producing consumer goods. Consumer goods are produced using four inputs: labour, capital, an imported intermediate good, and commodities. In this framework, the marginal cost can be expressed as a function of labour costs (including the costs of hiring and training), as well as the price of imported intermediate goods, the price of commodity inputs, the price of investment goods, and the rate of capacity utilization. ToTEM is a clear improvement over the previous model in its ability to capture the response of the Canadian economy and the Canadian dollar to changes in commodity prices. That's all I'll say about ToTEM for now. But this fall we'll be publishing an article in the that will discuss this new model in some detail. Let me now turn to the outlook for the Canadian economy as we at the Bank see it. The Canadian economy continues to adjust to major global developments. In the , released last month, the Canadian economy was judged to be operating just above its production capacity and was projected to return to capacity by the end of 2008, reflecting some anticipated moderation in U.S. economic growth and the effects of past increases in interest rates and the exchange rate in Canada. The level of the policy interest rate was judged, at the time, to be consistent with achieving the inflation target over the medium term. CPI inflation was expected to return to our 2 per cent target in the second half of 2007. Core inflation was projected to remain at 2 per cent throughout the projection period. In our , we said that the upside risk to Canadian output and inflation related primarily to the momentum of household spending and housing prices. It was judged to be roughly offset by the risk that the U.S. economy would grow more slowly than expected, thus reducing demand for Canadian exports. Information received since July suggests that real GDP growth for the second quarter may have been slightly weaker than anticipated in our . But the underlying trends in the economy appear to be in line with the broad thrust of our July projection in terms of both output and inflation. Finally, with the recently released July CPI now showing the effect of the 1 per cent reduction in the GST, I would like to remind you that, in setting monetary policy, the Bank's approach continues to be to look through any direct impact on inflation from changes in indirect taxes. In this context, core CPI, which excludes the effect of changes in indirect taxes, is an important indicator of the underlying trend of inflation. Allow me to conclude. As a trading nation in a global economy, Canada will continue to experience changes in its terms of trade. It is important to understand the effects of such changes, given their implications for both aggregate supply and aggregate demand, and for our standard of living. Movements in our terms of trade present important challenges and opportunities for Canadian businesses, individuals, and governments. Although adjusting to economic change is never easy, we respond to change has a real impact on our economic well-being. The speed with which we respond, the ways in which we deal with the challenges, and the extent to which we seize the opportunities, are all profoundly important. Over the past few years, Canada has responded rather well to a dramatic change in its terms of trade. Sound monetary policy has helped in two ways. Low and stable inflation has provided an important element of certainty in a time of rapid change. And monetary policy has helped to facilitate adjustment by supporting aggregate demand to keep the economy near its full potential and inflation on target. A strong world economy has also helped, making the adjustment process somewhat easier. But much of the success of this far-reaching adjustment is also a testament to the flexibility of Canadian workers and businesses.

r060913a_BOC

canada

Weathering Economic Shocks: The Importance of Flexibility

jenkins

Today, I would like to talk about the importance of flexibility to economic adjustment and, hence, about the need to adopt economic policies that promote flexibility in markets for goods, services, capital, and labour. I am particularly pleased to be discussing this issue here in British Columbia where adjustment to changing global and domestic economic developments has been front and centre in the management of your economy. First, I should explain what I mean by flexibility. As most of you are surely aware, the Bank of Canada has been openly discussing the importance of promoting policies that support economic efficiency, including financial system efficiency. Efficiency refers to the allocation of scarce economic resources to the most productive uses, in a cost-effective way. Flexibility refers to the ability of an economy to adjust to changing circumstances. When economic conditions change, this typically causes movements in relative prices that send important signals to markets. A flexible economy is one that adjusts to these signals and returns to its production potential as quickly, and with as little cost, as possible. Economic flexibility is what I wish to focus on today. Over the past several years, economic expansion in Canada and around the world has been robust. And, as we look ahead, prospects remain generally upbeat. In some respects, what we have witnessed in terms of economic performance is unprecedented, especially since it has been attained in the face of major global and country-specific shocks that, in the past, would have caused great difficulty and threatened to derail the expansion. This was certainly the case in Canada before the mid-1990s when the economy had a hard time dealing with economic and financial shocks. The boom-bust cycles of the 1970s, 1980s, and early 1990s stand out as clear evidence that we did not have our domestic house in order. The final straw was the extent to which the Canadian economy got caught up in the backwash of the 1994-95 Mexican peso crisis because of our high and unsustainable levels of public debt at that time. Indeed, the year 1995 proved to be a watershed. By then, the Bank had succeeded in reducing inflation and anchoring short-term inflation expectations to the 2 per cent target. The federal budget deficit began to shrink significantly in 1995, and by the 1997/98 fiscal year, it had moved into a surplus position. Other structural policies, including tax reform and free trade, were also beginning to pay dividends. Canada's economic record over the past decade stands in stark contrast to this earlier period. Output and employment have continued to grow steadily since the mid-1990s, even as our economy has been buffeted by a series of significant shocks. Let me recall some of those shocks. They started with the 1997-98 Asian financial crisis, which then spread to Russia and Latin America. This series of events in emerging-market economies led to a sharp decline in world demand and commodity prices and, hence, to a marked depreciation of the Canadian dollar. Next came the worldwide collapse of the high-tech bubble. It, too, depressed foreign demand for Canadian goods and services, as did the 9/11 terrorist attacks in the United States. On a relatively smaller scale, since the beginning of this century, the Canadian economy has had to contend with other domestic calamities that also had an international dimension to them. I'm referring, of course, to SARS and BSE. More recently, we have had to face intensified competition from major new global players, notably China and India. And, since 2003, we have experienced a sharp appreciation of our currency, which primarily reflects strong world demand and high prices for the energy and other commodities we produce. What have been some of the key characteristics of these shocks? The Asian crisis of 1997-98 and the circumstances we have been experiencing since 2003 have involved large movements in relative prices. By this I mean sharp movements in the prices of energy and non-energy commodities (relative to the prices of other goods we produce) and in the exchange rate for the Canadian dollar. These movements have triggered important shifts in economic activity and reallocations of production resources across sectors and regions of our economy. Following the Asian crisis, we saw a shift out of commodities and into manufacturing. Now we see a shift in the opposite direction. And the current intense competition from Asia is clearly evident in reduced prices for manufactured consumer goods. Adjusting to these shocks has not been easy--indeed, for many firms and their workers it has been downright painful. Still, as I said earlier, total output and employment have continued to grow at a good clip over the past decade--averaging 3 and 2 per cent a year, respectively. Furthermore, during the current episode of marked movements in relative prices, there has been broad-based economic growth across all Canadian regions. Canada is not the only economy that has coped better with recent shocks. To varying degrees, other countries have as well--which partly explains why world economic growth has held up better this time around. Clearly, many national economies have been able to respond more flexibly than in the past to unexpected developments. And this has helped to mitigate the impact of shocks, advance the adjustment, and support continued strong economic performance. This increased flexibility has been the product of economic policies and structural reforms that many countries, including Canada, have undertaken over the years to strengthen their economies and make them more resilient to shocks. But this does not mean that we have nothing to worry about as we look ahead. We live in an era of rapid change, and we operate in a global environment that is constantly shifting. Uncertainty, risks, and shocks are a constant feature of the economic landscape. For Canada, this is particularly relevant given how open our economy is to international trade and capital flows. At the Bank of Canada, we believe that world economic prospects remain favourable as we look out over the medium term. But while this reflects our central expectation of how the world will unfold, there are important upside and downside risks around this scenario. On the downside, persistent global imbalances immediately come to mind, as does the lack of success in the Doha round of trade talks. These risks could result in significantly slower global economic growth. At the same time, we cannot rule out the possibility of stronger growth, especially in Asia. Of course, we know that events can turn out very differently from our expectations today. So we must plan accordingly. In terms of potential risks and sudden developments, the best approach is to constantly ask ourselves what steps we can take to make our economy and domestic markets more flexible and thus better able to adapt. And we need to recognize that the pursuit of such an approach is a responsibility among firms, workers, and policy-makers. Firms and their workers need to be able to respond quickly to technological advances and to various shocks that require significant changes in the way they conduct business, the type of goods and services they produce, and the markets they choose to develop. A well-functioning market-based economy and clear relative price signals are critical in this context. At the same time, policy-makers need to be wary of barriers to adjustment, such as labour regulations that inhibit the movement of workers from one type of job, or from one sector or region, to another. Some of these issues are particularly relevant in a Canadian context, and I will return to them later. The key point I want to make here is that economic policies and structural reforms that enhance flexibility make it easier to withstand shocks and to make adjustments. And this helps to maintain output at the economy's production potential. Put differently, strong, well-functioning domestic markets for goods, services, capital, and labour are essential to the economic well-being of Canadians. In addition, with national economies so closely connected these days, actions by individual countries to increase flexibility translate into an even greater cumulative benefit for the world economy. Indeed, the greater the number of economies that are flexible enough to adapt to changing circumstances, the stronger and more sustainable world economic growth will be. So what are the policies that promote flexibility and thus position us to take advantage of the opportunities offered by globalization and to cope with unforeseen shocks that are sure to come our way? In Canada--and in many other countries--better macroeconomic management has been instrumental to the good economic performance of recent years. Specifically, a monetary policy focused on low, stable, and predictable inflation has helped Canadian businesses read price signals more clearly, respond to relative price changes more promptly, and generally allocate production resources more efficiently. And this, together with the Bank of Canada's response to deviations from the 2 per cent inflation target has contributed to solid and more stable economic growth over the past decade. A floating exchange rate--which is the other key component of our monetary policy framework--has also provided an important stabilization mechanism for the Canadian economy. Movements of the exchange rate provide clear price signals that help speed up adjustment to shocks with lower overall economic costs than if the exchange rate did not move. With a fixed exchange rate, it takes longer for price signals to be recognized, and the adjustment primarily takes place through changes in domestic prices and wages, at the cost of significant variability in output and employment. It is also important to recognize that it is simply not possible for a central bank to successfully control both the domestic and external values of its currency at the same time. We have only one instrument--our policy interest rate--and so we can have only one target. Thus, with inflation as our target, we naturally operate with a floating currency. A sound fiscal policy, focused on reducing public sector debt levels relative to the size of the economy, has also contributed significantly to economic stabilization. It gives governments flexibility to respond to evolving circumstances and unexpected developments. They can do this by letting automatic fiscal stabilizers work to help sustain the overall level of demand when the economy is weak or to relieve demand pressures when the economy is booming. We also know from bitter experience, especially through the late 1980s, that economic outcomes are better and adjustments less costly when macroeconomic policies are working in tandem. In this regard, given the current strength of domestic demand in Canada and the high level of resource utilization, governments need to guard against adding to any excess demand pressures. Despite considerable progress in Canada and elsewhere in maintaining macroeconomic stability, the growing integration of the world economy has made it clear that this is not enough. To enhance flexibility, raise the economy's growth potential, and increase resilience to shocks, we also need structural reforms. For Canada, structural reform has a broad context, with many priorities across a number of jurisdictions. I'll mention a couple that I consider to be particularly relevant. The financial system, with its vital role in supporting a healthy modern economy, has been and will continue to be a top priority. Here, the ultimate goal should be an innovative, efficient, and sound financial system that can provide specialized financing services competitively. Such a system enhances overall economic flexibility by helping to redirect capital and resources to the most productive uses, in a cost-effective way, following a shock. Removing internal barriers to the free movement of goods, services, and labour is another priority. This is an area that is rightly attracting renewed attention, as differences in regional economic performance and shortages of skilled labour are becoming more pronounced, and as demographic challenges begin to intensify. A number of initiatives to remove internal barriers have been undertaken over the years--but with mixed and generally modest results. Here, I'm thinking of the "Red Seal" program, which was introduced 45 years ago to help standardize and recognize workers' trade qualifications. I'm also thinking of the Agreement on Internal Trade (AIT), which was signed by First Ministers in 1994 and was aimed at reducing barriers to the movement of goods, services, investment, and labour. More recently, we have seen some progress in areas such as procurement practices, enforcement and dispute resolution, and licensing and residency requirements for employment. One recent example is the accord reached this past April between British Columbia and Alberta to strengthen enforcement and dispute resolution, and to harmonize labour credentials and business regulations and standards by early 2009. Another example is the agreement, earlier this year, between Ontario and Quebec to allow some further, albeit limited, movement of construction workers between the two provinces. Earlier this month, two temporary "foreign-worker units" started operating in Vancouver and Calgary to facilitate the entry of skilled foreign workers into Canada. And just last week, the Committee of Ministers Responsible for Internal Trade agreed on an action plan that embraces efforts across a range of internal trade issues. All this is encouraging because considerably more needs to be done to enhance the flexibility and functioning of our internal markets from coast to coast. Business regulations and standards, including those for the financial sector, need to be harmonized across Canada. Dispute resolution and enforcement under the AIT need to be strengthened. And, to make our labour markets more flexible, trades and professional designations should be recognized and fully transferable across the country. Based on a recent survey, more than one-third of all workers and about half of all foreign-trained workers still have problems getting their credentials recognized across Canadian jurisdictions. The good news is that, despite the challenges that we still face, overall, our economy fares well in international comparisons of flexibility and adaptability. In a 2005 study, the International Monetary Fund (IMF) concluded that "Canada is characterized by a relatively high degree of flexibility, of a magnitude comparable if not larger than many other industrialized countries, with the likely exception of the United States." For purposes of this study, the IMF looked at different indicators of economic flexibility--with uniform results. For example, the reallocation of production resources across sectors, in response to changing economic conditions over the 1980-2000 period, was quite high in Canada compared with other major industrialized countries (except the United States)--indicating a high degree of economic flexibility. The IMF also compared rates of firm turnover, and of job creation and destruction, across countries. Both of these measures were relatively high for Canada--again suggesting a high degree of flexibility. Other measures of the way in which our economy responds to macroeconomic disturbances also point in the same direction. As of the first quarter of 2006, interprovincial migration has shown a marked increase over the past two years to 333,000 individuals, representing over one per cent of the total Canadian population. Not surprisingly, the two provinces with a net positive inflow over this period are Alberta and British Columbia. And a more recent study by the IMF that focused on Canadian labour markets concluded that, overall, they are relatively flexible. So Canada does seem to rate high according to some measures of flexibility. But the challenge is to continue to promote flexibility in all of our domestic markets--for goods, services, capital, and labour. Continuous improvement is essential. Given the openness of the Canadian economy, we cannot be complacent. Before concluding, let me summarize the Bank's current thinking on the economy, as we laid it out last week in the press release announcing our decision to leave the target for the overnight rate unchanged at 4 1/4 per cent. Basically, we noted that the global economy has continued to expand solidly, with some moderation in U.S. economic growth but with some further strengthening in the rest of the world. Against this backdrop, commodity prices have remained firm. In Canada, the level of economic activity in the second quarter of 2006 was somewhat below the Bank's expectations, primarily because of weaker exports. Total and core CPI inflation came in slightly higher than expected in July, mainly because of price strength in the housing and services sectors. Nevertheless, all things considered--and here I would include the most recent labour force numbers--the underlying trends in the economy appear to be in line with the broad thrust of our projection for output and inflation in the July . We continue to expect that the economy will operate at about capacity through 2008, with total CPI inflation returning to the 2 per cent inflation target in the second half of 2007. In line with this outlook, the current level of the target for the overnight rate is judged at this time to be consistent with achieving the inflation target over the medium term. The key risks to the Canadian outlook for output and inflation over the next few quarters remain those set out in our July : on the upside, they relate primarily to the momentum in household spending and housing prices; on the downside, U.S. household demand could slow more rapidly than expected, thus reducing demand for Canadian exports. While both these risks appear to be a little greater than they were in July, we continue to judge that, overall, risks are roughly balanced. We will provide a full analysis of economic developments, trends, and risks in our next , which will be published on 19 October 2006. Let me now conclude. As a nation, we are clearly learning from experience and adapting to change. Over the past decade, we have done much to implement sound macroeconomic policies and structural reforms that have helped our economy become more flexible and thus more adaptable to change. Canada's strong economic performance in the face of major disturbances over this period attests to the importance of flexibility. However, our success to date does not mean that we can rest on our oars. Uncertainty, risks, and shocks will be as much a part of tomorrow's economic picture as they have been of yesterday's and today's. We all have a role to play in moving the Canadian economy to the forefront, in terms of flexibility and adaptability. The Bank of Canada is committed to doing its part.

r061019a_BOC

canada

Opening Statement before the House of Commons Standing Committee on Finance

dodge

Good afternoon, Mr. Chairman and members of the Committee. We appreciate the opportunity to meet with this committee, usually twice a year following the release of our . We were not able to meet last spring, so it has been a year since Paul and I were last before this committee. We believe that these meetings help us keep Members of Parliament and, through you, all Canadians, informed about the Bank's views on the economy and about the objective of monetary policy and the actions we take to achieve it. When Paul and I appeared before the Finance Committee last October, we noted at that time, that the global and Canadian economies were continuing to grow at a solid pace and that our economy appeared to be operating at full production capacity. In our latest , which we released this morning, we judge that the Canadian economy is currently operating just above capacity. While global economic growth is expected to be a little higher than previously anticipated, a weaker near-term outlook for the U.S. economy has curbed the near-term prospects for Canadian exports and growth. The Bank's outlook for growth in the Canadian economy has been revised down slightly from that outlined in July's . The Bank's base-case projection now calls for average annual GDP growth of 2.8 per cent in 2006, 2.5 per cent in 2007, and a return to 2.8 per cent in 2008. Weakness in labour productivity growth has led the Bank to lower its assumption for potential growth to 2.8 per cent for the 2006-08 period. Together, these factors imply that the small amount of excess demand now in the economy will be eliminated by mid-2007. Core inflation is expected to move a bit above 2 per cent in the coming months but return to the 2 per cent target by the middle of 2007 and remain there through to the end of 2008. Lower energy prices have led to a downward revision of the near-term projection for total CPI inflation. Total inflation (which includes the temporary impact of the GST reduction) will likely average about 1 1/2 per cent through the second quarter of 2007, before returning to the 2 per cent target and remaining there through to the end of 2008. As we noted at the time of our 6 September interest rate announcement, the risks around the base-case projection are judged to be a little greater than at the time of the July . The main upside risk relates to the momentum in household spending and housing prices, while the main downside risk is that the U.S. economy could slow more sharply than expected, leading to lower Canadian exports. The Bank judges that the risks to its inflation projection are roughly balanced. On 17 October, we left our key policy rate unchanged at 4.25 per cent. The current level is judged, at this time, to be consistent with achieving the inflation target over the medium term. We at the Bank will continue to pay close attention to the evolution of risks, as well as to economic and financial developments in the Canadian and global economies.

r061025a_BOC

canada

Opening Statement before the Senate Banking, Trade and Commerce Committee

dodge

Good afternoon, Mr. Chairman and members of the Committee. We appreciate the opportunity to meet with this Committee 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 objective of monetary policy and the actions we take to achieve it. When Paul and I appeared before this Committee last May, shortly after the release of our spring , we noted that the global economy had shown a little more momentum than had been anticipated: oil prices at that time were higher than previously assumed and metals prices had risen significantly. At that point, we were anticipating economic growth of about 3.1 per cent this year, 3.0 per cent in 2007, and 2.9 per cent in 2008. Things have changed somewhat since then. While global economic growth is expected to be a little higher than anticipated last spring, a weaker near-term outlook for the U.S. economy has curbed the near-term prospects for Canadian exports and growth. The Bank's outlook for growth in the Canadian economy has been revised down slightly from the outlook in last April's and the July of that report. The Bank's base-case projection now calls for average annual GDP growth of 2.8 per cent in 2006, 2.5 per cent in 2007, and a return to 2.8 per cent in 2008. Weakness in labour productivity growth has led the Bank to lower its assumption for potential growth to 2.8 per cent for the 2006-08 period. Together, these factors imply that the small amount of excess demand now in the economy will be eliminated by mid-2007. Core inflation is expected to remain a bit above 2 per cent in the coming months but return to the 2 per cent target by the middle of 2007 and remain there through to the end of 2008. Lower energy prices have led to a downward revision of the near-term projection for total CPI inflation. Total inflation (which includes the temporary impact of the GST reduction) will likely average about 1 1/2 per cent through the second quarter of 2007 before returning to the 2 per cent target and remaining there through to the end of 2008. As we noted at the time of our 6 September interest rate announcement, the risks around the base-case projection are judged to be a little greater than at the time of the July . The main upside risk relates to the momentum in household spending and housing prices, while the main downside risk is that the U.S. economy could slow more sharply than expected, leading to lower Canadian exports. The Bank judges that the risks to its inflation projection are roughly balanced. On 17 October, we left our key policy rate unchanged at 4.25 per cent. The current level is judged, at this time, to be consistent with achieving the inflation target over the medium term. The Bank will continue to pay close attention to the evolution of risks, as well as to economic and financial developments in the Canadian and global economies.

r061106a_BOC

canada

Prospering in Today's Global Economy: Challenges for Open Economies such as Australia and Canada

dodge

Sydney this evening to talk about our two economies, which have so many features in common: healthy growth, low unemployment, solid prospects for the future, and sound macroeconomic policies. But I'd also like to talk about our economies in the context of the wider global market in which we both trade. Further, I'll discuss just how essential it is to our economic well-being, and that of future generations, that we buttress the global institutions that are so vital to stable international trade and financial systems. As major producers of commodities, both Canada and Australia rely heavily on international trade for our economic expansion, and we each rely extensively on global capital markets. So, what I would like to talk about first is how we see the global and Canadian economies unfolding and what we might expect to see in the future. Following that, I'll also talk about some of the policies that can best help countries like ours to deal with the challenges of today's global economy, looking at this from both a domestic and an international perspective. In Canada, we're feeling pretty positive right now about our prospects, despite the fact that the pullback we are now seeing in the U.S. economy is larger, and has come faster, than we had expected. That slowing has serious implications for global demand, of course, but it hits home particularly hard for us, since the United States is, by far, Canada's largest trading partner. After several years of strong expansion, the U.S. economy is cooling down, restrained by a pullback in the housing sector and slowing demand for autos. After growing robustly in the first quarter of this year, U.S. growth slowed to 2.9 per cent in the second, and the advance estimate is that growth was just 1.6 per cent in the third quarter. The Bank of Canada now projects that U.S. economic growth will average 2 to 2 1/2 per cent in the last half of this year and the first half of 2007. Activity should then recover to above 3 per cent in the second half of next year and throughout 2008. Slower U.S. growth has clearly caused Canadian GDP growth to fall short of expectations in the second and third quarters. After expanding at a 3.6 per cent annual rate in the first three months of this year, GDP growth slowed to only 2 per cent in the second quarter, and we expect a similar figure for the third quarter. But it's important to think of this as a mild, and likely very short-lived, cyclical slowdown for Canada. With near-term weakness in the U.S. economy, net exports will likely exert a considerable drag on Canadian growth. However, consumer spending and business investment are expected to remain robust. Overall, we at the Bank of Canada project 2.8 per cent growth for real GDP in 2006, slowing to 2.5 per cent next year but coming back up to 2.8 per cent in 2008. Core inflation is expected to move a bit above 2 per cent in the coming months but return to the 2 per cent target by the middle of 2007 and remain there through 2008. Total inflation will likely average about 1 1/2 per cent through the second quarter of 2007, before returning to the 2 per cent target and remaining there through to the end of 2008. The main upside risk to the Canadian economy continues to relate to the momentum in household spending and housing prices. This momentum is linked to strong consumer credit growth. By increasing home equity and thus expanding the availability of collateral, the recent strong increases in house prices have contributed to robust growth in consumer credit. There is a risk that these linkages could be stronger than assumed or that house prices could continue to grow more rapidly than expected, resulting in higher-than-projected household spending and, hence, greater upward pressures on inflation. The main downside risk to the Canadian economy relates to the possibility of a sharper slowdown in the housing sector in the United States and a broadening of the weakness in the housing sector to consumption and investment. A larger decline in domestic demand in the United States would lead to decreased demand for Canadian exports and broader weakness in the Canadian economy. This development would also lead to lower inflation. The slower growth in the U.S. economy is a sharp reminder of just how important a role its powerful appetite plays in absorbing the exports of many countries and just how critical that strong U.S. demand has been to global economic growth. Of course, the United States has been far from alone in absorbing goods and resources from around the world to feed its economic expansion. The extent of the strong worldwide demand, particularly the demand for commodities coming from the emerging powers of China and India, has fuelled Canadian and Australian growth and also has reminded us of just how closely intertwined countries have become. Canada has traditionally been known for its net exports of non-energy commodities. Minerals and lumber continue to be important commodity exports for us. However, over the past decade, thanks to plentiful oil and gas reserves and sharply higher prices for oil and natural gas, we are now increasingly known for our energy riches. Similarly, Australia's reserves and exports of minerals, uranium, and coal are among the largest in the world, and demand for those commodities helps to shape the views of global markets about your country. As well, we're both major exporters of grains, traditionally among the top three in the world. As such, I can certainly understand and sympathize with your farmers who are suffering the effects of drought. With such strong world demand and interest directed towards our commodities, it's perhaps a good time to pause for a moment and reflect on how we might try to strengthen the global trade and financial systems that we rely on so much. World commodity markets are subject to ups and downs. The movements in commodity prices and our exchange rates can pose serious economic challenges for firms and workers. In turn, central bankers and governments must design policies that allow businesses and workers to react rapidly to changing economic circumstances. The healthy, steady prosperity of our two economies is a testament to domestic policies that are working to encourage flexibility, and thus facilitate adjustment. On the domestic front, it seems that both Canada and Australia have been on the right track--and we both have the economic record to demonstrate that! In terms of monetary policy, both the Bank of Canada and the Reserve Bank of Australia have embraced a policy of inflation targeting backed by a floating exchange rate. For over a decade, both the Reserve Bank of Australia and the Bank of Canada have concentrated on maintaining low and stable inflation. Inflation targeting helps to preserve confidence in the future value of money and, in that way, anchors inflation expectations. This helps business in making appropriate investments, by maximizing the clarity of the signals that are sent by prices. Controlling inflation is also crucial to maintaining the confidence of markets at home and abroad. Central banks pursue inflation targeting by adjusting interest rates with the goal of keeping total supply and demand in the economy in rough balance. By aiming to keep the economy running at or near full capacity, monetary policy can make it easier for resources to shift from sectors that are shrinking to sectors that are expanding. This is particularly important in times such as these, when large swings in relative prices highlight the need for rapid adjustments in economic activity. And it's especially important for countries like Canada and Australia--open, trading nations that rely particularly heavily on the production and sale of commodities for their economic well-being. Of course, a central bank that targets inflation must have a floating exchange rate. Experience has shown that for countries such as ours, exchange rate flexibility facilitates adjustments to shocks. Both Canada and Australia have reasonably flexible economies, by which I mean they have the ability to quickly adjust to changing circumstances. And while we recognize that both countries have taken steps to improve flexibility in recent years, there is still much more to be done. In my own country, for example, we continue to grapple with the need to make labour markets more flexible and to foster competition. We also recognize the need to make financial markets as efficient as possible. In the past decade, both Canada and Australia have followed very good fiscal policies. In Australia, this has been built on an earlier period of debt reduction, while in Canada, we are in the process of reducing debt to levels that will be sustainable in light of forthcoming demographic pressures that we, like so many other nations, will be facing. But flexibility and good macroeconomic policy at home still aren't enough to guarantee our future prosperity: it's crucial to us all that we maintain a well-functioning international financial system, an issue to which I will now turn. It seems very clear to me that it is absolutely in the best interests of Canada and Australia to promote freer trade and greater financial stability around the globe. With respect to trade, it is vital that the multilateral negotiations that began five years ago at Doha under the World Trade Organization be restarted and brought to a quick and successful end, and that we all work to continue to strengthen the WTO. The future prosperity of so many nations, in the developing world as well as the developed, depends on these crucial trade talks. In terms of international financial issues, I think we can all recall quite clearly a fairly recent example of what can happen when the international financial order breaks down. The Asian financial crisis occurred almost a decade ago, yet who can forget how rapidly it swept around the globe; knocking down currencies, shaking up markets, spreading to other emerging-market economies, and throwing many into a tailspin. Demand for commodities contracted sharply during the Asian crisis, which eventually led to a dramatic decline in many world commodity prices. Some commodity prices hit lows not seen since the end of the Second World War, and that led to a sharp depreciation of our currencies. Some progress has been made since then, including the establishment of bodies such as the Financial Stability Forum and the G-20. The G-20 brings together systemically significant industrial and emerging-market economies and, as you know, will be meeting in Melbourne later this month. I'm looking forward to this meeting, and I want to say how much I appreciate your country's strong support of this very important forum. Such a forum can provide emerging markets, in particular, with an opportunity to improve the quality of their macroeconomic policies and their regulation of financial systems. And I think it's fair to say that thanks to these and other efforts, the global financial system today is more robust than it was in the late 1990s. But there is so much more that must be done. The Asian financial crisis reminds us of how closely connected economies have become, and of the vulnerabilities of open, trading nations like ours. We can best flourish when the rules of the game are clear and when everyone follows them in deed, as well as in word. This is why the work of strengthening the International Monetary Fund is so important. Born 60 years ago at Bretton Woods, New Hampshire, the IMF was part of a movement to create an international order, whether in finances or trade, that would work to the benefit of member states. As economies become more integrated and new players have emerged on the global stage, the Fund's central purpose--to promote a well-functioning international monetary and financial order--is more relevant than ever. And it remains crucial to countries such as ours, which are heavily involved in global trade. Underlying this purpose is a basic premise: that the welfare of all our citizens is enhanced by a growing global economy, with rising standards of living and with realized gains from the exchange of goods and services across countries. Canada's need for a well-functioning international financial order helps to explain why we have been working so hard to see real reforms to strengthen the IMF, and to shift everyone's focus back to the original goals of its founders. With the size of capital and trade flows in today's global economy, we need--now more than ever--a fortified IMF that is truly able to promote a well-functioning, market-based international financial system. By "well-functioning," I mean a financial system that is both efficient and stable, so that markets can do their job of allocating savings to investments through the pricing of capital, and of smoothing economic adjustments through movements in relative prices. How should the IMF be reformed? Well, to solve global problems, we need to have everyone represented at one table and all participants fully engaged. But since 1997, the work of the IMF has suffered. Over the past number of years, many emerging-market economies have shifted some of their attention away from the centre of the global financial system, towards regional initiatives. This trend must be reversed. The fastest-growing parts of the world economy should have a growing voice at the IMF. At its recent meeting in Singapore, the Fund began the process of making itself appropriately representative of today's global economic reality. But the importance of this step will be lost unless we can improve the Fund's effectiveness in promoting a framework that supports a well-functioning global economy. I believe the key to that improvement lies in a strengthened surveillance function. So, how exactly should surveillance be strengthened? In my view, the IMF can play a pivotal role in mitigating serious global risks by serving, in the words of John Maynard Keynes, as a "ruthless truth teller." This expression is a wonderful turn of phrase, not only for its colourful language, but because it neatly encapsulates the critical objectives of effective IMF surveillance. The Fund's surveillance should determine the "truth" about the economic policies and circumstances of member countries, and then "tell" or communicate this truth transparently to all members and to the international community at large. To determine the truth, the IMF must be focused on the right surveillance priorities; namely, the exchange rate, monetary, fiscal, and financial policies of member countries. Surveillance should focus on these areas alone, and on the potential spillover effects that these policies may have on other members. These are the priorities that reflect the reality of an increasingly integrated global economy. This is not to say that there is one single prescription for macroeconomic and financial policies that all countries must rigorously follow. But what is important is that the particular policies chosen by a country must not hinder economic adjustment. The purpose of IMF surveillance must then be to determine whether the policies being followed by a country are coherent, and whether they have the potential to cause spillover effects in the rest of the world. Surveillance must not get bogged down in domestic microeconomic issues that have little or no bearing on the functioning of the global economy. Once the Fund staff have done their best analysis of the truth, the Fund must communicate, or tell it, clearly and transparently. I understand that being told the truth can be difficult for national authorities. After all, I was one of those national authorities back in the 1990s who was on the receiving end of IMF criticism. While at that time, we in Canada did not enjoy hearing the truth about our deteriorating fiscal situation, the criticism did help provide the impetus for us to take some tough decisions. Transparent truth telling also serves a very important function in that it allows markets to discriminate in the event of a global disruption. When investors have good, reliable information, they can make better decisions. This can help limit contagion and minimize the occasions when countries are sideswiped by the poor policy decisions of others. This is particularly important for emerging economies that do not have the wealth, income levels, or institutional capacity to withstand a serious shock. While the meanings of "truth" and "tell" are fairly clear, what can be said about the word "ruthless"? What this means is that surveillance must be uncompromising and free from interference, political or otherwise. If the policies of any country--large or small--pose risks for spillovers or impede market-based adjustments in the global economy, the truth must be told. Market integration and leverage have magnified the potential impact of policy spillovers. While risk sharing has also increased, markets remain far from complete; more and more countries can now have systemic effects. To sum up, we need to agree that the IMF should provide a candid assessment of policies that can create external instability or that can prevent adjustment to external imbalances. A more robust IMF can help to maintain the stability of the international financial system that is so important to our businesses and to our economies generally. It's very clear that Australia and Canada have both benefited greatly from the strong global economic growth in recent years. But we can't take that growth for granted. I have discussed domestic policies that are especially important for open trading nations like ours: sustainable fiscal policies, a monetary policy based on inflation targeting, a flexible exchange rate, and flexible markets that can respond to changing economic circumstances. By following these prescriptions, both Australia and Canada should be well placed to cope with whatever developments come about in the global economy. But we must also work hard to help shape that global economy. We need to do our utmost to ensure continued free trade in goods and services and to resist protectionism. And we must work together and with other countries to make the international financial system as efficient and effective as possible. An important part of that effort must be to modernize the IMF. With a stronger international system and solid domestic policies, both Australians and Canadians can look forward to continued strong economic growth in the years ahead.

r061108a_BOC

canada

The Canadian Economy and Financial Markets in Perspective

longworth

Good morning. It's a pleasure to join you at this important gathering. The hedge fund industry has been growing so quickly that meetings like this one are welcome-- they provide a chance to step back and look at context and trends. And that's what I propose to do this morning. Specifically, I'd like to speak about volatility in both the real economy and in financial markets and discuss how it has been affected by monetary policy and financial innovation. Of course, there's money to be made from the volatility of financial assets. Hedge funds, like other financial market participants, try to profit from price movements. Hedge funds are also a source of financial innovation and market liquidity. From the perspective of a central banker, I can say that on balance, at most times, hedge funds make markets more liquid and efficient. And in all likelihood, this has contributed to reducing financial volatility, at least in some important markets. In Canada, as in other parts of the world, there has been a significant decline in macroeconomic volatility since the early 1980s. Over roughly the same time period, there has also been a reduction in the volatility of fixed-income markets. On the other hand, we have not seen a parallel decline in the volatility in the prices of other assets such as equities and housing, which, as Kenneth Rogoff and others have noted, raises some interesting questions. This morning I'd like to look at these trends and discuss some of the factors--especially monetary policy and financial innovation--that have been driving them. But first, I think it would be useful to explain in what sense volatility matters, and where the interest of the public and the central bank lies. I'll leave time at the end of my remarks for comments and questions. Why volatility matters Central banks value stability. The Bank of Canada's ultimate goal is to contribute to the maximum economic growth that can be sustained over time, and thus to rising living standards for Canadians. The best way to achieve this goal, we've learned from experience, is to keep inflation low and stable. Low and stable inflation not only helps to mitigate fluctuations in production and employment, but also allows output levels to reach their sustainable maximum. While central banks are best known for their monetary policy work, we also have a very large stake in the stability of the financial system. Importantly, financial instability can take a serious toll on the economy. During the Asian crisis of the late 1990s, for example, financial instability led to large declines in real output in a number of countries, as banks failed and there was contagion across the region. When financial markets are excessively volatile, investment decisions are more difficult to make, risks are harder to assess, and business investment in plant and equipment is inhibited. Central banks also value financial stability because monetary policy is transmitted through the financial system. As a participant in the financial system, the Bank of Canada relies on efficient markets to effectively transmit changes in its policy rate through the economy. I should clarify what kinds of financial volatility are of concern to a central bank. Generally speaking, prompt adjustment in the prices of assets to new information is to be expected. Most of the time, these changes reflect the appropriate pricing and transferring of risk as circumstances change. When prices do not accurately reflect changing circumstances, however, resources are likely to be misallocated and efficiency suffers. Moreover, when volatility increases sharply in such a situation, and becomes pervasive across financial markets, the financial system can become impaired. That is, it becomes less capable of enabling price discovery, allocating credit, transferring risk, settling claims, or providing market liquidity. If the financial system were to lose any of these capabilities because of excessive volatility, the Bank of Canada would be concerned, mainly because of the potential for detrimental economic consequences. As a central bank, we tend not to worry about financial volatility for its own sake, but about the potential financial instability and economic cost of excessive financial volatility. So, in a nutshell, both macroeconomic and financial stability are needed to sustain maximum economic growth over the long term. Excessive volatility in either economic or financial variables can exact a toll on the economy. Let's turn now to what's been going on in the macroeconomic landscape over the past few decades. In 1991, the Bank of Canada and the federal government introduced an explicit inflation target-- the most significant change in Canadian monetary policy in many years. In addition to helping achieve the important end goal of low and stable inflation, the inflation target has entailed three additional benefits. First, success in achieving the target has anchored inflation expectations, which in turn helps to keep inflation low and to stabilize the economy. Second, an explicit inflation target has made the central bank more accountable, since it provides a concrete objective to account for. Third, this accountability for a clear target has in turn encouraged the central bank to be more transparent in its operations and communications. I'll elaborate on the role of increased transparency later in my remarks. Since 1995, the inflation target has been the 2 per cent midpoint of a 1 to 3 per cent control range. And since that time, inflation has, in fact, been close to 2 per cent. I think this chart tells a clear and interesting story. Chart 1: Inflation since 1975 and the inflation control range since 1991. As you can see, inflation in Canada was high and variable in the 1970s and early 1980s, and then declined in the mid-1980s and again after 1991. CPI inflation averaged 8.1 per cent from 1971 to 1980, 6.0 per cent from 1981 to 1990, and 2.1 per cent from 1991, when the inflation target was introduced, to the present. I should add that many other countries have also seen a sustained decline in inflation over the past decade and a half. In Canada, the variability of inflation, measured by its standard deviation, declined in tandem with the rate of inflation. This pattern of declining volatility was equally true for core inflation and other underlyin g measures of inflation. Low, stable, and--I should emphasize-- predictable inflation tends to support sustainable economic growth. Let me elaborate on this idea by pointing to three of the macroeconomic benefits that accrued in the 1990s as inflation declined and stabilized close to the 2 per cent target. First, owing to greater certainty about the inflation outlook, there was a decline in the variability of relative wages, and thus a better allocation of labour. Second, we saw longer labour and financial contracts, with lower transaction and bargaining costs for firms and households, and a reduction in time lost to labour disputes. Third, there was a reduced need for individuals and businesses to protect themselves from unexpected inflation, resulting in a more appropriate allocation of resources. Now let's look at output. One of the most noteworthy macroeconomic stories in recent years has been a significant reduction in the variability of output across most G7 countries, a trend that has come to be called In Canada, the data show that the variability of quarterly real GDP growth declined from the 1980s to the 1990s, and has remained low this decade. Note that the chart shows output growth itself, not its volatility. And I should add that this decline in volatility is actually further progress in a significant, long-term decline in the volatility of GDP that has taken place--with a few interruptions--since the 1920s. In the past 25 years, we've also witnessed lower variability in the output gap --the difference between actual output and the economy's capacity to produce in a sustainable fashion--and in the unemployment rate. Overall, the business cycle appears to have become less pronounced and, since 1991, Canada has avoided a recession. What's been driving this reduction in the variability of output? Some research has emphasized the increased competition that has come with globalization, and improved inventory control, particularly in the durable goods industries. It's also likely that improved financial products for households have played a role, allowing for smoother growth in consumption. But a key factor has been better monetary policy--the monetary policy that has delivered the low and stable inflation we've experienced since the early 1990s. I'll turn now to trends in financial volatility over the same period. Here, we could start with a question: To what extent has the decline in macroeconomic volatility over the past 25 years been matched by a decline in financial volatility? The answer is that it depends on which market we look at. In brief, the volatility of fixed-income markets has declined significantly, but the volatility of other financial assets has not. The decline of volatility in fixed-income markets is what economic theory would predict. A reduction in the level and variability of inflation should lead to lower interest-rate volatility, especially further out the term structure. As well, an economy in which output is less volatile should tend to have lower interest rate volatility. Let's look at the volatility of 90-day commercial paper rates since 1981. From the early 1980s to the early 1990s, volatility at the short end of the market fell by more than half. Since 1995, when the Bank began targeting inflation at the midpoint of a 1 to 3 per cent inflation-control range, volatility for short-term interest rate instruments has fallen further, and since the late 1990s, it has remained in a historically low range. I should add that although the decline in the volatility of short-term rates was almost certainly driven by the decline in the level and the variability of inflation, the most recent period was also likely influenced by changes in the way the Bank implements monetary policy. I'm referring to increased transparency and improved communication, which, all else being equal, should mitigate interest rate volatility. Since introducing an inflation target, the Bank of Canada has become increasingly open and transparent about its views in its s and s, press releases, and speeches. At the end of the year 2000, the Bank introduced "fixed announcement dates." That is, we started to make our policy rate announcements eight times a year on a fixed schedule. This schedule has reduced uncertainty in financial markets about the timing of policy actions, and has helped to direct attention to the medium-term perspective of monetary policy. This focus has in turn allowed us to more effectively communicate our views on the future path of inflation. Of course, reduced market uncertainty should, in principle, lead to a decline in volatility. And the focus on macroeconomic fundamentals over the medium term helps market participants and the public to better understand the Bank's assessment of the balance of forces that affect inflation in Canada and hence to anticipate the direction of monetary policy. Our research tends to confirm that the fixed announcement date process has, in fact, enabled financial markets to better price fixedincome instruments. Now, let's look at volatility at the longer end of the market. The volatility of the returns for benchmark Government of Canada 10-year bonds has also declined substantially over the period, as is evident in the chart. The past two years have been marked by sustained low volatility. Lower interest rates and reduced volatility have certainly benefited Canadian borrowers, and, by extension, improved the investment climate. Although both U.S. and Canadian 10-year benchmark bonds show a trend decline in volatility since the early 1980s, in the past six years or so, the volatility of Canadian 10-year bonds has been lower than that of their U.S. equivalent. The explicit inflation target in Canada may well be anchoring inflation expectations here more strongly than in the United States. Improved Canadian fiscal policy since the mid-1990s has also played a role in the relative decline in volatility in Canada, as the upside risk to the future path of the debt-to-GDP ratio has diminished. However, when we turn to other asset markets--particularly equities, but also house prices and currency--we don't see any significant trend decline in volatility. The fact that there has not been a significant downward trend in stock market volatility or in the volatility of other financial assets--against a backdrop of lower macroeconomic volatility--is a bit of a puzzle. Let's look at the volatility of the Toronto Stock Exchange. As you can see, there is no clear trend in the volatility of the S&P/TSX composite index over the past 25 years, although the past two years, on average, do show a reduced level of volatility. This recent decline in volatility has also been seen in the equity indexes of many other countries. But as the chart shows, Canada has experienced similarly low levels of stock market volatility in the past, only to see it rebound to the high levels previously experienced. The recent decline in stock market volatility may presage a longer period of reduced volatility--but it's too early to tell. In fact, as Kenneth Rogoff points out in a recent paper, a decline in short-run business-cycle volatility may not necessarily lead to a decline in asset-price volatility. Equity returns, he points out, should depend on long-run expected growth and volatility, and long-run expected volatility--that is to say, uncertainty about long-run growth rates--does not necessarily diminish in proportion to reductions in business-cycle volatility. Moreover, lower interest rates and lower risk premiums may make prices for long-term assets, such as stocks and housing, more sensitive to perceived changes in both risk and in the path of future interest rates, thus making these prices more variable. This possibility may, in fact, offset any reduction in financial market volatility that would otherwise stem from reduced macroeconomic volatility. So far, I've focused on the impact that monetary policy and the decline in macroeconomic volatility has had on the volatility of bond markets. But other structural factors in financial markets have also affected financial market volatility. Over the past 25 years, and especially in the past decade, we've seen a good deal of financial and technological innovation in financial markets. This innovation can, over time, help to increase efficiency and reduce volatility. Let me mention four aspects that are likely to prove important. First, innovations in electronic trading and in back-office systems have resulted in lower trading costs and increased price transparency and competition, and, in the end, resulted in greater liquidity. Debt and equity markets have seen sharp rises in turnover. Increased market liquidity tends to place downward pressure on volatility--prices become less sensitive to large transactions and absorb news more easily. Trading in Government of Canada bonds, to take one example, is at an all-time high, and bid-ask spreads on these bonds are the narrowest ever experienced. Second, we've seen important improvements in risk management at banks and other financial institutions. Substantial progress has been made in identifying and controlling the concentration of exposure to specific risks, especially market risk and credit risk. Third, the introduction of derivative instruments, such as credit derivatives, has allowed a better distribution of risk across the system, as well as better risk management by institutions. And fourth, there's been an increased use of active arbitrage strategies by a growing number of players, which brings me back to hedge funds. As I said earlier, hedge funds have had a largely positive impact on the efficiency of financial markets in Canada. But before I elaborate on this, I would like to step back and say a few words about the concerns that hedge funds could potentially pose for a central bank. Given our role in promoting financial stability, it would be fair to say that any concerns we might have about the impact of hedge funds would stem largely from our concern about systemic risk. Potential concerns fall into two main categories. First is the possibility that hedge funds could simultaneously implement similar investment strategies that exacerbate movements of prices away from fundamentals, potentially leading to financial problems for other investing institutions. However, the increasing number of goodsized hedge funds that employ different investment styles or strategies--including styles that assume that prices will return to fundamentals--is an important mitigating factor in this regard. In other words, the world is very different than it was at the time of the Long-Term Capital A second potential concern is that counterparties could become overexposed to hedge funds. In their prime brokerage businesses, the banks are directly exposed to hedge funds. If several large hedge funds experienced simultaneous losses stemming from moves in market prices, the banks might suffer significant credit losses. And these losses could lead to a rise in systemic risk and, perhaps, a crisis characterized by a blurring of market, credit, and liquidity risks, all magnified by leverage. Prime brokers are now much more aware of the risks than at the time of LTCM, and are carefully monitoring their risk exposures. Moreover, banking supervisors around the world, including the Office of the Superintendent of Financial Institutions here in Canada, are well aware of the need to stay on top of the banks' risk-management practices in this area. Potential systemic concerns continue to be monitored by central banks and other public-policy institutions, and there appears to be no reason to sound the alarm on these concerns at this time because of the mitigating factors that I've mentioned. Another issue of broad interest relates to investor protection. It concerns the disclosure practices of hedge funds, as well as disclosure related to hedge-fund-based investment products, particularly those sold to retail investors. This important issue is being examined in Canada by the provincial securities commissions. Overall, then, given the Bank's strong interest in promoting the efficiency and stability of the financial system, our focus with regard to hedge funds is the systemic nature of any risk. When it comes to supervision and investor protection, we rely on other bodies. Having said that, let me quickly add that it is important for all these agencies to share information effectively, something we strive to do in Canada. So, how do hedge funds benefit financial markets? First, it's useful to note that the largely positive influence of hedge funds stems from their sophistication, their size, the diversity of their objectives and strategies, and the instruments they use. Hedge funds add to the depth and liquidity of Canadian financial markets. And the ability of hedge funds to use leverage and their tendency to actively trade greatly amplifies their presence in the markets, and further adds to liquidity. Moreover, the variety of arbitrage strategies and instruments employed by hedge funds not only makes markets more complete, but also makes prices more reflective of underlying fundamentals. These prices in turn provide better signals for others to act upon. And of course to the extent that an investment decision is actually a hedge , risks become more effectively managed. The overall effect of increased liquidity and more effectively managed risk should, in principle, be lower volatility. Now, by their very nature, these structural factors would tend to have an enduring impact on the reduction of volatility. Cyclical factors, however, may also have played a role in reducing the volatility of equity markets--and possibly fixed-income markets as well--in the past couple of years. This suggests that at least part of the decline may be reversed in the future. As a recent BIS paper points out, "to the extent that cyclical factors played a role in containing volatility, some increase should be expected in the event of a [possible] slowdown in the global economy." In plain English, we've seen robust growth in the global economy in recent years. Volatility typically rises at turning points. If growth in the global economy were to slow appreciably, we would likely see increased uncertainty and a rise in financial market volatility. All this to say that it is too early to know the extent to which the effects of lower macroeconomic volatility and financial innovations will endure, and whether the recent decline in stock market volatility is the beginning of a trend in markets outside of fixed income, or whether it is largely due to cyclical factors. Volatility is a fact of life in both the real economy and financial markets. But a reduction in the variability of output, inflation, and interest rates is generally to be welcomed. What is still unclear is whether we will see further declines in the volatility of rates on long-term bonds and of equity prices as markets adjust to the decline in macroeconomic volatility that we have already seen, and as financial innovations and technological improvements continue to be introduced and adopted. What you can be sure of is the Bank of Canada's commitment to low and stable inflation and to promoting the stability and efficiency of the Canadian financial system. Lower macroeconomic volatility has been hard won and has helped to sustain steady economic growth. I'd be happy now to respond to your questions and comments.

r061211a_BOC

canada

Improving Financial System Efficiency: The Need for Action

dodge

Governor of the Bank of Canada to the Economic Club of Toronto Two years ago, I gave a speech here in Toronto in which I dealt with the theme of efficiency as it relates to the economy in general and to the financial system in particular. Today, I want to return to the theme of financial system efficiency. In doing so, I will draw on material from our latest published last week. This publication, for those of you not familiar with it, is one way that the Bank contributes to the soundness of the financial system. The FSR reports on developments and trends in financial systems here and abroad, summarizes recent research by Bank staff on financial sector policies, and promotes discussion of how to strengthen our financial system. In short, the goal of the FSR is to improve financial system efficiency and stability. When I spoke two years ago, I stressed that all of us need to keep in mind the goal of efficiency, and that Canadian financial institutions and markets need to be as efficient as possible. Since that time, the global financial services sector has continued to undergo sweeping changes. The integration of global financial markets is continuing. Exchanges and financial institutions are consolidating, and new financial instruments are constantly being developed. All of this is changing the way that global markets operate, with important implications for the competitiveness and efficiency of Canadian markets and institutions. Today, I want to talk about how Canada has been responding to these developments. In doing so, I hope to underline just how important efficiency is for everybody who is concerned about Canada's long-term economic health. But before I begin, I should start by saying why financial system efficiency is so important. When a financial system is operating at peak efficiency, investors receive the highest risk-adjusted returns on their investments, and borrowers minimize the costs of raising capital. With an efficient financial system, economic resources are allocated to the most productive investments. Another key reason to promote efficiency in the financial system is the importance of the financial sector to the industrial base. The financial services sector represents more than 6 per cent of Canada's GDP. However, the longterm health of this sector may be at risk unless we all act to increase its efficiency and competitiveness. I'll return to this topic in a few minutes. But the point I want to stress now is that an efficient financial system is crucial for achieving sustained economic growth and prosperity in Canada. Let's examine how Canada's macroeconomic policies support efficiency. As a central banker, I will start with a brief look at monetary policy; in particular, our policy of inflation targeting. As you may know, last month the Bank and the Federal Government renewed our joint inflation-targeting agreement for another five years, until the end of 2011. Since Canada adopted inflation targeting, we have seen a number of important economic benefits. Inflation has been lower and more stable, and inflation expectations have become well anchored on the 2 per cent target, not just in the short term, but also in the long term. With this low and stable inflation, along with other important policy improvements, the peaks and valleys of the business cycle have become less pronounced, and the economy has shown increased flexibility in adjusting to various types of shocks. Because consumers and businesses have greater certainty about the future purchasing power of their savings and income, borrowers pay a much smaller premium to compensate investors for inflation risk. In short, we have seen lower costs for borrowers, more predictable returns for investors, and a more efficient allocation of resources. But we should always be looking to see if there are ways to make good performance even better. This is why the Bank is launching a concerted research program to see if our already very successful inflation-targeting framework can be improved. In particular, we want to find answers to two questions. First, what would be the costs and benefits of an inflation target lower than 2 per cent? Second, what would be the costs and benefits of replacing the current inflation target with a longer-term price-level target? We hope to see intensive research on these issues, conducted both inside and outside the Bank, over the next three years. This would give the Bank and the Government of Canada enough time to examine the results and take them into account before the next renewal of our agreement in 2011. Canada's fiscal policies have been, and will continue to be, important in supporting the efficiency of markets. Governments, both federal and provincial, have worked hard to achieve fiscal balance and are now working to further reduce their ratios of public debt to GDP. Continued progress on this front will support efficiency by allowing investors to remain confident that the proceeds of their investments will not be subjected to excessive taxation in the future. This additional confidence can lead to better allocation of resources. A well-functioning market for federal debt is also important for Canadian fixed-income markets in supporting the efficient allocation of resources. So the Bank, in its role as fiscal agent for the government, will continue to work with the federal government and with market participants to support liquidity and the smooth functioning of markets for government debt. Finally, the Bank of Canada supports efficiency through our role in promoting a safe and sound financial system. We do this both through our legislated responsibility to oversee systemically important clearing and settlement systems, and through our responsibility-- one that we share with federal and provincial agencies, regulators, and market participants--to actively foster the safety and soundness of the financial system. When everyone is confident that the financial system is safe, there is less need either to keep precautionary resources or to spend on arrangements to guard against the effects of financial instability. Canada's clearing and settlement systems have been judged to be very sound. In addition, they have been designed to operate using a relatively small amount of liquidity compared with systems in other countries. And this frees up resources that can be put to more productive use elsewhere. Our main goal in this area is to guard against costly financial instability. Recently, there has been discussion in the United States and the European Union about the potential threat to financial stability posed by hedge funds. As my colleague David Longworth pointed out in a recent speech, we at the Bank have looked at the effect of hedge funds on the stability of markets, in particular, markets in Canada. It is important that central banks and others continue to monitor hedge funds for potential systemic risks. But in our judgment, there appears to be no reason to sound the alarm at this time. This is not to say that increased transparency by hedge funds might not improve the efficiency of markets, and that additional disclosure might not increase investor protection. These issues are being examined by securities commissions and others. So, to sum up the macroeconomic side, the frameworks for our monetary, fiscal, and financial stability policies are second to none in the world, and do their job to support and encourage efficiency. But on their own, sound macroeconomic policies are not enough. Canada also needs microeconomic policies that spur competitiveness and support efficiency. Let me now review a few of these structural issues. I'll begin by talking about financial institutions, then address issues of efficiency in securities markets, enforcement, pension regulation, and fixed-income markets. When I raised the topic of financial institution efficiency two years ago, I noted that following the 1964 Porter Commission, Canada became a world leader in terms of modernizing regulation. Parliament passed legislation creating a regulatory framework for financial institutions that led to greater competition, lower costs, and improved efficiency. Over the years, with the right policies in place, Canadian financial institutions capitalized on the comparative advantage provided by our regulatory framework to become world leaders in efficiency. But over roughly the past decade, several countries have greatly improved their regulatory frameworks, eroding our comparative advantage. A number of foreign institutions have become better placed than before to exploit new technologies in order to enhance efficiency, and to offer their clients new instruments and combinations of services. It is in this rapidly-changing environment that our financial institutions must compete. Clearly, if we want our financial institutions to remain a major economic driver in Canada, then we need to make sure that the regulatory framework under which they operate encourages competition and innovation, and does not prevent them from maximizing efficiency. As the Minister of Finance said in his economic update, "Competition drives firms to become more efficient, invest in new technologies, and introduce new products and services that benefit consumers." This leads to the question of whether our financial institutions are efficient. Some observers have examined our financial services sector as a whole, using the data in the national accounts, and have noted that the productivity of this sector appears to be lower than that of other countries, particularly the United States. For us in Canada, where improving productivity is an increasingly important issue, such an assessment should be a concern. So, at the Bank of Canada, we are looking carefully at this issue. While our work is not complete, we did publish some of the initial findings in the current FSR. the risk of oversimplifying, I will stress two main findings. The first is that in terms of net operating income per worker and assets per worker, employees of Canadian banks are at least as productive as their counterparts in U.S. banks of comparable size. Canadian banks also do well in some other measures of efficiency. But the second main finding is that, compared with U.S. banks, there are unexploited economies of scale for Canadian banks. This suggests that Canadian banks are less efficient with regard to the scale of their operations and if banks could reap economies of scale, there would be efficiency benefits to flow through to the Canadian economy. Overall, our research concluded that legislative and regulatory changes have benefited efficiency in Canadian financial services. This shows the importance of removing any remaining restrictions that inhibit competition and efficiency, but provide little or no benefit in terms of financial soundness. Our findings are still preliminary, and so far the research has been confined to banks. But as data become available, we plan to complete this research and extend it to other parts of the financial sector. Now let me turn to the need to support efficiency through the regulation of securities markets. In the past, I have suggested that Canada would be best served by developing securities regulations that take into account the size and complexity of the firm doing the reporting. The principles of Canada's regulatory framework must apply to all firms, and must be as good as, or better than, those of any other country. But the application of the rules can, and should be tailored appropriately to take into account the size and complexity of the company. Historically, Canada's public markets have done well in funding smaller companies efficiently. It is important for the future of our markets that this continue. Canada should try to develop a comparative advantage in securities regulation for these smaller firms if it is to remain a market of choice for companies, both Canadian and foreign. The United Kingdom has made major strides in this area by consolidating its regulatory authorities ten years ago and, more recently, by beginning to implement a principles based set of rules that simplifies administrative processes for issuers. Authorities in the euro area are moving to unify their regulatory regimes. Even in the United States, Treasury Secretary Henry Paulson has called for a streamlining of U.S. regulatory authorities. Against this backdrop, we in Canada increasingly look as if we are stuck in the middle of the 20th century, and are not positioning ourselves well to compete in the 21st century. For the sake of efficiency, we need a single, uniform framework for securities regulation. Rules need to be applied in a uniform way across the country, and tailored to be appropriate for firms of all sizes, while providing appropriate protection for investors. Let me turn now to enforcement. Markets work more efficiently when they operate under clear, transparent, and reasonable rules and principles. But even the best rules won't help if they are not enforced. While we have seen some first steps to strengthen enforcement over the past couple of years, there still is a perception, both in Canada and abroad, that Canadian authorities aren't consistent in their efforts to enforce the rules against insider trading and other offences, nor tough enough in rooting out and punishing fraud. chaired by Tom Allen, has recently argued that information should be made more readily available to--and shared more readily by--investigators and prosecutors, and that training for these groups should be improved. A federal-provincial working group was recently formed to address these issues. But we cannot lose any momentum in this area. It's vital that we move quickly and forcefully to strengthen enforcement, so that investors and firms are confident that everyone is playing by the rules. I recognize that improving enforcement will require considerable effort and extensive co-operation among prosecutors, the police, securities commissions, and industry groups. But we can't lose sight of the fact that this will pay off in the long run. For example, at the Bank, we've put a great deal of effort into co-operating with law-enforcement agencies, and the justice system, to fight counterfeit currency. And while levels of counterfeits are still higher than we would like, we have seen a steady decline in the number of counterfeits detected since the beginning of 2004. Thanks to increased effort and co-operation, we're moving in the right direction. Pension regulation is another important issue for the efficiency of Canada's capital markets. There is a crucial need for a framework that provides the appropriate incentives for employers to establish and maintain pension plans, so that the vast pools of capital in these plans can make their maximum contribution to the efficiency of the Canadian economy. But our current regulatory framework instead provides a number of disincentives for firms to establish or maintain defined-benefit (DB) pension plans. These disincentives, along with recent low long-term interest rates, have led to increased solvency deficits among many defined-benefit plans. An update on the state of funding of DB pension plans is included in the current FSR. To address some of the problems facing DB plans, the federal and Quebec governments have introduced steps designed to help plan sponsors meet the solvency funding test by obtaining letters of credit. Other jurisdictions are also looking into these issues, including the Ontario Government, which has just launched an expert commission to review pension laws. The measures taken by the federal and Quebec governments will bring significant relief to some DB plans. But these are partial measures, and they do not address the fundamental disincentives faced by organizations sponsoring DB plans. It is important to get these incentives right, so that DB pension plans, which have a long-term investment perspective, can continue to grow. This long-term perspective fits well with Canada's need to finance the major investments in infrastructure that are essential for future economic growth. This match, between the need for investment in infrastructure and the need for pension funds to find long-term assets, seems perfectly suited to the private-public partnership model, or P3. But this match can't be made if governments do not have an appropriate framework for using P3s when looking at infrastructure improvements. There are still relatively few P3s in Canada, compared with countries that have a well-developed framework for P3 investments. In the June issue of our FSR, we looked at some of the constraints on the In summary, if capital markets are to make their maximum contribution to growth and provide financing for needed infrastructure, then action is essential both to reduce the disincentives for pension plan sponsors and to improve the framework governing private investment in public infrastructure. Efficiency in fixed-income markets Finally, let me turn to developments specific to Canada's fixed-income markets. There has been progress in improving the efficiency of Canada's fixed-income markets, much of which stems from the decision taken by the federal government in 2005 to eliminate restrictions on the amount of foreign property that can be held in registered retirement and pension plans. The elimination of the Foreign Property Rule enhanced efficiency in a number of ways. First, it led to the development of the "Maple Bond" market. There is an article on this topic in the current FSR. With the removal of the Foreign Property Rule, foreign borrowers began to issue Maple Bonds, which are denominated in Canadian dollars and sold in the Canadian market. Foreign issuers have found Canadian investors eager for a product that allows them to diversify their fixed-income holdings geographically and by industry, and to earn higher risk-adjusted yields without taking on currency risk. This diversification makes the Canadian bond market more complete, and represents a better allocation of resources, thus increasing efficiency. Second, by increasing competition with domestic investments, the development of the Maple Bond market has led to pricing of other domestic corporate bonds that better reflects fundamentals. This improved pricing of risk benefits the Canadian financial system as a whole. Third, the development of the Maple Bond market has helped to increase trading and narrow spreads in the Canadian-dollar swap market. Since most foreign issuers don't have a natural need for Canadian dollars, the proceeds from the sale of Maple Bonds are typically swapped back into the home currency of the borrower. This additional activity has led to narrower spreads on cross-currency swaps, which also benefits domestic borrowers looking to raise funds abroad. In these three ways, the efficiency of Canadian fixed-income markets has been improved. Other developments have also served to boost the efficiency of Canada's fixed-income markets. For example, we continue to see the growth of electronic trading systems that improve the functioning of markets, particularly fixed-income markets. It is crucial for any country that these markets function well, especially the markets for its government debt, and initiatives led by the private sector to increase transparency appear to be headed in the right direction for improving efficiency in this area. Ladies and gentlemen, allow me to conclude. In my speech two years ago, I spoke about how Canada was once a world leader in terms of supporting efficiency. I talked about the Porter Commission, which came out strongly in favour of greater competition, freer markets, and effective regulation that served to enhance efficiency. Government, regulators, and the Bank of Canada responded positively to that report by acting to promote efficiency, and the private sector took advantage of new opportunities, leading to great benefits for the Canadian economy. Today, a similar effort is needed. While Canada's macroeconomic policies are second to none in supporting efficiency, our structural policies need work. We need to revisit the spirit of the Porter Commission and build regulatory frameworks that promote competition, innovation, and efficiency. In particular, we need action to support efficiency through the way that we regulate our financial institutions, securities markets, and pension funds. Equally importantly, we need action to improve the way we enforce our regulations. But improving efficiency is everybody's business. Once policy-makers do their job, it is up to the private sector to respond and take advantage of the opportunities to improve efficiency. The Bank of Canada remains committed to doing its part. If we all promote efficiency, then we all can reap the benefits of a more efficient financial system and a stronger economy in the future.

r070118a_BOC

canada

Release of the

dodge

Today, we released the January , which discusses current economic and financial trends in the context of Canada's inflation-control strategy. The Canadian economy is judged to have been operating at, or just above, its production capacity at the end of 2006, following weaker-than-expected growth in the second half of last year. This slowdown stemmed from reduced demand for Canadian exports--related to weakness in the U.S. automotive and housing sectors--and from the need for Canadian businesses to adjust inventories. Looking ahead, real GDP growth is now expected to average about 2 1/2 per cent in the first half of 2007, rising to about 2 3/4 per cent in the second half of this year. In 2008, growth is projected to remain in line with the growth of potential output (estimated at 2.8 per cent), keeping the economy operating near its capacity throughout the projection period. Expressed on an average annual basis, this profile implies growth of 2.3 per cent in 2007 and 2.8 per cent in 2008. Total consumer price inflation will continue to be affected by movements in energy prices and, during the first half of 2007, by last year's reduction in the Goods and Services Tax (GST). Total inflation should average just above 1 per cent in the first half of this year, returning to the 2 per cent target in early 2008. Core inflation should return to 2 per cent in the first half of 2007 and stay there. On 16 January, the Bank left its key policy rate unchanged at 4.25 per cent. The risks around the Bank's inflation projection continue to be judged to be roughly balanced, but the main upside and downside risks have diminished somewhat since the October . The current level of the policy interest rate is judged, at this time, to be consistent with achieving the inflation target over the medium term.

r070125a_BOC

canada

Monetary Policy and Developments in the Global and Canadian Economies

dodge

Good afternoon. I'm happy to be here in Toronto to take part in your Outlook 2007 event. I'd like to begin with a few words about the framework that guides the Bank of Canada in conducting monetary policy. After this brief introduction, I will spell out the Bank's interpretation of recent economic developments and our outlook for 2007 and 2008, both in Canada and elsewhere. Then, I'll say just a few words on another important topic--the need to improve our understanding of the interdependencies of the global economy, and thus to strengthen the surveillance function of the International Monetary Fund. Finally, I will open the floor for your questions and comments. So let me begin by discussing our framework for monetary policy. The Bank of Canada has been around for over 70 years. Throughout this period, the Bank has had one over-arching mandate: to promote the economic and financial welfare of Canadians. Over the years, we have learned that the best contribution that monetary policy can make in this regard is to give Canadians confidence in the future value of their money. We do this by keeping inflation low, stable, and predictable. In earlier decades, the Bank of Canada tried various approaches to achieving price stability by controlling variables that indirectly affected prices. For example, in the 1970s, the Bank aimed to control the growth of monetary aggregates. But there were problems with all the methods we tried. Finally, at the beginning of the 1990s, the Bank decided that the best way to achieve price stability was to target inflation directly. We reached a formal agreement with the federal government that spelled out the details of our inflation-targeting system. This agreement has been renewed four times. The latest renewal occurred last year, and extends through to the end of 2011. In that renewal, we agreed to continue our policy of targeting consumer price inflation at the 2 per cent midpoint of a 1 to 3 per cent target range over the medium term. We also set out a research program to explore whether our very good policy framework can be made even better. In particular, we want to examine the potential costs and benefits of moving to a lower inflation target, and the potential costs and benefits of pursuing a price-level path instead of an annual inflation target. That said, the research would need to uncover compelling evidence in favour of a change before we would want to alter the system that has proven so successful over the past 15 years. A key part of that success is that the framework sets out a rather simple paradigm that allows people to understand and predict how the Bank will react to economic developments. If the economy is moving above the limits of its capacity, so that the trend of inflation is threatening to move above our target, we tend to raise interest rates, all other things equal. This restrains demand in the economy and brings demand back into balance with supply, thus reducing inflationary pressures. Conversely, if the economy is moving below its capacity limits and the trend of inflation is likely to fall below the target, we tend to lower interest rates. This stimulates demand and brings it back in line with supply, thus increasing inflationary pressures. This simple paradigm is very helpful because monetary policy works better when it is understood. Because people understand the paradigm, they can anticipate how we will react to events that have an impact on inflation in Canada. Once every quarter, we spell out our views about where we see the starting point for the economy in terms of the balance between total demand and supply, and our base-case projection for how we see the economy evolving. Last week, we published our most recent outlook in our . Let me now take you through that document, and talk about our base-case projection for the global and Canadian economies. I'll begin with the global economy. Over the past five years, global growth has been very strong, and this growth has continued in recent months. Overseas, growth in the euro area has been slightly stronger than expected, while growth in China has continued to outperform expectations. In Japan, we have seen encouraging signs that business investment and exports remain strong, although household consumption has been weaker than expected. Global growth likely exceeded 5 per cent in 2006. Our base-case projection is that the world economy will expand by about 4 3/4 per cent this year, and by about 4 1/2 per cent next year--a more sustainable pace. The strong growth of recent years has had several important implications for Canada. It boosted the prices of many of the commodities that we export--including oil and natural gas. This led to strong increases in our terms of trade and to a corresponding rise in the external value of our currency. But more recently, some of these effects have begun to ease slightly amid signs of moderating global demand and, in some cases, increased supply. Oil prices have come down from their highs, as have some metals prices. This has led to a recent reduction in our terms of trade, a decline in the external value of our currency, and a slowing in nominal GDP growth, implying reduced growth of government revenues. For Canada, the performance of the U.S. economy is crucial to our prospects, so let me turn to the situation there. After a strong start to 2006, U.S. economic growth moderated. This moderation largely reflected a substantial downturn in the U.S. housing market and a cyclical slowdown in the market for automobiles. There are two important points to be made here. First, there is little evidence that the weakness in these two sectors has spread to the rest of the U.S. economy. Indeed, household consumption has remained firm, backed by employment gains seen in a very healthy service sector. Second, recent evidence suggests that a significant portion of the adjustment in these sectors has already taken place. The adjustment in the automotive sector appears to be well advanced, and the housing sector is working through its adjustment. This bodes well for the U.S. outlook. Our base-case projection is that real GDP growth should recover to the rate of growth in potential output by the second half of 2007, before moving slightly above potential growth through 2008. On an annual basis, growth is projected to be 2.5 per cent in 2007 and 3.2 per cent in 2008. Let me now turn to the Canadian economy. In the second half of 2006, final domestic demand for Canadian goods and services continued to grow robustly. But Canadian businesses began to reduce production of a number of goods and to reduce their rate of inventory investment. Much of the impetus for this reduction was the slowdown in U.S. demand for automobiles and housing. The inventory correction and lower exports served to restrain real GDP growth in Canada in the second half of 2006. When Statistics Canada publishes the national accounts data for 2006, we expect it to show that growth for the second half averaged about 1.6 per cent. In line with the paradigm I outlined earlier, we looked at the implications of these developments, and at many other pieces of information, in order to determine the starting point for the level of total demand relative to supply. The Bank's conventional measure of the output gap suggests that the economy was operating just above its production potential in the fourth quarter. There have also been other signs of upward pressures on capacity and inflation. In our winter , the percentage of companies reporting that they would have difficulty in meeting an unanticipated increase in demand was still above average. The employment-to-population ratio stayed very high in December compared with historical experience, while the unemployment rate was at a 30-year low. Finally, the Bank's measure of core inflation--which we use as an operational guide--had remained slightly above 2 per cent, and above our earlier expectations, because of pressure from prices for shelter and some other services. On the other hand, there were also some signs of downward pressure on inflation. There has been an easing in the underlying trend increase in wages in recent months. And the percentage of firms reporting labour shortages in the Bank's winter was slightly below average. Overall, our judgment is that the economy was operating right at, or just slightly above, the limits of its capacity at the end of 2006. That's a quick look backwards. Now, let me turn to the Bank's base-case projection for the rest of this year and for 2008. Overall, we project that real GDP growth will pick up during 2007, averaging about 2 1/2 per cent in the first half of this year, and about 2 3/4 per cent in the second half. The detailed breakdown can be found in the , but the bottom line is that we project that the Canadian economy will continue to operate close to its production capacity through to the end of 2008. The Bank projects that core inflation will stabilize at close to 2 per cent as pressures from house prices ease and the economy remains near potential. Total consumer price inflation will continue to be affected by movements in energy prices and, for the first half of the year, by last year's cut in the Goods and Services Tax. Overall, given recent energy prices in futures markets, total inflation is projected to average just above 1 per cent in the first half of the year, before returning to the 2 per cent target in 2008. That's a look at our base-case economic projection. But if there's one thing we can be certain about, it's that the economy will not evolve exactly as set out in our base case. So a very important part of our outlook is the assessment of the risks surrounding our projection. There are risks on both the upside and the downside. The main risks are the ones that we have been talking about for the past six months or so. The main upside risk to our inflation projection comes from stronger household demand in Canada. With the increases in house prices in many parts of the country, consumption could be stronger than expected as households borrow against the increased equity in their homes. There has been strong growth in various indicators of household credit over the past year, although the pace of growth has eased in recent months, and we have seen a slight deceleration in the annual rate of increase of new house prices more recently. So while this main upside risk remains, it appears to have diminished somewhat since October. The main downside risk continues to come from the United States, where clear weakness remains in the housing sector. But there are some encouraging signs. As I mentioned earlier, the slowdown in the U.S. housing and automotive sectors does not appear to have spread more broadly. There is evidence that a significant portion of the adjustment in the automotive sector has already taken place, while the adjustment in the housing sector continues. So, in the Bank's judgment, the main downside risk to our inflation projection for Canada does remain, but it has also diminished. Overall, we judge that the risks to our inflation outlook are roughly balanced. In addition to these risks, we are faced with a great deal of uncertainty about the trend growth rate of potential output in Canada. We are fairly confident in our assessment of the contribution of labour force growth to future potential output. However, there is a lot of uncertainty about the trend rate of productivity growth. We use the past trend rate--roughly 1.5 per cent--as the basis for our projection of future productivity growth. But recent data on productivity have been disappointing. It is unclear how much of this weak performance is caused by cyclical factors that will be reversed in due course, and how much represents a permanent downward shift in the trend rate of productivity growth. Adding to the uncertainty is the way the data tend to be revised over time. Remember that you calculate productivity by dividing total output by total hours worked. Both numbers are revised over time, sometimes fairly dramatically. This makes the challenge of understanding what's happening to the trend rate of productivity growth more difficult. Finally, there does remain a possibility of a disorderly resolution of global imbalances. In general, the term "global imbalances" refers to the large and persistent current account deficit seen in the United States that is mirrored by current account surpluses in Asia and many oil-exporting countries. These current-account imbalances have resulted from imbalances in global savings and investment. While the U.S. economy has seen very strong domestic consumption and negative savings in recent years, many other economies--particularly in Asia and the OPEC nations--have seen too much saving and not enough domestic consumption. This global savings glut outside the United States has contributed to low long-term interest rates and to what some observers have called a "wall of liquidity" that has led to strong investment flows into many assets, and higher prices for these assets. As long as market participants have reason to believe that policy-makers will take appropriate actions, there is no reason to expect that these imbalances won't be unwound in a gradual and orderly way. Indeed, this is what the Bank's base-case assumes. So far, financial markets have handled these imbalances smoothly. This smooth handling of global imbalances has been helped by innovations in financial markets that have led to new ways to price and transfer risk. Currently, there is little evidence to suggest that these risks are being distributed inappropriately across the global economy. But assessing such risks is very difficult. It requires the ability to conduct analysis at a global level and a real understanding of the interdependencies in the global economy. National authorities, here in Canada and elsewhere, do their best to carry out this analysis. But this analysis can be greatly helped by an organization with global reach, and which is dedicated to looking at the global economy as a whole. This organization already exists--it is the International Monetary Fund. In recent years, there have been some who have called into question the relevance of the IMF. But at the Bank of Canada, we believe that the IMF still has an important role to play. The danger posed by global imbalances shows that we need an international institution charged with supporting the smooth functioning of the global economy. Now, it is true that the IMF does need to change if it is to better carry out this task. At the Bank of Canada, we have spent a great deal of effort over the past year or so thinking about this topic. We believe that a strengthened IMF can best support the global economy by improving the way it conducts surveillance. The Fund has a very important role to play in analyzing spillovers and interdependencies. And it is the only institution that can perform this role: it is global in scope, and it regularly convenes the national authorities from the world's most important economies. So how can we best accomplish the goal of strengthening Fund surveillance? I would say two things. First, the IMF needs to update the rules for conducting surveillance. We need a clear statement that surveillance will focus on exchange rate, monetary, fiscal, and financial policies, and on whether or not a country's policy choices are coherent. This is not just because these policies can affect other members of the global economy, but also because these global effects can, in turn, have repercussions for a country's own economic prospects. Second, the Fund should adopt the idea of setting out an annual work program for surveillance. Each year, the members, along with the Managing Director and staff, would update and specify--in concrete and transparent terms--the objectives and priorities of surveillance for that year. I mention these issues today because we have a window of opportunity to move forward on IMF reform. There is today, at least in some quarters, a willingness to strengthen this institution, to make it more relevant. As the world's economies become increasingly globalized, I would argue that now, more than ever, a strengthened IMF is in every country's interest. The risk of a disorderly resolution of global imbalances may be relatively small, but it remains an important risk for all economies. Strengthening the IMF is one way of reducing this risk.

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Opening Statement before the House of Commons Standing Committee on Finance

dodge

Good morning, Mr. Chairman, and members of the Committee. I'm happy to be here and to assist the Committee, insofar as I am able, in your study on income trusts. I should start by making clear where the Bank of Canada's main interest in the income trust sector lies. Our interest in income trusts relates to the efficient functioning and health of Canada's financial system. A safe and efficient financial system is essential to Canada's economic well-being. The Bank of Canada works with other government agencies, as well as market participants, to promote the safe and efficient functioning of the financial system. Capital markets are a key component of that system. And so we are naturally interested in developments in financial markets--such as the evolution of the income trust market--that have the potential to affect financial system efficiency. With that introduction, let me quickly summarize the highlights of the Bank's analysis of this topic. I'd refer committee members to the June 2006 edition of our . In that publication, we noted that limited evidence suggests that income trusts can enhance market completeness in a couple of ways. First, income trusts can provide diversification benefits to investors, because trusts can have different risk-return characteristics than either equities or bonds. Second, the income trust structure appears to allow some firms improved access to market financing. So, insofar as income trusts allow investors to achieve risk-return benefits that they could not otherwise achieve, and serve as a source of financing to firms that might not otherwise have had access to markets, it can be said that income trusts enhance market completeness, and therefore support financial system efficiency. That same article also noted two areas where the standards for trusts are not the same as those for corporations, and where improvement is clearly needed--standards related to accounting, and those related to governance. These are the aspects of income trusts that we at the Bank have looked at and on which we are best able to comment. Of course, there are very important public policy questions related to income trusts that fall outside the Bank's mandate. The Bank has done no specific research on how the income trust structure affects economic performance, or would affect the future productivity of the Canadian economy. But, based on general economic principles and my understanding of the structure of the Canadian economy, I can say that while the income trust structure may be very appropriate where firms need only to manage existing assets efficiently, it is definitely not appropriate in cases where innovation and new investment are key. To the extent that the system was favouring the use of the income trust structure in these cases, the incentives for innovation and investment were reduced, and the potential for future productivity growth was reduced. Finally, members of the Committee should realize that the different risk-return characteristics of income trusts may not enhance market completeness if they arise from differences in tax treatment. Clearly, there has been a very significant tax incentive to use the income trust form of organization in cases where this would not have been the appropriate form of organization from a business efficiency point of view. By giving incentives that led to the inappropriate use of the income trust form of organization, the tax system was actually creating inefficiencies in capital markets, inefficiencies that, over time, would lead to lower levels of investment, output and productivity. While we at the Bank have not done any research on how the rules of the tax system could be designed so that they do not give inappropriate incentives that would bias the choice of firms to operate either as an income trust or as a corporation, the changes proposed by the government last October would appear to substantially level the playing field. For the income trust sector to deliver efficiency benefits through the enhancement of market completeness, it's important that the tax system provide a level playing field.

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Promoting Stability, Confidence and Well-being

longworth

Good afternoon. It's good to be in Kitchener-Waterloo, an urban region well known for its dynamism. GDP growth here is among the fastest of all regions in the province. The strengths of the twin cities--in research, advanced manufacturing, and information technology, among other sectors--are well known. Less well known, perhaps, is the region's success in responding effectively to changes in the world economy. From the making of shoes and buttons to digital imaging and advanced communications, this ongoing success in dealing with change is a testament to your flexibility and entrepreneurial spirit. It may also reflect the emphasis this region has long placed on training and education. Education acts as a kind of bedrock, a foundation that helps people deal with change and face the future with confidence. Change is often difficult. As you know, this region has had to cope with a good deal of difficult economic adjustment. What make change easier to deal with is a backdrop of stability in underlying policy fundamentals. That is what the Bank of Canada can help to provide. As the nation's central bank, the Bank of Canada has a mandate to promote economic and financial stability and well-being. To fulfill this mandate, we work in three main areas: conducting monetary policy, promoting a safe, sound, and efficient financial system, and designing and issuing secure bank notes. In my remarks today, I'd like to explain this work. A useful way to do this is to outline, for each area of responsibility, the goal, and the means by which we try to achieve that goal, and then provide an assessment of how we've been doing, as well as our plans for improvement. Let me start by describing our work in monetary policy. The ultimate aim of Canadian monetary policy is to help our economy achieve its maximum sustainable growth, and thus contribute to rising living standards for Canadians. The best way to achieve this objective, we've learned from experience, is by working towards a specific, concrete goal--that of keeping inflation low, stable, and predictable. Inflation control contributes to better economic performance in many ways. Let me highlight two of them. First, low and stable inflation allows us to read price signals clearly, which in turn helps both individuals and companies to make sound, long-term economic decisions. If you recall the 1970s and early 1980s, when inflation was contained--when it was both high and variable--you'll remember the high degree of uncertainty that prevailed then. Prices were hard to compare and hard to predict. As a result of this uncertainty, people found it difficult to make sound spending and investment decisions. Investors wouldn't commit resources for long periods of time; labour negotiations were acrimonious; and the overall economy was not as productive as it could have been. Happily, this experience can now be relegated to the "bad old days." So that's one advantage of inflation control--greater certainty about the future value of money. Second, when inflation is contained, and monetary policy is set to keep the economy running close to capacity, we can deal more effectively with economic shocks. Resources can more easily be reallocated from sectors where demand is relatively weak to sectors where demand is relatively strong. This is especially important during periods when there are large movements in relative prices--that is, in the prices of some goods and services relative to other prices--such as we've seen in recent years. Over the past five years, energy and non-energy commodity prices have gone up a good deal in comparison with those of non-commodity manufactured goods, and the exchange rate has changed considerably, further affecting the prices of many goods. Yet overall, the economy has adjusted well against the backdrop of low, stable inflation. To summarize: keeping inflation low and stable gives people confidence--confidence in the future value of their money, confidence in their financial decisions, and confidence in the ability of the economy to withstand shocks and grow in a sustainable fashion. Since 1991, to help us keep inflation low and stable, the Bank of Canada and the Government of Canada have had an explicit inflation target. And since 1995, the target has been the 2 per cent midpoint of a 1 to 3 per cent range. The inflation target helps to anchor people's expectations of inflation, and that in itself helps to keep inflation low and the economy relatively stable. The target also helps us in our deliberations and decision making at the Bank of Canada. I should also mention that the inflation target has another important benefit--it makes us more accountable for our actions. How does the target guide our decision making at the Bank? Well, if the economy is moving above the limits of its capacity, so that the trend of inflation threatens to exceed the target, we tend to raise interest rates, all other things being equal. This restrains demand in the economy and brings it back into balance with supply, thus helping to reduce inflation pressures and return inflation to target. Conversely, if the economy is moving below its capacity limits and the trend of inflation is likely to fall below the target, we tend to lower interest rates. This stimulates demand and brings it back in line with supply, thus bringing inflation back up to target. This symmetric approach to monetary policy has a stabilizing influence on the economy, and thus helps to prevent costly boom-and-bust cycles. So, that's the goal and the strategy for achieving it. How well have we done in pursuing the objective? The simple answer is: very well indeed. Let's look at developments in four key areas. First, inflation, as measured by the all-item consumer price index. Since 1995, inflation has been low and on target, averaging 2 per cent per year. Over the same period, inflation has also been stable--it's been within the 1 to 3 per cent control range 80 per cent of the time--and thus significantly less volatile than it was in the period before targeting. Finally, inflation has become predictable--forecasters and financial markets appear to believe that the Bank will continue to keep inflation near the target. In fact, the consensus forecast for 2008 and beyond is for an inflation rate of almost exactly 2 per cent. Second, interest rates. Interest rates are important to all Canadians. Again, with inflation targeting, both short- and long-term interest rates have been lower and less volatile than in the past. As a result, borrowing and investment decisions can now be made with greater certainty. And interestingly, in contrast to what might have been deemed possible just a decade ago, interest rates in Canada are currently lower--and long-term rates have become more stable--than they are in the United States. The third variable I'll mention is output. The growth of output, which is a good indicator of the overall health of the economy, has been generally higher, and significantly more stable over this time period. Part of the reason for this stability is inflation control. A stable price environment can help the economy to adjust quickly and effectively to economic shocks--events such as 9/11 and the Asian financial crisis of 1997-98. And in fact, Canada has not experienced a recession since 1991. Finally, labour markets. Labour markets have also shown a significant improvement. Time lost to labour disruptions has decreased, the length of union contracts has increased, and the unemployment rate has fallen to a 30-year low. So that's the big picture, and it's a favourable one. I'd like to say a few words now about the current situation--how we've done recently in pursuing our monetary policy objective. In a nutshell, the economy is doing well, and inflation is close to target. Total CPI inflation is 1.6 per cent, or 2.1 per cent if adjusted for the change last year in the GST and other indirect taxes. Core inflation, which excludes eight of the most volatile components of the consumer price index, as well as the effect of changes in indirect taxes, provides a useful guide for the conduct of monetary policy. It is now at 2 per cent. The economy is currently judged to be operating at, or just above, its potential, and the outlook to 2008 is for it to remain close to potential. The outlook is for core inflation to remain near 2 per cent from now to the end of 2008, and for total CPI inflation to return to the 2 per cent target early next year. If you're interested, you can read more about our take on the Canadian economy in last month's . So, as you can see, low and stable inflation is a means to a very important end--sustained economic growth. Overall, then, monetary policy has been successful in achieving its objective. But can we do better? We might be able to improve upon the current inflation target. Last November, you may have heard that the Bank and the Government of Canada renewed the 2 per cent inflation target for a five-year period. What you may not have heard was that the agreement committed the Bank to continuing its research on how monetary policy might be improved for the decades ahead. The goal, as always, is to have a monetary policy regime that contributes most effectively to overall economic performance. Two of the key issues we'll be looking at are, first, the costs and benefits of having a lower inflation target, and second, the costs and benefits of having a "price-level" target instead of an inflation target. A price-level target is similar to an inflation target, except that higher-than-target inflation in one time period needs to be offset by lower-than-target inflation in the next time period, and vice versa. If inflation comes in lower than target over a certain time period, monetary policy will be focused on raising inflation beyond the target over the subsequent time period. In price-level targeting, the past is not "forgotten," but must be offset, so that average inflation becomes somewhat more predictable over longer periods of time than it is with inflation targeting. Over the next few years, we'll also be focusing our research efforts on several other important issues. We'd like to better understand the implications of globalization for the Canadian economy, including the implications for inflation in Canada. We'd like to improve our understanding of the sectoral and regional aspects of economic adjustment. And we'd like to look at how productivity and demographic change affect the economy's potential to grow. Now I'll turn to the second area in which we promote economic well-being--the financial system. I should start here by saying just exactly what I mean by the financial system. The financial system consists of three main elements--institutions, such as banks and credit unions; financial markets, such as the bond and equity markets; and clearing and settlement systems, such as the Large Value Transfer System, which handles large-value and time-sensitive payments. It's through the financial system that savings become productive investments, money and financial claims are transferred and settled, and risks are effectively allocated. Because it deals with promises to pay, the financial system depends to a very large extent on confidence. Individuals and institutions need to be confident that commitments will be honoured, and that the system will work, even in times of turbulence. The Bank of Canada's objective here, then, is to promote the stability and efficiency of the financial system--which in turn encourages people to have confidence in it. There are three direct means by which the Bank promotes financial system stability, and one indirect means by which we promote both stability and efficiency. First, we oversee Canada's main clearing and settlement systems. These are the systems that transfer hundreds of billions of dollars of financial assets each day. These systems are designed to make sure that all financial claims they deal with will be honoured--even if a large participant were to fail. The focus of the Bank's work is making sure that key systemic risks are identified, and establishing minimum standards to control that risk. With these risk-control standards in place, the private sector operators of the system can find the most efficient way to meet them. Second, we provide liquidity, both on a routine basis and in times of system-wide financial stress. An appropriate amount of liquidity helps to keep markets operating smoothly, and is thus vital to the stability and efficiency of the financial system. On a routine basis, the Bank provides overnight credit to financial institutions to cover any temporary shortfalls that arise in the payments system. These overnight loans help to stabilize the system, and they reduce the need for participants to hold large precautionary balances at the central bank. From time to time, there are shocks that can stress the whole financial system--a stock market crash, for example, or a terrorist attack--and these shocks can increase the demand for liquidity. In such a situation, the Bank of Canada can increase the supply of liquidity to support the smooth functioning of the system, and/or indicate publicly that it is willing to provide liquidity as needed. For example, following the terrorist attacks of 9/11, the Bank increased the supply of liquidity in the payments system to $1 billion from the then-typical $50 million. Third, as the country's "lender of last resort," the Bank of Canada can step in to provide "Emergency Lending Assistance" to a solvent bank (or to other deposit-taking institutions covered by our policy) in the event of a serious liquidity problem. This kind of lending is aimed at preventing a loss of confidence in a solvent financial institution, as well as any spillover effects. And fourth, we promote the stability and efficiency of the Canadian financial system by working in close co-operation with federal and provincial regulators, and public sector partners, and as a member of international bodies to strengthen the financial system worldwide. One of the main activities here is monitoring the domestic and international risks that have a bearing on the stability of the financial system. We communicate our research in speeches, in reports, and in our . I should also mention that as "fiscal agent" to the federal government, the Bank has a number of other responsibilities that also have an influence on stability and efficiency. For example, we provide policy advice to the government on how to fund the federal debt in a stable and low-cost manner. Related operations that we conduct on behalf of the government also tend to support the stability and efficiency of fixed-income markets. Now, how well are we doing with this objective? Well, I said that the objective is to allow Canadians to have confidence in the country's financial system. On the financial stability side, we carry out a regular assessment of the risks in our . In December, our overall conclusion was that Canada's financial, non-financial, and household sectors are in good shape. This assessment reflects favourable fundamentals--especially solid domestic and global growth, and the prudent financial behaviour of business. Of course, there are always risks. In December, we mentioned the possible spillover effects of an abrupt slowdown in the U.S. economy, which may affect the financial health of customers of Canadian banks, and a possible disorderly resolution of the large, global current account imbalances, but the Canadian financial system appears to be in a good position to withstand such shocks, should they occur. On the efficiency side, our view, as expressed in the Governor's December speech to the Economic Club of Toronto, is that Canada could be doing better in a number of areas, especially in the regulation of financial institutions, securities markets, and pension plans, and in the enforcement of laws governing securities markets. In carrying out our financial system work, can we do better? A sound and efficient financial system requires constant vigilance. We plan to maintain this vigilance, and to continue our research into financial system issues to help us promote stability and improved efficiency. Specific goals for the next two or three years are: to develop a more formal framework to assess financial system stability; to improve the collection and use of financial data; and to enhance the ability of the financial system to continue operations in the face of serious disruptions. We also plan to have our financial system research and policy evaluated by an external party. The third and final responsibility I'd like to look at is the design and distribution of bank notes. Bank notes are the most tangible part of a central bank's work. Everyone uses paper money. I should point out something that might surprise some of you here in the "Technology Triangle"--despite the many alternatives to cash, the demand for cash continues to grow, roughly in line with nominal GDP growth. The main objective of our bank note work is to provide Canadians with paper money that can be trusted--money we can use with (here's that word again) confidence. Of course, bank notes should also be beautiful, durable, and easy to handle, but if they can't be used with confidence, either because of high inflation or because of widespread counterfeiting, they lose much of their value. What's our strategy for achieving this objective? Well, as I said earlier, the Bank is committed to keeping inflation low and predictable, and we have a pretty good track record on that front. To deter counterfeiting, we do three key things. First, we take a great deal of care in designing bank notes. As I speak, my colleagues at the Bank are hard at work designing the next generation of bank notes, planned for introduction beginning in 2011. A significant part of the design effort goes into making the notes secure against counterfeiting. Second, we conduct broad-ranging education efforts to help the public, retailers, and law-enforcement officers to authenticate genuine bank notes and detect counterfeit ones. In fact, if any of you would like some help in this regard, I invite you to go to our website and click on "Bank Notes," where you'll find some useful training material. Third, we promote vigorous law enforcement. We work closely with police forces and the Crown, and provide them with information and training that can help in the prosecution of counterfeiters. In 2004, the Bank launched an annual Law Enforcement Award of Excellence for Counterfeit Deterrence. How well have we done in pursuing our bank note objective? I think a reasonable assessment would be "fairly well." Canadians confidence in their money. They use bank notes for day-to-day transactions without worrying unduly about counterfeiting. Can we do better? We think we can. In addition to examining whether refinements to the monetary policy target would be worth pursuing, as I mentioned earlier, we believe that we can further reduce the incidence of counterfeiting. Specifically, by 2009, we aim to reduce the level of counterfeiting to fewer than 100 counterfeits detected annually per million notes in circulation, down from about 225 per million last year, and 470 two years ago. We also have plans to work with the RCMP to build a database of counterfeiting information. Finally, we intend to improve our bank note distribution system, and to monitor the use of alternative means of payment. I'll conclude my remarks now. I've discussed the three major areas of responsibility in which the Bank of Canada pursues its mandate--often together with partners--to promote the economic and financial well-being of the country. I'm sure you noticed how often I used the words "stability" and "confidence" in my remarks. Stability and confidence are the preconditions for strong economic and financial performance. We aim to build on our successes as we continue to promote stability and earn the confidence of Canadians--and by doing so, we will further enhance the economic and financial well-being of Canadians.

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Standing Senate Committee on National Finance

jenkins

Good morning, Mr. Chairman, and Senators. Thank you for the opportunity to appear before you as you examine Bill S-217, which would amend the Financial Administration Act and the Bank of Canada Act. The preamble of this bill addresses some very important issues: the need for Canadians to trust in the management of the public purse, and the importance of openness and accountability. I can assure you that the Bank of Canada takes these issues very seriously. In terms of the management of the public purse, let me quote from the Bank's new medium-term plan, which was put up on our website earlier this month: "Good governance is an investment in preserving the trust of Canadians in our ongoing stewardship of the Bank. It means being accountable for our actions, decisions, and use of public funds..." In terms of openness and transparency, in many ways, the importance of these issues goes to the heart of our main responsibility: the conduct of monetary policy. Openness and transparency in our conduct of monetary policy is critical for two fundamental reasons. First, monetary policy is more effective when Canadians understand what the Bank is doing and why. Second, it is through openness and transparency that the Bank is held accountable to Canadians. How do we try to live up to our commitment to openness and transparency? We publish our balance sheet weekly and at the end of each month. Our success on the monetary policy front is measured against our explicit inflation target of 2 per cent for the total consumer price index. We announce our target for the overnight rate of interest eight times a year. We publish a and four times a year. The Governor and I appear before the Commons Finance Committee and the Senate Banking Committee twice a year. Senior Bank officials give speeches regularly across the country. And we table our in Parliament. We provide all of the information required by the Bill, in one form or another, on an annual basis. And since our quarterly expenditure flow can be so irregular, and because we do our planning and state our desired outcomes on an annual basis, the most useful way of delivering the required information is on an annual basis. The issue before us today is whether the amendments to the Bank of Canada Act contained in Bill S-217 will add value in terms of the proposed additional financial reporting. We certainly can provide that additional information, but, in our view, it is not evident that providing that information would satisfy a cost-benefit analysis. The Bank of Canada is not a commercial enterprise. Our balance sheet is structured to enable us to carry out two main responsibilities: the conduct of monetary policy and activities related to our role as lender of last resort. In terms of revenues and expenses, in 2006, we remitted $1.9 billion to the government through seigniorage. In the same year, our operating expenses were $264 million. It is not evident that providing, for example, a cash-flow statement or statement of retained earnings would contribute to meeting the objectives of Bill S-217. In summary, the Bank of Canada very much supports the objectives of this Bill: the promotion of sound financial management, openness, and accountability. As the Bill says, "Canadian taxpayers need to feel confident that public monies are being managed prudently." What is not self-evident in the case of the Bank of Canada, given our mandate, is whether the benefits of providing the additional information outweigh the costs.

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Adjusting to Economic Change

kennedy

It's a pleasure to be here in Saskatoon. The last time someone from the Bank of Canada spoke to this Chamber of Commerce was five years ago, when Governor Dodge discussed "Inflation Targeting During a Difficult Year." Just five years ago, but what a different world it was then. The world economy wasn't nearly as strong. Commodity prices were soft. From that vantage point, it would have been difficult to predict what happened over the next five years. Who could have foreseen the price of potash rising 50 per cent, oil prices going up about 200 per cent, or the price of uranium appreciating fivefold? Who could have known that the Canadian dollar would appreciate by more than a third? More importantly, who could have predicted that the Canadian economy would fare so well in dealing with these significant changes? The past five years have indeed been a period of great and relatively rapid economic change, both here in Saskatchewan and across the country. In my remarks today, I'd like to describe this change and discuss its significance to our economic well-being. Then I'd like to look at some of the factors that explain the success of the adjustment process thus far. Finally, I'd like to suggest what needs to be done to ensure that we'll continue to be up to the task of meeting the challenges ahead. Let's start by turning back the clock, and looking briefly at what was going on five years ago. Of course, the big news five years ago this month was the Olympics in Salt Lake City. There, the fastest woman on ice, Saskatoon's Catriona LeMay Doan took gold - , as she'd done in 1998 - in speed skating. And the women's hockey team, led by another Saskatchewan athlete, Hayley Wickenheiser, won all five games they played, and also took home the gold medal. Now, how was the economy faring? Well, it wouldn't have won a gold medal, but the economy wasn't doing too badly, especially considering the slowdown that occurred in the wake of 9/11 in 2001. The world economy was growing at just over 3 per cent, and the Canadian economy at just under 3 per cent. The national unemployment rate was 7.7 per cent. And inflation, at just over 2 per cent, was under control. Let's turn now to what has happened since 2002. In each of the four years that followed, world GDP growth has been over 4 per cent in real terms. Last year, it was 5.2 per cent. In fact, the world economy has grown more during this period than in any other five-year period since the second world war. Of course, strong non-inflationary growth of the global economy is desirable and good for most countries. But it is particularly true for Canada, given that so much of our economic well-being is derived from trade with the rest of the world. The strength of the global economy has had the important effect of increasing the demand for - and raising the prices of - many commodities that Canada exports, including oil and natural gas, copper and nickel, potash and uranium. At the same time, the prices of many imports have fallen, owing in part to global competition. This has resulted in what is called a "positive terms-of-trade shock" - the prices we get for our exports have increased relative to the prices we pay for our imports. As a result, we are richer as a country. In tandem with this improvement in our terms of trade, we've seen a major rise in the external value of our dollar. In February 2002, the Canadian dollar was at a historic low. Today, at around 85 cents, the dollar is worth about 37 per cent more against the U.S. dollar than it was then, and about 30 per cent more against a trade-weighted basket of currencies. This rapid and substantial movement in the exchange rate reflects fundamental changes in the economy. But that doesn't mean that adjusting to it has been easy. Adjusting to such an appreciation in the external value of the dollar can be difficult for many companies and workers, especially when competition is fierce, as it is now. But a strong dollar also presents opportunities. Businesses, for example, can more easily buy productivity-enhancing machinery and equipment from abroad, and the evidence is that they are doing just that. Consumers benefit because the prices of imports are lower when they're bought with a stronger dollar. Changes in our terms of trade also have implications for the allocation of resources within our economy. The strong commodity prices I mentioned have led to increased profitability in mining and oil and gas extraction. This, in turn, has prompted strong gains in both investment spending and employment in those sectors of the economy. Most sectors with a low exposure to international trade (such as personal services) have also experienced relatively strong levels of profitability and solid gains in employment. On the other hand, with the substantial rise in the exchange rate and increased competition from many of the Asian economies, many industries with a high exposure to international trade - typically manufacturers - have faced difficult adjustments since the end of 2002. This has been reflected in lower rates of profitability, modest gains in production, and declines in employment. But overall, Canada has adjusted well to the challenges of the past five years. Since 2002, our labour markets have performed well - the unemployment rate is now close to a 30-year low. And our average annual economic growth rate has been greater than the average growth rate of the G-7 countries as a whole. That's the national picture. In many respects, Saskatchewan is a microcosm of these trends. Real provincial GDP growth is solid and close to the national average. In the past five years, Saskatchewan has seen its labour participation rate increase significantly - from 65.7 to more than 70 per cent - and the unemployment rate has dropped from 5.4 per cent in February of 2002 to 4.1 per cent last month, indicating a robust labour market. Of course, Saskatchewan has been helped a good deal by the increase in world commodity prices that I mentioned earlier - especially for energy, potash, and uranium, while manufacturers here have faced challenges similar to those faced by manufacturers elsewhere in Canada. To summarize, the past five years have been a time of large and significant economic adjustment. Despite the stresses and strains that such a change can cause, Canada has done very well, all things considered. The economy is strong, Canadians are working, and they have seen increases in wealth and income. What are some of the factors that explain this successful adjustment? In an open economy like Canada's, the most important factor is flexibility. By flexibility, I mean the ability of the economy to adjust to changes in circumstance - that is, for resources to shift from areas of weakening demand to areas of strengthening demand - and for the economy to return to its production potential quickly, with as little cost as possible. But flexibility doesn't just happen - it's a function of structural policies, human capital, and our business culture. And flexibility is facilitated by two other elements that are required for success in economic adjustment - sound monetary and fiscal policies. Let's look at monetary policy first. The two key components of our monetary policy framework are inflation targeting and a floating exchange rate. These work together and reinforce one another to promote stability and to facilitate economic adjustment. How does this happen? Let's look first at inflation control. Low, stable, and predictable inflation provides many benefits. It helps people deal with change. One way it does this is by allowing prices to send clear signals, which in turn help individuals and companies to make sound, long-term economic decisions. In addition, and very importantly, when inflation is contained, monetary policy can be set to keep the economy running close to capacity, acting as an automatic stabilizer, so the economy can more effectively absorb shocks. These benefits are complemented by our flexible exchange rate. A floating dollar also acts as an automatic stabilizer, helping the economy to absorb shocks - especially external shocks that affect our economy differently than the economies of our major trading partners. Movements in the exchange rate are also important for the information they contain. They send signals to businesses and consumers about where to make investments and purchases, thus helping them adjust to the shifting currents of the global economy. But monetary policy cannot do its job well if it's not accompanied by sound fiscal policy. The federal government has had a budget surplus every year since 1997-98, and since 1999-2000, the provinces and territories as a whole have, more often than not, also been in a surplus position. Fiscal discipline is important, first, because it frees resources - resources that would otherwise be required to service debt - for more productive uses, and second, because it gives governments room to manoeuvre to deal with unanticipated events. Our sound fiscal situation has clearly helped Canada to weather the changes of the past five years. But sound monetary and fiscal policies are not enough to explain the success of the adjustment process. The flexibility of our economy has also been extremely important. When I say flexibility, I mean first and foremost the ingenuity and skills of our workers and business leaders. That's why education and training are so vital. Of significance for Saskatchewan's future well-being is the recent rise in what is called the "educational attainment" of its labour force. But flexibility is also a function of the ease and speed with which resources can be reallocated in an open economy. That's why we need to ensure that there are no unnecessary structural impediments to economic adjustment - impediments such as barriers to investment, to labour mobility, and to trade. In the past five years, the Canadian economy has demonstrated increased flexibility. But, as I'll explain in a moment, more can be done. Finally, I should point out that the adjustment process in the past five years has been helped a good deal by the favourable backdrop of strong growth in the global economy. Robust demand for Canadian goods has helped to offset some of the stresses and costs of adjustment. With this in mind, I think it's useful to point out that while Canadians control their monetary policy and fiscal situation, and , through various measures, encourage flexibility, we have less control over the external environment. And it's only prudent to keep in mind the possibility that the external environment may not always be favourable. So, the question arises: what do we need to do so that Canada remains able to respond effectively to the challenges of the future, in both good times and bad? All Canadians have a stake in the national economy. And we all have a role in helping to promote policies and actions that foster sustainable economic growth - whatever the backdrop. For its part, the Bank of Canada will continue to work toward the goal of keeping inflation low and stable, and we will do our part in promoting a sound and efficient financial system. Indeed, all policy-makers have a key role in promoting efficiency, productivity, and further economic flexibility. In an increasingly competitive world, the bar is always rising, so we cannot rest on our laurels. The policy areas in which we have more work to do will be familiar to you. In the financial sector, which I know best, securities regulation needs to be made simpler and more efficient. And generally, many business regulations need to be harmonized across Canada and some across the NAFTA region. And barriers within Canada to the free movement of goods, services and labour need to be removed. Tackling this issue is especially important now, as shortages of skilled labour are becoming more pronounced. And it will become even more important as demographic challenges begin to intensify. It would be helpful if trades and professional designations were recognized and fully transferable across the country, and if we could resolve the difficult issue of recognizing the qualifications of many talented immigrants. A related policy area that supports productivity and flexibility is education and training. Canadian workers benefit - indeed, the whole economy benefits - when they have the knowledge and skills required to take advantage of change and opportunity. As I have already said, much of Canada's prosperity depends on active engagement with the wider world. The recently re-started World Trade Organization talks to reduce barriers to international trade are particularly important to us, and need to be brought to a successful conclusion. In addition, further action should be taken to promote the orderly resolution of global financial imbalances - which refers to the large U.S. current account deficit, mirrored by large surpluses in Asia and in major oil-exporting countries. The United States needs to increase its savings rate, while Asia and the OPEC nations need to increase their domestic consumption. And some countries, particularly China, need to develop more flexibility in their currency arrangements. So that's the challenge for policy-makers. Business leaders and workers also face the challenge of adapting and prospering in a rapidly changing global economy. They have a stake in, and can lend support to, initiatives in the policy areas I have just mentioned. But businesses also need to innovate and aggressively tap new markets. They can invest in efficient machinery and equipment, and they can invest in their employees. And workers do their part when they invest in themselves - by learning and acquiring new skills. Before I conclude, let me say a few words about how the Bank of Canada sees the Canadian economy adjusting to the changes that have been taking place in the world. As stated in the January , the economy is judged at this time to be operating at, or just above, its production capacity at the end of 2006, following weaker-than-expected growth in the second half of the year. While the global economy has been expanding in a robust fashion, U.S. economic growth slowed in 2006, with weakness concentrated in the housing and automotive sectors. This weakness does not appear to have spread to the rest of the U.S. economy, and with signs that a significant amount of the adjustment in these sectors has already taken place, U.S. economic growth is expected to pick up through 2007. With continued solid growth in the rest of the world, the global economy is expected to grow by 4.7 per cent in 2007, and 4.5 per cent in 2008. Non-energy commodity prices are expected to decrease modestly from the very high levels reached toward the end of 2006. This global outlook bodes well for Canada. Real GDP growth should average about 2 1/2 per cent in the first half of 2007, rising to about 2 3/4 per cent in the second half of the year. In 2008, growth is projected to stay in line with the growth of potential output, estimated to be 2.8 per cent, keeping the economy operating near its full production capacity. The underlying trend of inflation, as measured by core CPI inflation, should be close to 2 per cent through 2008. Total CPI inflation is expected to average just above 1 per cent in the first half of 2007, returning to the 2 per cent target in 2008. In line with this projection, in January we judged the current level of the policy rate to be consistent with achieving the 2 per cent inflation target over the medium term. The risks to this outlook for the Canadian economy are reasonably well balanced. The biggest downside risk is sharper or more prolonged weakness in the U.S. economy, and the upside risk comes from the strength of the Canadian housing market and credit growth putting upward pressure on demand and inflation. In addition, there remains a small possibility of a disorderly resolution of global imbalances, particularly if policy-makers fail to take appropriate actions. I'll conclude now, and then I'd be happy to hear your comments and answer your questions. The past five years have been a period of significant economic adjustment. Canada is a wealthier country as a result of this change. We will continue to prosper, whether the external environment is favourable or not, provided that we learn the larger lesson - that it is essential to be flexible and adjust effectively to changes in economic circumstance. The current favourable outlook, for both Canada and the global economy, should not lead to complacency. We all have a stake in meeting the challenge of adjustment. As citizens, business leaders, workers and policy-makers, we all have a role in ensuring that Canada can respond effectively to changes in the economic landscape, and that Canadians can seize the opportunities that such changes often bring.

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Meeting Global Economic Challenges: The Need for Flexibility

dodge

Good afternoon. I'm very happy to be here in Calgary today to talk to you about what I see as one of the most important issues that we face in dealing with global economic challenges; namely, how we can increase the flexibility of our economy. I'll spend a bit of time talking about some of the structural concerns that I think are very important to our future prosperity. In light of the global challenges that have become very clear to us all, I'll particularly focus on the necessity of a well-trained and flexible workforce. But first, I'd like to provide you with some context for my remarks by saying a few words about the framework that we follow at the Bank of Canada in conducting monetary policy. Our primary objective at the Bank is to promote the economic and financial welfare of Canadians. Over the years, we have learned that the best contribution that monetary policy can make in this regard is to give Canadians confidence in the future value of their money. We do this by keeping inflation low, stable, and predictable. How we can best achieve this goal has been a matter of much study and debate and, indeed, some trial and error. But by the early 1990s, the Bank decided to achieve price stability by directly targeting inflation. A formal agreement between the Bank and the federal government set out the goals for reducing inflation to 2 per cent by 1995. And that inflation-targeting system worked so well that it has been renewed four times, most recently, near the end of last year. This means that we will continue with our goal of holding inflation to 2 per cent - the midpoint of a 1- to 3-per cent target band - over the coming five years. But we don't want to rest on our laurels. We have been pondering whether it might be possible to improve upon what has been a very good policy for the Canadian economy. To that end, the Bank has announced a major research program for the next three years to probe whether there might be ways to improve our inflation-targeting regime. In particular, we want to examine the potential costs and benefits of moving to a lower inflation target, as well as the potential costs and benefits of pursuing a price-level path instead of an annual inflation target. But that said, the research would need to show very strong evidence in support of any change before we would be willing to alter the system that has proven so successful over the past 15 years. A very important factor in the success of our inflation-targeting paradigm is the effort that we have put into making this system understandable, transparent, and predictable. In doing so, we've managed to help people comprehend how the Bank will react to economic developments, and thus, we've reduced the risk of misunderstandings. The basic principles are pretty simple. When the economy is expanding beyond the limits of its capacity in a way that would threaten to push inflation above our target, we tend to raise interest rates, all other things being equal. This action helps to restrain demand in the economy, thus reducing inflationary pressures. Or, if the economy is expanding more slowly and would likely operate below capacity, which would threaten to push inflation below our target, we would tend to lower rates. This would likely give demand a bit of a boost, thus nudging inflation back towards our target. Now, an essential element of this paradigm is that it aims to make very clear that we are targeting the inflation rate. That can sometimes be hard to appreciate in a country as large and diverse as Canada, where there are frequently sizable differences in inflation pressures in different parts of the country. Right now, inflation rates in Alberta are dramatically higher than those in central Canada. In January, for example, national inflation, measured by the total consumer price index across the country, showed an average increase of 1.2 per cent per year. But the national average masked a much higher annual inflation rate of 3.9 per cent here in Alberta. In contrast, the annual rate was considerably lower in Ontario, at 0.3 per cent, and in Quebec, at 0.6 per cent. Of course, the different rates of inflation in different regions reflect changes in the relative prices of goods and services across Canada. The energy and mining sectors, which are particularly important in the West, have been gaining strength in recent years relative to the manufacturing sector, much of which is based in central Canada. As part of this shift in activity between industrial sectors, we have seen waves of new workers flood into Alberta to fill jobs in the booming energy industry. That is driving up demand and prices for housing and other goods and services here. These regional and sectoral distinctions are important. But our mandate at the Bank of Canada is to work for the economic benefit of Canadians. It's therefore crucial that we keep our focus on the inflation rate. We can't concentrate on just one region, because at any given time, it's very likely that different regions will be experiencing quite different economic conditions. And since we at the Bank of Canada have only one policy lever - our ability to control the overnight interest rate - we can focus on only one policy goal: the national inflation rate. But, we do take note of the difficulties that various sectors of the economy are experiencing, and we are well aware of the diverse issues facing different regions. To better understand concerns across the country, we have staff in regional offices - including our office in Calgary - who actively seek input from businesses. One message that we have been hearing is that business widely recognizes the importance of flexibility and the need to be able to rapidly adjust to changing circumstances. That realization has certainly helped Alberta to better adjust to economic upheaval and change more quickly today than it did during the 1970s and '80s. Since those days, we've all learned that it does no good to try to shelter the economy from adjustments driven by global changes such as large swings in energy prices. So, let me talk a bit more about flexibility. I'm going to address this from two perspectives. First, I'll give the macroeconomic view, and then I'll look at the microeconomic issues. Canadian governments, both federal and provincial, are in a strong fiscal position. At the federal level, overall government debt has been reduced. Alberta has successfully eliminated its debt, and other provincial governments have worked hard to balance their books. This success has given governments more flexibility to deal with cyclical shocks. More importantly, lower debt-to-GDP ratios have meant that over time, the share of government revenues that must go to servicing debt has been reduced. That frees up revenues to help governments deal with looming demographic issues without the necessity of raising taxes. At the same time, federal and provincial governments have made strides in preparing for these demographic changes, with reforms designed to ensure the long-term viability of the Canada Pension Plan. So, from a fiscal point of view, Canada is in a position that is envied by almost every other country in the world. And, as I said earlier, we at the Bank of Canada have kept the rate of inflation low, stable, and predictable. This has allowed business and consumers to have confidence in the value of their money. So, I can say with assurance that Canada, because of its strong fiscal position and low inflation rate, has the flexibility needed to deal with whatever comes its way in the future. But while good macroeconomic policies are a necessary condition for meeting the challenges we face, they are not sufficient. Improved microeconomic policies are also required to increase flexibility and contribute to growing productivity over time. There are a number of important aspects to these policies, but I can talk about only a few today. And the first that I want to focus on relates to labour. Critical to building a flexible labour force is, as always, the education and training of young people. We must not only invest in basic education for our children. We must also prepare for an economy where most workers will expect to train and re-train throughout their careers; an economy where it will be considered normal to add skills or change career paths through life. We have to recognize that changing demographics mean there will be fewer and fewer young people in the labour pool to draw upon. We must therefore learn to concentrate on making the most of our experienced and trained workers. How can we make the very best use of the skills of those workers who are now in their 50s and 60s? Many individuals may wish to remain active in the labour force well past the conventional retirement age, and to increase our flexibility, it's important that we remove any barriers to their continued participation. This means that we, as employers, have to be more flexible in setting up work schedules. It means that we, as employers, must look at the redesign of pension plans. It also means that we, as employers, must put more effort into upgrading skills and increasing our openness to hiring mature workers. And it means that we, as employers, have to put more emphasis on mentoring programs, so that younger workers can benefit from the skills and experience of older workers, ensuring that intellectual capital is not lost. I've talked about government obligations and about our obligations as employers. But individuals also have an obligation to seize every opportunity to learn new skills. Failure on any of our parts would be very short-sighted and will mean lower standards of living for us all. And these are ongoing obligations. Even in times like these, when the labour market is very tight, none of us can afford to lose sight of the importance of skills development. We must keep in mind that it's not just developing and using skills that's important. Provinces must ensure that they don't set up road blocks that impede the mobility of workers. In this respect, I really do commend the provinces of Alberta and British Columbia for their recent pact allowing a free flow of labour and investment across the Rockies. Labour markets are not the only things that must be able to adjust - flexibility is important in all of our policies. We need legal and regulatory frameworks in place that encourage competition and allow market incentives to flow through. We really must eliminate barriers to interprovincial trade. As you know, these can take the form of a wide range of regulatory obstacles in areas as diverse as transportation, packaging, or financial services. Policies that encourage flexibility are crucial for Alberta if the economy here is to capitalize on its current strengths and build a solid base for the future. The important and growing knowledge base in Alberta is creating opportunities to develop industries that complement the oil and gas sector. It also provides a platform, built on skilled professionals and financial resources, for expanding the vital education and health sectors. A challenge, as well as an opportunity, for Alberta relates to the production and use of hydrocarbons in a time of increasing global concern about climate change. Around the world, there is a growing demand for products and technologies that limit or reduce the emission of greenhouse gases. And what better place than Alberta for the development of these types of technologies? As I've mentioned, the dramatic growth in the province's oil and gas sector has made Alberta a magnet for workers, many of whom have the specialized knowledge and spirit of innovation needed to develop such new products. The province's knowledge base and rising prosperity also give Calgary a great opportunity to build a solid financial services sector. This industry could be very important for Calgary's future. Financial services is a sector that attracts highly skilled workers who add a great deal of value. And Calgary has some natural advantages. It is situated in the heart of the oil patch and is already home to the Venture Exchange and to a fledging commodity exchange. But Calgary is unlikely to be able to fully exploit these advantages until Canada, as a whole, develops a more efficient framework for its securities market. From the analysis that we have done at the Bank of Canada, it's clearly in the interests of all Canadians, but particularly in the interests of Calgarians, to establish a uniform Canadian regulatory framework. This must be based on uniform principles, which are applied appropriately, taking into account the size and complexity of the issuer. And our securities laws must be consistently enforced. Just as Alberta played a lead role in reshaping the Canada Pension Plan to make it a model for the world, I trust that the Government of Alberta and the Calgary business community will play a lead role in establishing a uniform framework for securities regulation in Canada - a framework that will help to develop this city's potential beyond the oil and gas sector. Before concluding, I'd like to say just a few words about our most recent thinking on what we at the Bank of Canada see happening globally and in our national economy. Last month, I attended the Group of Seven meetings in Germany. The discussions on the global economy were very much in line with what we had set out in the Bank's January . Global prospects remain very favourable. While weakness in the U.S. housing sector is likely to continue for a short while, the weakness doesn't appear to have spread to the rest of the U.S. economy, and growth is expected to pick up over the course of 2007. The Bank judges that the Canadian economy was operating at, or just above, its production capacity at the end of last year. We continue to project that it should operate near its capacity throughout 2007 and 2008. Total CPI inflation at the national level should average just above 1 per cent in the first half of this year, returning to the 2 per cent inflation target in early 2008. Core inflation should remain near 2 per cent through to the end of next year. That's a look at our base-case economic projection. But if there's one thing we can be certain about, it's that the economy will not evolve exactly as set out in our base case. So, a very important part of our outlook is the assessment of the risks surrounding our projection. There are risks on both the upside and the downside. The main upside risk to our inflation projection continues to come from stronger household demand in Canada. Consumption could be stronger than expected, as households borrow against increased equity in their homes. Various indicators of household credit have also shown strong growth over the past year. The main downside risk continues to come from the United States where, as I mentioned, clear weakness remains in the housing sector. But there are some encouraging signs. The slowdown in the U.S. housing and automotive sectors does not appear to have spread more broadly. There is evidence that a significant portion of the adjustment in the automotive sector has already taken place, while the adjustment in the housing sector continues. Overall, we judge that the risks to our inflation outlook in Canada are roughly balanced. However, there remains a possibility of a disorderly resolution of global imbalances. On 6 March, we left our key policy interest rate unchanged at 4 1/4 per cent. In line with our outlook, the current level of the target for the overnight rate is judged, at this time, to be consistent with achieving the inflation target over the medium term. I've discussed some of what I see as the major challenges that we all face. I've also emphasized the crucial need for flexibility on all of our parts: government, labour, and business. This flexibility is vitally important. It will enable all of us to successfully capitalize on the opportunities presented by an expanding global economy. I'd now be happy to answer your questions.

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Promoting Sound Economic Policies Globally and Locally

dodge

It has been three years since I last had the opportunity to address the Council of the Americas. Since then, the global economy has continued to expand at a remarkable pace. Indeed, over the past five years, it has grown more than in any five-year period since the Second World War. In my opinion, much of this performance can be credited to the increasingly widespread acceptance of the need for a liberalized worldwide financial and trade order. Many countries that once closed themselves to the outside world are now actively engaged in the global economy. Notable examples are China, India, and, within the Americas, Chile. Many states that twenty five years ago would have been considered "less-developed countries," or that were within the sphere of the former Soviet Union, are now experiencing the benefits of economic openness, and millions of people have been lifted out of extreme poverty. In Canada and the United States, it is understood by many - although certainly not by all - that it is in our own interest, both economic and geopolitical, to increase the number of countries taking part in a liberalized financial and trade order. While there have been clear successes, particularly in Asia, there have also been clear disappointments. Within Latin America, there have perhaps been more disappointments than successes. And even in those Latin American countries that have taken real steps to join the global economy, anti-globalization sentiment remains quite strong. So today, I want to talk about the factors that have led to either success or setback in our progress towards a liberalized global framework for trade and finance. Then, I want to talk about the particular challenges that we face in promoting active involvement in the global economy by countries throughout Latin America. I will confine my remarks to economics, although the challenges clearly extend well beyond this domain. The best place to begin is with the aftermath of World War II. Delegates to the Monetary and Financial Conference at Bretton Woods, New Hampshire, began to create an economic order where trade could flourish, and postwar reconstruction could take place. Led by a strong contingent of American, British, and, if I may say so, Canadian representatives, the delegates set out to establish new international institutions. These would serve as tables around which policy-makers would gather to work out what could be called the "rules of the game" for a new financial and trade order. Over time, policy-makers at these new institutions had some real success in developing the rules of the game for several important areas. Early on, there was the establishment of the International Monetary Fund (IMF), and the International Bank for Reconstruction and Development, which would become the World Bank. Later, the General Agreement on Tariffs and Trade was launched, which would ultimately become today's World Trade Organization (WTO). And over time, the Organisation for Economic Co-operation and Development (OECD) evolved to become a venue where financial authorities could gather and discuss how best to promote strong economies through liberalized markets, freer trade, and sound macroeconomic policies. Initially, the rules of the game were meant to apply to many of the so-called "first world" nations, including the United States, Canada, Western Europe, Japan, Australia, and New Zealand. And for many years after the Second World War, the rules that had been developed served these countries reasonably well. Indeed, the global economic order was sufficiently successful that a number of other nations began to see how their economies and their citizens could benefit from taking part in it. And so, more nations began to adopt the policy frameworks needed to become engaged in an increasingly inter-connected global economy. I'll have more to say on this in a few minutes. But first, I want to discuss the struggles of policy-makers to keep the rules of the game relevant, given the changing nature of the global economy. The need to keep the rules of the game updated is no surprise. After all, the world economy has changed tremendously over the past few decades. Enormous advances in transportation, communications, and information technology have led to widespread gains in productivity and massive changes in the structure of the world economy. While this has been going on, new economic powerhouses have emerged. In response to these developments, the rules of the game have evolved somewhat, as have the institutions supporting the global financial and trade order. But to be blunt, neither the rules nor the institutions have fully kept up with the times. To illustrate my point, I'm going to say a few words about the IMF in particular. The Fund was critical in establishing some of the rules for monetary policy and exchange rates in the years immediately following the Second World War. But more recently, the IMF has been perceived by some countries as being irrelevant, and its activities have sparked resentment and outright hostility in other countries, including some in Latin America. A major source of this hostility and perception of irrelevance is the fact that the Fund has not evolved in step with the global economy. And this lack of evolution contributed to the Fund's inability to prevent or even to mitigate international crises such as the Asian Crisis of 1997 and the Argentinean crisis in 2001. In the absence of global co-operation to update the rules of the game, and an effective IMF to support these rules, we have seen a drift towards regional initiatives. And rather than using the IMF to efficiently pool international reserves, countries such as China have set out to accumulate very high levels of reserves. I have made several speeches in other places about the need to strengthen the surveillance function of the IMF, to improve its governance, and to make it more representative of today's global economy. I won't repeat those arguments here; if you are interested in the details of our recommendations for the IMF, I'd invite you to read the lecture I gave one year ago at Princeton University. The point I want to make today is that strengthening the IMF could help some countries - including those in Latin America - to willingly support and engage with the Fund. And this would increase the chances that these countries would willingly engage in the global economy. Unfortunately, in recent years, the attention of Canada and the United States has focused mainly on Asia. We have worked hard to help the Asian economies integrate into the global economy and take their rightful place at the policy-makers' table. We've encouraged these countries to play by the rules of the game with respect to international trade, in particular, by supporting their accession to the WTO. But at the same time, we have become concerned that these nations, notably China, are not always following the rules of the game with respect to monetary and exchange rate issues. Rather than deal with this issue through a strengthened IMF, we in the G-7, including the United States, have often dealt with it on a country-by-country basis. My contention is that all of us in the G-7, particularly the United States - which truly believes in a liberal financial and trade order - should lead the effort to strengthen multilateral institutions, such as the IMF. Not only would a stronger IMF be a more effective forum for dealing with the policy challenges now seen in Asia, it would also be more effective in encouraging the countries of Latin America to engage more fully in a liberalized financial and trade order. Because of our recent focus on Asia, we have, in many ways, neglected the need to promote economic progress and development in our own backyard. We need to pay equal attention to encouraging global economic involvement and promoting appropriate policies in our hemisphere, so that the countries of Latin America and their citizens can share the benefits of globalization. But this is not a simple task. The challenges of Latin America differ from those in Asia and other regions. And the task is made more difficult because there is no table around which the economic policy-makers of this hemisphere regularly gather. There is the Organization of American States (OAS), but it deals mainly with political and strategic issues. There is , but it deals with the limited range of issues common to the central bankers of the Americas. There is the Inter-American Development Bank, but it is more project-oriented than policy-oriented. And at the IMF, the countries of Latin America and the Caribbean island nations are divided among four executive directors. In short, we really do need a table around which all the economic policy-makers of the Americas can gather. Unfortunately, there is no OECD for the Americas. If there were an OECD for the Americas, what would it do? Essentially, it could serve the same function as the original OECD did for Western Europe. It could be a forum where economic policy-makers would discuss how best to promote strong economies through sound monetary, financial, and fiscal policies, as well as how to promote liberalized markets and freer trade. I do not know how such a table could be created, or how we could ensure that discussions would be as fruitful as the ones at the OECD. But creating such a table could be a very positive step, and I would be most interested in hearing your thoughts on this during our discussion period. Let me now take a few minutes to discuss some of the issues that could be dealt with at an OECD for the Americas. I'll begin with my subject area: monetary policy. The first point to make is that Latin America has to overcome a history of high inflation and, occasionally, hyperinflation. High inflation has not only held back economic development in Latin America, it has also had a devastating effect on its poorest citizens, who cannot shield themselves from its pernicious consequences. Inflation has exacerbated the problems of an already skewed income distribution. Some countries have made substantial progress in getting inflation under control and keeping it under control. I am thinking here of Chile, Mexico, and more recently, Brazil. In these cases, central banks were given sufficient independence from government and tasked with controlling inflation, although I hasten to add that the independence of the Brazilian central bank has never been formally legislated. These central banks were then able to make progress by adopting an inflation-targeting framework, supported by a floating exchange rate. In a Latin American setting, inflation targeting has been tremendously helpful in promoting macroeconomic stability, facilitating investment, and very importantly, aiding the most vulnerable members of society. Indeed, a low-inflation environment has allowed banks to offer credit to some households for the very first time - often a crucial first step in escaping poverty. I'll say more about the banking sector in a moment. I should also mention that some smaller nations in the Caribbean and Central America have achieved low inflation, quite appropriately, by fixing their exchange rate to the U.S. dollar. But while we can celebrate some monetary progress, we must also consider the country with the most troubled monetary policy history: Argentina. This is a country that has all the natural advantages needed to be one of the richest in the hemisphere. But Argentina has consistently failed to live up to its potential, and bad policy choices are largely to blame. The independence of Argentina's central bank has been repeatedly undermined, and unfortunately, the current policy path chosen by the government is once again leading to high inflation in that country. Of course, Argentina isn't alone in this regard. Perhaps the most important thing that Canada and the United States can do is to demonstrate our support for those countries that have made the right policy choices. In this way, we can show the citizens and their governments that they are on the right path to development. That is why the Bank of Canada has worked closely with the , the , and the , to provide support and technical assistance as they implemented inflation targeting. Next, I'll say just a few words about financial system policy. Here, I'm referring to the rules governing banking and the financial sector, as well as policies to support sound clearing and settlement systems. This is an area that is often overlooked. A sound and stable banking sector is, of course, enormously helpful in encouraging investment, which leads to increased employment and economic activity. And, as I just mentioned, extending access to credit to a broader segment of the population is a critical step towards economic progress. With increased access to credit, the poorest members of society are enabled to break out of the poverty trap. Progress in the financial sector area has been quite good in several countries for a number of years. Indeed, one could argue that there has been more progress in Latin America on financial system policies than there has been in Asia. The result has been that some commercial banks from the United States, Canada, and Europe, have expanded into the region. But it is important that we also encourage local financial institutions in Latin America. In the long run, having a sound and vibrant financial sector in place is in everybody's interest, even those financial institutions that would face increased competition in these markets. Another point to be made here is that policies must be put in place to encourage the development of local capital markets across Latin America, beginning with government bond markets. It is through both capital markets and financial institutions that savings are efficiently turned into productive investments, stimulating economic growth and helping to alleviate unemployment and poverty. Clearly, an OECD-like table, where policy-makers in Latin America can learn from each other, and from our experience in Canada and the United States, could be tremendously helpful in this area. It would be very beneficial to have a forum where economic policy-makers could gather to discuss issues and devise solutions to help strengthen financial sector policies across the Americas. Now let me turn to fiscal policy. In many ways, this has been the Achilles heel of Latin American economic policy. There are very few examples of sound fiscal frameworks in the region, although I would point to Chile, which has adopted the prudent policy of sequestering the windfall gains realized from the sharp increase in the prices of its exports. Elsewhere, Mexico and Brazil have made some progress, although not as much as they might like to see. And even where there has been improvement, countries still lack an anchor for their fiscal policy, although I have to acknowledge that, more often than not, the problems are political rather than economic. That's no different from the situation in many of the OECD countries in the 1960s and 1970s. But what was helpful to the fiscal authorities of the OECD is that they received support from the analysis carried out at that institution, as well as from their colleagues around the OECD table. This is another area where a regional table for the Americas would be a tremendous help. Fiscal authorities from the region could gather to exchange policy advice and develop strategies to deal with their situations. And civil servants could gather to share best practices with regard to tax and expenditure issues. We in Canada and the United States can offer advice. But, ultimately, fiscal policy in most of Latin America is a political problem, and it will be up to the people and governments of Latin America to solve it. The final area I want to address is trade policy. We can all agree that more open trade is key to economic development. Canadians and Americans have clearly benefited from freer trade, and there is a reasonable degree of support for further trade liberalization. However, in Latin America, there is much greater resistance to freer trade, and much greater popular support for protectionist policies. Indeed, a number of countries have chosen to adopt trade policies that impede growth and jeopardize improvements in living standards. But while governments in Canada and the United States generally favour and advocate freer trade, we don't always act on our own beliefs. And since we do a poor job in demonstrating our own willingness to live by the principles we espouse, it's not surprising that we in Canada and the United States have been unable to convince our neighbours in the Americas that the best way to raise incomes and lift people out of poverty is by taking on the challenges of free trade and global competition. One way for us to do a better job is to work more diligently towards a resumption of the Doha Round of trade talks, and to show a greater willingness to open our own markets to products in which Latin American countries have a comparative advantage. I recognize that it is easy for me, as a central banker, to say that we need to confront our own protectionism. But this is a political problem that we in Canada and the United States have to solve. These areas - monetary policy, financial sector policy, fiscal policy, and trade - are what I see as the four major economic policy challenges for Latin America. And these are four areas where it would be very helpful to have a forum for economic policy-makers in the Americas, a forum that could facilitate greater co-operation in the hemisphere. My remarks today reflect a long-standing tradition at the Bank of Canada of working with our central bank colleagues throughout the hemisphere. But beyond the Bank's collaboration in the region, Canada enjoys an enduring connection with the Americas. More Canadians now travel to Latin America and the Caribbean than to any other part of the world outside the United States. Canada joined the OAS and signed NAFTA in the early 1990s. Our involvement with the Americas has grown, encouraged by democratic transition, increased commercial and investment opportunities, and the movement of people. And Canada's engagement will continue to grow. In a speech last month, our Prime Minister noted that Canada "will seek to re-engage relationships throughout the Americas, with our partners in Mexico, the Caribbean, and Central and South America." Ladies and gentlemen, allow me to conclude. The prosperity that we enjoy in Canada and the United States is a testament to the ability of free markets to generate wealth and raise living standards. We understand the gains that can come from building a strong global financial and trade order, backed by appropriate rules of the game. Other governments have worked hard to engage in this global order because they, too, understand the benefits that it can bring to their citizens. We now face two challenges. First, we must think globally about how best to update the rules of the game to take into account the evolving nature of the global economy. Second, we must act locally, within our own hemisphere, to help our neighbours to see that integration into the global economy is in everyone's interest. Neither of these tasks will be easy. They will require patience and persistence. And along the way, we will encounter governments that are more inclined to withdraw from the process than to engage with the global economy. But we can't let the difficulty dissuade us from our goal. To the delegates at Bretton Woods, the task of rebuilding the world's economy must have appeared daunting indeed. And there were times when the political will to see this task through appeared to be lacking. But eventually, a spirit of co-operation overcame the obstacles, and policy-makers gathered around tables at international institutions and built a liberalized financial and trade order - an order that has led to the prosperity we know today. It is time to rekindle that spirit of co-operation and to build a table for the Americas, so that the benefits of the global economy can be spread throughout our hemisphere.

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Dealing with Uncertainty in the Conduct of Monetary Policy

kennedy

Bonjour. It's great to be here to give you my best wishes as you begin preparations for the CFA Institute's sixtieth anniversary celebrations. I want to speak to you today about dealing with uncertainty. I know you need to deal with uncertainty in your work as CFA charter holders. Uncertainty is also a fact of life for central bankers. To quote Alan Greenspan, "uncertainty is not just an important feature of the monetary policy landscape; it is the defining characteristic of that landscape." In my remarks today, I'll discuss the uncertainty inherent in monetary policy-making, and explain the strategies we at the Bank of Canada use to deal with that uncertainty. I should emphasize that the uncertainty I'll be speaking about relates to the models, indicators, and data we use to conduct monetary policy, to what we call "risks" to the economic outlook - that is, possible outcomes around our "base-case" projection. To make my remarks concrete, I'll refer to how we estimate the potential output of the economy. But first, I think it would be useful to provide a brief sketch of what monetary policy aims to achieve. The main goal of monetary policy is to help the country achieve strong, sustainable economic performance, and, in doing so, to contribute to rising living standards for Canadians. Experience has shown that the best way for a central bank to meet this goal, given the instruments at its disposal, is by keeping inflation low and stable. Low and stable inflation increases confidence in the future value of money, and allows for clear price signals. These benefits, in turn, help consumers, savers, and investors to make sounder economic decisions. The Bank of Canada has a clear inflation objective, and that is to keep the annual increase in the consumer price index as close as possible to 2 per cent. That objective, together with our transparent framework for how we go about achieving it, helps to anchor inflation expectations, and adds a significant amount of certainty to the economic and financial environment. An important element of controlling inflation and promoting sustainable growth is keeping the economy operating in line with its production capacity. For the central bank, this means getting a good reading on this capacity, which we call the economy's . Potential output is not directly measurable. And it changes over time with changes in productivity, the capital stock, and the composition of the labour force. So, as we try to keep demand in balance with the economy's capacity to produce at a sustainable pace, the Bank is dealing with variables that are both hard to measure and evolving. When aggregate demand pushes the economy beyond its capacity limits, thus threatening to raise inflation above target, the Bank will - all things being equal - raise its policy interest rate. And, in symmetric fashion, when unused capacity puts downward pressure on inflation, threatening to push it below the target, the Bank will - all things being equal - lower the policy rate. Of course, there's a lot packed into that phrase, "all things being equal." One complication involves persistent movements in relative prices, which can affect inflation. For instance, a trend reduction in the prices of imported consumer goods puts direct downward pressure on inflation, since the prices of these goods are included in the consumer price index. This, in turn, provides scope for the economy to operate at a higher level than would otherwise be the case. A second complication is the time lag between a policy action and its effects. While a change in the policy rate can begin to affect output fairly quickly, it typically takes 18 to 24 months for the full effects to be felt on inflation, and that means that the Bank has to be forward looking and base its decisions on projections of pressures on inflation. It also means that a large part of what we're doing as we deliberate on the appropriate interest rate setting is trying to look through the "noise" of the moment to get a sense of the underlying trends. We need to look through short-term, temporary volatility that will have disappeared by the time our actions have an effect on inflation. A third and related complication arises when a shock hits the economy. Beyond the initial element of surprise, there can be uncertainty about the magnitude of the effects of the shock, about how the economy will be affected, and about how long the shock will last. Try to imagine steering a ship. The ship's captain needs to regularly ascertain the ship's current location by means of various instruments and readings, scrutinize the charts to see whether there are any obstacles ahead, and then apply judgment to determine the best course to arrive safely at the destination. In like fashion, a central bank cannot directly see everything ahead, and so it must rely on models, data, and indicators, and then apply judgment to determine the best course for meeting the monetary policy objective. And the economy, like a large ship, takes time to respond to a change in course. But unlike the precise instruments and readings available to the captain, our models, data, and indicators provide only approximate information. Models, data, and indicators are invaluable in informing monetary policy, but a good deal of uncertainty is inherent in them. By definition, models are simplifications of reality, and never entirely reflect the complexity of a dynamic economy. Our main indicators are derived from data, but the data we use are often subject to a good deal of revision. And for certain variables that are fundamental to conducting monetary policy - potential output is a good example - there are no direct measures at all. Our destination, however, remains clear: achieving the 2 per cent inflation target. So, how do we at the Bank of Canada deal with the uncertainty inherent in the models, indicators, and data we use when conducting monetary policy? As CFA charter holders, you'll be aware of Peter Bernstein's writings on risk. His advice is to treat uncertainty as a "friend" - "with care, consideration, and attention to consequences." And that's the bottom line for the Bank of Canada, too. We treat uncertainty about our models and data - and the risks to the outlook as well - with care, consideration, and attention to consequences. Again, consider the captain of a ship. Like the captain, we need to know first where we are . That means knowing, among other factors affecting inflation, the current level of output relative to potential. To do this, we first run our models for potential output with the most recent data and revisions, which brings us up to date on recent history. But we also look at a range of other data and indicators before coming up with a judgment about our current situation. Then we have to determine what lies , which means that we try to determine the growth of potential output going forward, as well as the future growth rate of the economy and the trend for inflation. We use judgment to decide on a course of action, keeping in mind that the "ship" of the economy responds slowly to a change in the policy interest rate, and that there could be headwinds or tailwinds to deal with. And because we get monthly data on inflation and output, we can correct our course, if necessary, on subsequent policy interest rate announcement dates. Let me expand on this. In conducting monetary policy, the Bank uses three main strategies to reduce uncertainty. First, we to produce economic projections and to examine alternative assumptions about key variables. The use of multiple models helps to provide comprehensive information and analysis, and helps to guard against policy errors that could result from relying on a single economic model. The models we use range from single-equation indicator models to multi-equation reduced-form models to dynamic stochastic general-equilibrium models, such as our newest model of the Canadian economy, ToTEM. The second strategy we use to reduce uncertainty is to before we make an interest rate decision. These include both quantitative and qualitative measures covering international and domestic economic developments, the regional business outlook, monetary and credit conditions, and the views and expectations of financial market participants. As we sift through this information, we try to look through the noise and discern fundamental trends. We look carefully at both corroborating and non-corroborating evidence. Finally, we . The Bank of Canada does this by means of a committee that debates the issues and comes to a decision. Interestingly, research suggests that the composition of a committee and the structure of a meeting can affect the quality of decision making, both in central banking and elsewhere. The Bank's committee is called the Governing Council. It consists of the Governor, the Senior Deputy Governor, and four Deputy Governors. The Governing Council is advised by staff and by a Monetary Policy Review Committee, which looks at the evidence and the projections, and raises issues. Open discussion and debate are encouraged. Decisions benefit from the exchange of differing views among members - what James Surowiecki calls the "wisdom of crowds." These differing views arise largely from different weightings of various aspects of the analysis presented by Bank staff. The Bank's clear goal - meeting the inflation target - helps to focus the deliberations. And with decisions made every six to eight weeks, there are frequent opportunities to take new soundings and adjust course. A good example of how we apply these strategies is the way we estimate potential output. Potential output is important in understanding inflation dynamics over time, but, as I said earlier, it cannot be measured directly. We're not sure that our models fully capture potential output, especially when the economy is undergoing significant structural change. To add to the challenge, some of the data used in these models are frequently revised. So, in addition to the readings we get from our models, we also consider a number of alternative indicators of pressure on capacity. These indicators include the rate of capacity utilization, measures of labour shortages, building vacancy rates, reports from our quarterly regional surveys of firms, and the recent behaviour of inflation relative to expectations. Of course we also consider more direct influences on inflation such as import prices, cost pressures such as wages relative to productivity, and inflation expectations. I should also mention that we meet, on a regular basis, with a wide variety of business people to discuss their investment and hiring intentions, their costs and their pricing decisions, and any constraints they may be facing. The information we obtain from these meetings helps us to interpret the numbers and better informs our judgment. Of course, the strategies I have mentioned complement one another. Taken together, they help the Bank to arrive at a comprehensive and balanced view of developments in the Canadian economy, the outlook for inflation, and the appropriate monetary policy action to keep inflation on target over the medium term. Let me conclude. In my remarks today, I've described how the Bank of Canada deals with the uncertainty that underlies the conduct of monetary policy. The task of monetary policy is, and is sure to remain, a challenging one, given the limits of understanding something as complex and dynamic as the modern, globally integrated economy. While dealing with uncertainty is a challenge for all central bankers, Canadians no longer have to worry about one form of uncertainty that plagued us in the 1970s and early 1980s: that of high and variable inflation. Canadians can be certain that the Bank of Canada will continue to direct its policy actions at meeting the 2 per cent inflation-control target, and thus contribute to the sustainable growth of the Canadian economy. Uncertainty may indeed be the "defining characteristic" of monetary policy, but our clear inflation target, and our success in meeting it, give us solid ground on which to stand.

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Release of the

dodge

Today, we released the April , which discusses current economic and financial trends in the context of Canada's inflation-control strategy. Growth of the Canadian economy has been essentially in line with the Bank's expectations as set out in the January . But inflation has been higher than expected. After considering the full range of indicators, the Bank now judges that the Canadian economy was operating just above its production capacity in the first quarter of this year. Over the projection horizon, domestic demand continues to be the main driver of growth in Canada. With the U.S. slowdown now expected to be somewhat more prolonged than previously projected, net exports should exert a slightly greater drag on growth in 2007. The Canadian economy is projected to grow by 2.2 per cent in 2007 and 2.7 per cent in both 2008 and 2009, returning to its production capacity in the second half of 2007 and remaining there through 2008 and 2009. Core inflation should remain slightly above 2 per cent over the coming months, given pressures on capacity and the impact of higher core food prices. But with the economy projected to return to its production capacity in the second half of this year and with further easing of pressures from housing prices, upward pressure on core inflation is expected to moderate, bringing core inflation back to 2 per cent by the end of 2007. Total CPI inflation is projected to rise above the 2 per cent inflation target in the second half of this year, peaking below 3 per cent near the end of 2007 before returning to the target by mid-2008. The Bank continues to judge that the risks to its inflation projection are roughly balanced, although there is now a slight tilt to the upside. On Tuesday, the Bank left its key policy rate unchanged at 4 1/4 per cent. The current level of the policy interest rate is judged, at this time, to be consistent with achieving the inflation target over the medium term.

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Opening Statement before the House of Commons Standing Committee on Finance

dodge

Good morning, Mr. Chairman and members of the Committee. We appreciate the opportunity to meet with your committee, which we usually do twice a year, following the release of our . We believe that these meetings help us to keep Members of Parliament and, through you, all Canadians, informed of the Bank's views on the economy and about the objective of monetary policy and the actions we take to achieve it. When Paul and I appeared before the Finance Committee last October, we noted then that the outlook for growth in the Canadian economy had been revised down slightly from earlier expectations. In our latest , which we released last Thursday, we noted that Canada's economic growth did indeed slow, but recently, inflation has been higher than expected. After considering the full range of indicators, the Bank now judges that the Canadian economy was operating just above its production capacity in the first quarter of this year. We expect that, over the projection horizon, domestic demand will continue to be the main driver of growth in Canada. With the U.S. slowdown now expected to be somewhat more prolonged than previously projected, net exports should exert a slightly greater drag on Canada's growth in 2007. The Canadian economy is now projected to grow by 2.2 per cent in 2007 and 2.7 per cent in both 2008 and 2009. This would return the economy to its production capacity in the second half of 2007 and keep it there through 2008 and 2009. Core inflation should remain slightly above 2 per cent over the coming months, given pressures on capacity and the impact of higher core food prices. But with the economy projected to return to its production capacity in the second half of this year and with further easing of pressures from housing prices, upward pressure on core inflation is expected to moderate, bringing the core inflation rate back to 2 per cent by the end of 2007. Total CPI inflation is projected to rise above the 2 per cent inflation target in the second half of this year, peaking below 3 per cent near the end of 2007 before returning to the target by mid-2008. We at the Bank continue to judge that the risks to our inflation projection are roughly balanced, although there is now a slight tilt to the upside. Last Tuesday, the Bank left its key policy rate unchanged at 4 1/4 per cent. The current level of the policy interest rate is judged, at this time, to be consistent with achieving the inflation target over the medium term. Mr. Chairman, Paul and I will now be happy to answer your questions.

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

dodge

Good afternoon, Mr. Chairman and committee members. We appreciate the opportunity to meet with your committee, which we usually do twice a year, following the release of our . We believe that these meetings help us to keep members of the Senate and, through you, all Canadians, informed of the Bank's views on the economy and about the objective of monetary policy and the actions we take to achieve it. When Paul and I appeared before your committee last October, we noted then that the outlook for growth in the Canadian economy had been revised down slightly from earlier expectations. In our latest , which we released last Thursday, we noted that Canada's economic growth did indeed slow, but recently, inflation has been higher than expected. After considering the full range of indicators, the Bank now judges that the Canadian economy was operating just above its production capacity in the first quarter of this year. We expect that, over the projection horizon, domestic demand will continue to be the main driver of growth in Canada. With the U.S. slowdown now expected to be somewhat more prolonged than previously projected, net exports should exert a slightly greater drag on Canada's growth in 2007. The Canadian economy is now projected to grow by 2.2 per cent in 2007 and 2.7 per cent in both 2008 and 2009. This would return the economy to its production capacity in the second half of 2007 and keep it there through 2008 and 2009. Core inflation should remain slightly above 2 per cent over the coming months, given pressures on capacity and the impact of higher core food prices. But with the economy projected to return to its production capacity in the second half of this year and with further easing of pressures from housing prices, upward pressure on core inflation is expected to moderate, bringing the core inflation rate back to 2 per cent by the end of 2007. Total CPI inflation is projected to rise above the 2 per cent inflation target in the second half of this year, peaking below 3 per cent near the end of 2007 before returning to the target by mid-2008. We at the Bank continue to judge that the risks to our inflation projection are roughly balanced, although there is now a slight tilt to the upside. Last Tuesday, the Bank left its key policy rate unchanged at 4 1/4 per cent. The current level of the policy interest rate is judged, at this time, to be consistent with achieving the inflation target over the medium term. Mr. Chairman, Paul and I will now be happy to answer your questions.

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The Importance of Appropriate Exchange Rate Regimes

dodge

Thank you and good morning. It's great to be here and to have an opportunity to talk about some key issues that relate to your meeting's theme of convergence. I think that it is very important that economies all over the globe converge towards becoming part of a market-based, liberalized trade and financial order. Why do I think that such an order is so important? Well, in part it's because history has helped to demonstrate its virtues. But it's also extremely important to bear in mind the context, that is, the world in which we live today. This is a world in which adjustment is perpetual, where change is driven by the development of new technologies, where sectors and nations continually attempt to secure some new advantage. And in this world, price signals from markets help us to understand what adjustments are needed. So, this market-based, liberalized trade and financial order is really the best that we have found for promoting growth and prosperity. But it is critical that members of this system adhere to a common set of rules or policies that operate for the benefit of all. In this way, we can encourage a healthy pace of global economic growth. Of course, many policies are necessary to move an economy towards converging on a market-based, liberalized trade and financial order. I'll elaborate further in my remarks on some of those policies. But today, I will focus on one particular policy. That is the vital role that a flexible exchange rate regime can play for many countries in helping their economies to operate for the maximum benefit of all citizens. Now, I should be clear right off the top that I'm not saying a floating exchange rate is the one and only choice for all countries at all times. A fixed exchange rate can be the right choice for economies - especially small economies - where an independent monetary policy is difficult to execute. In such a situation, the costs associated with having a flexible currency may outweigh the benefits. But for many - and indeed, for most large economies - a flexible exchange rate can bring important economic benefits, benefits that clearly outweigh the costs. A flexible rate supports a market-based, liberalized financial order, an order that has the great advantage of providing for continuous adjustment in response to price signals. A flexible exchange rate adds one more market-determined price. It not only absorbs shocks, but it uses prices to facilitate changes. At the same time, we must always remember that a flexible exchange rate is just one of several key policies that are critical to achieving economic efficiency. But a flexible rate is crucial if a country is to pursue an independent monetary policy aimed at price stability. During my remarks, I will illustrate some of my points by drawing on Canada's lengthy experience with a floating exchange rate. Our experience can be very instructive for others, even though 57 years have passed since Canada broke with the Bretton Woods system and implemented a flexible exchange rate regime. We have had more experience with this type of exchange rate mechanism than almost any other country in the world, so we have a deep understanding of how it works. Canada's bold - some might say radical - decision in 1950 to break with the Bretton Woods system was driven by a couple of problems. Some of these problems still plague many emerging-market economies today. In the late 1940s, Canada was dealing with a large inflow of foreign capital and postwar investment, as well as strong household demand. Following an earlier revaluation of the Canadian dollar, short-term capital was flowing heavily into the country amid speculation about another revaluation. Rising commodity prices were also adding to upward pressure on the dollar. All of this led to concerns about inflation, as well as worries that capital inflows might lead to a sizable increase in the country's foreign debt. Unfortunately, the fixed exchange rate meant that policy-makers had to focus monetary policy on exchange rate stability, rather than on steps that would have been appropriate to stabilize domestic prices. To give the Bank of Canada the freedom to pursue policies aimed at stabilizing prices, authorities took the critical step of allowing the dollar to float at values set by the market. I'd also like to remind everyone that this policy continues: the Bank of Canada today still has no specific target for the dollar, because we believe that market conditions should determine the currency's value. The 1950 decision to float the currency was controversial, especially with the International Monetary Fund and most of its member states, which subscribed to a fixed exchange rate regime. But in the postwar years, experience proved that a floating exchange rate was truly beneficial for domestic policy. However, during the 1970s and 1980s, the Canadian-dollar foreign exchange market was quite thin. As a result, the Bank of Canada had to intervene on a day-to-day basis with the aim of providing liquidity and reducing volatility. This strategy of "leaning against the wind" was pursued symmetrically, with the goal of smoothing fluctuations in either direction. By the 1990s, however, markets had become deep enough that daily interventions were no longer helpful. Government policy now restricts such interventions to the most exceptional circumstances and, in fact, Canada hasn't intervened to influence the Canadian dollar since 1998. Despite Canada's success with a flexible exchange rate system, there are still critics who find it hard to deal with the uncertainty that can come with a floating dollar. Large currency movements, such as the roughly 35 per cent appreciation in the Canadian dollar since early 2003, can be hard for businesses to deal with. A floating currency does entail somewhat larger transactions costs and, in the short run, additional risks for business. In this regard, the development of deep and well-functioning forward foreign exchange markets is extraordinarily important in assisting businesses to hedge their foreign exchange risk. Such well-developed markets, along with financial institutions geared to providing business - especially small business - with the opportunity to hedge at low transactions cost, minimize the additional exchange risks that businesses face under a floating exchange rate regime. But even with well-developed foreign exchange markets and the ability of firms to hedge, some still fear that a flexible exchange rate will introduce undue risks and uncertainties. They argue that fixed exchange rates are the solution. But a fixed exchange rate is no panacea. Over time, a fixed nominal exchange rate can actually heighten uncertainty and, eventually, add to volatility. A fixed rate limits the actions of central bankers because monetary policy must be aimed at protecting the fixed level of the exchange rate. Under a regime of fixed nominal exchange rates, the economy is forced to absorb the full effect of changes in world prices through changes in domestic nominal wages and prices. To bring this about, the burden initially falls on output and employment and, eventually, spreads to most wages and prices. And because domestic wages in particular tend to be "sticky," changes in output and employment need to be quite large. Thus, adjustment tends to be more difficult and more costly for many individuals, businesses, and the economy, than would be the case under a flexible exchange rate regime. In economies where domestic wages and prices are not perfectly flexible, it's not only central bankers who face constraints under a fixed exchange rate regime. Controls on financial transactions will often be required, and eventually, controls over parts of the real side of the economy may be needed to maintain the fixed nominal exchange rate. Authorities who ignore these constraints, or who lack the fiscal discipline required by a fixed exchange rate regime, can end up creating uncertainty and the very volatility that they were trying to avoid. Let me just say that the greatest benefit Canada has found with a floating currency is the way in which it helps the economy deal with economic shocks. Perhaps this is a good time for me to take a moment and explain in more detail just how the floating exchange rate system now fits into Canada's monetary policy framework. Our monetary policy aims to protect the domestic purchasing power of our currency by keeping inflation low, stable, and predictable. We aim to keep inflation, as measured by the consumer price index, at a 2 per cent target. By doing so, we support the conditions necessary for strong, sustainable economic growth. Of course, there will always be economic shocks that require a response and adjustment. As a medium-sized, open economy and an important producer of commodities, our terms of trade can shift significantly as the relative prices of commodities, manufactured goods, and services change. Such changes in relative prices are a signal to shift real resources out of sectors with declining profitability, and into sectors where profits are rising. Under a floating rate regime, movements in the currency help to smooth that process and to minimize the adjustments in other areas of the economy. This all serves to demonstrate why it has been very important to us to maintain our flexible exchange rate, rather than fix our currency to the U.S. dollar. The United States is certainly our closest neighbour and by far, our largest trading partner. But the structures of our two economies are very different. This means that each of us often requires different adjustments and different policies in reaction to shocks. Canada's floating exchange rate facilitates these adjustments without forcing our economy through some very difficult changes in the overall level of output, wages, and prices. Let me put this in more concrete terms and, in so doing, share a valuable lesson learned from the Asian crisis of 1997. As a commodity-producing nation, we were hit pretty hard by the dramatic fall in commodity prices. Our floating dollar fell sharply and thus, helped with the significant but necessary adjustment. With the decline in the nominal exchange rate, our non-commodity sectors saw their competitive positions improve. They were therefore able to absorb some of the resources that were being quickly shed by the commodity producers. Our floating exchange rate allowed us to achieve a decline in wages without a decline in wages and to hold inflation near our target. Let me give you another example. In recent years, the demand for and the prices of Canadian commodity exports have been rising sharply. This has helped to create an economic boom, and investment flows into Canada have increased. Our floating dollar has appreciated sharply and thus, has forced some necessary adjustments. As their competitive positions improved, our commodity producers have been able to absorb some of the resources that were being shed by the non-commodity sectors, which have seen their competitive positions deteriorate. As a result, we've seen a shift in relative wages without fueling inflation. Thus, the flexible exchange rate has again helped the economy to absorb shocks and has allowed the Bank of Canada to keep inflation near the 2 per cent target. Adjustment is never easy, but on balance, a flexible exchange rate regime has definitely helped Canada to maintain production close to full capacity and to minimize the effects of the boom-bust cycles in various sectors. A floating exchange rate can bring a number of important benefits, but as I said, there are other important components of a sound policy framework. A well-functioning domestic financial system is crucial to achieving efficient domestic allocation of capital and to dealing with external shocks. That is why policy-makers around the world have been putting a lot of emphasis on improving domestic banking and financial systems. Organizations such as the G-7, the G-10, and the Financial Stability Forum have all examined ways to improve financial system stability. And for his hard work in this area, I'd like to congratulate Tim Geithner of the U.S. Federal Reserve, who is also your next speaker. With all of these efforts, we have seen some real improvements in financial system stability in recent years. Since the 1990s, countries have also found that it's very important to develop domestic markets for debt, for their own protection, as well as for the good of the global economic system. And in this area, we have also seen some real signs of progress. A decade ago, with the peso crisis still fresh in people's minds, who would have believed that Mexico would be in a position today to issue long-term, fixed-rate, peso-denominated bonds at such narrow spreads over U.S. Treasuries? Fiscal policy is also important. Governments must behave in a fiscally responsible manner. That doesn't mean that the books must be perfectly balanced each and every year. But it does mean that governments must maintain, and be committed to maintaining, a manageable debt-to-GDP ratio and avoid running up debt that will tie the hands of future governments. Let me conclude by going back to where I started my remarks. I have spoken about how a liberalized, global trade and financial order is important for promoting economic growth and prosperity. And I have focused on the importance of a floating exchange rate regime, which is a key element in promoting good performance, both domestically and globally. For systemically important countries, we should be promoting floating rates supported by well-developed and well-functioning domestic financial markets. But it has to be acknowledged that it can take some time for emerging-market economies to put these well-developed markets in place. And along the way, some management of capital flows and a degree of intervention in foreign exchange markets may be needed, in these economies. These capital controls and foreign exchange interventions are awkward, and over time, they can lead to a lot of problems. So they must be eliminated as quickly as possible. But, to the extent that countries are making progress towards more flexible exchange rate regimes, those of us with well-developed markets already in place will have to have some tolerance for this awkwardness. And those of you in the ACI will have to continue to trade in this somewhat awkward environment. In the meantime, I can say that we at the Bank of Canada will be doing all that we can to provide assistance and to persuade countries in transition to move as rapidly as possible, to facilitate the desired convergence.

r070510a_BOC

canada

A Sound Pension System – Handling Risk Appropriately

dodge

Good afternoon. I'm happy to be here to talk about the importance of Canada's pension system. It goes without saying that a sound system of private pensions is important from the perspective of pensioners who rely on a given plan for their retirement income. For firms, a pension plan can help to attract and retain staff, and so the business community also counts on a sound pension system. And as a central banker, I know that a sound pension system is important from the perspective of economic and financial market efficiency. Given the significance of our pension system, policy-makers in Canada need to keep working on improving its operation. Ultimately, it is crucial for all Canadians that our pension system function as well as possible. But what is it that makes a system of private pensions function well, or not? As I see it, a key to answering this question is understanding how pension plans deal with risk, in all of its many forms. So today, I want to spend some time discussing private pensions and risk, and suggest what needs to be done to make sure that those who have to bear risk also have the right incentives to deal with it in the most appropriate manner. I will focus on who is best placed to bear risk, and on how risk management can be better supported. Let me start with a fundamental question: Why do people save for their old age? Essentially, people save during their working years so they can retire at some point and not suffer a precipitous drop in income and living standards. Economists might put it somewhat less elegantly, saying that people save in order to smooth their lifetime consumption. In the absence of any kind of pension system, individuals, businesses, and society as a whole would all face a number of challenges and risks. I want to spend a few minutes talking about the challenges and risks from these three perspectives, beginning with individuals. First, individuals without a pension plan would have their personal savings as their only source of retirement income, aside from income from the publicly funded Canada Pension Plan/Quebec Pension Plan and the Old Age Security/Guaranteed Income Supplement. And so, individuals would naturally be exceedingly cautious with their investments, particularly as they approached retirement age. In short, individuals without pensions would likely be too with their savings to generate a sufficient rate of investment return. Second, individuals can recognize that they lack the expertise to handle their investments in the most effective way, and so will try to acquire this expertise. This could come by way of an investment adviser, or by investing their savings in managed, diversified retail investment vehicles such as mutual funds. The challenge posed by this approach is that it can be , since individuals outside a pension plan have to purchase investment advice and ongoing funds management retail, not wholesale. Third, individuals without a pension plan face in a couple of ways. Market conditions could be such that at the time of retirement, the value of their assets could be abnormally low. Or interest rates could be abnormally low at the time of retirement. In either case, the person would need to spend a much greater amount to purchase an annuity or other guaranteed stream of income compared with a period when market conditions were more favourable. The fourth point is related to the third. Sellers of annuities have to deal with the risk that those individuals who expect to live much longer than actuarial tables would suggest are the ones who buy annuities. To deal with this , sellers compensate for the risk by charging significantly more for the annuity. In other words, the cost of an annuity is much greater for an individual than it is for members of a group. Both of these last two points demonstrate that without a pension system, individuals would need significantly higher levels of savings to ensure adequate funding for their retirement. And all of these points I raised demonstrate that pensions generate enormous benefits by making it much simpler for individuals to successfully save for retirement. But while the benefits of pension plans are obvious for individuals, let's not lose sight of the benefits for businesses and for society as a whole. From the perspective of business, pension plans are typically thought of as a recruitment and retention tool. But historically, pensions were also the way that good employers helped workers to save so that they could avoid penury in old age. And with a pension plan, older workers had the ability to retire, and thus did not need to keep working well beyond the point of their greatest productivity. As for society as a whole, pensions provide a couple of important benefits. First, no society wants to see large numbers of its senior citizens relying entirely on government transfers, although there is fairly universal agreement across most countries that it is desirable to have some degree of public income support for people in their old age. Beyond that, however, a well-functioning pension system is an important source of the long-term risk capital that is essential to finance growth. Most of the challenges and risks I've mentioned can be mitigated, to a greater or lesser extent, through the pooling effect that a pension plan provides. Of course, different kinds of pension plans deal with risks in different ways. First, let me briefly discuss defined-contribution plans and the way they deal with risks. A defined-contribution plan mitigates, at least partially, many of the challenges and risks I mentioned for individuals. For example, the costs of funds management and investment advice are pooled. Further, pooling helps to mitigate the risk that individuals will not have saved enough to purchase an appropriate annuity. However, a defined-contribution plan leaves individuals completely exposed to market risk. The value of a member's contribution could fall sharply just before retirement, or an individual could retire during a period of abnormally low interest rates. Defined-contribution plans reduce, but do not eliminate, risks for employers. Because of market risk, this type of plan can fall short of the goal of ensuring adequate retirement income for all employees. The retirement incomes of two people with identical work histories can differ greatly, if they retire at separate times when the prevailing market conditions are very different. Finally, defined-contribution plans do significantly mitigate risks for society as a whole, but there may still be a less-than-optimal investment of the pools of contributions. I will come back to this point in a minute. In summary, defined-contribution plans can mitigate a number of risks to individuals, businesses, and society as a whole. However, appropriately structured defined-benefit plans can do better. Now let's turn to defined-benefit plans. I'll spend the balance of my remarks today discussing these plans and how they mitigate various risks. A properly structured defined-benefit plan mitigates all the risks for individuals that a defined-contribution plan does, for essentially the same reasons. But, in one crucial area, defined-benefit plans provide an important additional risk-mitigation benefit to individuals, because they are much better-structured to mitigate market risk. Since defined-benefit plans pool risk across all plan members - past, present, and future - the precise retirement income of a plan member can be defined in advance and does not depend on market conditions at the time of retirement. However, defined-benefit plans do not eliminate , which is the risk that all members of a pension plan could live longer than the actuarial tables predict. For individuals, there also remains a risk that the plan sponsor will be unable, for some reason, to deliver on its promise to pay the defined pension benefit. Still, defined-benefit plans do a better job of mitigating risks for individuals than do defined-contribution plans. For society as a whole, defined-benefit plans can also mitigate risks more effectively. While defined-contribution plans typically offer members a limited range of investment choices, the managers of defined-benefit pension plans have both the ability and the incentive to invest in the kinds of assets that the average individual investor might not normally consider. This helps to reduce the possibility I mentioned earlier that these pools of contributions could be invested in a less-than-optimal way; that is, that there could be a reduced supply of long-term risk capital for the economy. Further, pension managers are more likely to invest in alternative asset classes and to engage in arbitrage between markets. All of these activities make financial markets more complete, and thus enhance their efficiency. But how do defined-benefit plans aid employers? They can serve as a powerful tool for attracting and retaining staff. And, if they function well, defined-benefit plans can eliminate the risk of employees retiring with very low incomes. But defined-benefit plans represent the transfer of a lot of risk to the plan sponsors. And for some sponsors, the liability associated with a defined-benefit plan can dwarf the sponsors' net worth. So for employees, employers, and society as a whole to fully realize the benefits of defined-benefit plans, three conditions must be met. First, sponsors need the ability and incentives to manage their risks appropriately. Second, the risk that a sponsor will be unable to fulfill its promise must be properly managed. And third, the group-longevity risk I spoke of earlier must be dealt with in some manner. Some of the risks I've spoken about are managed according to laws and regulation. For example, there are laws that protect employees from the risk that a sponsor might be unable to pay a pension because the pool of contributions was used for some other purpose. And we have regulations that prescribe how large these pools have to be relative to the benefits promised, and that place conditions on how they must be managed. Beyond the legal and regulatory frameworks, there are accounting, actuarial, and economic frameworks that support the management and assignment of various types of pension risk. And generally, Canada's legal and regulatory framework has served Canadian workers and employers well, certainly better than those in many other OECD nations. But there are some shortcomings in our frameworks today. And these shortcomings are putting a great deal of pressure on the sponsors of defined-benefit plans. Sponsors have been scaling back or restricting new entries into these types of plans, largely because they do not have the right incentives to maintain or operate defined-benefit plans. So what needs to be done to improve the incentives for sponsors of defined-benefit plans? Going forward, how can we promote the proper assignment and management of risk? In answering these questions, we should keep in mind two principles of effective risk management. First, it's important to be clear about who bears the consequences of a risk and, by implication, who owns that risk. The party that owns the risk needs to have the proper incentives to manage it. Second, the owner of the risk needs to have sufficient flexibility to effectively manage that risk. Let me underline six main areas of concern about the current incentives for the assignment and management of risks. In doing so, I will be able to address all the issues facing defined-benefit pension plans. But I do want to touch on the issues I see as being most important. First, Canadian sponsors of trusteed defined-benefit plans have been reluctant to make special contributions to cover actuarial deficits. There are a number of factors at work here, but I will focus on just two of them. One is that there is often a great deal of uncertainty about the legal status of any actuarial surplus. While the ownership of any surplus depends on the specific wording of the rules that govern a given pension plan, in general, provincial and federal pension law has evolved to increasingly give employees rights to pension surpluses, even though employees typically bear none of the responsibility for any deficit. Another factor is that tax regulations discourage sponsors from building surpluses in excess of 10 per cent. Partly as a result of these two factors, sponsors of defined-benefit plans have incentives to keep plans only minimally funded and to avoid surpluses. But it is entirely appropriate, from time to time, for defined-benefit plans to run significant surpluses - or deficits - given the way they pool risks across all members - past, present, and future. Secondly, sponsors can be hampered by regulations that do not always take sufficient account of their ability to make contributions in the future. Regulators typically determine funding adequacy in one of two ways. One method assumes that the sponsor is a going concern and will be around to make up any shortfall in pension obligations before they come due. The other method assumes that the sponsor could become insolvent at any time, and so sufficient funds to cover actuarial liabilities must always be available to cover that risk. But the use of the solvency test can, in some circumstances, place an inappropriate burden on sponsors that are unlikely to become insolvent. Consider what happens when asset values are temporarily depressed relative to liabilities. In this case, the solvency deficit can be significantly larger than the going-concern deficit. This would require the sponsor to make a special contribution that should be reversed once asset values recover. But if the sponsor does not have access to the surplus, and so cannot reclaim this special contribution once asset markets recover, then the sponsor's expected costs are raised inappropriately. The third area of concern relates to accounting rules, or perhaps more specifically, to our use of these rules. This area is becoming increasingly important to pension plan sponsors because international accounting standard setters are examining a move to unsmoothed, so-called "fair-value" methods. These accounting rules are intended to replace rules that smooth changes in asset and liability values with rules that focus on values at a point in time. But it is not at all clear how useful or relevant it is to determine point-in-time values of assets and liabilities in a defined-benefit plan. For plans as a whole, what we are interested in is not today's values, but expected values far into the future. If this review results in changes to accounting standards, it could make sponsor balance sheets and income statements much more volatile. So sponsors will have an increased incentive to hold assets with low volatility. This incentive may make pensions more expensive because sponsors would be less likely to take on assets with higher expected returns. Put another way, plan sponsors could be given the incentive to become overly risk-averse, meaning an increase in the cost of providing for future liabilities. A fourth concern relates to the group-longevity risk I spoke about earlier. It may seem odd to consider the notion of people living longer to be a huge problem. Nonetheless, increased longevity poses a tremendous risk for sponsors. This risk can be mitigated in a number of ways. For example, contribution rates can be adjusted to reflect changes in average life expectancy. Or, the level of benefits can be adjusted, as can the date at which a person becomes eligible to collect a pension. Making these adjustments is often unpleasant, but it is necessary. And so sponsors and plan members both need to have the incentives to deal with group-longevity risk properly. The fifth concern relates to the fourth. In the past, there have been labour agreements that called for improvements to defined-benefit pensions, without matching funding provisions. How the cost of a new benefit promise will be covered should be made crystal clear to shareholders, workers, and regulators, at the time the change occurs. Finally, and very importantly, many sponsors may be too small to adequately manage the risks and costs of sponsoring a defined-benefit plan. But risks can be mitigated by sponsors forming multi-employer plans, thus pooling risks across a number of plan sponsors. This is a very important point, because at the moment, smaller employers are simply unable to offer defined-benefit plans to their employees. If structures such as large multi-employer pension plans could be created, this could help them to pool both costs and risks, making it easier for smaller employers to sponsor defined-benefit plans. It could also provide a measure of increased pension portability for employees. These are six areas of particular concern for the management of risk in defined-benefit pension plans. As I said, this is not an exhaustive list. But it does capture what I see as the most important challenges facing defined-benefit plans. Now to conclude, let me point to a number of steps that should be considered to address these issues. First, we should reduce the disincentives for sponsors to run actuarial surpluses in good times that will offset actuarial deficits in other periods. More clarity regarding the legal ownership of surpluses is needed, so that the sponsor that owns the risks also owns the benefits from taking those risks. In addition, we should examine the rules governing the tax treatment of contributions when plans are in actuarial surplus. Second, we should accept the fact that some defined-benefit plans run by creditworthy sponsors will have substantial solvency deficits from time to time, and make these easier to handle. In this area, I would note that there has been real progress in some jurisdictions, since sponsors are now allowed greater use of letters of credit to cover temporary solvency deficits. Third, we should ensure that our accounting rules - and most importantly, how we make use of these rules - are appropriate for defined-benefit plans. What we are interested in is not today's values, but expected values far into the future. Fourth, we should strengthen incentives to share group-longevity risk between plan sponsors and members. Fifth, the costs of plan improvements should be made clear to shareholders and workers at the time they are promised. Finally, we could examine mechanisms that facilitate the formation of multi-employer plans so that risks can be pooled across a number of plan sponsors. After all, municipalities in Ontario pooled together to form OMERS, and we should examine ways to construct similar pension arrangements for private sector employers. As I said, an effective defined-benefit pension system is a tremendous asset for individuals, for employers, and for our society as a whole. Putting these plans on a sustainable footing involves strengthening the legal, regulatory, accounting, actuarial, and economic frameworks that determine how these plans operate. If we get it right, these changes would give sponsors the appropriate degree of flexibility needed to manage risk effectively. And, ultimately, Canada can have a better-managed pension system that is good for members, good for employers, good for the economy, and good for Canadian society.

r070515a_BOC

canada

Government Borrowers Forum

dodge

Thank you, it's a pleasure to welcome you here today to discuss some important issues related to our common interest in the development of capital markets throughout the world. We are all interested in seeing the continued development of international capital markets, as part of the advancement of a market-based, liberalized trade and financial regime. Let's remember that an open, market-based economic system is increasingly vital, in a world where change is driven by the development of new technologies and modes of competition; and where adjustments are occurring all the time. In such a world, price signals from markets can help us to understand what adjustments need to be made. A liberalized, market-based regime is really the best that we have found for promoting growth and prosperity, higher standards of living, and the development of a domestic economy that is flexible enough to cope with shocks. There are, of course, many policies needed for an economy to become more flexible and market-based. But today, I want to particularly focus on the importance of local-currency bond and money markets. First, however, let me briefly outline the other necessary policies. Fundamentally, a commitment to maintain low, stable, and predictable inflation is crucial. In most countries, that commitment is best supported by a flexible exchange rate regime, which facilitates adjustments when the inevitable shocks to relative prices, global trade, and capital flows occur. One other important policy is that governments must be fiscally responsible. This doesn't mean the books must be perfectly balanced each and every year. But it does mean that governments maintain, and be committed to maintaining, a manageable debt-to-GDP ratio, and avoid running up debt that can hobble future governments, and prevent necessary adjustments. And finally, openness to global trade is of key importance to an economy's growth and prosperity. A great deal of attention is rightly paid to these very important policies, which form the essential building blocks in an economy. But today, I want to focus on the issue of having sound local-currency bond and money markets. First, I'll talk about the real advantages right at home that come with local-currency bond and money markets. I'll also refer to Canada's history in developing such markets, and to some elements that remain a work in progress. I hope that our experience might be of some use to authorities in many emerging market economies, which are now developing their own local-currency markets. And their efforts are bearing fruit - the outstanding stock in these emerging economies' local bond markets now exceed $4 trillion US - a four-fold increase in value over roughly the past decade. I'll also consider how these domestic markets can fit into, and do their part in stabilizing, the global financial structure. Now, these are my personal observations which are based on 40 years experience in public finance, and as seen from two perspectives: both as a central banker, and before that, as a federal Finance department official. Over the years, I've come to appreciate that a sound local-currency government bond market helps on three distinct policy fronts. First is the discipline that it can impose in terms of macroeconomic policies. Second, it supports economic and financial efficiency. And third, it helps in the development of a stable financial system. Let me now deal with each of these points in turn. In terms of macroeconomic policy, a government must build credibility with its own citizens first of all. Citizens need comfort that the government bonds that they hold will keep their value; that governments won't default on their obligations, or resort to large tax increases or inflation to ease the real burden of repayment. This initial hurdle of building credibility can be difficult to get over, as many emerging markets can attest to today. But once this hurdle has been cleared, a well-functioning, local-currency government bond market brings with it the incentives for authorities to keep in place the sound policies that I mentioned in my introduction. Those policies should include monetary policy aimed at maintaining low, stable, and predictable inflation, which leads to an environment of lower interest rates - both nominal and real - and lower debt servicing costs in the future. They also include prudent fiscal policies, which then reinforce public confidence in the government and, in turn, in the domestic markets. Of course, none of this suggests that all government borrowing must be denominated in the local currency. There will be times when a government will borrow in foreign currency, perhaps for projects that will support a future flow of foreign currency that can, in turn, help repay this borrowing. The real risk here comes when governments find themselves repeatedly borrowing in foreign currencies, to finance current domestic spending. Let me now mention Canada's history in developing our local-currency bond and money markets, because it has parallels with the situation in which many emerging market economies now find themselves. In the 1950s, Canada was a relatively small, but very open economy that relied heavily on foreign trade, was dramatically influenced by fluctuations in commodity prices, and had a long history of foreign capital inflows to finance major projects. The Bank of Canada's primary emphasis at that time was on the development of a government treasury bill market, to assist in the more effective implementation and transmission of monetary policy. In addition, the Finance Department, with the central bank as its fiscal agent, wanted to promote the development of a well-functioning government bond market. This would help to provide the government with low-cost and stable financing. Moreover, Canada had also moved to a floating exchange rate, and so it was even more important that our debt be issued in the domestic currency. But the authorities also saw the financial system efficiency benefits that could flow from the development of a well-functioning government bond market. In particular, it would support development of, and access to, market-based credit for firms. The broader goal was to develop the foundation for an efficient domestic fixed-income market for private issuers. Of course, our markets have been continually evolving, and so we have had frequent consultations with market participants. These consultations have led to the development of a well-functioning and liquid market for government debt right across the yield curve. This market provides the pricing benchmarks for all other fixed-income instruments and their derivatives, thus facilitating market access for firms seeking debt financing. So what have we learned over the years? Well, experience has shown that in order to maintain an efficient, well-functioning local-currency debt market, it's helpful to focus on the key aspects of liquidity, transparency, regularity, and integrity in the structure of government bond and money markets. As such, our efficient government debt market contributes to overall capital market efficiency by providing key benchmark and hedging tools. Now, in terms of financial system stability, the development of our domestic bond and money markets has led to stronger and sounder financial institutions. Stronger institutions and more complete markets facilitate better allocation of domestic savings. This increases domestic investment, and thus, encourages stronger economic growth. Creating local-currency bond and money markets can insulate an economy from global economic shocks in two ways. First, by providing more stable and secure sources of liquidity. And second, and perhaps more important, it can allow for a better matching of the currency of obligations to the currency of receipts. In addition to contributing to a more stable domestic financial system, the development of domestic-currency markets is important to promote financial stability. Economies with a sound financial system can help to prevent shocks from spreading around the world. The Asian financial crisis of 1997-98 really helped to illustrate how a crisis can spread among economies with weak financial systems, including, in some cases, serious mismatches in foreign currency assets and liabilities. This is why policy-makers around the world have been putting a lot of emphasis on improving domestic banking and financial systems. To develop a sound financial system requires several policy steps. The BIS Committee on the Global Financial System has outlined five key measures needed to develop deep and liquid bond markets. Allow me to list them. First, an economy must have a competitive markets structure; second, it must have liquid, benchmark bond issues; third, markets must be efficient, with low transactions costs; fourth, markets should be safe, sound and robust; and finally, it's important that there is a wide variety of market participants. I see from your program that these are issues that you will be talking about in more detail later this afternoon. Ladies and gentlemen, I have spoken about how local-currency bond and money markets can help an economy, by giving the authorities incentives to follow good macroeconomic policies, and by supporting financial and economic efficiency. And, I've talked about how such markets can help in the development of a sound domestic financial system. This, in turn, can promote financial stability, both within a country and more broadly, in the global financial system. At the start of a conference like this, I thought it important to use my time to remind ourselves of it is we need strong, local-currency bond and money markets. Speaking generally, the steps that Canada took in the past to develop its local-currency bond and money markets be applicable to today's world, and to the various emerging market economies that are now trying to find their own path. But what is certain is that the original principles that guided us in creating those markets - liquidity, transparency, regularity, and integrity - are as valid today as they were 50 years ago.

r070521a_BOC

canada

Making Global Economic Institutions Work – What the World Needs Now

dodge

It is certainly an honour and a privilege to be able to address the Chicago Council on Global Affairs. For 85 years, the Council has promoted the idea that the United States should take a leading role in addressing global challenges. And it has done so consistently through the years, even during times when isolationism was more fashionable. Sixty years ago, just a few months after the Council celebrated its 25th anniversary, Secretary of State George Marshall delivered his famous commencement address at Harvard in which he outlined what would become known as the Marshall Plan. To those who asked why the United States should take such a pre-eminent role in rebuilding war-torn Europe, Marshall said: "It is logical that the United States should do whatever it is able to do to assist in the return of normal economic health in the world, without which there can be no political stability and no assured peace." That sentiment remains absolutely true today. But the Marshall Plan was not the only major event of 1947. That year also marked the opening of the United Nations Conference on Trade and Employment in Havana, Cuba - the first step in the creation of a rules-based multilateral trading system. It is fitting that we should mark the 60th anniversary of these events, not just to commemorate their happening, but to celebrate the economic progress that they made possible - progress that has lifted millions of people out of poverty and, to repeat Marshall's words, "without which there can be no political stability and no assured peace." The postwar reconstruction of Europe and the development of a rules-based multilateral trading system came a couple of years after the United Nations conference at Bretton Woods, New Hampshire that led to the creation of the International Monetary Fund (IMF) and the World Bank. These institutions were joined in 1948 by the Organisation for European Economic Co-operation (OEEC), which was formed to administer aid under the Marshall Plan. The OEEC eventually evolved into the Organisation for Economic Co-operation and Development (OECD), which has been an extremely useful venue where economic and financial authorities can gather and discuss how best to promote strong economies through liberalized markets, freer trade, and sound macroeconomic policies. These institutions provided a framework that helped the so-called "first world" nations establish a market-based trade and financial order. And with this order in place, the economies of the first world nations - including the United States - thrived. In fact, they flourished so much that, over the years, a growing number of countries have seen the desirability of becoming part of this increasingly global order. This expansion, which continues today, is certainly a welcome development. It holds out the prospect of spreading growth and prosperity to millions more. This process is also very much in our own interest in the United States and Canada, since it will allow us to develop larger markets, leading to greater innovation and efficiency, along with increased productivity and incomes. Of course, it's important to recognize that this process implies adjustments for our own economies and for our citizens, and that these adjustments are often difficult and painful. But, in the end, there are always clear net gains to be realized from the expansion of trade. However, today's market-based, global trade and financial order faces two main challenges. In my opinion, we need to deal with them with some urgency. First, there remain significant imbalances in global savings and investment, and all of us should be doing what we can to maximize the chances that these imbalances can be unwound in a smooth and gradual way. By and large, this means promoting policies that allow market-based adjustments to take place. Second, to facilitate market-based adjustments, we need to strengthen the institutions that support the global trade and financial order. So, today, I will talk about what needs to be done to help facilitate the orderly resolution of global imbalances and, in particular, discuss what needs to be done within our global economic institutions to help in this effort. Let me begin by talking about global imbalances. The word "global" is the key to seeing both the nature of the problem and the path to its solution. There is no single cause of these imbalances. In China and many other Asian countries, we have seen very high levels of net savings. This is partly because, in the absence of social safety nets, households accumulate large amounts of precautionary savings. And it is partly because of the lack of a well-developed financial system that these savings are not being allocated efficiently. As well, the absence of market-based mechanisms within these economies - including the lack of a flexible exchange rate - impedes domestic economic adjustment. In addition to this, we have seen many oil-exporting countries record large trade surpluses, as the price of crude oil has risen. So, many Asian and oil-exporting countries are experiencing high levels of desired savings relative to desired investment. The U.S. economy is in the reverse situation. Over the past few years, the United States has become a large net borrower, as government deficits rose and household savings fell. As a result, we have seen lower desired savings relative to desired investment in the United States. In the future, these global imbalances will have to be corrected through an increase of net savings in the United States and a reduction of net savings in Asia and in the oil-exporting countries. But, given the recent behaviour of international financial markets, and based on recent commentary, one might start to think that global imbalances are no longer something to be concerned about. And it is true that we are seeing some positive indicators. Domestic demand has picked up in Europe and Asia, and has slowed somewhat in the United States. Oil prices appear to have stabilized, and the U.S. dollar has depreciated on a trade-weighted basis, helping to encourage U.S. exports and discourage imports. The U.S. current account deficit has shown signs of stabilizing. And China has taken some steps towards increasing household demand and building more market-based adjustment mechanisms. These steps include the introduction of some exchange rate flexibility, which can help increase China's real income and domestic demand. All of these developments are helpful in terms of resolving imbalances. However, I worry that it is far too early to start discounting the threat posed by the persistence of global imbalances. There are a couple of risks that embody this threat. One is the risk of rising protectionism. We have already seen troubling signs. Some lawmakers are proposing tariffs or quotas on imports from some Asian countries in response to the perception that these countries are manipulating their exchange rates. The other risk is that financial markets could lose confidence that policy-makers worldwide will continue to take appropriate actions. Such a loss of confidence could lead to a sharp swing in market sentiment and an abrupt, and costly, resolution of imbalances. So how can we best encourage an orderly resolution of imbalances? The first point to be made is that a global problem requires a global solution. Those who point the finger only at the United States, calling only for a reversal of its fiscal and current account deficits, are missing the point, as are those who say that the problem would go away if China would just let its currency appreciate more rapidly. The world as a whole is a closed economy. This means that large swings in demand in one place need to be offset by compensating swings in other places. So, if the United States were to dramatically increase its net savings to suddenly wipe out its fiscal and current account deficits, the global economy would likely head rapidly into recession unless other economies took immediate steps to reduce their net savings by increasing their domestic demand. The other point to make is that the key to a smooth and orderly resolution of imbalances lies in letting market-based adjustment mechanisms work. After all, savings-investment imbalances occur all the time between regions in a single country, such as Canada or the United States. But these imbalances don't tend to cause problems, because market mechanisms help to resolve them. Relative wages and prices change, as do relative returns on capital. And labour moves within a country to promote an orderly adjustment process. Over time, authorities in many countries have come to understand that they need to make market-based adjustment mechanisms work. Their role in promoting market-based adjustments is to implement a coherent framework of macroeconomic policies, supported by a safe and sound financial system. From a central banker's point of view, our best contribution to this effort is to deliver monetary policy focused on providing low and stable inflation, supported by a floating exchange rate. Given the consensus on this point in terms of economies, it seems clear to me that we can promote a smooth resolution of imbalances by removing impediments to market-based adjustments in the economy. And this is where our global economic institutions come in. I spoke earlier about the birth of the Bretton Woods institutions following World War II. The success of the Bretton Woods conference was due in no small part to the commitment shown by the American delegation and Harry Dexter White. Along with the leader of the British delegation, John Maynard Keynes, White was instrumental in setting out the original goals of the IMF. Under the Articles of Agreement, the Fund is charged with promoting international monetary co-operation by providing the machinery for consultation and collaboration on international monetary problems, and is tasked with facilitating the expansion and balanced growth of international trade. In short, the Fund was designed to be an institution where national authorities could work out the "rules of the game" for the international economy. Thanks in part to this U.S. leadership, the world thus had an institution dedicated to promoting a market-based international financial order and to avoiding the protectionist, "beggar-thy-neighbour" policies that so hobbled the world economy in the 1930s. Delegates at Bretton Woods were ultimately able to see how their own country's interest was clearly wrapped up in a collective interest. Treasury Secretary Henry Morgenthau referred to the conference as the end of economic nationalism. While the world and its economy have undergone revolutionary change in the past 60 years, we still need institutions where authorities from the key nations in the global economy can work out the rules of the game for economic policies. At Bretton Woods, it sufficed to have the allied nations around the table. But today, there are a number of different players who need to be present if we are to successfully remove impediments to market-based adjustments in the global economy. We need to make sure that these new players are at the table. But at the same time, we very much need the United States to show the same leadership that it did at Bretton Woods 60 years ago. Where should we concentrate our efforts? I mentioned the OECD at the beginning of my remarks. This institution has been enormously helpful over the years. Indeed, I can recall attending OECD meetings in the 1970s and 1980s, when national authorities developed a consensus on the policies that would provide the strongest base for sustainable economic growth. These included monetary policy directed at keeping inflation low and stable, a disciplined fiscal policy, structural policies that encourage economic flexibility, and a framework for trade liberalization. But while the OECD continues to provide excellent analysis, particularly in terms of structural policies, it is not yet a truly global table. Indeed, there are only two economic tables with a fully global representation: the World Trade Organization (WTO) to deal with trade issues, and the IMF to deal with macroeconomic and financial stability issues. My comments on the WTO will be very brief. I mentioned increased protectionism as a key risk stemming from the persistence of global imbalances. This risk is heightened by the lack of progress at the Doha round of trade talks. It is essential for countries to see the common interest in reducing trade barriers, and to work multilaterally through the WTO to accomplish this. Large emerging-market economies need to play their part. But so does the G-7. This means we need to be willing to talk seriously about agricultural issues. I know that, politically, this is a hard sell here in the heartland of America, as it is in many parts of Canada. But the global economy needs leadership in order to restart these talks, bring them to a successful conclusion, and reduce the threat of protectionism. Let me now turn to the IMF. It has become quite common these days to question the relevance of this institution. Some people say that the IMF should be scrapped, because countries now have ready access to private capital flows in global markets and no longer need to borrow from the Fund. Indeed, those countries that have IMF loans are scrambling to repay them as quickly as possible. But this viewpoint ignores the Fund's original mandate to promote international monetary co-operation by providing the machinery for consultation and collaboration on international monetary problems. The question then becomes, How can the IMF best fulfill this role today? I would argue that, given the Fund's structure, its worldwide perspective, and its considerable expertise, there are important ways for the Fund to do this. It can improve its surveillance function and, in doing so, it can more effectively engage the national authorities of all countries. What do I mean by "improving surveillance?" To answer that question, it's best to have some context. In earlier decades, the Fund would have a dialogue with individual member countries about whether that country was following policies consistent with a fixed exchange rate regime and, under certain circumstances, the appropriateness of the fixed rate itself. But following the collapse of the Bretton Woods system in the early 1970s, surveillance naturally moved away from a narrow focus on exchange rates. For countries that were borrowers - or potential borrowers - from the Fund, discussion focused mainly on the conditions that a country would need to meet in order to access IMF funding. It certainly had little to do with the policies needed to enhance stability and to facilitate domestic and global adjustment. It is clear that today there is a need to refocus surveillance on policies that enhance domestic economic stability, and thereby, support global stability. Surveillance should be confined to a country's exchange rate, monetary, fiscal, and financial policies, and to the question of whether or not the policy choices are coherent, and thus consistent with maintaining external stability. If these policies are inappropriate, or not coherent, they can damage not only one's own domestic economy, but they can also have spillover effects abroad. When Keynes talked about the IMF, he sometimes said that it should engage in "ruthless truth telling." Indeed, the Fund's surveillance activities must be applied with an even hand and must deal objectively, accurately, and honestly with the key macroeconomic policies of countries. Of course, it isn't always easy to be on the receiving end of this surveillance. I know, because I was one of the national authorities back in the 1990s who heard IMF criticism directed his way. At that time, we in Canada did not enjoy hearing the truth about our deteriorating fiscal situation, but the criticism did help to provide the impetus for us to take some tough decisions. All countries should be subject to this ruthless truth telling, and we in the G-7 must show leadership by demonstrating our willingness to listen to the truth about ourselves. In conducting surveillance, there is a complication that must be kept in mind. The goal must be to promote the sound policies that I mentioned earlier, so that market-based adjustments are not impeded. But some of the key emerging-market economies that are systemically important do not yet have sound financial systems in place to handle some of these necessary policies. Here, I am talking about policies such as full capital account liberalization or completely flexible exchange rate regimes. Let me be clear: it is crucial that these countries put in place sound financial systems as quickly as possible, so that they can move to adopt a coherent policy framework. But, to the extent that countries are making substantial progress, and are committed to further progress as rapidly as possible, those of us with well-developed financial markets will have to have some tolerance while these transitions are occurring. The final point that I will make about surveillance may well be the most important. The Fund must step up its efforts to extend surveillance beyond bilateral discussions. Because of its global perspective, the Fund is the natural institution for conducting multilateral surveillance on issues that threaten global financial stability, and where responsibility for action is shared among many countries. It is the natural institution where national authorities can work with expert staff to assess spillover effects of domestic policies. And it would be tremendously helpful to the global economy if the Fund were to return to its original role of serving as a table for discussion. It is very important that the national authorities responsible for the implementation of macroeconomic and financial policies talk to each other around a table where all systemically important economies are represented. Along with strengthening its surveillance function, having the Fund serve as a global table is the other important way that it can fulfill its original mandate of supporting the global economy and promoting international financial stability. Of course, there's more to IMF reform than improving surveillance and increasing the engagement of national authorities. Systemically important emerging-market economies will need a greater voice at the table over time. This is important for the Fund's legitimacy. And it is absolutely essential that improvements be made in the governance structure of the Fund, that the role of the Executive Board be re-examined, and that the accountability of the Managing Director and Fund staff to the Governors of the Fund be strengthened. But those issues could serve as topics for another entire speech. There will be some who will conclude that I am wildly optimistic to think that there is any potential for success in either the multilateral trade talks or in substantially transforming the IMF. But what better place for optimism than Chicago, where crowds have packed Wrigley Field, season after season, waiting almost a century for the Cubs to win the World Series again? The owners of the Cubs invested a lot of money this past winter, trying to fulfill the optimists' vision of a World Series. But the vision I outlined today doesn't need money. What it needs is leadership; leadership from all of us in the G-7 and, in particular, from the country whose efforts 60 years ago helped to establish the global economy that we know today. It is imperative to drive for a multilateral trade deal, through the WTO, to counter the protectionist threat; and to promote a multilateral approach, through the IMF, to resolve global imbalances. An IMF that is strengthened along the lines that I spoke of today would be enormously helpful in this regard. I am grateful for the opportunity to present these ideas to you today; ideas that should fit with the Chicago Council's philosophy. By keeping a common goal in mind, we can remove the impediments to market-based adjustments and be successful in our efforts to defuse the danger of global imbalances. In so doing, we can continue to promote the market-based, global trade and financial order necessary for continued global economic growth, for our continuing prosperity, and for the world stability that Marshall spoke of 60 years ago.

r070613a_BOC

canada

Demographics, Labour Input, and Economic Potential: Implications for Monetary Policy

dodge

Good afternoon. I'm very happy to be here in St. John's and to have the opportunity to address the Board of Trade. Once a year, the Bank of Canada holds a meeting of its Board outside of Ottawa. There are several reasons why we hold these meetings outside Ottawa, but perhaps the most important is that it gives us the opportunity to meet with, and to listen to, business and labour leaders from various parts of the country. I certainly hope that we will have time for a good discussion following my remarks. It is very important for us to hear and to understand your perspectives and preoccupations. This information helps us in our task of gauging the country's economic prospects over the medium term and setting monetary policy so that our economy can deliver the maximum sustainable growth of employment and incomes over the long term. Of course, with the passage of time, the "long term" turns into the "near term." And in my remarks today, I want to discuss an issue that has gone from being a long-term, theoretical question to being a near-term, practical consideration for monetary policy; that is, the impact of Canada's aging population on our economic potential. The Bank addressed this subject in the April edition of its and, today, I want to elaborate a bit on this topic. I plan to talk about how we see trends in the labour force evolving in the future, and about the implications of these trends for monetary policy, in particular, and for the economy in general. Then, I'd like to take a few minutes to discuss the current state of the Canadian economy and its prospects, before opening the floor to your questions and comments. So, let me begin by talking about demographics and trends in the labour force. I should start by explaining how this topic fits into the conduct of monetary policy. The concepts involved are reasonably straightforward, but things can get pretty complicated rather quickly. My aim is to give you a clear and accurate description of the issues without burying you in jargon or complex details. Over the years, we at the Bank of Canada have learned that the best contribution that monetary policy can make to the economic welfare of Canadians is to keep inflation low, stable, and predictable. We try to keep the annual increase in consumer price inflation at 2 per cent, which is the middle of a 1 to 3 per cent inflation-control range. If inflation expectations are well anchored, an environment of low and stable inflation can be sustained when the economy is operating at its production potential; that is, when the economy is generating the maximum amount of output that it can without sparking inflationary pressures. Economists call this amount of production the "potential output" of the economy. If the economy operates above its production potential, this can lead to upward pressure on future inflation. Similarly, if the economy operates below its potential, this can lead to downward pressure on future inflation. Unfortunately for central bankers, there is no way to directly measure an economy's potential output; it must be estimated. Nevertheless, we do know that growth in potential output does vary from year to year. How fast it grows essentially depends on two things: growth in the hours that our population can spend at work, and growth in the productivity of that work. The greater the number of people in the labour force, and the greater the time that they spend at work each week, the greater the output that can be produced without triggering inflation. And the higher the level of investment in machinery, equipment, and structures, again, the greater the output that can be generated without leading to inflation. Of course, there is more to productivity than just the quantity of labour and capital. Quality matters as well. Improved education and training of the labour force can make a big difference in terms of the productivity gains that can be realized over time, as can the way a company organizes itself to get the work done. But in the interest of keeping things simple, let me focus on my main point; that growth in potential output equals the growth in the total hours supplied by the labour force - what economists call "trend labour input growth" - plus the growth in trend labour productivity. Over the past several years, the Bank has estimated trend labour input to be growing at an annual rate of about 1 1/4 per cent, although the actual growth has been a bit higher over roughly the past 4 years. And, based on long-term trends, the Bank has assumed the annual growth of trend labour productivity to be 1 3/4 per cent, although over the past 4 years, average productivity growth has come in well short of this figure. I'll say a few words about productivity in a few minutes. But my focus today is on trend labour input, so let me spend a bit of time on this issue. Just over half of Canada's economic growth since 1980 can be attributed to growth in labour input. Much of this rise in labour input has come from the fact that Canada's working-age population is continuing to grow. But we have known for some time that our population is aging and that this will have a profound impact on labour input, as members of the baby boom generation begin to retire, over the next few years. It's difficult to overstate the importance of the changing age profile of the workforce. According to Statistics Canada, 40 years ago, the median age in Canada was about 25, which means that there were as many people younger than 25 as there were older than 25. Twenty years later, the median age had risen to about 31, and last year, the median age climbed to almost 39. Statistics Canada projects that, under a medium population-growth scenario, the percentage of working-age Canadians - that is, Canadians aged 20 to 64 - is expected to peak in about 2011, and then fall off fairly sharply, even as our total population continues to increase. But if the percentage of working-age Canadians is still approaching its peak, and only the leading edge of the baby boom generation is approaching retirement age, why is that a concern for monetary policy today? It's because we know that participation in the labour force tends to change over time: Participation is typically low in the early working years, from age 15 to 24, because a large portion of these individuals are still attending school. Participation then increases and stabilizes in the prime working years of 25 to 54, before declining in the late fifties and beyond, as people make the transition out of the labour market and into retirement. So, with the first of the baby boomers now older than 60, and many more of this generation right behind them, we know that the shifting age distribution of the population has begun to have, and will continue to have, a direct impact on the supply of labour in the economy, and thus, on the growth of our economy's potential output. Of course, we cannot directly measure how much labour Canadians want to supply to the economy. We have to infer this measure by looking at actual participation rates and the hours actually worked each week. But these two variables tend to fluctuate with the ups and downs of the economic cycle. At the Bank, we try to look through these fluctuations to get a sense of the trend of labour input over time. I mentioned earlier that growth in labour input has been an important factor in overall economic growth in recent decades. Where has this growth come from? Besides the continued increase of the total working-age population, the employment rate of women has risen sharply, more than offsetting a small decline in the rate for men. While these two factors have increased labour input, there has also been a small declining trend in the average number of hours worked per week. All told, as I noted, the Bank has estimated that trend labour input has been growing at an annual rate of 1 1/4 per cent in recent years. But because of the labour force's changing age profile, which I just mentioned, we can expect that the growth of trend labour input will start to drop significantly below this current estimate. Indeed, demographic and economic models suggest that annual growth of trend labour input will fall to about 1 per cent in 2010, and that it will continue to fall to about 0.6 per cent in 2015. Of course, there is always an element of uncertainty involved in forecasting anything, particularly people's behaviour. Several factors could serve to slow the projected decline in the growth of trend labour input. Chief among these is the possibility that the participation rate of older workers might increase. Why might this occur? The reasons include the fact that the nature of work is changing: it's becoming less physical and more service-oriented. And people are remaining healthier later in life. As life expectancy increases, people may want to remain in the workforce longer. In addition, strong demand for labour in the economy might make it more attractive for older workers to remain in the labour force. These are all uncertainties. But what we can be certain about is that, over the next few years, as the baby boom generation reaches - and passes - the previous traditional retirement age, the proportion of older workers who choose to remain in the labour force will have a significant impact on the growth of trend labour input in the economy. It's worth noting at this point that changes in immigration are not likely to have any major impact on trend labour input. While immigration of workers with skills in short supply can, at the margin, increase labour input, this is unlikely to have any significant impact on the population's age structure. In sum, it seems clear that growth in trend labour input will decline, and contribute less to the growth of potential output in future years. In the April , we said that we expect the growth rate of trend labour input to decline by 0.1 percentage points in 2009. But from 2011 to 2020 we will see a more significant slowdown, as population growth continues to slow and the decline in the employment rate accelerates. Remember that if there is a slowdown in trend labour input and the trend rate of productivity growth remains unchanged, the growth rate of potential output will also slow down. In other words, the economy will not be able to grow as quickly without sparking inflationary pressures. So it will be increasingly important that our economy uses the labour that is available in the most efficient way. What does this mean for policy-makers? To begin with, it means that we must remove any unnecessary barriers either to labour force participation or to labour mobility. Governments should remove barriers to older workers remaining in the workforce. In this regard, we have seen some encouraging signs recently. Mandatory retirement provisions have been eliminated in a number of provinces. And last year, British Columbia and Alberta reached an accord to harmonize labour credentials and business regulations and standards by early 2009. These are just a couple of examples of positive policy moves. Canada's labour force has shown remarkable strength and flexibility, much more so than in previous decades. But more can be done to boost the flexibility of our labour markets. Let me now talk briefly about productivity. The need for Canada to focus on productivity is certainly not new. Trend productivity growth has been subdued since the late 1970s and, unlike that of the United States, has failed to post a meaningful increase on a consistent basis over the past decade or so. There are a number of potential causes. Canada appears to have taken less advantage of information and communications technologies and has invested less, not just in physical capital per worker but also in research and development, workplace reorganization, and worker training. And, most recently, the movement of labour and capital to take advantage of high prices for resources and strong domestic demand has likely led to some adjustment costs in the form of slower productivity growth. But while we don't fully understand the causes behind Canada's productivity performance, it is absolutely clear that the record of the past few years has been very disappointing. On average, the annual growth in productivity since 2003 has fallen well short of our assumed rate of 1 3/4 per cent. For this reason, in our October 2006 , we lowered our assumption for annual trend labour productivity growth to 1 1/2 per cent. The combination of our views on the growth of trend labour input and trend labour productivity led to our projection for potential output growth of 2.8 per cent this year and 2008, and 2.7 per cent in 2009. This compares with the 3 per cent assumption for annual growth of potential output that the Bank had been using earlier this decade. That's a quick look at how the Bank sees developments in trend labour input and trend productivity. We'll continue to work on these important issues, and will have more to say about them in coming months. In August, in the summer edition of the , we will publish articles on trend labour input and past productivity performance, and we'll return to the issue of the outlook for productivity growth in our October . Let me now turn to developments in the Canadian economy since the time of the April . In that document, we said that we judged that the Canadian economy was operating at a level just above its production potential in the first quarter of this year, and that this had been contributing to higher-than-expected inflation. And we projected that with average annual real GDP growth of 2.2 per cent this year, the Canadian economy would move back down to its full production potential in the second half. Core inflation was projected to move down to 2 per cent in 2008, and total inflation was projected to return to target by mid-2008. Since that time, economic developments in the rest of the world have been essentially in line with the expectations we had in April. However, economic growth in Canada has come in stronger than we had been expecting. Indeed, the national accounts indicated that the Canadian economy grew by 3.7 per cent in the first quarter of this year - more than a full percentage point higher than we projected in the April . So, the economy is now judged to be operating further above its production potential than was earlier thought to be the case. Inflation in Canada has also been stronger than we anticipated in April. Inflation for services prices continues to run well above 2 per cent, and inflation for goods prices - particularly semi-durable goods - has been higher than anticipated. Some of this strength may prove to be temporary. Nonetheless, there is an increased risk that future inflation will persist above the 2 per cent inflation target. The base-case projection in our April was developed using a number of assumptions, including an assumption that the Canadian dollar would continue to trade within a range of 86.5 to 89.5 cents U.S. But since that time, the Canadian dollar has moved well above that range. Indeed, since the April , the Canadian dollar has been significantly stronger than other major currencies against the U.S. dollar. Much of this appreciation can be linked to factors such as the strength of demand for Canadian goods and services, continuing firm prices for commodities, and a positive outlook for Canadian economic growth. But over this period, the overall response of the Canadian dollar to these factors appears to have been stronger than historical experience would have suggested. So, since April, we have seen two things: an increased risk of future inflation and a rise in the Canadian dollar that appears to have been stronger than historical experience would have suggested. At our last fixed announcement date, we said "that some increase in the target for the overnight rate may be required in the near term to bring inflation back to the target." As we prepare for our next fixed announcement date on 10 July, we will look at all the available evidence. And, in our on 12 July, we will publish an updated analysis of our outlook for growth and inflation, including trends and risks. Let me now conclude. Canada's aging population has been an issue of interest for a number of years. But as the leading edge of the baby boom generation begins to retire, this is no longer an abstract issue for policy-makers. The projected decline in the growth of trend labour input has real consequences for the conduct of monetary policy. Declining growth in trend labour input implies lower growth of potential output. And if the trend rate of productivity growth remains unchanged, this means that inflationary pressures can begin to build at a lower rate of economic growth. What should policy-makers be doing? First, we should minimize constraints on labour mobility and participation, so that there are no artificial barriers to prevent people who want to work from doing so. Second, we should concentrate on increasing productivity, so that we can have sustainable economic growth and rising standards of living in the future. And finally, from the Bank of Canada's perspective, we will have to continue to take into account the evolution of Canada's labour market as we continue to conduct monetary policy with a view to keeping inflation low, stable, and predictable.

r070621a_BOC

canada

Global Integration, Monetary Policy, and the International Monetary System

macklem

Good afternoon. It's a pleasure to be in Winnipeg, and it's an honour to join you as you celebrate the CFA Institute's sixtieth anniversary. Today is the longest day of the year. But I don't want it to that long, so I'll get right to the point. I'd like to discuss two aspects of global integration - how it's affecting our economy, and why it underscores the need for a sound monetary framework, both at home and internationally. Now, Manitoba - right in the middle of our vast country - might seem an odd place to talk about globalization. But this province, like the rest of Canada, is very much affected by global economic forces. Some businesses - particularly in the manufacturing sector - are facing fierce competition from new suppliers in emerging Asia. Other businesses are benefiting from strong foreign demand and high prices for commodities. Most of Manitoba's exports go to the United States, so it might be tempting to think that what really matters is North American demand. But the prices of many of Manitoba's exports - both commodities and manufactured goods - are set in world markets, and thus influenced by the demand for, and the production of, these goods in Asian and other emerging-market economies. So, Manitoba, and Canada as a whole, are very much a part of the integrated world economy. I'll start by highlighting two key developments in the global economy and describe how they're affecting Manitoba and Canada. Then I'll discuss how monetary policy helps Canada to weather, and indeed to profit from, changes in the global economy. I'll wrap up by returning to the international stage and suggest that, in an increasingly integrated world economy, we all have a greater stake in a sound international monetary system. As trade barriers have come down, and as the costs of transportation and communication have diminished, international trade has grown and living standards have improved. Since 1970, trade as a share of GDP has risen from about 25 per cent to almost 45 per cent in industrialized countries. Over the same time period, trade in emerging-market economies has increased from less than 15 per cent of GDP to roughly 60 per cent. Much of the recent growth in trade has come as large emerging-market economies, such as China and India, have been integrating into the world economy. With this integration has come a significant increase in the global demand for commodities, as well as rapid growth in the production of manufactured goods in Asia. That brings me to the first of the global developments I'd like to mention - a marked rise in the prices of commodities relative to those of manufactured goods. In the past five years, energy prices have risen by about 150 per cent, and non-energy commodity prices have increased by about 80 per cent. Over the same time period, the price of nickel - Manitoba's biggest commodity export - has risen by about 500 per cent, and the price of copper has increased by more than 300 per cent. At the same time, the prices of many manufactured consumer goods, such as clothing, computers, entertainment equipment, and household appliances have decreased in many countries. In Canada, the prices of durable and semi-durable manufactured goods, excluding automobiles, have declined by about 1 to 2 per cent per year, on average, over the past five years (although more recently, prices for semi-durable goods have strengthened). Given its endowment of natural resources, Canada has benefited greatly from strong commodity prices. But, just as clearly, new competition from China and other emerging Asian economies is posing some tough challenges for Canadian manufacturers. Global integration has also been affecting international savings and investment flows. Indeed, in the past dozen or so years, what is sometimes called "financial openness" has increased significantly. Since 1995, the stock of cross-border investment in advanced countries has grown from about 40 per cent of GDP to more than 120 per cent of GDP, and emerging markets have seen a similar increase, albeit from a lower base. This leads me to the second development I want to highlight. In recent years, desired global saving appears to have increased relative to desired global investment, which has made credit abundant and relatively cheap. Federal Reserve Chairman Ben Bernanke has called this a global "saving glut." The International Monetary Fund has emphasized the weakness of global investment relative to global growth. But whether it's high saving or low investment, the net effect is that large pools of internationally mobile capital have been searching for seemingly scarce investment opportunities, putting downward pressure on long-term interest rates. As investors have searched for higher returns, risk spreads have narrowed, and interest in alternative investments and more innovative investment vehicles has expanded. While there are several reasons for this abundance of global credit, global integration is almost certainly an important part of the story. Saving rates in Asia are relatively high and exceed the region's investment needs. In addition, with the sharp rise in the price of oil in recent years, a number of the major oil-exporting countries have seen a large increase in their saving that has outstripped the growth of their investment demand. With the integration of these economies into world markets, and with investors seeking international diversification, new pools of capital have been injected into the global financial system. How have these developments been affecting the Canadian economy? I'll discuss them in reverse order. The implications of abundant global credit are readily apparent. Long-term interest rates in Canada have been low. Even with some back-up in yields in recent weeks, yields on 30-year Government of Canada bonds remain well below 5 per cent. The Canadian stock market has been buoyant, and risk spreads on corporate debt are near historical lows. Household credit and money growth have been strong, and cross-border investment flows have accelerated. The rise in the prices of commodities relative to manufactured goods has reinforced many of these same effects. Since Canada is a net exporter of commodities and a net importer of manufactured goods, the rise in commodity prices has made Canada wealthier as a nation. The increased value of Canada's natural resource endowments is showing up in higher domestic stock market prices and increased cross-border investment flows. It has also been a major factor supporting robust consumption and investment growth in Canada. And of course it's showing up in a higher Canadian dollar. In the past five years, the Canadian dollar has gained about 45 per cent against the U.S. dollar. This appreciation since 2002 reflects a combination of factors, the most important of which is the significant increase in commodity prices. The other implication of the rise in the relative price of commodities is economic adjustment, by which I mean the reallocation of labour and capital from weaker sectors to stronger sectors. The manufacturing sector, faced with higher costs for energy and other inputs, new sources of competition from Asia, and a stronger Canadian dollar, is going through a difficult adjustment. Our own surveys suggest that most manufacturers are responding to these challenges by making changes in the way they do business. Part of this adjustment has involved reducing employment. In the past three years, employment in manufacturing has declined by about 250,000 jobs. At the same time, the primary and service sectors have been expanding capacity and employment in response to strong demand. Over the past three years, employment in these sectors has increased by about 900,000 jobs, more than offsetting the reduction in manufacturing employment. Of course, this adjustment is not affecting all parts of the country in the same way. Growth in output, employment, and incomes has been fastest in Western Canada. Nevertheless, growth in Canada has been broad based. Strength in domestic demand has supported solid growth of output and employment right across the country. Manitoba is in the middle of Canada in more ways than one. It has a well-diversified economy that closely resembles the structure of the Canadian economy. And in the past three years, GDP in Manitoba has grown by an average of 2.8 per cent, very close to the national average. Economic adjustment is always difficult, but it's necessary if we are to put capital and labour to work where they are most needed. This, in turn, helps to support rising living standards for Canadians. The main point here is that the Canadian economy has adjusted - and is continuing to adjust - to take advantage of our opportunities in an integrated global economy. Now let me turn to the role played by monetary policy. The Bank of Canada Act directs the Bank to "promote the economic and financial welfare of Canada." What we've learned from experience is that the best contribution monetary policy can make to Canada's economic and financial welfare is to maintain low, stable, and predictable inflation. Since 1991, Canada's monetary policy framework has consisted of two main elements - an inflation target and a flexible exchange rate. This framework has allowed Canada to pursue an independent monetary policy - a policy suited to our own circumstances. The two main elements work together and reinforce each other. The result has been low and stable inflation, with less volatility in output and employment. Let me elaborate on each of these elements. First, the inflation target. Since 1995, the target for inflation has been the 2 per cent midpoint of a 1 to 3 per cent inflation-control range. To keep inflation at 2 per cent, the Bank tries to keep a balance between the overall demand for and supply of goods and services in the Canadian economy. When overall demand and supply are in balance, the economy can operate at its full potential, and inflation is stable. Inflation control contributes to better economic performance in several ways, but let me highlight two that are particularly relevant in the current context. First, when inflation is low and stable, relative price signals are clear and readily apparent, and this helps businesses and households to make sound economic decisions. Second, meeting the inflation target helps to anchor inflation expectations to the target which, in turn, helps to keep inflation low and the economy more stable. In the 1970s, which was the last time Canada experienced a commodities boom on the scale of recent experience, monetary policy failed to anchor inflation expectations. So, when sharply higher oil prices pushed inflation up, workers and firms extrapolated this higher inflation forward, and prices and wages more broadly began to rise more quickly. The result was higher and more variable inflation, and a more painful economic adjustment. The other element of our monetary policy framework is the flexible exchange rate. The flexible exchange rate helps the economy to absorb shocks. Just as the Manitoba Floodway absorbs some of the deluge of a spring flood, the floating dollar helps the economy to absorb shocks - especially external shocks that affect our economy differently than those of our major trading partners. The flexible exchange rate also supports economic adjustment because it is much easier to have changes in the relative price of Canadian goods and services come through movements in the exchange rate than to require all domestic prices and wages to adjust. Now, I said that the inflation target and the flexible exchange rate work together to promote our economic well-being. What this means in concrete terms is that relative prices can change without spilling over into generalized inflation, and the economy can operate close to its potential. This means that labour and capital are allocated more efficiently, and resources that move out of contracting sectors are put to work in expanding sectors. And that's what we've been seeing in Canada. With unemployment at a 33-year low, it's clear that Canada has been going through this difficult process of adjustment with considerable success. Our job at the Bank of Canada is to continue to aim for 2 per cent inflation so that when prices change, these are clearly relative price changes, and longer-run inflation expectations remain anchored at the 2 per cent target. To summarize, our monetary policy framework has served us well in maintaining a domestic environment of growth and stability. Together with other domestic policies, it has helped Canada to adjust to some significant changes in the global economy. But sound domestic policies are not sufficient to eliminate spillover effects from decisions and events on the other side of the world. And, while global integration creates new opportunities, it also poses certain risks. In particular, if other countries fail to pursue sound policies, we could see abrupt changes in global financial conditions, with harmful spillover effects in Canada and elsewhere. It is this possibility that points to the need for a global table where countries can come together and take account of their economic and financial interdependence. A stable global economy is in everyone's interest. This is where the International Monetary Fund (IMF) fits in. It is the institution best placed to fulfill this role. With 185 member countries, the IMF truly spans the globe. And with a large, well-trained and very professional staff, the IMF has the "human capital" to analyze the increasingly complex linkages among economies. The IMF began operations 60 years ago - in fact, just as the predecessor of the CFA Institute came into being. The IMF's mandate was to promote international economic growth and financial stability. This mandate remains relevant today. But a great deal has changed since the IMF first opened its doors. The IMF was set up to oversee the global monetary system in an era of fixed exchange rates. Today, flexible exchange rates are the norm; private capital flows dwarf IMF resources; financial markets are much more sophisticated and vastly more interconnected; and major new players are integrating into the global economy. To be effective in this world, the IMF must change the way it pursues its mandate. Recognizing this challenge, the IMF's managing director, Rodrigo de Rato, launched a strategic review of the Fund's role in 2004. The review covers a number of elements. The most critical is to decide exactly what the IMF should do to fulfill its mandate. I will focus my remaining comments on this issue. To be effective in a much larger and more integrated global economy, the IMF needs to become a more proactive institution, focused on limiting negative spillovers and preventing financial crises. And this means that the IMF needs to strengthen its main crisis-prevention tool - surveillance of its member countries and of the global economy. We need IMF surveillance to help member countries set sound policies, and to provide all members with the assurance that everyone is playing by the rules of the game. We need the IMF to evaluate the coherence of policy frameworks across countries, to assess the spillover effects of one country's policy choices on other countries, and to speak out when countries thwart adjustment to economic fundamentals to the detriment of other countries. And we need the IMF to be an effective global forum where members can come together to address international economic and financial issues. The groundwork for improved surveillance has been laid. As announced by Mr. de Rato three days ago in Montreal, the Fund and its members have just completed a revision of the guiding framework for surveillance. This is the first significant revision of the surveillance framework in 30 years, and it is a major accomplishment. The next step is to implement this framework. This will require establishing and periodically updating clear priorities and responsibilities for surveillance. Implementing the revised framework will improve the quality, the candour, and the even-handedness of IMF surveillance. Under the revised guiding framework, surveillance will focus on the four pillars of macroeconomic policy - exchange rate, monetary, fiscal, and financial policies - as they affect external stability. In implementing improved surveillance, it will be important to better integrate financial sector analysis and assessments into country reviews, and to take a broader, multi-country perspective. It is also very important that IMF surveillance be - and be seen to be - even-handed. This means that all members - not just those on fixed or managed exchange rates - should come equally under Fund surveillance. Improving Fund surveillance by applying best practices universally across its membership would benefit members. I promised at the outset not to take advantage of this being the longest day of the year. So, allow me to conclude with three key points. First, adjusting to a changing world economy is difficult, but Canada is doing well by profiting from new opportunities and responding to new global realities. Our monetary policy framework is helping the Canadian economy to absorb external shocks and to adjust to changing circumstances. Second, sound domestic policies are central to maximizing the benefits of globalization, while minimizing the risks. But as global markets grow and broaden, and countries become more interconnected, we have an increasing stake in a sound international monetary system, and in an institution to support it. Third, and finally, the IMF is best placed to be that institution. But to realize its potential, we need to modernize the way it pursues its mandate. A process of renewal is well under way, and it is important that the IMF and its members seize the opportunity to build an IMF for the 21st century.

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Release of the

dodge

Today, we released the July update to our , which discusses current economic and financial trends in the context of Canada's inflation-control strategy. Economic growth and inflation in Canada in the first half of this year have been stronger than was expected in the April . The Bank judges that the economy is now operating further above its production potential than was projected in April. The Canadian economy is now projected to grow somewhat more strongly in 2007 and somewhat more slowly in 2008 and 2009 than we previously projected. Higher interest rates across the yield curve and a stronger Canadian dollar are expected to bring aggregate demand and supply in Canada back into balance in 2009. Inflation is projected to be slightly higher and more persistent than in the April . With the direct effect of the GST cut ending, and with the impact of the temporary decrease in gasoline prices in late 2006, total inflation is expected to peak at about 3 per cent in the fourth quarter of this year. However, as excess demand diminishes, total CPI and core inflation should decline to 2 per cent by early 2009. The main upside risk to the Bank's inflation projection is that household demand in Canada could be stronger than projected. Higher levels of household borrowing and broad money growth point to this risk. On the downside, the adjustment in the Canadian economy to the rapid appreciation of the Canadian dollar may dampen demand for Canadian goods and services and reduce inflationary pressures more than projected. As well, the ongoing adjustment in the U.S. housing sector could be more prolonged. In the context of our new projection, the upside and downside risks appear to be roughly balanced. On Tuesday, the Bank raised its key policy interest rate by one-quarter of one percentage point to 4 1/2 per cent, and we said that some modest further increase in the overnight rate may be required to bring inflation back to the target over the medium term. Paul and I would now be happy to take your questions.

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The Bank of Canada's Research Agenda and the Future of Inflation Targeting

duguay

The last few weeks have been a time of turbulence in financial markets. In times such as these, it is common for people to focus on day-by-day or even hour-by-hour events, and to lose sight of the future. But tonight, I want to focus on the future; specifically, the future of inflation targeting in Canada. I want to discuss the key issues facing us as we consider refining our monetary policy framework in the years ahead, and to speak about the Bank of Canada's research program in this important area. I will finish with some remarks on recent developments in the Canadian economy and in financial markets. It may seem as if the Bank of Canada has been talking about inflation targeting forever. But as an approach to monetary policy, inflation targeting is not all that old - less than 20 years. In the words of economics professor Ken Kuttner, inflation targeting is still in its adolescence. And like many adolescents, it still has a few issues to work out. But let me be clear: Whatever issues there may be, our policy framework of inflation targeting, supported by a floating exchange rate, remains the most effective approach yet devised for conducting - and explaining - monetary policy in a country like Canada. No central bank that has adopted inflation targeting has later abandoned it. Together with sound fiscal policy, inflation targeting has clearly made a significant contribution to Canada's economic welfare. Consumers and businesses have been able to manage their finances with greater certainty about the future purchasing power of their savings and income. Economic signals sent by movements in relative prices have been clearer, and labour markets have been able to function better. Low and stable inflation has also meant that interest rates, both in nominal and real terms, have been lower. Inflation targeting has also been quite successful in anchoring inflation expectations and in dampening economic fluctuations, owing largely to the transparency of communications that the framework encourages. Well-anchored inflation expectations have helped to reduce the propagation of price shocks to wages and prices and to dampen the sensitivity of inflation to excess demand and supply. This has made the conduct of monetary policy more effective and efficient. In effect, we've created a virtuous circle. A better monetary policy framework has led to better inflation outcomes, increased policy credibility, and a more stable macroeconomic environment. Reflecting the success of the inflation-targeting regime, the government and the Bank of Canada renewed the inflation-target agreement in November of last year for another five-year period. As part of that renewal, we took the opportunity to refine and clarify our framework, and we reached conclusions in three areas: the use of core inflation measures, the role of asset price movements in the conduct of policy, and the appropriate time frame for bringing inflation back to target following a shock. We concluded that we should continue to look at measures of core inflation as a way to gauge the strength of underlying inflation, although our target remains total CPI inflation. As for asset price movements, we will continue to take them into account to the extent that they have implications for future inflation. And we will continue, generally, to aim to return inflation to the 2 per cent target over a six- to eight-quarter horizon, unless faced with shocks where a slightly shorter or slightly longer horizon would be more appropriate. Should such a case occur, we would communicate it transparently. While inflation control is clearly the right assignment for monetary policy, there always remains the question of whether the specific regime established in the 1990s will deliver the greatest contribution to economic performance in the decades ahead. So, when the inflation-targeting agreement was renewed last year, the Bank published a background document that spelled out two basic questions, which we hope to answer: Is 2 per cent the right target? And should the Bank express its target in terms of a path for the of prices, instead of the rate of inflation? Let me spend a bit of time discussing these two questions. When the Bank and the Government of Canada first agreed on a series of targets for inflation in 1991, a 2 per cent rate of inflation was seen by the Bank as a step towards price stability, which had yet to be defined. But it was also seen by most as a very ambitious target. After all, it had been decades since the Canadian economy had experienced a sustained period with inflation at 2 per cent or less. Indeed, during the 1980s, we had had trouble containing inflation to 4 per cent. In addition, there were fears at the time that the introduction of the Goods and Services Tax could rekindle inflationary pressures. But inflation quickly fell into line following the announcement of the targets, and has averaged very close to 2 per cent since the end of 1991. Since then, we have seen that the economy functions better at a low rate of inflation. But this experience raises the question: Would a lower inflation rate lead to further efficiency gains for the Canadian economy? There are a number of reasons to think so. Lower inflation would reduce the misallocation of resources by reducing price dispersions and making price signals clearer. It would also reduce the costs of updating prices and the economic distortions coming from a non-indexed tax system. We have been researching this issue for some time. Back in 1998, the Bank published a number of papers that examined the theoretical arguments and the empirical evidence on the potential benefits of lower inflation, most notably a paper by McGill University's Chris Ragan and several papers by Bank researchers. But it has proven difficult to quantify the expected benefits of lower inflation. In a recent commentary, David Laidler of the C.D. Howe Institute expresses lingering pessimism about finding material efficiency gains. He focuses instead on the distributional benefits of lower inflation, arguing that these will take on increased importance as our population ages and a growing number of Canadians rely on fixed incomes. However, advances in modelling offer new ways of quantifying the expected efficiency gains. These have been explored in two recent papers by Bank staff: one co-authored with Steve Ambler - the outgoing Special Adviser at the Bank of Canada - the other with Laval professor Kevin Moran. Their early results suggest that this is an avenue worth pursuing further. But while there may be benefits to be gained from a lower inflation target, there may also be costs involved in getting there. As I mentioned earlier, Canadians' expectations of inflation have now become firmly anchored on 2 per cent. Adjusting those expectations down to a lower level, say 1 per cent, may not be easy, although the cost of lowering inflation expectations can be expected to be lower than when inflation targeting was first adopted, given the credibility that the Bank - and our inflation-targeting framework - have acquired. However, the lengthening of non-indexed wage and debt contracts would raise some transition costs. Two main arguments have traditionally been advanced against the idea of targeting a lower inflation rate. The first is the concern about downward wage rigidity: That it is more difficult to adjust real wages downwards in an environment of very low inflation because this will likely involve cuts to nominal wages. The second argument is that central banks could have problems implementing a stimulative policy in a very-low-inflation environment because nominal interest rates cannot go below zero. With respect to downward wage rigidities, research described at the time of the 2001 renewal of the target, as well as labour market developments generally, do not appear to provide a compelling argument against a lower inflation target. But the zero-bound constraint on interest rates remains a critical issue. The adoption of price-level targeting, however, could help central banks deal with the zero-bound constraint. So let me now turn to the topic of price-level targeting. The essential difference between a target for the price level (which could rise over time) and an inflation target is that under pure inflation targeting, past deviations from the target do not have an impact on the future targeted rate of inflation. Movements in the price level that are perceived to be "one-off" events are ignored. Bygones are bygones. But with price-level targeting, past inflation performance does matter. If inflation had been below trend, causing the price level to fall below target, monetary policy would need to generate above-trend inflation for a while in order to return the price level to the target over time. Symmetrically, if inflation had been above trend, lifting the price level above its target, the central bank would need to bring about temporarily below-trend inflation to return the price level to its target path over time. Economic theory suggests that targeting a path for the price level would benefit the economy by adding certainty about prices over the long term. This should support economic efficiency by reducing the risks associated with long-term financial contracts. Providing added certainty about future prices would be of particular benefit to people living on fixed incomes. And as I mentioned earlier, price-level targeting might also help central banks avoid some of the difficulties associated with the "zero-bound" issue. If people anticipate that the central bank would take the appropriate measures to achieve the target, expectations about the future price level could become very well anchored. In these circumstances, it would take smaller moves in nominal interest rates to bring about the needed change in aggregate demand, and hence the zero bound is less likely to become a problem. Let me explain. If a shock were to bring the price level below the target, the anticipation that prices would return to target over time would lower real interest rates and help boost demand, thus requiring a smaller reduction in nominal interest rates. Put another way, the drop in prices below target would induce buyers to take advantage of the temporarily low prices. This would alleviate the problems posed by the zero bound. There is, however, concern about how a central bank would need to respond to certain shocks under price-level targeting. Under inflation targeting as it is now practised, one-off relative price movements or changes in indirect taxes would not trigger a monetary response as long as inflation expectations remain anchored. By focusing on the future trend of inflation, an inflation-targeting central bank accommodates one-off shifts in the price level and need not disturb the balance between aggregate demand and supply. But under price-level targeting, persistent relative price shocks would require a monetary policy response designed to bring about offsetting changes in other components of the consumer price index, which may involve shifts in the balance between aggregate demand and supply. It may be possible for a central bank to target the level of a core price index, which is less subject to relative price movements, rather than the total index. But this could add significantly to the communications challenges posed by price-level targeting. These communications challenges are likely to be greater for a central bank that practises price-level targeting than for one that practises inflation targeting. The general public can easily relate to a well-publicized and straightforward number like the inflation rate, and to an inflation target that remains constant over time. It could be more difficult to communicate that the central bank's target was a particular level of a price index, which itself could be rising over time, and that the path of inflation needed to get to this target number would change, depending on whether the price level was above or below the target. Yet, a solid public understanding is important if the full benefits of increased certainty about the future price level are to be realized. Any debate about the pros and cons of price-level targeting is bound to be based on theory, because only one country has had any real experience with it: Sweden in the 1930s. So we don't have much empirical evidence. That said, we now have the ability to construct the kinds of complex economic models - multi-goods models with relative price movements - that are important for conducting research into price-level targeting. Given the nature of the questions we have regarding both a lower inflation target and price-level targeting, there is a clear need for a lot of research to be done in a short period of time if we are to have a thorough discussion of the alternatives before the next renewal in 2011. And so the Bank has begun a concerted and ambitious research program for the next three years. But we know that this task is too large for us to accomplish ourselves. We very much want to get others involved in this research agenda, so that we can benefit from their knowledge and expertise. The Bank has held special sessions connected with meetings of various economic groups, and we will be hosting joint conferences with other central banks, as well as our own research conference. The Bank has also launched a new website: . This site is intended to be a hub where interested researchers can find out what research has been done, and what is being planned. At the Bank of Canada, we want to be confident that we have developed the best policy framework to deliver on our mandate of promoting the economic and financial welfare of Canadians. Inflation targeting has proven its worth in helping Canada achieve solid economic performance. But it is still relatively young, and there is some room for it to grow. Over the next few years, we hope to answer some of the lingering questions we have had about inflation targeting. We are not yet at the end of monetary history. With the Bank's research agenda, we hope to write the next chapter of the story. And we hope that many others, including some of you here tonight, will join us in that effort. Let me now turn to recent developments. I'll start with some words about the events in global financial markets. Over the past few weeks, there has been significant turmoil in financial markets around the world, and risk aversion has increased substantially. At the heart of the matter has been a reassessment of risk in credit markets triggered by concern about exposures to U.S. sub-prime mortgages. It has been extremely difficult to re-establish market prices for certain assets, particularly highly-structured asset-backed instruments. This is due in part to insufficient transparency - both about the actual assets that are backing these securities and about the distribution of exposure to these assets. The difficulty for market participants to evaluate risk and price it appropriately, together with the risk of an abrupt correction, was highlighted in the June issue of our . For some time we had been commenting that the narrow yield spreads on risky assets was raising questions about whether risk was being priced appropriately, a concern shared by other central bankers. Signs of difficulty within global financial markets have been evident in the market for asset-backed commercial paper (ABCP) and in the drying up of liquidity in money markets more generally. Yields on short-term government debt fell sharply as investors tried to shift into risk-free assets, and demands for liquidity put upward pressure on overnight interest rates. Most major central banks responded by providing liquidity to support the functioning of markets, conducting operations to reduce the upward pressure on overnight interest rates. The Bank of Canada undertook normal open market buyback operations to provide liquidity. It also temporarily expanded the list of collateral eligible for use by market participants in these buyback operations to include all securities already eligible for collateral in the Large Value Transfer System. As well, the Bank increased its supply of settlement balances as it normally does when it sees increased demand for cash balances. Let me emphasize that the Bank of Canada's operations to provide liquidity do not represent a change in the stance of monetary policy, but are meant to meet increased demand for liquidity to help re-establish well-functioning financial markets. Within the private sector, there have been important initiatives to support the functioning of markets. Canada's major chartered banks have confirmed that they are supporting their own bank-sponsored asset-backed commercial paper programs. As well, a number of major investors and liquidity providers have been pursuing an orderly restructuring for third-party structured finance asset-backed commercial paper. These initiatives should help support the functioning of financial markets in Canada. Now let me conclude by turning to developments in the Canadian economy. I think it would be useful to recall what the Bank said in the that we published in July. In that document, we said that economic growth and inflation in Canada in the first half of this year had been stronger than expected, and that the economy was now operating further above its production potential than was projected at the time of the April . Our base-case projection was for average annual economic growth of about 2 1/2 per cent through 2009, slightly below our estimate of the growth rate of potential, allowing the economy to return to its production potential in 2009. Inflation was projected to be slightly higher than in the April , returning to the 2 per cent target by early 2009. We identified both upside and downside risks to our inflation projection, noting that these appeared to be roughly balanced. The main upside risk related to the strength of household spending. The main downside risks related to the effects on the Canadian economy of the stronger Canadian dollar and of the ongoing adjustment in the U.S. housing sector. We increased our key policy interest rate to 4 1/2 per cent on 10 July, and said at that time that in line with our outlook, some modest further increase in the policy rate may be required. Economic data published since the July have been roughly in line with expectations. Domestic demand in Canada has remained robust, against the backdrop of strong labour and housing markets. But given recent events in global credit markets, we need to assess the extent to which the risks around our July projection have shifted. Specifically, we are asking ourselves two questions: First, how much greater is the risk to the Canadian economy now posed by developments in the U.S. economy? And second, to what extent would the re-pricing of credit risk lead to a sustained tightening of credit conditions in Canada? We will be considering these questions as we prepare for our next interest rate announcement on 5 September.

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A Clear Case for Transparency

dodge

It has been about 26 months since I last spoke to you here in London and certainly, much has changed in the world since then. We have seen a remarkable continuation of robust global growth, fuelled by increases in international trade and facilitated by the continuing evolution and expansion of capital markets. Domestic demand began to grow more strongly in Europe and Asia and to slow in the United States, and this began to ease some of the concerns related to global imbalances that I spoke about during my last visit. However, credit spreads continued to narrow, and lending standards loosened through the early part of 2007, while the growing use of structured financial products increased the distance between investors and underlying credits. Although central bankers raised concerns over the past 18 months or so about the pricing of credit and whether it appropriately reflected risk, it was not until the late spring of this year that spreads on risky assets began to widen, triggered largely by concerns related to the market for U.S. subprime mortgages. In August, concern turned into consternation, as investors in structured products - especially asset-backed commercial paper (ABCP) - "discovered" that U.S. subprime mortgages might be included in the assets underlying their products. Compounding this consternation was the worry that counterparties might be in a weaker financial state than previously anticipated, because of their own exposure to these assets. This led to a tightening of conditions and to dislocations in money markets more generally. One key factor behind the recent troubles in the money markets was, I believe, a lack of transparency. Transparency can, of course, mean different things in different contexts. In terms of financial markets, I am referring to the ability - as well as the willingness - of participants to obtain and use full and timely knowledge of market activity, including the precise nature of what is being traded. It was living through the events of August, in combination with ongoing efforts by the Bank of Canada to strengthen the functioning of international financial institutions, that has led me to use my remarks today to make a clear case for transparency. In doing so, I will not limit my comments to financial markets. Transparency is an underlying theme that pervades much of what policy-makers should do, both domestically and internationally. So, I will begin my remarks with a discussion of financial markets and how a lack of transparency has contributed to the market dislocations that we have seen recently. I will then return to a theme I spoke about when I was last here - the importance of strengthening our international financial institutions and increasing the transparency of their advice and operations. Finally, I'll say a few words about the health of the Canadian economy. Let me begin my remarks by recalling the 2005-06 period, when many central bankers - including me - were becoming concerned with what appeared to be an excessive easing of credit conditions, or what was described as a "wall of liquidity" building up around the globe. What was creating this wall of liquidity? Well, as I mentioned the last time I was here, at its very base was a global excess of desired savings relative to desired investment. These excess savings were acting to drive down real longer-term interest rates, even during a time when many central bankers were raising policy interest rates. As longer-term interest rates declined, investors intensified their search for better returns. This search for yield led to a narrowing of spreads on risky assets. As well, there was a loosening of lending standards in some markets, as lenders became more willing to take on risk. It also provided the opportunity for an increase in the issuance of structured products. Packaging and selling loans with a structure that allowed higher-risk assets to take on the qualities of a lower-risk loan fuelled the demand for higher-risk assets and embedded significant leverage. This financial engineering was a factor that spurred merger and acquisition activity, including corporate takeovers by private equity firms, as well as lending in markets such as the market for subprime mortgages in the United States. In many cases, these structured products have become increasingly complex and more difficult for investors to understand. The securities often made use of leverage and contained layers of derivatives on top of various types of assets; assets that were packaged and repackaged, sold and resold, in a myriad of forms. In this complex process, transparency about the underlying credit was often lost. Because the originators of the loans intended to securitize them rather than leaving them on their balance sheets, they lacked the incentives to carefully assess the creditworthiness of the borrower. And investors often lacked the ability, or did not make the effort, to see through the complexity of the instrument. Thus, investors were unaware of the creditworthiness of the root asset and the potential difficulties with the liquidity of the instrument itself. Compounding the problems was the fact that the models upon which these structured products were valued assumed that they could be readily traded in a liquid market. In August, that assumption was tested and found not to be fully warranted. I do want to emphasize that there were significant benefits to the development of these new, complex instruments. They provided the ability to separate different types of risk, such as credit or market risk. This promoted better risk management and allowed these risks to be borne by those best able to do so. Both banks and non-banking institutions created different types of loans that could be packaged and sold to different investors across the global economy. And taking many loans off balance sheets enhanced the ability of the banking sector to originate new loans while remaining well capitalized. As I mentioned earlier, central bankers had been worried for quite some time that credit spreads were not appropriately reflecting risk. So, we welcomed the re-pricing of risk that began in the spring of this year. Indeed, by May, we saw spreads on high-yield corporate bonds and emerging-market bonds beginning to widen to levels closer to historical norms. We also saw a re-pricing of U.S. subprime mortgages to reflect rising delinquency rates. This process meant that some people who had taken on a great deal of risk had to face losses. But in general, the necessary re-pricing of risk was proceeding, and markets were functioning properly. In August, however, the process hit a fairly major bump in the road. To begin with, we saw that the spread of the risks inherent in structured products also meant a wide dissemination of any underlying problems associated with the assets at the root of these instruments. Moreover, the complexity and lack of transparency in many of the structured products added to the market dislocations. It was extremely difficult for investors to peel back the layers of these securities and derivatives to determine, with confidence, both the creditworthiness of the assets backing a particular security and the market value of the security itself. Even supposedly sophisticated investors became extremely uncertain and that, in turn, led to fear. Such fear made markets less liquid - the money market in particular - and the "wall of liquidity" evaporated under the summer sun. Investors sought shelter and security in the least risky, shortest-term, and most transparent assets. The re-pricing of credit risk is an ongoing process. Unfortunately, it may take somewhat longer than in previous periods, because of the opacity and legal complexity of so many of these structured products. All of this implies that it's too early to draw any definitive conclusions from the current experience. But one lesson, which I hope will be clear to everyone, is the absolute importance of transparency if markets are to function properly. Vendors of financial instruments need to structure these investments in such a way that market players can clearly see what they are buying. Credit-rating agencies need to clearly indicate that their ratings for highly structured products should not be used with the same degree of certainty as their ratings for conventional, single-name issuers. At the same time, investors will have to take on more responsibility for diligent research, so that they can better understand the nature of their investments and demand greater transparency where it is now lacking. Investors should not rely simply on the pronouncements of rating agencies to deliver their seal of approval! Instead, they must do their own homework and make a concerted effort to understand what they are buying. However, this process can be successful only if they have access to all the information they need. Now I want to spend just a few minutes discussing the role of central banks, and the Bank of Canada in particular, during August. As liquidity dried up, central bankers in many parts of the world quite appropriately became involved. Many central banks injected short-term liquidity into money markets where required, fulfilling two fundamental roles. First, it is absolutely normal and proper that central banks should provide liquidity when banks that are quite solvent are faced with markets that have become illiquid - a point that Walter Bagehot recognized more than a century ago. Banks need to know that they can access the central bank's liquidity facilities when required. At the Bank of Canada, our Standing Liquidity Facility is available at the end of day, and can be accessed at a penalty rate of 25 basis points above our target for the overnight rate, by institutions that can pledge a broad range of easily priced securities as collateral. Following the onset of the market dislocations, we increased our supply of settlement balances as we normally do when we see increased demand for cash balances. Our second very fundamental role is to conduct our monetary policy in a transparent way to keep our policy interest rate close to its target, in order to control inflation. The events of August put strong upward pressure on the key overnight rate that we use in the conduct of monetary policy. And so we carried out open market buyback operations to inject liquidity in order to maintain that rate. We also temporarily expanded the list of securities eligible for use by market participants in these buyback operations. All told, our actions in these roles were effective in improving the functioning of the overnight money market. So we have now restored our original list of securities eligible for use in buyback operations, and we have gradually reduced the level of settlement balances. I want to be absolutely clear on one point: The actions that we took to provide liquidity to support the smooth operation of financial markets did not in any way signal a change in our monetary policy. In fact, it was a step in maintaining our monetary policy stance by keeping our target for the overnight rate at 4 1/2 per cent, which we judged appropriate for keeping inflation on target over the medium term. But while the overnight market in Canada is well on its way back to normal operations, this does not mean that all of the problems in money markets have been resolved. Term funding remains somewhat expensive, and the yield spread between bankers' acceptances and treasury bills remains abnormally wide. With respect to the market for asset-backed commercial paper, Canada - like other countries - has seen some problems. One specific segment of the Canadian ABCP market - the market for third-party, or non-bank-sponsored, structured finance, asset-backed commercial paper - has had particular problems. This represents roughly one-third of Canada's about $120 billion ABCP market. At the core of the difficulty are the guarantees of liquidity behind these securities, which differ from the guarantees provided in the United States and Europe. Canadian third-party ABCP tends to include a clause that guarantees liquidity only in the event of a "general market disruption." Many, but not all, of the liquidity providers have declined to step in as this paper has come due, essentially saying that the continued operation of some parts of the commercial paper market indicates that there has not been a general market disruption. Efforts to resolve problems in the market for third-party ABCP are under way. Discussions between investors and liquidity providers - most of whom are international banks - are continuing in Montreal. And I remain hopeful that, over time, we will see useful results. The balance of Canada's ABCP is composed of conduits sponsored by Canada's major banks. These banks have agreed to provide global-style liquidity support to their conduits. But they have not been immune to both global and local problems. As a result, the banks' conduits have been rolling over at shorter terms and higher interest rates and, in some instances, the banks have been taking some maturing paper onto their balance sheets. Nevertheless, the major banks appear to be well placed to deal with the current dislocations. In a joint statement last month, these institutions said that their commitment to support the ABCP market is underpinned by the strength of their financial positions, their confidence in the underlying assets, and their ongoing commitment to provide liquidity for their conduits upon maturity. Further, data published by Canada's Superintendent of Financial Institutions show that our domestic banking sector is well capitalized. At the Bank of Canada, we welcomed this effort to help re-establish well-functioning money markets in Canada. And we are confident that our banks have the capacity to continue to support their conduits as necessary. I said earlier that one of the lessons of the events of August is the absolute importance of transparency if debt markets are to function properly. But the importance of transparency is not limited to money markets and debt instruments. In my view, there is a clear case for transparency more generally in the operation of all financial markets. In most countries there are fairly clear rules requiring transparency in the operation of mutual funds, so investors can tell what they are purchasing. Hedge funds, by their nature, are less transparent. But there is also, I believe, a clear case for increased transparency, at least with respect to their objectives, operating procedures, and governance. The objective of accounting standards is also to increase transparency. But it is very difficult for firms to put a precise value on complex instruments for reporting purposes. For many of these instruments, there is no well-established market against which they can be marked. And the models against which these instruments are valued are simply that - statistical models that can only generate estimates of value within what is often a wide range. This means that it is very important for firms to be transparent about the methods used to estimate values and about the range of possible values around these estimates. Let me now say just a few words about the importance of transparency in government-sponsored institutions, whether domestic or international. I will begin with a few words about sovereign wealth funds, which control increasingly large amounts of money and are significant global financial forces. Some of these funds, such as the public pension funds in Canada, already adhere to very high standards of transparency. But in other cases, there is often insufficient transparency in the operation of these funds. Too often, the objectives behind these funds are not clearly defined, and this can lead to misconceptions about their motives, particularly those that have their origins in foreign exchange reserves. As is the case with private pools of capital, high standards of transparency for reporting and governance, as well as objectives, would be helpful for these public pools of capital. Finally, I would note that the same need for transparency applies to our international financial institutions. In this vein, we at the Bank of Canada, along with our colleagues at the Bank of England, have been working to promote a strengthening of the surveillance capacity and governance practices of the International Monetary Fund (IMF). As work continues to improve surveillance, we must also be expanding our efforts to help to make the IMF a truly representative institution for countries around the world, by ensuring that emerging-market economies have an appropriate voice within the institution. As well, we must ensure that the Fund is governed in a transparent way, and that the Managing Director and staff are accountable for the work that they do. Before concluding, let me say a few words about Canada's economic situation. Canada has enjoyed roughly 15 years of sustained economic growth, with low and stable inflation and increasingly healthy public finances. Our unemployment rate is the lowest it has been in about 30 years, and a greater proportion of the population is now working than ever before. At least part of the credit for our continued economic performance should go to our sound framework for macroeconomic policy, which includes the transparent monetary policy of inflation targeting that I mentioned earlier, as well as a sound fiscal policy. Over the past five years, robust global demand - particularly for energy and other primary products - has been a key contributor to solid economic growth in Canada and a significant improvement in our terms of trade. Overall, the Canadian economy has been adjusting well to changing relative prices, supported by our flexible exchange rate regime. Labour has shifted from areas and sectors where there is less demand to those where demand is greater. For about the past three years, the Canadian economy has been operating near, or above, its production potential. Strong economic growth has led to rising incomes across the country. The market for skilled labour is tight throughout Canada, but especially in the western provinces. In these circumstances, there has been some upward pressure on inflation. Against this backdrop of rising incomes and employment, it is not surprising that housing sales and prices have continued to rise, despite Canada's more conservative mortgage-lending practices. What do we see as we look ahead? The Bank's last full economic projection was conducted for the that we published in the middle of July. In that document, we projected continued strong economic growth outside North America and somewhat slower growth in the United States over the next several quarters. In that context, our base-case projection for Canada was for average annual economic growth of about 2 1/2 per cent through 2009, slightly below our estimate for the growth rate of potential. This would allow the economy to return to its production potential in 2009. Inflation was projected to return to its 2 per cent target by early 2009. Recent developments suggest that the near-term economic prospects for the United States are weaker than earlier expected. It now seems likely that the adjustment in the U.S. housing sector will be more pronounced and more protracted, exacerbated by the dislocations in financial markets. This implies weaker demand for Canadian exports than had been earlier expected. However, economic growth in Canada in the first half of this year turned out to be stronger than we had projected. And so at our fixed announcement date last week, we said that the Canadian economy now appears to be operating further above its production potential than we had estimated in July. Domestic demand remains robust, buoyed by our continued strong labour market and higher-than-expected increases in housing sales and prices. But recent developments in financial markets have led to some tightening of credit conditions for Canadian borrowers, which should temper the growth of domestic demand. Against this background, we judged that the current level of our target for the overnight interest rate - 4 1/2 per cent - is appropriate. However, there are significant upside and downside risks to the outlook for inflation. On the upside, there is a possibility that household demand in Canada could be stronger than anticipated, while on the downside, the ongoing adjustment in the U.S. housing sector could be more severe and spill over to the U.S. economy more broadly. In addition, there is uncertainty about the extent and duration of the tightening of credit conditions in Canada and, hence, about the tempering effect this will have on the growth of domestic demand. Let me conclude. Dislocation in financial markets is not easy to deal with, and it is certainly not welcome. But if we can learn and retain the extremely valuable lessons from these events, particularly in terms of the critical importance of transparency, then global financial markets can emerge from these events stronger and more efficient than before, to the benefit of us all.

r070925a_BOC

canada

Turbulence in Credit Markets: Causes, Effects, and Lessons To Be Learned

dodge

Vancouver and to have the opportunity to address the Board of Trade for the fourth and final time in my capacity as Governor. When considering a topic for today, I had planned to use the quiet moments of the summer to organize my thoughts about the evolution of the Canadian and global economies since 2001, and offer some ideas about the lessons that could be learned from the events of the past seven years. Unfortunately, as many of us here well know, this past summer was rather short on quiet moments. In August, the attention of policy-makers and the business community in general was focused on some fairly serious turbulence in financial markets. And so, rather than using my speech today to look back over the past seven years, I will instead look back over the past seven weeks and review what has taken place in global and Canadian financial markets. Of course, events are still unfolding and will likely continue to evolve for some time. Still, it's not too early to discuss some of the causes and effects of the market turbulence and, along the way, identify some of the lessons to be learned from these events. I will also talk about the actions that the Bank of Canada took in response. I'll then have a few words to say about the potential impact of the market turbulence on the outlook for the Canadian economy. To get a grasp on the events of the summer, it's important to have some context. The turbulence in financial markets did not come about against a backdrop of economic weakness. Indeed, over the past number of years, the global economy has shown remarkable strength. We were also seeing encouraging signs of growth being spread more evenly. At the same time, there was continued robust demand for Canadian goods and services, and this led to a significant improvement in Canada's terms of trade, helping to support the Canadian dollar. But there were signs of potential trouble in the global economy. To begin with, we were seeing a growing excess of desired global savings relative to desired investment. Quite naturally, this served to drive down real longer-term interest rates, even as central banks around the world were in the process of raising short-term policy rates. With the decline in longer-term interest rates, investors stepped up their demand for riskier assets that would deliver greater returns than investments with a lower risk. This search for yield led to a narrowing of spreads between the yields of risky assets, such as lower-rated corporate bonds, and the yields on government bonds. The narrowing of risky spreads became so pronounced and so persistent that many central banks - including the Bank of Canada - began to question whether these spreads adequately reflected the credit risks that were involved. A re-pricing of risk was probably necessary, but the real question was how, and in what manner, it would take place. Besides the need for a re-pricing of risk, other factors contributed to the market turbulence this summer. Originators of loans - both bank and non-bank institutions - were increasingly opting to securitize the loans they made, including U.S. subprime mortgage loans. By "securitize," I mean to bundle loans together into securities backed by the cash flows generated by the loan repayments. These securities were often sold in tranches that offered varying degrees of protection from the default risk involved. These structures allowed higher-risk assets to take on the qualities of lower-risk assets, and this fuelled the demand for the creation of higher-risk assets, which led to a global decline in standards for mortgage loans and the emergence of bonds with weaker covenants. Further, some of these assets embedded significant leverage. The originators of these loans had fewer incentives to carefully assess the creditworthiness of borrowers, because once the loan had been securitized and sold, the originator no longer faced the consequence if the borrower defaulted. I'll return to this point a bit later. But for now, suffice it to say that this decline in lending standards, combined with financial engineering, was helping to spur merger and acquisition activity, including private-equity takeovers, as well as lending in markets such as the U.S. subprime mortgage market. The process of securitization is not new. Securities backed by mortgages, credit card receivables, or other types of assets, have been around for years. But increasingly complex securities have been developed in response to the demand for higher returns. And as these securities have become more complex and opaque, in many cases it has become harder to determine the quality of the assets at the root of the security and to assess the counterparty risk. This is not to suggest that the evolution of these new, complex instruments has been a negative development. Indeed, these instruments have allowed the separation of different types of risk, such as credit and market risk. This has promoted better risk-management practices, and has allowed different types of risk to be borne by those best able to do so. Securitization has encouraged innovation and enhanced the ability of the banking sector to originate new loans while remaining well capitalized. The final point to make in terms of the causes of this summer's turbulence has to do with how these complex securities are valued. Trading of these securities in the secondary market is rare and, if trading does occur, it takes place in the over-the-counter market. As such, prices for these securities are not very transparent. Most of these highly structured securities are valued on a "marked-to-model" basis, meaning that statistical models are used to provide values. But the models typically provide only estimates of values, and these estimates can vary widely if there are changes in the assumptions on which they are based. Indeed, many of the models assume that the assets underlying these securities can be readily traded in a liquid secondary market. In August, it became clear that this assumption would not always hold. So, we can now see many of the factors that made credit markets vulnerable to this summer's dislocations. The re-pricing of risk I mentioned earlier was, in fact, under way before August. By late spring, the spreads on lower-rated corporate bonds had begun to widen to levels that were closer to historical averages. As we moved into summer, however, we saw rising delinquency rates and higher probabilities of default on U.S. subprime mortgages. And so, there were rising expectations of losses for holders of securities backed by these mortgages. But because of the complexity and opacity of some of these securities, it was extremely difficult for investors to determine, with confidence, both the creditworthiness of the assets backing a particular security and the market value of the security itself. In these circumstances, uncertainty led to contagion and dislocations in money markets more generally, even those markets that have nothing to do with U.S. subprime mortgages. Market liquidity, which was recently thought to be too abundant, became scarce. Some investors found that the assets that they assumed were liquid were, in fact, frozen. Even the market for overnight loans was affected. Investors suddenly became extremely risk averse, leading to a surge in demand for the least risky assets, such as government bonds and treasury bills. The re-pricing of credit risk is an ongoing process, and the events of this summer represent a bump in the road. Unfortunately, that bump means that it may take a while to achieve an appropriate pricing of risk. This is because it will take time to unravel some of these complex and opaque instruments to get to the underlying assets, and then to find values for the assets themselves. Over time, market forces can be expected to work this out. But markets need information in order to operate efficiently. So, it is in the interest of market participants to make sure that parties have access to all the necessary information. This is the first lesson to be learned - the importance of transparency in financial markets. Two weeks ago in London, I spoke about how the events of the summer helped to make a clear case for transparency. Investors should demand greater transparency where it is now lacking. Vendors of financial instruments will then need to structure them in such a way that market players can clearly see what they are buying. More fundamentally, investors must take on more responsibility for diligent research, so that they can better understand the nature of their investments. Put another way, investors must do their own homework instead of simply relying on the word of credit-rating agencies. It seems to me that many of these desired outcomes will be accomplished through natural market forces responding to these events. For example, when investors demand much higher rates of return for opaque products, there will be a strong incentive for vendors to provide products that are more transparent. Similarly, credit-rating agencies will likely find it to their advantage to explain more clearly the rationale for, and limitations of, their ratings for highly structured products. They should make it clear that their ratings should not be used with the same degree of certainty as ratings for conventional, single-name issuers, and that the securities involved do not trade with the same degree of market liquidity. There will undoubtedly be calls for tighter government regulation for credit-rating agencies. But I would caution against any knee-jerk regulatory response. Given the events of the summer, it seems likely that those credit-rating agencies that do not work harder to ensure that users understand the nature of their ratings will soon have fewer clients willing to pay for their services. There is one other lesson I want to mention at this point. We need to think about how to get the right incentives in place for loan originators, so that credit quality is maintained and credit is appropriately priced. As I mentioned earlier, the creation of loans for immediate securitization reduced the incentive for originators to maintain credit standards. This indicates a classic principal-agent problem: Since the originators were immune from default risk once the loan was securitized and sold, they often lacked the proper incentives to adequately assess the creditworthiness of the borrower. We need to think hard about how to get the incentives right. It may be that natural market forces will go a long way towards rebalancing incentives, but there may also be an active role for policy-makers in this regard. Another issue related to securitization concerns the capitalization of banks. If banks are moving securitized loans off their balance sheets, but still providing liquidity guarantees for these securities, how much capital should they be required to set aside? The authorities at the Basel Committee may need to revisit this issue in light of recent experiences. This summer's turbulence had an effect on many segments of the money markets, including the market for overnight funds. The overnight market is now well on its way back to normal operations in Canada, and I'll talk about that in a few minutes when I discuss the role of the central bank. However, problems in other areas of the money markets have not yet been resolved. In terms of the market for asset-backed commercial paper (ABCP), about two-thirds of Canada's roughly $120 billion ABCP market is composed of conduits sponsored by our major domestic banks. These banks have agreed to provide global-style liquidity support to their conduits, and investors have every reason to be confident that our banks have the capacity to continue to support their conduits as necessary. Although the spreads between bank-sponsored ABCP and treasury bills have narrowed a bit in recent days, it is somewhat surprising that they have not narrowed further and more quickly, given the strong balance sheets of Canadian banks. The remainder of Canada's ABCP is third-party, or non-bank-sponsored, and roughly three-quarters of this is highly structured. Because liquidity for this paper was guaranteed only in the event of a "general market disruption," liquidity providers - most of whom are international banks - declined to step in as this paper has come due. Thus a fundamental work-out, or restructuring, of third-party ABCP is required. Discussions in Montreal between investors and liquidity providers as to how to achieve such a restructuring are progressing. I would encourage the parties involved to support this process - all investors and all international banks. I remain hopeful that, over time, this process will lead to useful results. Now let me talk about the actions of the Bank of Canada over the past seven weeks. Essentially, our actions helped us fulfill two fundamental roles of a central bank - providing liquidity to the payments system, and formulating monetary policy. In terms of the first role, it is absolutely normal and proper that central banks should provide liquidity to the payments system, especially when financial institutions are faced with markets that have become illiquid. This is precisely the situation in which we found ourselves this summer. With money markets seizing up, many institutions found it difficult to obtain necessary liquidity. So the Bank of Canada, like other central banks, made it clear that institutions could access our regular liquidity facility when required. The Bank of Canada's Standing Liquidity Facility can be accessed daily, at a rate 25 basis points above our target for the overnight rate, by direct clearers involved in Canada's wholesale payments system. To access this liquidity, institutions can pledge a range of easily priced securities as collateral. The events in August placed strong upward pressure on the overnight interest rate, moving it above our target. And so we carried out open-market buyback operations to inject liquidity, with the goal of bringing the actual overnight rate closer to our target. We also temporarily expanded the list of securities that market participants could use as collateral in these buyback operations. In addition, we provided liquidity by increasing our supply of settlement balances as we normally do when we see an increased demand for cash balances. All told, were effective in helping to improve the functioning of the overnight money market. So we have now restored our original list of securities eligible for use in buyback operations, and we have gradually reduced the level of settlement balances. And while it is true that many term money market spreads remain abnormally wide, the market is functioning. There have been increasing numbers of transactions in this area and spreads are beginning to narrow. In these circumstances, there does not appear to be anything the Bank of Canada could usefully do to improve the functioning of this market. The events of the summer have also had some important implications for our role as the country's monetary policy authority. Before explaining these implications, I should start with some background. The Bank's policy rate is our target for the overnight interest rate. This rate is crucial for the transmission of monetary policy throughout the economy. When we adjust our target for the overnight rate, we set in motion a chain of consequences that influences other interest rates in financial markets and, through the cost of credit, spending, production, employment and, ultimately, the rate of inflation. By adjusting our target, we are aiming to keep total demand and supply in the economy in balance, thus keeping inflation low, stable, and predictable. During the summer, however, we saw a widening of the spread between short-term market interest rates, such as the rate for commercial paper, and our target for the overnight rate. Should these wider spreads persist, it would represent a tightening of credit conditions in the economy that would occur independent from any movement in our target for the overnight rate. Thus, any given policy rate would be somewhat more restrictive than was previously judged. This leads me to what is perhaps the most important lesson that central bankers can learn from these events. Let me emphasize this by returning to the point I made earlier about how the process of securitization enhanced the ability of financial institutions to make loans. It seems to me that in recent years, central bankers may not have fully appreciated just how much the increase in securitization represented an easing of credit conditions. Loans were being shifted off balance sheets, allowing more loans to be made. If securitization led to the creation of loans that would not otherwise have been made, then this was a source of demand in the economy that we as central bankers likely did not fully take into account. Any given policy rate would thus be less restrictive than was earlier judged, implying that interest rates globally might have been lower than would have been optimal. However, since both global and domestic inflation have been largely contained over this period, we should not exaggerate the magnitude of this effect. A reduction in securitization now seems likely, and we can expect a degree of re-intermediation by financial institutions. All other things equal, in Canada, this will lead to a higher cost of credit relative to the overnight interest rate than was the case prior to this summer. But how much tightening will this lead to in the longer run? And will the process of re-intermediation persist, and thus affect the conduct of monetary policy going forward? These are key questions that we at the Bank of Canada need to think about. And it may be some time before we have definitive answers. Finally, the more immediate question is: What are the implications of the turbulence in money markets for Canada's economy? As the Bank noted in its interest rate announcement earlier this month, the near-term economic prospects for the United States are weaker than earlier expected, as events in financial markets will likely exacerbate the adjustment in the U.S. housing sector, making it more pronounced and more protracted. This implies weaker U.S. demand for Canadian exports. However, economic growth in Canada in the first half of this year turned out to be stronger than we had projected, and near-term prospects for economic growth outside North America continue to be very favourable. And so at our last fixed announcement date, we said that the Canadian economy now appears to be operating further above its production potential than we had estimated at the time of our July . Domestic demand remains robust, buoyed by our continued strong labour market, rising wages, and higher-than-expected increases in housing sales and prices. But as I mentioned, the turbulence in financial markets has meant some tightening of credit conditions for Canadian borrowers. This should temper the growth of domestic demand, although the extent of this effect is difficult to assess. Against this background of a likely weaker track for exports and tighter credit conditions, along with signs of stronger domestic demand, we judged that the current level of our target for the overnight interest rate - 4 1/2 per cent - is appropriate. However, there are significant upside and downside risks to the outlook for inflation. On the upside, there is a possibility that household demand in Canada could be stronger than anticipated, while on the downside, the ongoing adjustment in the U.S. housing sector could be more severe and spill over to the U.S. economy more broadly. In recent days, the Canadian dollar has moved sharply above the trading range assumed in the July , and we need to look at the causes of this strengthening, should it persist. And, as always, we need to assess the effect of movements in the exchange rate on the balance of aggregate demand and supply in the Canadian economy. In addition, as I noted, there is uncertainty about the extent and duration of the tightening of credit conditions in Canada and, hence, about the tempering effect this will have on the growth of domestic demand. Gauging the effects of the financial market turbulence on credit conditions, and the implications for the Canadian economy, will be one of the Bank's most pressing tasks over the coming months. We will provide analysis of these issues in our next , which will be published on 18 October. Ladies and gentlemen, let me conclude. This was not a very pleasant summer for many people. Turbulence in financial markets is not easy to deal with, and it is certainly not welcome. But if we can learn from these events and retain the valuable lessons, then global financial markets can emerge from this turbulence stronger and more efficient than before. Ultimately, this can be to the benefit of us all.

r071003a_BOC

canada

Liquidity, Liquidity, Liquidity

longworth

Good evening. It's a pleasure to be here. Sound financial investment is important to individuals, to firms, and to society as a whole. By definition, investment is forward looking, and thus our future financial well-being is shaped by the soundness of the investment decisions we make today. History shows that sound investment requires confidence, and one of the key elements that underpin confidence is liquidity. Indeed, Governor Kevin Warsh of the Federal Reserve Board says that liquidity, is, in fact, a form of confidence. The events that ensued from the U.S. subprime-mortgage crisis have tested the confidence of many investors, and raised questions about where all the liquidity - which seemed so plentiful a few months ago - has gone. Now, one of the great things about our two official languages is that we often have several words to describe one thing - or more accurately, to distinguish between slightly different forms of one thing. We have snow, sleet, and slush - though not, I hope, until December. . But sometimes, when it might be useful to have several words to distinguish between similar concepts, we have only one word, and that word is forced to take on several meanings. "Liquidity" is such a word - it's used to mean slightly different things in different contexts. In my remarks this evening, I'd like to examine three concepts of liquidity that are of interest in economics and finance. The first I'll call , which has to do with "overall monetary conditions," including interest rates, credit conditions, and the growth of monetary and credit aggregates. The second is , which refers to how readily one can buy or sell a financial asset without causing a significant movement in its price. A third form of liquidity that I'll be touching on very briefly is balance sheet liquidity, which refers broadly to the cash-like assets on the balance sheet of a firm (or household). For non-financial firms, is often measured by the short-term liquid assets on their balance sheet. For banks, which must manage their liquidity very closely, balance sheet liquidity is reflected in a detailed breakdown, by maturity, of their assets and liabilities - especially those coming due in the short term. The ability of banks to fund themselves is often referred to as . The common element in these concepts is that liquidity is the ability to obtain cash - either by turning assets into cash on short notice or by having access to credit. I'll focus largely on the first two concepts, macroeconomic and market liquidity. In each case, I'll suggest why liquidity matters, both in a general sense and to policy-makers, and I'll describe how it's measured. Then, I'll discuss the state of liquidity, in its various forms, both before the summer turbulence and after. I'll conclude by describing the current situation and saying a few words about the Bank of Canada's role with respect to each type of liquidity. As I noted earlier, I am using the term macroeconomic liquidity to refer to "overall monetary conditions." Any economy, whether national or global, functions best when there's enough - but not too much - liquidity. So, how much is the right amount in a national economy? The answer depends on the central bank's objectives. In Canada, our monetary policy objective is to meet the inflation target. This goal has been achieved with considerable success since the target was introduced in 1991. In general, when inflation is tending to remain on target, liquidity is adequate. If there were too much liquidity in the economy, inflation would threaten to rise above target. If there were too little, inflation would tend to fall below it. To put this same notion in different terms, the risk of having too much, or too little, liquidity in our domestic economy is essentially the same risk that is posed by future inflation being higher or lower than the target. The key indicators of macroeconomic liquidity, in terms of price, are the policy interest rates and the term structure of interest rates paid by borrowers. In terms of quantity, the key indicators are the growth of monetary and credit aggregates and the state of credit conditions more generally. In normal times, central bankers tend to place more emphasis on interest rates than on monetary and credit measures. Nevertheless, the growth rates of monetary and credit aggregates do appear to have some explanatory power regarding the future evolution of spending and inflation, and are thus useful additional indicators of liquidity. For example, in Canada, real M1 measures help to predict near-term growth in real GDP. And the M2-family aggregates help to predict core CPI inflation one to two years ahead. One particularly important aspect of macroeconomic liquidity is the liquidity that central banks make available to the financial system on a day-to-day basis - often referred to as central bank money. In Canada, this typically comes through the provision of settlement balances in the wholesale payments system - the Large Value Transfer System (LVTS) - supplemented, when required, by open market purchase and resale agreements. The goal of this provision is to keep our key policy rate, the overnight rate, close to the target we set for it. As well, our standing liquidity facilities, made available to LVTS participants at the end of the day, provide liquidity, as required, to individual financial institutions at 25 basis points above the overnight rate. , Finally, to get a sense of macroeconomic liquidity, one can aggregate macroeconomic liquidity across countries to obtain average world real interest rates and the average growth of monetary and credit aggregates. These measures will tend to be reflected over time in the behaviour of global spending and average global inflation rates. Global macroeconomic liquidity sets the backdrop against which we make monetary policy in Canada. This liquidity can affect the foreign demand for Canadian products and, at times, can influence the prices of Canadian imports. A key point is that, because Canada has a flexible exchange rate regime, we can achieve the inflation target over time - of the degree of liquidity in the global economy. This is because such a regime allows us to have a monetary policy that is independent of other countries. Now I'll turn to liquidity in financial markets. Market liquidity refers to the extent to which one is able to quickly and easily buy and sell financial assets in the market, without moving the price. Market liquidity captures the aspects of immediacy, breadth, depth, and resiliency in markets. Immediacy refers to the speed with which a trade of a given size and cost can be completed. Breadth, often measured by the bid/ask spread, refers to the costs of providing liquidity. Depth refers to the maximum size of a trade for any given bid/ask spread. Resiliency refers to how quickly prices revert to fundamental values after a large transaction. Generally speaking, the more liquid the market, the better. But there is an important caveat - if market participants come to expect that market liquidity will always be ample, and they acquire assets with the assumption that they can liquidate their positions quickly and at fairly predictable prices, they may end up taking on more risk than has been factored into the purchase price. And this could sow the seeds of a nasty correction in the event of a shock and a rapid decline in market liquidity. That said, liquidity is the lifeblood of markets. Over the past 50 years, and particularly in the past 10 to 15 years, we've seen a significant trend increase in liquidity in financial markets around the world, including the markets for bonds and other fixed-income products, and those for equities, derivatives, foreign exchange, and commodities. What gave rise to this increase in market liquidity? First, there have been structural factors in markets themselves. The appearance of new players, the introduction of new financial instruments, and advances in technology have all added to the liquidity of financial markets. New participants, such as hedge funds, have become active in many financial markets, thus introducing new capital into these markets, adding to their liquidity. Financial innovation, typically enabled by technology, has often supported the liquidity of financial markets. The growth of electronic trading systems and innovation in back-office systems have lowered trading costs and increased price transparency and competition, and, in the end, resulted in greater liquidity. In addition to these structural factors, two other significant long-term developments have underpinned the growth of liquidity in financial markets. First, efficiency gains in the financial sector, better inventory management, and better macro policy - including monetary policy - resulted in what has come to be called the "Great Moderation," which was a significant reduction in the variability of output, inflation, and long-term interest rates across most G-7 countries, starting in the mid-1980s. And this moderation has, in turn, contributed to the liquidity of financial markets by reducing some of the fundamental sources of financial volatility and risk. Second, globalization has resulted in more liquid financial markets. Globalization has significantly increased international capital flows, since many emerging-market countries have relaxed their capital controls. Globalization has also helped to spread financial innovation, in part through the operations of large international banks. This increase in market liquidity has generally been beneficial. It has tended to place downward pressure on volatility - prices have typically become less sensitive to large transactions and usually absorb news more easily. So that's a look at macroeconomic and market liquidity. Now I'd like to provide a snapshot of the liquidity situation before the summer turbulence. Let me start with the state of macroeconomic liquidity. For several years, the world economy has been characterized by ample liquidity. In comparison with historic norms, long-term real interest rates have been low, and money and credit have grown fairly quickly in most G-7 countries and in such emerging-market countries as China and India. The major reason for the unusually low long-term real interest rates appears to be a high level of desired savings relative to desired investment. Interestingly, despite ample (or perhaps overly ample) global liquidity - which historically has led to rising inflation - inflation has been fairly well contained around the globe. Central banks have been keeping their eyes on inflation and have not hesitated to raise policy rates as required. Parenthetically, I would add that a number of other developments - developments that did not really contribute to global macroeconomic liquidity - may have left the impression that there was a "wall of liquidity" out there. These developments include the rapid growth, in real terms, of the global economy; an increase in the ratio of financial assets to GDP; increases in corporate holdings of cash; growth in many of the major "real-money accounts," such as pension funds, central bank reserves, and sovereign wealth funds; the ongoing reinvestment of fixed-income assets that come to maturity; and the payouts that occur when firms are acquired. Against a backdrop of low real interest rates, much of this money was involved in a "search for yield," and, in this search, the prices of risky assets were bid up. The situation in Canada before August was similar to the global one - that is, it was marked by ample macroeconomic liquidity. Indeed, the Bank of Canada's July noted that there were upward pressures on inflation, and that the growth of household and business credit, as well as the growth of monetary aggregates, was robust. We therefore raised the policy interest rate to 4.5 per cent and expressed the view that "some modest further increase in the overnight rate" might be required to bring inflation back to target over the medium term. As for market liquidity, it had generally been growing over the past few years. Bid/ask spreads were narrow, and volatility was low in foreign exchange markets and in equity and fixed-income markets. Shocks, when they occurred, were contained - that is to say, they didn't spread widely across markets - and episodes of volatility subsided fairly quickly. And shocks did occur. Four episodes come to mind: the May 2005 downgrade of Ford and GM debt; the sell-off of risky assets in May and June of 2006; the collapse of the American hedge fund, Amaranth Advisors, in September of 2006; and finally, the "flight to quality" in February of this year. These episodes were apt to be costly for those directly affected and reminded investors that investments pose risks, and that prudence requires that these risks be understood and managed. Overall, however, because these episodes were well contained and of short duration, they may have left investors too complacent, and therefore contributed to postponing an overdue repricing of risk. Indeed, central banks, including the Bank of Canada, had for some time identified the possibility of "a significant price reversal in riskier assets." Let me now describe how the late summer turbulence in financial markets affected various forms of liquidity. Throughout the year, delinquency rates and foreclosures associated with subprime mortgages in the United States have been rising. These mortgages have, over the years, been increasingly repackaged, or securitized, into asset-backed securities (ABSs) such as residential mortgage-backed securities (RMBSs). More recently, these RMBSs, along with other assets and ABSs, have been further repackaged into other structured products, such as collateralized debt obligations (CDOs) and asset-backed commercial paper (ABCP). Because the magnitude of the delinquencies and foreclosures was unexpected, it is not surprising that we have seen a repricing of many assets with exposure to the U.S. subprime-mortgage market. The subsequent downgrade by credit agencies of many CDO tranches - especially those that included U.S. subprime mortgages - made market participants aware of the risk inherent in these products, and also made them realize that credit risk more broadly may not have been priced appropriately. So, to the extent that the repricing of credit risk that we have seen in recent months has, in fact, been a renormalization of the value of risk, these events are to be welcomed. Many of these structured products lack transparency - particularly those backed by other structured or securitized products, such as ABCP backed by CDOs. It is often difficult for investors to determine the underlying assets that ultimately provide the cash flow for these products - and, therefore, to determine their direct exposures. While securitization helps disperse risk to those more willing to bear it, it can also obscure to the investor in which instruments and with which actual and potential counterparties the ultimate risk resides. Because of this lack of transparency, uncertainty among market participants began to build in early August, and perceptions of counterparty risk rose. Bid/ask spreads widened, market depth diminished, and market liquidity evaporated. As events unfolded around the world, the rate on overnight collateralized transactions in Canada moved above the target overnight rate in the second week of August. This market response was not unique to Canada. The overnight interbank rates in the United States and Europe also moved above the respective target policy rates and became very volatile. As a result, central banks, including the Bank of Canada, moved quickly to provide significant amounts of liquidity to their financial systems in the form of central bank money, which, as I noted earlier, is a key aspect of macroeconomic liquidity. Shortly after mid-August, conditions in the Canadian overnight market began to improve. From that time until the recent technical pressure, stemming partly from month-end payment flows, the Bank of Canada had not had to intervene intraday: total settlement balances had steadily decreased, and the overnight rate had remained slightly below target. After all that has occurred over the past two months, it would seem that the most pronounced impact - aside from major, ongoing concerns regarding the structured-product market - has been an increase in the spreads in money markets - whether in ABCP, corporate paper, or bankers' acceptances - of most industrialized countries. Market liquidity in these particular markets has not returned to its former state. While short-term funding for banks was always accessible through the money market, we went through a period in which it was very difficult to obtain funding beyond a week or two. Perceptions of increased counterparty risk, combined with precautionary hoarding of funds by financial institutions, helped to create that situation. This precautionary behaviour has occurred because financial institutions are uncertain about the extent of their potential exposure to ABCP (which they will have to take back on to their balance sheets, since they are the sponsors or liquidity providers), or to the financing of previous leveraged buyout transactions. In the past couple of weeks, however, there have been an increasing number of transactions at longer terms in world money markets, including the Canadian market for bankers' acceptances, and spreads have narrowed somewhat. However, liquidity in money markets is still quite limited in Canada and abroad. The situation in money markets contrasts with that in other markets, such as spot foreign exchange and equity markets, where repricing has occurred and market liquidity has returned. These markets are functioning reasonably well. Liquidity in corporate bond markets is somewhere between these two situations, with highly rated firms having little difficulty accessing market funding (though at higher spreads than before August), while access for low-rated firms is significantly constrained. I would now like to turn to the current situation. In particular, I will look at the Bank of Canada's role for each type of liquidity. With respect to the provision of central bank liquidity to the financial system, let me stress that the Bank's goal continues to be to keep the overnight interest rate close to its target. We will continue to monitor the situation in the overnight market and adjust settlement balances and undertake open market purchase and resale operations as necessary, as we have done in recent days in response to upward technical pressure. This pressure does not appear to be linked to changes in the rest of the money market. With respect to domestic macroeconomic liquidity, we set the overnight interest rate to keep inflation near its 2 per cent target over the medium term. Our next fixed announcement date is 16 October. Between now and then, we will be reviewing all the relevant factors affecting the inflation projection. At the time of our last announcement, we noted that there are significant upside and downside risks to the outlook for inflation. On the upside, there is a possibility that household demand in Canada could be stronger than anticipated, while on the downside, the ongoing adjustment in the U.S. housing sector could be more severe than anticipated and could spill over to the U.S. economy more broadly. Recently, the Canadian dollar has moved sharply above the trading range assumed in the July , and we need to look at the causes of this strengthening, should it persist. And, as always, we need to assess the effect of movements in the exchange rate on the balance of aggregate demand and supply in the Canadian economy. In addition, there is uncertainty about the extent and duration of the tightening of credit conditions in Canada and, hence, about the tempering effect this will have on the growth of domestic demand. As I noted earlier, the Bank monitors Canadian credit conditions closely, and we will be looking at the level of interest rates paid by households and firms, as well as at any changes in the availability of credit granted to them for spending on goods and services. Over the summer, credit spreads rose all along the term structure, but, because of significant declines in risk-free rates, increases in the level of interest rates paid by firms are largely confined to short-term maturities, where credit spreads have risen the most. With respect to the direct participants in the Large Value Transfer System, Canada's wholesale payments system, the Bank of Canada's Standing Liquidity Facilities are available at the end of each day, on an overnight basis, for individual institutions that have a shortfall in their settlement balances because of temporary difficulties with their funding liquidity. Many observers have asked whether there is more that the Bank of Canada could be doing to deal with the market liquidity situation in money markets, as well as the funding liquidity situation of banks. We have been asking ourselves the same question. While it is true that many term money market spreads remain abnormally wide, the market is functioning. There have been increasing numbers of term money market transactions, and spreads are beginning to narrow. In these circumstances, there does not appear to be anything that the Bank of Canada could usefully do to improve the functioning of this market. Indeed, the best contribution the Bank of Canada can make in this situation is to keep inflation low and stable by maintaining macroeconomic liquidity at an appropriate level, and to keep the overnight interest rate close to its target. With these conditions in place, market liquidity should be restored, over time, through the operation of normal market forces. A helpful backdrop is the overall strength of the Canadian economy, supported by a high level of balance-sheet liquidity in Canadian non-financial corporations. Liquidity is essential to the well-functioning of both the real economy and financial markets. The Bank of Canada carefully monitors and analyzes liquidity in all its guises as part of our ongoing assessment of the economy and the financial system. Throughout this most recent period of financial market stress, the Bank has paid particular attention to both the and the of liquidity - in the macroeconomy, in financial markets, and in balance sheets. We will continue to monitor events as they unfold, and we will take appropriate policy actions as required.

r071018a_BOC

canada

Release of the

dodge

Today, we released the October , which discusses current economic and financial trends in the context of Canada's inflation-control strategy. Since the , and against a backdrop of robust global economic expansion and strong commodity prices, the Canadian economy has been stronger than projected. It is now operating further above its production potential than had been previously expected. , the outlook for the U.S. economy has weakened. The Canadian dollar has appreciated sharply, and credit conditions have tightened. Despite these tighter credit conditions, the momentum of domestic demand in Canada is expected to remain strong. The combined effect of a weaker U.S. outlook and a higher assumed level for the Canadian dollar implies, however, that net exports will exert a more significant drag on the economy in 2008 and 2009 than previously expected. As a result, Canada's gross domestic product is projected to grow by 2.6 per cent in 2007, 2.3 per cent in 2008, and 2.5 per cent in 2009. With the economy moving back towards balance, and with the direct effect of the stronger Canadian dollar on consumer prices, core inflation is projected to gradually decline to 2 per cent in the second half of 2008. Total CPI inflation is expected to peak at about 3 per cent later this year and then move back down to the 2 per cent target in the second half of 2008. But there are a number of upside and downside risks to the Bank's inflation projection. The main upside risk is that excess demand in the Canadian economy could persist longer than projected. The main downside risk is that output and inflation could be lower if the Canadian dollar were to be persistently higher than the assumed average level of 98 cents U.S. for reasons not associated with demand for Canadian products. All factors considered, the Bank judges that the risks to its inflation projection are roughly balanced, with perhaps a slight tilt to the downside. The Bank also judges, at this time, that the current level of the target for the overnight rate is consistent with achieving the inflation target over the medium term.

r071021a_BOC

canada

Credit Market Turbulence and Policy Challenges Ahead

dodge

Governor of the Bank of Canada to the Institute of International Finance I'm delighted to have the opportunity to address the Institute as it celebrates 25 years of important contributions to the stability of the global financial system. Given the Institute's membership and its focus on financial stability, I feel safe in saying that all of us here today watched this summer's turbulence in credit markets with interest, to put it mildly. What began in the spring as a repricing of credit risk turned into dislocations that have yet to fully run their course. Because of our shared interest in these events, what I thought I'd do today is discuss some of the challenges that these events have posed, not just for central bankers, but for policy-makers and private sector institutions more generally. My goal today is to try to identify some of the questions and issues that we need to consider. As a point of departure, it would be useful to have a common understanding of the factors behind this summer's turbulence. I'll be brief here. Ten days ago, Charles Dallara did a nice job of summing up one of these factors in his letter to Tommaso Padoa-Schioppa, wrote: "Strong global growth, plentiful liquidity, and a search for yield together led to a relaxation of credit standards and to pricing that was not commensurate with underlying risks and fundamentals." There were other key factors that led to the events of this past summer. In a couple of previous speeches, I have noted the complexity and opacity of some of the structured products at the heart of the recent turbulence. Because of this complexity and opacity, it is extremely difficult for investors to determine, with confidence, both the creditworthiness of the assets backing a particular security and the market value of the security itself. Even supposedly sophisticated investors did not understand the nature of the assets underlying these structured products. The other factor I'd point to is the increasing use of securitization to meet the growing demand for structured products. This allowed higher-risk assets to appear to take on the qualities of lower-risk assets, fuelling the demand for the creation of higher-risk assets and leading to the relaxation of credit standards. To be clear, the problem was not the use of securitization per se; rather, it was that originators of the securitized loans at times did not have the proper incentives to carefully assess the creditworthiness of borrowers. In many cases, once the loan had been securitized and sold, the originator no longer faced the consequences if the borrower defaulted. It seems to me that in recent years, we at the Bank of Canada and, I suspect, other monetary authorities as well, may not have fully appreciated just how much the increase in securitization represented an easing of credit conditions. Loans were being sold and, to a greater or lesser extent, moved off balance sheets, allowing more loans to be made. If securitization led to the creation of loans that would not otherwise have been made, then this was a source of demand in the economy that we as central bankers may have only partially taken into account. Any given policy rate would thus have been less restrictive than was earlier judged, implying that, in hindsight, interest rates globally might have been a little lower than would have been optimal. However, since both global and domestic inflation have been largely contained over this period, we should not exaggerate the magnitude of this effect. But following recent events, a reduction in securitization globally is now likely, along with a degree of re-intermediation by financial institutions. Indeed, in the Bank of Canada's latest , published on Thursday, we projected that the cost of credit for Canadian firms and households relative to our policy interest rate will be about 25 basis points higher over the projection horizon than it was prior to the summer. The challenge for monetary authorities is to determine the persistence of this tightening and re-intermediation, because it could affect the conduct of monetary policy going forward. Aside from this issue for monetary authorities, this summer's events have led to policy challenges in other areas that are of mutual interest to central banks, regulators, and private sector financial institutions. Let me spend some time now discussing two of them: those related to transparency and those related to liquidity. Let me begin with transparency. Following the events of this summer, it may take awhile to achieve an appropriate pricing of risk, because it will take time to unravel some of the complex, opaque structured products to get to the underlying assets, and then find values for the assets themselves. Over time, market forces can be expected to work this out. But, to operate efficiently, markets need information. So, it is in the interest of market participants to make sure that parties have access to all the necessary information. Once again, Charles Dallara put it well in his letter to the IMFC. He wrote: "disclosure practices need to be improved so as to allow investors and other market participants to properly assess and price risk, thus effectively exercising market discipline." The desired outcomes are clear enough: Investors should demand greater transparency where it is now lacking. Vendors of financial instruments will then need to structure them in such a way that market players can clearly see what they are buying and what leverage is embedded in the instrument. And credit-rating agencies will have to be clearer about the basis on which their ratings are assigned. But fundamentally, investors and investment advisers must take on more responsibility for diligent research, so that they can better understand the nature of their investments, instead of simply relying on the word of credit-rating agencies. Many, indeed, perhaps most, of these desired outcomes can, and should, be accomplished through natural market forces responding to these events. For example, when investors demand much higher rates of return for opaque products, there will be a strong incentive for vendors to provide products that are more transparent. However, markets will work only if issuers follow the basic principle of providing clear, straightforward, pertinent information about the security that they are selling. Further, this information needs to be provided in a way that is understandable to the reasonably informed investor. Put another way, the prospectus or term sheet should inform, not obfuscate. If I can draw an analogy, just as food companies are required to list all ingredients on their labels, so should issuers list the "ingredients" of a security. And just as food companies are required to provide that information in a sufficiently clear manner, so that people who can't tolerate peanuts, for example, know that there are peanuts in a product, so should securities issuers be sufficiently clear. But I want to emphasize my key point - the best route to increased transparency is the use of market forces, rather than detailed, prescriptive, and potentially burdensome regulations. Similar principles of transparency should apply in terms of the role of credit-rating agencies. And again, market forces can be quite useful in achieving appropriate levels of transparency. Let me elaborate on this point by referencing our experience with ratings for asset-backed securities in Canada. We had a situation where the same rating system was being used for very different types of securities. At one end of the spectrum were the most basic, plain-vanilla asset-backed securities, where the nature of and risks associated with the underlying assets were clear. At the other end of the spectrum were the most complex securities, where the risks were less clear, the underlying assets could be synthetic and could not be readily traded, and where significant leverage may have been embedded. It seems obvious that the same rating system is not appropriate in these different cases. So credit-rating agencies should make it clear that their ratings for complex, opaque securities ought not to be used in the same manner as ratings for conventional bonds issued by single-names. There have been calls for stricter regulations for credit-rating agencies. After significant market events, it's always appropriate to review the regulations and our roles as governments, central banks, and regulators in terms of these ratings. But I would caution against any knee-jerk regulatory response. Given recent events, it seems likely that those credit-rating agencies that do not work harder to ensure that users understand the nature of their ratings will soon have fewer clients willing to pay for their services. The general principle in securities markets is that disclosure should be clear and transparent. And insofar as credit-rating agencies observe this principle, the use of market forces is once again the preferred route to the desired outcome, rather than burdensome regulation. Now let me discuss some issues related to liquidity. I'll start with a point that may appear to be obvious, but is quite important, given this summer's events. Ultimately, it is banks, and only banks, that can provide liquidity throughout the financial system, because it is only banks that have access to the ultimate source of liquidity: the central bank. Why is this important? The financial system has evolved steadily over the past few decades. If you think back about 50 years or so, the lion's share of financing was provided through banks. Now, most financing is done through markets. But securities markets do not access central bank liquidity facilities. And so, when market liquidity dries up, as it did in money markets this summer, it falls to the banking sector to provide liquidity. The recent market turbulence has shown that this re-intermediation back to banks has had implications that had not been anticipated. Indeed, these events have highlighted the increased importance of liquidity in a market-based financial system and the risks to the system when there is a rapid erosion of market liquidity and banks are called upon to quickly provide liquidity and credit. This re-intermediation has taken place following a period that saw an expanding use of securitization, where assets such as loans, credit card receivables, and derivatives were bundled and sold as asset-backed securities, often with significant amounts of leverage embedded. As I mentioned earlier, this process allowed banks and, in particular, nondeposit-taking financial institutions, to originate more loans than they would have if it had been necessary for them to hold these assets on their balance sheets. And it is the greatly expanded use of this securitization process, where loans were being originated for the purpose of distribution, that led to the relaxation of credit standards that Charles Dallara referred to. Again, this does not mean that the expanded use of securitization per se is a bad thing. Indeed, there are many examples of well-structured products that have dealt with the principal-agent problem that was, in many ways, the root cause of the relaxation of standards in the U.S. subprime-mortgage market. But the question can be asked: "Are there ways to encourage the more appropriate use of securitization?" It may be possible, for example, to have asset-backed securities carry some manner of "branding" or "certificate of origination" that would provide a clear incentive for the loan originator to exercise due diligence in extending the loan before it is securitized. Or, we can look for ways to encourage more originators or conduits to keep a portion of the product they are selling on their books - in particular, a portion of the riskiest tranche. So, there are market-based ways that could help to resolve the problems in the market for asset-backed securities. Given time and increased transparency, the market for assetbacked securities should normalize, since it serves an important function for market participants by helping to distribute and diversify risk. This entire market is not dead. But it seems clear that investors will, at the very least, seek greater returns for opaque, complex instruments than for well-branded, plain-vanilla asset-backed securities. The specific market for asset-backed commercial paper is a somewhat different story. Because this short-term paper must be redeemable at maturity, despite the longer-term assets that back it, it must carry a guarantee from a liquidity provider. So, there is a question of how liquidity providers should take into account the potential for liquidity calls to be made, both in terms of the capital they hold against this potential, and the liquidity of the assets on their balance sheet. This issue, which came to the fore this summer, represents a key challenge for the members of the IIF. How do you make provisions for liquidity calls that may come against the guarantees that your institutions provide, and for the support of products that represent a reputational risk should they fail? These are not easy questions to answer, but it is important that you provide your own answers and be prepared to discuss them with your regulator in the context of the implementation of Basel II. And I am pleased to see that the IIF has been working hard on these particular issues. Finally, this summer's turbulence has raised a number of system-wide issues related to liquidity. In the event of a serious disruption in securities markets that would threaten financial stability, are there policies that would be helpful? The Financial Stability Forum has been looking at this issue. And of course it is not only commercial banks that need to worry about this, it is also a problem for central banks in their role as the ultimate providers of liquidity to the banking system. Over the summer, central banks have seen that their standing liquidity facilities have worked quite well with respect to the market for overnight funds. Different central banks have different practices and facilities in place to provide liquidity to the banking sector. In Canada, we have clear rules for accessing our Standing Liquidity Facility to cover routine overnight liquidity needs. And we have clear rules regarding emergency lending assistance for individual solvent banks with acute liquidity problems. But are there principles that would suggest that some market failures would be best dealt with if we had a readily accessible facility that would provide liquidity to banks at terms longer than overnight, collateralized with a possibly wider range of securities? Such a facility would have to allow for suitable term premiums and penalties. The types of market failure that such a facility would be designed to deal with would obviously need to be thoroughly examined and discussed, as would the pros and cons of any specific proposal, including a consideration of all other issues that might be generated. The experience of other countries suggests that it is difficult to avoid having a stigma attached to the users of such a facility. But such a facility would be designed to help to mitigate system-wide tightness. And such a facility would have to be set up so that it is clear that the Bank would not use it as a backdoor route to easing monetary policy. I would be very interested in hearing your views on this topic. Of course, the events of this summer have raised concerns beyond the issues I have just mentioned. The Bank of Canada is working closely with the Department of Finance and other Canadian regulatory authorities in reviewing this summer's events and the issues that they have raised. I hope the IIF will address these liquidity issues, because I truly believe that effective, private sector, market-based solutions are more likely to be efficient and are more likely to provide scope for institutions such as yours to achieve the desired outcomes without choking off the innovations that have proven so helpful to the financial system over the years. Let me conclude. The challenges that have been posed by the recent market turbulence are global in nature. And so it follows that the responses to these challenges should also be global in nature. The logical forum for policy-makers to deal with this issue is the Financial Stability Forum. And indeed, the FSF has formed a working group to look at the risk-management practices of financial institutions in terms of liquidity, market, and credit risk, including how complex credit products and investment vehicles are treated and disclosed. The group will look at a number of issues, including accounting and valuation procedures for financial derivatives, particularly those that are narrowly traded or difficult to price in times of stress. They will also look at the role of credit-rating agencies in evaluating and rating structured products. The FSF working group is also looking at the basic principles of prudential oversight for regulated financial entities, especially relating to exposures and contingent claims and liabilities, both on- and off-balance sheet. The working group hopes to complete an interim report in the next few months, and then present a final report to G-7 ministers and central bankers at the spring meetings of the IMF next year. But, as I noted throughout my remarks, it may well be that the best responses to the challenges I've mentioned come, not from policy-makers, but from the financial institutions at the heart of the turbulence. And so I ask the membership of the IIF to continue to think about and work on the challenges I've mentioned today. Is there a way to accomplish the outcomes we all desire primarily through the use of market forces? Much of the groundwork may have already been laid. I know that, back in March, the IIF put out a report on the principles of liquidity-risk management. This report touches on many of the challenges and issues I outlined today, and makes recommendations for both the private sector and policy-makers. The report also says that the IIF hopes to generate a constructive dialogue. I applaud this sentiment, and I hope that my comments today can further that dialogue, so that we can move forward together to find answers to the challenges that face us all.

r071106a_BOC

canada

North America in Today's Global Economic Setting

jenkins

Good afternoon. I'm very happy to be here today and to have the opportunity to address the Canadian Association of New York. The goals of the organization, as set out in your mission statement, are laudable ones. And I hope today to make a contribution towards your efforts "to disseminate information and knowledge relating to Canadian business." In recent months, much has been said, and written, about developments in financial markets. The turbulence in global credit markets, which had its roots in developments in the market for subprime mortgages here in the United States, has been a focal point of attention for market participants and policy-makers around the world. At the Bank of Canada, we have worked hard to understand the causes of this financial market turbulence and assess the implications. But while attention has been focused on financial markets, it's important not to lose sight of other developments and trends with implications for the real economy. So today, I want to switch the focus back on to the real side of the Canadian and U.S. economies. What I plan to do is discuss the implications of global economic trends for the evolution of the ties between our two economies. First, I want to look at how the economic links within North America have been evolving. Second, I'll talk about how trends in the global economy have been affecting those links. Then, I'll look at some of the policy implications of these evolving trends, and close with a few words about the state of the Canadian economy. Let me begin by going back almost exactly 20 years to the signing of the original U.S.Canada Free Trade Agreement (FTA) in October 1987. Since this watershed event, businesses on both sides of the border have cemented the already-close economic ties that existed between our two countries. This agreement recognized the growing importance of trade for both economies. Of course, Canada does rely more on trade than the United States. But since the implementation of the FTA in January 1989, trade flows measured in constant dollars have more than tripled for both countries, and trade as a share of GDP has risen sharply. Indeed, more broadly, the volume of world trade has risen at an annual rate of 8.4 per cent since 1990, compared with an average annual rate of growth for world GDP of 3.75 per cent over the same period. It is safe to say that this tremendous growth in world trade has been far greater than anyone had expected. Given the close trade ties between our two economies, it is not surprising that there has traditionally been a rather strong correlation between economic growth rates in Canada and the United States. Our economies have tended to move fairly closely together throughout economic cycles. So it's not hard to see how, for example, developments in the auto sector in the United States are felt almost immediately in Canada, or how swings in housing starts in the United States affect Canada's forest products industry. In the Bank's latest , we noted that our base-case economic projection for the United States incorporates a 15 per cent decline in residential investment this year, and a further 11 per cent drop next year. All else being equal, our analysis suggests that this would lead to a reduction in the growth of Canada's GDP of 0.4 percentage points this year and 0.3 percentage points in 2008. Following the implementation of the Free Trade Agreement, Canada began to send an increasing share of its exports to the United States. From 1990 to 2000, the percentage of Canadian goods exported to the United States rose from just under 75 per cent to just under 87 per cent. Of course, the original FTA turned into the North American Free Mexico has also increased the concentration of its exports that go to the United States, reaching a peak of about 89 per cent in the year 2000. But below the surface, the story is much more interesting and complex. While the share of Canadian and Mexican exports to the United States remains higher today than before free trade, the share of imports received by both countries from the United States is not higher. Further, the year 2000 looks to have been a turning point. With the accession of China to the World Trade Organization in 2001, that country and, to a lesser extent, India started to become increasingly important global players. So the share of both Canadian and Mexican exports to the United States began to decline at about that time, while both countries began to import more from outside North America. I don't want to overstate the situation. The United States remains Canada's most important import source and export destination by far. But despite these close ties, it is clear that developments in the global economy have affected the economic links between Canada and the United States. To understand how these links are changing, it's important to understand the differences in how the structures of the U.S. and Canadian economies have been responding to recent global developments. Over the past decade, we have seen a number of economic shocks that have affected the U.S. and Canadian economies differently. Why has this happened? Part of the reason has to do with the rise to prominence of economies such as China and India. Because of their size and their growing share of world output, it is their influence, rather than the U.S. economy, that is increasingly shaping the global business cycle and determining the prices of traded goods, including commodity prices. The other, related, reason why our two economies have been affected differently is, of course, the fact that commodity-price shocks result in opposite movements in the terms of trade for Canada and the United States. This means that when Canada's terms of trade have improved - that is, when Canadians receive higher prices for exports and pay lower prices for imports - the terms of trade for the U.S. economy have tended to deteriorate. And the situation has been the reverse when Canada's terms of trade have deteriorated. What this negative correlation in the terms of trade tells us is that even though the two economies are integrated, they have very different structures that, quite naturally, respond in different ways to certain shocks. Consider both the Asian crisis of 1997-98 and the events of the past five years or so, as China and India have risen to economic prominence. Both of these events have had significant implications for the economies of In the case of the Asian crisis, we saw a marked slowdown in global economic growth, which resulted in a sharp decline in the prices for many of Canada's primary commodities. With these swings in relative prices, Canada saw its terms of trade deteriorate, while the U.S. terms of trade improved. In these circumstances, we saw a decline in the exchange rate for the Canadian dollar against the U.S. dollar. These movements sent price signals that triggered important shifts across sectors and regions of the Canadian economy. With lower commodity prices, resources flowed out of commodity-producing sectors and into sectors such as manufacturing. But over the past five years, we have seen essentially the reverse take place. There has been very vigorous global growth, accompanied by high prices for the commodities that Canada produces. As a result, Canada's terms of trade have seen a sharp improvement, while the U.S. terms of trade have deteriorated. And the Canadian dollar has appreciated against the U.S. dollar. Not surprisingly, resources have shifted back to the production of commodities where prices have risen, and away from sectors such as manufacturing. Economic data clearly illustrate the structural changes that have been brought about by the integration of China and India into the global economy and by the increasing competition coming from emerging economies more generally. Consider Canada's manufacturing sector. This sector expanded in terms of both its share of employment and its share of GDP, following the implementation of the original Free Trade Agreement. And, as I just noted, the sector expanded strongly in the wake of the Asian crisis. But since 2000, in the face of high commodity prices, a strong dollar, and rising competition from Asia, Canada's manufacturing sector has declined in terms of its shares of employment and output. So what are the implications of these developments for policy-makers? In answering that question, I want to make a general observation, and that is the importance of allowing market-based adjustment mechanisms to work in an economy. Markets send price signals that indicate the best way for resources to be allocated to the highest value-added activities. This implies that policy-makers should not try to impede or frustrate these market signals. And it implies that our economies will be best served by policies that promote flexibility - policies that allow economies to respond to price signals and to adapt to changing circumstances. Let me make three points about how policy-makers can encourage flexibility. The first thing to note is the importance of continuing to promote free trade, and resisting the siren song of protectionism. We must never forget that trade - whether in goods or services - is a positive-sum game. That is to say, in the end, all countries can be winners. But if countries yield to protectionist pressures, everyone in the international community will be worse off in the end. 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, protectionism will only result in trade flows being diverted to other countries. But to support an open and robust global trading system, we also need to actively support a market-based international financial system. Policies that thwart market-based economic adjustments can threaten global growth and stability. That is why we at the Bank of Canada have been quite active in saying that surveillance at the International Monetary Fund should be focused on countries that are following policies that do not allow market-based adjustments to take place. The second point I want to make is the importance of sound macroeconomic policies. I'll confine my remarks here to monetary policy. Although there are differences in approach, both the Bank of Canada and the U.S. Federal Reserve have inflation control as a fundamental goal, with that goal supported by a floating exchange rate. For an economy as open as Canada's, having a flexible exchange rate is a critical element in allowing it to pursue an independent monetary policy that is appropriate to its specific domestic circumstances. And by focusing on inflation control, both the Bank of Canada and the Federal Reserve are allowing changes in relative prices to send those clear signals that help the economy adjust to different circumstances. Of course, it is not easy for businesses competing in the global economy to adapt to sharp movements in exchange rates. But movements in exchange rates encourage the kinds of adjustments that are necessary in response to economic shocks. In the absence of a floating exchange rate and with limited labour market mobility between Canada and the United States, the adjustment that would otherwise take place would be significantly more costly and more difficult. The third point I want to make is the need to have structural or microeconomic policies in place that encourage flexibility and adaptability. In Canada, we have made good progress in improving the flexibility of our economy. This is evident in the way that the economy has been able to adjust to the various shocks that have come its way in recent years. Indeed, although these shocks have had different effects across sectors and regions of the country, growth in overall output and employment has remained solid, while inflation has remained low and stable, as resources have shifted to those sectors whose products have been in high demand. But this does not imply that we should not be looking to improve Canada's structural policies. There are some priority areas in this regard. Considerably more needs to be done to enhance the flexibility and functioning of our internal markets from coast to coast. Business regulations and standards, including those for the financial sector, need to be harmonized across Canada. And, to make our labour markets more flexible, trades and professional designations should be recognized and fully transferable across the country. Columbia and Alberta is an important step in that direction. But more progress of this sort is needed in Canada. Policies that support flexibility can obviously help economies adjust to economic shocks. But there is also a longer-term payoff that can come from encouraging flexibility. When policies provide the right environment for entrepreneurship to flourish, economies can adapt to longer-term global economic forces and continuously exploit their comparative advantages. Consider some of the iconic firms here in the United States, and how a company such as IBM has evolved. IBM was once primarily a manufacturer of "business machines," as its name implies. But as other countries and economies developed and became better placed to manufacture goods, IBM redefined itself and used its comparative advantage to become a "business solutions" firm, offering software, consulting, and even financing services in addition to computers. Let me now turn to recent developments. A little more than two weeks ago, the Bank published its In that document, we noted that growth in the Canadian economy has been stronger than projected, supported by the robust global economic expansion and strong commodity prices. Canada's economy is now operating further above its production potential than had been previously expected. We also noted three major and related developments since the summer that have affected the outlook for the Canadian economy. First, the Canadian dollar has appreciated sharply. In the , we noted that while the dollar has been supported by firm commodity prices, and strong domestic demand, the magnitude of the recent appreciation appears to be stronger than historical experience would have suggested. The second major development affecting the Canadian outlook is the weakening of prospects for the U.S. economy, and the third is a tightening of credit conditions. Despite these tighter credit conditions, the momentum of domestic demand in Canada is expected to remain strong. But the combined effect of a weaker U.S. outlook and a higher assumed level for the Canadian dollar implies that net exports will exert a significant drag on the Canadian economy. Given these developments, the Bank revised its projection for growth. We now project Canada's gross domestic product to grow by 2.6 per cent in 2007, 2.3 per cent in With the economy moving back towards balance, and with the direct effect of the stronger Canadian dollar on consumer prices, core inflation is projected to gradually decline to 2 per cent in the second half of 2008. Total CPI inflation is expected to peak at about 3 per cent later this year and then move back down to the 2 per cent target in the second half of 2008. But there are a number of upside and downside risks to the Bank's inflation projection. The main upside risk is that excess demand in the Canadian economy could persist longer than projected. The main downside risk is that output and inflation could be lower if the average level of the Canadian dollar were to be persistently higher than the 98 cents U.S. level that we assumed in the , for reasons not associated with demand for Canadian products. Given recent information, both the upside and downside risks appear to be greater than they were when we completed the . In the , we said that after considering all factors, we judge that the risks to the Bank's inflation projection are roughly balanced, with perhaps a slight tilt to the downside. And we also said that we judge, at this time, that the current level of the target for the overnight rate is consistent with achieving the inflation target over the medium term. Let me conclude. The Canadian and U.S. economies remain highly integrated, and there is every indication that our economic ties will remain strong. But developments in the global economy and the growing prominence of emerging economies have important implications for policy-makers on both sides of the border. Indeed, while our economies are highly integrated, they have different structures, and they respond differently to shocks that are increasingly global in either nature or origin. So, it is important that policy-makers heighten their focus on the need to promote and enhance flexibility. Our economies must be able to adjust to changing circumstances. If we are successful in this effort, not only will both the Canadian and U.S. economies be able to deal with economic shocks, but we will also be able to sustain strong economic performance in North America. And that is the best outcome for Canadians and Americans alike.

r071120a_BOC

canada

Managing Risks to Financial System Stability

duguay

Good afternoon. I'm very pleased to be here today. When I was offered the opportunity to speak to you, early this year, I thought this would be the perfect occasion to promote the Bank of Canada's work on financial system stability, to share our assessment of some of the risks and vulnerabilities facing the system, and to underscore the necessity of striving continuously to identify emerging risks, to understand the possible consequences, and to implement measures to contain the impact, should they materialize. The recent dislocations in credit markets have brought these issues into sharp focus. Among other things, the market turbulence has highlighted the critical role that confidence and liquidity play in financial markets. Confidence in the ability of the financial system to withstand shocks is essential if savers are to be encouraged to put their money into investments, and liquidity is a prerequisite to trade and price discovery in financial markets. The recent events also drove home the fact that shocks never materialize in quite the manner that we expect. Certainly, many of the individual sources of the recent turbulence in global financial markets had been apparent for some time, prompting warnings from numerous stakeholders, including the Bank of Canada. Among the concerns expressed was a fear that, in their quest for higher yields, global investors might have underpriced risk and rushed into products whose complexity made it extremely difficult for them to judge the risk exposure they were assuming. But while these key sources of vulnerability had been correctly identified, no one anticipated the extent of the strains that developed in the interbank money markets. With this as background, I'd like to explore a few of these issues from the Bank of Canada's perspective. I've organized my thoughts around five general questions. First: Just what do we mean by financial system stability, and why does it matter? Second: What is the Bank of Canada doing to foster stability? Third: What lessons are we learning from the recent turbulence? Fourth: What is being done at home and at the international level? And fifth: What can you, as chartered financial analysts, do to help? I will then close with a few words about Canada's current economic situation. To begin, let me focus on what I mean by financial system stability and why it matters. The financial system is composed of financial institutions such as banks, caisses populaires, pension funds, and insurance companies; financial markets such as debt and equity markets; and settlement arrangements such as the payments and securities settlements systems. The financial system provides the channels through which savings become investments, money and financial claims are transferred and settled, and, ultimately, risk is allocated. A key role of the financial system is to provide insurance against adverse economic outcomes by allocating risk to those who are most willing and most able to bear it. The result is a more effective allocation of capital which, in turn, can contribute to more productivity-enhancing investments and improved living standards. But for the financial system to perform this important role, households and firms must have confidence in its ability to withstand shocks. This is a crucial point, because problems in one area of the system can quickly spread, as recent events have vividly demonstrated. Thus, to help the financial system perform its role efficiently, public authorities and market participants themselves put a great deal of effort into finding ways to strengthen the system. And since shocks can never be fully anticipated in advance, we must strengthen the shock absorbers in the system, while still allowing room for innovation. This involves such elements as a secure system for large-value payments, deposit insurance, bankruptcy laws, central bank provision of liquidity, and sound riskmanagement practices, including capital cushions and prudential regulation. Let me be very clear, the goal of these shock absorbers is not to prevent losses, but to absorb them without impairing the effective functioning of credit markets and the financial system in general. And because the best levees can break down in a hurricane, we need strong crisis management that will mitigate the fallout from financial shocks without weakening the incentives for prevention of such breakdowns. One method that is increasingly being used to gauge the robustness of the financial system is the conduct of simulations to identify vulnerabilities to extreme shocks . stress testing of the Canadian financial system was undertaken recently through the Canada used its models to design a macroeconomic scenario involving a disorderly resolution of global imbalances and to assess the possible impact on corporate default probabilities by sector. Major Canadian banks were then asked to estimate the losses they might incur under such a scenario, and their results were assessed by the central bank, the obtained from their own less complex models. The results generated by sophisticated internal models used by banks were broadly in line with those generated by the Bank of Canada and the Fund. They showed that major Canadian banks have enough capital to withstand a severe macroeconomic shock. This is useful information, but such simulations do not tell the whole story. For instance, they ignore important feedback from market participants. Factoring these effects is no easy task, but it is a prerequisite to a full assessment of risk in the financial system. This is an active area of research at central banks, including the Bank of Canada, as well as at international organizations such as the Now, let me talk more specifically about the Bank of Canada's role in helping to maintain a robust financial system, the second of my five points. Promoting financial system stability is a common goal for a number of public and private sector bodies, both nationally and internationally. In Canada, the public sector responsibility is shared among a number of agencies including the central bank, the Department of Finance, OSFI, the Autorite des marches financiers , and provincial securities commissions. As Canada's central bank, our key functions in the area of financial system stability are to provide liquidity to facilitate the settlement of financial transactions and to ensure that the risks of a systemic disruption in the payments and settlements systems are virtually eliminated. The Bank also contributes to financial stability by providing an environment of low, stable, and predictable inflation through monetary policy. We use our key position at the centre of Canada's financial system, our membership in international Settlements, and the Financial Stability Forum - and our extensive research capabilities to foster the safety, soundness, and efficiency of the financial system in Canada and internationally. For example, the Bank has been an active promoter of improved transparency in domestic markets and of IMF reform - including strengthened IMF surveillance - internationally. The promotion of financial system stability is complementary to our conduct of monetary policy in two ways: First, because monetary policy works through financial markets; and second, because financial turbulence may affect aggregate demand and require a monetary policy response. For example, a reassessment of default risk that increases risk premiums and results in tighter credit conditions may require a lower policy rate than would have otherwise been the case. We communicate our research and analysis of trends and developments in the financial system, including policy and infrastructure developments, as well as our assessment of systemic risks and vulnerabilities, in our semi-annual The next issue of the FSR will be published on 6 December and will examine, among other things, recent developments in the market for asset-backed commercial paper, as well as the current debate around credit-rating agencies. The FSR will be available on our website on that date. That's a quick overview of the work that we do to strengthen financial system stability. Now, let me go on to the third question that I raised in my introduction, which relates to the lessons we've learned from this year's turbulence in global financial markets. While the turbulence is not over, it is not too early to begin to probe its causes and effects and start to draw lessons as to how we can strengthen the ability of the financial system to deal with stress. The recent turbulence was triggered by greater-than-expected losses on U.S. subprime mortgages, which unexpectedly spread around the world because these mortgage loans were re-packaged into opaque structured products funded, in many cases, by short-term asset-backed commercial paper. Liquidity evaporated in the market for structured products as investors shunned them. A flight to the safety and liquidity of government securities ensued, and credit spreads increased. Many commercial banks were affected, with the impact coming from such sources as their direct holdings of these structures, their commitments to provide funding to conduits, their difficulty in securitizing loans, and the fact that companies began to fall back on their bank lines of credit. At the same time, many banks became reluctant to make loans to one another because of uncertainties around counterparty risk and about their own future funding needs. The effect was to increase the cost and reduce the availability of credit, both in Canada and globally. In Canada, the ABCP problem took on a unique characteristic since non-bank sponsors had issued paper with restrictions on the back-up lines of credit which prevented their access to these lines. This prompted a call for a standstill (known as the Montreal Proposal) to effect an orderly workout for most of these ABCP conduits. The standstill period has been extended to 14 December and it has been reported that progress is being made in the negotiations to convert short-term paper into medium-term tradable financial instruments. Although some dislocation continues, it appears that the financial system has thus far weathered the turbulence reasonably well. Canadian and global banks have had large enough capital cushions to withstand the shock and support an expansion of their balance sheets. Canadian banks have been able to issue medium-term paper and capital-eligible subordinated debt to meet existing and future funding needs. However, it is clear that there is now a greater awareness of risk - an awareness that was slow in developing, despite numerous warnings of the possibility of a sudden repricing of risk in credit markets. And this repricing is being hampered by a lack of liquidity in markets for some structured products because of the complexity and opacity of these new products. In a sense, we are witnessing the growing pains of an immature segment of the market, a segment that did not exist five to seven years ago. So, there are lessons to be learned and corrections to be made. Most of the corrections will undoubtedly be driven by market participants themselves, who will seek greater disclosure and greater standardization of structured products, and who will adopt stronger risk-management practices, including lesser reliance on credit ratings. The recent market events have made crystal clear just how crucial disclosure is to financial markets. To operate efficiently, markets need information. At the heart of the summer's market turbulence were structured products that were so complex and opaque that even some sophisticated investors couldn't understand exactly what they were buying. This lack of transparency led to a breakdown when investors started to question the value of the assets backing the securities that they owned. So, it is in the interest of market participants to make sure that all parties to a transaction have access to all the necessary information. Investors must demand greater transparency where it is now lacking. Vendors of financial instruments will then need to structure them in such a way that market players can clearly see what they are buying and what leverage is embedded in the instrument. In this way, market discipline will be more effectively exercised. Credit-rating agencies can help with this by being more forthcoming about the assumptions on which they based their ratings, and by adjusting their ratings promptly when circumstances require. The role credit-rating agencies played in the recent market turmoil has generated a great deal of debate. Bank of Canada research to be published in next month's FSR notes that there are some natural self-correcting market forces at work, which should help to ensure that rating agencies improve their rating process in the future. There may still be a useful role for regulators in fostering an industry-led code of conduct and in reconsidering the role that ratings play in various regulations. But they should avoid any knee-jerk response to calls for stricter regulations for rating agencies. Allowing market forces to chart the route to the desired outcome is generally preferable to burdensome regulation, which may have the unintended consequence of absolving the regulated entity from responsibility for its ratings. One important lesson from recent developments is just how vital liquidity is in a marketbased financial system. We saw very clearly this summer how banks may be called upon to fill the gap by providing credit when there is a sudden erosion of market liquidity. This is because only banking institutions, including credit unions and caisses populaires centrals, can provide liquidity throughout the financial system, since only these institutions have direct access to the ultimate source of liquidity: the central bank. But the modern financial system has evolved in such a way that, today, financing is increasingly done through securities markets. And the recent turbulence has shown that sudden reintermediation when liquidity dries up can have implications that had not been anticipated. The provision of liquidity through regular operations - the Bank of Canada's standing liquidity facility to direct clearers, our supply of settlement balances in the Large Value Transfer System, and our open-market buyback operations with primary dealers - has been effective in keeping the overnight rate close to target. However, liquidity further out the maturity spectrum was more problematic, owing in part to the precautionary build-up of liquidity by financial institutions. This raises the question of whether some market failures might be better dealt with if the central bank had a facility that would provide liquidity at terms longer than overnight, collateralized with a possibly wider range of securities. The types of market failure that such a facility would be designed to deal with would obviously need to be very carefully considered to avoid weakening the incentive for preventative risk and liquidity management by market participants. That being said, it is the case although term money market spreads remain wider than usual, they have narrowed considerably, and the market is functioning. Indeed, liquidity has returned in the market for bankers' acceptances. Since the recent market turbulence has been felt around much of the globe, you won't be surprised to hear that the issues that I've highlighted thus far are being actively discussed at a global level. And this brings me to my fourth point, which is the international perspective . The global community - market participants, regulators, and policy-makers alike - are all examining the causes and effects of this summer's events and attempting to distil lessons from them. Important work has already begun through a number of international bodies, including ministers and central bank governors to establish a working group to identify weaknesses that merit attention from policy-makers, and to recommend actions to enhance market discipline and institutional resilience. The working group, which includes Canada's Superintendent of Financial Institutions, is looking into a number of issues. First is the financial institutions risk management practices including liquidity management, stress testing, and assessment of counterparty risk. Second, the FSF group is also probing valuation and risk disclosures, including the role of credit-rating agencies. Third, it is reexamining the principles and practices of prudential oversight, particularly with respect to off-balance-sheet exposures. And fourth, it is exploring issues related to the authorities' capacity to respond to market turbulence, including the tools available to central banks and supervisors in times of distress . Numerous other bodies - IOSCO, the Basle addressing many of these issues. Market participants, including financial institutions, hedge funds, and rating agencies are also assessing the need for changes in light of recent events. For example, the Institute of International Finance has established a committee to review a host of issues, including risk management, the use of off-balance-sheet vehicles, the valuation of complex products, and transparency. To this point, I've talked about the efforts that are being made at the institutional and international levels to understand the reasons behind the recent market turbulence and draw lessons for the future. Now, for my fifth and final question, I'll turn to you, my audience, and ask: What can chartered financial analysts do to help? As I said earlier, disclosure is a very important principle in financial markets, one that seems to have been lost in the period leading to the latest turbulence in credit markets. But effective disclosure goes beyond making information available. It involves ensuring that the information is understood by investors. This is an area where you can play an important role. Investors must demand greater transparency where it is now lacking, and credit-rating agencies will have to be more forthcoming about the basis on which their ratings are assigned. But all of you, as investment professionals, have a special responsibility for diligent research and for helping your clients understand the nature of their investments. I'm glad to see that this is reflected in the CFA code of conduct, which requires that members: "use reasonable care and exercise independent professional judgment when conducting investment analysis, making investment recommendations, taking investment actions, and engaging in other professional activities." Let me now say a few words about what we economists call the "real side" of the economy. The recent turbulence in global financial markets has occurred at a time of robust global economic expansion and strong commodity prices. In the context of ongoing global developments, the Bank has identified several important issues and increased associated downside risks that currently face the Canadian economy. The marked volatility and sharp appreciation of the Canadian dollar warrant particular attention. Indeed, the volatility we have seen in foreign exchange markets has been extremely high and the magnitude of the recent appreciation of the Canadian dollar has been stronger than historical experience would have suggested. The weakening of prospects for the U.S. economy is another issue. At the same time, the Canadian economy is operating above its production capacity and the momentum in domestic demand has been strong in spite of the tightening of credit conditions that has occurred in the wake of recent financial market turbulence. As always, we at the Bank of Canada will be considering all the accumulated information on trends and developments in the global and Canadian economies, and their implications for the outlook for inflation in Canada, as we sit down to make our decision for the 4 December fixed announcement date. Let me conclude. The financial market dislocation that arose in the summer from the reassessment of credit risk has yet to fully run its course. But it seems that, so far, Canada has come through the recent turbulence reasonably well. There has been some tightening of credit conditions, but it appears that Canadian companies and Canadian banks are in a strong position to withstand the turmoil. Still, there are important lessons to be learned in terms of how we can continue to strengthen the resilience of our financial system. For our part, we at the Bank of Canada will carefully examine how liquidity is supplied to the economy. We will continue to do research to understand financial system mechanisms and developments so as to increase our ability to identify risks. And we will work with our partners to implement preventative measures. I am confident that you will do your part, too.

r071205a_BOC

canada

Opening Statement before the House of Commons Standing Committee on Finance

carney

I would like to begin by saying how pleased I am to appear before this committee to discuss my perspectives on the medium-term policy issues facing the Bank of Canada. I am looking forward to many future appearances before both this committee and its counterpart in the Senate, since a critical component of the Bank's accountability to Canadians is having the Governor appear periodically before Parliamentarians to explain the Bank's views on the economy, monetary policy, and the financial system. I would like, however, to emphasize at the outset that I am not yet the Governor of the Bank of Canada. Under the Bank of Canada Act, the current governor - David Dodge - remains very much responsible for Canada's monetary policy until the end of January. In recent years, the Bank has operated under a convention whereby monetary policy decisions are taken on a consensus basis by the Bank's Governing Council. I am also not yet a member of the Governing Council. And so, in answering your questions today, I shall endeavour to comment neither on the current stance of monetary policy nor on the economic outlook, so as to avoid prejudicing upcoming decisions of the Governing Council. I trust that all those listening will recognize these important caveats. Reflecting my current position, I would like to focus on the principal medium-term policy challenges facing the Bank. As set out in the preamble to the Bank of Canada Act, the Bank's objective is "generally to promote the economic and financial welfare of ank achieves this objective by: conducting monetary policy to maintain a rate of inflation that is low, stable, and predictable; promoting the safety and soundness of Canada's financial system; acting as the Government of Canada's fiscal agent to provide efficient and effective funds management; and supplying quality bank notes that are readily accepted and secure against counterfeiting. This is very important to the Bank, and we have worked closely with crown prosecutors as well as our partners in law enforcement - particularly the RCMP - and the retail sector to deter counterfeiting through bank-note-related education, communication, and compliance. These efforts have yielded important results, and they will continue. With that introduction, I will concentrate the balance of my remarks on the Bank's work in monetary policy and the financial system. With respect to monetary policy, I am in the fortunate position of inheriting an exceptionally sound and robust policy framework. Over time, it has become clear that the best contribution monetary policy can make to the promotion of the economic and financial welfare of Canada is to keep inflation low, stable, and predictable. Put another way, inflation control is not an end in itself; rather, it is the means whereby monetary policy can best contribute to solid economic performance. Specifically, the Bank aims to keep the annual rate of consumer price inflation at the 2 per cent midpoint of a 1 to 3 per cent control range. By doing so, monetary policy helps to keep the economy as a whole operating at full capacity and promotes sustainable economic growth. Canada has been served extremely well by its inflation-targeting policy framework, which has been widely emulated. The Bank's exemplary record of inflation control has meant that we have avoided the destructive effects of high inflation prevalent in earlier decades - effects that were disproportionately felt by poorer Canadians, and which reduced our output and increased our unemployment. Despite all the shocks that Canada has faced since inflation targets were introduced, Canada's real output since that time has expanded at an average rate of 3 per cent per year and the unemployment rate has fallen to levels not seen in more than three decades. As in countries where inflation targeting has been adopted, inflation and interest rates have generally been lower and less volatile. An explicit inflation target was first formalized in a joint agreement between the Bank and the Government of Canada in 1991. Given its initial success, this agreement has been extended four times with small modifications; most recently until the end of 2011. This agreement sets out one clear objective - the inflation target - and creates a transparent accountability framework for the Bank of Canada. The Bank supports that framework through frequent and open communication with Canadians. If inflation deviates from the target, the Bank will explain the reasons why, what it will do to return it to target, and how long the process is expected to take. It is important to underline that the Bank approaches inflation control in a symmetric way. A floating exchange rate is a key element of our monetary policy framework. It allows Canada to pursue an independent monetary policy appropriate to our own economic circumstances. Although there is no target exchange rate for the Canadian dollar, the Bank does care why the exchange rate is moving and what the potential impact will be on output and inflation. The exchange rate is an important relative price in our economy. Movements in the exchange rate influence the levels of imports and exports, which can help to keep total demand and supply in balance. Further, exchange rate movements act as a signal to shift resources into sectors where demand is strongest. A floating exchange rate helps to smooth that process and to minimize the adjustments in other areas of the economy. The challenge for the Bank is to understand the reasons behind currency movements, incorporate those with our assessments of other data, and set a course for monetary policy that works to keep total demand and supply in balance and inflation on target. This means that the Bank has to make judgments about the causes and likely persistence of exchange rate movements, the speed and degree to which the exchange rate changes "pass through" to domestic prices, and the possible impact of exchange rate movements on confidence and, through confidence, on consumption and investment. It is true that exchange rate movements can be, and have been, rather volatile. In these circumstances, it is not surprising that some have called for Canada to fix its currency to the U.S. dollar. In my opinion, it would be a mistake to do so. It would mean that, de facto, Canada would adopt U.S. monetary policy, despite the reality that the structures of our economies are very different and, as a consequence, often require different types of adjustments in response to global developments. We cannot avoid adjustment; the question is simply how we adjust to global economic forces. With a fixed exchange rate, the adjustments would have to come through movements in overall output and in all wages and prices. History has shown that these adjustments are more protracted and more difficult than exchange rate adjustments. Again, however, I stress that this position does not mean that the Bank is indifferent to movements in the exchange rate. Another important aspect of our policy framework is the need to be forward looking, given the lags between policy actions and their effects on the economy. Indeed, a forward-looking perspective is essential to the success of inflation targeting. The joint agreement between the Government of Canada and the Bank of Canada on the inflation target has helped concentrate inflation expectations around 2 per cent. More fundamentally, the successful management of monetary policy by my predecessors has created a self-reinforcing process whereby increased policy credibility further anchors inflation expectations, which then contribute to a more stable macroeconomic environment, which, in turn, enhances policy credibility. We should not underestimate the value of these hard-won gains, and I have no intention of forfeiting them. Wellanchored inflation expectations help to reduce swings in interest rates, lower the cost of borrowing for Canadians, contribute to a more stable, competitive cost of capital for our firms, and, ultimately, support more sustainable growth in output and employment. Despite our successes, the Bank has an obligation to Canadians to continually evaluate possible improvements to its policy framework. As a result, the Bank has launched a concerted research program to examine whether and how the monetary policy framework in Canada might be improved. The program is focusing on the potential costs and benefits of targeting a lower rate of inflation, of pursuing a price-level target instead of an inflation target, and the challenges of communicating these potential changes to Canadians. The Bank will conduct this research and publish its findings in an open manner in order to encourage debate and suggestions. T he research would need to uncover compelling evidence in favour of a change before we would want to alter the system that has proven so successful over the past 15 years. The conduct of monetary policy over the coming years will be challenged by four underlying trends. Their precise speed is difficult to predict, but their influence will be impossible to ignore. First, the globalization of product, capital, and increasingly - given outsourcing and technology - labour markets; Second, the resolution of global imbalances. This requires both the need for stronger domestic demand growth in countries with large current account surpluses, and the move to a flexible exchange rate regime in those systemicallyimportant countries that currently actively manage their exchange rates. As the Bank has consistently noted, this process may proceed in an uneven manner; Third, the pace and direction of financial innovation and integration. This has important implications for the degree of financial intermediation, the levels of nominal and real interest rates, and the monetary policy transmission mechanism; and, Fourth, the evolution of potential growth in Canada, reflecting the balance of profound demographic changes and developments in Canadian productivity. These underlying economic and financial trends complicate the pursuit of our inflation target, not only because none is likely to proceed at a steady, predictable pace, but also because they are all interrelated. For example, global imbalances, financial integration, and historically low nominal interest rates can all be partially explained by the familiar process of global integration that is currently taking place on an unprecedented scale. The Bank must better understand these forces in order to effectively meet its responsibilities. It should also continue to share its perspectives on these broader trends so that individual Canadians, companies, and governments have the necessary context when making their savings and investment decisions. The strength of our financial system will help determine the ultimate impact of these trends, since each has the potential to affect asset-price volatility and the stability of growth and employment. Where financial systems are strong and resilient, they cushion shocks, efficiently allocate resources, and help improve the effectiveness of monetary policy. Where they are weak, however, they can amplify the impact of shocks on macroeconomic activity and reduce the effectiveness of monetary policy. As a consequence, the Bank has a fundamental role to play in promoting the safety and stability of Canada's financial system. The Bank's role in financial stability is at the heart of our legislated mandate to promote the economic and financial welfare of Canada. Before concluding, I would like to make five brief comments in this regard. First, as Canada's central bank, we have legislative oversight responsibility for the safety and soundness of systemically important clearing and settlement systems. Second, we play a central role in providing liquidity to facilitate the settlement of financial transactions. The Bank has traditionally undertaken open-market buyback operations only in Government of Canada debt, and offered standing liquidity facilities against high-quality collateral, in order to keep the overnight rate close to the target policy rate. However, recent events have raised questions over the appropriate role for central banks in the provision of liquidity in money markets. As my colleague Pierre Duguay noted last month, the Bank is currently examining whether some market failures might be best addressed if the central bank had a facility that would provide liquidity at terms longer than overnight, possibly secured with a wider range of securities. Third, the response to the recent turbulence in financial markets should reaffirm that market participants are fundamentally responsible for their actions. For example, investors must understand the price dynamics and liquidity risks of the products they buy, rather than relying solely on credit-rating agencies. The market is beginning to lead many of the necessary changes, as institutions are improving their liquidity management and credit discipline, and originators and distributors of new loans are beginning to adjust their products to standardize terms and align incentives. At the same time, accurate and timely information about underlying risks is essential for the market to differentiate and properly price risk. Thus, as Governor Dodge highlighted in September, enhanced disclosure and transparency are crucial. Fourth, recent global events have underscored the importance of continued close cooperation among authorities in Canada. The Bank will continue to work collaboratively with its partners, including the Department of Finance, OSFI, the Canada Deposit Insurance Corporation, and provincial securities commissions, to promote the safe and efficient operation of the key elements of our financial system. Finally, the Bank will continue to use its membership in international bodies, and its extensive research capabilities, to foster the safety, soundness, and efficiency of the international financial system. For example, the Bank and the Government of Canada have actively promoted reform of the International Monetary Fund through a strengthened surveillance function. Strengthened IMF surveillance can play an important role in the resolution of global imbalances and the development of a more robust international financial system. As part of the international response to recent market turbulence, the Bank is also working through the Financial Stability Forum as that body considers possible changes to accounting and regulatory standards and the extent to which enhanced oversight can improve the management of credit and liquidity risk in global financial institutions. In conclusion, let me say that it is an honour and a privilege to have been chosen to serve Canadians as the eighth Governor of the Bank of Canada. I am particularly looking forward to leading the Bank's talented and dedicated staff as we face the challenges of the years ahead. I will do my best to live up to the very high standards of those who came before me and am confident that my experience in both the public and private sectors will help me contribute to the Bank's important work on behalf of all Canadians.

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

dodge

Good morning, Mr. Chairman and committee members. Let me start by saying how much I have appreciated our semi-annual meetings with this committee over the past seven years. The discussions that Paul and I have had with you have been very valuable for the Bank of Canada. I hope that you have found them equally useful and that these regular appearances will continue long after I have left the Bank. Today's meeting comes just a couple of hours after we published the latest edition of our . But it has been quite some time since we issued our October . Nevertheless, I want to begin with the economic outlook as we saw it in October. I will then talk about developments since that time and our current assessment of the risks to the outlook. The Bank's outlook from October is summarized in of the . In October, we saw strong global economic growth continuing in 2008 and 2009, although we foresaw considerably weaker U.S. growth in 2008 than had previously been the case. The global outlook is summarized in Table 1. In Canada, we were looking for weaker economic growth in the fourth quarter of this year and the first half of 2008, but some strengthening thereafter. As you can see from Table 2, we were expecting continued strong final domestic demand throughout the projection period, but considerably weaker net exports. This outlook reflected weaker U.S. growth and a stronger Canadian dollar, which was assumed to average 98 cents U.S. over the projection period. Inflation was expected to peak in the fourth quarter of this year before returning to the 2 per cent target around the middle of 2008, as you can see Against this background, we left the target for the overnight rate unchanged at 4 1/2 per cent on 16 October, and judged the risks to our outlook to be roughly balanced with perhaps a slight tilt to the downside. Now, let me turn to developments since October. The Canadian economy continues to operate above its production capacity. Given the strength of domestic demand and weak productivity growth, there continue to be upside risks to the Bank's inflation projection. However, other developments since October suggest that the downside risks to the Bank's inflation projection have increased. Difficulties in global financial markets, related to the valuation of structured products and anticipated losses on U.S. subprime mortgages, have worsened since mid-October. These difficulties are expected to persist for a longer period of time than previously thought. In these circumstances, bank funding costs have increased globally and in Canada, and credit conditions have tightened further. There is an increased risk to the prospects for demand for Canadian exports since the outlook for the U.S. economy - particularly, the U.S. housing sector - has weakened. All these factors considered, the Bank judges that there has been a shift to the downside in the balance of risks around its October projection for inflation through 2009. In light of this shift, the Bank decided to lower the target for the overnight rate at our fixed announcement date on Tuesday. At our next interest rate decision in January, we will assess all economic and financial developments and the balance of risks, and have a full updated projection for the economy and inflation in the to be published on 24 January 2008. Mr. Chairman, Paul and I will now be happy to answer your questions.

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Reflections on Developments in the Canadian Financial System

dodge

Governor of the Bank of Canada to the Canadian Club of Toronto and the Empire Club of Canada I'm happy to be here in my home town of Toronto to deliver my final public speech as Governor of the Bank of Canada. Nearly seven years ago, I gave my first public speech in Toronto, so it is fitting that I should be here for my last. It has become a tradition that I deliver a speech late in the year on issues related to the financial system. When I say "financial system," I mean financial institutions and markets, together with the clearing and settlement systems through which financial assets flow. This tradition of speaking about the financial system began in 2004 with a speech I gave to a joint meeting of the Empire and Canadian Clubs about the need to promote economic efficiency in Canada. You may be asking why the Bank of Canada, with its well-known responsibility for monetary policy, would put such emphasis on financial system issues. The answer is that the two are tightly linked. We care a great deal about the financial system because a serious disruption in it would affect our ability to conduct monetary policy, and because increasing the efficiency of the financial system can increase the effectiveness of our monetary policy. At the same time, contributing to a stable economy through sound monetary policy helps reduce the risk of instability in the financial system. I'll talk about monetary policy a bit later. But first, I want to look back over the past seven years - in particular, the past seven months - and discuss some of the developments that we have seen in terms of financial system issues. To begin, I will give a brief overview of the Bank's role in the financial system, and review some of the issues I've raised in the past few years. Then, I will discuss the dislocations in financial markets that began during the summer, and talk about how problems related to information contributed to the market turbulence. Finally, I'll look at the effects that these events continue to have, both on financial markets and on the outlook for the Canadian economy. One reason for giving these financial system speeches near year-end is so that they coincide with the publication of the December edition of the Bank's (FSR). The purpose of my previous speeches was the same as the Bank's purpose in publishing the FSR; that is, to improve public understanding of financial system developments and trends, to point out potential vulnerabilities in the system, to highlight some of the Bank's research, and to promote discussion of financial system issues in general. Ultimately, the goal is to help provide the context that will lead to stronger financial system policies in Canada. The latest issue of the FSR was published last week, and it deals extensively with the market turbulence that began during the summer. The Bank actively works to promote a financial system that is both stable and efficient. I've already mentioned that financial instability can impair the Bank's ability to conduct monetary policy. But most importantly, a stable financial system is crucial for an economy to function well. In Canada, the responsibility for promoting financial stability is shared by a number of agencies. Our partners include the Department of Finance, the Corporation, and provincial regulators and securities commissions. The Bank is also the ultimate provider of liquidity to facilitate the settlement of financial transactions and is the lender of last resort for financial institutions. Despite the importance of financial system efficiency, there is no single body responsible for promoting it. What do I mean when I say "efficiency?" An efficient system is one where scarce economic resources can be allocated to the most productive uses in a costeffective way. In an efficient financial system, investors can get the highest risk-adjusted returns on their investments, and borrowers can minimize the costs of raising capital. Inefficiencies can stunt investment and cut into economic growth. The Bank of Canada contributes to financial system efficiency through our monetary policy, which keeps inflation low, stable, and predictable. We also have a legislated role to oversee Canada's most important clearing and settlement systems. These systems have been designed to provide certainty that large-value payments or securities transactions will settle in real time, while using relatively small amounts of liquidity. This frees up resources that can be put to better use elsewhere. Over the past four years, I have tried to highlight some important efficiency issues for I spoke of the need to promote efficiency in our financial institutions, arguing that our policy framework should provide greater incentives for innovation by encouraging competition while, at the same time, giving our financial institutions the scope to improve efficiency. There remains much work to do to encourage innovation, competition, and efficiency. I also spoke about the need to improve Canada's securities regulation so as to have uniform laws and regulations, based on principles that apply to everyone, but tailored to take into account the differing size and complexity of firms. There has not been as much progress here as I would have hoped. So, Canada remains at risk of seeing its capital markets eroded as business migrates to other financial centres. I've also talked about the need to improve enforcement in securities markets, because markets work more efficiently when they operate under clear, transparent, and reasonable rules and principles, which are enforced and are seen by all as being enforced. Some progress has been made here, and I welcome the commitment of the RCMP to improve and to implement many of the recommendations set out by Nick Le Pan in his report last week. However, much better co-operation and coordination of efforts among securities commissions, law-enforcement agencies, Crown prosecutors, and ministers of justice and attorneys general is absolutely crucial. Another efficiency issue I've raised is the need to strengthen Canada's regulatory, legal, and accounting frameworks related to private defined-benefit pensions, so that risks are dealt with in an appropriate way. Pension funds can generate important gains in terms of economic efficiency. They help to achieve a more efficient allocation of savings; they are invested by asset managers who have the incentive and the ability to invest across varied asset classes; and, with their very long investment horizons, pension funds can be used to finance long-term investment projects at competitive rates of return. Reviews of pension regulations are under way at both the provincial and federal levels. If we can collectively get these changes right, sponsors would have the appropriate incentives needed to manage risk effectively, thus enhancing the viability of our system of private, voluntary defined-benefit pensions for the good of Canadian workers and firms, and for the benefit of our capital markets. These issues are critical for Canada's future economic prospects. The role of the Bank of Canada has been to do the research and provide the analysis to inform public policy in these areas. I am confident that this work will continue at the Bank in the years ahead. It is up to the responsible authorities to act on these research findings, and to move these issues forward. At the heart of many of the issues that I've just mentioned are problems related to information. Indeed, one of the key lessons of the past seven months is how information asymmetries can lead to, or exacerbate, disruptions in financial markets. So let me now turn to a discussion of these recent events, and look at how problems with information contributed to the market turbulence. To truly understand these events, it's important to have some context. You can find a detailed account of recent events in the December issue of the FSR. The turbulence in financial markets came about against a backdrop of remarkable strength in the global economy. We had seen continuing robust demand for Canadian goods and services that led to a significant improvement in our terms of trade, helping to support the Canadian dollar. Despite this positive backdrop, there were signs of potential trouble in the global economy. As early as 2003, the Bank had flagged concerns about global imbalances. The high level of global desired savings relative to desired investment naturally served to drive down real longer-term interest rates, even as central banks around the world were in the process of raising short-term policy rates. With the decline in longer-term interest rates, investors stepped up their demand for riskier assets that would deliver greater returns. This search for yield led to a narrowing of spreads between the yields on risky assets and government bonds. This narrowing of risky spreads became so pronounced and so persistent that many central banks began to question whether they adequately reflected the credit risks that were involved. In fact, the Bank of Canada highlighted this precise concern as far back as our June 2004 issue of the A repricing of risk appeared necessary, but the real question was how, and in what manner, it would take place. Besides the need for a repricing of risk, other factors have contributed to the market turbulence that began this summer. Originators of loans - both bank and non-bank institutions - were increasingly opting to securitize the loans they made in the form of highly structured asset-backed securities, some of which embedded very significant leverage. These were often sold in tranches that provided varying degrees of protection from the default risk involved. Such structures allowed higher-risk assets to appear to take on the qualities of lower-risk assets. The increased use of leveraged structured products was pioneered in major financial centres such as New York and London, although eventually, non-bank institutions began to market these products elsewhere, including here in Canada. The ease with which these highly structured products were sold fuelled the demand for the creation of higher-risk assets, including U.S. subprimemortgage loans. This, in turn, contributed to the global decline in lending standards. At times, the originators of these loans had fewer incentives to carefully assess the creditworthiness of borrowers. This is because the originators were sometimes distributing all of the loans they had made. In these circumstances, once the loans had been securitized and sold, the originator no longer faced the consequence if the borrower defaulted. I'll return to this point a bit later. But for now, suffice it to say that the decline in standards for loan origination, combined with financial engineering, was helping to spur greater lending. The process of securitization is not new. Securities backed by mortgages, credit card receivables, or other types of assets, have been around for years. Indeed, the development of a market for "plain vanilla" asset-backed securities was important since it allowed for the expansion of credit through the market. Initially, this market developed in a reasonably transparent way, in that the nature of, and risks associated with, the underlying assets were clear. Here in Canada, for example, an investor could know with certainty that the mortgages backing securities met the lending standards set by Canada Mortgage and Housing Corporation, or that the loans backing a security were of high enough credit quality that a bank or a retailer was prepared to stake its reputation on the securities. These plain-vanilla asset-backed securities continue to exist and remain an important source of high-quality market-based financing. But more recently, we have seen the emergence of increasingly complex structured products, which were developed in response to the demand for higher returns. And as these securities have become more complex and opaque, in many cases, it has become harder to assemble and understand all the information needed to determine what kinds of assets are backing the security, the quality of those assets, and the counterparty risk involved. A final point here has to do with how these complex securities are valued. Trading of these securities in secondary markets is rare. Thus, prices for these securities are not very transparent. Most of these highly structured securities are valued on a "marked-to-model" basis, meaning that statistical models are used to provide values. But the models typically provide only estimates of values, and these estimates can vary widely if there are changes in the underlying assumptions. Indeed, many of the models assume that the assets backing these securities can be readily traded in a liquid secondary market - an assumption that is clearly not always valid. So it becomes extremely difficult to put a firm value on a particular security at any given time. So, we can now see that many factors made credit markets vulnerable to the recent dislocations. The repricing of risk I mentioned earlier was, in fact, under way before August. By late spring, the spreads on lower-rated corporate bonds had begun to widen to levels closer to historical averages. As we moved into summer, however, we saw rising delinquency rates and higher probabilities of default on U.S. subprime mortgages. And so, there were rising expectations of losses for holders of securities backed by these mortgages. But because of the complexity and opacity of some of these securities, it is extremely difficult for even sophisticated investors to determine, with confidence, both the creditworthiness of the assets backing a particular security and the market value of the security itself. In these circumstances, uncertainty led to contagion and dislocations in money markets more generally, even those markets that have no link to U.S. subprime mortgages. Liquidity, which was recently thought to be too abundant, became scarce. Some investors found that the assets that they assumed were liquid were, in fact, frozen. Investors suddenly became extremely risk averse, leading to a surge in demand for the least-risky assets, such as government bonds and treasury bills. The lack of transparency and problems with information have clearly contributed to the ongoing market turbulence. The global repricing of credit risk is taking longer than many of us initially expected. This is because it is taking more time to unravel some of these complex and opaque instruments to get to the underlying assets, and then to find values for the assets themselves. In addition, uncertainty remains about the extent to which banks are holding these securities, how much they may be required to take onto their balance sheets, and what value to place on them. This uncertainty has exacerbated problems in the global interbank funding market, but because of their strong balance sheets, Canadian banks have been somewhat less affected. Over time, market forces can still be expected to work out these problems. But markets need information to operate efficiently. So, it is in the interest of market participants to make sure that parties have access to all necessary information. Globally, markets for structured asset-backed securities remain under stress. In Canada, the problems have been most acute in the market for structured, non-bank-sponsored, asset-backed commercial paper. The information needed to properly price these products is only now beginning to be made available. With this information, investors and the providers of assets and liquidity are now progressing towards restructuring agreements. As we go forward, we can expect that investors will demand greater transparency where it is now lacking. Vendors of financial instruments will then need to structure them in such a way that market players can clearly see what they are buying. More fundamentally, investors must take on more responsibility for diligent research, so that they can better understand the nature of their investments. Put another way, investors must demand access to appropriate information so that they can do their own homework, and then they must do that homework. It seems to me that many of these desired outcomes will be accomplished through natural market forces responding to these events. For example, when investors demand much higher rates of return for opaque products, there will be a strong incentive for vendors to provide products that are more transparent. Let me touch briefly on the role of credit-rating agencies in all of this. There is an article in the current FSR that expands on the issues related to the possible reform of the creditrating process. One thing that is clear is that in the future, credit-rating agencies will find it to their advantage to explain more clearly the rationale for, and limitations of, their ratings for highly structured products. There are some natural, self-correcting market forces at work that should lead the rating agencies to improve their processes. Indeed, those credit-rating agencies that do not work harder to improve their processes will likely have fewer clients willing to pay for their services. As I understand it, most agencies are working on such improvements. But credit-rating agencies are not to blame for the lack of information about those highly structured products that were sold to highly-sophisticated investors in the so-called exempt market. In the retail market, securities regulators impose strict requirements about the information that must be provided through a prospectus or term sheet. But there are no such requirements in the exempt market. It seems to me that some very basic disclosure is needed in every market. And since securities designed for the exempt market are usually required to carry a rating from a credit-rating agency, one way to ensure that appropriate information is available could be to require issuers to publicly disclose the same information that they make available to credit-rating agencies. In this way, investors would have access to the information they need in order to make informed decisions. Another issue that we need to think about is how to get the right incentives in place for loan originators, so that credit quality is maintained and credit can be appropriately priced. I mentioned earlier that, in some cases, the creation of loans largely for immediate securitization reduced the incentive for originators to maintain credit standards. Since the originators were immune from default risk once the loan was completely securitized and sold, they lacked the proper incentives to adequately assess the creditworthiness of the borrower. It may be that natural market forces will go a long way towards rebalancing incentives, but the question can be asked: Are there ways to encourage the more appropriate use of securitization? It may be possible, for example, to have asset-backed securities carry some type of "branding" or "certificate of origination" that would provide a clear incentive for the loan originator to exercise due diligence in extending the loan before it is securitized. Or, we can look for ways to encourage originators to keep a substantial portion of the riskiest tranche of the product they are selling on their own books. Let me now discuss the impact of these recent market dislocations, both on our work at the Bank of Canada, and on the Canadian economy. The impact on the Bank has been two-fold. First, we have undertaken open-market buyback operations and made sure that Canadian banks have had access to our Standing Liquidity Facility, so that they have been able to deal with any overnight liquidity difficulties. This is a normal role for any central bank, and it will continue. But, in the wake of recent events, we are currently looking at whether some types of liquidity disruptions in Canada might be better addressed if the Bank of Canada had a facility that would provide liquidity at terms longer than overnight. We are also examining changes necessary to allow the Bank to accept a wider range of securities for our buyback operations. The Bank's other role, of course, is to conduct monetary policy with the aim of delivering low, stable, and predictable inflation. We have been working to ensure that the financial system has the proper amount of liquidity so that the overnight interest rate - our key policy rate - remains close to target. But what we have seen since this summer is a widening of the spread between short-term market interest rates, such as the rate for commercial paper, and our target for the overnight rate. This is important, because these short-term market rates are a crucial link in the way monetary policy is transmitted: from our key policy rate, to the cost of credit, to spending, production, employment and, ultimately, to the rate of inflation. These wider spreads have persisted, and they represent a tightening of credit conditions in Canada. These tighter credit conditions have come as financial market difficulties have intensified over the past few weeks and as bank funding costs have increased globally. At the same time, there is an increased risk attached to the prospects for demand for Canadian exports because the outlook for the U.S. economy - particularly the U.S. housing sector - has weakened. Uncertainty related to all of these factors has led to exceptional volatility in financial and currency markets globally. While there remain upside risks to inflation in Canada, all factors considered, the Bank judges that there has been a shift to the downside in the balance of risks around our October projection for inflation. In light of this shift, we lowered the target for the overnight rate last week. Before our next interest rate decision in January, we will assess all economic and financial developments and the balance of risks, and do a full projection for the economy and inflation. Ladies and gentlemen, as you know I will be stepping down as Governor of the Bank at the end of January, and concluding more than thirty-five years of involvement in economic policy within the public service. Since this is my last public speech as Governor, I thought it might be apt to conclude my remarks today with three of the most important lessons for economic policy that I - and I believe many Canadians - have learned over the past thirty-five years. The first lesson is that both individuals and firms must always be prepared to adjust quickly to changing global economic circumstances. The world will evolve in ways that we cannot predict, so we must be prepared to deal with change and seize new opportunities as they arise. Perhaps even more importantly, we should not cling to activities that are no longer economically justified, however difficult and painful adjustment may be. Not adjusting is not an option. In the end, rapid adjustment is less painful than prolonging activities where we no longer hold a comparative advantage. This is the lesson that I and many other Canadians learned from our difficulties in the 1970s and the early 1980s. Second, we have all learned the importance of achieving and maintaining sustainable levels of public debt. Canadians paid a very real price in the 1990s to control the growth of public debt, and have wisely used the favourable conditions of the past decade to bring down the ratio of public debt to GDP. Although conditions will not necessarily be as favourable over the next decade as they have been recently, nonetheless, further efforts to reduce the debt-service burden are needed in order to prepare for the inevitable effects of the aging of our population. Third, we have all learned that the most important contribution a central bank can make to economic welfare is to maintain confidence in the future value of money. In the 1970s, we all witnessed the economic and social instability caused by high and volatile inflation. In the 1980s, we paid the price of recession to get inflation under control. Since the early 1990s, our inflation-targeting regime has kept inflation low, stable, and predictable at 2 per cent. This, together with fiscal consolidation, has helped to keep growth more steady, employment to rise to historically high levels, and unemployment to fall to levels not seen for decades. My colleagues at the Bank will continue to search for technical improvements in our inflation-targeting regime, but I am confident that the Bank and my successor, Mark Carney, will continue to keep inflation low, stable, and predictable, for the benefit of all Canadians. Finally, let me close by saying that it has been an enormous privilege for me to be able to serve Canadians for three and a half decades. I am grateful for having had that opportunity, and I am hopeful that, in some way, my efforts over the years may encourage others to follow in the service of Canada and its people.

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Transparency: The More, The Better?

kennedy

Association des femmes en finance du Quebec Transparency is the cornerstone of a well-functioning financial system. It's an issue that has been getting a lot of attention, and deservedly so, as we consider what has gone wrong in the market for asset-backed commercial paper. I'll be happy to take any queries you might have on this topic during the question and answer session following my remarks. But first, I want to talk to you about transparency in central banking and in setting monetary policy. Then, I'll close my remarks with a review of the changing monetary policy outlook over the past six months, which serves to illustrate my key points. So, what has been done, and what more can we do to improve transparency in monetary policy? Are there any limits? I'll approach these questions from three perspectives: transparency about the Bank's policy framework; transparency about the inputs, the processes, and the reasoning behind monetary policy decisions; and transparency about our assessment of the outlook for the economy and monetary policy. That last element, disclosing more of the Bank's assessment about the outlook, including forward-looking statements about monetary policy actions, is particularly tricky and really tests the limits of transparency. Nevertheless, it is in this area that there may be the most room to increase transparency. But first, we must figure out if it would be beneficial to provide more information for market participants, firms, and individuals. More fundamentally, would it improve the effectiveness of monetary policy? And if we find that it would be beneficial, how can we convey this information so that it would be readily understood? Or more importantly, how can we convey this information in a way that will not be misunderstood? At the Bank of Canada, we do not believe in constructive ambiguity, nor in saturating the market with a lot of information that has no clear message. Real transparency involves judgment: communicating what is important, what clarifies, and not what obscures. I'll have more to say on this in a few minutes. But first, let's back up one step to look more closely at just why transparency is so important to the conduct of monetary policy. It has become very clear over time and with experience, that monetary policy is most effective when the policy objective is clearly understood and accepted. When consumers and savers, business owners, and financial market players, all understand the Bank of Canada's policy objective - and believe that it is attainable - then they can make better long-term plans and decisions. And when everyone expects this target to be maintained, and acts accordingly, then the target becomes self-reinforcing. But the benefits of transparency don't stop there. I believe that transparency also helps us to make better decisions. The extra rigour that comes from holding the rationale behind our decisions up to external scrutiny leads to better results. Finally, the Bank of Canada is a public institution - funded by, and accountable to, the taxpayer. Information and analysis gathered in the context of the Bank's business should be considered a public good - except when the release of such information would compromise the implementation of the Bank's mandate. In general, more transparency is better than less. But this does not mean that there are no limits. First, there is the need to protect the confidentiality of some information and analysis that is given to the Bank by outside parties, be they public- or private-sector institutions. Indeed, public release of third-party, confidential information would jeopardize the central bank's ability to get all the information it needs to make good monetary policy decisions. Second, there is the need to protect the integrity of some internal policy deliberations . For example, the public release of policy advice and recommendations could stifle the free debate and consensus building that is necessary for sound policy-making. We want to hear all aspects of an argument, but it could be hard for staff members to play devil's advocate, knowing that such a position will be made public and could be taken out of context. And certain information should not be released while policy is still being developed, or has not yet had its full effect. In such cases, premature transparency could lead to misinterpretation or be acted on inappropriately, which could derail good policy intentions and could potentially be damaging to Canada's economic interests. Third, there is the need for good quality information. Providing useful, relevant information is far more important than dumping a large quantity of information of questionable quality. Too much information can actually cloud what is important. As a result, actions and decisions can become less transparent, because the really important, effective, and relevant information gets lost in the minutiae. Good quality information must not only be accurate, it must also be communicated clearly and simply, so that it won't be misunderstood. This is especially germane when we try to be transparent about our assessment of the outlook by publishing our economic projections, along with the risks and uncertainties surrounding them, and forward-looking statements about possible future policy actions. Debates about the limits to transparency for effective monetary policy are certainly not unique to the Bank of Canada. Central banks around the world are still learning the best ways to communicate monetary policy. This is an important element of the art, rather than the hard science, of central banking. I believe that we at the Bank of Canada have made great strides in this area. So let's now take a closer look at the issue of transparency in setting monetary policy from the three perspectives that I mentioned at the outset: transparency about our policy framework; transparency about the inputs, the processes, and the reasoning behind monetary policy; and transparency about our assessment of the outlook. The Bank made a major leap forward in increasing transparency about our policy framework when we adopted an explicit inflation target in 1991. This target provides a clear objective for monetary policy, which has helped to anchor financial and economic decisions. It makes it easy to measure the success of monetary policy and to hold the Bank accountable for its actions. Canadian individuals and firms can align their savings, investment, and spending plans with a common inflation-control objective. If inflation persistently deviates from the target, we are committed to explaining the reasons why, what we will do to return it to target, and how long we expect the process to take. Previously, when we targeted monetary aggregates, for example, there was ambiguity about what the bank was trying to achieve, and we were not always clear about the implications of such a target for output, inflation, and interest rates. Now, as well as being clear about our objective, we are also being transparent about our assessment of the factors that influence inflation and about how we implement monetary policy. We conduct monetary policy in a symmetric way, worrying as much about the trend of inflation falling below target as we do about it rising above target. To keep inflation on target, we try to keep the economy operating near its full capacity. When the demand for goods and services pushes the Canadian economy against the limits of its capacity, and inflation is poised to rise above target, the Bank will raise interest rates to cool off the economy. And when the economy is expected to operate below its production capacity, and inflation is poised to fall below target, the Bank will lower interest rates to stimulate growth. We also factor in shocks that directly affect inflation. Because we target domestic inflation, we have a floating currency. A central bank cannot successfully control both the domestic and external values of its currency at the same time. And a flexible exchange rate is an important price signal of changing global and domestic circumstances that can help to prompt and facilitate necessary adjustment. This is our paradigm for the conduct of monetary policy, and we have been so transparent about it that we have devoted entire speeches and published a great deal of staff research on the topic. We do this so that a careful observer can understand just how monetary policy will adjust to changing circumstances. Our inflation target is established under an agreement with the federal government. When this is reviewed periodically, we look for ways to improve the conduct of monetary policy based on recent experience and research in order to clarify aspects of our framework. In the most recent review, for example, we examined how to deal with assetprice bubbles and looked at the appropriate time horizon for returning inflation to target following an economic or financial shock. In preparation for the next review of our inflation targeting agreement in 2011, we are conducting an intensive research program into possible improvements to our policy framework. Specifically, we are looking into the merits of a lower inflation target and price-level targeting. Now, let's look at transparency about the inputs, the processes, and the reasoning behind monetary policy decisions . Just a little over a decade ago, the Bank didn't even issue a press release when it made an interest rate decision. Now, our rate announcements are widely anticipated. There is a very high level of interest, stretching from households to office towers, in what the Bank of Canada has to say on interest rates, inflation, and the economy. This interest is at least partly the result of a series of measures taken by the Bank to increase transparency. After the introduction of the inflation target, we moved in 1994 to become more open about how we implement monetary policy by targeting the overnight interest rate. A further major step towards greater transparency came in 1995 when we began to publish a regular and later added to provide a window for financial markets and the general public into the analysis behind our conduct of monetary policy. Soon after that, the Bank began to publicly announce interest rate changes through press releases. These steps helped to increase understanding and acceptance of the Bank's policy objective. Still, there was a lot of ambiguity and uncertainty in financial markets about exactly when the Bank of Canada might change its monetary policy stance. So, in 2000, we decided to set eight fixed dates each year for interest rate announcements, regardless of whether rates were changed or not. This commitment to a timetable provided more certainty for markets, a better focus for external commentators to develop and expand their own views on the economic outlook, and regular opportunities for us at the Bank of Canada to review the accumulation of data and to update our views about the outlook for inflation and the appropriate course for monetary policy. This extra focus and rigor has, in my opinion, improved our decision-making process. Of course, the Bank retains the option of moving between dates in extraordinary circumstances, an option that has been exercised only once since fixed announcement dates were established. Most of the information and analysis that the Bank uses when it makes monetary policy decisions are based on data that are also available to the public. There was a time when one such input - our - was not publicly available. But after we conducted research to determine which of our survey questions provided the most useful information, we began to publish the results of those questions. The motivation was not only to help improve the public's understanding, but also to be as open and transparent as we could, given our responsibilities as a public institution. We continue to examine whether we can make public more of the inputs to monetary policy, without compromising the policy-making process. Indeed, in the upcoming January we will be including responses to two additional questions on past sales and credit conditions. I'll now turn to the third perspective, which is transparency about our assessment of the outlook for the economy and monetary policy. Because it can take as long as two years for monetary policy actions to have their full effect on inflation, we must always be looking well into the future. So, the questions become: how can we effectively communicate the kind of uncertainty and the many risks that any views about the future must always include? How can we talk openly about possibilities and risks in a way that won't be misunderstood? It would not aid transparency if our assumptions and projections of what might transpire - assessments which are, by their very nature, conditional - were misconstrued as more concrete predictions or commitments. At the Bank of Canada, the Governing Council sets out its base-case projection for inflation and growth in the Canadian economy four times a year in our and . This base-case projection reflects Governing Council's best judgment about the most likely outcome, based on a number of assumptions. Over the years, we have become increasingly transparent in describing our projections, and the underlying assumptions. This January, we will include in our projection tables on global economic growth - tables that previously had only been included in full . We have provided more detail about how we see the economy unfolding, what forces might affect inflation, and what assumptions we have had to make about more volatile or uncertain variables. This, in turn, helps to explain the reasons behind our most recent decisions and provides some insight into possible future actions. The base-case projection embeds changes in the policy interest rate that would be necessary to achieve our 2 per cent inflation target over the medium term. We describe the direction and magnitude of that interest rate path in a few words, in Chapter 4 of the and when we update the base-case projection in the may also give an indication of the time horizon for this path. We have also become more forthcoming in recent years about the risks that we see surrounding the base-case projection and whether we think these risks are balanced or not. Our policy rate statements, in press releases and in the Overview section of the and reflect our best judgment in the context of the overall outlook at that time, including the balance of risks. But that, too, is no guarantee that the future will play out the way we expect. There are several ways we might consider providing more transparency about the risks and uncertainties around our base-case projections. Some central banks use fan charts showing confidence intervals that can suggest the extent of uncertainty around a particular factor in the overall forecast. Another approach is to publish complete alternative scenarios in addition to presenting a base-case projection. And some academics have called for more transparency by sharing the monetary authorities' probability estimates of different risks. Examining some of these possibilities is in our work plan for the year ahead. What is not in our work plan is the use of stock words and phrases to signal policy intentions. This isn't our practice at the Bank of Canada. Instead, we try to spell out the situation as we see it. We set out our base-case projection for the economy and the key risks; we make clear the indicators that we're closely following; and by being clear about our paradigm, we try to help a careful observer to better understand how monetary policy could evolve, depending on changing circumstances. But we count on outside observers to do their own analytical heavy lifting as well. In preparing for our interest rate decisions, we look at market prices, external commentary, and other analysis. We rely on observers to provide their own perspective on the outlook. If our views differ substantially from the consensus of external observers, we might consider either redoing our own analysis, seeking out further information, or communicating more explicitly our views and analysis to help those observers to understand the factors that we consider to be important. As I have said on many occasions, if you are considering placing a bet between what you think we said we were going to do and what you think we ought to do, I'd go with the latter. So, let me conclude by looking at the evolution of monetary policy over the past six months. It certainly has been a fluid situation, and an excellent example of how forwardlooking assessments can change quite rapidly. Back in July, we raised our policy rate by a quarter of one percentage point because we judged that the economy was operating, at that time, at a level further above its production potential than had been projected at the time of the April . As we expected both total and core CPI to remain above 2 per cent, we concluded that some modest further increase in the overnight rate might be required to bring inflation back to 2 per cent over the medium term. By the end of the summer, the situation had changed in many respects. The Canadian economy was operating even further above its production potential than estimated in July, which was putting upward pressure on inflation. Developments in financial markets had led to some tightening of credit conditions for Canadian borrowers, however, which would temper the growth in domestic demand. And the U.S. economic outlook had also weakened. This, together with a higher assumed level for the Canadian dollar, suggested that there would be more drag from net exports in 2008 and 2009 than previously expected. Given these developments, we held our policy rate steady through September and October. We identified several risks to the outlook for inflation and judged them to be roughly balanced, with perhaps a slight tilt to the downside. In the event, the downside risks prevailed. When we re-examined our monetary policy stance early in December, the Canadian economy was growing broadly in line with the Bank's expectations, reflecting in large part the underlying strength of domestic demand. But both total CPI and core inflation were now below the Bank's expectations, reflecting increased competitive pressures related to the level of the Canadian dollar. In addition, other developments since October suggested that the downside risks to our inflation projection had increased. Global financial market difficulties had worsened, tightening credit conditions further, and there was an increased risk to the prospects for the demand for Canadian exports, since the outlook for the U.S. economy had weakened further. So, on 4 December, we judged that the balance of risks had shifted to the downside, and we lowered our target for the overnight rate to 4 1/4 per cent. Now, as we prepare for our next interest rate announcement on 22 January, and our two days later, we are preparing our regular quarterly economic projection and risk assessments, so that we can fully assess the implications of all economic and financial developments since the October , and set the appropriate course for monetary policy. At the Bank of Canada, we are very interested in any ideas you might have on this topic of transparency in monetary policy - what the limits are and how transparency can continue to be improved. In my view, generally, more is better. Apart from the need to protect confidential information and not compromise the policy-making process, the true limits to transparency in monetary policy lie in communicating effectively in the face of uncertainty, a skill which we are constantly striving to master.

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Release of the

dodge

Good morning. I'm pleased to be here with you today, for my final press conference as Governor of the Bank of Canada, to discuss our January The Canadian economy continues to operate above its production capacity, despite some slowing in growth and inflation in the fourth quarter of 2007. Financial conditions have deteriorated since October, leading to tighter credit conditions in industrialized countries. Given this, and a deeper and more prolonged decline in the U.S. housing sector, the outlook for the U.S. economy in 2008 is now significantly weaker than at the time of the . The weaker U.S. economy will lead to additional downward pressure on Canada's export growth. Despite tighter credit conditions, domestic demand in Canada is expected to remain strong, supported by continued income growth associated with the increase in commodity prices seen since October. Overall, the Bank now projects that the Canadian economy will expand by 1.8 per cent in 2008 and 2.8 per cent in 2009. This growth profile implies that the economy will move into excess supply in the second quarter of this year, and then return to balance in early 2010. Inflation is projected to fall below 1 1/2 per cent by the middle of this year before returning to 2 per cent by the end of 2009. This reflects a price-level adjustment related to increased competitive pressures in the retail sector stemming from the level of the Canadian dollar, as well as the recent reduction in the GST. Excluding the impact of the GST reduction, total CPI inflation is projected to average close to the 2 per cent target throughout 2008 and 2009. Of course, there are a number of upside and downside risks to the Bank's base-case projection for inflation. But overall, we judge these risks to be roughly balanced. On 4 December and on 22 January, the Bank lowered its target for the overnight rate by one-quarter of one percentage point, bringing it to 4 per cent. Further monetary stimulus is likely to be required in the near term to keep aggregate supply and demand in balance, and to return inflation to target over the medium term.

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Opening Statement before the House of Commons Standing Committee on Industry, Science and Technology

jenkins

House of Commons Standing Committee on Thanks very much, Mr. Chairman. I'm pleased to be here with you today and hope to help your committee as it examines the impact of exchange rate movements on the Canadian economy. With me is John Murray, who was recently appointed as a deputy governor and member of the Bank of Canada's Governing Council. To begin, as a little background I would like to quickly review the framework within which we conduct Canada's monetary policy. The Bank of Canada Act calls on us to mitigate "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." Over time, we have learned that the best way to fulfill this mandate is to keep inflation low, stable, and predictable. Specifically, that means we aim to keep the annual rate of inflation, as measured by the consumer price index, at 2 per cent. To keep inflation on target, we aim for a balance between total demand and total supply in the economy. By maintaining low and stable inflation, our monetary policy helps to keep the economy operating at full capacity and promotes greater stability in economic output. This is crucial in helping the economy to adjust to changing economic circumstances. Now, what does all of this have to do with the exchange rate? Well, the exchange rate of the Canadian dollar is a key element of our monetary policy framework. Without a floating exchange rate, we would not have the ability to conduct an independent monetary policy appropriate to our domestic situation. This means that we do not have a target for the Canadian dollar. But the exchange rate is an important relative price in our economy and we pay very close attention to its movements. Movements in the exchange rate influence the levels of imports and exports, which can help to keep total demand and supply in balance, and have a direct influence on price levels in our economy. Further, exchange rate movements act as a signal to shift resources into sectors where demand is strongest. Our floating exchange rate helps to facilitate that process. That said, we recognize that these types of adjustment can be, and have been, difficult for some sectors and regions of the country. When the Canadian dollar rises or falls, we try to determine the degree to which those movements are due to changes in world demand for our goods and services, and how much is due to other, unrelated factors. It is important that we understand the causes of exchange rate movements, because the implications for the economy - and the appropriate monetary policy response - depend on the reasons for the change. We must then incorporate this information with our assessments of other data, and set a course for monetary policy that works to keep total demand and supply in balance, and inflation on target. Exchange rate movements can also be, as we have seen recently, quite volatile. That has sometimes led to calls, for example, for Canada to fix its currency to the U.S. dollar. That would be a mistake. The United States is certainly our closest neighbour and by far, our largest trading partner. But the structures of our two economies are very different. This means that each of us often requires different adjustments and different policies in reaction to shocks. Canada's floating exchange rate helps in this process by acting as a shock absorber. We cannot avoid adjustment; the question is how we can best adjust to changing global and domestic economic forces. With a fixed exchange rate, the adjustments would have to come through movements in overall output and in all wages and prices. History has shown that those adjustments are more protracted and more difficult when the nominal exchange rate is not allowed to move. Again, however, I stress that this does not mean that the Bank is indifferent to movements in the exchange rate. Now, let me conclude with a few summary comments on our latest released last week. Copies are available for committee members. In this, we said the Canadian economy continues to operate above its production capacity, despite some slowing in growth in the fourth quarter of 2007. The Bank projects that economic growth in 2008 will be weaker than was expected in October, averaging a little over 1 per cent in the first half of this year and a little over 2 per cent in the second half. On an average annual basis, the economy is projected to expand by 1.8 per cent in 2008 and 2.8 per cent in 2009. Both core and total CPI inflation are projected to fall below 1 1/2 per cent by the middle of this year before returning to 2 per cent by the end of 2009. On 4 December and on 22 January, the Bank lowered its target for the overnight rate by one-quarter of one percentage point, bringing it to 4 per cent. In line with the Bank's outlook, further monetary stimulus is likely to be required in the near term to keep aggregate supply and demand in balance, and to return inflation to target over the medium term. With that, Mr. Chairman, John and I would now be happy to take your questions.

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The Implications of Globalization for the Economy and Public Policy

carney

Governor of the Bank of Canada I am delighted to give my first public address as Governor of the Bank of Canada in Vancouver, not only because my roots are here in the West, but also because Vancouver aptly symbolizes the subject of my remarks today - globalization. I chose to speak about globalization at the outset of my tenure because it will continue to be one of the forces shaping our economy and economic policy for years to come. Steady advances in transportation, communication, and information technologies, underpinned by the more widespread adoption of free-market economic policies, are shrinking the globe and expanding the global economy. It is incontestable that the current wave of globalization has been, on balance, of great benefit. Hundreds of millions of people have already been lifted out of poverty, with the real potential for hundreds of millions more to share their destiny. Globalization has also had numerous economic benefits for Canada. The recent period of international integration has coincided with the second-longest expansion in our nation's history, characterized by rising real incomes, surging employment, and low, stable, and predictable inflation. However, these outcomes are not preordained; to reap fully the benefits of globalization, policy-makers must weigh its implications and respond effectively to its challenges. In my time today, I will discuss these policy challenges, particularly those related to the conduct of monetary policy. First, I will talk about how the current wave of globalization differs from previous periods of economic integration, and then I will address some of the economic impacts of globalization. Before concluding, I will also say a few words about the current outlook for the Canadian economy, which, not surprisingly, is importantly influenced by global economic developments. In some respects, the current wave of globalization resembles earlier episodes. There have been occasional periods of intense economic integration over the centuries, most notably during the Roman Empire and in the latter half of the 19th century. These have shared several common features: for example, technological innovations that shrank economic distances (e.g., standardized roads, the telegraph and, more recently, the Internet) and, very importantly, governments that pursued supportive economic policies. These governments recognized the long-term benefits of economic integration and were large enough to internalize the costs - both political and fiscal - of promoting public goods such as the rule of law; common standards for trade, products, and services; and the liberalization of trade. Many of their decisions, such as the repeal of the Corn Laws in England, were unpopular at the time, but ultimately proved beneficial. We should all hope that similar courage will begin to guide participants in the current Doha Development Round of trade negotiations. So, is there anything different about this period of integration? I would argue that there are three aspects. First, the sheer scale of the process is unprecedented; second, the relative size of the emerging economies being integrated into the core of the global economy means that their policies matter for advanced economies, as well as for their own; and third, the widespread adoption of supply-chain management by business further enhances the depth of integration. In terms of scale, it is safe to say that never in history has economic integration involved so many people, both in raw numbers and as a percentage of the global population. For example, when North America and the periphery of Europe were integrated during the latter half of the 19th century, their total population was half the size of the thenadvanced countries. The comparable ratio for postwar Japan was 10 per cent. Contrast that with China and India today, which alone represent 2.5 times the current population of advanced countries. Of course, the entire populations of China, India, and other emerging markets are not being instantly integrated into the global economy. If you adjust for the percentage of the population in the traded-goods sector, however, the effective global labour supply quadrupled between 1980 and 2005, with most of the increase taking place after 1990. This trend is set to continue: The globally integrated labour force is projected to double again by 2050. Similarly, the scale of cross-border flows of goods, services, and capital is now unprecedented. The global economy has opened dramatically - merchandise exports now make up about 20 per cent of global GDP, compared with about 9 per cent at the height of the last great wave of globalization, roughly a century ago. According to research at the OECD, advances in communications technology mean that up to 1 in 5 services are now tradable, although this potential has only just begun to be tapped. capital flows are now roughly 15 per cent of global GDP, compared with 3 per cent at the turn of the last century. The second difference that characterizes this wave of globalization is that, given the relative size of emerging markets, their policies matter. For the most part, the economic policies of emerging-market countries have improved the welfare of both their citizens and our own, through the gains from trade. With some policies, however, most notably in the degree of exchange rate flexibility and, by extension, in the conduct of their domestic monetary policies, some emerging markets have run great risks. In particular, they continue to import, what is, for them, overly loose monetary policy that will ultimately lead to adjustments in the real exchange rate through higher domestic inflation, with the attendant economic distortions, adjustment costs, and risk of a hard landing. Moreover, at the global level, there are important spillovers of these policies onto other economies, such as Canada's. Export-promotion strategies underpinned by undervalued exchange rates are generating unprecedented reserve accumulation, as central banks intervene to forestall exchange rate adjustment. In contrast to earlier periods where emerging markets imported capital to finance investment, today's largest emerging economies are important capital exporters, to such an extent that they have been significant drivers of lower global long-term interest rates. Since the level of long-term interest rates influences risk appetite and capital allocation, the extent to which they are determined by non-market forces can lead to distortions. Indeed, the low level and relative stability of long-term interest rates encouraged investors to "search for yield," which in turn contributed to the dramatic increase in highly structured credit products, including those backed by U.S. subprime mortgages. The third aspect of today's globalization that is different is the relative novelty of global supply-chain management. Advances in information technologies, specialized production processes, and reduced communication and transportation costs have all led to a whole new range of goods and services becoming tradable. For example, over the past 30 years, the share of imports as a percentage of manufacturing production has tripled to nearly 30 per cent. These developments mean that firms are now able to increase production efficiency in ways previously unimaginable. In addition to the rising trade in components or intermediate products, an entirely new class of tradable services - including financial, engineering, medical, and legal - has emerged. There is reason to believe that these trends will continue. With these advances, it is easy to imagine a product designed and marketed in Canada, will be assembled in China, using parts sourced from elsewhere in emerging Asia and supported by technicians in India. By breaking down production processes along a global supply chain, firms are better able to find the efficiency gains that have led to increased productivity and lower prices. Integration has had a clear dampening effect on the prices of manufactured goods. In effect, technology and globalization are facilitating more widespread application of two of the most powerful forces in economics: the division of labour and comparative advantage. This allows companies to organize the production process in the most costeffective way possible, which maximizes the likelihood that Canada will retain positions in the high-value-added segments of many industries. A recent analysis by the Conference Board of Canada suggests that, at least with respect to Asian supply chains, Canadian firms could do more to exploit opportunities. At the same time, the rapid increase of manufacturing in emerging markets has led to strong demand for many commodities, and thus, to steady upward pressure on the prices of many of the commodities that Canada produces and exports. The combination of lower prices of our imports and higher prices for our exports means, by definition, an improvement in Canada's terms of trade. Rising terms of trade alone have bolstered real disposable income per capita by 8.5 per cent over the past five years, and have contributed to healthier corporate balance sheets and continued improvement in government fiscal positions. Canada has adjusted well to the sharp movements in our terms of trade. Through conversations that we at the Bank have had with business leaders, through the responses to questions in our Business Outlook Surveys, and through data showing an average annual increase of 8 per cent in the volume of business investment since 2002, there is clear evidence that the Canadian economy is becoming increasingly oriented to high-end services. Within the goods sector, firms are specializing and concentrating on those areas where they hold a comparative advantage. Globalization is commonly charged with being responsible for increasing inequality and falling wages in certain sectors of industrialized economies, as lower-skilled jobs are shifted offshore. Indeed, the OECD's 2007 noted that the share of labour income relative to GDP has fallen in a majority of member countries, including Canada, over the past two decades, while in 16 of the 19 countries where data are available, the earnings of workers at the top of the wage distribution have risen relative to earnings of those at the bottom of the distribution since the early 1990s. While globalization has played a role in these trends, the story is much more complex. There is considerable evidence that technological change is behind a large part of the declining ratio of labour income to GDP. Further, labour income in Canada has continued to rise in recent years because of strong employment growth. What is clear is that globalization has affected the makeup of the labour force in many countries by promoting a shift of lower-skilled, labour-intensive production processes to emerging markets and encouraging the growth of higher-skilled, knowledge-based production in industrialized countries. While it is true that this adjustment process can be, and has been, difficult for certain individuals and firms, the overall picture is quite positive. In countries where labour markets are flexible, displaced workers have been more able to re-skill or retrain and, on balance, find more productive employment. Since December 2002, employment in Canada's manufacturing sector has fallen by roughly 14 per cent, or 320,000 jobs, while employment in other goods-producing sectors has risen by roughly 23 per cent, or 382,000 jobs. Further, over the same period, employment in the services sector has risen by more than 1.4 million jobs. Average hourly earnings have increased over this period at an average annual pace of 3.3 per cent. Moreover, everyone in our economy benefits from the lower cost of imports. While Canada's impressive employment performance cannot be ascribed to globalization per se, clearly globalization has not prevented it. At the same time, just as globalization has a long way to run, the adjustment process is far from finished. That is why it is so important for Canada to continue to improve its economic flexibility - a point that has been made repeatedly in Bank of Canada speeches. It is plain from this discussion of the economic impact of globalization that it also has important implications for the conduct of monetary policy. I will touch briefly on four implications that are relevant for the Bank of Canada. It should be recognized at the outset, however, that these implications can be conflicting, and none is relentless, so they need to be considered carefully. First, the Bank needs to be mindful of the possibility that movements in the terms of trade may affect the relationship between core and total CPI inflation. Recall that globalization has led to lower prices for many manufactured goods and higher prices for many commodities, particularly energy products. While both of these groups are represented in the total consumer price index, many energy prices are excluded from our core measure of inflation because of their volatility. In the pursuit of our 2 per cent target for total CPI, we use our core measure as an operational guide because it has been a good gauge of the underlying trend of inflation and has been a better predictor of future changes in the total index than has total CPI itself. Forthcoming research at the Bank of Canada indicates that this relationship continues to hold in Canada, although it has diminished in many other countries. We will continue to monitor the stability of this relationship, and the Bank will also continue to look at a range of measures to assess the underlying trend of inflation. Considerable judgment must always be applied, and no one measure should be relied on exclusively. Second, globalization may affect the degree and speed of the pass-through of exchange rate movements to domestic prices. It is widely believed that globalization acts as a stabilizer that should dampen exchange rate pass-through because the increased competition faced by businesses will lead them to compress their margins to remain competitive and absorb rising costs. Eventually, however, local prices should adjust to exchange rate movements, if they persist. We may, in fact, be seeing this effect here in Canada, since some retailers in the automotive and book sectors have recently adjusted prices downwards in the face of greater competitive pressures stemming from the rise of the Canadian dollar. Third, globalization may have a conflicting influence on productivity. I have already mentioned how globalization promotes higher productivity by allowing firms to arrange their production processes in the most cost-effective ways. Again, however, the reality in Canada is more complex. The large swings in relative prices fed by globalization have sparked a reallocation of resources between sectors and regions. This reallocation can lead to a temporary slowing in productivity growth as the adjustments take place. This is particularly true in the natural resources sector, where investments typically have long lead times, where a substantial amount of labour has been absorbed, and where high commodity prices have encouraged the production of more marginal resources. These effects may be behind a portion of Canada's disappointing productivity record in recent years. Fourth, the impact of globalization on market interest rates is an area where economic theory and reality do not quite align. The increase in the effective labour supply in the global economy should have raised the return on investment, all other things being equal, and led to an increased demand for capital to employ this extra labour. This, in turn, would be expected to lead to higher interest rates. As I mentioned earlier, however, longterm interest rates around the world have fallen in recent years, partly because of the exchange rate policies of some emerging markets. There are several other possible explanations for this phenomenon, including the balance of private savings and investment in emerging-market economies, itself the product of the economic policies in these countries. Given these four effects, some have argued that the large scale of the current globalization is undermining the effectiveness of monetary policy. I disagree. In short, provided that a country retains a flexible exchange rate, it retains control of its monetary policy. The rate of inflation in Canada is a function of the effectiveness of our monetary policy in the face of both global forces and evolving domestic circumstances. Essentially, the main challenges for monetary policy posed by globalization are: the impact on the growth of our economy's potential output, and changes in relative prices, such as the prices for energy or manufactured products. The growth rate of our economy's potential matters because it affects the balance of supply and demand in the economy. If the effects of these changes are not addressed by monetary policy, they will affect the degree of inflationary pressures in the economy. As for relative price changes, the Bank tries to look through one-off changes, since these only temporarily affect inflation. However, the "temporary" price-level shifts driven by globalization can last a long time, and the pace of the shifts can be variable. It is the job of the Bank of Canada to conduct monetary policy in a manner that takes into account such persistent shocks and ensures that they do not affect inflation expectations. So how have these different factors been affecting the conduct of monetary policy in Canada? Many of the factors just discussed featured prominently in the recent Tokyo meeting of the G-7 finance ministers and central bank governors. Key topics included the slowdown in the U.S. economy and the related tightening of credit conditions in most advanced economies. In addition to outlining a series of measures to improve the functioning of financial markets, my colleagues and I agreed that each country should continue to take fiscal and monetary policy measures appropriate to their particular economic circumstances. Canada's current economic circumstances were spelled out in the Bank's last month. In that document, the Bank said that the economy has been operating above its production capacity, thanks to strong domestic demand. This demand has been supported by a rise in real incomes, stemming from the gains in Canada's terms of trade which, as I mentioned earlier, have been driven by globalization. The evolution of our terms of trade will depend importantly on demand from major emerging markets. The impact from our terms of trade is one factor that could lead to stronger domestic demand growth than we had assumed. This is something that we at the Bank will continue to watch closely. Another issue that will continue to be important for us is the evolution of the passthrough to prices of movements in the exchange rate. As I noted earlier, some retailers - notably of motor vehicles and books - have adjusted prices downwards in the face of greater competitive pressures stemming from the rise of the Canadian dollar. In the , the Bank said that we expect this to be a one-off movement in prices, but there is a possibility that there could be greater and more persistent downward pressure on prices than we assumed. The Bank also identified the downside risk that the tightening in credit conditions could be greater and more protracted than assumed. As well, there could be a more prolonged slowdown in the U.S. economy, exerting a greater drag on Canadian GDP growth and inflation. These two risks are, of course, related. In line with our base-case projection and the associated risks, the Bank lowered the target for the overnight rate by one-quarter of one percentage point on 22 January. This followed a similar reduction on 4 December, and brought the Bank's key policy rate to 4 per cent. In making the announcement in January, the Bank said that further monetary stimulus is likely to be required in the near term to keep aggregate supply and demand in balance and to return inflation to target over the medium term. As I said recently, the timing and degree of that stimulus will be determined at future fixed announcement dates, after we have conducted a thorough analysis of, and applied our judgment to, all information available to us at that time. Let me conclude with some brief thoughts about how policy-makers in general should approach the issue of globalization. There are tremendous benefits from embracing this integration of markets, but there are adjustment costs as well, in the form of exposing our economies to global competition and swings in relative prices. The challenge for policy-makers is to ensure that the benefits of globalization are maximized and widely shared. In general, this means making sure that policies do not frustrate market-based adjustments, but rather are aimed at promoting flexibility in markets - particularly labour markets. This means maximizing the ability of workers to relocate if they wish, maintaining appropriate social safety nets that do not discourage employment, and focusing on lifelong learning and training. Beyond labour markets, governments should focus on domestic integration. The Trade, Investment and Labour Internationally, governments should also concentrate on removing barriers to trade and investment to maximize the benefits of globalization. These imperatives will be tested during the current economic slowdown. From the Bank of Canada's perspective, our challenge is to understand the various ways in which globalization affects both financial stability (a topic for another speech) and inflation. At the Bank, we will continue to share our perspectives on globalization and other broader trends so that individual Canadians, companies, and governments have the necessary context when making their savings and investment decisions. Finally, in light of the growing importance of global forces and the risk of negative spillovers from the policies of some emerging markets, we will continue to use our participation in international fora to shape global institutions and national policies so that globalization can fulfill its promised benefits for all.

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

jenkins

Standing Senate Committee on Thank you, Mr. Chairman, for the opportunity to appear before this committee. With me is John Murray, a deputy governor at the Bank of Canada and member of the Bank's Let me start by saying that the issue of internal trade barriers is critically important, and I'm very pleased, Mr. Chairman, that your committee is examining it. We have reviewed previous submissions to this committee, and you will see that our focus will be slightly different. Rather than address the details of any given restrictions to internal trade, I'd like to focus on how trade and impediments to internal trade affect the overall performance of the Canadian economy. In these remarks, I'd like to address two important issues from that perspective: the need for flexibility in adjusting to economic change, and the need for economic policies that promote flexibility in markets for goods, services, capital, and labour. Economic flexibility refers to the ability of an economy to adjust to changing circumstances. Changes in economic conditions often relate to movements in relative prices, which in turn send important signals to markets. A flexible economy is one that adjusts to these signals and returns to its production potential as quickly, and with as little cost, as possible. Over the past decade or so, economic expansion in Canada and around the world has been robust, despite a series of major shocks. These shocks included: - the 1997-98 financial crisis in Asia, which spread to Russia and Latin America - the worldwide collapse of the high-tech bubble - the 9/11 terrorist attacks in the United States - SARS and BSE - intensified competition from China and India - and, since 2003, a sharp increase in commodity prices and an associated sharp increase in the external value of our currency. More recently, of course, we have been faced with the fallout of credit market turbulence associated with problems in the American subprime-mortgage market and the increased use of structured financial products. It's important to note that all of these shocks were international in origin and/or in dimension. Many of these shocks - notably, the Asian crisis and the recent sharp run-up in commodity prices - involved large movements in relative prices, that is, in the prices of energy and non-energy commodities, as well as large movements in the exchange rate for the Canadian dollar. And these movements have in turn triggered important shifts in economic activity, as well as reallocations of production resources across sectors and regions of the country. All of this underscores the fact that we live in an era of rapid change, and we operate in a global environment that is constantly shifting. Uncertainty, risks, and shocks are constant features of the economic landscape. For Canada, it is particularly important that we recognize this reality, given how open our economy is to international trade and capital flows. The best approach to dealing with risks and sudden developments is to constantly ask ourselves what steps we can take to make our economy and domestic markets more flexible, and thus better able to adapt to changing circumstances. And we need to recognize that this is a shared responsibility among firms, workers, and policy makers. Firms and their workers need to be able to respond quickly to technological advances and to shocks that require changes in the way they conduct business, the kinds of goods and services they produce, and the markets they choose to develop. A well-functioning market-based economy that sends clear relative price signals is critical in this context. At the same time, policy-makers need to be wary of barriers to adjustment, such as labour regulations that inhibit the movement of workers from one type of job, or from one sector or region, to another. To enhance flexibility, to raise the growth potential of the economy, and to increase its resilience to shocks, we need policies that encourage structural reforms. For Canada, structural reform has a broad context, with priorities across a number of jurisdictions. The financial system, with its vital role in supporting a healthy modern economy, has been and will continue to be one priority. An efficient and sound financial system enhances overall economic flexibility by helping to redirect capital and resources to the most productive uses, in a cost-effective way, following a shock. Removing internal barriers to the free movement of goods, services, and labour is another priority. These barriers are rightly attracting attention in Canada as differences in regional economic performance and shortages of skilled labour are becoming more pronounced, and as demographic challenges intensify. A number of initiatives to remove internal barriers have been undertaken over the years, but with mixed and generally modest results. The Red Seal Program was introduced more than 45 years ago to help standardize and recognize workers' trade qualifications. The barriers to the movement of goods, services, investment, and labour. One very important reached in April 2006 between British Columbia and Alberta to strengthen enforcement and dispute resolution and to harmonize labour credentials and business regulations and standards by early 2009. Considerably more needs to be done to enhance the flexibility and functioning of our internal markets from coast to coast. Business regulations and standards, including those of the financial sector, need to be harmonized across Canada. Dispute resolution and enforcement under the AIT need to be strengthened. And to make our labour markets more flexible, trades and professional designations should be recognized and fully transferable across the country. A significant step forward would be for others to adopt The Bank of Canada also has an important role to play in helping the economy to adjust to economic change. The Bank's monetary policy aims at keeping inflation low, stable, and predictable, which in turn helps Canadian businesses to read price signals more clearly, respond to relative price movements more promptly, and allocate production resources more efficiently. I'll conclude by saying that uncertainty, risks, and shocks will be as much a part of tomorrow's economic picture as they have been in the past. We all have a stake in Canada's economic well-being, and we all have a role to play in improving our flexibility and adaptability. From that perspective alone, this committee's study of issues related to internal barriers to trade is timely and important. Thank you, Mr. Chairman. John and I would be happy to respond to your questions and comments.

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Addressing Financial Market Turbulence

carney

Governor of the Bank of Canada to the Toronto Board of Trade Since last summer, many of us here today have been preoccupied with the ongoing dislocations in financial markets. What began in securities linked to U.S. subprime mortgages has spread to a broad range of structured assets, conventional credit markets, and, to a lesser extent, equities. As a consequence, some of the world's largest financial institutions have recorded substantial losses, the cost of borrowing has increased, and the availability of credit has decreased. More than seven months on, the end is not yet in sight, although it is safe to say that we have reached the end of the beginning of this turmoil. This is not because the dislocations in markets have eased; in fact, strains in financial markets have intensified recently, but rather because we are entering a new phase where policy-makers and market participants have a better understanding of both the shortcomings in the current financial system and what needs to be done - by both groups - to address them. This response is important for all economies. Even though most of the practices that contributed to the crisis took place beyond our borders, and our financial institutions are in comparatively robust health, Canada is not isolated from global events. Some of our institutions have suffered losses, and our economy is beginning to feel the effects of the deterioration in global financial conditions. Moreover, going forward, national markets will be judged by new standards of liquidity, transparency, and the greater integrity that comes from properly aligned incentives. Our institutions will have to compete in that environment. In my remarks today, I would like to discuss briefly three of the factors behind the market turbulence and then outline corresponding priorities for the official sector and market participants. This list is far from exhaustive, but I chose these three because they are among the most important, and because efforts are now under way - in both the public and private sectors - to address them. Causes of the Turbulence Recent events represent an overdue repricing of risk; the direction of which was predicted by many and desired by some. However, the speed and virulence of the repricing has illustrated the adage "Be careful what you wish for." While the repricing was triggered by significantly higher-than-expected defaults in U.S. subprime mortgages, we should all recognize that the trigger could have come from a wide range of sources. The social and economic costs of the events in the subprime market are concentrated in the United States, while the financial costs are both widely dispersed and - relative to the scale of the system - readily absorbable. In short, as painful as they are to those affected, subprime losses have been important primarily because they have revealed deeper flaws in the financial system. While a number of underlying causes can be identified, I will concentrate on three in particular. The first relates to liquidity. In recent years, market participants were overly confident that liquid markets would continually provide an outlet for new products and represent an ongoing source of funding liquidity for financial institutions. Ample market liquidity had its origins in benign macroeconomic conditions, low and relatively stable long-term interest rates, financial innovation, and the broadening list of financial market participants. Ultimately sowing the seeds of its own demise, market liquidity fed a supreme confidence in the ability to sell holdings at prices that matched mark-to-model valuations. This overconfidence encouraged the rapid growth of the "originate-to-distribute" credit model. In this model, the borrower often became separated from the end investor by several transactions, as credit risk was repackaged, tiered, securitized, and distributed. Many originators and distributors felt confident that long-term credit risk had been transformed into short-term "warehouse" risk prior to distribution and that distribution itself was irrevocable. Others knew that they had not fully eliminated these risks, but felt they could get out in time. Such confidence was misplaced. Risk had not disappeared, it had merely been redistributed, and that distribution was often not final. The current market disruptions represent, in part, the painful process of finding out where that risk ultimately lies. Liquidity was also the Achilles heel of many asset-backed commercial paper (ABCP) programs and structured investment vehicles. In many such vehicles, medium-term, illiquid, hard-to-value assets were funded by short-term money market securities at yields only marginally higher than those offered by the most liquid, transparent, risk-free securities. As confidence that this paper could be rolled over faltered, there was indiscriminate selling of structured assets. In markets where backstop liquidity was judged not to be automatic, such as the ABCP currently involved in the Montreal Accord, noteholders could no longer redeem their paper. In markets where backstop liquidity was robust, investors could exit and, as a result, ABCP came back on the balance sheets of financial institutions, which in turn raised concerns about the scale of their exposure. From a medium-term perspective, the disappearance of segments of ABCP markets around the world will have important implications for the viability of many securitized products, since ABCP represented an important funding source for the most senior tranches of securitized credit structures. The second cause of current market disruptions has been the lack of transparency and inadequate disclosure that characterizes many highly structured financial products. These shortcomings were ignored when times were good to the extent that many investors did not actually understand the characteristics of the securities that they owned. Market participants were often less surprised by the deterioration in subprime market fundamentals than by the marked-to-market losses of subprime collateralized debt obligation (CDO) securities, given the defaults in the underlying mortgages. This surprise, in turn, has prompted a broad re-evaluation of structured products and, in some cases, indiscriminate selling. Even months later, the opacity of these structured products has made them harder to value, thus dramatically reducing secondary market liquidity. Poor disclosure of many securitized products continues to make it difficult for new investors to enter the market confidently and purchase securities despite distressed prices and the presence of still-substantial global liquidity. Indeed, as I will discuss in a moment, the high cost of default protection in many markets - such as that for corporate bonds - implies a pessimism about actual default probabilities that appears excessive. At the same time, widespread uncertainty about the distribution of losses has fed concerns over counterparty risk. With the assumption that risk had been irrevocably transferred found wanting, market participants became uncertain about the true financial situations of their counterparties, and have sometimes been reluctant to lend, even at very short horizons. The resulting "reckless prudence" has, on occasion, created very unusual conditions in interbank markets and intensified the already sharp reduction in market liquidity. Inadequate transparency was also a factor behind the breakdown of trust in credit-rating agencies, which has amplified the stresses in financial markets. This breakdown occurred for several reasons. First, the default and ratings transition probabilities of structured products have not always been consistent with those of corporate and sovereign ratings. Moreover, recent events have brought into focus some potential conflicts of interest in the ratings business. The fall from grace of the rating agencies has had a significant impact because rating agencies had grown more powerful than anyone intended. Indeed, many investors seem to have performed little or no in-house credit analysis of their investments; in other words, they substituted a subscription to a ratings publication for analysis and due diligence. The third and final cause that I will mention was a series of misaligned incentives. It has been belatedly recognized that the severing of the long-term relationship between the originator and the borrower has contributed to the decline in credit quality. Historically, the original lenders (or originators of a credit) would be meticulous with their documentation and careful with their due diligence, because they knew that they would likely retain the exposure to risk of default until the loan matured. However, as originators became increasingly confident that they could sell off the loan, documentation and credit standards declined to the now-infamous extreme of "Low doc/NINJA" (no income, job or assets) loans to U.S. subprime borrowers. Performance has deteriorated accordingly: for example, default rates for U.S. subprime mortgage loans made in 2006 have already reached almost 8 per cent less than two years after origination, a rate 2.5 times the comparable figure for similar loans made in 2004. There also appear to have been a number of problems with incentive alignment in several global financial institutions. These include mismatches between the timing of trader compensation and the realization of profits from their trades, an insufficient recognition and compensation of risk-management professionals, and provision of funding at riskfree rates to trading desks that placed risky bets. All of these factors encouraged excessive risk taking. Finally, it appears possible that the incentives provided by a series of regulations may have encouraged crowded trades. The so-called "cliff risk" created by the mandated use of ratings is one example. A paradox of the current turbulence is that a desire to shelter in the perceived safety of AAA-rated assets led to a dangerous explosion in the supply of synthetically created AAA-rated assets. Since many of these assets were financed by excessive leverage and many participants were constrained by mandates to sell on downgrades, the rush to the exits has proven extremely destabilizing. Before addressing specific responses in detail, I would like to make a couple of general points. The first is that, while the need to restore well-functioning markets is of paramount importance, the official sector can afford to take some time to ensure that the actions they take are appropriate. This is because many of the market practices that contributed to the dislocations have stopped. At present, many financial institutions are, at best, assuming limited access to market-based liquidity and, in the extreme, hoarding liquidity. It is an understatement to say that credit exposure is once again receiving active scrutiny. The demand for complex, opaque securities has dried up. With institutional memory longer than a few months, even in the financial sector, there is no need to rush to judgment or to impose hastily conceived measures. The other point is that market participants have every reason to learn the lessons of these events and to change their be haviour as required. As I will discuss in a moment, there are some encouraging signs in this regard. That said, recent events have revealed serious and widespread shortcomings that, if not addressed promptly, completely, and credibly, will demand a more activist response on the part of regulators. The ultimate response will likely be a combination of improved private sector standards and more effective regulation. With those general points in mind, I would like to describe the current responses to the three factors I just mentioned. First, in terms of liquidity, in many countries the official sector has been working to strengthen and modernize their liquidity arrangements where necessary. Since August, many central banks have provided liquidity to keep the financial system functioning, while not favouring any one market. In the case of the Bank of Canada, our provision of liquidity through standard operations has been effective in keeping the overnight interest rate close to our target. However, as in other countries, liquidity further out the maturity spectrum has been more problematic. While liquidity in term money markets in Canada is currently better than it was in December and better than that now experienced in other jurisdictions, it has not yet returned to historical norms. There are a number of ways in which the Bank of Canada is seeking to improve its ability to provide liquidity to the system. First, the Bank has indicated that we plan to expand the list of collateral that we will accept in our Standing Liquidity Facility. Last week, we issued a consultation paper on our plans to take some types of ABCP as collateral by March. We also plan to accept U.S. Treasuries as collateral by the middle of the year. Second, we are examining the types of term purchase and resale facilities that we should make available in times of financial instability or market failure. These facilities could be similar to the term purchase and resale agreements (or PRAs) that the Bank conducted in December and will be conducting again over the next few weeks. In both of these cases, announcements of these term PRAs were made as part of coordinated actions taken by major central banks to address liquidity pressures in funding markets. The G-10 central banks will continue to work together and will take appropriate steps to address these liquidity pressures. Finally, in its recent budget, the Federal government announced proposals to amend the Bank of Canada Act in order to modernize our authorities to support the stability of the financial system. In parallel with these initiatives, liquidity management at financial institutions must also be improved. Reinvigorated institutional memory has reminded a broad range of institutions of the importance of liquidity management and credit discipline. It is worth noting that, a year ago, the Institute of International Finance published a thoughtful document that outlined potential vulnerabilities in the management of liquidity risk at financial institutions and suggested best practices in the private and official sectors. However, as with so much in life, implementation is everything. Regulators are now developing new guidelines and increasing their focus on liquidity management to redress these shortcomings. The second priority area for action is the need for improvements in both transparency and disclosure practices. Such improvements would help to reduce the information asymmetries that impede the smooth functioning of markets. Globally, there is an urgent need for credible, timely disclosure. Recent reports from Canadian financial institutions have met this requirement. However, information alone is insufficient; investors also need to know how to interpret it. The combination of the relative novelty of fair value accounting and extremely volatile markets has made this interpretation more difficult. Some have questioned the utility of requiring mark-tomarket valuations of all assets and liabilities on a corporate balance sheet. The point can be made that, in the current circumstances, existing accounting rules provide a degree of precision that is not warranted. By reflecting market moves, fair value accounting certainly increases the volatility of reported earnings. Whether it contributes pro-cyclically to market volatility depends on the behaviour of management. Management's incentive to realize mark-to-market losses depends not only on their expectations of future market moves but also, importantly, on the extent to which investors reward them for capping downside risk or penalize them for higher book leverage caused by unrealized losses. This depends, in part, on investors' interpretation of existing rules. Investors should keep several factors in mind. First, in volatile markets, reported earnings will be volatile. Second, investors should distinguish between realized and unrealized losses. Third, securities may be marked-to-market using imperfect proxies, such as thinly traded derivative indices. As a consequence, investors should be wary of assigning unwarranted precision to such valuations. Fourth, for many complex securities, valuation might be better expressed as a range of outcomes. Since current accounting rules do not permit this, investors must use their judgment to construct valuation distributions. Institutions should provide the information necessary to facilitate such judgments. From a medium-term perspective, the Financial Stability Forum is looking at accounting and valuation procedures for financial derivative instruments, particularly those for complex, narrowly traded products that become difficult to price in times of stress. More generally, authorities around the world are promoting prompt and full disclosure by financial institutions of losses and valuations of structured products, and are seeking to improve the understanding and disclosure of institutions' exposure to off-balance-sheet vehicles. Loss recognition by major financial institutions is proceeding much more rapidly than during previous periods of financial turmoil. This will ultimately speed the recovery process, provided that investors realize that the rules of the game have changed. Losses that would have been hidden in reserves in the past are now quickly, and sometimes imprecisely, in the open. Some of these losses will be revised later; thus, reported earnings may be more volatile than realized final results. What can authorities do themselves to encourage greater transparency in structured products? First, as announced last week, the Bank's high disclosure standards for the ABCP that it will accept as collateral in its Standing Liquidity Facility may encourage market participants to raise their own standards. In the end, it will be their decision. While issuers and arrangers have every incentive to improve the transparency of structured products, ultimately, disclosure guidelines are set - or not - by regulators. One lesson from the ABCP situation may be that blanket disclosure exemptions were too broad. At the same time, however, authorities should resist the temptation to bring forward overly prescriptive regulations. Rather, they should consider greater application of principles-based regulation. There is no point in regulators trying to anticipate every new product or to restrain their development. There is a point in encouraging issuers to ensure the adequacy of their disclosure within a principles-based framework and to bear the consequences if it is subsequently found wanting. As I commented earlier, the evolving role of rating agencies relates closely to issues of disclosure and trans parency. Authorities are examining the role of credit-rating agencies in evaluating structured products and the impact of the mandated use of ratings due to investment guidelines or regulation. Going forward, securities regulators will want to see agency incentives aligned more closely with those of investors, and will ensure that agencies are quicker and more thorough in reviewing past ratings. Other regulators must also take responsibility for looking at the extent to which the mandated use of ratings has encouraged credit outsourcing, led to pro-cyclical price movements, and encouraged discontinuous crowded trades. Since rating agencies rely on their reputations, they have powerful incentives to sharpen their practices, improve the information content of their ratings for complex financial instruments, ensure that all material facts are disclosed in a concise and timely manner, and address inherent conflicts of interest in the ratings process. Recent announcements by rating agencies in this regard are encouraging. I should again stress that investors must not rely exclusively on changes in the rating methodologies of the agencies to repair deficiencies in their own risk-management practices. In a mark-to-market world, with leveraged, collateralized positions, investors need to make their own judgments about the creditworthiness, liquidity, and price volatility of the securities they own. The third priority area for action concerns the proper alignment of incentives. The market dislocations have revealed some examples of serious principal-agent problems, most notably, within the originate-to-distribute model. For securitization markets to function well, the incentives of originators should be aligned with those of end investors. Indeed, originators and distributors are finding it difficult to sell products where they do not face first loss or otherwise retain exposure through reputational risk. I have little doubt that, over time, originators and distributors will adjust. Incentive alignment is a necessary but not sufficient condition to revive many structured-product markets. It will need to be accompanied by greater standardization, improved transparency, and the development of an appropriate investor base. Another example of misaligned incentives can be seen in the risk-management practices and remuneration structures of financial institutions globally. Many financial institutions have pay structures that reward short-term results and encourage potentially excessive risk taking. Investors should take the lead in demanding compensation structures that are more aligned with their interests. Others have suggested that the regulators themselves should make these determinations. While I think regulation of compensation within private institutions is entirely inappropriate, I do think that regulators need to consider carefully the incentive impact of compensation arrangements as they assess the robustness of risk-management and internal control systems. Regulation also creates incentives. The Financial Stability Forum is reviewing the basic supervisory principles of prudential oversight and the possibility that the incentives created by accounting standards and bank capital regulation are contributing to procyclicality in the financial system. Let me conclude with some comments on the role of monetary policy. At a time of great uncertainty, it is more important than ever that monetary policy act as a stabilizing force. This underscores the importance of keeping inflation low, stable, and predictable. This means that the Bank will continue to watch developments in the real economy for their impact on inflation. Developments in the financial sector will be important from a monetary policy perspective only to the extent that they are expected to influence developments in the real economy and, therefore, inflation. I do not mean to downplay the current financial turbulence - it has clearly begun to affect the U.S. economy and, to a lesser extent, ours as well. At the Bank of Canada, we will continue to monitor these effects, while aiming neither to favour particular market segments nor to insulate market participants from the consequences of their decisions. Those consequences will continue to reveal themselves in the weeks and months ahead. This will remain a difficult process. However, the responses that I have just outlined will help the market translate uncertainty into risk, and encourage the appropriate repricing of risk so that markets can ultimately return to more normal functioning. However, this will not mean a full return to the status quo ante. While risk will still be distributed, securitization will be increasingly transparent and standardized, and perhaps eventually exchange traded. First loss will likely remain, to some degree, with the originator. Liquidity and balance sheet strength will be more highly valued. Volatility will be less restrained by overconfidence. In short, we will see a world in which financial institutions with sound credit judgment, effective risk management, and patient capital can prosper; a world in which capital is allocated more efficiently; a world that rewards the traditional attributes of Canadian financial institutions. I feel very positive about Canada's medium-term prospects in such a world.

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Trends and Challenges in the Global Economy and What They Mean for Canada and Ontario

jenkins

London Chamber of Commerce Good morning. First, I would like to thank the London Chamber of Commerce for inviting us here today. It's a pleasure for me to be back in London, given my close family ties and my years at the University of Western Ontario. As is the case for so many cities and regions in Canada, London's economy and that of southwestern Ontario are directly affected by changes in the global economy. And, as with so many things in life, the better we understand the forces of change, the better equipped we are to deal with them. What I'd like to do this morning is discuss some of the key trends in the global economy, as well as the challenges they present, and then talk about some of the implications for Canada and for Ontario. And because one of the main reasons that we have come to London is to hear your thoughts and concerns, I'll leave plenty of time for your comments and questions. The turbulence in global financial markets, which has been with us since last August, continues to be a major focus. But rather than starting there, allow me to first step back and provide a perspective that covers the past five or six years. From 2002 to 2007, the world economy expanded strongly, growing by an average of 4.6 per cent per year, measured in terms of real GDP. The growth of world trade was even more impressive, at about 7 per cent on an annual average basis. This period of robust growth benefited most nations, and was strongest in emerging-market countries such as China, India, and Brazil. In industrialized countries, growth was also steady and solid. What we are now confronting is a marked slowdown in global economic growth, emanating primarily from the sharp correction under way in the U.S. housing market and the associated tightening in credit conditions linked to the collapse of the U.S. subprimemortgage market. I will come back to discuss these financial developments in a moment. But in keeping with the theme of taking a longer-term perspective, it's important to note that some slowing in global economic growth was necessary. After five to six years of nearly unprecedented growth, levels of economic activity around the globe were straining capacity limits and beginning to put upward pressure on inflation. These pressures can be seen in the sharp run-up in commodity prices. Compared with the beginning of 2002, U.S.-dollar prices are more than 5 times higher for crude oil, and more than triple for metals and grains. In real terms (that is, compared with the increase in overall consumer prices) the price of crude oil has more than quadrupled over this period, and is now above the levels reached in the 1970s and early 1980s. The impact of these elevated commodity prices on consumer prices can be seen in the latest numbers on total consumer price inflation. In the United States, the United Kingdom and the euro zone, total CPI inflation is currently at 4.0 per cent, 2.5 per cent, and 3.5 per cent, respectively. Emerging-market countries are also facing rising price pressures. Core inflation, which excludes the effects of rising food and energy prices is, however, running closer to 2 per cent in industrial countries. With global economic growth slowing, it is unlikely that the higher prices of food and energy will spill over into prices and costs more generally, but this risk is something central banks are watching closely. In other words, central banks are focused on keeping inflation expectations well anchored. With that backdrop, let me now discuss three key challenges facing the global economy and, by extension, Canada and Ontario: first, the slowdown of the U.S. economy and the associated financial turbulence; second, global trade imbalances; and third, competition from emerging-market countries. The most immediate challenge facing the global economy is the marked slowdown in the U.S. economy. This slowdown involves several interconnected elements, and, given our close trade links to the United States, has very direct consequences for Canada. One element is the sharp and protracted correction under way in the U.S. housing sector. This correction stems from the fact that house building had risen to unsustainable levels and from the related implosion of the subprime-mortgage market with its weak underwriting standards. Construction, sales, and prices in the housing market have fallen dramatically, and inventories of unsold houses remain high. Another element is, of course, the financial turbulence and changes in credit markets that we've witnessed over the past eight months. Given the complexity of this situation, let me spend a little more time on it. To understand the cause of this turbulence, it's again useful to look back over the past five or six years. During this period, a decline in inflation, together with an excess of global savings relative to desired investment, resulted in real interest rates that were low by historical standards. It was also a period, as I noted earlier, of strong, steady global economic expansion. In this macroeconomic setting, spreads between higher-risk and lower-risk investments declined. At the same time, a variety of new financial instruments, such as new types of asset-backed securities and collateralized debt obligations, were introduced. Investors who were looking to enhance their returns were attracted to these products. This led to greater leverage (that is, debt financing) and to investors taking on risks that many clearly did not fully understand. The link back to the United States is that many of these new, or structured, products had subprime mortgages embedded in them. Once delinquencies and defaults on these mortgages started to mount, and given the opacity of these investment products, risk premiums started to widen, market liquidity started to dry up, and credit conditions tightened. And these financial market reactions were felt globally. I will quickly add, however, that the pressures in Canadian financial markets have been less intense because of the relatively healthy balance sheets of households, firms, and financial institutions in The entire episode, which is by no means fully played out, can be seen as an overdue repricing of risk, a recognition of losses, and a recapitalization of balance sheets. Governor Carney spoke recently about this topic, so I won't dwell on it here, but suffice it so say that these events highlight the need for change in both the private and public sectors so that markets can return to more normal functioning. In the private sector, the most pressing needs for change include greater transparency in financial products, improved risk and liquidity management, and more rational, better-aligned incentives. For our part, we at the Bank are taking steps to support the functioning of markets by expanding the list of eligible collateral that we will accept in our Standing Liquidity Facility, by examining types of term operations and term lending, and by modernizing our legislative authority to support the stability of the financial system. The second challenge facing the global economy and Canada has to do with the large current account imbalances that exist today. In a nutshell, the United States has been running a very sizable current account deficit for a number of years, while most of the rest of the world - is especially Asia and oil- exporting countries - has been running current account surpluses. Large imbalances such as these are not sustainable over long periods, so the question arises: what needs to be done to effect an orderly resolution? Two main adjustments are needed. First, those countries with large surpluses need to rely more on domestic demand as a source of growth, and those with deficits (mainly the United States) need to increase their national savings rate. Second, there is a need for more exchange rate flexibility. This is particularly the case for China, but also more broadly across Southeast Asia. China continues to resist exchange rate flexibility, and thus adjustment, through the accumulation of foreign exchange reserves, which now total US$1.5 trillion. I want to quickly add that greater exchange rate flexibility is in China's own best interest. It would greatly enhance their ability to manage their own economy, including dealing with their mounting inflationary pressures. The third major challenge is the integration of China and India into the global economy. Not surprisingly, some perceive the growing economic clout of and competition from China and India as a threat, especially as both countries increasingly produce more highvalue-added goods and services. But the growth of emerging-market economies represents a tremendous opportunity for Canadian businesses. We need to exploit our comparative advantages and see these rapidly expanding markets as places to do business. So, that's a quick look at some of the trends in and the challenges posed by the global economy. Let me now turn to the home front and discuss some key economic issues facing Canada and Ontario, in light of these global developments. These global economic trends represent significant and, in a very real way, competing or contrasting, forces shaping developments here at home. Strong commodity prices are generating a substantial boost to incomes in Canada. In economic jargon, we have had an increase in our terms of trade - the prices of the products we sell internationally are rising faster than the prices of the products we import. The resulting rise in real incomes is providing support for domestic demand in Canada, which has been showing up in rising consumption, construction spending, investment in machinery and equipment, and, more broadly, in employment gains. At the same time, the weakness of the U.S. economy, the strength of our dollar (reflecting the increase in our terms of trade and the relative weakness of the U.S. dollar), and competition from Asia have led to flat to declining exports, especially in the manufacturing sector. Thus, overall, what we have had in Canada is strong domestic demand offsetting a weak traded-goods sector. Monetary policy has been calibrated based on judgments about the relative strengths of these competing forces, with an eye firmly fixed on the policy objective of keeping inflation at our 2 per cent target. Currently, total CPI inflation in Canada is 1.8 per cent. Excluding the one-time effect of the January GST cut, total CPI inflation is 2.4 per cent, and core inflation (which excludes the more volatile Staying on top of all the forces at play is an essential preoccupation of the Bank of Canada. As we said in our last policy press release a month ago, the correction in the U.S. housing sector, knock-on effects of this correction to other parts of the U.S. economy, and the tightening of credit conditions in global financial markets have led us to conclude that the risks surrounding the Canadian economy have shifted to the downside, resulting in our decision to lower our policy interest rate by 50 basis points to 3.5 per cent. We also said that further monetary stimulus is likely to be required in the near term to keep aggregate supply and demand in balance and to achieve the 2 per cent inflation target over the medium term. With that global and national perspective, I'll now talk about some of the issues, challenges, and opportunities facing the Ontario economy. Ontario's economy is being confronted by both cyclical and structural economic forces. On the cyclical front, we have the marked slowdown in the U.S. economy. This has had a direct impact on the province's forest products industry - from lumber, to doors, windows, and building materials generally - and on the automotive industry. But these and other industries are feeling the effects of strong structural forces. Clearly, competition from emerging-market countries is one of those forces. Because of these cyclical and structural forces, demand has turned away from a number of products that Ontario has traditionally produced. In other words, relative prices have moved against some key segments of the Ontario economy. To draw a comparison to the national situation, one could say that there has been an adverse movement in Ontario's terms of trade. Of course, the rise in value of the Canadian dollar over the past five or six years has been an important part of these relative price movements. At the same time, some sectors of the province's economy are benefiting from these changes in relative prices, including the mining and agrifood sectors. We must also remember that the manufacturing sector is not homogenous - the high- tech sector standing out as an example. And Ontario has strong financial services and health services sectors. What this adds up to is the need for adjustment within the Ontario economy in response to these global forces. Adjustment is not easy. But London and its surrounding area does seem to me to stand out as an example of the importance of having the flexibility to respond and adjust to changing circumstances. Some 20 years ago, manufacturing accounted for 20 per cent of the jobs in London, compared with 14 per cent today. This decline has been more than offset over the past 20 years by employment gains in financial, business, and professional services, and in transportation and warehousing. In addition, we have seen significant investments, including in the manufacturing base of this community, in technology that supports world-class operations. The result for London over this period has been rising employment and rising real incomes. Good macroeconomic management is certainly part of what is needed to help provinces, cities, and communities adjust to global change. This includes sound fiscal policies, policies that help to reduce public sector debt levels relative to the size of the economy. The Bank of Canada also has an important role to play. The Bank's monetary policy aims at keeping inflation low, stable, and predictable. This, in turn, helps households, businesses, and governments to read price signals more clearly, respond to relative price movements more promptly, and allocate production resources more efficiently. When relative prices move to the extent that they have in recent years, markets are essentially telling us that there has been a fundamental change in the type of products that the rest of the world wants to buy from Canada. In setting monetary policy, our job is to understand what this means for Canada's overall economic picture, which implies a focus that is national in nature and scope. To conclude, the first point I wish to make is the importance of allowing market-based adjustment mechanisms to work. Markets send price signals that indicate the best way for resources to be allocated. Second, it is also important for households, businesses, and governments to take a medium- to longer-term perspective in making decisions. The global forces at play are not going to disappear any time soon. We therefore need to encourage flexibility and adaptability in the Canadian and Ontario economies. In other words, more needs to be done to enhance the functioning of our internal markets. Policies that support flexibility can obviously help economies adjust to cyclical economic shocks. But encouraging flexibility can also have a longer-term payoff. When policies provide an environment where initiative and innovation can flourish, the Canadian economy is able to adapt to longer-term global forces in ways that continuously exploit our comparative advantages. Thank you for your attention. I would now be happy to respond to your questions and comments.

r080410a_BOC

canada

Credit Markets, Financial Stability, and Monetary Policy

longworth

Good afternoon, ladies and gentlemen. It's good to be here in my home province of Alberta to discuss with you some interesting topics at a very interesting time. I remember back in January thinking that the previous five months had been the busiest of my career at the Bank of Canada. However, I believe I can now say that the past eight months have definitely been the most active - and most interesting - in my Bank of Canada career. Today, I'd like to discuss some of the crucial issues that we have been dealing with during this period. I'll begin with a brief overview of some key events that have led to the turbulence that continues to upset financial markets and that greatly contributed to the remarkably wide credit spreads that we now witness. I'll discuss some of the ongoing analysis of these credit spreads that we are conducting at the Bank of Canada. I will then turn to the policy issues around financial stability that the turbulence has highlighted and describe some of the work that we are doing to promote financial stability throughout this period of uncertainty. Finally, I'll describe how we take financial market developments into account as we conduct monetary policy and the important role that this policy plays in promoting economic and financial stability for Canadians. How did this happen? What were some of the root causes of the current market turbulence? We know that for a number of years, desired world savings exceeded desired world investment. As a result, long-term real interest rates decreased around the world. This led investors to search for yield, and they became willing to take on risk at lower premiums than they had demanded in the past. Part of this search for yield led to rapid growth in the demand for, and development of, more complex structured financial products, such as collateralized debt obligations (CDOs) backed by asset-backed securities or by other CDOs, and assetbacked commercial paper (ABCP) backed by CDOs, some of which (after 2000) were based on U.S. subprime mortgages. These complex instruments were rated by credit-rating agencies using the same scale that they had used in the past for plain-vanilla corporate debt. Some sellers of these complex financial instruments emphasized that these products were highly rated - many were AAA - but placed little emphasis on their other features. A number of investors failed to perform their own research or due diligence and instead relied too much on credit ratings as a measure of the ultimate risk in holding these complex debt instruments. In doing so, they failed to take into account other risks such as liquidity risk. The complexity of these instruments frequently made them opaque, and too often investors put their money and confidence into investments that they did not fully understand. At the same time, U.S. policy interest rates rose, and the basic loan quality of U.S. subprime mortgages worsened through 2005 and 2006, although this worsening did not become broadly apparent until the first half of 2007. The belated realization by the rating agencies of the poor quality of these loans resulted in downgrades of structured products with exposure to subprime mortgages, often by multiple notches. These instruments were held by a variety of investment funds, including many sponsored by banks. Indeed, some products were directly held by banks themselves. Investors in Canada, as well as those in the United States, soon came to realize that highly rated structured debt instruments could fall substantially in value and were subject to severe downgrades. As a result, they began to shun almost any type of structured product, partly because the complexity of such products made it difficult for many market participants to understand these instruments and, therefore, to accurately price the risk that these products posed to financial institutions. In Canada, this included instruments such as ABCP. Almost immediately, non-bank-sponsored ABCP stopped rolling over in Canada, which led to the standstill under the Montreal Accord. As market players observed the downgrades of structured products based on U.S. subprime mortgages and the drying up of ABCP markets, two additional concerns emerged. First, there was a concern about the financial health of counterparties, particularly banks. Second, there was a concern that securitization would proceed at a much slower pace than in the past, thus requiring re-intermediation that would result in a more rapid expansion of bank balance sheets and an associated need for capital. These two concerns led to a significant increase in the interest rate spreads of bank debt over government benchmarks. As time has passed, it has not been only bank credit spreads that have widened. We know from past experience that variations in credit spreads can be driven by several different factors. One basic component of credit spreads is expected loss from default, while a second relates to risk premiums, of which there are two main types: a credit-risk premium and an illiquidity premium. The credit-risk premium is related to the variability of underlying expected loss, and both this premium and the expected loss from default itself are affected by changes in macroeconomic activity. The illiquidity premium relates to a lack of general market liquidity. The credit and illiquidity premiums, like other risk premiums, can vary with any change in the risk appetite of investors. Now, let me look specifically at the Canadian situation. From early 2004 to mid-2007, spreads on Canadian corporate investment-grade and high-yield bonds were fairly stable and narrow relative to historical norms, as were those in most other industrialized countries. (This can be seen in Chart 1.) But these spreads began to widen last summer as the crisis in the subprime-mortgage market started to take hold. Some of this widening can be explained by rising concerns about Canada's economic outlook due to the impact here of a possible recession in the United States. However, credit spreads - while not all at historic peaks - are now far wider than one would have predicted, based on past experience with economic downturns, and given the fact that Canada's economy is in a healthier position than the U.S. economy. (Chart 2 shows spreads on investmentgrade bonds in both Canada and the United States.) One partial explanation for the current wide credit spreads - globally, not just in Canada - relates to an unusual rise in factors not related to credit risk, such as the systemic drying up of market liquidity for debt issued by corporations, particularly for debt issued by investment-grade companies like financial institutions. Another partial explanation is that the current wide credit spreads are being driven by what appears to be excessive pessimism about expected default rates. We can see evidence of this in the very high cost of default protection in many markets, despite some improvement recently. shows the evolution of credit default spreads in North America and Europe, for both investment-grade and "crossover" companies, that is, those with lower-quality but still investment-grade ratings or slightly below.) As we work to better understand the forces behind these particularly wide credit spreads, we do realize that as difficult as it can be to price risk, the current situation demonstrates how much more difficult it is to price uncertainty. Market participants are facing issues and questions that are unfamiliar and that cannot be easily answered, which is creating this uncertainty. The first source of this uncertainty is the unique nature of the U.S. experience with the kind of housing crisis that the U.S. economy is facing. This is the first time in more than a half-century that we have seen such a fall in nominal U.S. house prices. A second source of uncertainty in markets relates to questions about the solvency of financial institutions. When market participants lose confidence in their ability to assess the solvency of their counterparties, which are often other financial institutions, they become reluctant to lend to one another. In the current example, when firms did agree to loan to each other, they often demanded unusually high short-term interest rates, which contributed to the wide credit spreads that we have been witnessing. Most recently, we've seen a powerful example of this uncertainty playing out in the situation involving Bear Stearns. The positive news is that financial institutions have revealed more of their losses and exposures, and have taken steps to rebuild capital. These actions have tended to settle markets. As I alluded to earlier, market uncertainty has been global in nature. Most industrialized countries have seen sharp and often unprecedented widening in the spreads between rates in short-term credit markets, such as the 3-month London Interbank interest rates. (Chart 4 shows how short-term spreads have widened significantly since last August. Canadian spreads are now significantly below their peaks, but remain elevated relative to historical norms.) A third source of market uncertainty relates to the degree of de-leveraging of hedge funds, proprietary desks, and other highly leveraged institutions. With some prime brokers facing capital constraints and with the volatility of asset prices having risen, certain institutions - including hedge funds - are seeing their lines of credit cut and their margin requirements raised. This typically forces them to sell assets, which has exacerbated the illiquidity in markets, making it extremely difficult for market participants to price these assets or, at times, to find a market for them. One might assume that this situation could create an excellent buying opportunity for sizable, unleveraged institutional investors, the so-called "real money funds." Yet most have remained largely on the sidelines. They may be held back by the continued uncertainty, perhaps waiting to see if the market has further to fall, thus creating even better buying opportunities. Again, the increased provision of information by financial institutions on their losses and exposures should be very helpful in easing uncertainties. Now, let me turn to issues regarding financial stability policies that have arisen out of this period of turbulence. I will touch briefly on three issues: first, polices related to transparency and information; second, policies regarding the regulation of financial institutions; and third, central bank financial stability policies. We know that markets work best when relevant information is available to all. One result of the recent turmoil is that concerns have been raised regarding the transparency of complex financial instruments and the role of the information supplied by credit-rating agencies. In Canada, issues regarding the transparency of instruments have been most pronounced with respect to ABCP - particularly the non-bank-sponsored ABCP covered by the Montreal Accord. There has already been some movement towards greater transparency in the bank - -sponsored segments of this market. But greater transparency of financial instruments isn't enough - investors also need to know how to interpret the information. Although credit-rating agencies have helped with interpretation in the past, they have recently come under scrutiny for their role in the financial market turbulence. However, because rating agencies rely on their reputations, they have strong incentives to improve the information content of their ratings for complex financial instruments, to ensure that all material facts are disclosed in a concise and timely manner, and to address inherent conflicts of interest in the ratings process. They have shown an ability and willingness to learn from their mistakes, and they are regularly refining their rating processes. This does not mean, though, that investors can rely exclusively on the judgment of others. In the end, investors must accept responsibility for understanding and managing the credit risk in their portfolios. I'll turn now to some issues regarding financial institutions and their regulation. I'll focus on a few issues related to the models of operations in these institutions, the management of risks, and the management and regulation of liquidity. We can now see that one of the key problems with securitized U.S. subprime mortgages rested with the so-called "originate and distribute" model in which mortgage originators, many of whom did not face the same regulations as banks, entered into mortgage contracts with homeowners, and then laid off these assets as they were securitized. In principle, there is nothing wrong with having a model based on "originate and distribute," but in practice, a number of major things went wrong, as we saw in the recent U.S. example. For example, some originators did not have sufficient incentives to conduct appropriate credit checks on clients. This model is now being closely examined by regulators in the United States and around the world, to ensure that the right incentives for originators and distributors are in place and are appropriately aligned. Risk management within banks themselves is also facing scrutiny. In many cases, their risk-management practices did not prepare banks for the recent market turbulence, and so these market practices need to be addressed. While the Basel Committee on Banking Supervision has devoted most of its time over the past several years to completing its work on capital adequacy, it is now devoting more time and resources to the analysis of risk-management processes in banks and to the principles of liquidity management for banks. Let me turn now to the financial stability policies of central banks. When there is a clear market failure and a major disruption to financial stability, a central bank - depending on circumstances - may wish to relieve liquidity pressures on the financial system by doing one or more of the following. It may choose to extend the maturity of its market operations; it may coordinate closely with other central banks when there is an international dimension to the problem; it may choose to widen the range of securities in its market operations or loan facilities; or, it may choose to increase the frequency of its market operations. We opted for the first three of these with the term purchase and resale operations announced on 12 December and 11 March. Although we typically carry out purchase and resale operations with an overnight maturity, the two operations announced in March were for a much longer maturity (the two March operations were both for 28 days). Both of these announcements were coordinated with the actions of four other central banks and were supported by two other central banks. In all of these operations, the range of eligible securities was essentially the widest allowed under the Bank of Canada Act. Recently announced amendments, which will modernize the Act, would allow for a further widening in eligible instruments for such operations. As required by these proposed amendments, the Bank will publish its policy governing the use of these powers. The Bank will carefully consider the circumstances under which these powers would be used. In terms of its lending operations, the Bank of Canada is not legally constrained by its Act in the type of financial instruments that it can accept as collateral under its Standing Liquidity Facility (SLF), a facility that can be used in both normal and in turbulent times. On 31 March, we announced that, in the future, we will take ABCP securities that meet certain criteria - including transparency criteria - as collateral under our SLF. We had two broad policy objectives in making this announcement: first, that the eligibility criteria should mitigate any risks to the Bank that might be associated with accepting ABCP securities as collateral for the SLF. And second, we stated that the eligibility criteria should facilitate the development of a well-functioning market for ABCP by promoting more transparency for investors and by encouraging an active secondary market for these securities. The Bank has also announced that it will take U.S. Treasuries as collateral under the SLF by mid-year. In addition to the above, the Bank continues to work on examining policies related to the use of term operations and term lending facilities at times of major disruption to financial stability. This work is benefiting from the experiences and analysis of other central banks. Earlier, I mentioned that when there is a major disruption to financial stability, a central bank may have to increase the frequency of its operations. Well, for monetary policy reasons - to keep our key overnight interest rate close to its target - we have often had to carry out special purchase and resale agreements (at times, more than once per day.) That leads naturally into the topic of monetary policy in times of financial turbulence. It's very clear that at a time of great uncertainty, it is more important than ever that monetary policy act as a stabilizing force. This underscores the importance of keeping inflation low, stable, and predictable and requires us at the Bank to continue to watch developments in the real economy for their impact on inflation. We are certainly aware of the continuing developments in the financial sector. But from a monetary policy perspective, these are important only to the extent that they are expected to influence developments in the real economy and, therefore, inflation. I do not mean to downplay the current financial turbulence - it has clearly been a factor affecting the real economy in the United States and, to a lesser extent, in Canada as well. At the Bank of Canada, we will continue to monitor these effects, while aiming neither to favour particular market segments nor to insulate market participants from the consequences of their decisions. In terms of the financial turbulence, credit spreads in particular - and the credit conditions faced by businesses and households more generally - have an influence on aggregate demand and thus, potentially, on inflation. This needs to be taken into account in setting policy interest rates. (Charts 5 and 6 give an indication of the cost, in level terms, of short- and longer-term borrowing, respectively.) In our October , we estimated that the tightening of credit conditions was worth about 25 basis points relative to our overnight interest rate target. Then, in the January to the we noted that the tightening in credit conditions could be greater and more protracted than previously assumed. As well, we stated that there could be a more prolonged slowdown in the U.S. economy. Given the situation, we lowered our policy rate by 25 basis points. In our 4 March policy rate announcement, we indicated that deterioration in economic and financial conditions in the United States could be expected to have significant spillover effects on the global economy. We also said that those developments suggested that important downside risks to Canada's economic outlook, which were identified in the January , were materializing and, in some respects, intensifying. In response, we lowered our policy rate by 50 basis points to 3.50 per cent, and said that further monetary stimulus is likely to be required in the near term to keep aggregate supply and demand in balance and to achieve the 2 per cent inflation target over the medium term. I've talked about some of the causes of, and the lessons learned from, the recent financial market turbulence. In particular, as I mentioned at the outset of my remarks, we at the Bank of Canada are continuing our analysis of the unusually wide credit spreads that we've been seeing and what these mean for the stability of the financial system and, potentially, for the economy, inflation, and monetary policy. It's very clear that these unusual spreads, and the financial market upheaval that exacerbated these spreads, will continue to have an impact for some time to come. We do not know just when or how this turmoil will ultimately be resolved. You can be confident, however, that our focus at the Bank of Canada will remain on our core functions of supporting financial stability, and maintaining consumer price inflation at our 2 per cent target. In this way, we will continue to maintain an anchor for the economy through what will continue to be very interesting times. Thank you very much for your attention, and now I'll be happy to take your questions.

r080424a_BOC

canada

Release of the

carney

Governor of the Bank of Canada at a press conference following the release of the Today, we released our April , which discusses current economic and financial trends in the context of Canada s inflation-control strategy. Growth in the global economy has weakened since the January , reflecting the effects of a sharp slowdown in the U.S. economy and ongoing dislocations in global financial markets. Growth in the Canadian economy has also moderated. Buoyant growth in domestic demand, supported by high employment levels and improved terms of trade, has been substantially offset by a fall in net exports. Both total and core CPI inflation were running at about 1.5 per cent at the end of the first quarter, but the underlying trend of inflation is judged to be about 2 per cent, consistent with an economy that is running just above its production capacity. The U.S. economic slowdown is projected to be deeper and more protracted than in the . The projection reflects a more pronounced impact on consumer spending of the contraction in the U.S. housing market and significantly tighter credit conditions. The deterioration in economic and financial conditions in the United States will have direct consequences for the Canadian economy. First, exports are projected to decline, exerting a significant drag on growth in 2008. Second, turbulence in global financial markets will continue to affect the cost and availability of credit. Third, business and consumer sentiment in Canada is expected to soften somewhat. Nevertheless, domestic demand is projected to remain strong, supported by firm commodity prices, high employment levels, and the effect of cumulative easing in monetary policy. The Bank projects that the Canadian economy will grow by 1.4 per cent this year, 2.4 per cent in 2009, and 3.3 per cent in 2010. The emergence of excess supply in the economy should keep inflation below 2 per cent through 2009. Both core and total inflation are projected to move up to 2 per cent in 2010 as the economy moves back into balance. There are both upside and downside risks to the Bank's new projection for inflation; these risks appear to be balanced. In line with this outlook, some further monetary stimulus will likely be required to achieve the inflation target over the medium term. Given the cumulative reduction in the target for the overnight rate of 150 basis points since December, including the 50-basispoint reduction announced on 22 April, the timing of any further monetary stimulus will depend on the evolution of the global economy and domestic demand, and their impact on inflation in Canada.