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r150625a_BOC

canada

Building Trust, Not Walls: The Case for Cross-Border Financial Integration

schembri

Good afternoon. Thank you for the invitation to speak to you today. I am especially pleased to be in Windsor in 2015, which marks the 50th anniversary of The benefits of the pact and subsequent Canada-U.S. trade agreements are plainly evident in the steady flow of commercial traffic here at Canada's busiest border crossing. Windsor residents understand better than most that Canada remains the largest trading partner of the United States. In 2014, trade between our countries amounted to more than $850 billion--40 per cent of Canada's entire GDP. You also understand that this high level of trade is not just a feature of geography. It is the result of almost 200 years of good-neighbour collaboration, founded on trust, not walls. As a result of these co-operative efforts, we have achieved a high degree of cross-border access and economic integration that is the envy of the world. And most importantly, both countries have benefited. Today, I want to talk to you about cross-border financial collaboration, another key aspect of our relationship with the United States, as well as with other countries. We all know that a well-regulated and globally integrated financial system is essential for promoting trade and achieving sustainable economic and employment growth. However, the recent global financial crisis clearly demonstrated that while financial systems are indeed highly integrated across countries, many were inadequately regulated and supervised. In Canada, our financial system was, and is, well regulated and supervised. No Canadian banks failed during the crisis. The strength of our financial system helped us avoid the worst of the damage. Yet, we still lost 430,000 jobs and our exports plunged by more than 16 per cent. That experience taught us a valuable lesson. In a trading economy like ours, keeping our own financial house in order is not sufficient to shelter us from global financial storms. We need financial stability not just within countries but across them. The G-20 responded to the crisis with a comprehensive financial reform agenda, weaknesses, to promote global financial stability, and to enhance financial and economic integration. Since then, FSB member countries have made unprecedented progress on these objectives. I'll start with a brief overview of important reforms to the global banking system and to shadow banking--which refers to credit intermediation activities outside the traditional banking system--that have made the financial system as a whole safer. Then, I'll zero in on two reform areas that need more work: global banks that are "too big to fail" and over-the-counter (OTC) derivatives markets. Finally, I'll say a few words about a third policy issue that is critical for supporting financial integration--cross-border payments. Led by the G-20, the FSB and the international standard-setters are developing and monitoring the implementation of the required regulatory standards. successful reform efforts have helped rebuild trust in financial integration that was severely damaged by the crisis. A significant accomplishment is the Basel III framework, which has made global banks much stronger and more resilient. The framework, which requires banks to hold more capital and liquidity and imposes a backstop leverage limit, has largely been finalized. Although the deadline for full implementation is not until 2019, many jurisdictions, including Canada, are well ahead of schedule. As for shadow banking activities, they represented key sources of financial instability during the crisis through faulty subprime mortgage securitization and runs on money market funds and repo markets. The FSB is creating a comprehensive approach to monitor and assess these non-bank credit intermediation activities. Regulatory standards have been developed for several of the activities. For example, standards exist for securitization, specifically risk retention and disclosure; money market funds, including liquidity and valuation; and repo and securities-lending transactions, chiefly minimum haircuts. Several other types of shadow banking entities, such as broker-dealers, investment funds and finance companies, have been categorized by their economic function within a principlesbased regulatory framework. Policy tool kits have been developed for each. Implementation of these standards is ongoing globally and in Canada and will be monitored and promoted by country and thematic peer reviews conducted in The next priority is to make further headway on the two areas I mentioned earlier--ending the threat of banks considered too big to fail and improving the safety of OTC derivatives markets--that pose complex cross-border issues. To address the problem of too big to fail, most clearly exemplified by the hugely disruptive failure of Lehman Brothers in September 2008, the FSB has taken three bold policy actions. First, the effectiveness of the supervision of large internationally active banks has been increased. Second, approximately 30 of the most systemically important global banks-- those so large that their failure would have an impact on the entire financial system --have been identified and will have to hold more capital to make them safer and discourage them from becoming even more systemically important. At this point, there are no Canadian banks on this list. (OSFI) identified six of our banks as systemically important at the domestic level, mandated that they hold 1 per cent more capital and strengthened its oversight of them. Third, and perhaps most significant, the FSB has developed a set of policy standards, known as the resolve these global banks when they become non-viable. The objective of resolution is to maintain their critical functions, such as deposit taking, payments and lending, without disrupting the financial system and without taxpayers being the first line of defense. The Key Attributes were a major breakthrough, and these standards are gradually being implemented. However, because these global systemically important banks operate in many jurisdictions through subsidiaries and branches, we need to tackle a number of difficult cross-border home-host issues. For example, whose rules will govern the resolution, those of the home jurisdiction of the parent bank or those of the host jurisdiction of the subsidiary or Where will the capital to absorb losses be held? In the parent bank? The How do we ensure that cross-border financial contracts are maintained and not torn up in resolution? The FSB is methodically addressing each of these questions and making solid progress. In the meantime, there is a risk that some countries, understandably concerned about the safety of their own financial systems, may take measures that run counter to the spirit of the G-20 reforms to promote financial integration. An example of this is the set of rules governing foreign bank operations in the Dodd-Frank Act of 2010, the most comprehensive reform of the financial system that the United States has undertaken since the Great Depression. Dodd-Frank, subsidiaries and branches of international banks of a certain size will have to meet separate capital and liquidity requirements inside the United What does this mean for Canadian banks? Our largest banks have sizable U.S. operations. Some will likely meet the size threshold and will be subject to these new requirements. These national rules will not only impose new legal and administrative costs on Canadian banks, but might also constrain their ability to allocate capital and liquidity efficiently in the North American market. And if a Canadian bank with U.S. subsidiaries were to fail, it bears asking whether the pre-emptive actions of U.S. authorities would create obstacles for the orderly resolution of the consolidated bank by Canadian authorities, led by the Canada Deposit Insurance This "one-size fits all" approach overlooks the existing degree of integration between our two economies, Canada's impressive record for financial stability and the fact that Canadian banks have long been active and well trusted in the That, in brief, is where we stand at the moment on cross-border bank-resolution issues. And, as you will see in a minute, the cross-border issues related to OTC derivatives are equally complex. OTC derivatives were largely unregulated before the crisis. For example, when Lehman Brothers failed, it had roughly one million outstanding derivatives contracts. No one outside the company knew the full extent of Lehman's exposures. Uncertainty rippled through the market, spreading fear about the solvency of other banks and impairing the functioning of markets. This experience highlighted the interconnectedness within markets and how the failure of one institution can pose a systemic risk that threatens the entire financial system. Under the G-20 reforms aimed at reducing systemic risk, countries have agreed to report all transactions to trade repositories and to centrally clear all standardized contracts. Again, much progress has been made on improving the reporting and central clearing of transactions. The challenge ahead is to ensure that the rules for on-the-ground implementation of some of these reforms are consistent across jurisdictions. To understand how complicated this is, it is useful to compare the processes for the Basel III framework with that for OTC derivatives. Because the Basel Committee already had granular rules for bank regulation, a process was established to achieve a multilateral consensus on the next set of bank standards. For OTC derivatives, no such process existed because they had previously been largely unregulated. The United States--the jurisdiction most affected by the crisis--was the first to respond, with the Dodd-Frank Act. Other countries were slower off the mark, and this has led to differences in implementation, especially among major jurisdictions. These differences are slowly being resolved. In the meantime, market participants are trying to cope with these regulatory inconsistencies. As a consequence, the costs of cross-border trade are rising and markets are starting to fragment. Canada and other jurisdictions are caught in the middle. One of the ways countries are managing these inconsistencies is by recognizing each other's regulatory approaches when they achieve similar prudential outcomes. took the lead in OTC derivatives rule-making in the United States, has recognized that OSFI's requirements are equivalent to the U.S. rules in a number of cases. However, the Commission still wants Canadian banks to submit to its oversight, which could include on-site visits. Canadian and U.S. authorities are working together to limit the additional burden this places on affected banks. As noted, monitoring exposures in the derivatives market is important for helping to reduce systemic risk. To do so, authorities need access to transactions data held in trade repositories. However, a provision in Dodd-Frank that requires authorities using these data to sign an indemnity in the event of their misuse effectively precludes the Bank of Canada, OSFI and others (including the U.S. Federal Reserve) from obtaining this information. Consequently, the data on OTC transactions performed by Canadian banks and reported by them to U.S. trade repositories are currently not being used to assess systemic risk in the OTC derivatives market. To summarize, national authorities should strive to build trust and achieve more cross-border recognition of comparable regulatory requirements. Such an approach would reduce regulatory uncertainty and enhance the ability of market participants--ranging from global banks to small factory owners and farmers--to hedge risks and protect themselves from economic shocks. Let me turn now to cross-border payments, an issue that all of you have likely had some experience with as consumers or in your businesses. As you know, sending funds to or receiving them from the United States or any other country is slow, inconvenient and costly. You won't be surprised to hear that a recent report by the Federal Reserve described cross-border payments in much the same way. And you'll be pleased to hear that the Fed and the Bank of Canada are working with the financial industry, including payments associations, to promote efforts within their respective jurisdictions to modernize cross-border payments. In its report, the Fed argued that the U.S. payments system is at a critical juncture because of three factors: technological advances in high-speed data networks; the related need to ensure the safety and security of payments; and user demands for faster, less costly domestic and cross-border payments, manifested by the growth of other means, such as PayPal. To improve cross-border payments, a number of key barriers need to be addressed. They range from regulatory requirements for anti-money laundering rules to a lack of standardization of electronic formats. Standardizing formats would allow more business information to be transmitted with payments. These barriers are not easy to overcome. Resolving them, however, will significantly increase efficiency and greatly reduce the costs of cross-border payments. What can we do to overcome these challenges to cross-border integration? The ideal, of course, would be a broad agreement among all G-20 members. But securing a multilateral compromise could take several years. Still, we shouldn't abandon this possibility. The FSB has helped build trust through its consensusforming processes and should continue to press for the timely development and consistent implementation of global minimum standards. In this vein, and especially with regard to Canada, we should urge U.S. authorities to respect the G-20 leaders' agreement at the 2014 Brisbane Summit to defer to each other's regulatory requirements when they achieve a similar prudential outcome. If this were to occur, Canada would clearly benefit, given its strong and crisis-tested regulatory and supervisory framework. At the same time, it would be wise to consider alternative approaches. For instance, Canada and the United States should consider the option of a bilateral agreement on the resolution of banks with cross-border operations in order to clarify responsibilities and enhance co-operation. We have a long history of stable financial and economic integration, and U.S. financial institutions and legal frameworks are similar to ours. If any two jurisdictions could achieve such an agreement, it is Canada and the United States. We could set an example for other countries. In this regard, the 1988 free trade agreement between Canada and the United States offers a useful precedent. It served as a template for other regional agreements at a time when multilateral trade negotiations were making little headway. On cross-border payments, we should come to terms on more efficient arrangements, including harmonizing standards, reducing processing times and establishing direct links between our respective systems. We could, for instance, explore opportunities to enhance the existing FedGlobal program for crossborder payments, which is currently limited to northbound transactions. Let me conclude with a few words of wisdom from a great American poet. In his poem "Mending Wall," Robert Frost questions his neighbour's belief in the old adage that "good walls make good neighbors." Instead, Frost writes, before we build a wall we should first consider what we are "walling in or walling out." The message I take from his words is that good neighbours should work together to build trust, not walls. Canada and the United States have long-established economic and financial ties built on trust that have served both countries well. Today, we have a unique opportunity to advance the global financial reform agenda in the critical, but thorny, areas of bank resolution, OTC derivatives and payments. We both have much to gain by strengthening financial integration between our countries. More efficient cross-border financial services will facilitate more trade. And more trade will contribute to stronger economic growth in both countries.

r150715a_BOC

canada

Release of the Monetary Policy Report

poloz

Governor of the Bank of Canada Press conference following the release of the Good morning. Senior Deputy Governor Wilkins and I are happy to be here with you again to answer your questions about today's interest rate announcement, and our latest (MPR). Let me begin with a few remarks around the issues that were most important to the Governing Council's deliberations. Since our last MPR in April, global economic developments have been quite disappointing, and these have led to a significant downgrade of our estimate of Canadian economic growth for 2015. There were three factors behind this First, Canadian oil producers have lowered their long-term outlook for global oil prices, and have cut their plans for investment spending significantly more than previously announced. Second, China's economy is undergoing a structural transition to slower, domestic-driven growth, which is reducing Canadian exports of a range of other commodities. Third, Canada's non-resource exports have also faltered in recent months. While this is partly due to the first-quarter setback in the U.S. economy, it's still a puzzle that merits further study. Given the collapse in oil prices, and declines in some other key non-energy commodities, the economy is now operating on two distinct growth tracks: the resource track and the non-resource track. These tracks are not independent -- the cancellation of an investment in the oil patch will often lead to a hit in the manufacturing sector, for example. But we can do some rough decompositions to illustrate the situation. I draw your attention to Chart 18, on page 19 of the MPR. There we can see the sharp drop in oil and gas output, which constitutes 10 per cent of our economy, and the slowdown in non-energy commodity production, which represents a further 8 per cent. The remaining 82 per cent is seeing steady growth, although it has moderated slightly so far this year, due to the setback in the U.S and spillovers from the resource sector. As the non-resource track regains momentum, it is expected to become the dominant trend at the aggregate level. We expected this to begin in the second quarter. But it did not, because of the three factors I listed above. A major shift in a country's terms-of-trade is one of the most complex situations an economic forecaster can face. We have said from the beginning that while there would be both negative and positive effects from lower oil prices on Canada, the negative effects would dominate, and they would come first. The positives would be more gradual, taking the form of stronger consumer spending, both here and in the U.S., and increased non-resource exports, because of stronger U.S. spending and a lower Canadian dollar. These positives have been slow to emerge, but we can see them working. Export sub-sectors that are usually sensitive to exchange rate movements have been outperforming. The setback in the U.S. economy appears to have been mainly temporary, as U.S. labour market performance has been strong. In Canada's non-resource sector, the labour market has been performing well, and our conversations with companies indicate rising capacity constraints. This implies that increased investment and more employment gains are likely in the months ahead. In short, we expect these positive trends to begin to outweigh the negatives coming from the resource sector during the next few months. These considerations figured prominently in the Governing Council's deliberations, because the state of total demand in the economy relative to our production capacity is what drives our inflation outlook. The economy has been operating below full capacity for some time, which is why we estimate that the underlying trend in inflation is running at around 1.5 per cent to 1.7 per cent. Core inflation is higher than the underlying trend, because a decline in the dollar is raising the prices of imports. Total inflation is much lower, because of past declines in fuel prices. As the temporary effects dissipate, all these measures of inflation will converge on the underlying trend. The weak economic performance in the first half of this year means that Canada has more excess capacity, which is increasing the downward pressure on the underlying trend in inflation. To put it in the language of our risk management framework, the three factors I mentioned earlier moved us out of the neutral zone, to a place where the downside risk to future inflation is material. This would imply a slower return to full economic capacity and sustainable 2 per cent inflation. At the same time, financial stability risks remain elevated. Of particular note are the vulnerabilities associated with household debt and rising housing prices. And we must acknowledge that today's action could exacerbate these vulnerabilities. However, as we noted in our , financial vulnerabilities would usually translate into full-blown risks -- with attendant consequences for the economy -- only if there was a trigger, such as a widespread and sharp decline in economic activity and employment. The terms-of-trade shock we are experiencing, which has already translated into an increase in excess capacity and downward pressure on inflation, has the potential to act as such a trigger, if left unaddressed. Accordingly, the Governing Council agreed that acting at this time was consistent both with the Bank's primary mission -- the pursuit of its inflation target -- as well as helping to manage financial stability risks, even if there could be some increase in financial vulnerabilities in the process. Let me remind you that monetary policy operates with a long lag and there are many transmission channels through which interest rate changes affect the economy, including longer-term bond yields and the exchange rate. This needs to be taken into account when predicting how the economy will respond to our actions, and when. It also makes it difficult to pin down the precise timing when Canada will reach full capacity with inflation sustainably at target -- it could just as easily be sooner as later than projected. Let me also remind you that there are many uncertain elements and risks to our outlook, which are discussed in the MPR. One additional element I could mention is the prospect of interest-rate liftoff in the U.S. Although we have no special insight into when this might occur, we have said many times that it would be welcome, for it would be consistent with a more positive outlook for the U.S. economy. Nevertheless, because the Canadian economy is dealing with a large terms-of-trade shock, it is likely to be less synchronized with the U.S. economy than in the past. Furthermore, we would expect any rises in global bond yields to be at least partly imported into Canada -- with possible implications for the Canadian dollar -- and with an uncertain net effect on our economy. To conclude, the Canadian economy is undergoing a significant and complex adjustment, even while it is still trying to overcome persistent global headwinds. In the judgment of the Governing Council, today's action is required to help facilitate the adjustment of the economy to this unusual situation. With that, Carolyn and I would now be happy to take your questions.

r150825a_BOC

canada

The Long-Term Evolution of House Prices: An International Perspective

schembri

Thank you for the invitation to speak here today. Every August since 1961, when John Diefenbaker was prime minister and you could buy a house for $15,000, business and government economists have gathered here in Kingston to discuss issues of the day. CABE has carried on this tradition of convincing economists to attend a conference while everyone else is on vacation. The promise of a good chart is probably all the convincing most of us need. I've got plenty of those for you today. I want to talk to you about the evolution of house prices and the underlying determinants of their long-term movements. As you know, developments in the housing sector and the related mortgage market are important, for both the Canadian economy and its financial system. My presentation, then, is part of our ongoing effort at the Bank to promote an informed discussion of housing and house prices. In our quarterly and our biannual we usually take a "here and now" perspective . But today I want to provide more context by stepping back and looking at house prices in two across time, over the past 40 years; and across countries--in particular, across a group of countries that share economic circumstances and policy frameworks similar to Canada's. I'll begin with a quick look at some stylized facts about the evolution of house prices. Then, I'll examine their long-run determinants from both the demand and supply sides. Finally, I'll comment on the implications of house prices for financial stability and the recent experience with macroprudential housing-related policies, including their complementary interaction with monetary policy. Let's start with trends in house prices. shows indexes of real house prices since 1975 for two sets of advanced economies. shows Canada and a set of comparable small, open economies (Australia, New Zealand, Norway and Sweden) with similar macro policy frameworks and similar experiences during and after the global financial crisis. In particular, they did not have sizable post-crisis corrections in house prices. For comparison purposes, shows a second set of advanced economies that did experience significant and persistent post-crisis declines in house prices. Chart 1: Real house prices have increased globally since 1995 Three points about these charts. First, there are notable variations across countries. While there is some common movement, local circumstances clearly matter. Second, broadly speaking, real house prices across both sets of countries experienced no material upward trend from 1975 to 1995. Third, a generalized upward movement in house prices began in the second half of the 1990s and is continuing today, even after post-crisis corrections. Real prices remain well above 1995 levels for almost all countries. These trends suggest that there are common factors at the global level or simultaneously in each country that have arisen over the past 20 years and have pushed up real house prices. Understanding these common and idiosyncratic determinants of house prices is important for both macroeconomic outcomes and financial stability and thus the conduct of monetary and macroprudential policies. To analyze these trends, let's start with some basics. A house is simultaneously both a consumption good and an asset. It delivers a stream of non-financial housing services and, at the same time, is also a store of wealth. For most of us, it is the largest asset we own. A household's decision to purchase a house depends on the utility of the services it provides, its price, and its ongoing user cost. The user cost includes depreciation, maintenance and interest costs, less the expected price growth. In the housing market, the price is determined by the total demand for housing services and the stock of houses. The equilibrium house price thus depends on the user cost, which includes the expected price appreciation, and this, in turn, depends on the expected evolution of demand and supply factors. To complicate matters, a number of other dimensions influence the choice of the data being analyzed: Housing can be owner-occupied or rented. Housing units can be single-family houses or multiple-unit dwellings. Housing is a composite good consisting of both a structure and land. Housing prices can be for existing or new houses, or both. For my purposes today, I'll focus primarily on owner-occupied houses, the total of singles and multiples and the composite price for existing houses measured at the national level. Four broad sets of demand factors have likely contributed to rising real house prices across advanced economies since 1995: macroeconomic--rising disposable incomes and lower long-term interest rates; demographic--population growth, driven in part by migration, and shifts in age structure and family size; credit conditions--broader access to and more efficient funding of mortgage credit due to financial liberalization and innovation; and other factors--improvements to the macro-policy framework, international investment, preference shifts and regulatory and tax changes. House prices and income First, let's look at house prices and income. Since 1995, house prices in Canada and the set of comparable countries have increased faster than nominal personal disposable income ( During this period, all of these countries experienced solid income growth, with the strongest growth in Norway and Chart 2: House prices have increased relative to income During the global financial crisis, these countries also experienced house price corrections. This caused the ratios of house prices to income to decline temporarily, after which they continued climbing. So why did house prices rise faster than income? There are a number of possible explanations. Consider population growth. shows population growth rates in our set of comparable countries over two periods, 1975 to 1994 and 1995 to 2015. Population growth rates were the highest in Australia, Canada and New Zealand over the entire sample. Moreover, growth rates increased in all countries, except Canada, in the post-1995 period relative to the pre-1995 period. Therefore, population growth could help explain the rise in house prices relative to income for most countries over the latter part of the sample. One of the factors that has affected population growth rates is migration. Net migration was highest in Australia and Canada over the entire sample. In addition, net migration increased importantly in all five countries in the second half of the sample period ( In Australia, Canada and New Zealand, the rate of population growth of the approximate house-owning cohort of those aged 25 to 75 declined in the second part of the sample period. This likely reflects the aging of their populations as the postwar baby boom generation moved from youth into middle age ( Nonetheless, the growth rate of this cohort still remains well above 1 per cent for these three countries. Chart 3: Population growth has contributed to house price increases, aided by net migration Chart 4: Population growth in house-owning age cohort has declined in some countries In Canada, it is noteworthy that the average family size decreased from about 3.5 in 1976 to below 3.0 in 2011, a decline of approximately 20 per cent. evidence suggests that this pattern is similar in the other advanced economies in our sample. This decline in the average family size has supported the rate of household formation, and thus, has partially offset the impact of the lower growth rate of the house-owning cohort on the demand for houses in Australia, Canada It is also important to consider where population growth is occurring. shows that over our sample period, the pace of urbanization, measured by the change in the urbanization ratio, has increased since 1995 in all of the countries in the comparable group, except New Zealand. Australia and Canada are notable for the size of the shift, which could be explained by a number of factors. These include the well-known agglomeration economies of scale provided by urban areas and the location preferences of home-owners, especially youngerage cohorts and recent immigrants. The urbanization of the population in Norway also stands out. This could potentially explain why house prices have grown faster in Norway than in Canada, even though population growth in Canada has been higher than in To sum up, population growth and the shift in demand for housing toward urban areas have exerted strong upward pressure on house prices. Credit conditions A third demand factor affecting house prices is the improvement in mortgage credit conditions. Lower long-term interest rates and financial liberalization and innovation have improved housing affordability in advanced economies, especially since the mid-1990s. I'll say a few words about each of these changes that have influenced the availability of credit. Since 2000, real 10-year government bond yields have trended downward across all advanced countries, including those in our comparison group, with a slight increase during the recent financial crisis ( Chart 6: Real long-term interest rates have trended downward since 2000 The decline in yields has been attributed to higher global savings and stronger monetary and fiscal policy frameworks, which have credibly reduced inflation and risk premiums by increasing macroeconomic stability in the roughly 15-year period (known as the Great Moderation) that preceded the global financial crisis. Since the crisis, persistently weak global demand--especially real investment--coupled with sustained low central bank policy rates and large asset purchases has helped to lower long-term interest rates and, in turn, reduce financing costs for financial intermediaries and mortgage rates for households. Other things being equal, this decline has helped improve the affordability of home ownership and support demand for houses. Credit conditions have been positively affected by financial liberalization and innovation. Recent work by the International Monetary Fund has catalogued the related effects of these two factors on access to housing market finance and mortgage market development across countries. The trend in advanced economies from the mid-1990s until the crisis has been toward higher maximum loan-to-value ratios, longer amortizations for mortgage borrowers and more flexible funding arrangements for mortgage lenders in terms of covered bonds and mortgage securitization. The assessment and diversification of mortgage credit risk have also improved. As a consequence, a broader set of borrowers and lenders has become involved in obtaining and providing mortgage finance. shows a positive relationship between a summary index of mortgage finance conditions, constructed by the IMF, which captures both financial liberalization and innovation, and the depth of the mortgage markets across several advanced economies. Although data for New Zealand are not available, the chart indicates that the other four countries in our comparison group have mortgage finance conditions in place that generate deep mortgage markets and foster broad and often less procyclical access to mortgage finance. Again, other things equal, this supports demand for owner-occupied housing and higher house prices. shows that home-ownership rates in Canada and Sweden (over a shorter sample period) have risen, suggesting that these changes to mortgage finance have had a positive impact on housing affordability. In Australia, the rate of home ownership has declined. This may be due to a more modest change in mortgage credit conditions. Or, more likely, affordability has been eroded by rapidly rising house prices, which have increased the most in Australia among the comparison group. For Norway, there has been no material change in the home-ownership rate over this limited time period. Chart 7: Housing finance index, mortgage market depth and home ownership rates As I noted earlier, important innovations have fostered deeper, more efficient and diversified mortgage financing. I'll comment on the two most significant: covered bonds and securitization. Covered bonds have been popular in Denmark for a long time. They were introduced and have become more widely used in Sweden and Norway and, to a These bonds have played a growing role in mortgage finance in the post-crisis period because they are generally viewed as safer than private-label securitization. They give investors access to dual collateral: the mortgages securing the bonds as well as other assets on the issuer's balance sheet should the mortgages prove insufficient. Securitization of mortgages also increased significantly in the pre-crisis period in some countries, especially private-label securitization in the United States ). While these vehicles were successful in raising large amounts of mortgage funding before the crisis, they were an important source of financial vulnerability during the crisis because the incentives to originate and securitize subprime mortgages were misaligned and the related risks were opaque and not well priced. Chart 8: Mortgage funding by covered bonds and securitization has risen Since the crisis, we have seen a dramatic decline in private-label securitizations of residential mortgages, which has not recovered, despite global financial reform efforts led by the G-20 to address the serious weaknesses in their design. Publicly supported securitization has continued to play an important role in funding residential mortgages over this period, however, especially in the United Other factors supporting demand A number of other related factors have likely supported the demand for houses in our comparison group and in advanced economies more generally. All of the countries in our comparison group had solid macro and financial policies characterized by monetary policy frameworks comprising explicit and credible inflation targets and flexible exchange rates; sustainable fiscal positions; and effective financial regulatory and supervisory frameworks. As a result, these countries achieved a high degree of macro and financial stability over the post-1995 period; in particular, they kept inflation low. This stability had a number of important consequences. It reduced uncertainty for households and firms. As noted, it also lowered risk premiums and long-term interest rates. And it fostered financial and mortgage market development. These countries all coped with the crisis and its aftermath relatively well. Economic and financial stability strengthened the demand for houses because it enhanced the perception that they are safe, high-quality assets. households may have decided to shift more of their wealth into housing and consume more housing services as their income increased by buying more owner-occupied dwellings over time. This trend was supported by government policies (although not widespread in our comparison group) to promote home ownership, especially for younger and lower income households. Now let's look at the supply factors that have influenced the prices of houses, in particular, regulation and geography. Such supply constraints tend to be most binding in urban areas. Coupled with the observed shift in demand related to population growth in urban areas, supply constraints may have put significant upward pressure on house prices in urban areas in advanced economies. The regulatory factors include land-use or zoning restrictions that specify, for example, minimum lot sizes or maximum development density; the establishment of greenbelts around urban areas, which represent a more sweeping land-use restriction; and development fees. In terms of geographical constraints, the most common are bodies of water and landscape features such as mountains, wetlands and other terrain not suitable for residential development. To what extent are these sorts of constraints affecting house prices in urban provides some suggestive evidence on the impact of land-use regulations on median price-to-income ratios. Many of the cities with higher ratios also have obvious geographical constraints--Hong Kong and Vancouver are good examples--so the two sources of supply restrictions likely interact to put upward pressure on prices. To examine the implications of these supply constraints, it is useful to consider the impact of urban population density on house prices. indicates that, over the period from 1995 to 2014, there was a strong positive relationship between increases in population density and house prices in Canadian urban centres. Greater population density, combined with regulatory and geographical constraints, creates price incentives that cause shifts in the available housing mix. In particular, as the prices of single-family homes rise, condos become a more affordable alternative. Chart 9: Land-use regulation and geographical constraints increase the price-to-income ratio In Vancouver, bounded on three sides by water with coastal mountains as a backdrop, condo development has dominated housing starts since the early 1990s. We are now seeing a similar shift to condos in Montreal and Toronto In recent years, Toronto and Vancouver have seen price growth in single-family houses outpace multiples (mainly condos) by a factor of two to three. About a third of the Canadian housing stock is in Toronto, Montreal and Vancouver so this change is significant. Outside of Canada's big three cities, condos are only now becoming as important as single-family homes. Given these supply constraints, the increasing urbanization of Canada's population is putting upward pressure on Canadian house prices. Chart 11: With increasing population density and binding supply constraints, multi-unit starts are dominating in Canada's biggest cities In view of these demand and supply factors, which have tended to work together to cause house prices to rise faster than income since 1995 in advanced countries, especially in urban areas, what are the implications for monetary policy and, perhaps more importantly, for financial stability policy? The advanced economies in our comparison group had similar experiences during and after the global financial crisis. They suffered sizable declines in exports to their major trading partners that were more severely affected by the crisis. Their domestic financial institutions and markets were adversely affected by spillovers from global financial stresses. Liquidity and credit conditions tightened severely. In response, they loosened monetary policy, with sharp declines in policy interest rates. Their credible inflation-targeting frameworks, flexible exchange rates and resilient financial systems meant that such countercyclical monetary policy easing was effectively transmitted into lower real interest rates along the maturity spectrum. This easing supported the economic recovery by boosting domestic demand, notably in sectors sensitive to interest rates, such as housing, and caused house prices to recover from declines experienced during the crisis. But, to date, the global recovery has been weak, so global and domestic interest rates have remained at historically low levels. This has underpinned the demand for, and the prices of, houses in the post-crisis period. Since elevated house prices have important implications for financial stability, the Bank of Canada is closely monitoring the housing market . In particular, as we noted in recent issues of our , rising house prices contribute to two material vulnerabilities that can affect financial stability: 1. Higher house prices are generally associated with higher levels of household indebtedness and leverage. 2. Higher house prices represent a potential source of asset-price misalignment if influenced by expectations of price appreciation not consistent with evolving fundamentals. Such misalignment could suddenly correct and create financial stress. The likely trigger for both vulnerabilities would be a major global shock that generated a sharp increase in unemployment and possibly in interest rates as well. If these vulnerabilities were triggered, the adverse impact on the financial system and the economy would be amplified by the exposure of banks and other intermediaries to them. Now, when we look at the post-crisis experiences of the countries in our comparison group, they have similar levels of household leverage, measured by household debt as a ratio of GDP ( Household leverage has risen along with house prices, as households have taken advantage of low post-crisis interest rates. The one exception is New Zealand, where a modest degree of household deleveraging seems to have occurred. For Canada, the ratio of household debt to GDP has risen since 1975, although the growth of this ratio has notably declined since 2010. For Sweden and Norway, the ratio also grew at a modest pace in the post-crisis period. The inflections in the rate of leverage growth that we see in the chart after the crisis may be due to the macroprudential measures these countries implemented. Such measures have allowed stimulative monetary policy to flow through to households with the capacity to borrow. Charts 13a and b draw on recent work by the IMF, which shows that macroprudential policies in the form of maximum loan-to-value (LTV) or debt-toincome (DTI) ratios have tightened across a broad range of countries over the past 10 years. The IMF's research, as well as that of other economists, has found evidence suggesting that the tightening has helped to: reduce the procyclicality of household credit and bank leverage; moderate credit growth; improve the creditworthiness of borrowers; and lower the rate of house price growth. The most effective macroprudential policies to date appear to have been the imposition of maximum LTV and DTI constraints. Increased capital weights on bank holdings of mortgages have also had an impact. While long-term evidence on these instruments is not yet available, permanent measures that address structural regulatory weaknesses and that are relatively straightforward to implement and supervise will likely be the most effective over time. Chart 13: The use of macroprudential policies to address housing vulnerabilities is increasing In Canada, we have had four successive rounds of macroprudential tightening, primarily in terms of the rules for insured mortgages ( ). I'll mention just a few of the highlights. The maximum amortization period for insured loans has been shortened from 40 years to 25. LTV ratios have been lowered to 95 per cent for new mortgages, and 80 per cent for refinancing and investor properties. These latter two changes effectively eliminate new insurance for refinancing and investor properties. Qualification criteria such as limits on the total debt-service ratio and the gross debt-service ratio, as well as requirements for qualifying interest rates, have also been tightened. Recent evidence suggests that these measures have resulted in higher average credit scores, which have improved the quality of mortgage borrowing ( ). With respect to household credit growth, shows that the trend growth of mortgage credit declined from 14 per cent in 2007-08 (3-month growth, annualized) to around 5 per cent in 2013-15. Chart 14: Canadian post-crisis macroprudential policies have contributed to higher borrower quality and lower household credit Let me conclude with a few key points from the mountain of facts, graphs and analysis that I have reviewed with you today. As I mentioned at the outset, the purpose of my presentation is to help provide more context for an informed discussion about housing and house prices given their importance to the Canadian economy and the financial system. First, real house prices have been rising relative to income in Canada and other comparable countries for about 20 years. There are many possible explanations, mostly from the demand side, but also from the supply side. Second, in terms of demand, demographic forces, notably migration and urbanization, have played a role in the evolution of house prices, as have improving credit conditions through lower global real long-term interest rates and financial liberalization and innovation. There are, of course, other demand factors that warrant more data and analysis, including the impacts of foreign investment and possible preference shifts. Third, in terms of supply, the constraints imposed by geography and regulation have decreased housing supply elasticity, especially in urban areas. This reduced supply elasticity has interacted with demand shifts toward more urbanization to push up house prices in major cities. Fourth, the credible and effective macro and financial policy frameworks in place in Canada and the other countries considered here have contributed to a high degree of macroeconomic and financial stability. Consequently, in the face of a protracted global recovery, their countercyclical policies successfully underpinned domestic demand in the post-crisis period. The resulting strength in the housing market has increased household imbalances, but the risks stemming from these vulnerabilities have been well managed by complementary macroprudential policies. The experience in these countries therefore suggests that macroprudential policies that address structural weaknesses in the regulatory framework are best suited for mitigating such financial vulnerabilities. They reduce tail risks to financial stability and enhance the overall resilience of the financial system. Thank you. Enjoy these last few days of summer.

r150921a_BOC

canada

Riding the Commodity Cycle: Resources and the Canadian Economy

poloz

Governor of the Bank of Canada This isn't the first time that a governor of the Bank of Canada has come to Calgary to talk about commodities. I suspect it won't be the last. It's an obvious discussion topic here in Alberta, where resources make up more than a quarter of the economy. Of course, such riches aren't unique to Alberta. Natural resources have been a big economic story for this country since the time of European contact. Today, Canada is the only major exporter of natural resources among the G-7 nations. Oil is just one part of the story--we are also a major producer and exporter of coal and natural gas, base and precious metals, minerals such as potash, and agricultural and forest products. Because Canada has been endowed with such a wide variety of resources, we've had to learn how to deal with large swings in their prices. I don't just mean the usual high degree of volatility common among many raw materials. I'm also referring to the long-term swings in prices that are often called "super cycles." What's important to remember is that these long-term swings are driven by the fundamental economic laws of supply and demand, as well as the continuous technological progress that can affect both output and consumption. The pattern is familiar. A large and persistent increase in demand leads to sustained upward pressure on resource prices over a number of years. The higher prices act as an incentive to boost supply, and companies act by, for example, investing in new capacity and finding methods to increase efficiency. While high prices can certainly spur research and development, technological progress has been a constant theme in natural resource industries. Such advances uncover ways to raise output and lower production costs. And it's because of this progress that inflation-adjusted commodity prices have generally been trending lower for 200 years. The investments that lead to increased output can take years, if not decades, to complete. But, over time, the higher output generated by those investments combines with stabilizing demand to bring about a period of downward pressure on prices. Faced with lower prices, companies may scale back investment and production. Ultimately, the lower prices will encourage demand, and the reduced investment will crimp future supply, leading to higher prices. And producers will ride the price cycle all over again. Any economy that relies on natural resources will naturally be challenged by large movements in their prices. These shocks are more than just swings in national income; they also force businesses to make decisions about the way resources such as capital and labour are allocated. These decisions often lead to difficult adjustments, but they are necessary for maximizing our economy's potential. While an abundance of raw materials may complicate the management of companies and the conduct of economic policy, it's far better for a country to have resources than not to have them. Even when prices are falling, as they have been recently, our endowment represents a store of value and a source of future riches. What I'll do in the rest of my time today is talk about some of the global forces that have been driving recent swings in commodity prices and look at how they may evolve in the years to come. Then, to emphasize just how uncertain the outlook can be, I'll talk about some alternative scenarios that could dramatically alter the future for producers. Finally, I'll revisit some of the lessons that policymakers and business leaders can apply today and in the future. Let's take a look back at resource prices over the past 15 years or so. We saw a large and persistent increase in demand, sparked by rapid economic growth in emerging markets. In China, the world's most populous country, economic growth averaged about 10 per cent annually between 2001 and 2011, a period that included the global financial crisis. Chinese growth has meant enormous demand and rising prices for many of Canada's resources, particularly coal and oil, as well as base metals such as copper, nickel and aluminum. As millions of people in emerging markets left rural areas for cities, demand increased for building materials such as the iron ore used in steel, and this supported prices. Although the financial crisis led to price declines, many raw materials rebounded sharply. By April 2011, the Bank of Canada's commodity price index had reached its post-crisis peak. However, rapid growth tends to moderate as an expansion matures. Chinese economic growth has eased to an average of 7.5 per cent since 2012, as authorities have tried to engineer a more sustainable and domestically oriented expansion. Similarly, India, which saw annual GDP growth near 9 per cent from 2005 to 2010, has also moderated since 2012. While it's true that these cooling growth rates have had an impact on prices, we shouldn't forget that emerging markets are still an important source of demand. Indeed, since the start of the decade, the Chinese economy, now the world's second-largest, has more than doubled in size when measured in current dollars. In terms of supply, we've also seen responses that are putting downward pressure on prices for metals and some energy goods. For example, the iron ore supply continues to expand despite lower prices, thanks to the impact of multiyear investments made when prices were higher. These investments led to expanded capacity in low-cost areas such as Australia and Brazil. Now let me say a few words about oil prices. This topic is obviously of great importance here in Alberta because of its impact on employment and the overall economy. But it's also important for Canada as a whole, given the implications for national income and interprovincial trade, as well as the industry's sizable influence on business investment. Why did oil prices fall so much? The main reason is that supply rose sharply, thanks primarily to technological advances in oil extraction everywhere. This includes the oil sands, tight oil and the Bakken deposits. Consider in particular the technological progress that enabled producers to tap tight oil reserves. Output from the United States alone, which essentially didn't exist before 2008, reached 4.2 million barrels per day last year. That increase is roughly equivalent to all the oil that Canada produces in a year. Given the dramatic drop in prices over the past year, the Bank has spent a lot of time speaking with business leaders to try to gauge precisely how they will react. At the start of the year, oil companies were saying that they intended to cut investment by about 30 per cent. Prices didn't recover as much as was forecast at the time, so companies subsequently told us that they would cut their investment intentions by about 40 per cent. Currently, based on discussions I've had over the past couple of weeks, many firms are still revising their longer-term expectations for oil prices. The Bank will continue to assess what the impact may be on their investment spending. What this means for the evolution of oil prices is very hard to say. The Bank's usual practice is to assume for our projection that oil prices will remain stable and use our economic models to test alternative scenarios. I know many companies do the same. But that can be risky: because the vast majority of oil transactions are financial, rather than between producers and users, prices tend to be more volatile than the underlying fundamentals. Before I move on, let me emphasize a point. Lower prices for base metals and oil today do not mean that long-term investments, which may take years to complete and last for decades, were somehow a mistake. Without those investments, we would never have been able to capitalize on the higher prices, which boosted Canada's aggregate income. What matters for a given investment is how prices evolve over the life of the project, which is impossible to know when long-term investment decisions must be made. From the end of 2008 to the end of 2010, the price of copper tripled, while oil and nickel prices more than doubled. If you believe in market forces, these movements represented a clear signal to invest and expand output. Those who were able to recognize the opportunity, make adjustments and exploit the higher prices were rewarded, and the increased income brought important benefits to Canada's economy. Now let me spend some time talking about the future. The price cycle I've sketched out may appear to be fairly predictable. But history has repeatedly shown that new technologies can quickly upend assumptions about future demand and supply. For example, back in the 1970s, there were predictions that the world would run out of copper by the end of the century. The people who made that forecast did not foresee that copper wire, long a staple of communications infrastructure, would be replaced by fibre-optic cable, with its glass threads made from silica. This technology helped reduce the demand for copper, in essence extending its supply. Similarly, digital photography had a dramatic impact on the photo-processing industry. Twenty years ago, the idea that everyone would carry around telephones that were also good-quality cameras was ridiculous. People took pictures with cameras that were loaded with film and took the film to a developer. The processing consumed a lot of silver. Back then, if you didn't anticipate the emergence of digital photography, you might have expected this source of demand would continue indefinitely. Instead, according to the Washington-based Silver Institute, the use of silver in photography peaked in 1999 and has fallen by almost 80 per cent since. It's these sorts of technological advances that make predictions about future demand and supply so difficult. But it's also these technological advances, combined with Canada's many gifts of natural resources, that will generate the opportunities to secure our future prosperity. Our goods will remain in demand; we will continue to have lumber for houses, metals for industrial production and oil for use in plastics--and it's hard to imagine that Canadian roads won't continue to need new asphalt repairs. Further, it's important to remember that Canada's endowment is extremely diverse. While the cycles for base metals and oil have turned lower, there is still substantial demand that's supporting the prices of many agricultural goods. As I noted, with continued growth in emerging markets, their populations are becoming increasingly urbanized. In North America, 82 per cent of the population lives in urban areas. That compares with 55 per cent in China, and just 30 per cent in other emerging markets such as India. This trend toward urbanization is likely to continue. With it will come growing demand for goods linked to household consumption--particularly agricultural products. Consider the hundreds of millions of people who are climbing the income scale in India and China. Their changing diet implies much more than just stronger demand for traditional protein sources. It also implies demand for inputs such as fertilizer, animal feed, fish feed, oilseeds and specialty crops such as lentils and chickpeas. Indeed, the latest traffic figures from Port Metro Vancouver show sharp growth in shipments of wheat and specialty crops, and solid gains in meat, poultry and potash. Canada is particularly well placed to tap growing demand for fish and other seafood. Canadian seafood exports to China in the first half of the year grew by 11 per cent compared with the same period last year. To take just one example, 60,000 lobsters are flown from Halifax to Shanghai every week, aided by advances in shipping and production technology. Thanks in part to this demand, lobster prices have been rising sharply. In terms of aquaculture, however, there appears to be considerable growth potential. While mussel farming output grew by about 35 per cent from 2009 to 2013, farmed salmon production plateaued over that period at about 100,000 tonnes a year. Canada has more coastline than any other country in the world. Yet the volume of our seafood output is dwarfed by countries such as Norway, which produces seven times as much as Canada does. I'll leave it to others to figure out how best to tap this potential resource. Rare earth minerals, the 17 elements used in high-tech products such as cell phones and hybrid vehicles, represent another potential source of growth for Canadians over time. It's impossible to know with certainty where opportunities will emerge 30 years from now. What new technological advances lie just over the horizon? Consider, for example, the future of water desalination. Right now, the process of removing salt from sea water is too energy-intensive to be economically feasible on a large scale. But perhaps we are just one technological breakthrough away from solving this problem. Imagine the impact if the chronic droughts plaguing western North America and Australia could be eased by desalinated ocean water. The point of this exercise is to emphasize just how uncertain the future is. Businesses, consumers, governments--we must all plan for the future based on the best information we have. At the same time, natural uncertainty requires us to be flexible to adapt to circumstances that can change rapidly. In concrete terms, this means business leaders must be aware of the risks involved in resource production, manage those risks as best as they can, and be ready to react to market signals and seize opportunities. History has shown that the companies that are nimble are the ones that are best poised to thrive over time. Policy-makers can help in these efforts by encouraging economic flexibility. This means allowing the necessary adjustments to take place and not frustrating flows of investment or labour from one region to another. Canada's labour market showed impressive flexibility when oil prices were rising, as workers flocked to Alberta to fill demand. And, in our latest , the Bank saw evidence of labour shortages easing in regions where some interprovincial workers are returning from the oil patch. Before I conclude, let me say a few words about how monetary policy fits into the picture. There are lessons that we can take from previous price cycles. The most important of these is the value of our monetary policy framework. We can't do much about resource price shocks. But our policy can help the economy adjust to them. In particular, our floating exchange rate helps absorb some of the impact of the price movements and sends signals that facilitate adjustments. Think back to the previous decade. From 2002 to 2012, oil prices went from about US$25 per barrel to more than US$100 per barrel, leading to a jump in our national income. Over the same period, the Canadian dollar appreciated from a record low of around 62 cents U.S. to above parity, helping to reduce the inflationary risks that came with the stronger growth and increased income. Similarly, over the past year, both oil prices and the Canadian dollar have fallen sharply. The floating currency is helping to reduce the disinflationary risks that have come with the cut in our national income. Further, allowing the currency to float frees the Bank of Canada to concentrate our single policy tool on our single target, which is inflation. If we tried to offset these currency movements, we would end up frustrating the natural shifts in economic resources. By focusing on our mandate to keep inflation low, stable and predictable, the Bank has built up credibility, and Canadians have well-anchored inflation expectations, even in the face of large price swings. For example, when we have seen big moves in energy costs, such as the price of gasoline, there has been little evidence that consumers began to adjust their overall inflation expectations, either upward or downward. Why is this important? Since Canadians see our commitment to our target as credible, that makes it much easier for us to reach our mandated goal without needing big swings in output or interest rates. Those of you who can recall our experience with the oil price shock of the 1970s will remember the subsequent effort required to bring inflation under control. Without a credible target and with unanchored expectations, inflation soared. Extremely high interest rates were needed to get price increases back under control. Another point to remember is that swings in commodity prices can affect the normal relationship between the total inflation rate and the core measure of inflation that we use as an operational guide. For example, total inflation is currently being pushed down by the impact of lower energy costs. In contrast, core inflation, which strips out the most volatile inflation components, is facing upward pressure because recent declines in the exchange rate are boosting the prices of imported goods. However, we expect these to be one-off effects, and, as such, we would look through them. As we noted in our July , when all the temporary factors are stripped out, the underlying trend in inflation in Canada is in the range of 1.5 per cent to 1.7 per cent, below our target of 2 per cent. Given these complications, the Bank is looking at how we measure core inflation as part of our regular review of our inflation-targeting regime. Next year, we will answer the question of whether the Bank should continue to focus on one preeminent measure of core inflation and, if so, whether our current core measure will remain in that role. In our interest rate announcement earlier this month, the Bank noted that the resource sector is continuing to adjust to lower prices, and that these complex adjustments will take considerable time. Our inflation-targeting regime will help facilitate these adjustments. Canada has seen this movie before--we've managed it well in the past, and I'm confident we will continue to manage it well in the future. It's time to conclude. As Albertans know well, it can be hard to ride the cycles in raw materials prices. But resource price fluctuations affect all countries, whether they are consumers or producers. Canada is fortunate to be both, and we shouldn't ignore the resources that we have been blessed with. Natural resources bring opportunities. Over the years, Canadians have used our endowment to build a prosperous economy. We will continue to do so. And rather than resist market forces, Canadians should heed the signals sent by price movements. We've adjusted to rising prices; we can adjust to falling ones. These adjustments are never easy. They are often difficult and painful for affected individuals and their families. But they are necessary. For our part, the Bank of Canada will continue to promote low, stable and predictable inflation. Doing so is the best contribution we can make to helping promote both strong, steady economic growth and the flexibility needed to ease those adjustments and help our resource-rich country thrive.

r151010a_BOC

canada

Integrating Financial Stability into Monetary Policy

poloz

Governor of the Bank of Canada The experience of the global financial crisis and subsequent Great Recession has led policy-makers to question some basic assumptions. Long-held beliefs about monetary policy no longer apply in today's global environment. Ten years ago, the idea that focusing on price stability could actually contribute to the buildup of dangerous imbalances was very much a minority view. Central bankers now understand that financial stability issues must somehow be integrated into the conduct of monetary policy. And both central bankers and leaders of financial institutions are working to understand the impact of the sweeping regulatory reform agenda that is being implemented. Around the world, researchers are looking at the issues from several angles. How are financial system reforms affecting monetary policy? How can different monetary policy choices affect financial stability? Today, the idea that central bankers should pay little heed to stability issues and simply "stick to our knitting" of inflation control, a position once advocated by many, seems quaintly naive. Through painful experience, we have been reminded that a well-functioning financial system is critical for economic activity and the transmission of monetary policy. We saw the emergence of excessive risk taking, aided by financial engineering and shortcomings of oversight, during an extended period of low and stable inflation and low volatility. The crisis showed us how financial imbalances in one sector of one economy could be amplified and propagated across the entire financial system, leading to the worst global downturn since the Great Depression. So what I will discuss today is how central banks integrate financial stability concerns into the pursuit of our goals of price stability and macroeconomic stabilization. This exercise is fraught with risks and uncertainties and it is complicated by the fact that macroeconomic and financial stability objectives are not always consistent with each other. Coping with this becomes a problem not of policy optimization, but of risk management. In other words, we put aside the idea of engineering the perfect policy and focus instead on the more realistic goal of finding an appropriate policy setting, given the risks and uncertainties. The debate about using monetary policy to respond to financial imbalances has evolved rapidly since the pre-crisis era. A decade or so ago, the discussion was essentially between those who argued that monetary authorities should lean against imbalances such as asset-price bubbles and those who said that monetary policy should be reserved for cleaning up the mess after the bubble popped. Before the financial crisis, the Bank of Canada basically straddled the two camps. On the one hand, we argued that it's very difficult to identify an assetprice bubble, and central bankers have no comparative advantage in making this determination. Like many, we questioned the wisdom of using the blunt instrument of interest rates on a bubble that could be confined to one asset class. Indeed, if a bubble was particularly large and persistent, a central bank that used the cure of higher interest rates could end up causing the very economic damage it was trying to prevent. On the other hand, the Bank recognized that price stability was a necessary, but not sufficient, condition for financial stability. Given our keen interest in a wellfunctioning financial system and our macro perspective, we worked to raise awareness of stability threats. Our decision to begin publishing our (FSR) in 2002 showed our early commitment to promoting financial stability. We used the phrase "global imbalances" a lot in speeches leading up to the crisis. In other words, we weren't content to just stand on the sidelines and wait to clean up messes. The widespread and extremely high cost of the Great Recession made it clear just how difficult the clean-up job can be. It has been roughly seven years since the crisis, and the damage done to the global economy has left many central banks still struggling with weak growth and inflation. However, the more fundamental lesson we learned is that "lean versus clean" is a false dichotomy. It's far too simplistic to say that financial stability threats compel central banks to choose between leaning and cleaning. In a perfect world, we would have a macroeconomic model sophisticated enough to capture the emergence and resolution of financial imbalances, along with their related impacts on the real economy. With such a model, we would be able to incorporate financial stability threats into our reaction function, if not with absolute precision, then at least as well as we incorporate other economic variables. Unfortunately, we don't live in that perfect world. A general-equilibrium model containing a grand synthesis of real and financial variables doesn't exist and isn't likely to. I don't mean to downplay the importance of research and the development of stylized models, which are crucial in helping us understand aspects of the relationship between the real economy and financial stability. But the reality is that central banks have to cope with tremendous uncertainty regarding financial stability issues, and this is layered on top of the regular uncertainties of monetary policy concerning unobservable variables such as potential output. Given all of the uncertainty, it seems to me the proper response of the monetary authority is to acknowledge and accept all the things we don't know, gauge the risks facing the economy as best we can, and manage those risks as we conduct monetary policy. I'll describe our risk-management framework in detail later on. But we still have the question of how policy-makers should respond to financial imbalances, particularly those that are concentrated in a specific sector or asset class. The Bank of Canada's view is that monetary policy should be the last line of defence against threats to financial stability, behind the joint responsibility of borrowers and lenders, appropriate regulatory oversight within the financial sector, and sound macroprudential policies. Let me say a little bit about each of these. Borrowers and lenders are the first line of defence. They bear the ultimate responsibility for their own decisions at the individual and firm level. It is not the role of monetary policy to protect individuals from making bad choices. It is possible that the sum of those bad decisions could threaten financial stability or the economy as a whole, and so we monitor the situation as a matter of course. But there is no reason to assume that, in all circumstances, equilibrium will devolve into turmoil as borrowers and lenders inevitably sow the seeds of a financial crisis. Indeed, market discipline enhanced by appropriate transparency can be very helpful in this regard. That's not to say policy-makers have no role in enhancing this line of defence. Financial education and efforts to improve financial literacy can help consumers better understand the important decisions they make. In Canada, we have seen increasing levels of household debt that represent a key vulnerability for the financial system. The main driver behind this rise has been an increase in home-backed debt against a backdrop of rising house prices, particularly in two of Canada's largest cities--Toronto and Vancouver. Among other factors, this was due to low interest rates that resulted in the ratio of debt service to income, including principal repayment, remaining roughly unchanged since 2008. Given this, the increase in household debt levels is no surprise. Rather, this rational response by consumers to easy monetary policy is a sign that the transmission mechanism has been working. I'm not trying to diminish the threat posed by elevated household debt. We are continuing to watch this closely. The point is that there is more to the story than the debt-to-income ratio. Because house prices have generally been rising faster than incomes, we have seen increases in the size of a first-time mortgage that a new borrower might take out. Mathematically, the total debt-to-income ratio rises as a result. But it doesn't necessarily mean an increase in the vulnerability of the economy or the financial system. The second line of defence is sound regulatory oversight of the financial sector. This oversight has been significantly strengthened since the financial crisis. Basel III has made the world a safer place; there can be no doubt about that. But even before the crisis, Canada's banking system was well served by its strong regulatory environment and prudent culture, which allowed our institutions to avoid the worst of the turmoil. Given the scale of the damage caused by the financial crisis, it's not surprising that authorities devised a reform agenda of corresponding proportions. The G20 pledged to do everything necessary to address the weaknesses exposed by the crisis. With Basel III, we gave ourselves an ambitious task. We aimed for a financial reform package that would be implemented consistently across jurisdictions and would not impede the ability of financial institutions to innovate, intermediate and foster economic growth. The road to implementation hasn't been as smooth as one would like. But that's hardly surprising, given the political processes and trade-offs required to put the reforms in place and the many differences among the jurisdictions involved. What's important now is that we finish the job. Ensuring the safety of the global financial system is in all of our interests. We can't be distracted and lose sight of this objective. For financial institutions, that means meeting both the letter and the spirit of the new capital and liquidity regulations. And policy-makers should expect institutions to respond to the new regulatory regime. We are seeing competitive forces leading to innovation, in market-based finance, for example. To be clear, such innovation is a good thing. Even as we implement the new rules, we need to be cognizant of their full impact and ensure that we don't stifle competition and innovation. That said, the scars of the financial crisis will not fade quickly, and we are determined not to let another such crisis occur. The proper implementation of the Basel rules will go a long way to preventing certain threats to financial stability from forming in the first place. It will also reduce the potential consequences of those threats by making the financial system much more resilient. Nonetheless, Basel III can't prevent the formation of all financial imbalances, such as those in housing markets. Elevated house prices can become a concern for central bankers, particularly if they are associated with higher levels of household indebtedness and leverage. And we know that house prices can deviate in a meaningful way from underlying fundamentals, especially if expectations of price gains are based on simple extrapolations and become disconnected from economic fundamentals. A sudden reversal of such misalignments can cause significant stress in the financial system and the economy as a whole. That is where the third line of defence--macroprudential policy--comes into play. Macroprudential policies have a relatively short history, and there isn't a lot of empirical evidence yet. But one set of tools that has been used more frequently and studied more extensively consists of those that deal with housing. The International Monetary Fund and several central banks--including the Bank of Canada--have looked at this area. They've found that some macroprudential policies, such as limits on mortgage loan-to-value ratios and increased capital weight on bank holdings of mortgages--can moderate the growth of credit and house prices as well as improve the average creditworthiness of borrowers. The impact of recent macroprudential tightening in Canada, which was aimed primarily at rules for insured mortgages, appears to support these findings. If we accept that properly implemented macroprudential policies can help to effectively combat financial vulnerabilities by strengthening resilience in the financial system and reducing systemic risk, this supports the view that authorities should look to these policies first when imbalances arise, before turning to monetary policy. Across the advanced economies, there is a wide variety of governance models for macroprudential policy-making. In many cases, the mandate is centralized-- sometimes within the central bank, as is the case at the Bank of England, or outside the central bank, as in the United States. Some macroprudential bodies have the power to write regulations; others are limited to monitoring and making recommendations. While their precise roles may differ, it's crucial that central banks be involved, because we bring a unique, system-wide perspective that can help identify and assess systemic vulnerabilities and risks. Further, our interests in financial stability cut across the Bank of Canada's functions--not only do we need a wellfunctioning financial system to transmit our monetary policy, but we also have oversight of systemically important financial market infrastructures and, of course, we are the lender of last resort to the system. When more than one body is involved in macroprudential policy, there needs to be a mechanism to discuss and coordinate responses and to provide checks and balances within the regulatory system. In Canada, the Senior Advisory Committee fulfills this role. The committee is chaired by the Deputy Minister of Finance and includes the Bank of Canada, the Office of the Superintendent of Financial Consumer Agency of Canada. It is an informal forum where members can share information and perspectives on their own policies as well as on the overall regulatory environment. The committee's strength lies in the way it allows members to understand the views of other members and to coordinate macroprudential policies, which is essential, given the potential side effects that macroprudential and monetary policies can have on each other. The last line of defence is monetary policy, and this is the context in which we think of leaning against imbalances. To be clear, I'm defining leaning as choosing a different path for interest rates than would be optimal for the inflation target in order to mitigate risks to financial stability. This could mean, for example, accepting a significant delay in getting inflation back to target so as not to exacerbate financial vulnerabilities along the way. At this point, let me remind you of a complicating factor for policy-makers that I mentioned earlier--the fact that macroeconomic and financial objectives aren't always consistent. It's clear that financial system policies--including global frameworks such as Basel III and country-specific macroprudential policies--can reduce the likelihood of financial imbalances and crises by reducing tail risks. However, it is also clear that these policies, and the state of the financial system in general, can also influence the effectiveness of monetary policy. So we need to deepen our understanding of the links and potential trade-offs between monetary and financial system policies. Let me explain. Sometimes the economic and financial cycles move in tandem. Consider a demand shock where excess demand and upward inflationary pressure lead the central bank to raise interest rates. Here, monetary policy can restrain both demand and credit growth. Now consider a different scenario, where a central bank is running easy monetary policy to try to encourage borrowing and spending. Over time, the increased borrowing could potentially lead to imbalances, in the housing market for example. In this case, you could have macroprudential policy tightening that's working in the opposite direction of monetary policy. It's therefore crucial to deepen our understanding of how the various transmission channels for monetary policy can be affected by variables that could be targets for financial system policies. Central banks, including the Bank of Canada, have made progress in developing new economic models and adapting existing ones to integrate financial system variables and stresses as we conduct monetary policy. We've added potential sources of vulnerability, such as the balance sheets of households, companies and banks, to our macroeconomic models. We are using enhanced frameworks, fuelled by more and better data, to help monitor the financial system and make more informed judgments about stability risks and how they might interact with each other. We have boosted the profile of our semi-annual FSR publication. We will continue to strive for a better understanding of the interactions between monetary policy and financial stability, and I expect to see a large amount of groundbreaking research that will shed light on various aspects of this relationship. However, there is a fundamental problem--policy-makers need models that analyze a wide variety of variables and shocks in order to do their projections, but it is enormously difficult to capture bubble-related behaviour within a typical general-equilibrium model. So we have to rely on our regular models and supplement them with stylized models that give us insights into specific financial stability issues. These models show us a view of certain parts of the economic picture, but we will never have a single tool that can provide the complete picture by itself. So, given that we're working with an incomplete picture of the economy, what is a central bank to do? At the Bank of Canada we take a risk-management approach to monetary policy. Let me explain what that means, and what it doesn't mean. Since the early 1990s, inflation targeting has become increasingly popular among central banks, and Canada was an early adopter. Under our current agreement, we aim to keep inflation around a target of 2 per cent, and we usually try to accomplish this over six to eight quarters. Even in the absence of financial stability threats, the practice of monetary policy requires the central banker to deal with vast amounts of uncertainty. Think of the most important aspects of a macroeconomic model--the level and growth rate of potential output, the real neutral interest rate, and the transmission of terms-of- trade shocks. None of these can be observed; they all must be estimated. The assumptions that we make in running our models inject uncertainty throughout the policy-making process. And, since the crisis, we have also been confronted with the risk that our models have been distorted because of fundamental shifts in economic behaviour. Now, on top of all this uncertainty, we have to add the uncertainty represented by risks to financial stability, a concept that is difficult to quantify. Adding this whole other dimension of uncertainty complicates the practice of monetary policy by forcing us to weigh both sets of risks, the probabilities that they will be realized and the potential consequences of a policy error. So how do we manage the risks? At the Bank of Canada, we try to be realistic about the things we don't know and do a thorough examination of the related risks. Every time we come to a decision, there are a number of potential paths for policy that could be consistent with the inflation goal. In the process of formulating policy, we weigh these possibilities and focus on those that fall into a zone where the range of likely outcomes makes us reasonably certain that we'll achieve the inflation target over an acceptable time frame and that financial stability risks will evolve in a constructive way. Still, we know there can be times when setting policy to achieve the inflation target within the usual time frame can increase the level of financial stability risk to an unacceptable level. This would take us out of the zone where the risks are essentially balanced. Because the flexibility in our framework allows it, we reserve the right to choose our policy tactics so that our actions don't significantly worsen financial stability concerns by opting for a policy path that aims to return inflation to target over a longer time frame than normal. Risk management, then, does not mean that the central bank will adjust policy to try to lean against every emerging financial imbalance. Since we are an inflation- targeting central bank, our policy tool must always be directed first at our inflation target. Even in extreme conditions, when financial stability risks constrain monetary policy from achieving the inflation target over a reasonable time frame, a central bank would want to ensure that all macroprudential options were exhausted before trying to address those risks with monetary policy. Let me give a real-life example to illustrate how we put our risk-management approach into practice. Last year, before the oil price shock hit the Canadian economy, our policy was in the zone I just described, with inflation on course to return to target in a reasonable time frame and vulnerabilities in the household sector looking as if they would evolve constructively. The oil price shock changed the outlook dramatically. It represented a potentially sizable reduction of our national income and threatened to drive inflation below target for an unacceptably long time. The expected sharp decline in economic activity and employment also represented a possible trigger for Canadian financial stability risks related to elevated household debt. Our monetary policy was knocked out of the zone, and the downside risk to future inflation was material. So, in January, we lowered our policy interest rate, and we did so again six months later as the impact of the shock became clearer. We knew that easing policy would have implications for financial stability. However, we also knew that those concerns had to remain subordinate to the primary mission of achieving our inflation target and getting our policy back in the zone where the risks are balanced. Our risk-management approach implied that, in the absence of any additional macroprudential measures, our actions would affect the balance of risks in opposite directions. Lowering interest rates could worsen vulnerabilities related to household debt at the margin, but it would also lessen the chances of the oil price shock triggering financial stability risks. In the current context, getting the economy back to full capacity with inflation on target is central to promoting financial stability over the longer term. It's time to conclude. The dramatic events of the financial crisis required a dramatic reaction. New financial sector rules are being implemented to make the global economy safer. For financial institutions, this is a long and difficult path, but the stakes are too high to contemplate leaving the job incomplete. Policymakers are working hard to understand the impact of new regulations and to develop effective frameworks and best practices for implementing macroprudential policies. For central banks, we know that financial stability has now become a permanent preoccupation. We can't have a firm grasp on the economy and its outlook without also having a good understanding of the links between financial stability and monetary policy. At the Bank of Canada, we will remain committed to delivering on our mandated inflation goal. We will continue to strive toward improving our understanding of how monetary policy and financial stability influence each other. And we will continue to use the flexibility in our inflation targeting framework as needed to integrate financial stability concerns into the conduct of monetary policy, while always keeping inflation control as our primary mission.

r151012a_BOC

canada

Integrating Financial Stability into Monetary Policy

poloz

Governor of the Bank of Canada I appreciate the opportunity to be part of this event. As usual, NABE is confronting some of the most important and difficult issues in economics at this meeting. For central bankers, as we work to understand and react to the aftermath of the global financial crisis, the key question is how we should integrate financial stability concerns into the conduct of monetary policy. Over the weekend, I attended the annual meetings of the International Monetary Fund and the World Bank, where this question was a topic of discussion. There is some urgency to this issue, given the way the crisis highlighted how much we have yet to learn about the linkages between the financial system and the real economy. If you think back to the pre-crisis period, nobody gave much credence to the idea that focusing on price stability could somehow contribute to the buildup of dangerous imbalances. Central bankers now know that we must consider financial stability as we set policy. The idea that central bankers should pay little heed to financial stability issues and simply "stick to our knitting" of inflation control--a position once advocated by many--seems quaintly naive. Fortunately, the profession appears to be up to the challenge. Understanding real-financial linkages is a research priority at the Bank of Canada and elsewhere. After all, we've seen how financial imbalances in one sector of one economy can be amplified and propagated across the entire financial system, leading to the worst global downturn since the Great Depression. So what I will do today is share our perspective on how we integrate financial stability concerns into the pursuit of our goals of price stability and macroeconomic stabilization. This exercise is fraught with risks and uncertainties, and it is complicated by the fact that macroeconomic and financial stability objectives are not always consistent with each other. Coping with this becomes a problem, not of policy optimization, but of risk management. In other words, we put aside the idea of engineering the perfect policy and focus instead on the more realistic goal of finding an appropriate policy setting, given the risks and uncertainties. The debate about using monetary policy to respond to financial imbalances has evolved rapidly since the pre-crisis era. A decade or so ago, the discussion was essentially between those who argued that monetary authorities should lean against imbalances such as asset-price bubbles and those who said that monetary policy should be reserved for cleaning up the mess after the bubble popped. Before the financial crisis, the Bank of Canada basically straddled the two camps. On the one hand, we argued that it's very difficult to identify an assetprice bubble, and central bankers have no comparative advantage in making this determination. Like many, we questioned the wisdom of using the blunt instrument of interest rates on a bubble that could be confined to one asset class. Indeed, if a bubble was particularly large and persistent, a central bank that used the cure of higher interest rates could end up causing the very economic damage it was trying to prevent. On the other hand, the Bank recognized that price stability was a necessary, but not sufficient, condition for financial stability. Given our keen interest in a wellfunctioning financial system and our macro perspective, we worked to raise awareness of stability threats. Our decision to begin publishing our (FSR) in 2002 showed our early commitment to promoting financial stability. We used the phrase "global imbalances" a lot in speeches leading up to the crisis. In other words, we weren't content to just stand on the sidelines and wait to clean up messes. The widespread and extremely high cost of the Great Recession made it clear just how difficult the clean-up job can be. It has been roughly seven years since the crisis, and the damage done to the global economy has left many central banks still struggling with weak growth and inflation. However, the more fundamental lesson we learned is that "lean versus clean" is a false dichotomy. It's far too simplistic to say that financial stability threats compel central banks to choose between leaning and cleaning. In a perfect world, we would have a macroeconomic model sophisticated enough to capture the emergence and resolution of financial imbalances, along with their related impacts on the real economy. With such a model, we would be able to incorporate financial stability threats into our reaction function, if not with absolute precision, then at least as well as we incorporate other economic variables. Unfortunately, we don't live in that perfect world. A general-equilibrium model containing a grand synthesis of real and financial variables doesn't exist and isn't likely to. I don't mean to downplay the importance of research and the development of stylized models, which are crucial in helping us understand aspects of the relationship between the real economy and financial stability. But the reality is that central banks have to cope with tremendous uncertainty regarding financial stability issues, and this is layered on top of the regular uncertainties of monetary policy concerning unobservable variables such as potential output. Given all of the uncertainty, it seems to me the proper response of the monetary authority is to acknowledge and accept all the things we don't know, gauge the risks facing the economy as best we can, and manage those risks as we conduct monetary policy. I'll describe our risk-management framework in detail later on. But we still have the question of how policy-makers should respond to financial imbalances, particularly those that are concentrated in a specific sector or asset class. The Bank of Canada's view is that monetary policy should be the last line of defence against threats to financial stability, behind the joint responsibility of borrowers and lenders, appropriate regulatory oversight within the financial sector, and sound macroprudential policies. Let me say a little bit about each of these. Borrowers and lenders are the first line of defence. They bear the ultimate responsibility for their own decisions at the individual and firm level. It is not the role of monetary policy to protect individuals from making bad choices. It is possible that the sum of those bad decisions could threaten financial stability or the economy as a whole, and so we monitor the situation as a matter of course. But there is no reason to assume that, in all circumstances, equilibrium will devolve into turmoil as borrowers and lenders inevitably sow the seeds of a financial crisis. Indeed, market discipline enhanced by appropriate transparency can be very helpful in this regard. That's not to say policy-makers have no role in enhancing this line of defence. Financial education and efforts to improve financial literacy can help consumers better understand the important decisions they make. In Canada, we have seen increasing levels of household debt that represent a key vulnerability for the financial system. The main driver behind this rise has been an increase in home-backed debt against a backdrop of rising house prices, particularly in two of Canada's largest cities--Toronto and Vancouver. Among other factors, this was due to low interest rates that resulted in the ratio of debt service to income, including principal repayment, remaining roughly unchanged since 2008. Given this, the increase in household debt levels is no surprise. Rather, this rational response by consumers to easy monetary policy is a sign that the transmission mechanism has been working. I'm not trying to diminish the threat posed by elevated household debt. We are continuing to watch this closely. The point is that there is more to the story than the debt-to-income ratio. Because house prices have generally been rising faster than incomes, we have seen increases in the size of a first-time mortgage that a new borrower might take out. Mathematically, the total debt-to-income ratio rises as a result. But it doesn't necessarily mean an increase in the vulnerability of the economy or the financial system. The second line of defence is sound regulatory oversight of the financial sector. This oversight has been significantly strengthened since the financial crisis. Basel III has made the world a safer place; there can be no doubt about that. But even before the crisis, Canada's banking system was well served by its strong regulatory environment and prudent culture, which allowed our institutions to avoid the worst of the turmoil. Given the scale of the damage caused by the financial crisis, it's not surprising that authorities devised a reform agenda of corresponding proportions. The G20 pledged to do everything necessary to address the weaknesses exposed by the crisis. The proper implementation of the Basel rules will go a long way to preventing certain threats to financial stability from forming in the first place. It will also reduce the potential consequences of those threats by making the financial system much more resilient. Nonetheless, Basel III can't prevent the formation of all financial imbalances, such as those in housing markets. Elevated house prices can become a concern for central bankers, particularly if they are associated with higher levels of household indebtedness and leverage. And we know that house prices can deviate in a meaningful way from underlying fundamentals, especially if expectations of price gains are based on simple extrapolations and become disconnected from economic fundamentals. A sudden reversal of such misalignments can cause significant stress in the financial system and the economy as a whole. That is where the third line of defence--macroprudential policy--comes into play. Macroprudential policies have a relatively short history, and there isn't a lot of empirical evidence yet. But one set of tools that has been used more frequently and studied more extensively consists of those that deal with housing. The International Monetary Fund and several central banks--including the Bank of Canada--have looked at this area. They've found that some macroprudential policies, such as limits on mortgage loan-to-value ratios and increased capital weight on bank holdings of mortgages--can moderate the growth of credit and house prices as well as improve the average creditworthiness of borrowers. The impact of recent macroprudential tightening in Canada, which was aimed primarily at rules for insured mortgages, appears to support these findings. If we accept that properly implemented macroprudential policies can help to effectively combat financial vulnerabilities by strengthening resilience in the financial system and reducing systemic risk, this supports the view that authorities should look to these policies first when imbalances arise, before turning to monetary policy. Across the advanced economies, there is a wide variety of governance models for macroprudential policy-making. In many cases, the mandate is centralized-- sometimes within the central bank, as is the case at the Bank of England, or outside the central bank, as in the United States. Some macroprudential bodies have the power to write regulations; others are limited to monitoring and making recommendations. While their precise roles may differ, it's crucial that central banks be involved, because we bring a unique, system-wide perspective that can help identify and assess systemic vulnerabilities and risks. Further, our interests in financial stability cut across the Bank of Canada's functions--not only do we need a wellfunctioning financial system to transmit our monetary policy, but we also have oversight of systemically important financial market infrastructures and, of course, we are the lender of last resort to the system. When more than one body is involved in macroprudential policy, there needs to be a mechanism to discuss and coordinate responses and to provide checks and balances within the regulatory system. In Canada, the Senior Advisory Committee fulfills this role. The committee is chaired by the Deputy Minister of Finance and includes the Bank of Canada, the Office of the Superintendent of Financial Consumer Agency of Canada. It is an informal forum where members can share information and perspectives on their own policies as well as on the overall regulatory environment. The committee's strength lies in the way it allows members to understand the views of other members and to coordinate macroprudential policies, which is essential, given the potential side effects that macroprudential and monetary policies can have on each other. The last line of defence is monetary policy, and this is the context in which we think of leaning against imbalances. To be clear, I'm defining leaning as choosing a different path for interest rates than would be optimal for the inflation target in order to mitigate risks to financial stability. This could mean, for example, accepting a significant delay in getting inflation back to target so as not to exacerbate financial vulnerabilities along the way. At this point, let me remind you of a complicating factor for policy-makers that I mentioned earlier--the fact that macroeconomic and financial objectives aren't always consistent. It's clear that financial system policies--including global frameworks such as Basel III and country-specific macroprudential policies--can reduce the likelihood of financial imbalances and crises by reducing tail risks. However, it is also clear that these policies, and the state of the financial system in general, can also influence the effectiveness of monetary policy. So we need to deepen our understanding of the links and potential trade-offs between monetary and financial system policies. Let me explain. Sometimes the economic and financial cycles move in tandem. Consider a demand shock where excess demand and upward inflationary pressure lead the central bank to raise interest rates. Here, monetary policy can restrain both demand and credit growth. Now consider a different scenario, where a central bank is running easy monetary policy to try to encourage borrowing and spending. Over time, the increased borrowing could potentially lead to imbalances, in the housing market for example. In this case, you could have macroprudential policy tightening that's working in the opposite direction of monetary policy. It's therefore crucial to deepen our understanding of how the various transmission channels for monetary policy can be affected by variables that could be targets for financial system policies. These types of questions are urgent research priorities for the Bank of Canada as we work toward renewing our inflation- targeting agreement with the federal government next year. Indeed, assessing the costs and benefits of possible monetary policy interventions to address financial stability concerns continues to be a priority in the lead-up to the renewal. Let me give you a taste of some of the specific areas the Bank is looking at in terms of the relationship between financial stability and monetary policy. We are gathering empirical evidence about the effects of household debt levels on monetary policy. We are conducting research specifically on financial imbalances in the household sector to determine the best way to minimize the risk of future crises. We are developing models that will do a better job of quantifying the costs and benefits of using monetary policy to combat the buildup of imbalances. We are drawing lessons from the experiences of other central banks and the different ways they have reacted to financial stability developments. And we are looking at ways of measuring how much safer the financial system has become following regulatory reform in Canada and elsewhere. You can monitor the results of these efforts on our website, where we have a section dedicated to the research that is informing the renewal of the inflation-control target. Central banks, including the Bank of Canada, have made progress in developing new economic models and adapting existing ones to integrate financial system variables and stresses as we conduct monetary policy. We've added potential sources of vulnerability, such as the balance sheets of households, companies and banks, to our macroeconomic models. We are using enhanced frameworks, fuelled by more and better data, to help monitor the financial system and make more informed judgments about stability risks and how they might interact with each other. We have boosted the profile of our semi-annual FSR publication. We will continue to strive for a better understanding of the interactions between monetary policy and financial stability, and I expect to see a large amount of groundbreaking research that will shed light on various aspects of this relationship. However, there is a fundamental problem--policy-makers need models that analyze a wide variety of variables and shocks in order to do their projections, but it is enormously difficult to capture bubble-related behaviour within a typical general-equilibrium model. So we have to rely on our regular models and supplement them with stylized models that give us insights into specific financial stability issues. These models show us a view of certain parts of the economic picture, but we will never have a single tool that can provide the complete picture by itself. So, given that we're working with an incomplete picture of the economy, what is a central bank to do? At the Bank of Canada we take a risk-management approach to monetary policy. Let me explain what that means, and what it doesn't mean. Since the early 1990s, inflation targeting has become increasingly popular among central banks, and Canada was an early adopter. Under our current agreement, we aim to keep inflation around a target of 2 per cent, and we usually try to accomplish this over six to eight quarters. Even in the absence of financial stability threats, the practice of monetary policy requires the central banker to deal with vast amounts of uncertainty. Think of the most important aspects of a macroeconomic model--the level and growth rate of potential output, the real neutral interest rate, and the transmission of terms-oftrade shocks. None of these can be observed; they all must be estimated. The assumptions that we make in running our models inject uncertainty throughout the policy-making process. And, since the crisis, we have also been confronted with the risk that our models have been distorted because of fundamental shifts in economic behaviour. Now, on top of all this uncertainty, we have to add the uncertainty represented by risks to financial stability, a concept that is difficult to quantify. Adding this whole other dimension of uncertainty complicates the practice of monetary policy by forcing us to weigh both sets of risks, the probabilities that they will be realized and the potential consequences of a policy error. So how do we manage the risks? At the Bank of Canada, we try to be realistic about the things we don't know and do a thorough examination of the related risks. Every time we come to a decision, there are a number of potential paths for policy that could be consistent with the inflation goal. In the process of formulating policy, we weigh these possibilities and focus on those that fall into a zone where the range of likely outcomes makes us reasonably certain that we'll achieve the inflation target over an acceptable time frame and that financial stability risks will evolve in a constructive way. Still, we know there can be times when setting policy to achieve the inflation target within the usual time frame can increase the level of financial stability risk to an unacceptable level. This would take us out of the zone where the risks are essentially balanced. Because the flexibility in our framework allows it, we reserve the right to choose our policy tactics so that our actions don't significantly worsen financial stability concerns by opting for a policy path that aims to return inflation to target over a longer time frame than normal. Risk management, then, does not mean that the central bank will adjust policy to try to lean against every emerging financial imbalance. Since we are an inflation- targeting central bank, our policy tool must always be directed first at our inflation target. Even in extreme conditions, when financial stability risks constrain monetary policy from achieving the inflation target over a reasonable time frame, a central bank would want to ensure that all macroprudential options were exhausted before trying to address those risks with monetary policy. Let me give a real-life example to illustrate how we put our risk-management approach into practice. Last year, before the oil price shock hit the Canadian economy, our policy was in the zone I just described, with inflation on course to return to target in a reasonable time frame and vulnerabilities in the household sector looking as if they would evolve constructively. The oil price shock changed the outlook dramatically. It represented a potentially sizable reduction of our national income and threatened to drive inflation below target for an unacceptably long time. The expected sharp decline in economic activity and employment also represented a possible trigger for Canadian financial stability risks related to elevated household debt. Our monetary policy was knocked out of the zone, and the downside risk to future inflation was material. So, in January, we lowered our policy interest rate, and we did so again six months later as the impact of the shock became clearer. We knew that easing policy would have implications for financial stability. However, we also knew that those concerns had to remain subordinate to the primary mission of achieving our inflation target and getting our policy back in the zone where the risks are balanced. Our risk-management approach implied that, in the absence of any additional macroprudential measures, our actions would affect the balance of risks in opposite directions. Lowering interest rates could worsen vulnerabilities related to household debt at the margin, but it would also lessen the chances of the oil price shock triggering financial stability risks. In the current context, getting the economy back to full capacity with inflation on target is central to promoting financial stability over the longer term. It's time to conclude. The dramatic events of the financial crisis required a dramatic reaction. New financial sector rules are being implemented to make the global economy safer. Policy-makers are working hard to understand the impact of new regulations and to develop effective frameworks and best practices for implementing macroprudential policies. For central banks, we know that financial stability has now become a permanent preoccupation. We can't have a firm grasp on the economy and its outlook without also having a good understanding of the links between financial stability and monetary policy. This is a critical area of research for central bankers everywhere, and we look forward to the contributions that economists will make in the months and years ahead. At the Bank of Canada, we will remain committed to delivering on our mandated inflation goal. We will continue to strive toward improving our understanding of how monetary policy and financial stability influence each other. And we will continue to use the flexibility in our inflation targeting framework as needed to integrate financial stability concerns into the conduct of monetary policy, while always keeping inflation control as our primary mission.

r151021a_BOC

canada

Release of the Monetary Policy Report

poloz

Governor of the Bank of Canada Press conference following the release of the Good morning. We are happy to be here to answer your questions about today's interest rate announcement, and our October will begin with a few remarks about the issues that were most important to the Let's start with the global context. We expect the global economy to strengthen over the next couple of years, although on a lower path than predicted in our last MPR in July. Growth is being supported by accommodative monetary policy and the positive effects of low oil prices in a number of economies. The U.S. economy continues to strengthen largely as we expected, shaking off the temporary factors that held it back earlier in the year. We see particular strength in areas that are important to Canadian exports, such as business investment. However, we also see weaker growth prospects in a number of emerging-market economies, particularly China. Governing Council spent a lot of time discussing what this means for Canada. There has been volatility in financial markets and downward pressure on the prices of many commodities that Canada sells. China is transitioning to a lower and more sustainable long-term growth path. While this transition may not happen in a straight line, China should continue to be a solid source of growing demand for commodities. If you look at Chart 8 of the MPR, for example, you'll see that Chinese imports of copper are still rising strongly in volume terms. Nonetheless, there is downside risk for some emerging-market economies, particularly in the context of U.S. monetary-policy normalizing. In our discussions, we thought it was important to keep in mind that many of these countries have become more resilient in recent years: they have been restructuring their economies, strengthening their fiscal positions, and moving to more flexible exchange rates. Given these factors, if uncertainty fades about the prospects for China and other emerging markets, there is some upside risk to our commodity price assumptions, with implications for Canada. Let's now turn to Canada. While the first half of the year was weak, there are clear signs of a pickup in growth. Taken as a whole, the second half should see growth in line with our July outlook, and we expect the economy will gather strength over the next couple of years. The complex adjustment to Canada's terms of trade shock is playing out over two tracks. In the resource sector, we see firms cutting production and investment. We are also seeing spillovers into other areas of the economy. It's not surprising that car sales and housing markets in energy-producing regions aren't doing as well as those in other regions. We estimate that the oil price shock, on its own, took about 1 1/4 percentage points off GDP growth in the first half of the year. At the same time, Canada's non-resource economy is doing much better. Table 4 in the MPR shows that retail sales, housing starts and labour markets are showing solid strength outside of the energy-intensive provinces. Non-energy exports are also showing encouraging signs. You'll recall that in July we were puzzled because non-energy exports had faltered by more than would have been expected given developments in the United States. So Bank staff have updated the analysis that they did last year by looking at more than 4,000 export categories. This work was posted today on our web site. It shows that categories of exports that were expected to lead the recovery--such as building materials and fabricated metal products--have grown strongly in recent months, and new sources of export growth are emerging. While it's clear that there are risks to our outlook, the bottom line is that economic momentum is building in Canada. Real GDP growth should increase over the next two years, although by less than we forecast in July. Lower commodity prices and the drop in energy-related business investment are acting as significant drags. At the same time, stronger U.S. demand, a lower Canadian dollar and the monetary stimulus we added earlier this year are all having a positive effect on growth. Governing Council considered carefully the implications of the commodity price shock on potential output because it is important to gauging the outlook for inflation. Potential output growth--the sustainable rate of non-inflationary growth--is a tricky thing to estimate under normal circumstances. It is even more so now, due to the adjustments in investment and jobs that are underway. Overall business investment has been revised sharply lower. This is because investment in the resource sector is being reduced faster than it is growing in the non-resource part of the economy. This means that, over the near term, potential output is likely to grow in the lower part of the range of estimates that the Bank presented in April. Potential output growth should eventually recover as existing capacity expands and new firms are created in the non-resource sectors. This process will unfold over a long period. Taking this on board, we can expect the economy to return to its full potential around mid-2017. The underlying trend in inflation is still around 1.5 to 1.7 per cent. Core inflation is currently higher than the underlying trend, because the lower dollar is raising the prices of imports. Today, we published a paper that outlines our staff estimates of exchange rate pass-through to inflation. Total inflation, however, remains much lower than the underlying trend because of past declines in fuel prices. We expect inflation to return to 2 per cent in a sustainable way as the output gap closes. We see the risks around the profile for inflation as roughly balanced. As part of our risk management approach to monetary policy, Governing Council always considers financial stability risks. We know that accommodative policy has implications for financial vulnerabilities in the household sector. In the current context, getting the economy back to full capacity with inflation on target is central to supporting financial stability over the longer term. Taking all of these developments into consideration, the Bank judges that the current stance of monetary policy remains appropriate. Therefore, we kept the target for the overnight rate at 1/2 per cent. We would now be happy to take your questions.

r151027a_BOC

canada

Inflation Targeting—A Matter of Time

lane

Thank you for inviting me to speak to you here in Halifax. In my remarks today, I want to take you inside the Bank of Canada and walk you through our monetary policy decision making. In particular, I want to discuss how we take into account the dimension of time. Let's start with a very basic reality: all Canadians make choices in the present that we know will have consequences far into the future. Anyone who makes a decision on whether to take a job, pursue further education, buy a house or save for retirement has to form a view of what the results will be. Businesses deciding whether to hire more workers, expand their plant and equipment, seek new customers, adjust their prices, or finance their operations face a similar reality. As CFAs, you know that time is at the centre of every financial decision you make or advise on. The Bank of Canada's mandate--to deliver low, stable and predictable inflation-- is fundamentally rooted in the importance of time. Our job is to make sure that those longer-term decisions are not wrong-sided by unexpected changes to the value of money. The confidence Canadians have in their money can't be taken for granted: it's something we work hard to achieve and maintain. When we look around the world or even back over Canadian experience, we see many cases in which either high inflation--or its opposite, deflation--has had damaging, or sometimes even devastating, effects. The second aspect of time that we have to address is that, for the Bank of Canada too, our short-term decisions have long-term results. To achieve a good inflation outcome, we need to make decisions on our policy interest rate in the short run--every six weeks. These decisions influence how the economy and inflation will evolve over a much longer period. As you know, six weeks can be a long time for the economy and the markets. We approach each decision with a vast set of new information. To start with, inflation itself can fluctuate, both for fundamental reasons and as a result of various temporary and one-off factors. In addition, we receive all kinds of other economic data from Canada and the economies that affect us; financial market and commodity price data; as well as many relevant news items about economic policies, foreign conflicts and even the weather. So how do we react to all that information--without overreacting--and keeping our eyes on the prize? I hope you aren't disappointed that I won't tell you what we will do next. To tell the truth, I don't really know. A lot can happen between now and our next policy announcement on December 2! What I will do is spell out the logic of our approach--how we think about the underlying trend in inflation and how we make sense of the stream of information coming in. Let's start with some background on our inflation-targeting framework. Canada's decision in 1991 to set a target for inflation did not come out of the blue: it was a product of two decades of unacceptably high and variable inflation. During the 1970s and 1980s, inflation became part of everyone's calculations. Adjustments for inflation were a contentious element in wage negotiations. Interest rates rose into high double digits, building in a premium for the high expected rate of inflation and the uncertainty around it. High and variable inflation also had very different effects on different groups: some saw their salaries, savings and pensions erode away, while others reaped windfalls on their houses and financial investments. For most of that period, Canada's monetary policy struggled to find a clear direction. Half a century ago, it was anchored by the Bretton Woods system of fixed exchange rates. That system collapsed in the early 1970s in the face of increasingly open financial markets and contradictory policies in the United States and other major economies. In the mid-1970s, Canada, like many other advanced economies, tried targeting the rate of growth of the money supply. This approach was based on extensive research showing that inflation tended to be associated with increases in the supply of money in the economy. But with deregulation and financial innovation, the relationship between the rate of expansion of the money supply and the rate of inflation proved unstable. Money supply targets were no longer viable and were abandoned in 1982. Before and after that money-targeting period, the Bank of Canada had no clear policy framework to guide monetary policy actions and anchor the public's expectations of inflation. Inflation rose higher as monetary policy reacted by accommodating the inflationary pressures coming from commodity prices, fiscal deficits and higher inflation in other countries. While inflation was eventually tamed during the 1980s, it was a long and arduous process that came at the cost of several years of sub-par economic growth. In 1991, recognizing the importance of inflation to the economic and financial well-being of Canadians and the central role of monetary policy in controlling inflation in the longer run, the Bank began pursuing an explicit target for inflation. The results have been impressive. Since 1991, inflation in Canada, as measured by the consumer price index (CPI), has been remarkably stable. Inflation has averaged 2 per cent ( ), and its variability has fallen by roughly two-thirds. Chart 1: Inflation has been remarkably stable since the early 1990s Canadians have benefited in a number of important ways. Greater price stability has allowed consumers and businesses to manage their affairs with greater certainty about the future purchasing power of their incomes and financial assets. Real and nominal interest rates have also been lower across a range of maturities, in part, because they no longer include a substantial premium to compensate investors for inflation risk. More broadly, low, stable and predictable inflation has facilitated more stable economic growth in Canada and lower and less-variable unemployment ( Our inflation-targeting regime has also stood the test of the 2007-09 global financial crisis. As the fallout was hitting the Canadian economy, the Bank of Canada responded. We eased monetary policy aggressively to forestall a deeper and more prolonged economic slump. Inflation targeting gave us the flexibility to allow that strong policy response. It provided an analytical framework for calibrating how far we should go, and for how long. It also anchored the public's confidence that, despite the extreme conditions of that period, policies would remain on track to achieve the 2 per cent inflation target. A particularly useful feature of our inflation-targeting framework is that, every five years, we renew our agreement with the federal government. The agreement sets the target for inflation and the parameters for achieving it. And the renewal process provides the opportunity and the discipline to reassess our approach in a systematic way and look for room for improvement. Table 1: Inflation targeting has facilitated stable economic growth But the bar for any major change is high. We know that inflation targeting has turned out to be far superior to any other framework that has been tried. Also, as I have stressed, part of the purpose of a monetary policy framework is to allow Canadians to make longer-term decisions without having to worry too much about inflation--and that argues against changing our framework unless it's really necessary. Let's now look at time and the way in which it enters into how we target inflation. Targeting inflation involves important challenges, because we don't control inflation directly. Normally, we influence inflation through our policy interest rate--more precisely, a target for the overnight interbank rate. Our policy rate affects other interest rates in the economy, overall financial conditions and, in turn, the economy at large. It affects inflation through the amount of excess demand or supply in the economy--the output gap--which can generate pressures for inflation or disinflation. The exchange rate and expectations can also play important roles in transmitting the effects of monetary policy to inflation. There can be long lags in this transmission process--and these lags can vary significantly, depending on the economic context. Total inflation can be "noisy" because many temporary sector-specific factors impinge on inflation in the short run and, in many cases, are quickly reversed ). Some examples are consumer energy prices such as gasoline prices, or prices of certain food products that may fluctuate because of weather and other factors. In Canada, for example, 90 per cent of the observed monthly variations in the CPI are linked to price changes in just eight categories of goods and services, which together amount to only about one-seventh of the whole CPI basket. There are many examples of such temporary factors, but let me take just one. In the early 2000s, auto insurance premiums soared by about 30 per cent over a span of one year. By itself, this one component of the CPI basket was adding a full percentage point to inflation ( This outcome was not reflective of broader inflationary processes. Chart 3: Total CPI inflation during the episode of high auto insurance premiums In this setting, we can't hit our inflation target precisely or continuously--and we don't try to. To illustrate, consider what would happen if we raised our policy rate mechanically whenever inflation was above target and lowered it whenever inflation was below target. We would end up reacting to a lot of temporary factors. And because our policies work with long lags, we would have to overreact, making huge adjustments in our policy rate to have any effect, followed by huge corrections to compensate for the lagged effects of our own policies. This would lead to what has been called "instrument instability"--a kind of policy over-steering that would quickly land us in the ditch. This reasoning points us in two directions. First, we need to be able to look through temporary factors that affect inflation in the short run, so that we don't overreact to shocks that are going to reverse themselves anyway. Second, we need to understand and anticipate the forces that will affect inflation in the future so that our policy decisions will keep inflation on target until their effects have worked their way through the economy. Both of these elements go into making a judgment on the underlying trend in inflation and how it is evolving. So, rather than trying to hit the inflation target continuously, we set a time horizon for reaching it. Normally it's two years, based on estimates of what is a reasonable time frame for policies to have their effects and for temporary shocks to dissipate. But we have the flexibility to return sooner or to take longer, depending on the nature of the shocks affecting the economy. In particular, under flexible inflation targeting, we have the scope to take longer to get back to target in a situation where returning to target within two years would require aggressive policies that could result in a buildup of imbalances in our financial system and possible instability down the road. This point was made explicit in our inflation-targeting framework the last time we renewed it in 2011. The timing for a return to target thus requires a judgment on the balance of risks. Even when inflation is at target, we can't afford to be complacent. Sometimes there are forces pushing inflation higher or lower, and we need to use monetary policy to counteract them. In such cases, the policy rate will need to deviate from its long-run level to provide the stimulus or restraint necessary to offset these forces. There are also some situations in which we need to get ahead of shocks that we can see will have a significant effect on inflation in the future. Otherwise, we would be in a situation of trying to catch up with these effects after they have already become entrenched. That was the logic of our January 2015 rate cut. We could see that a 60 per cent decline in the price of oil would, on balance, be bad for the Canadian economy. So even though it was still uncertain how large and prolonged that effect would be, we needed to act promptly to achieve our inflation target. The combination of long- and short-run factors affecting inflation, the lags in the effects of our policies, and the uncertainties around each element makes monetary policy fundamentally an exercise in risk management. While one can try to write a reaction function or rule to describe monetary policy, a rule or function can only go so far. For example, the Taylor rule holds that monetary authorities adjust the policy rate in response to deviations of the inflation rate from target and output from potential. That's a useful rule of thumb, but too mechanical to go very far in explaining how policy actually behaves. Inflation targeting is also "informationally inclusive," meaning it doesn't just react to the current inflation rate and GDP. It also takes account of a broad range of other information. That information includes economic data as well as soft information such as the responses to our and a wide range of more informal conversations that we conduct with businesses and other Canadians. We use a combination of models and our own judgment to understand the underlying forces working on inflation. We want to get as clear a picture as possible, not only of what is actually going on, but also of what could go wrong if the unexpected happened. In thinking about targeting inflation over time, an aspect that has received a lot of attention recently is underlying inflation: the inflation rate that would prevail in the absence of various sector-specific and one-off factors that can affect the measured CPI from month to month. Conceptually, underlying inflation should be driven mainly by the amount of excess supply or demand in the economy, together with the public's expectations of inflation. Underlying inflation has been a particularly important concept this year. We have the impact of the oil price shock, which is pushing inflation down via prices of gasoline and other consumer energy products. At the same time, the weaker Canadian dollar, which is largely associated with the lower prices of oil and other Canadian commodity exports, has been pushing measured inflation upward. A number of other one-off factors have also been affecting inflation. Our challenge is to distinguish the trend from the temporary to avoid overreacting to the temporary--and give the public confidence that inflation will return to the right track. For this reason, the Bank of Canada, along with many other central banks, uses a number of measures to calculate core inflation, which are designed to minimize the influence of transitory price movements ( An effective core measure must have four key properties. It must be less volatile than total inflation; closely track long-run movements in the total CPI (in other words, be "unbiased"); be related to the underlying drivers of inflation, notably the output gap, in order to reliably predict future trend movements in the total CPI; and be easy to understand and explain to the public. Table 2: Select central bank practices regarding core inflation Since 2001, the Bank of Canada has featured one measure of core inflation as our operational guide for monetary policy: CPIX, which excludes eight of the most volatile components of the CPI and adjusts the remaining components for the effects of indirect taxes ( Included in those eight components are mortgage interest costs, which CPIX strips out for a different reason: to avoid giving a perverse reading of the impact of monetary policy on core inflation. (A measure of core inflation that includes mortgage interest costs increases when policy is tightened to bring down inflation.) Chart 4: Measures of core inflation such as CPIX help to discern genuine movements in the underlying trend of inflation Another exclusion-based core measure, CPIXFET, takes out food, energy and indirect taxes. Yet others calculate core inflation using a trimmed mean, which excludes different components each month based on whether or not they are exhibiting volatility at that specific point in time. More sophisticated methods track common price movements across categories in the CPI basket. Such movements are more likely to reflect aggregate demand fluctuations than sector-specific developments. The advantage of these tools is that they take information on all the prices in the CPI and use objective methods to filter that information. The disadvantage is that in some cases they are constructed using techniques that, while firmly founded in logic and statistical theory, are very opaque. All the measures have followed similar tracks ( ). Each measure satisfies the key properties identified above to differing degrees. They all display less volatility than total inflation ( ). And all but one track long-run movements in total CPI very closely. While the various measures are correlated with the output gap to differing degrees, they all have some predictive power for total inflation ( But no formula can completely exclude idiosyncratic factors. We've had some examples of those lately with automobile pricing, telecoms, consumer electricity and natural gas. The products that are subject to idiosyncratic factors can change from period to period; obviously, we can't change our measure each time that happens. Nor should we ignore those sector-specific factors: sometimes, movements in individual prices can be an advance warning of wider price movements, so we have to look at them in the right context. Chart 5: Core inflation measures are near 2 per cent Chart 6: All core measures display less volatility than total CPI Chart 7: Core measures reflect slack to differing degrees As we prepare for the renewal of our inflation-control agreement with the federal government in 2016, we are examining the properties of these measures of core inflation to determine whether the Bank should continue the practice of identifying one pre-eminent measure as its operational guide and, if so, whether CPIX should continue to play that role. We published today on our website our latest technical assessment of these measures of core inflation. I want now to discuss one factor that can have a particularly important effect on inflation: the exchange rate. Inflation targeting can only work with a flexible exchange rate, which gives the Bank of Canada room to set monetary policy independently of other countries. We don't target the exchange rate or even publish a forecast. With a floating exchange rate, the external value of the Canadian dollar can change for a variety of reasons, and that affects inflation in Canada through two channels. It has a direct pass-through effect on the prices of imported goods. The exchange rate also affects inflation more indirectly through its impact on aggregate demand in the Canadian economy, mainly through its effects on the competitiveness of Canadian-produced goods and services relative to those produced elsewhere. The pass-through effects are transitory, while the effects on aggregate demand will generally persist over a longer period. The importance of both of these kinds of effects is particularly clear when the change in the exchange rate is as large as it has been recently: in less than two years, the Canadian dollar has lost more than 20 per cent in value against the The effect of this depreciation on exports and the real economy is already evident. It has improved the competitiveness of Canadian producers. Export categories that historically have been sensitive to exchange rate movements are showing stronger activity. Examples include building and packaging materials, furniture and fixtures, clothing and textile products, and large motor vehicles (e.g., heavy trucks and buses). Exports of services, which constitute about 15 per cent of total exports, are also benefiting. The pass-through effects are also quite significant. They are estimated to be So how does monetary policy react? If the change in the exchange rate is seen as a temporary factor reflecting other structural changes, it is clearly appropriate to look through the pass-through effects in assessing underlying inflation and in making policy. That is the case at the present time. The depreciation of the Canadian dollar is driven mainly by two factors. First, it is associated with the sharp decline in Canada's terms of trade as the prices of oil and other Canadian commodity exports have decreased. These commodity price developments are, in turn, a result of the dynamics of supply and demand for those commodities in a global market, certainly not a result of Canadian monetary policy. Second, it is part of the general strengthening of the U. S. dollar as that economy strengthens and the Federal Reserve moves closer to normalizing monetary policy. Chart 8: The exchange rate pass-through effects on inflation are significant By that logic, we exclude the direct impact of the pass-through effect of the exchange rate movement in assessing underlying inflation. Therefore, we judge that underlying inflation is around 1.5 to 1.7 per cent. Of course, the effect of the weaker Canadian dollar in stimulating the Canadian economy is an essential element of our projection that underlying inflation will return sustainably to target, with the economy back to its potential, over the next couple of years. Although we believe that's the right decision at the present time, it would not always be the right call. There are times, as in the 1970s, when exchange rate movements are part of a broader inflationary process. In such cases, looking through the pass-through could put us on a treadmill of accommodating higher inflation. Moreover, identifying pass-through depends on a combination of estimation and judgment. For that reason, we issue our estimate of the underlying trend in inflation as our own judgment in the current policy context, rather than as an alternative measure of core inflation. Expectations of inflation, which are based on actual inflation as well as the credibility of our target, also play a central role in the conduct of monetary policy. Many economic decisions depend on expectations of future inflation. For businesses, inflation expectations influence their stance in wage negotiations and price setting, as well as in assessing rates of return for decisions on production, hiring and investing in productive capacity. For households, expectations have an impact on savings decisions as well as on their choice of alternative savings vehicles. Through their influence on all of these decisions, expectations tend to become self-fulfilling. It would be much more challenging to keep inflation on target if expectations were to become unanchored--or anchored at a lower or higher level. For these reasons, we keep a close eye on expected inflation. We measure business expectations with our own quarterly and recently began tracking household expectations with a quarterly online poll of 1,000 Canadian consumers. The poll measures both the inflation expectations of participants over various time horizons and the uncertainty surrounding those expectations. It also covers a wide array of other economic expectations that will inform the Bank, and Canadians in general, on issues ranging from labour market prospects to personal finances. Let me wrap up. Our inflation-targeting framework has stood the test of time. It has proved vastly superior to any other policy alternatives that have been tried. Our periodic renewals are important opportunities to make sure it continues to serve its purpose and to suggest improvements. I have focused on one set of improvements that we are considering: how we assess the underlying trend in inflation, separating it from price movements that are likely to be temporary. The critical test is the confidence you have that inflation will remain within our target range. We would like the public to take 2 per cent inflation for granted. We don't, however, take your confidence in us for granted. We know we have to earn your trust by delivering, without fail, on that commitment.

r151113a_BOC

canada

Innovation, Central-Bank Style

wilkins

Everyone here knows that companies must innovate to thrive. You may not know that the same is true for central banks, even if we're the one kind of bank you wouldn't imagine going out of business. Just like private companies, central banks are often focused on immediate issues. This is hardly surprising, given what has been thrown our way these past few years: a financial crisis, the Great Recession and then the oil price shock. And a central bank exists in the first place to set a solid foundation for the economy and the financial system. In recent years, we've kept inflation low and stable. This has made it easier for people and companies to recover from the downturn. Working with other authorities, we also avoided major disruptions in our financial system. Given this track record, why does innovation matter to the Bank? It matters because the world is moving quickly: who would have imagined 20 years ago that interest rates would be below zero in a number of advanced economies? That Canadian-dollar assets would be held as foreign reserves? Or that there would be a Bitcoin ATM in your local pub? Confident as we are in how we do things now, the Bank keeps its eyes on the future. Failing to do so would be a mistake for our business and could have real negative consequences for the Canadian economy. So, for us, innovation isn't just about reacting to the most recent crisis; it's about pushing ourselves so we're ready for whatever the future holds. This is why I'm happy to be here this morning. The Rotman School of Management and the Munk School of Global Affairs are world-leading organizations. People here are passionate about innovation. Now, students here know that to stay ahead of the curve, you need a plan. We have a three-year plan that we're putting in place, and that's what I want to discuss today. I'll start by talking about how our plan continues our tradition of innovating by questioning the answers. I'll then go over some of the tough policy and research issues that we'll have to tackle and that motivated us to create this plan. This will lead me to explain how we'll get past the obstacles to new ideas by changing our corporate culture. Finally, I'm going to ask you--and all the people who care about what the Bank does--to get involved in a constructive dialogue. The Bank of Canada was itself an innovation when it was created during the Great Depression to support the economic and financial well-being of Canadians. Over the past 80 years, the Bank has done exactly that by carrying out four main lines of business. You know about our monetary policy role, because you read about how we set interest rates to return the economy to its potential and meet our inflation target of 2 per cent. In our financial stability role, we monitor the health of the Canadian financial system and act as the lender of last resort. One example of this work is the extraordinary liquidity that we provided to the system during the 2008 crisis. We're also the federal government's fiscal agent, which means that we manage about $650 billion in federal debt and around $70 billion in foreign reserves. Finally, we're responsible for the bank notes in your wallet. More work goes into them than might be evident: developing new security features, combating counterfeiting and researching new trends in electronic payments and digital currencies. Those responsibilities, combined with a balance sheet of nearly $100 billion, put the Bank at the heart of the Canadian financial system. Even though the Bank has had the same mandate for 80 years, we haven't been afraid to change our paradigm when circumstances demanded it. The change in monetary policy is stark. Under the Bretton Woods system that prevailed after the Second World War, the U.S. dollar could be exchanged for gold at a rate of $35 per ounce, and other countries pegged their currencies to the greenback. In 1950, Canada was a bit of an international rebel when it became the first industrialized country to adopt a floating exchange rate. Canada returned to a fixed peg in the 1960s, before letting the dollar float for good in 1970. Believe it or not, letting markets determine the value of a currency was revolutionary at the time. That didn't solve all our problems, to say the least. Inflation became rampant: for a stretch of more than 20 years, it never fell below 2 per cent and sometimes exceeded 10 per cent. Interest rates exploded: for a few months in the 1980s, homeowners paid more than 20 per cent on a 5-year mortgage. The Bank had to react. Its leaders knew this and researched alternative monetary policy regimes. In central banking, just as in business, it can take a long time to bring an idea to market; it took about a decade to develop the inflation-targeting regime that we adopted in 1991. Targeting inflation seems like an obvious choice today, now that it's been replicated in all major advanced economies. When we started studying it, however, many economists would have told you that it was unworkable. Not afraid to innovate, we were the second central bank in the world to set an inflation target, a few short months after New Zealand. It was a few years before the idea of targeting inflation was fully accepted by the Canadian public, and the Bank took a lot of heat for it. These days, most central bankers see inflation targeting as a success. It is credited with contributing to the "Great Moderation"--the 25 years or so before the financial crisis, when the performance of advanced economies was unusually good. I wish I could say that was the end of the story. In reality, this success probably distracted central banks from confronting the hard questions about the buildup of financial risks that led to the global crisis. It's a stern reminder that we must resist confirmation bias and complacency. If the Bank's history teaches anything, it's that we must always be ready to consider questions that challenge our old answers. How do we do that? By giving innovative thinking a central place in our strategic plan and by creating a corporate culture that fosters different perspectives and challenges the status quo. As former Governor David Dodge once said to Bank staff, "we can have clashes of ideas secure in the knowledge that there are no winners or losers ... what we're doing is exploring all aspects of an issue." Let me turn to what's in our plan. The Bank of Canada remains committed to inflation targeting and to the expert execution of all of its responsibilities. The Bank is also committed to exploring how best to contribute to the Canadian economy in a world that is going through fundamental structural change. It's in this context that the Bank is seeking to advance the frontiers along all its business lines. Let me focus on monetary policy. The current inflation-targeting framework is working well, so the bar for change is high. But history tells us we can't cling indefinitely to a particular way of doing business. One important challenge for central banks now is that conventional monetary policy is stretched to its limits in some countries, where policy interest rates are at, or below, zero. Because of this, a number of countries are using innovative monetary policy measures to return inflation to target. Canada was fortunate to avoid the worst of the crisis, thanks to the relative strength of our economy, our prudently managed and resilient financial system, and well-anchored inflation expectations. Tiff Macklem, my predecessor and your dean, can take a lot of credit for that. It's not surprising that we are focusing our research firepower on the monetary policy lessons from the crisis. The first lesson is that we have to be innovative with the instruments we have in our monetary policy toolbox. Structural changes have reduced the economy's potential to grow without creating inflation, so the neutral rate of interest is lower than it was before the crisis. That means that, if we continue to target a 2 per cent inflation rate, it's more likely that policy interest rates will fall to zero than in the past. Remember, only a few years ago, many believed zero was where monetary policy was out of bullets. We now observe that some European countries have tested this limit. There, central banks are charging commercial banks for their deposits, and governments are effectively getting paid to borrow. We published today an interesting staff paper that looks at the experience of negative nominal interest rates in a number of countries, such as Denmark and Switzerland. finds that the cost of securely storing cash is the main constraint on how low rates can go in these countries. It's too early to tell how effective negative rates are at creating additional demand. However, it seems that, in the experience of these countries, the exchange rate channel might be particularly important. Our staff, along with many other central bank researchers and academics, are also assessing how effective other innovative monetary policy measures have been. Today, we are publishing other staff research papers that cover some of these issues. The Bank of Canada was one of the innovators when we used a tool called forward guidance. That's when central banks communicate their intentions on the path of the policy rate or other policy actions. The evidence suggests that forward guidance, when it is clearly communicated and credible, can be an effective policy tool. It probably works best when it's reinforced by other policy actions. Other innovative tools central banks have experimented with to ease monetary conditions are different kinds of asset-purchase programs. We studied the experience of the United States, Europe and other places, like Japan. These central banks designed their purchases based on the part of the market they most wanted to affect. To lower yields further out the curve, they purchased longer-term government bonds. To improve credit conditions in specific areas, they bought distressed assets such as corporate bonds and mortgage-backed securities. Our research found that these purchases were successful in affecting yields. Research in this area will continue, at the Bank and around the world, because the situation continues to unfold and it will take years to understand all the effects of these innovations. The second lesson from the crisis is that policy-makers must consider the risks and vulnerabilities in the financial system when setting monetary policy. In the lead-up to the crisis, the world economy was bolstered by financial tailwinds that were poorly understood. In its aftermath, the global recovery is being held back by financial headwinds that we also don't understand well. To address this blind spot, the Bank is making a big investment in economic modelling and research. Economists use theoretical and statistical models to forecast the future and study different policy scenarios. A good model allows us to isolate the cause-and-effect relationships at play in a complex system. Our workhorse models, such as the Terms-of-Trade Economic Model, do a good job of assessing the impact of economic shocks. But they can't handle the behaviours and market disruptions that give rise to financial crises. So this is an area where we are pushing the frontiers. It's a big challenge to integrate the financial sector and its interactions with the economy in our models in a realistic way. It's even more difficult when you consider the fact that finance is being transformed by technological and social trends, as well as post-crisis regulatory reforms . This effort will yield a big payoff to public policy. Our models will inform the discussion with our federal partners on the right mix of policies--monetary, fiscal or macroprudential--that authorities should use to handle a specific problem and support the economic and financial well-being of Canadians. We need to understand better under what circumstances it would be appropriate for the Bank to use monetary policy for financial stability purposes. Models are just the starting point. No model can give the whole picture. That's why we engage with the outside world to gather some of the missing pieces, here and abroad. This allows us to ask the right questions and apply our judgment. Innovation doesn't stop with simply adapting our theoretical frameworks and gathering information on the world as we see it today. We must also challenge our thinking by contemplating alternative futures. The international monetary system could look completely different 20 years from now. China is increasingly opening its financial markets and liberalizing capital flows with the rest of world. While this is clearly positive for the global economy in the long run, this is a huge change and the transition could be bumpy at times. That means we need to think about how the world financial system will evolve and what Canada's place in it will be. Will the renminbi become a reserve currency? How would that affect the demand for other reserve currencies, Global and domestic payment systems--the backbone of the financial system-- could also look completely different. Technology is advancing and new players like PayPal and Apple Pay are competing with the traditional ones. The Bank will help lay the groundwork for the next generation of Canada's payment systems. Then there are disruptive technologies, such as the distributed ledger that's at the heart of Bitcoin, or peer-to-peer lending facilities like the Lending Club. These developments are pushing more and more financial activity outside the traditional financial sector. The sharing economy is upending entire industries. Here, I'm thinking about things like peer-to-peer home rental services such as VRBO and mediated services such as Uber. These types of trends raise questions for the Bank. Consider a cashless society where everyone uses e-money, which is monetary value stored electronically and not linked to a bank account. If this money were denominated in Canadian dollars, who should issue it? Who should earn the seigniorage? The central bank, as it does today, or the private sector? What would the financial system look like in each case? The Bank needs to consider all these questions. Cash is a public good that many people still prefer, especially for smaller transactions. As we think about alternative futures, we have to envision a world in which people mostly use e-money, perhaps even one that's not denominated in a national currency, such as Bitcoin. This would create a new dynamic in the global monetary order, one in which central banks would struggle to implement monetary policy. And, central banks couldn't act as lenders of last resort as they do for their own currencies. This means that households and businesses could suffer important losses if such an e-money were to crash. We need to anticipate this and manage the risks and benefits that could arise from the broader adoption of e-money. The Bank will explore these and many other trends over the course of our threeyear corporate plan. To do this, we're expanding the range of techniques we use for analysis. For example, we've begun to capitalize on "big data" to do things that aren't possible with traditional economic statistics. Prices collected from retail websites can be used to study pricing behaviour. Social media used by people of all ages to express likes and dislikes may become a vital source of data to understand the perception and credibility of monetary policy. We're also drawing on techniques from behavioural economics to study such things as how people form expectations. If we don't start now to find new approaches to handle these and other alternative futures, we won't be prepared for whatever comes our way. Our strategic plan focuses on new ideas. And if we want the new ideas to match our ambitions, we need the right corporate culture. No matter how successful it is, any business faces natural obstacles that can get in the way of innovation. That is why we are being proactive to make sure they don't get in our way. The first obstacle to innovation is homogeneous thinking. It's human nature to have affinity with people who think the same way and use the same jargon. But the echo chamber you create is limiting. People at Rotman and Munk know you often have to look outside your own industry to find ways to improve. We certainly did this during the financial crisis with the creation of liquidity facilities, which involved economists, market experts, IT specialists, lawyers and accountants. Scientists in our Currency Department also cast a wide net when they develop new security features for bank notes. A few years ago, they turned a material used in cancer therapy research into a machine-readable security feature. We got a patent for this innovation. The second obstacle to innovation is that people generally avoid conflict. Not everyone enjoys being at the centre of debate or playing devil's advocate. Having smart and entrepreneurial people is critical to generate innovation, but it's not sufficient; you must also have a culture that values inquiry and encourages people to speak freely. There is a lot of wisdom in the concept of integrative thinking proposed by former Rotman Dean Roger Martin: often, two ways of looking at a problem can offer insights. Leaders have to give the example. Good leaders have flexible minds and are open to being challenged. They take the time to listen. They look at all facets of a problem to come up with the best strategy. They don't step on newly sprouted grass too early. So we've added innovation as a formal topic of discussion at our senior leadership meetings. We've also put innovation at the heart of our leadership expectations. These expectations are being integrated into our leadership training and embedded in performance management, recruitment and other management practices. Practically speaking, this focus will translate into our managers spending more time with employees and on their employees' ideas. Leveraging our most important asset--our people--will spur creative ideas and diversity of thought. We're also implementing new practices to help staff assess the kinds of alternative futures I mentioned earlier. We're developing an innovation lab for cross-functional groups to assess the implications of low-probability, high-impact economic scenarios. I expect this inquisitive "black hat" perspective will benefit our everyday operations as well. The last obstacle to innovation I'll mention is aversion to risk, which is common among central bankers. This is understandable, given our responsibility as economic stewards. There are no take-backs and writedowns in central banking. That said, we can't escape the fact that innovation entails risks. A company that creates iPads and iPhones will occasionally produce a Newton. Mark Zuckerberg had it right when he said, "In a world that's changing really quickly, the only strategy that is guaranteed to fail is not taking risks." We have to find a way to embrace risks and the occasional failure that comes with risk without jeopardizing our mission. This is why we're fostering a culture of informed risk taking. To support it, we have a risk-management framework that helps us anticipate, mitigate and manage the risks that could undermine our ability to fulfill our mandate. It also gives us scope to do groundbreaking research and improve our operations and business practices. Reputation figures prominently in our risk analysis. It deserves special attention because it is vital to the success of all of our work. Monetary policy is a good example of this, because it's more effective when people believe that the Bank will achieve its inflation target. Our credibility took years to build and we intend to preserve it. If we take appropriate risks, our actions will stand the test of time, even if they initially face criticism. The most important thing for the Bank is to do the right thing, not the most popular one. To get to the right answers, we need to engage with people outside the Bank. If we don't engage, we leave ourselves open to confirmation bias and tunnel vision. John Maynard Keynes wrote during the Depression that "It is astonishing what foolish things one can temporarily believe if one thinks too long alone, particularly in economics." That's truer now than ever. What I've learned since joining the Bank of Canada over 14 years ago is that we need to be deliberate in reaching out to people beyond our own four walls. We do it through consultations with the public and market participants. We also talk to about 100 firms every quarter as part of our to get a sense of what entrepreneurs see on the ground. As part of our plan, we devised new ways to reach out. First, we've recently launched a program in which outstanding scholars will work with Bank researchers. We will benefit from this injection of outside leadingedge thinking. We're also hosting conferences on the most important economic and financial issues facing Canada. Earlier this year, we held a conference on disappointing global growth rates. And we're getting ready for others, on e-money and inflation targeting. Second, we're engaging domestic and international counterparts more than ever. It's important that people outside the Bank understand what we're working on when it's still in the early stages, not when it's all baked into policy. That's why, this week, we've expanded the range of work we post on our website. We've started publishing staff research papers under a new process that's independent of Governing Council. These papers are works-in-progress that will eventually be submitted to peer-reviewed journals. We're also publishing staff analytical notes and discussion papers on timely and topical issues. way, people can benefit from our analysis while it's fresh. We expect that this kind of work, at times, will show results that are not fully aligned with the views of the Bank's Governing Council. That's okay. The innovation process demands that researchers have the intellectual space to explore ideas. Third, it's not all about us. The Bank's culture emphasizes sharing our knowledge. Few people know that we provide technical assistance to other central banks. Our assistance spans the globe and runs the gamut of issues, from economic models to bank note quality inspection to business continuity. One area where our help is frequently solicited is web design, because our website has been recognized as the best in central banking. Closer to home, we've introduced new programs to encourage the next generation of researchers, including the Graduate Student Paper Award and the Governor's Challenge. The Governor's Challenge is a monetary policy competition for undergraduate students in economics that is going on right now. These efforts have a big payback. We learn from other central banks' experiences and from the original ideas students have. Let me wrap up. If there's one idea I want to leave you with today, it's this: when the world is moving around you, standing still is a risky strategy. At the Bank, we put innovative thinking at the centre of our strategic plan to make sure that we can navigate what's ahead. For us, innovation comes from taking a hard look at what we're doing and considering alternatives. Hubris is the enemy of sound policy. Innovation comes from involving people, like you here today, in our quest to find the best answers. Our commitment to innovation extends to all parts of our business. It will give us the tools to support Canada's economic and financial well-being for the next 80 years and beyond.

r151208a_BOC

canada

Prudent Preparation: The Evolution of Unconventional Monetary Policies

poloz

Governor of the Bank of Canada It's no secret that economists love a good debate, so much so that they often have the same debates over and over. A lively argument is currently under way about what's causing disappointingly weak growth in the world economy. A prominent Harvard University economics professor once suggested that the U.S. economy was headed for what he called "secular stagnation." Extended periods of strong economic growth were no longer likely, he said, because of a chronic shortfall in demand. I'm not referring to Harvard's Professor Lawrence Summers, who holds this secular stagnation view today. Rather, I'm talking about Professor Alvin Hansen, who coined the phrase "secular stagnation" in 1938, during the Great Of course, soon after Hansen published his views, U.S. growth took off amid a burst of spending and demand related to the Second World War. And stagnation did not return after the war ended; instead, the United States experienced one of the strongest and longest-lasting expansions on record. What happened? Hansen's population assumptions changed, for one thing, as the post-war period saw increased immigration and a baby boom. Technological advances helped boost productivity growth, for another thing. But an important ingredient was the revival of what John Maynard Keynes famously described as "animal spirits." During the Depression, consumer and business pessimism was pervasive. Once confidence revived, pent-up demand was unleashed and selfsustaining growth returned. This bit of history should help us to understand the global situation today. Many countries, including Canada, are again facing the sort of demographic challenges that Hansen saw in the 1930s. And many would argue that technological advances are less likely to fuel steady growth as they did in the 1950s and 1960s. Summers and other secular stagnation supporters argue that the level of interest rates needed to bring the economy back to full capacity is below the effective lower bound for monetary policy, so central banks are powerless to stimulate enough demand to use up excess supply. Others, including me, disagree. It's true that demographic forces are leading to slower growth in the labour force, which reduces the neutral interest rate in the economy and increases the chances that monetary policy will be constrained by the lower bound on interest rates. But recovering from a shock like the global financial crisis can be a long drawn-out process--just as it was in the 1930s--as consumers and businesses repair their balance sheets and rebuild their confidence in the future. Ultimately, I see this as a cyclical issue, not a secular one, although the cycle is proving to be longer than usual. More to the point, I take issue with the word "stagnation." The world's policymakers put in place measures to mitigate the damage of the crisis and prevent the worst. We have strengthened our financial architecture to protect against future crises, and the system is still adjusting. Growth has been slow, but it hasn't been non-existent. Many of those policies remain in place, sustaining growth and avoiding stagnation until such time as Keynes's animal spirits, which have been crushed over the past seven years, revive. No matter where you stand on the issue, it's clear that the expansion in the developed world is slower now than it was in previous decades, and it will probably remain that way. This is because population growth is slowing as the positive impact of the post-war baby boom is mostly behind us now. However, economic progress can still come through productivity-enhancing technologies, which historically have defied prediction. And there is a plethora of structural policies that can raise trend economic growth--such as trade liberalization or labour market reform--which are being actively discussed by the G20. In the Bank's last Canadian economy would return to positive growth in the second half of this year, and that annual growth would continue to increase in 2016 and 2017. That would see the economy use up its excess capacity, and return inflation sustainably to the 2 per cent target, around mid-2017. So far, that forecast seems to be playing out, as we said in our interest rate announcement last week. Beneath the surface, however, our economy faces a complex and lengthy adjustment to lower resource prices--an adjustment that will unfold over the next several years. While the resource economy works through this adjustment, the non-resource economy should continue to gather momentum, driven by improved export performance. This will be followed by rising investment, growth in the population of companies and a steadier trend in new job creation. The adjustment process is being facilitated by a stronger U.S. economy, a lower Canadian dollar and low interest rates. The risks around this outlook are roughly balanced, which is to say that there are things that could disappoint us and others that could surprise us on the upside. On the downside, weakness in emerging markets such as Brazil and China could turn out to be more pronounced than we expect, or commodity prices could fall further as new supply weighs on prices. On the upside, however, it is possible that as momentum builds consumer and business confidence will see a synchronized upturn--not just in Canada, but in the United States--adding more momentum to growth. This factor is important to economic cycles, yet inherently it can't be forecast. There are many such elements of uncertainty in the process of making monetary policy. That's why the Bank has characterized its decision-making process as one of risk management. We go beyond determining the most likely outcome for the economy. We also identify the major risks we face, in either direction, and think about how we should react if those risks materialize. In short, we're paid to worry, and to be prepared. That's just prudent policy-making. So it's fair to ask what we would do in the unlikely event that the economy was hit with another major negative shock, one that significantly threw off our projection. With the economy already exhibiting slow growth and interest rates already very low, there would appear to be very little room to manoeuvre. Indeed, the Bank's policy rate today is 0.5 per cent, just one-quarter point above the record low set in 2009, a dark time for the global economy. Back then, at the height of the financial crisis, we believed that our key rate was at its effective lower bound, and we would need other tools in order to provide any additional monetary stimulus. As a result, the Bank spelled out how it would conduct unconventional policies in an annex to our April 2009 MPR. Since then, we have reflected on our experience and have seen how other central banks have conducted their own unconventional policies. We have updated that document and are publishing it on our website today. I'm going to elaborate on these policies, but before I do, I need to be absolutely clear about two things. First, today's remarks should in no way be taken as a sign that we are planning to embark on these policies. To reiterate, our base case sees the Canadian economy returning to full capacity around mid-2017 and the risks to the outlook are roughly balanced. We don't need unconventional policies now, and we don't expect to use them. However, it's prudent to be prepared for every eventuality. Second, I should stress that the framework we're publishing today won't be the last word on unconventional policies. The post-crisis adjustment process is still unfolding and central banks continue to learn lessons from the experience. Best practices will continue to evolve. So, what's in the central bank's tool kit when interest rates are already very low? Let me remind you of some key principles around the use of unconventional policies. These haven't changed since 2009. Regardless of the situation, the Bank will keep its primary focus on achieving the inflation target. And because we want our policies to be as effective as possible, we'd concentrate the use of our tools in specific sectors or markets, while aiming to minimize any unnecessary market distortions. Finally, we would conduct operations carefully in order to minimize the risks to our balance sheet. Forward guidance The first tool is one that many have used to good effect, and that's forward guidance. By forward guidance I mean more than simple boilerplate language a central bank might use to indicate the expected direction of the next interest rate move. I'm referring to statements such as the conditional commitment we made in 2009--when we pledged to keep the key policy rate unchanged for a year as long as the outlook for inflation didn't change. Forward guidance can lower longer-term interest rates by signalling to investors that the policy rate will stay at a given level longer than previously anticipated. It also provides more certainty about the path for short-term interest rates, reducing the risk premium built into longer-term rates. By lowering the entire yield curve, the policy action affects a wider range of borrowers, boosting demand in the economy and leading to higher output and inflation. For forward guidance to be most effective, it has to be credible. When we made our conditional commitment, both words were important: "conditional" and "commitment." We backed our commitment by offering term financing at the overnight rate for the entire period. And we repeatedly stressed that the pledge was conditional on the inflation outlook. As it turned out, we raised interest rates weeks before the commitment expired because we saw signs that inflation was returning to its target more rapidly than we anticipated. That conditionality demonstrates that the inflation target remains the Bank's primary mission. As I've said before, forward guidance comes with costs. It distorts the market's processing of new information by taking specific types of uncertainty off the table. This concentrates the market's position on one side of the distribution of possible outcomes. Exiting from forward guidance restores two-way trading and the market's ability to absorb economic and financial volatility, which is natural. Large-scale asset purchases A second tool that the Bank outlined in 2009, but has never used, is large-scale asset purchases. I emphasize the term "large-scale" because a central bank engages in asset purchases in the normal course of business--that is how the central bank balance sheet grows along with the economy and enables the distribution of a growing stock of bank notes. Large-scale asset purchases, often referred to as "quantitative easing," entails the central bank creating new reserves and using them to purchase large quantities of securities such as government bonds or private assets including mortgage-backed securities and corporate bonds, from the private sector. Such purchases have three effects. First, they create new liquidity in the banking system, which can increase the availability of credit if the system has tightened, allowing firms and households to continue to make buying decisions and supporting economic growth. Second, large-scale asset purchases tend to lower the interest rates on the purchased assets, and on other types of debt of similar duration, which in effect flattens the yield curve, bringing longer-term interest rates down closer to shortterm interest rates. As with forward guidance, this can enhance the impact of lower policy rates by spreading the effect to a wider range of borrowers, thereby boosting economic growth. At the same time, higher asset prices can create a "wealth effect," which can also boost spending and confidence. Third, such purchases of assets tend to put downward pressure on the exchange rate, since they reinforce market expectations of a lower profile for interest rates for a longer period. This can boost aggregate demand further, through increased export sales or, more simply, because existing export sales produce more revenue measured in domestic currency. All this can happen while the central bank's policy rate is unchanged. Several major central banks have deployed this tool since the crisis, including the U.S. the Bank of Japan. Their experience shows that this tool can be effective in extending the central bank's impact well out on the yield curve. Funding for credit A third unconventional monetary policy tool that has been developed since 2009 is called funding for credit. The idea is to make sure that economically important sectors continue to have access to funding even when the supply of credit is impaired. In this case, the central bank would provide collateralized funding at a subsidized rate as long as banks met specified lending objectives. The Bank of England and the U.K. Treasury set up such a program in 2012. It was designed to encourage lending to households and businesses at a time when banks were facing increasing funding costs, which meant that borrowers weren't getting the full benefit of low policy rates. While the Bank of Canada has never engaged in funding for credit, at the height of the crisis the government put in place the "Insured Mortgage Purchase bought insured mortgages from lenders, which made room on their balance sheets for new mortgage lending. This program was clearly aimed at one market segment that was at risk of impairment and so had a similar purpose to funding for credit. Negative interest rates The fourth unconventional monetary policy tool I want to cover is negative interest rates, which is something you have heard a lot more about recently. In 2009, the Bank said it couldn't cut its policy rate below 0.25 per cent, because we believed that zero or negative interest rates might be incompatible with some markets, such as money market funds. This was a common view at the time. Since then, we have seen the experience of several central banks, such as the ECB and Swiss National Bank, which have adopted negative policy interest rates. There, we've seen that financial markets have been able to adapt and continue to function. Given these and other developments, the Bank is now confident that Canadian financial markets could also function in a negative interest rate environment. Let me pause at this point to answer an obvious question. Why would anyone ever accept a negative nominal return when they could always simply hold cash and earn a zero return? A big part of the answer is that there are costs to holding currency, particularly in large quantities, and these costs affect the lower bound. Because of the costs, which include storage, insurance and security, central banks can charge negative rates on commercial bank deposits without seeing a surge in demand for bank notes. Last month, the Bank published a staff discussion paper that analyzes those costs and the convenience benefits of electronic payments, and reflects on the experience of other countries. We now believe that the effective lower bound for Canada's policy rate is around minus 0.5 per cent, but it could be a little higher or lower. This suggests that we have more room to manoeuvre in response to adverse shocks than we believed back in 2009. We will continue to watch the experience of other countries--the Swiss policy rate, for example, is currently minus 0.75 per cent--and we will also consider what adjustments might need to be made to the Bank's operational framework should they ever be required. To sum up, once interest rates reach very low levels, the central bank still has meaningful tools that it can deploy in its pursuit of its inflation target: offering forward guidance to financial markets to enhance policy effectiveness, largescale asset purchases, funding for credit, and pushing short-term interest rates below zero. There are a few other lessons we've learned about unconventional monetary policies in the past few years. Let me just touch on a couple. One lesson concerns when to use which tool. When we published our unconventional policy framework in 2009, there was an implied sequence to the various measures. Forward guidance was tried first, with quantitative easing and other measures held in reserve in case forward guidance proved to be insufficient. But what we've learned since is that there shouldn't be a predetermined order. The effectiveness of each tool will depend on the situation, making it more a matter of choosing the right one at the right time. Furthermore, the various measures can be mutually reinforcing when used in combination, so it makes little sense to commit to a particular sequence for using them. Another lesson we've learned from the global experience is that while unconventional monetary policies can help stimulate the economy, there may be limits to their impact. Take negative interest rates, for instance. While we now believe that interest rates can be pushed below zero, there still is a lower bound, so we can't be cavalier about how much more room to manoeuvre we have. Further, there is evidence that consumers and businesses respond less to interest rate declines when interest rates are already very low. And there is evidence that their responsiveness is also lower when confidence is low and they are trying to reduce debt. I expect that few of us find this to be surprising. At the same time, it is fair to say that the limits of large-scale asset purchases are still being tested. Our understanding of this tool will grow as we watch it being used in other economies--and this includes the eventual conclusion, and exit from, their programs. Fundamentally, economists have long been aware that the effectiveness of monetary policy has its limits once interest rates reach very low levels. As Keynes noted as he watched the Great Depression unfold, fiscal policy tends to be a more powerful tool than monetary policy in such extreme circumstances. It may sound ironic, but the circumstances under which it may be appropriate to consider unconventional monetary policies are also those under which fiscal policy tends to be most effective. Even so, it is worth knowing that monetary policy can still make a meaningful contribution in such extreme conditions, alongside fiscal and structural policies, in restoring growth and achieving our inflation targets. A final lesson I must touch on is that very low interest rates--and the unconventional monetary policy tools that can be deployed to enhance their effects--tend to create financial imbalances that can grow through time. These risks must be accepted should the downside risk to the economy lead to even worse outcomes if realized. But the dynamic effects of those growing financial imbalances on the future economy must be taken into account by policymakers--and that is a complex task, indeed. It's time for me to bring us back to the present and conclude. In a world where many economies continue to resort to unconventional monetary policies, Canada's outlook is encouraging. The lower Canadian dollar and the interest rate actions taken earlier this year are working and it will be some time before we see their full impact. The overall economy is growing again, even as the resource sector contends with lower prices, because the non-resource sectors of the economy are gathering momentum. This is all taking longer than we imagined back in 2008, but our judgment is that our economy can get back to full capacity with inflation sustainably on target around mid-2017. Given this outlook, it may seem like an odd time to be updating our unconventional monetary policy tool kit. I certainly hope we won't ever have to use these tools. However, in an uncertain world, a central bank has to be prepared for all eventualities. We will continue to watch how these policies work in other economies and adjust our own thinking at the Bank of Canada as appropriate. In short, should the need arise, we'll be ready.

r151215a_BOC

canada

Release of the Financial System Review

poloz

Governor of the Bank of Canada Press conference following the release of the Good morning. It's a pleasure for Senior Deputy Governor Wilkins and me to be with you today to talk about the December issue of the Bank's (FSR), which we published this morning. Let me take a moment to give some context for this report. The FSR highlights key financial vulnerabilities and some potential triggers that could turn those vulnerabilities into risks to the stability of Canada's financial system. The FSR is an essential complement to our --together, these two reports give the basis for a complete discussion of monetary policy within our risk-management framework. At our last interest rate announcement, we kept our key policy rate unchanged, as the economy was unfolding reasonably in line with our latest projection in October. We also said that risks to financial stability were evolving as expected. Today's FSR provides the analysis behind that assessment. Our interest in financial stability risk has grown since the financial crisis, for two distinct reasons. First, the global regulatory architecture has been strengthened to prevent future crises, and how the system adapts to those changes needs to be well understood. Second, persistently very low interest rates in response to the crisis are fuelling new financial vulnerabilities that bear constant monitoring. Let me start with the financial stability implications of new regulations for financial intermediaries. The global financial system is clearly safer than it was before the crisis. This is important, for it means that vulnerabilities that appear worrisome today need to be assessed against a more resilient system. At the same time, our financial system is adapting to new regulations, and we must be alert for any new vulnerabilities that might emerge as a result. As one example, some observers contend that new capital and liquidity rules have led to reduced market-making in secondary fixed-income markets and may also be responsible for occasional liquidity shortfalls and market gaps. We analyze this vulnerability in greater depth in today's FSR. In fact, it is proving very difficult to assess the liquidity issue empirically. Most of the available data suggest that government-bond liquidity may have improved in recent years, but these data tell only part of the story. The Bank recently established the Canadian Fixed-Income Forum to enable a continuing dialogue, and we've modified our operations to help alleviate some of these issues. The Governing Council believes it's important to continue studying the matter, not just as it pertains to government bonds, but also to other asset classes. Given the new regulatory architecture, we may not know just how resilient market liquidity is until there's a true stress event. Let me now turn to vulnerabilities being created by persistently very low interest rates in Canada. The post-crisis situation has quite naturally fuelled the accumulation of household debt, as well as heightened activity in the housing sector. We can observe other elements of risky financial behaviour, but these two vulnerabilities have been our main focus for some time and have continued to grow in importance since our last FSR. In terms of household debt, income growth hasn't kept pace with increases in borrowing, since mortgage growth continues to rise. More borrowing was expected, given the reductions in our policy interest rate earlier this year. It's important to remember that while rate reductions have increased vulnerabilities at the margin, they've also mitigated the risk to the financial system by helping offset the decline in incomes and employment tied to the drop in commodity prices. Our analysis shows that there has been an increase in the number of highly indebted households in Canada, by which I mean those whose debts are more than 350 per cent of their annual gross income. Not only are there more of these highly indebted households, they also carry a growing share of household debt. These people are more likely to live in British Columbia, Alberta or Ontario, where house price gains have been the largest. The Governing Council's reading of the situation is that these vulnerabilities are quite highly concentrated--about 720,000 households fall into this vulnerable category. In terms of the housing market, we continue to see regional markets evolving along different tracks, as we've indicated before. Activity in the energy-producing regions of Alberta, Saskatchewan, and Newfoundland and Labrador has declined noticeably, which was expected following the decline in oil prices. The housing markets of Toronto and Vancouver have seen renewed momentum, driven by stronger employment growth and migration, both interprovincial and international. The Governing Council's base-case scenario continues to be a constructive one: housing activity should stabilize in line with economic growth as the driver of growth in the economy switches from household spending to non-resource exports. However, recent momentum in prices in Toronto and Vancouver may increase the likelihood of a correction in house prices, which could affect vulnerable households. Unsurprisingly, house prices are correcting in oilproducing regions. As in the past, we have illustrated how certain triggers could turn these vulnerabilities into full-blown risks to the Canadian financial system. Risks assessed in this FSR are (1) a severe recession that would reduce households' ability to service their mortgages and cause a broad correction in house prices; (2) an unexpectedly sharp rise in global risk premiums that could spill over to the cost of domestic financing; (3) economic or financial stress emanating from China and other emerging markets; and (4) more downside risk in resource pricing. These risks are not meant to be exhaustive but rather are used to illustrate the potential consequences of the vulnerabilities we have identified. Other possible triggers might include a large-scale credit event in the global resource sector or a sovereign credit event, for example. The Governing Council acknowledges that certain vulnerabilities are still edging higher, but the overall level of risk they pose to the Canadian financial system has remained roughly unchanged since our June report. In this regard, recent changes by Canadian authorities to the rules for mortgage financing will help to mitigate these risks as we move into 2016. Finally, I'd note that the FSR features reports that take a close look at aspects of the Canadian and global financial systems. With this issue, there's a report that analyzes the microdata related to household debt, as well as a review of mortgage securitization in Canada. These are very important and useful reports, and I hope you'll take the time to read them. With that, Carolyn and I will be happy to respond to your questions.

r160107a_BOC

canada

Life After Liftoff: Divergence and U.S. Monetary Policy Normalization

poloz

Governor of the Bank of Canada Good morning, and Happy New Year to all. Here we are at the beginning of 2016, almost eight years after the global financial crisis, which spawned the most synchronized worldwide economic downturn in history. A rerun of the Great Depression of the 1930s was averted, but the recovery has been anything but synchronized. In fact, the dominant theme across the global economy has become started its interest rate normalization process after seven years of keeping its recently cut its deposit rate to negative 0.3 per cent. Other central banks also cut rates in the past year, including the Bank of Canada. It is very important that we understand the reasons for these policy divergences. On one level, they simply reflect actions taken by central banks tailored to their own economies. But the underlying forces acting on the global economy are powerful, slow moving and affect various economies differently. This means that the theme of divergence--both financial and economic--is likely to remain with us for some time to come. The recent move by the Federal Reserve is the first step in a long and measured process of policy normalization. This is a welcome development because it means that the U.S. recovery has largely put behind it the conditions that led to the financial crisis. While this normalization process will be tailored to the U.S. economy, it will have implications for Canada. One effect we can expect to see over time is a decompression of global term premiums. Let me put that in plain language. Central banks such as the Fed, the ECB, the Bank of England and the Bank of Japan have used large-scale asset purchases (or quantitative easing, if you prefer) and other unconventional policies, such as forward guidance, to help push longer-term interest rates lower. This has given monetary policy a broaderbased stimulative impact on the economy. Investors have demanded less of a premium to hold debt for a longer term--the so-called global term premium has been compressed. As U.S. monetary policy continues to normalize, longer-term interest rates in the United States will naturally rise as the term premium decompresses. Canada's financial markets are closely linked with U.S. markets, and, historically, higher longer-term interest rates there have meant higher longer-term rates here. Take yields on 5-year Canadian government bonds, for example. These are a key benchmark for our mortgage market. On average over the past 30 years, when U.S. 5-year bond yields rose, about three-quarters of the increase was reflected in Canadian 5-year bonds. If a significant term premium decompression were to occur in the current context in Canada, it could introduce a downside risk into our inflation outlook. Of course, what happens in both the U.S. bond market and our own over the next few months will depend on the circumstances prevailing at the time. The Bank of Canada doesn't have a great deal of direct influence over longer-term interest rates. But we do have firm control over our policy rate--the target for Canada's overnight rate. We will continue to conduct an independent monetary policy in response to our own economic circumstances in order to meet our 2 per cent inflation target. That's our primary mission. We have a number of tools at our disposal--both conventional and unconventional--to mitigate risks to our inflation target or to our financial system, should they arise. As I said at the start, the divergence we're seeing in monetary policy globally comes from central banks reacting to the particular needs of their own economies. One important force affecting virtually every economy is the sharp decline in energy and other resource prices that we've seen over the past year or so. This appears to be mainly the result of increased supply capability across a wide range of commodities--an oft-repeated, textbook cycle that has resulted from a prolonged period of high prices. This decline in commodity prices affects various economies very differently, depending on whether they are a net exporter or net importer of resources. Economists use a measure called the "terms of trade" to help gauge the impact of this type of shock on an economy. The terms of trade is the ratio of the prices a country receives for its exports to the prices it pays for its imports. A rising terms of trade therefore means that the country's income is increasing. A falling terms of trade, on the other hand, means less income for the country overall. As a major exporter of resources, Canada saw its terms of trade move sharply higher from 2001 through 2008, and this was largely maintained until mid-2014. Since then, however, falling world prices for oil and other commodities have reversed much of that rise. Measured at annual rates, this represents a loss of more than $50 billion in national income, or about $1,500 for every Canadian. This shock is leading to significant and complex economic adjustments in Canada--in effect, a reversal of the forces that drove our economy during the years when resource prices were rising. To help understand these forces, let's recall what happened to the economy during the period of rising oil prices. Back in 2002, when oil prices were around US$25 per barrel, investment in the oil and gas sector represented about 17 per cent of total business investment here in Canada. By 2014, that figure had jumped to 30 per cent. The share of oil and gas in Canada's merchandise exports almost tripled over that same period. This rise in the importance of our energy sector was a natural response to higher prices for oil--because the world was offering more for each barrel, we invested more in our capacity, and more Canadians moved to work in the oil patch. This is also why the impact of the sudden drop in oil prices has been so large. Net importers of natural resources, such as the United States and Europe, are seeing the opposite phenomenon. Their overall income is now higher because import prices are lower relative to their export prices. But other commodityintensive economies, such as Australia, Mexico, Chile and Brazil, are working through conditions similar to those here in Canada. Of course, most countries have a diverse domestic economic structure. Certainly, that is the case here in Canada. So, just as we see divergence in economic performance between countries in response to lower resource prices, so, too, we see divergence within Canada, among our different sectors and geographic regions. For example, the unemployment rate in the energy-intensive provinces--Alberta, Saskatchewan, and Newfoundland and Labrador--has risen more than two percentage points since November 2014, while it has remained unchanged in the rest of the country. This divergence is also evident in consumer spending. For example, motor vehicle sales have fallen by about 10 per cent in those three provinces over this period, while they've climbed by more than 10 per cent elsewhere. The fact is that a decline in commodity prices such as the one we have seen is one of the most complex shocks that a policy-maker can face. We know that the overall effect on Canada is unambiguously negative because of the loss of income from exporting commodities I mentioned earlier. Nevertheless, at the global level, the positive effects on importing countries will more than offset the negative effects on exporting countries, yielding a net positive impact on global growth. However, the real complexity appears beneath the surface, where the drop in commodity prices sets in motion sectoral and regional forces that can take years to play out. These include higher consumer spending in response to lower energy costs, falling investment and employment in the economy's resource sector, and rising investment and employment in the non-resource sectors--in other words, the reverse of what we saw from 2002 to 2014. There is no simple policy response in this situation. The forces that have been set in motion simply must work themselves out. The economy's adjustment process can be difficult and painful for individuals, and there are policies that can help buffer those effects, but the adjustments must eventually happen. The most important facilitator of adjustment in these circumstances is a flexible exchange rate. Indeed, this is exactly why countries choose to have flexible exchange rates--to help buffer the economy from shocks that cause this kind of divergence. We have seen ample evidence of this adjustment channel in recent months. Resource-producing countries with falling terms of trade, such as Canada, Australia and Mexico, have seen their currencies depreciate against countries that are net consumers of resources, such as the United States. It is not a coincidence that the Canadian dollar is about where it was back in 2003 and 2004; oil prices are also about where they were back then. Let's consider for a moment how this works. As I said, lower resource prices mean lower income for Canada as a whole. Economic growth slows, as it did early last year. At first, the slowdown was concentrated in oil-producing regions as companies cut investment spending. But then it began to spill over into other sectors through supply chains and lower consumption spending as workers were laid off. In this context, and in anticipation of the spreading fallout, the Bank lowered interest rates to help buffer the economy and keep inflation aimed at our target. The depreciation of our currency is a natural part of the process. It does several things at once. First, it offsets a part of the drop in commodity prices, which are usually priced in U.S. dollars. In other words, Canadian-dollar revenues for commodity exporters fall by less than U.S. dollar revenues. Second, the depreciating dollar boosts Canadian-dollar revenues for exporters of other goods, which are also often priced in U.S. dollars. This then allows those companies to compete more effectively for future export sales. Those increased sales eventually mean more growth and rising investment in the non-resource sectors of the economy, and more employment. In other words, the exchange rate decline helps to facilitate a shift in the economy's growth engine from the commodity sector to the non-commodity sectors. We have already seen stronger growth in exports of non-commodity goods such as machinery and equipment, furniture, pharmaceuticals, aerospace and electronics, to name a few. This is helping to offset the weakness in the resource sector tied to lower commodity prices, but this natural process will take time to translate into more investment spending and new job creation. Third--and this will sound like a less desirable part of the process--a lower Canadian dollar raises the price of imported goods for everyone. This spreads the impact of the loss of income across the entire economy, rather than leaving it just in the commodity-producing sector. Even so, there are large regional and sectoral differences in Canada's economy--with the resource-producing regions taking a much harder hit. The exchange rate can't absorb the shock in its entirety for any one sector or region, so those underlying adjustments will continue for some time. With this same story unfolding in other commodity-exporting countries, along with continued currency weakness in Japan and Europe, there has been a steady rise in the global value of the U.S. dollar. Some observers have voiced concerns about the disruptive effects of excessive exchange rate variability and suggested that a stronger U.S. dollar could derail global growth. Let me address both of those points in turn. First, it's important to remember that variability in exchange rates and interest rates is natural; financial markets generally react to movements in underlying economic fundamentals. So when you think about movements in financial markets and how they might affect an economy, it's important not to lose sight of the underlying cause of the movement and its impact. If financial markets did not respond to these underlying events, or if this financial variability was somehow suppressed, then all of the adjustment to the fundamental shock would be borne by the most important economic variables, such as employment and inflation. As a central banker, I want to see stability in those variables while much of the variability is absorbed by financial markets. Such variability acts as a shock absorber for the broader economy. To make this point concrete, consider what would happen if commodity prices fell significantly and the Canadian dollar started to decline, but the Bank of Canada acted to prevent that depreciation. That would mean raising interest rates and slowing the entire Canadian economy, and the process of adjustment to the commodity price shock would be made slower and more painful. Second, some commentators have expressed concern about the potential of a stronger U.S. dollar to stifle growth. Indeed, U.S. net exports have deteriorated over the past year as the U.S. dollar has appreciated. But this focus on the possible economic consequences of an exchange rate movement misses the fundamental point. The U.S. dollar has not risen out of the blue, but in the context of a solid U.S. economic expansion and a softening of growth elsewhere. Accordingly, the rise in the U.S. dollar may be causing a moderation of U.S. GDP growth through higher imports and lower exports, but it is not causing a softening in U.S. demand. Rather, the stronger U.S. dollar diverts some of the growth in U.S. demand outward, boosting growth in other countries. In other words, the rising U.S. dollar doesn't stifle global growth, it redistributes it. What we've observed since mid-2014 is that countries with declining terms of trade have generally seen their net exports improve in real terms, while those with rising terms of trade have seen their net export positions worsen. This is how floating exchange rates redistribute demand--to countries struggling with falling terms of trade from countries that are enjoying rising incomes--and this helps the upturn become more synchronized. Nonetheless, the multi-dimensional nature of this global shock vastly complicates the adjustment process. To illustrate, consider that while Canada goes through its adjustment, some of its competitors are doing the same, and their currencies are depreciating along with Canada's. This will make the adjustment process more challenging compared with a case where Canada was the only country that had to adjust. This should serve as a reminder that a flexible exchange rate is not a policy panacea. Other complementary policies can be deployed to offer a broader array of buffers while still encouraging the necessary longer-term adjustments, including fiscal policies and policies that make labour markets more flexible. Before I conclude, let me say a few words about how this all relates to our primary mission: controlling inflation. The impact of a terms-of-trade shock is incredibly complex. While the reduced income means less demand and downward pressure on inflation, the depreciating currency means higher prices for imported goods and services. We're seeing this in Canada right now. We'll update our estimates and give a new, full outlook for the Canadian economy in our next in a couple of weeks. It's possible to imagine a situation where a sharply weaker currency could drive a country's inflation significantly above target, even with the continued presence of excess capacity in the economy. The greater the divergence of inflation from target, the more skeptical people might become that the divergence would be temporary. In other words, there could be a risk that inflation expectations would become de-anchored. Managing that risk might even require a tightening of monetary policy that, in the end, would produce below-target inflation. That is not our situation in Canada. The Bank of Canada has almost 25 years of inflation-targeting history, and inflation expectations in Canada are very well anchored as a result. Certainly, our experience in the post-crisis years has tested those expectations repeatedly, and they have remained solid. This credibility is a crucial benefit of our inflation-targeting system. It allows us to look through inflationary forces that we expect to be temporary, such as those coming from movements in the Canadian dollar. We do not take our credibility for granted--in fact, we treasure it, and would never put it at risk. As we've said repeatedly over the past year, we at the Bank are studying a number of issues as we prepare to renew our inflation-targeting agreement with the federal government. One of these issues is what measure or measures we should use to gauge underlying inflationary pressures. The best-known measure, core inflation, is facing upward pressure because of the impact of the lower Canadian dollar on the prices of imported goods. As such, core inflation is overstating the underlying trend of inflation in the economy. Later this year, we will answer the question of whether we should continue to focus on one measure of underlying inflation and, if so, whether core inflation will keep that role. Allow me to conclude. As the global economy enters a new year, divergence has become the dominant theme. Economies are reacting in different ways to a seismic shift in global resource prices. These different reactions have divergent implications for monetary policy from country to country. Divergence of monetary policy should be expected. Financial markets have been focused on policy divergence for some time, and we should be prepared for this preoccupation to last. This will probably mean more variability in global financial markets than we have seen in the recent past. Such variability is a natural reaction to shocks and a buffer for the real economy--and the variables that count, like employment, growth and prices. Movements in exchange rates are helping economies, including ours, make the adjustments that must take place. We've been in this situation before. The Bank of Canada will continue to run an independent monetary policy, anchored by our inflation target, and we will use our tools to manage risks along the way.

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Monetary Policy Report Press Conference Opening Statement

poloz

Governor of the Bank of Canada Press conference following the release of the Good morning, and thank you for coming today. Let me begin as usual with a few remarks around the issues that were most important to the Governing Council's deliberations. At the global level, 2015 was a little disappointing as the world dealt with diverging economic prospects and shifting terms of trade, but we expect gradual strengthening to resume in 2016. There has been considerable attention paid to recent developments in China, and this has added to volatility in global financial and commodity markets. However, it was Governing Council's judgment that China will remain on its transition to a more balanced and sustainable growth path, from around 7 per cent annual growth to around 6 per cent. Volatility in equity markets is, of course, not always a reflection of weak economic fundamentals. Nevertheless, the global equity-market correction may inject a further measure of caution into business decision making. Our global outlook remains positive, albeit cautiously so. Governing Council believes that the U.S. economy remains solid--the fourth quarter of 2015 was soft, but we believe this to be largely temporary for reasons we discuss in the (MPR). Solid fundamentals, including strong employment gains, high consumer confidence and very strong investment outside the energy sector should see U.S. growth return to close to 2 1/2 per cent this year. Not coincidentally, the Canadian economy appears to have stalled in the fourth quarter. There were some temporary factors at work for us, too, but the main issue was slower exports to the U.S. We expect growth to pick up to 1 per cent in the first quarter, along with the U.S., and then to move back above 2 per cent for the remainder of the year. Our new annual growth forecast for 2016 is 1.4 per cent; however, much of the downward revision in that figure is because of the weakness we saw in the final quarter of last year. On a fourth-quarter-overfourth-quarter basis, growth for 2016 is projected to be a more solid 1.9 per cent. In its deliberations, Governing Council focused mainly on the implications of lower prices for oil and other commodities for Canada and for monetary policy. This shock is complex because it sets in motion several forces: Canada earns less income from the rest of the world, our resource sector begins to shrink, the Canadian dollar depreciates, and the non-resource sector expands. That is a lot of structural change. We are publishing a discussion paper today that offers additional analysis of this process. One implication is that it may take up to three years for the full economic impact to be felt, and even longer for all of the structural adjustments to take place. Since our last MPR in October, the magnitude of this shock has clearly grown. Firms are still cutting investment spending, but we had already built most of the downside into our October MPR. The bigger change in our projection comes from the impact of even lower oil prices on Canadian income. As one measure of this change, our base case forecast suggests that it will now take longer to absorb the economy's excess capacity--probably until late 2017, perhaps later. This is a significant setback compared with our October projection. Nevertheless, we expect growth to exceed potential through most of 2016 and 2017, so the gap should be substantially closed by late 2017. When considering our policy options, Governing Council needed to bear in mind that our base case forecast omits a key consideration; namely, the government's intention to introduce fiscal measures to stimulate the economy. Our convention is not to guess about these things, but to incorporate actual announcements. Suffice it to say that were we to incorporate a degree of new fiscal stimulus in this projection today the output gap would close sooner than in our base case, but how much sooner would depend on the scale and nature of the fiscal measures. It is fair to say, therefore, that our deliberations began with a bias toward further monetary easing. The likelihood of new fiscal stimulus was an important consideration--others included: First, the Canadian dollar has declined significantly since October, which means that the non-resource sectors of our economy are receiving considerably more stimulus than we projected then. Let's remember that it typically takes up to two years for the full effect of a lower dollar to be felt. Second, past exchange rate depreciation is already adding around 1 percentage point to our inflation rate. This is a temporary effect, and is currently being offset by lower fuel prices--another temporary effect. However, we must be mindful of the risk that a further rapid depreciation could push overall inflation higher relatively quickly. Even if this is temporary, it might influence inflation expectations. Governing Council continues to see the underlying trend in inflation as somewhat below 2 per cent, given the persistent, and recently widening, slack in the economy. Inflation expectations remain well anchored at about 2 per cent. With the economy expected to resume above-potential growth in the near term, our expectation is that inflation will converge on 2 per cent as the output gap closes and the temporary effects of low oil prices and past exchange rate depreciation dissipate. To summarize, the drop in oil and other commodity prices constitutes a significant setback for the Canadian economy, and has set in motion a protracted adjustment process. That will mean the continuation of a two-track economy, with the resource sector shrinking and other sectors picking up speed, all facilitated by a lower Canadian dollar and supported by very stimulative monetary policy. While that adjustment process sounds mechanical, in fact, it is personal. It is disrupting the lives of many Canadians, whether through job losses or through higher prices for imported goods. Monetary and fiscal policies can help to buffer some of these effects, and help speed up the process by fostering growth in other sectors of the economy, but the adjustment must ultimately take place. Although the economy may grow more slowly than we would like during that transition, it can still achieve above-potential growth and absorb its excess capacity. We are encouraged by the resilience and flexibility of the Canadian economy as signs of adjustment are already evident. Meanwhile, the world economy is expected to strengthen on the back of stimulative policies and low energy costs, the U.S. economy is on a solid track and our past monetary actions continue to produce results. These are all positives that should be recognized. In this context, as complex and uncertain as our situation is, Governing Council decided that the current stance of monetary policy remains appropriate. Let me conclude by saying publicly "au revoir" to our good friend and colleague, Deputy Governor Agathe Cote, who served the Bank with distinction for over 32 years. Her official end-date is January 31st. We will miss having her in Governing Council, and wish her well. With that, I'll now be happy to take your questions.

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

murchison

Advisor to the Governor invitation to appear before this committee to talk about the Canadian dollar. Since 1991, the Government of Canada and the Bank of Canada have had a formal agreement that says our monetary policy should be directed at controlling inflation. Over time, we have seen that keeping inflation low, stable and predictable is the best way the Bank can fulfill its mandate to promote the economic and financial welfare of Canadians. We have one main monetary policy tool--our control over the overnight interest rate--and we use this tool to help maintain the rate of inflation at the agreed 2 per cent midpoint of the 1 to 3 per cent control range. This means that Canada must have a floating currency. Since we have a target for inflation that aims to preserve the domestic value of the Canadian dollar, we cannot also have a target for its external value. At the Bank, we describe the flexible exchange rate system as an "economic shock absorber." By that, we mean that movements in the currency help the economy adjust to shocks, such as swings in both the demand for and prices of the goods and services that Canada produces. These swings cause shifts in our terms of trade--the ratio of the prices Canada receives for its exports to the prices it pays for its imports--and these shifts require economic adjustments in response. The adjustments can be difficult for the individuals and companies that are directly affected. But experience shows that it's less painful for these adjustments to take place through the exchange rate, rather than only through movements in wages and domestic prices. Since roughly the middle of 2014, we've seen very large declines in the prices of many commodities that Canada produces and exports. Oil is the most obvious example, but it is not the only one. Others, such as copper and aluminum, have also fallen sharply. Resources have always been an important part of our economy, and the Bank of Canada's commodity price index, which tracks the world prices of our most important resources, dropped by more than 50 per cent from mid-2014 to the end of 2015. Over the same period, Canada's currency depreciated from about 94 cents U.S. to about 72 cents U.S., not far from its level today. Before I talk about the adjustment process, there are two points I want to stress. First, this isn't the first time that Canada's economy has had to deal with sharp movements in resource prices. When former Governor Gordon Thiessen appeared before this committee in April, 2000, he said, "The downward movement of the Canadian dollar...was largely a response to the sharp decline in world prices of the primary commodities that Canada exports. Our economy had to adjust to this reality; the exchange rate decline facilitated a shift in activity from the primary sector to manufacturing and other export sectors." The same could be said today. Further, let's remember that the dollar appreciated as commodity prices and our terms of trade rose from 2003 until roughly mid-2014, helping to smooth the required adjustments during that period. The second point is that Canada is not the only country that is adjusting to falling resource prices. Let me draw your attention to of the evolution of the terms of trade and the real effective exchange rates of various countries since the middle of 2014. It shows that commodity-rich open economies, such as Canada, Chile, Australia, New Zealand and Brazil, have all seen both their terms of trade and their currencies weaken. In contrast, net commodity importers such as the United States and the United Kingdom have seen their currencies strengthen. In the same , we spell out how we expect the Canadian economy to adjust to this decline in our terms of trade. The first response is a restructuring of our resource sector, and we have already seen cuts in investment and employment among commodity producers. This has happened relatively quickly. We also expect to see a broader impact from the loss of income, which will weigh on household spending and business investment outside the resource sector. This impact is more protracted and is not forecast to peak until next year. At the same time, the decline in commodity prices is sending a signal to shift productive resources back into the non-resource sector. This will be a long and complex process, but movements in the exchange rate are helping in this regard. Governor Poloz spoke about this adjustment in some detail in a speech in Ottawa last month. Let me recap some key points. First, the depreciation of the Canadian dollar partly offsets the drop in commodity prices, since commodities are usually priced in U.S. dollars. In other words, resource exporters see their Canadian-dollar revenues fall by less than their Second, the depreciating dollar helps Canadian exporters outside the resource sector. Those that set their prices in Canadian dollars experience improved competitiveness, while those pricing in U.S. dollars get a boost in revenues. We are already seeing signs of this effect. Among industries that are sensitive to exchange rate movements, we have identified 21--representing almost 30 per cent of non-energy goods exports--that are showing an upward trend in shipments. Included in this group are industries such as pharmaceuticals, motor vehicle engines and parts, and industrial machinery, which have also seen higher employment since the middle of 2014, according to Statistics Canada's Survey of also showing a more general increase in manufacturing employment since the beginning of 2015. The final impact of the lower Canadian dollar I'll mention is that it raises the prices of imports. On the one hand, that means all Canadians lose some purchasing power for imports, including goods such as fresh produce that have no simple substitute. It also means price pressures for companies that rely on imported inputs. On the other hand, the depreciation makes Canadian goods and services more attractive relative to imports. Consider tourism, for example. We are seeing more international visitors choose Canada as a destination. Tourism spending has increased for 10 straight quarters in real terms. On balance, the depreciation ultimately leads to increased demand and sales, which means more growth, investment and employment in the non-resource sector. Finally, let me say a few words about how the currency affects the outlook for inflation. The impact of the resource price shock on inflation is complex. The loss of income from resources means less demand in the economy and, therefore, slower inflation. There is also the direct impact of lower energy costs. At the same time, the depreciation in the currency is raising the prices of imports and therefore boosting inflation. In the January MPR, we estimated that the passthrough from the lower dollar added between 0.9 and 1.1 percentage points to the total rate of consumer price inflation in the fourth quarter of 2015. In addition, because the currency had depreciated further in recent months, we said there is a risk that the pass-through will remain higher. It's important to note that we expect these forces currently affecting the inflation rate to be transitory; that is, we expect them to drop out of the annual inflation rate so they won't feed into people's expectations of future inflation. However, Governor Poloz and other members of Governing Council have been clear that they will watch closely to ensure that longer-term inflation expectations don't become unanchored from our target. The bottom line is that we are forecasting that total inflation will return to almost 2 per cent by the end of 2017. To sum up, the depreciation of the Canadian dollar reflects the sharp decline in global resource prices and our terms of trade. As Governor Poloz said, the impact of this shock is complex, and the required structural adjustments will be lengthy and difficult for many Canadians. However, our system of inflation targeting with a floating exchange rate is best for helping these adjustments take place as easily as possible. Thank you.

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Monetary Policy and Financial Stability—Looking for the Right Tools

lane

Thank you for the opportunity to speak here today. My remarks will focus on the following question: Should a central bank's decisions on monetary policy account for the stability of the financial system and, if so, how? We at the Bank of Canada are grappling with this question, and it is being debated by economists and policy-makers around the world. This topic is not new, but finding the right answer now seems more urgent than ever. The global financial crisis that began eight years ago has taken an enormous toll, both economic and, more important, human. Around the world, including in Canada, the crisis ushered in a period of subpar economic growth and inflation, which continues to the present day. So it's easy to see why promoting financial stability--and preventing crises in the future--is such a high priority for world leaders and all those involved in the financial system. This priority has given rise to an ambitious and comprehensive agenda of reforms to make the global financial system more resilient. But, in thinking about how to prevent financial crises, it's also natural to look at monetary policy. After all, when a central bank influences the cost of financing through changes in the policy interest rate, its actions affect the economy by changing asset prices, encouraging or discouraging risk taking, and influencing credit flows. This suggests that monetary policy has the ability to influence financial stability, for good or ill. If a central bank eases monetary policy, it stimulates the economy, largely by encouraging households and companies to borrow more and pushing up the prices of many types of financial assets. The increased borrowing, together with the greater wealth that comes with higher asset prices, encourages households to spend more, generating income for other households and creating opportunities for companies. But, at the same time, more debt and higher asset prices may create vulnerabilities in the financial system. In Canada in the period since the global financial crisis, the most concerning vulnerabilities have been in the household sector--notably the combination of rising indebtedness and elevated house prices. But a wider set of vulnerabilities, in more than one sector, was important in setting the stage for previous crises. For example, heightened risk taking by investors and elevated leverage in large financial institutions and in shadow banking activities were among the factors that turned a downturn in the U.S. subprime mortgage market into a global financial crisis. While increasing such vulnerabilities at the margin is a normal consequence of an easing of monetary policy, they may become of particular concern if interest rates stay low for an unusually long time. In the presence of such vulnerabilities, an event such as an adverse macroeconomic shock can stress the financial system or even trigger a crisis. Since monetary policy can contribute to financial vulnerabilities, it could also be argued that it can be adjusted to limit them. But whether and how to do that can't be considered in isolation from the central bank's mandate. For the past quarter century, the Bank of Canada has had the responsibility of using monetary policy to achieve low, stable and predictable inflation, a goal cemented in our 2 per cent inflation target. This is our primary mission, which guides our setting of the policy interest rate. While a failure to maintain financial stability would ultimately impair our ability to achieve the inflation target, it is generally understood that we should aim to get inflation sustainably back to target within about two years. Within this framework, financial system developments are always part of monetary policy discussions, because of their importance for the real economy and especially because of the transmission of the effects of monetary policy. We have some flexibility within our inflation-targeting framework: we might accept a slower return of inflation to target, if necessary, to avoid adverse effects on financial stability. But the expectation has been that we would only rarely, if ever, use the framework's flexibility in this way. This is not to say that our framework is immutable. The law governing the Bank since 1935 says we should "regulate credit and currency in the best interests of the economic life of the nation." How we fulfill that requirement has evolved over the years. Inflation targeting was established in Canada in 1991 under an agreement with the federal government, which we renew every five years. We are currently working toward the next renewal, which takes place later this year. This process gives us an opportunity to re-examine our mandate and consider other ways of doing things. Financial stability, and its relationship to monetary policy, figures prominently in our current research agenda. In the time I have, I will discuss how our thinking on the interactions between monetary policy and financial stability has been evolving, tell you about some interesting recent research by our staff and touch on some questions that have yet to be resolved. Let me start by saying that central banks have always had a role in providing stability to financial systems. Some of our tools are in the category of crisis management; others for crisis prevention. When the financial system comes under stress, a central bank may need to calm financial markets through open market operations or act as the lender of last resort to financial institutions to forestall bank runs. These tools were used effectively by many central banks during the global financial crisis of 2007-09. Some of the Bank of Canada's financial system activities are also designed, in part, to make the system less prone to crisis. An example is the oversight of key financial market infrastructures, such as payment systems and central counterparties. Such oversight is intended to bolster their risk management so that they can support the continued functioning of financial markets in times of stress. More broadly, central banks are well placed to analyze systemic vulnerabilities and how they might play out. In this vein, in 2002, the Bank of Canada began publishing a semi-annual to raise awareness of the most important risks to Canada's financial system. But the Bank of Canada is only one of several official bodies whose policies have an influence on financial stability. Others control many of the relevant tools-- such as capital requirements, the regulation of housing finance, the regulation of financial market conduct and the framework for resolution of financial institutions. The Bank's analysis of emerging risks and vulnerabilities can contribute to informing decisions by those other bodies. It is in this context that we consider the question I raised at the beginning of this speech: the possible role of monetary policy in underpinning financial stability. While maintaining stable financial conditions was once understood to be part of the purview of monetary policy, that changed in the wake of the period of high inflation in Canada and many other advanced economies during the 1970s and 1980s. That experience, together with influential research on monetary policy, convinced the economics profession that maintaining price stability is the best-- or even the only--contribution monetary policy can make to promoting a country's economic and financial well-being. The inflation-targeting regime we have today is an outgrowth of that experience. Inflation targets have been very successful at maintaining price stability because they give everyone an easy way to understand monetary policy and, over time, create a virtuous circle in which realized inflation and expectations reinforce each other. A central tenet of the framework is that a central bank uses the policy interest rate solely to counter risks to inflation. If it tried to do other potentially conflicting things, such as keeping unemployment artificially low or containing volatility in the financial markets, its credibility could erode, the virtuous circle could break down and inflation could go back to being unpredictable. The question of whether central banks can use monetary policy to promote financial stability as well as price stability has re-emerged from time to time. It has often been couched in terms of using monetary policy to prevent or deflate asset-price bubbles--perhaps to dampen irrational exuberance in stock markets. But the question is really more general, related to the use of monetary policy in countering an excessive buildup of leverage in the economy. Identifying such financial imbalances is not as straightforward as it sounds, and using monetary policy to address them was seen as a potential distraction from the task of targeting inflation. Moreover, during the Great Moderation, such imbalances were not seen as a serious obstacle to stabilizing the economy. Confronted with the choice of whether to "lean" or to "clean"--leaning against emerging financial imbalances by keeping interest rates higher than they otherwise would be or cleaning up in the event the risks they create are realized by providing stimulus--central bankers at that time generally agreed that cleaning would be best. That consensus was shattered by the global financial crisis. Unlike past episodes in recent history, the crisis began in the world's most sophisticated financial systems, causing widespread economic devastation. It stirred up persistent and formidable headwinds to economic growth, also making it very difficult for central banks to bring inflation back to target. After this brutal wakeup call, economists went back and re-examined the possible role monetary policy plays in setting the stage for crises. Looking at the historical evidence, it would be fair to conclude that few, if any, crises have been caused by monetary policy alone. The global financial crisis, like the Great Crash of 1929, also reflected widespread regulatory shortcomings and other weaknesses in a number of countries. But it is likely that monetary policy played at least a contributing role in encouraging the buildup of leverage and asset prices in a fragile financial system. The nature and importance of that role in the run-up to these and other crises is the subject of ongoing research and debate. So, can monetary policy target inflation and still promote financial stability? This question can be addressed in two parts. First, let's consider a case in which monetary policy is the only tool available to promote both macroeconomic and financial stability. Later, I'll consider how monetary policy might complement other policies that work more directly on the financial system. Sometimes inflation targeting and financial stability are complementary. For example, if the economy is running above potential, creating inflationary pressures, while financial vulnerabilities are also building, then both considerations point to tighter monetary policy. In retrospect, this appears to have been the case in many countries in the period leading up to the 2007-09 global financial crisis ( The chart shows estimates by the International Monetary Fund of output gaps and credit gaps during that period; while such estimates are obviously imprecise, they suggest that in most of those countries, inflation targeting and financial stability may have been complementary, rather than conflicting goals. A second example is one in which the economy is in recession, or operating below potential, and the financial system is going through a phase of deleveraging and low asset prices ( monetary policy is the right action for both inflation control and financial stability purposes. An example is the United States after the 2007-09 crisis: easy monetary policy cushioned the economy and also helped heal a broken financial system. In both of these cases, there is no trade-off for monetary policy. There are other situations, however, where there could be tension between the two objectives. One is when the economy has been hit by a highly persistent adverse foreign demand shock--such as a recession in the economy of a major trading partner-- while the domestic financial system is unimpaired ( Chart 1: Macroeconomic and financial imbalances increased before the global financial crisis In this case, inflation targeting calls for policy easing to support economic activity and return inflation sustainably to target. But that easing would also disproportionately affect domestic sectors that are highly sensitive to interest rates like housing and other consumer durable goods, encouraging the buildup of financial vulnerabilities. This has been the situation in Canada for the past seven years, as reflected in increasing levels of household indebtedness and elevated house prices--although, as I'll discuss later, regulatory measures have been used to mitigate the resulting financial system risks ( Chart 2: Household debt and house prices are high relative to disposable income Given the situation in Canada, we have focused our research on the lowdemand, high-debt scenario. Empirical research shows that a buildup of household debt in the economy makes a financial crisis more probable, so we wanted to understand the costs and benefits of leaning against financial imbalances through tighter monetary policy. Our researchers used several of the Bank's economic models to examine these issues. On the benefits side, they estimated that increasing the Bank's policy rate by 1 percentage point for one year would reduce real household debt by 2 per cent over five years. Everything else being equal, less household debt reduces the vulnerability of the economy and the financial system; the results, however, suggest that this difference may be very small. On the cost side, the same increase in the policy rate might cut output by up to 1 per cent and push inflation down by 0.5 percentage point relative to what it would have been otherwise. While, like any empirical results, these findings are a product of the methodology used, it is noteworthy that they are consistent across standard models--and indeed, similar results have been found using broadly similar approaches in other countries. These results suggest that, even though monetary policy could, in principle, be used to reduce vulnerabilities in the financial system, it may be too costly in practice. Interest rates affect all parts of the economy and are too blunt an instrument to address an imbalance in just one part of the economy--household credit. If you have a specific imbalance, you need a specific tool to address it. The analysis relies on a number of assumptions about how monetary policy affects debt and how debt affects financial stability. The relationship between monetary policy and financial stability may depend on the specific economic conditions in which we find ourselves. Moreover, the processes resulting in financial cycles, with periods of unsustainable debt buildup, occasional crises and periods of deleveraging, are not well captured by standard models. have more work to do before we can be fully confident about our conclusions. Here, I would like to focus on one critical aspect of the discussion: that monetary policy can affect financial stability only through its effects on household debt, even though it affects a wide swath of the real economy. However, we also need to envisage a case where the effects of monetary policy on financial stability are not limited to one sector, as in the case we just saw, but spread across many different parts of the financial system. In that case, monetary policy's ability to get in all the cracks of the financial system--to paraphrase former Federal Reserve Governor Jeremy Stein--would give it a more powerful influence on financial stability. Another aspect to consider is that risks to financial stability have two elements: the underlying vulnerability and the trigger that could cause a risk to materialize. Both elements are part of our risk-management approach to monetary policy. Over time, stimulative monetary policy may cause vulnerabilities to build up. That was part of our thinking in late 2013, when inflation was running persistently below target: we were concerned about the downside risks to inflation, but decided against easing policy further to avoid exacerbating growing household indebtedness and elevated house prices. Failing to ease monetary policy in an economic downturn could, however, worsen the contraction and cause a crisis. This scenario was part of our thinking at the beginning of last year, when Canada's economy was hit by the collapse in oil prices and we cut our policy interest rate. Although we knew that lowering the policy rate could worsen vulnerabilities related to household debt, we also knew that it would counter the risk that growth would crater and lessen the probability that the oil price shock would trigger financial stability risks. This discussion suggests that any adaptation of monetary policy to financial stability objectives is, to say the least, far from straightforward. Fortunately, monetary policy is not the only game in town. There are also macroprudential tools--regulatory measures that can be used to promote not just the safety of an individual financial institution, but also that of the entire financial system. Macroprudential tools can be used in two ways. One is to foster a more resilient financial system on an ongoing basis. To give just one example, regulators can establish ceilings on mortgage loan-to-value ratios on an ongoing basis, so that any correction in housing prices is less likely to create stress for the financial system. With a more resilient system, all of the financial stability concerns I have been discussing become more manageable. Authorities could also, in principle, adjust macroprudential tools to dampen financial cycles--tightening them when leverage is building up and risk taking is increasing, and easing those requirements when that cycle turns. For example, regulators can lower loan-to-value ratios in response to indications of rising household sector vulnerabilities. Another example is the countercyclical capital buffer introduced as part of the Basel III reform of bank capital requirements. Such countercyclical measures are designed, in part, to weaken the feedback loop between asset prices and credit growth that can lead to the kind of financial excesses that set the stage for a crisis. The track record of countercyclical measures in leaning against a financial cycle is not yet nearly sufficient to form a definite view of their practical effectiveness, however. The changes in mortgage finance regulations that we have seen in the last eight years in Canada include a combination of these elements. When the government successively increased the required down payments and tightened other regulations, it was partly to reduce the taxpayer's longer-term exposure to the housing market and partly to restrain the ongoing buildup of financial system vulnerabilities associated with rising household indebtedness and housing prices. If the effectiveness of macroprudential policies could be relied on, would that mean that monetary policy is off the hook, allowing the Bank to focus on its inflation target and leave macroprudential policies to take care of financial Perhaps, but not necessarily. There might be significant spillovers between monetary policy and macroprudential policies. When the government imposes tighter requirements on mortgage insurance, for example, it likely reduces demand for housing, which may, in turn, have a negative effect on growth and inflation. Household indebtedness may also affect the transmission mechanism of monetary policy, for instance, by influencing households' willingness to spend out of their disposable incomes. On the flip side, if prolonged low interest rates encourage people to take on more debt, financial stability concerns grow. So we need a better grasp of how monetary policy and macroprudential measures interact. Even if such spillovers are important, a clear assignment of policies could be effective in achieving both objectives: monetary policy to target inflation, macroprudential measures to target financial stability. Each could operate independently, focusing only on its own objective. The resulting combination of policies--a Nash equilibrium--could both achieve the inflation target and ensure an acceptable degree of financial stability ( Chart 3: Independent monetary and macroprudential authorities reach a Nash equilibrium under certain conditions Under certain conditions, as long as monetary policy has a larger effect on inflation than it does on financial stability risk and macroprudential policy has a larger effect on financial stability risk than it does on inflation, there would be no need, in theory, for the agencies responsible to coordinate their actions explicitly. They would need to share information with each other only so that each could use its own policy tool to account for the spillovers from the other policy on its own objective. This might mean, for example, that the central bank would need to run a more stimulative policy than it would have otherwise to offset the effect of macroprudential policies, and the macroprudential authority would impose more stringent measures than it would have otherwise to counteract the leverage and risk taking generated by looser monetary policy. In the end, we could see an increase in the level of households' indebtedness without a significant deterioration in their creditworthiness. This has been the situation in Canada over the past few years. This logic suggests that it is very important to have a public sector body with both the power and the paramount responsibility to use macroprudential tools to promote financial stability. This setup would leave monetary policy free to target inflation unfettered by possible financial stability concerns. The appropriate body might be a committee, as is currently the case in Canada, where the potentially relevant tools are shared among several public sector institutions. However, even with an ideal set of institutional arrangements, there may be limits to how independently monetary policy and macroprudential policy can work. Regulatory measures designed to contain risk might, if carried to extremes, distort incentives to allocate resources to their most productive uses. For example, some financial institutions may reduce their lending to riskier but innovative companies. It is also possible that, mindful of such adverse consequences, regulators may refrain from going as far as would be needed to preserve financial stability. And that, in turn, could inhibit the central bank from providing sufficient policy easing to support the economy. Thus, it is possible that, in a situation of sustained weak aggregate demand, relying primarily on monetary policy to provide stimulus may lead to financial vulnerabilities that macroprudential policy cannot, or should not, offset. In such circumstances, fiscal policy may be called upon to provide stimulus, particularly since it is likely to be more effective at low interest rates. Of course, fiscal policy also has its limits, since an excessive buildup of public debt can create its own problems for both the economy and the financial system. We saw that in Canada in the 1990s. But these costs need to be set against concerns that prolonged monetary policy stimulus may result in an excessive buildup of private sector vulnerabilities. These issues are relevant to the renewed discussion of fiscal policy that is now taking place in Canada. Allow me to conclude. During the years since the global financial crisis, we have been doing a lot of thinking and research to improve our understanding of the nexus between monetary policy and financial stability. This is a key question in this year's renewal of our inflation-control agreement. We will need to continue to examine these issues in the period ahead. Indeed, research on the nexus between monetary policy and financial stability is an important element of the Bank of Canada's 2016-18 medium-term plan. One thing is clear, though: monetary policy cannot take primary responsibility for maintaining financial stability. Other, prudential, tools are required to build a resilient financial system and, where needed, to address increasing vulnerabilities. Questions remain, however, about the financial stability effects of monetary policy itself and what, if anything, should be done to address them. Some of these questions pertain to how aggressively a central bank should strive to return inflation sustainably to target in the face of other economic forces. When the economy is hit by a large and persistent adverse shock, should we accept greater downside risks to inflation to avoid exacerbating financial imbalances? Or indeed, given such imbalances, should we tighten policy less aggressively as the economy returns to potential to avoid triggering financial system risks? For the foreseeable future, we are not likely to agree on a formula for addressing these issues. We are inevitably in the realm of judgment informed by the available evidence and analysis. That element of judgment in weighing financial stability considerations, including the implications of our own actions, is central to our risk-management approach to monetary policy.

r160224a_BOC

canada

Connecting the Dots: Elevated Household Debt and the Risk to Financial Stability

schembri

Thank you for the invitation to speak here today. Let me start by congratulating my host, the Guelph Chamber of Commerce, for the impressive work it has done over the years to strengthen the local business community and economy. Economic vitality needs to be nurtured, which is what members of your organization have been doing since 1827, when Guelph was little more than a gleam in the eye of its founder, John Galt. Although Galt never succeeded in establishing the bank that he knew was necessary for growth, early residents created a building society to help them save and borrow for their farms and businesses. That society supported the economic development of Guelph. My topic today is the financial system in Canada that emerged from those modest beginnings in Guelph and other communities across the country, and the role the Bank of Canada plays in helping to maintain its overall stability. Like the transportation system, the financial system is essential infrastructure. provides core functions necessary to facilitate economic activity and is constantly evolving, incorporating new technology and other innovations to become more efficient. It is as vital to the economy as our system of roads and highways. Although the Bank of Canada, unlike some other central banks such as the U.S. Federal Reserve or the Bank of England, is not responsible for directly overseeing banks and insurance companies, we help to promote financial stability and efficiency in a number of different ways. In these efforts, we take a system-wide perspective that encompasses all financial institutions and markets at the federal and provincial levels, especially those that are "systemic" or, in other words, critical to the functioning of the entire system. This system-wide perspective allows us to "connect the dots" not only across the financial system but, equally importantly, between the financial system and the real economy, including households and non-financial firms. By seeing how all the components work together, we can identify potential problems before they become serious and help maintain the flow of financial traffic. An important vehicle in our efforts to promote financial stability is the , which we publish twice a year. The summarizes the Bank's analysis of the main vulnerabilities and risks to the stability of the Canadian financial system. Its purpose is to inform both the private and public sectors of our assessments so that they can take appropriate steps to mitigate these vulnerabilities and reduce their exposures to them. In 2014, we incorporated into the a new framework for identifying and gauging vulnerabilities and assessing risks. In my talk today, I will cover three main points. First, I'll begin with an overview of this framework. Second, I'll illustrate the application of this framework by stepping you through our latest assessment of a key vulnerability, elevated household debt, drawing on recent Bank research into the increasing prominence of highly indebted households. And third, I'll briefly discuss the Bank's contribution to reducing vulnerabilities. The better we understand the sources and the transmission of financial system stress, the better we will be able to prevent, or at least limit, the impact of financial crises. To that end, our new framework informs and directs our riskassessment process. At the heart of the framework is the explicit identification of vulnerabilities and risks. Such transparency encourages everyone involved in the financial system to consider how to mitigate the vulnerabilities and react if the risks were to materialize. Our framework sets out three steps ( 1. identifying financial system vulnerabilities; 2. developing risk scenarios; and 3. assessing each risk scenario by determining the probability of it occurring, as well as its impact should it occur. The first step is identifying vulnerabilities, which are conditions that could amplify and propagate shocks throughout the financial system. Examples of potential vulnerabilities include high levels of indebtedness or leverage, liquidity and maturity mismatches, and the mispricing of assets. In contrast, risks are events or outcomes that could threaten the ability of the financial system to perform its core functions. Risks materialize when trigger events--which are adverse shocks such as the recent dramatic drop in oil prices--interact with vulnerabilities. To illustrate the difference between a vulnerability and a risk, imagine a bridge with fractures in its concrete supports. That's the vulnerability. The risk is that the bridge could collapse if a trigger event, such as an earthquake, shook its foundations. Focusing explicitly on vulnerabilities in the Canadian financial system allows us to highlight where the fragilities lie and how they are evolving. We identify a range of vulnerabilities and consider them in relation to a wide variety of financial institutions, markets, end-users and payment systems ( The second step is developing a risk scenario for each of the most serious vulnerabilities, including a list of possible triggers. A risk scenario describes how a trigger event will interact with a vulnerability to affect the financial system. Third, we assess the probability of each risk occurring and the impact if it did. The rating of risks summarizes our judgment on their importance to the financial system and their likely effect on the real economy. That, in brief, is our framework. Now, let's look at high household debt, a key vulnerability we analyzed in the December issue of the FSR. Table 1: Approach used to monitor vulnerabilities in the Canadian financial system Canada was spared some of the most serious negative consequences of the global financial crisis because of our strong financial regulatory and supervisory framework and the effectiveness of our policy response. This response included a reduction in the policy interest rate by the Bank of Canada to support aggregate demand and help achieve our inflation target. As a result of these policies, the Canadian economy recovered relatively quickly, supported by solid growth in household spending that was funded by household income growth and borrowing. The buildup of household debt, however, has increased the vulnerability of the economy and the financial system to adverse shocks to incomes and interest rates. With high indebtedness or elevated leverage--an important indicator of vulnerability in the financial system--the household sector is less resilient. During times of stress, people with higher debt will typically cut back on their spending disproportionately more than those with less or no debt. This means that high household indebtedness can amplify the impact of a shock. In more extreme cases, adverse shocks could lead to an increase in household defaults, which would mean losses for banks, other lenders and mortgage insurers. In the worst case, if the losses were extensive and spillovers were large, the increase in stress could potentially deplete the capital buffers built into the financial system to absorb losses, impairing its functioning, with large negative effects on economic activity. To understand the magnitude of this potential threat to the financial system we need to understand both the sustainability of household debt and the impact on the financial system of increased defaults, should they occur. That raises three key questions: 1. Which households are holding the debt? 2. How likely are the highly indebted to lose their jobs? 3. How able are highly indebted households to service their debt? Which households are holding the debt? from 2002 to 2014 show that household debt in Canada has not only increased significantly but has also become more concentrated over time in households with higher levels of indebtedness. For example, the level of debt held by Canadian households with a debt-togross-income ratio of less than 250 per cent has increased only modestly in inflation-adjusted terms over the past 12 years. In contrast, the debt of households with a debt-to-gross-income ratio equal to or greater than 250 per cent increased by almost 75 per cent over the same period. Within this group is a subgroup of highly indebted households, defined as those with a debt-to-gross-income ratio that is equal to or more than 350 per cent Most of the people in this subgroup are young--under the age of 45. The size of this subgroup doubled from around 4 per cent during the 2005-07 pre-crisis period to around 8 per cent of indebted households in 2012-14. amounts to about 720,000 households holding close to $400 billion in debt, about one-fifth of the overall household debt. A deeper dive into the characteristics of these highly indebted households reveals that, compared with less-indebted borrowers, highly indebted borrowers tend to be younger, have lower incomes and wealth and are less likely to have pursued post-secondary studies or training. Highly indebted borrowers are also disproportionately more likely to live in British Columbia, Alberta or Ontario, provinces where house prices are the highest ( How likely are the highly indebted to lose their jobs? Members of highly indebted households are more likely to lose their jobs because they tend to be younger and are less likely to have a post-secondary degree or training. Chart 1: The increase in household debt has been driven by highly indebted households under the age of 45 How able are highly indebted households to service their debt? An analysis by the Bank suggests that highly indebted households would be less able to make their payments after a shock. Although the median share of gross income needed to service the debt of highly indebted households has fallen notably over the past decade from 43 per cent of gross income to 34 per cent, largely as a result of much lower interest rates, the liquid financial buffers held by this group remain relatively modest, roughly equivalent to only 6.5 months of current debt servicing. Chart 2: Highly indebted borrowers are more likely to live in British Still, debt loads and arrears in Canada today are not nearly as high as they were for U.S. households at the start of the financial crisis. For example, relative to more U.S. households in 2007 carried debt, more of those households were highly indebted and twice as many of those highly indebted households had debt service ratios of 40 per cent or more Table 2: Incidence of debt and highly indebted households in the Assessing the risk associated with the vulnerability arising from more highly indebted households starts with the development and analysis of a plausible risk scenario. A number of triggers could set off the risk, but the most likely is a severe recession that causes a sharp, widespread rise in unemployment, which reduces the ability of households to service their debt. To gauge the effect of such a shock on the stability of the financial system we simulated a large and persistent increase in the unemployment rate of 5 percentage points. While the probability of such a scenario is low, it is similar to the magnitude of the adverse shock used by the International Monetary Fund in its 2014 assessment of the stability of the Canadian financial sector. Our simulations suggest that in response to this shock household arrears rates could rise significantly, from 0.4 per cent in 2014 to reach as high as 1.8 per cent after three years. About 20 per cent of this estimated rise would be attributable to the increase in debt and its greater concentration among highly indebted households since 2007. What would be the impact on the financial system and economy? What would be the possible implications for the financial system if the vulnerability arising from highly indebted households were triggered? The rise in household arrears could force some vulnerable homeowners to sell their homes or eventually default on their mortgages and other consumer debt. If defaults rose quickly or if many households were forced to sell their homes, house prices could drop sharply across Canada, particularly in Vancouver and Toronto, which have recently experienced exceptionally strong price growth. A broad-based decline in house prices would, in turn, have large direct effects on Canadian lenders and mortgage insurers. Results from stress tests show, however, that there are sufficient buffers in the financial system to withstand such a scenario. For example, the six largest Canadian banks, which hold roughly 70 per cent of outstanding mortgages, have increased the quantity and quality of their capital in recent years and are well diversified across regions and sectors. In addition, most of the mortgages they hold are supported by governmentbacked mortgage insurance programs or by high homeowner equity. Nonetheless, if such a decline in house prices occurred, the impact on the broader Canadian economy and the financial system would be large. What is the probability of this risk occurring? Despite the drop in the price of oil and some non-energy commodities, the probability of this risk being triggered remains low. The decline in Canada's terms of trade has set off a complex and lengthy chain of adjustments within the economy, as capital and labour re-allocate between resource and non-resource sectors. The negative impact of this shock has been felt most acutely in the oilproducing regions, where employment insurance claims have been rising. The non-resource sector, however, is expected to gain further traction, supported by a strengthening global economy--most notably in the United States--the stimulative effects of a lower Canadian dollar, and accommodative monetary and financial conditions. Indeed, the Bank's interest rate reductions in 2015 helped to reduce the probability of this risk materializing. Although the Canadian economy appears to have stalled in the fourth quarter of last year, we expect growth to pick up to 1 per cent in the first quarter and then to move above 2 per cent for the remainder of 2016. What is the assessed rating for this risk? Although there is a low probability of this risk being realized, the Bank's Governing Council assessed it as "elevated" because of the large potential impact it would have on the economy ( Table 3: Mapping the probability and impact of the FSR risk rating While the expected uptick in economic activity will help stabilize household debt as output, incomes and interest rates rise, economic growth alone may not be sufficient to mitigate this vulnerability. Other policies should be adopted to complement the impact of economic growth. To promote the stability of the financial system, a range of policy responses can--and have been--deployed. These include the following: Encouraging prudence on the part of borrowers and lenders. the FSR and other public communications, the Bank has informed households and lending institutions of its analysis and thereby raised their awareness of high household debt in an effort to encourage them to exercise appropriate caution. In particular, borrowers and lenders should take into account the impact of higher borrowing rates in the future on the cost of servicing mortgages and other loans. Enhancing market discipline through increased transparency. By making its analysis and assessments public, the Bank aims to also increase awareness of this vulnerability among the agencies responsible for assessing consumer creditworthiness, on one side, and bank analysts and investors, on the other side. Strengthening regulation and supervision of the financial sector noted earlier, financial institutions and markets in Canada were relatively well regulated and supervised before the global financial crisis. Since then, the regulatory and supervisory framework has been further strengthened. The Bank, along with other public authorities, has helped develop more rigorous global standards and promote their implementation in Canada. An important example is the implementation of the Basel III regulatory reforms, which require banks to hold more and higher-quality capital and meet new liquidity and leverage requirements. Consequently, Canadian banks are now in a better position to cope with unexpected downturns in economic activity. The Bank also works with other public authorities at the federal and provincial levels to stress-test the ability of financial institutions to withstand various macroeconomic shocks. These tests incorporate existing vulnerabilities. The goal is to encourage the institutions themselves, as well as the supervisory bodies, to take remedial measures to increase resilience, as necessary. Adopting macroprudential measures. n the immediate aftermath of the crisis, household debt and house prices resumed growing faster than disposable income in response to the lower interest rates and the recovering Canadian economy. The federal government and a number of agencies worked together to mitigate this growing systemic vulnerability. The Bank's analysis of these vulnerabilities helped to inform these decisions. For example, the federal government tightened rules for governmentsupported mortgage insurance four times over five years, starting in 2008. In December 2015, the federal government made a fifth change, increasing the minimum down payment for houses valued at from $500,000 to $1 million. released new guidance on mortgage underwriting and mortgage insurance that implemented enhanced global standards. announced that it would issue for public consultation proposed rules for how much capital the banks and mortgage insurers must hold against vulnerable insured mortgages. These measures help to limit access to borrowing to the most creditworthy households, for example, those with higher credit scores, and thus complement the accommodative monetary policy of the Bank of Canada by better targeting the stimulus to those households with the capacity to borrow. Keeping the focus of monetary policy on the right objective. Since the crisis, the Bank has kept its policy interest rate relatively low, by historical standards, to support economic growth and thereby achieve its primary goal of returning inflation to the 2 per cent target within a reasonable time frame. Because we conduct monetary policy within a risk-management framework, we recognize that elevated household debt could represent a risk to financial stability. Although we have the flexibility to choose a different path for interest rates to restrain the accumulation of household debt and mitigate vulnerabilities in the financial system, we have focused on attaining the 2 per cent inflation target. We believe that there are other measures, including public policies and private remedial actions, better suited to targeting and reducing these vulnerabilities than monetary policy, which affects the entire economy and is thus a very blunt instrument to address financial stability. To summarize my main points, then, the financial vulnerability associated with elevated household debt has increased over the past decade. It has done so, in part, because the debt has become more concentrated in highly leveraged households, especially those whose ability to service their debt may be more vulnerable to an economic downturn. Our assessment, therefore, of this vulnerability depends not only on the magnitude of the debt but also on its distribution. However, the Canadian financial system is very resilient and could withstand the triggering of this vulnerability. And public authorities in Canada have taken appropriate measures to mitigate it. Moreover, this vulnerability should stabilize as the economy and household incomes strengthen and interest rates normalize. The Bank is, nonetheless, concerned about high household debt and will continue to monitor it closely. Let me conclude. The Bank of Canada's mandate is to promote the economic and financial welfare of Canada. Those who established the Bank of Canada in the wake of the Great Depression clearly understood that the two goals of financial and economic stability must go hand-in-hand. One is a necessary condition for the other. But the experience of history tells us that economic stability, supported by the appropriate monetary policy to achieve low and stable inflation, is not sufficient for financial stability. That was an important lesson taught by the global financial crises of the late 1920s and 2000s. Other policies are needed to help to safeguard financial stability, namely, effective regulation and supervision of the financial system, and close monitoring and timely remediation of emerging financial vulnerabilities. The Bank of Canada makes important contributions to these other means of achieving financial stability. First, we use our system-wide perspective and our new framework to identify and assess vulnerabilities and risks and, thereby, "connect the dots" within the financial system and with the real economy. Second, we work collaboratively with our partner agencies, sharing our research and analysis with them and the public at large to collectively mitigate emerging vulnerabilities. The Bank's close collaboration with other agencies has helped Canada achieve a remarkable period of financial stability over the past quarter century. This collective effort to monitor and mitigate financial vulnerabilities, such as elevated household indebtedness, is essential to maintaining a stable and efficient financial system and promoting economic growth in Canada. Thank you.

r160330a_BOC

canada

Adjusting to the Fall in Commodity Prices: One Step at a Time

patterson

Good afternoon. Thank you for inviting me here today. It's a pleasure to be in Edmonton and speaking to the Chamber of Commerce. When I accepted this invitation, it took me all of about 10 seconds to decide what my topic would be: the impact of lower commodity prices on Canada's economy, which is important to all of us. As business leaders in Alberta, you know this better than most because you are experiencing it first-hand. At the Bank we have committed a lot of resources to understanding the impact on the economy of the drop in prices, and so I thought it would be helpful to share some of our insights, from a macro perspective, into the adjustment we are facing. Oil prices alone are down by well over 60 per cent since the highs we experienced in mid-2014. Given the supply dynamics that we are currently faced with, it is highly unlikely that we will see those levels again in the coming years. While this price drop is affecting all Canadians, it is being felt most acutely here in Alberta and other oil-producing regions. We at the Bank are well aware of the toll this is taking on firms and the hardship it means for many individuals and families. Yet the message that I want to share with you today is that Canada's economy is diverse and dynamic enough to achieve, in time, a new balance of economic growth. While energy and other commodities will continue to play a very important role in the domestic economy, we don't expect that they will account for as large a share of our exports as they did in the recent past. I want to focus on three key questions that are top of mind for us at the Bank and, most likely, for many of you. First, how do we assess the impact of this shock? Second, how will the economy adapt and how long will it take? And third, what will the economic landscape look like when it's done? In answering these questions, I will highlight a simulation of the commodity price shock that we ran through one of our economic models to help us understand the implications for the economy. I will also describe in some detail the insights into the adjustment process that the model gave us. Let me begin with some context. A broad-based boom in global commodity markets began in the early 2000s. It was fuelled by growing demand from emerging-market economies. Canada was a big beneficiary of the rising prices. Our terms of trade--the price of our exports relative to that of our imports--improved substantially. So did our real gross domestic income (GDI), which is a measure of the purchasing power of income generated in Canada. The terms of trade directly boosted GDI by approximately 7 per cent between 2002 and 2013. Rising commodity prices also boosted economic activity, particularly business investment, which generated job growth in the natural resource sector. In 2014, business investment in the oil and gas extraction sector peaked at almost $80 billion. As commodity prices and Canada's terms of trade improved, the Canadian dollar strengthened. From a low of about 62 cents U.S. in 2002, the dollar rose to average around parity between 2010 and 2013. This increase was not merely coincidental. In addition to the improvement in our terms of trade, other factors, such as international interest rate differentials and safe haven flows, were at play. All of these elements influenced the level of the Canadian dollar. In this environment, Canada's flexible exchange rate helped to prevent the economy from overheating. As the Canadian dollar appreciated, it became a headwind for some industries in the non-commodity export sector. This, in turn, reinforced incentives for capital and labour to shift to commodity-producing sectors and regions. Indeed, workers migrated in large numbers to regions of the country that were benefiting from job creation in the natural resource sector. The oil boom in Alberta provides the strongest example. Between 2002 and 2013, more than a quarter of a million people moved here from other provinces. We also saw the number of workers commuting to Alberta double during this period, rising to about 8 per cent of the province's workforce. I'm sure many of you felt the benefits of higher commodity prices. You likely witnessed changes in your neighbourhoods and city. But, by late 2014, you may have begun to feel a cold wind blowing. With the significant decline in commodity prices, the economy was faced with a material shock. Let me turn to my first question: how we assess a shock such as this. The Bank uses a variety of analytical tools and sources of economic intelligence to better understand and assess the impact of shocks like this one. Some of our tools, such as our , help us identify near-term impacts, including changes in business investment. Others help us look at a longer horizon. The recent oil price drop merited particular attention, not only because of the size and speed of the decline, but also because of the relative importance of oil production and investment. As oil prices began to fall, we closely monitored announcements of capital expenditures. We also analyzed the impact of past oil price shocks on investment and we talked with firms in the energy sector to understand how they were responding to the price decline. The picture that emerged was of a sizable contraction of investment in the oil and gas sector in the near term. And so in January 2015, and again in July, concerned about the impact of lower oil prices and the risks to inflation, and to facilitate the economy's adjustment to its new circumstances, we lowered our policy rate. For insights into the longer horizon, we ran a simulation of the shock in our A paper that we released with our January has all the details. is designed to capture the impact of terms-of-trade shocks, which is a necessity for analyzing an economy such as Canada's that is so heavily engaged in international trade. ToTEM is fed data on everything from consumer spending to household wealth, labour markets, wages, imports and exports, long- and short-term interest rates, business investment and government spending. The model helps us understand how these components interact in response to shocks. It also allows us to explore the linkages between the commodity and non-commodity sectors, as well as how the exchange rate and monetary policy facilitate adjustment to shocks. The ToTEM simulation provided insight into how a fall in commodity prices would affect the broader economy. The shock is complex because it sets in motion several, seemingly non-synchronous forces: on the one hand, it indicated that our resource sector would shrink and we would earn less income from the rest of the world; on the other hand, the non-resource sector would gradually begin to expand. At the same time, the Canadian dollar would depreciate. A front-loaded restructuring of the resource sector By convention, we assumed for the simulation that commodity prices would remain roughly where they were at the time (the third quarter of 2015), when West Texas Intermediate was trading at about US$46 per barrel, almost 60 per cent below its peak in June 2014. Our simulation suggested that, by the end of 2015, the commodity price decline would cause GDP to be 1 per cent lower than it otherwise would have been. And that's what happened. As investment fell, firms cut their workforces. You all likely have friends, neighbours or colleagues who were affected by the cuts. By December of last year, about 30,000 jobs had been lost in the mining, oil and gas extraction sectors in Alberta, Saskatchewan, and Newfoundland and Labrador, a decline of almost 20 per cent from the employment peak in 2014. But supplychain linkages and spillovers to other sectors meant that the losses were much broader: almost 70,000 jobs disappeared in these provinces. Regional divergences also emerged. While employment in these energyproducing provinces fell, it grew in the rest of Canada. As a result, unemployment rates rose by roughly 2 to 3 percentage points in the three provinces while remaining flat or declining in British Columbia, Ontario and Quebec. The employment decline in the resource sector also had an outsized impact on national aggregate earnings. Not only do these jobs pay well, they also tend to call for longer work days and, therefore, a greater number of hours worked. For example, in 2014, average hourly earnings and average hours worked in the resource sector were, respectively, about 40 per cent and 25 per cent higher than the national average. Our simulation suggests that the commodity price shock will cause aggregate earnings to be almost 2 per cent lower than they otherwise would have been by the middle of this year. Broader income and wealth effects The retrenchment in the commodity sector is the first and most visible step in the adjustment process. Over time, the losses in income and wealth associated with the price decline will spread across the country. As I mentioned earlier, our terms of trade improved substantially in the 10-year period before commodity prices began to fall. We have now lost about half of those gains. Measured at annual rates, this represents a loss of more than $60 billion in national income, or about $1,800 for every Canadian. This drag on household spending was initially small, because the restructuring in the commodity sector has been fairly concentrated and the monetary stimulus from the Bank's interest rate cuts last year helped support the broader economy. But the impact of lower real incomes is gradually building. We expect it to become the dominant source of drag on the economy by 2017. As their wealth and incomes decline, households will likely restrain their spending and we will see lower, but still positive, consumption growth. Now that I have given you some numbers around the impact of the oil price shock on the Canadian economy, let's turn to my second question: how long and what form the adjustment will take. It is difficult for us to be precise about the timing of the underlying shifts in the economy. But our best guess is that the full adjustment will take longer than two years, our normal forecast horizon. Having said that, we have a few clues that can help us to frame the timeline. First, in examining labour markets, we see an interesting development that suggests we may be adjusting to the economic shift more quickly than we have historically. In the past, regional shocks would have led to a persistent divergence in employment rates across provinces. Between 1976 and 1997, the average difference between employment rates in any one province and the national rate was 5.5 percentage points. This was much higher than the corresponding gap in But the gap in Canada has now shrunk to U.S. levels, below 4 percentage points, as we explain in a staff analytical note posted on our website today. While this is just one indicator of labour mobility, the convergence suggests that Canadians have become more willing to move to where the jobs are. That may mean that regional labour markets will adjust more quickly to the decline in commodity prices. Indeed, we are already seeing shifts in migration patterns. Net interprovincial migration to Alberta reversed in the fourth quarter of 2015. At the same time, over the past two quarters, Ontario registered the largest inflow of interprovincial migrants since 2002. In addition, the flow of workers who were commuting from their homes in other provinces to Alberta has fallen sharply. A second clue is the close but imperfect link between our terms of trade and the value of our currency. It is no surprise that the value of the Canadian dollar has fallen along with commodity prices. Since late 2011, when some commodity prices first began slipping, the Canadian dollar has lost almost one-third of its value. While many factors influence the exchange rate, its depreciation, which will certainly hurt some businesses, is a necessary part of the adjustment process. The weaker dollar acts as a buffer for Canada's exporters. It offsets part of the drop in U.S.-dollar commodity prices, softening the blow to the Canadian-dollar revenues of commodity exporters. Similarly, the depreciation boosts the Canadian-dollar revenues of non-commodity exporters that price their goods in The weaker dollar also makes Canada's exports more competitive. We are already seeing some evidence of this increased competitiveness. In particular, export categories sensitive to the exchange rate have performed better than average. These categories include building materials, furniture, industrial machinery and equipment, and pharmaceuticals. The service sector also benefits. Tourism is surging: the number of foreigners travelling to Canada jumped 11 per cent in January compared with the same month last year. Film and television production is also enjoying a revival across the country-- was filmed here in Alberta. And in Vancouver more than 350 productions were shot last year, a record that surpassed 2014 by 40 per cent. Estimates from ToTEM and other models suggest that it typically takes up to two years for the full effect of exchange rate movements to be felt. Since the loonie fell by roughly 15 per cent against the U.S. dollar in 2015, more gains are coming to the non-commodity sector, consistent with the notion of a two-track economy. What we are witnessing is a reallocation of productive resources to the noncommodity sector. And, of course, the resource sector is not standing still. We expect to see new efficiencies, further innovation and shifts in investments. For example, here in Alberta's industrial heartland, there are ongoing investments in upgrading and processing that will help diversify the mix of products from your natural resources. Now, let me turn to the last question I posed at the outset: what the economic landscape is likely to look like after these adjustments have worked their way through. Again, although we can't be precise about the timing, we expect that, several years from now, the Canadian economy will have found a new balance. Our simulation suggests that the share of the commodity sector in the economy will decline toward its pre-boom level. By 2020, the sector could account for roughly 40 per cent of exports, compared with about 50 per cent in 2014. Similarly, the sector's share of business investment could fall to 40 per cent, compared with 56 per cent in 2014. Lower commodity prices will lower incomes and are likely to lower the economy's potential output. This is the result of a number of factors, primarily the drop in investment in the resource sector, but also the rise in the price of imported capital, which negatively affects investment in all industries. With less investment, the country's stock of capital will be smaller than it otherwise would have been, lowering the economy's productive capacity. The extent to which potential GDP is permanently lower will depend on how much capacity is rebuilt in the non-commodity sector. As well, low oil prices could spur companies to innovate and achieve greater efficiencies in their production cycles. We are studying these questions now and will update our estimate of potential output in our April . While our modelling exercise laid out a plausible longer-term scenario for the economy, it is subject to many assumptions. Three are worth noting: (i) the magnitude--whether we have accurately assessed the extent of the declines in business investment; (ii) the timing--both with respect to the pickup of noncommodity exports and the reallocation of labour; and (iii) our assumption of flat oil prices. Let me say a few words about our oil price assumption. In the near term, the risks to oil prices appear to be balanced. While elevated inventories still represent the main downside risk, we now have an upside risk in the form of a faster-than-expected decline in U.S. oil production. In contrast, over the medium term, the risks remain tilted to the upside. The significant reductions in oil investment since late 2014 could leave future increases in global demand unmet, putting upward pressure on prices and drawing investment back into the sector. The level of prices that would balance the oil market in the medium term is still highly uncertain, particularly since technical improvements and other efficiency gains by oil-producing firms have lowered their costs of production. Moreover, as we highlighted in the January , low oil prices make it more likely that adverse threshold effects on economic activity may occur. If prices fell to such a low level that firms struggled to cover their ongoing costs, consolidation could accelerate, resulting in more-pronounced declines in production and weighing on the broader economy by hurting demand and confidence. Let me conclude. Our simulation of the commodity price shock is just one example of how we assess the various factors influencing the Canadian economy. Examining the shock in isolation enhances our understanding of its potential influence on our outlook for inflation. We consider this type of analysis, together with many other inputs, when we set monetary policy. As we note in our s, we conduct a rich analysis around our projections and identify risks to the inflation outlook. This analysis acts as the foundation for Governing Council to assess and exercise its judgment about the appropriate stance for monetary policy. Earlier this month, we left our policy rate unchanged at 0.5 per cent, since the economy was evolving broadly in line with our expectations and projections set out in January--about 1.5 per cent GDP growth in 2016 and 2.5 per cent in 2017. , we will update this forecast and take into account the fiscal measures that were announced last week. We are mindful that the changes to our economy that are under way are, and have been, difficult, particularly here in Alberta. Adjustments to large negative shocks take time. Although painful for many, the shifts are signs of a dynamic economy. We are fortunate that Canada's wealth is based on a broad set of natural and human resources and that the growth of our economy is powered by a wide range of industries. To make the most of our opportunities as a trading nation, we need to let the adjustment process unfold as effectively as possible. It won't be easy and it will take time. For the Bank, the best contribution we can make is to set policy that will help keep inflation low, stable and predictable, so that Canadians can plan and invest with confidence. And as business and community leaders, you can help by being proactive and innovative in your respective fields.

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China’s Great Transition: What It Means for Canada

wilkins

If I were to ask everyone here what the value of the Canadian dollar is these days, I expect you'd assume I meant relative to the US dollar. And you'd probably get the value bang on. This is understandable: the United States is our biggest trading partner, and most Canadians, especially business people like you, are well aware of the links between our two economies. Now, if I were to ask you about the exchange rate between the Canadian dollar and the Chinese renminbi, the answers probably wouldn't be as accurate. This makes sense too: it's not a number you often come across, even if you're reading news stories about China's slowing growth and financial volatility. Yet, China is Canada's second-largest trading partner and accounts for 17 per cent of the world economy. More than 400 Canadian companies have a foothold there. They are in sectors as diverse as life sciences, aerospace and information technology. China's currency is on the way to becoming a global reserve currency. A decade from now, our children may convert Canadian dollars into renminbi as easily as we do now for US dollars. We pay very close attention to China at the Bank of Canada because of its growing importance to our country's economic and financial well-being. Today, I want to share with you some of what we've learned by studying how China's economy and financial system have evolved, and to discuss the opportunities and challenges that lie ahead. This is relevant to all regions of Canada, especially here in Vancouver, our gateway to Asia. It's a real pleasure to be here, and I'd like to thank the Greater Vancouver Board of Trade for the invitation. In my remarks, I will walk you through four points that frame our thinking on China's rise on the world stage has been exceptional, even disruptive, and beneficial for the global economy and Canada. The slowing of China's growth to a more sustainable pace is not only inevitable, it's also desirable. History teaches us that this type of transition is difficult to manage, takes time and is very likely to be uneven. Canada is not immune to the risks China poses to the global economy, but we're well positioned to manage them. China's market reforms of the 1980s and its accession to the World Trade Organization (WTO) in 2001 marked the beginning of a remarkable transformation that has been felt around the world. For China, the process has been overwhelmingly positive, even though it has entailed some stresses, particularly environmental ones. Its economy has more than tripled in size. More than a quarter of a billion Chinese people have been lifted out of poverty, in what has been the largest migration of rural workers to cities in history. Life expectancy has increased by nearly three years. is hosting the G20 this year, just one example of its growing presence on the world stage. China's transformation has also yielded benefits for the global economy. It's true that China and other emerging markets have presented stiff competition to exporters around the globe, including in Canada. We see the result in the declining proportion of people working in manufacturing industries in advanced economies, which has been difficult for many. And it likely contributed to the buildup of imbalances in the global financial system ahead of the financial crisis in 2008. Yet, China's expansion also helped drive global trade to record highs. This means that exporters have been selling into a bigger market. At the same time, businesses and households have benefited from lower prices for many goods. China's growth has also meant better prices for the resources Canada sells. China has become the world's second-largest consumer of oil, with its demand doubling over the past 15 years. It now buys half of the world's output of base metals, compared with less than 20 per cent in 2001. This has helped make Canada richer. China's increased demand for commodities contributed to the big improvement in Canada's terms of trade--the price of our exports relative to that of our imports--between 2001 and 2008. Our terms of trade has fallen over the past couple of years, in part because of slowing growth in China, but it remains just over 10 per cent higher than it was when China joined the WTO. It's hard to overstate how quickly the economic links between our two countries have developed. Two-way trade between Canada and China increased more than fivefold over the past decade and a half, and our exports to that country now exceed $20 billion a year. British Columbia has seized this opportunity; for example, China bought just under one-third of the province's exports of forestry products last year, compared with only 4 per cent in 2001. Our governments have also worked to encourage trade and investment through accords, trade missions and other agreements with China. And the growth in foreign direct investment in both directions speaks to the deep links that have been formed. On the financial side, the Bank of Canada signed a $30 billion Canadian dollar/renminbi bilateral swap arrangement with the People's Bank of China in 2014. This paved the way for the opening last year of the Canadian Renminbi Trading Hub, which will make it easier for our companies to use renminbi in business transactions. Canadian financial institutions are active in China, and, just a few months ago, British Columbia became one of the first governments to issue Panda bonds in China. Let me turn to my second point. While China's economic growth has had an overall positive impact on the Canadian economy, that growth is slowing. It's slowing to a more sustainable pace, and this is not only inevitable, it's desirable. The Chinese economy expanded by a little less than 7 per cent last year. That sounds fast relative to advanced economies, but it's the slowest pace for China in 25 years and down from the double-digit numbers of a few years ago. The slowdown is natural. The economic strategy that the Chinese have pursued over the past 15 years cannot continue indefinitely. The strategy is simple: add more workers and more capital to increase the economy's potential to produce goods, and then sell those goods in global markets. This has run its course, for a couple of reasons. First, demographic forces are no longer in China's favour--the working-age population is projected to shrink by about 5 per cent by 2030. Second, China's reliance on investment is not sustainable--it was 46 per cent of GDP in 2014, compared with 25 per cent for other emerging-market and developing economies and 20 per cent for advanced economies. The strong investment policy is increasingly creating redundant or unproductive capital in China, which may boost growth in the short run but also increases the odds of painful economic adjustments in the future. A critical question is where growth in China is likely to settle if the transition is successful. Bank of Canada researchers judge that China has the potential to grow at an annual rate of around 6 per cent, on average, over the next 15 years. At that pace, it takes less than 12 years for the economy to double in size. To understand how such growth is possible, recall that China's GDP per capita is still only one-fifth of what it is in the United States. This means China still has a lot of room to catch up by adopting existing advanced technologies. As part of this process, the share of agricultural workers in China will continue to shrink, to the benefit of more productive sectors. With Chinese incomes rising, education levels should follow suit and boost productivity. These improvements in human capital could potentially more than make up for the decline in the working-age population. One implication for Canada is that China's demand for commodities should remain high and grow from a higher base, even if the country's economic growth is slower and less reliant on natural resources. My third point is that history shows that the transition to the next stage of development is difficult to manage, takes time and is quite likely to be uneven. If China is to achieve its potential to grow, it will have to avoid what economists call the "middle-income trap," in which developing countries that seem destined to join the club of advanced economies suddenly see their growth stagnate for many years. Chinese authorities recognize that their specific challenge is to shift from an economy fuelled by investment to one supported by domestic consumption. Another is to boost productivity. To meet these challenges and to achieve the economy's potential, Chinese authorities are working to fit a number of pieces together--much like a Chinese puzzle. There are many pieces, but let me mention three. Comprehensive social safety net The first one is outside the purview of central banking but crucial to achieving the rotation of demand toward consumption. I'm talking about a comprehensive social safety net. In advanced economies that have a public pension system, unemployment insurance and healthcare, risks are pooled, and people can spend more of their income because there is relatively less need to save for a rainy day. That's why people in developed countries save an average of around 5 cents of every dollar they earn. Contrast this with China, where urban households currently save nearly 40 cents out of every dollar earned. Chinese workers and capital will also need to adjust as the composition of the economy shifts out of state-owned sectors like coal and steel, toward more productive sectors like high value-added services. This will be a lengthy transition, in part because many people will need to relocate to different regions and perhaps even be retrained. China has taken steps in the right direction, bringing in pension reforms, higher healthcare spending and reforms to the household registration system that will give migrant workers access to basic services in smaller Chinese cities. China also made raising the level of social protection a priority in its new Five-Year Solid monetary policy framework The second piece, which is very relevant to central bankers, is a solid monetary policy framework to provide the foundation for sustainable growth. China faces what is known in international economics as the "policy trilemma." No country can sustainably maintain all of the following three policies: (i) a fixed exchange rate, (ii) independent monetary policy and (iii) free international capital flows. It's the classic case of "you can't have it all." Resolving this trilemma won't be easy, and it takes time. No one knows this better than Canada. We successfully confronted the trilemma and then later adopted inflation targeting in 1991, which was the perfect complement to a floating exchange rate and free capital flows. This monetary policy framework has served us well for the past quarter century. But we should remember that it took us several decades, and a number of policy reversals and missteps, to reach this point. History buffs will recall that Canada let markets determine the value of the Canadian dollar in 1950, then went back to a fixed exchange rate in 1962 and finally adopted a floating exchange rate in Yet we still lacked a robust monetary anchor and this contributed to a period of very high inflation that lasted through the early 1980s. The lesson for us is that orienting monetary policy toward achieving low and stable inflation can lead to better economic outcomes. China only recently moved from pegging the renminbi to the US dollar to maintaining its stability against a basket of currencies. This has increased the variability of the renminbi/US$ exchange rate and allows for exchange rate movements that could facilitate deep structural adjustments. Certainly, in Canada, we've seen that our floating exchange rate supports structural adjustments, like the reorientation toward the non-resource sector under way today. My colleague Deputy Governor Lynn Patterson gave a speech about this last week--I recommend it to anyone who wants to learn more about this transition. That said, if Chinese authorities gear monetary policy toward supporting the exchange rate, there may be trade-offs with pursuing domestic objectives. Moreover, the appropriate level of the basket itself changes over time, leading to speculative flows if the target level is not adjusted on a timely basis. Chinese authorities have committed to further liberalizing the capital account. Loosening restrictions on international flows, if managed well and at the right time, could help China's transition. Liberalizing the capital account would help to complete markets and expand access to market financing within China. That said, liberalizing the capital account is one of the most difficult challenges that developing economies face. Take the Asian Crisis as an example: countries liberalized their capital accounts before their financial systems were ready and suffered a currency crisis in 1997 that set their development back a few years. One of the lessons is the need for well-developed and resilient financial markets to allow for the pricing of risks and to accommodate large financial flows. This episode also illustrates that a lack of market-determined exchange rate flexibility can encourage excessive unhedged foreign currency borrowing. Hedging raises the cost of foreign borrowing and would have limited excessive exposures. Financial stability Financial stability is the last piece of the puzzle I'll mention. There are some points of concern here. In the aftermath of the global financial crisis, China embarked on a massive expansion of credit to support domestic demand. China's overall debt has grown much faster than the economy, now reaching some 285 per cent of GDP. Around 60 per cent of this is in the non-financial corporate sector, mainly state-owned enterprises. This sector is where a lot of the excess capital and non-performing loans may reside. There are other worries too, such as potential under-reporting of non-performing loans in the banking sector and the strong growth in lending and other financial activity by entities that may be lightly regulated. That is why Chinese authorities are working to strengthen regulation and oversight. For instance, they have improved the transparency of the country's debt, which should make it easier to spot problems before they spiral out of control. Local governments, for example, are now required to borrow by issuing bonds for new projects rather than by using opaque financing vehicles. Moreover, China is a net international creditor--of about US$1.7 trillion--which insulates it, to some extent, from the decisions of international investors. The People's Bank of China has so far been able to manage downward pressures on the renminbi that have come with capital outflows. An estimated US$600 billion left China last year. Some of the capital outflows have been Chinese corporations paying down foreign currency debt, which is a good thing. The People's Bank of China still has around US$3 trillion in reserves. There is concern in markets that, if capital account pressures were to continue, the central bank may have to either lower its target range for the currency or introduce morestringent capital controls. Chinese authorities are focusing on more proactive communications and reforms to foster trust in their financial system. This brings me to my final point. Canada is not immune to the risks that China's transition poses to the global economy. It is nonetheless well positioned to manage them. At the Bank of Canada, we've been thinking through what a shock from China would mean for our economy. Canada would be affected mainly through lower commodity prices and slower trade. Direct financial spillovers would likely be relatively small because our banks have little direct exposure to China. What's more, the US and European banks that our banks do business with have strengthened their balance sheets since the financial crisis. That said, uncertainty about China's prospects has had a surprisingly large effect on investor confidence in recent months, so this could be an important channel. To get a rough idea of how important the trade and commodity price channels could be, our staff conducted simulations using our economic models. They looked at what would be the effect on the Canadian economy if GDP growth in China were 1 percentage point lower than our baseline projection. They found that Canadian GDP would be 0.1 percentage point lower than it would have been otherwise. To give some perspective, if the same shock occurred in the US, the effect on our GDP would be six times greater. The effects of a shock from China would also depend on a number of other factors our models don't capture well, such as what parts of the Chinese economy were growing more slowly and how severely global financial markets were impaired. A significant depreciation of the renminbi, especially if it were sudden, could be disruptive to the global financial system, with implications for Canada. It would also depend on the progress the Canadian economy has made in its own adjustment to the drop in commodity prices that we've seen in the past two years. Canadian financial institutions have the capital and liquidity in place to handle adverse shocks like this. Stress tests conducted by the International Monetary Fund and Canadian authorities in 2013 showed that our banks can withstand a larger shock than even those we saw during the 2008 financial crisis or the recessions of the 1990s and 1980s. Ladies and gentlemen, let me conclude with a quote that dates back two centuries and that is attributed to Napoleon. He is reported to have said about China: << Ici repose un geant endormi, laissez-le dormir, car quand il s'eveillera, il etonnera le monde. >> It means, "Here lies a sleeping giant, let him sleep, for when he wakes, he will shake up the world." This was prescient. China's integration into the world economy has been nothing short of extraordinary. As China's economy continues to mature, its growth is slowing to a more sustainable pace. This is desirable. China has the potential to grow at a healthy pace over the longer run, but the transition will take time and there is uncertainty about whether this potential will be fully achieved. That means China may go through some periods of economic and financial volatility. The Bank of Canada will continue to watch developments in China closely, given its importance to the global economy and Canada. China's transition poses risks, and Canada is well positioned to manage them. At the same time, lower prices for oil and other commodities mean that Canada is going through its own complex adjustment. In March, the Bank of Canada left the policy interest rate unchanged, since the economy was evolving broadly in line with our expectations set out in our . Next week, we will update our projection and take into account all that has happened since January, including the measures announced in the federal budget. And if you're still wondering about the exchange rate and have resisted googling it, the answer is around five renminbi per Canadian dollar.

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canada

Monetary Policy Report Press Conference Opening Statement

poloz

Governor of the Bank of Canada Press conference following the release of the Good morning. Senior Deputy Governor Wilkins and I are happy to be here to answer your questions about today's interest rate announcement and our (MPR). Let me begin as usual with a few remarks about the issues that were most important to the Governing Council's deliberations. I'll start with a reminder of where we were at the time of our last MPR in January. Financial market participants started the year in a very anxious mood. The global growth outlook was being downgraded again, commodity prices were plumbing new lows and we had new intelligence that Canadian energy companies would be cutting investment even more than previously thought. In this context, we said that we entered deliberations with a bias to easing policy further, but first we needed to see the government's fiscal plan. Our new economic projection incorporates that fiscal plan, but let me first talk about three other important changes that we have also taken into account. First, projected global economic growth has once again been taken down a notch for 2016 and 2017. This includes the US economy, where the new profiles for investment and housing mean a mix of demand that is less favourable for Canadian exports. Second, investment intentions in Canada's energy sector have been downgraded even further. True, oil prices have recovered significantly from their extreme lows. But Canadian companies have told us that even if prices remain around current levels, there will be significant further cuts beyond what we foresaw in January. By convention, we incorporate the average oil price from the few weeks before we make our forecast, letting us look through variability in markets. Because of this, our oil price assumptions are only $2 to $3 per barrel higher than in January. Third, the Canadian dollar has also increased from its lows. Our assumption in this projection is US 76 cents, four cents higher than in January. While there are many factors at play, including oil prices, most of the increase appears to be due to shifts in expectations about monetary policy in both the US and Canada. The higher assumed level of the dollar contributes to a lower profile for non-resource exports in our projection, as does lower demand from the US and elsewhere. Governing Council judged that the combination of slower global and US growth, a new round of cuts to investment in Canada's energy sector, and a stronger Canadian dollar would have meant a lower projected growth profile for the Canadian economy than we had in January. I know this sounds contrary to what you have heard lately, because a range of monthly economic indicators have started the year strongly. Some of this strength represents a catch-up after temporary weakness in the fourth quarter, and some of it reflects temporary factors that will unwind in the second quarter. We think it is best to look through that variability, and note that the economy appears to be achieving average growth of close to 2 per cent in the first half of the year, which is encouraging. That brings me to the fourth important item that's changed since January--the recent federal budget. We can't be entirely certain about the full effects of the budget on the economy, as some will depend on how households react over time. But Governing Council judged that the budget actions will more than offset the negatives from the other three changes I just mentioned. The net effect is that our projected growth profile is generally higher than it was in January. When it comes to projecting inflation, we must consider our forecast for economic growth relative to the economy's potential, or capacity. We do a fulsome review of Canada's economic potential at this time each year, and this was an especially important part of the Governing Council's deliberations. That is because, as we highlighted in last October's MPR, it is particularly difficult to measure capacity when an economy is undergoing a structural adjustment, as Canada's is. That translates into increased uncertainty around the size of the output gap and the speed at which it will close, and therefore the point at which the disinflationary pressures we see today will dissipate. Specifically, the collapse in investment in the commodity sector will mean a slowdown in the economy's potential growth rate. In the near term, we've lowered potential output growth from 1.8 per cent to 1.5 per cent. You can find details in a staff analytical note we published today. Later this year, the natural sequence of higher non-resource exports and a tightening of capacity constraints should lead to higher investment and employment in the non-resource economy, and therefore growing capacity. Looking beyond the projection horizon, growth in potential output overall should pick up again. This newly-added capacity may give the economy some additional room for non-inflationary growth beyond what we are assuming today. Today's forecast suggests that the economy will likely use up its excess capacity somewhat earlier than we predicted in January--sometime in the second half of 2017. However, as I said, there is more than the usual degree of uncertainty around that timing. For example, we are taking a conservative approach in assuming that only some of the legacy effects of the past several years--such as reduced labour force participation by young people--will be reversed over the next few years. This would add back to economic potential some of what has been lost. However, we will need to monitor carefully data on investment, labour force re-entry and new firm creation to update this judgment over time. In sum, recent economic data have been encouraging on balance, but also quite variable. The global economy retains the capacity to disappoint further, the complex adjustment to lower terms of trade will restrain Canada's growth over much of our forecast horizon, and households' reactions to the government's fiscal measures will bear close monitoring. We have not yet seen concrete evidence of higher investment and strong firm creation. These are some of the ingredients needed for a return to natural, self-sustaining growth with inflation sustainably on target. In light of all of these considerations, Governing Council agreed that the current level of our policy rate remains appropriate. With that, Carolyn and I are ready to take your questions.

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canada

Opening Statement before the House of Commons Standing Committee on Finance

poloz

Governor of the Bank of Canada Appearance before the House of Commons Wilkins and I are happy to be back to discuss the Bank's (MPR), which we published last week. I extend particular greetings to the new members of this committee, and look forward to being with you twice a year to talk about the Canadian economy and our monetary policy. Carolyn and I were last here about 12 months ago, and it has certainly been a tumultuous year for the Canadian and global economies. Let me start with a quick review. As you know, the Canadian economy has been dealing with a massive shock to our terms of trade, brought about by a sharp drop in the price of oil and other commodities that began in late 2014. Because Canada is such an important producer of resources, particularly oil, this shock was a major setback. It set in motion a difficult adjustment process that has been very disruptive for many Canadians. Investment and output in resource industries have fallen precipitously, the decline in national income has curbed household spending, and the resource sector has seen significant job losses. These negatives have clearly outweighed the benefits of lower energy costs for households and businesses. From a monetary policy perspective, the shock posed a two-sided threat to our economy last year. First, it was a clear downside risk to our ability to reach our inflation target. Second, by cutting into national income, it worsened the vulnerability posed by household imbalances, as seen in our elevated debt-toincome ratio. To address both threats and to help facilitate the necessary economic adjustments, we lowered our policy interest rate twice last year, bringing it to 0.5 per cent. While we recognized the possibility that this reduction could, at the margin, exacerbate the vulnerability posed by household imbalances, the more important effect of lowering the policy rate last year was to cushion the drop in income and employment caused by lower resource prices. Another natural consequence of the shock to our terms of trade has been a decline in the Canadian-dollar exchange rate. It's important to note that this is not unique to Canada. Indeed, many resource-reliant countries have seen similar depreciations in their currencies. Both our policy moves and the lower currency have been helping to facilitate the economic adjustments, which have been playing out over two tracks. While weakness has been concentrated in the resource sector, the non-resource economy continues to grow at a moderate pace. And within that, non-resource exports are clearly gathering momentum. By the time we reached the new year, there was a clear sense of anxiety among many financial market participants. The outlook for global growth was being downgraded again, and commodity prices were plumbing new lows. At the Bank, we had new intelligence that Canadian energy companies would be cutting investment even more than previously thought. In this context, we said that we entered deliberations for our January interest rate decision with a bias to easing policy further, but decided to wait to see details of the government's fiscal plan. Since January, we've seen a number of negative developments. First, projected global economic growth has once again been taken down a notch for 2016 and 2017. This includes the US economy, where the new profiles for investment and housing mean a mix of demand that is less favourable for Canadian exports. Second, investment intentions in Canada's energy sector have been downgraded even further. True, oil prices have recovered significantly from their extreme lows. But Canadian companies have told us that even if prices remain around current levels, there will be significant further cuts beyond what we foresaw in January. By convention, we incorporate the average oil price from the few weeks before we make our forecast, letting us look through variability in markets. Because of this, our oil price assumptions are only $2 to $3 per barrel higher than they were in January. Third, the Canadian dollar has also increased from its lows. Our assumption in our current projection is 76 cents US, four cents higher than in January. While there are many factors at play, including oil prices, most of the increase appears to be due to shifts in expectations about monetary policy in both the United States and Canada. The higher assumed level of the dollar in our projection contributes to a lower profile for non-resource exports, as does lower demand from the United States and elsewhere. As the Bank's Governing Council began its deliberations for this month's interest rate announcement, we saw that these three developments would have meant a lower projected growth profile for the Canadian economy than we had in January. This may sound counterintuitive, given the range of monthly economic indicators that started the year strongly. However, some of this strength represents a catchup after temporary weakness in some areas during the fourth quarter, and some of it reflects temporary factors that will unwind in the second quarter. The other new factor we had to take into account was the federal budget. For the purposes of our MPR and interest rate announcement, we took a close look at the Finance Department's projections of the multiplier effect of the fiscal shock. Our analysis is that the Department's projections are reasonable in that they are within the range of estimates you would find in the economic literature, as well as in our own staff research. There is, of course, greater uncertainty as to how the budget measures will affect growth in the longer term, particularly since they will need to work their way through the household sector. In our report, we outlined the risk that households may be more inclined to save than historical experience would suggest. Taking all of these changes on board, our projected growth profile is generally higher than it was in January. We are now projecting real GDP growth of 1.7 per cent this year, 2.3 per cent next year and 2 per cent in 2018. Our forecast suggests that the economy will likely use up its excess capacity somewhat earlier than we predicted in January--sometime in the second half of 2017. However, there is more than the usual degree of uncertainty around that timing. It is always tricky to estimate an economy's potential output, and the difficulty is compounded when the economy is going through a major structural adjustment, as Canada is right now. We know that the collapse in investment in the commodity sector will mean a slowdown in the economy's potential growth rate. In the near term, we've lowered our estimate of potential output growth from 1.8 per cent to 1.5 per cent. In terms of the Bank's primary mandate, total CPI inflation is currently below our 2 per cent target. The upward pressure on imported prices coming from the currency depreciation is being more than offset by the impact of lower consumer energy prices and the downward pressure coming from excess capacity in the economy. As these factors diminish, total inflation is projected to converge with core inflation and be sustainably on target sometime in the second half of next year. To sum up where we are, while recent economic data have been encouraging on balance, they've also been quite variable. The global economy retains the capacity to disappoint further, the complex adjustment to lower terms of trade will restrain Canada's growth over much of our forecast horizon, and households' reactions to the government's fiscal measures will bear close monitoring. We have not yet seen concrete evidence of higher investment and strong firm creation. These are some of the ingredients needed for a return to natural, selfsustaining growth with inflation sustainably on target. With that Mr. Chairman, Carolyn and I would be happy to answer questions.

r160420a_BOC

canada

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

poloz

Governor of the Bank of Canada Wilkins and I are happy to be back to discuss the Bank's (MPR), which we published last week. It has been 18 months since Carolyn and I were last here. And it was about that time, in the fall of 2014, when the Canadian economy first started to feel the effects of a massive shock to our terms of trade, brought about by a sharp drop in the price of oil and other commodities. Because Canada is such an important producer of resources, particularly oil, this shock was a major setback. It set in motion a difficult adjustment process that has been very disruptive for many Canadians. Investment and output in resource industries have fallen precipitously, the decline in national income has curbed household spending and the resource sector has seen significant job losses. These negatives have clearly outweighed the benefits of lower energy costs for households and businesses. From a monetary policy perspective, the shock posed a two-sided threat to our economy last year. First, it was a clear downside risk to our ability to reach our inflation target. Second, by cutting into national income, it worsened the vulnerability posed by household imbalances as seen in our elevated debt-toincome ratio. To address both threats and to help facilitate the necessary economic adjustments, we lowered our policy interest rate twice last year, bringing it to 0.5 per cent. While we recognized the possibility that this reduction could, at the margin, exacerbate the vulnerability posed by household imbalances, the more important effect of lowering the policy rate last year was to cushion the drop in income and employment caused by lower resource prices. Another natural consequence of the shock to our terms of trade has been a decline in the Canadian-dollar exchange rate. It's important to note that this is not unique to Canada. Indeed, many resource-reliant countries have seen similar depreciations in their currencies. Both our policy moves and the lower currency have been helping to facilitate the economic adjustments, which have been playing out over two tracks. While weakness has been concentrated in the resource sector, the non-resource economy continues to grow at a moderate pace. And within that, non-resource exports are clearly gathering momentum. By the time we reached the new year, there was a clear sense of anxiety among many financial market participants. The outlook for global growth was being downgraded again, and commodity prices were plumbing new lows. At the Bank, we had new intelligence that Canadian energy companies would be cutting investment even more than previously thought. In this context, we said that we entered deliberations for our January interest rate decision with a bias to easing policy further, but decided to wait to see details of the government's fiscal plan. Since January, we've seen a number of negative developments. First, projected global economic growth has once again been taken down a notch for 2016 and 2017. This includes the US economy, where the new profiles for investment and housing mean a mix of demand that is less favourable for Canadian exports. Second, investment intentions in Canada's energy sector have been downgraded even further. True, oil prices have recovered significantly from their extreme lows. But Canadian companies have told us that even if prices remain around current levels, there will be significant further cuts beyond what we foresaw in January. By convention, we incorporate the average oil price from the few weeks before we make our forecast, letting us look through variability in markets. Because of this, our oil price assumptions are only $2 to $3 per barrel higher than they were in January. Third, the Canadian dollar has also increased from its lows. Our assumption in our current projection is 76 cents US, four cents higher than in January. While there are many factors at play, including oil prices, most of the increase appears to be due to shifts in expectations about monetary policy in both the United States and Canada. The higher assumed level of the dollar in our projection contributes to a lower profile for non-resource exports, as does lower demand from the United States and elsewhere. As the Bank's Governing Council began its deliberations for this month's interest rate announcement, we saw that these three developments would have meant a lower projected growth profile for the Canadian economy than we had in January. This may sound counterintuitive, given the range of monthly economic indicators that started the year strongly. However, some of this strength represents a catchup after temporary weakness in some areas during the fourth quarter, and some of it reflects temporary factors that will unwind in the second quarter. The other new factor we had to take into account was the federal budget. For the purposes of our MPR and interest rate announcement, we took a close look at the Finance Department's projections of the multiplier effect of the fiscal shock. Our analysis is that the Department's projections are reasonable in that they are within the range of estimates you would find in the economic literature, as well as in our own staff research. There is, of course, greater uncertainty as to how the budget measures will affect growth in the longer term, particularly since they will need to work their way through the household sector. In our report, we outlined the risk that households may be more inclined to save than historical experience would suggest. Taking all of these changes on board, our projected growth profile is generally higher than it was in January. We are now projecting real GDP growth of 1.7 per cent this year, 2.3 per cent next year and 2 per cent in 2018. Our forecast suggests that the economy will likely use up its excess capacity somewhat earlier than we predicted in January--sometime in the second half of 2017. However, there is more than the usual degree of uncertainty around that timing. It is always tricky to estimate an economy's potential output, and the difficulty is compounded when the economy is going through a major structural adjustment, as Canada is right now. We know that the collapse in investment in the commodity sector will mean a slowdown in the economy's potential growth rate. In the near term, we've lowered our estimate of potential output growth from 1.8 per cent to 1.5 per cent. In terms of the Bank's primary mandate, total CPI inflation is currently below our 2 per cent target. The upward pressure on imported prices coming from the currency depreciation is being more than offset by the impact of lower consumer energy prices and the downward pressure coming from excess capacity in the economy. As these factors diminish, total inflation is projected to converge with core inflation and be sustainably on target sometime in the second half of next year. To sum up where we are, while recent economic data have been encouraging on balance, they've also been quite variable. The global economy retains the capacity to disappoint further, the complex adjustment to lower terms of trade will restrain Canada's growth over much of our forecast horizon, and households' reactions to the government's fiscal measures will bear close monitoring. We have not yet seen concrete evidence of higher investment and strong firm creation. These are some of the ingredients needed for a return to natural, selfsustaining growth with inflation sustainably on target. With that Mr. Chairman, Carolyn and I would be happy to answer questions.

r160426a_BOC

canada

A New Balance Point: Global Trade, Productivity and Economic Growth

poloz

Governor of the Bank of Canada The year 2016 got off to a rough start, with plenty of financial market volatility. Of course, there is no shortage of fundamental issues to worry about: another downgrade to the outlook for global growth, uncertainty about the economic transition in China, the pace of normalization in the United States, worries about Europe, worries about Japan, just to cite a few. Financial markets have a love-hate relationship with volatility, and central bankers usually try to see through it all. But one worry I hear a lot these days hits pretty close to home--the idea that monetary policy just isn't working anymore. That's one myth I'd like to dispel right off the top. The fact is that policy actions--both monetary and fiscal--taken in the wake of the global financial crisis prevented what would have been a second Great Depression. But many of the negative forces that were acting then are still acting now. That's why ultra-low interest rates are not causing rapid growth and inflation. If you think monetary policy is not working, ask yourself what would happen if interest rates suddenly returned to 3 or 4 per cent. Most would agree that such a move would trigger a recession. This is just another way of saying that severe headwinds are still acting on our economies, years after the crisis, and low interest rates are keeping them at bay. It's a bit like riding a bicycle up a steep hill. Your progress may be slow, but that doesn't mean your legs aren't working hard or that your bicycle is broken. Monetary medicine hasn't cured everything, but it is working, and it has surely saved us from the worst. Still, as central bankers, we need to take market anxiety, and the volatility it creates, seriously, regardless of the source. Although volatility can go both ways, "market volatility" is usually code for "market declines," which can erode consumer and business confidence and cause a weakening in economic fundamentals. So, what I would like to do today is address another current source of anxiety in financial markets--the striking weakness of international trade. After all, international trade is the lifeblood of the global economy. Firms, consumers and investors alike all rely on it to keep the economy growing, create and sustain jobs and deliver investment returns. The exchange of goods and services has been happening as long as people have been able to produce more than they needed to survive, leaving them free to follow other pursuits. Expanding exchange into the international arena is the next logical step, and that is exactly how global history has unfolded. Trade is a grand facilitator that permits people and firms to specialize and innovate. The resulting improvement in living standards continues until trade reaches a balance point in the economy where all advantages have been exploited. That balance holds until circumstances change and people react to new opportunities. Given the central importance of trade, it's not surprising that investors are worried about what the data show. For roughly 20 years before the financial crisis, global trade had been expanding by more than 7 per cent a year--about twice as fast as the world economy. Trade collapsed in the wake of the crisis, but rebounded sharply in 2010. Since then, though, trade growth has again slowed dramatically, trailing even the tepid pace of global GDP growth. What is behind this slump in trade? Has the link between trade and economic growth changed? Is the trade slowdown a warning of another global recession? And, if trade is central to the productivity and efficiency of companies, what does the slowdown in trade mean for productivity growth? I hope to shed some light on these issues today, and help everyone better understand the forces that are at work. Let's dig into the data a little. The post-crisis slump in international trade was initially concentrated among advanced economies, particularly in Europe. More recently, the trade slowdown has been centred in the emerging markets of Asia, including China. This has led many investors to link weak trade to the slowdown in China, and therefore in the global economy. Recent work at the Bank of Canada and elsewhere shows that about half of the slowdown in trade growth among advanced economies in the post-crisis period can be explained by weak economic activity, especially sluggish business investment. Throughout this period, companies have been dealing with high levels of uncertainty about the prospects for the global economy, in some cases because of aggressive deleveraging. This has held back investment and, in turn, contributed to soft trade. Investment spending involves capital equipment, with inputs from many countries, and therefore is very trade-intensive. So when economic growth slows because of weak investment, trade slows disproportionately. While advanced economies were dealing with the worst of the crisis, China's economy continued to expand. This supported demand for commodities, thereby keeping a portion of international trade flows moving. Higher prices for commodities also prompted commodity producers to make big investments and ramp up supply. Ultimately, though, growth in China began to moderate to a more sustainable pace. More importantly, the Chinese economy has begun to shift away from investment-driven growth toward consumption, especially of services. Quite simply, this has meant less international trade. Even so, China's imports of many commodities continue to grow at double-digit rates. So, we have reason to expect global trade to grow more slowly than in the past: first, because global investment spending is in a lull, and second, because China's economy is restructuring toward more domestic consumption and less trade. We can certainly expect global trade to pick up when the world economy gets back onto a self-sustaining growth track, with stronger business investment. Still, as I just noted, cyclical factors can explain only about half of the trade slowdown, so we have more explaining to do. Indeed, I think we need to step back and consider the possibility that the rapid pace of trade growth that prevailed for the two decades before the crisis was the exception, and not the rule. Why would I say that? What we saw during the 1990s and 2000s was the result of the natural incentive to use trade to increase specialization, in reaction to reduced trade barriers and major advances in communication and transportation technology. During those years, countries formed regional trading blocs through arrangements such as the North American Free Trade Agreement and the European Union. Previously closed economies, such as China, became more This combination of elements gave the natural incentive to trade a great deal more room to grow. It paved the way for companies to build global supply chains--the "integrative trade model." A factory that made a product no longer needed to be next door to the product's designers. Firms could now exploit their comparative advantage by specializing, not just in one particular good or service, but in one part of a good or service. The result was an explosion of specialization as markets became global and companies became more efficient. As the Peterson Institute for International Economics put it in its recent persuasive report , "trade boomed during the 1990s and early 2000s in part because intermediate goods began However, any trend that goes on for 15 or 20 years becomes ingrained in our expectations. We should have realized all along that this process of integration simply could not continue at the same pace forever. At some point, trade would reach a new balance point in the global economy where firms had built optimal supply chains that crossed international borders, slowing the integration process, at least for the present. Yes, there are other structural reasons you can point to for the deceleration in global trade. A troubling number of protectionist measures have been put in place since the crisis, for example. But I believe that the most important structural factor behind the slowdown in trade growth is that the big opportunities for increased international integration have been largely exploited. China can join the WTO only once. That's not to say that further integration waves won't happen--I certainly hope they will. But if global trade has reached a new balance point, we should not fret that global export growth hasn't recovered to pre-crisis levels. Even so, we need to think about what this assessment of the state of global trade means for productivity. Productivity matters to all of us because its growth, along with the growth of labour, determines the potential growth rate of an economy. We already know that demographic forces are leading to slower labour input growth in most advanced economies. Productivity growth is also slowing. This combination points to lower global economic growth in the future. And there's more. The most important input into the equilibrium real rate of interest--what economists refer to as "the neutral rate"--is the underlying growth in economic potential. Investors are only beginning to come to grips with the implications of this downward drift in the neutral rate of interest and what it means for long-term investment returns. Obviously, it matters a great deal whether productivity growth is likely to remain low or recover as the world economy gains traction, and that depends on how you explain slowing productivity growth. Some have said that productivity growth is slow today because most of the truly important inventions happened years ago, and today's technological progress is more incremental. But I think a more natural place to look is at international trade, because companies that use trade to increase specialization also increase their productivity. And if that process has reached a natural limit, at least for now, then perhaps that also limits future productivity gains. A quick comparison of experiences in the United States and Canada illustrates my point. Let's look at US and Canadian manufacturing over the past 60 years. In 1955, roughly one-third of the workforce in both countries was employed in manufacturing. As has been well documented, these shares have been declining, as they have in all advanced economies, as companies built global supply chains and shifted activities to places that can produce the same goods at a lower cost. Last year, the share of the workforce involved in manufacturing was below 10 per cent in both countries, with the US figure a bit lower than the Canadian. Of course, today's factories are much more productive than those in 1955. US manufacturing is almost seven times more productive than it was 60 years ago, while Canadian factories are roughly five times more productive. Those are both big numbers, but what can explain the difference? The relative size of our economies may be one factor, since there are clearly more opportunities for economies of scale and scope in the larger US economy. But also consider this: over the same 60-year period, the importance of international trade to the US economy more than tripled, while the importance of trade for Canada only doubled. Here, I am measuring the importance of trade by looking at total trade--exports plus imports--as a share of GDP. One explanation for this difference is that Canada has always been dependent on trade. We were founded on a resource-export model, and since trade started out being very important, there is less room for its importance to grow. But, in my opinion, the basic insight here is that US companies pursued globalization and offshoring more than Canadian companies did, boosting the importance of trade to the US economy more than was done in Canada. When a company procures one slice of its value chain offshore, it does so to reduce costs. The result is that the average productivity of the domestic operation goes up. This isn't a productivity miracle; it's simply arithmetic. US firms are more likely to be larger than Canadian firms. That means they tend to have more outsourcing opportunities. Smaller Canadian firms are more likely to be part of the global supply chain of a multinational firm and have fewer opportunities to build an integrative-trade supply chain. And, of course, if you are in a resource-extraction business, there may be few opportunities to outsource. Ultimately, the integrative trade model is a powerful force for advancing living standards. We can see evidence of it in action everywhere. Most of us have examples in the mobile phones we are carrying in our pockets right now. It's true, of course, that the globalization of supply chains has required economic adjustments. These adjustments can be painful for individuals, and it is incumbent on policy-makers to help buffer the transition by ensuring adequate safety nets for workers and facilitating retraining and relocation. But the benefits of integrative trade shouldn't be ignored. It has meant increasing incomes for economies. It has made many products much more widely accessible to more people. And it has meant continued job growth at home. My argument is that a significant part of the strong productivity performance in the two decades before the crisis was due to globalization, and that the globalization process may have brought trade in the global economy to a new balancing point. Understanding this is one thing; the question is what can be done about it. I see at least three reasons to hope for future progress. The first is that a lot of productivity growth comes not from existing firms, who tend to be incremental about it, but from new firms. A new firm with a new product or service tends to see giant leaps in productivity as it goes from being a start-up to the "hockey stick" growth phase. A firm only makes that transition once, but an economy can reap the benefit over and over if there is a strong trend in new firm creation. An expanding economy generally sees a pretty steady growth in the population of companies. Under the surface, there is a steady rate of firm exit too. This is Schumpeter's process of creative destruction. So let me just point out that the growth of the population of companies slowed dramatically in a number of countries in the wake of the global financial crisis. I've been watching the Canadian and US data closely, because I'd interpret the emergence of firm creation as a strong sign that growth had become selfsustaining. In the Canadian data, firm population growth has picked up but remains slow, at around 1 per cent annually, well below pre-crisis rates. But in the United States, there has been a steady acceleration of firm population growth since 2011. The most recent figures are approaching 3 per cent annual growth, which is back to pre-crisis levels. If I am right, the US economy is due for another period of better productivity growth, and I have every reason to think that Canada will follow once we work through our adjustment to lower resource prices. A reversal of the cyclical slowdown in investment I mentioned earlier would also serve to support future productivity growth. A second reason for optimism about productivity is that even if most major economies have exploited most available opportunities for integration, gains may still be had from improvements to existing supply chains. Economies evolve over time, and comparative advantages are not set in stone. Consider China, which for years was the main destination for outsourced production. Today, its working-age population is shrinking. Unit labour costs have been rising quickly as the economy moves up the value chain. Now, we're seeing signs that labour-intensive production is shifting out of China and into nearby economies, such as Cambodia and Vietnam. All of this suggests that companies and investors may be able to find ways to improve the efficiency of supply chains in many geographic areas. This will show up as a new wave of integration and global trade growth. For policy-makers, of course, this means we should be working to help initiatives such as the TransPacific Partnership and the Comprehensive Economic and Trade Agreement between Canada and the European Union become a reality. Third, nobody can predict the future disruptive technologies that would allow the global economy to take its next giant step forward. History gives us no reason to be pessimistic with respect to future technological progress. Before I wrap up, let me make one more point. International trade, as measured by our standard global trade statistics, is not the only way for companies to exploit integration opportunities. Some companies find it more sensible to operate foreign affiliates in other countries while managing them from home. For some firms, this model effectively acts as a substitute for international trade. And this business model has been growing, even while traditional exports and imports have been slowing. We know that sales by Canadian-owned foreign affiliates now exceed total exports from Canada, approaching 30 per cent of GDP. In other words, these foreign affiliates are almost like another Canadian economy out there, supporting jobs in Canada in areas such as research and development, engineering, design and marketing, not to mention lawyers, accountants, and executives who manage the operation from home. In the United States, foreign affiliates are even more important, with sales equalling more than 40 per cent of GDP. This is a very real sign that companies are growing, becoming more productive and creating jobs at home, whatever the official trade data show. It's time to conclude. In a world full of anxiety, my goal today was to give investors one less thing to worry about. Most of the cyclical part of the slowdown in trade should be reversed as the global economy recovers, even if that is a slow process. Furthermore, there are opportunities for progress on the structural side in terms of both trade and productivity if conditions permit another wave of global integration. Moreover, the creation of brand-new firms could be the most promising source of new trade and productivity growth. I hope I've convinced you that the global economy can continue to recover, even if global trade growth remains lower than its pre-crisis levels. The weakness in trade we've seen is not a warning of an impending recession. Rather, I see it as a sign that trade has reached a new balance point in the global economy--and one that we have the ability to nudge forward. As for monetary policy, the Bank of Canada will continue to work on building a positive economic environment for investors, firms and consumers. We know that sound, clearly communicated monetary policy can facilitate trade, productivity and growth. And that's good for everybody.

r160506a_BOC

canada

Stress Prevention: Central Banks and Financial Stability

schembri

For the better part of the past two centuries, central banks have played an important role in the maintenance of financial stability, but primarily one of "stress or crisis management." In particular, central banks have served as lender of last resort, providing liquidity to prevent stress from sparking contagion in solvent, but illiquid, financial institutions. But that role is starting to change. While central banks responded boldly to the global financial crisis with liquidity provision and monetary policy actions to avoid a repeat of the Great Depression, the severity of the economic fallout obliges us to ask whether they could have done more to prevent it, rather than just trying to manage and mitigate its economic impact. This query goes well beyond considering whether monetary policy aggravated the financial vulnerabilities that contributed to the crisis and raises broader questions concerning the responsibilities of central banks. It's time, then, for central banks to rethink their role in financial stability: first, by recognizing that while the best contribution monetary policy can make to financial stability is price and macroeconomic stability, this is a necessary, but not sufficient, condition for financial stability; second, by focusing on crisis prevention through means other than monetary policy, while at the same time modernizing their role as liquidity provider or lender of last resort; and third, by enhancing their contribution to financial stability by exploiting two of their key strengths--their financial-system-wide perspective and their analytical capacity. In thinking about enhancing the role of central banks, we should reconsider two notions that have helped to advance our analysis. The first is the "lean versus clean" debate. As Lars Svensson has compellingly argued, monetary policy is too blunt an instrument to be used to mitigate financial vulnerabilities. Other tools are better suited for this purpose. The second notion is the "lines of defence" analogy, with monetary policy serving as the last defensive barrier when other measures to reduce financial vulnerabilities and mitigate systemic risks are either absent or inadequate. This view suggests that actions be taken sequentially . Consider, instead, how we promote road safety and prevent car accidents, which require the simultaneous application of standards for driver education and competence; automobile operations and safety; and road quality and appropriate signage. A similar tri-fold approach for financial stability would entail clear objectives accompanied by the necessary powers and instruments for financial education and information for consumers, lenders and investors; microprudential regulation and supervision; and macroprudential monitoring and regulation. So how can central banks broaden their contribution to financial stability? By promoting financial stability through the following measures: First, by encouraging prudence on the part of borrowers and lenders. Most central banks publish or contribute to financial system reviews or financial stability reports. Such reviews or reports monitor and assess financial vulnerabilities and risks and serve as an early warning mechanism. In addition, the underlying analysis in them provides a basis for recommendations for preemptive policy actions. These publications are thus an important means for central banks to contribute to financial stability. For example, the Bank of Canada has used its to inform households and lending institutions of our assessment of the vulnerability associated with elevated household debt in an effort to encourage all parties to exercise appropriate caution. Second, by enhancing market discipline through increased transparency. By making their analyses and assessments public, central banks can increase awareness of financial system vulnerabilities, risks and their potential triggers so that investors and other market participants can appropriately price and manage risk. Third, by strengthening regulation and supervision of the financial sector. Since the crisis, the regulatory and supervisory framework for financial systems has been strengthened, and more rigorous global standards have been implemented in many jurisdictions. Central banks contributed to the development of these standards through their involvement in international forums such as the Financial Stability Board and other standard-setting bodies. An important example is the Basel III regulatory reforms, which require banks to hold more and higher-quality capital and meet new liquidity and leverage requirements and have thus made the banking system more resilient. While some central banks, including the Bank of Canada, are not directly involved in overseeing the implementation of these new standards, they can help evaluate their effectiveness. By working with regulators to implement coherent macro stress tests on the banking system they can jointly assess the ability of the banking system to withstand severe macroeconomic shocks. These tests would incorporate existing vulnerabilities. Their main goal is to encourage the institutions themselves, as well as the supervisory bodies, to take remedial measures to increase resilience, as necessary. In addition, given their system-wide perspective, central banks can monitor and evaluate unintended consequences of regulatory standards on the financial system and real economy, especially with respect to market functioning and the availability of credit. Fourth, by contributing to the monitoring of systemic risk and the development of macroprudential measures. As noted, most central banks do in-depth analyses of financial vulnerabilities. They also often investigate possible remedial measures to mitigate the vulnerabilities and they share their work with other agencies responsible for macroprudential oversight. The mechanisms for doing this differ according to the macropudential policy framework in each jurisdiction. Valuable aspects of the analyses by central banks include monitoring for the impacts of financial innovation and possible instances of risky regulatory arbitrage, as well as the identification of data gaps. Again, because of a central bank's system-wide perspective and analytical capacity these contributions are essential for the formulation of appropriate macroprudential policy. Such policy initiatives come in all sizes, but let me give you an example of what we did here in Canada. In the immediate aftermath of the crisis, household debt and house prices resumed growing faster than disposable income in response to lower interest rates and the recovering economy. The Department of Finance and a number of agencies, including the Bank of Canada, worked together to mitigate this growing systemic vulnerability. The Bank's analysis of household debt and house prices helped inform the regulatory changes that were adopted. The federal government tightened rules for government-supported mortgage insurance, including increasing minimum down payments. For its part, Canada's bank regulator, the Office of the Superintendent of Financial Institutions, released new guidance on mortgage underwriting and mortgage insurance that implemented enhanced global standards. These measures were successful in slowing household credit growth and they complemented the Bank of Canada's accommodative monetary policy by better targeting the stimulus to the most creditworthy households. To further enhance our contribution to macroprudential oversight in Canada, we have two aspirations: 1. To develop a framework for system-wide macro-level stress tests that integrates different sectors of the financial system--banking, insurance and investment funds--as well as financial markets and financial infrastructures. 2. To improve our models to better understand the interactions between monetary and macroprudential policy. Let me summarize and conclude. The public often sees central banks as responsible for financial stability, but, in practice, this is a mandate the banks rightly share with the government and other financial regulators and supervisors. So although central banks don't themselves have a broad set of instruments to mitigate financial vulnerabilities, they do have that system-wide view, which they can and do use to promote financial stability by making public their analyses of financial vulnerabilities and risks and making recommendations for preventive policy actions. In the end, how central banks contribute to financial stability, in conjunction with other public authorities, will depend on the macroprudential framework in place. What we have learned from the participants at this conference is that the framework varies across jurisdictions, typically reflecting differences in institutional settings, and that the different structures seem to be working well. Thus, the important take-away from this evidence is that the framework's form matters less than its function and that the measure of success should be macroprudential outcomes, namely lower systemic risk and fewer instances of severe financial stress. At the same time that central banks are enhancing their efforts to promote financial stability, they must maintain their focus on monetary policy to achieve price and macroeconomic stability. These are necessary conditions for financial stability. On behalf of my colleagues here at the Bank of Canada, thank you for joining us and for sharing your views on this important issue.

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Doug Purvis was a friend of mine. I did my undergraduate degree in economics at Queen's University from 1974 to 1978 and, in my fourth year, was lucky enough to be invited to take Doug's graduate macro course. Doug was 30 at the time, only six years my senior, and already he had serious stature. For some reason, he took an interest in me, in my undergraduate thesis and my plans for graduate school, and we stayed in touch after I started work at the Bank of Canada in 1981. Needless to say, I admired him greatly and was crushed when he passed away in 1993. Therefore, it is truly an honour for me to be asked to deliver the Doug Purvis Memorial Lecture today. It is a unique opportunity to pay homage to someone special and, hopefully, to offer you a new insight at the same time. As I began to think about what I might discuss today, I found myself remembering an important talk--the Harold Innis Lecture--that Doug gave at the meetings of the Canadian effective tool for economic stabilization, but he drew us to a very important caveat--that stimulative fiscal policy meant government borrowing, and the accumulation of debt through that channel would one day have important side effects not captured in most macroeconomic models at the time. As Doug showed, these cumulative debt dynamics would, in time, have both domestic and international consequences. Those important side effects would manifest themselves in the medium term. Many of familiar quote, "the medium is the message," penned back in 1964 by the Canadian philosopher Marshall McLuhan, who may have been the most famous student of Harold Innis. This was typical of Doug--always clever with words, but in a way that connected with a very broad audience. My hope today is to do something similar in Doug's memory, leveraging his work and that of many others who followed. Back in 1985, Doug walked us through a series of theoretical models, mostly extensions of the Mundell-Fleming model with debt-stock effects captured; today, I will explore the same issues using a state-of-the-art policy model to simulate instructive counterfactuals during key episodes of Canadian economic history. Of course, I now find myself actually in the job I was dreaming of while sitting in Doug's macro class 38 years ago. I'm quite sure Doug would never have forecast that. In fact, he was rather hoping I would land in academia. But as a central banker, it would be unusual for me to give a lecture on fiscal policy per se. In fact, what I will do is focus on the implications of alternative mixes of monetary policy and fiscal policy for public sector and private sector debt, and for financial stability. The concept of a monetary/fiscal policy "mix" is itself not all that precise. For one thing, measuring a shift in policy stance requires a definition of what is neutral, which is particularly uncertain in the case of monetary policy. Further, while the change in nominal interest rates is the most reasonable proxy for the change in the stance of monetary policy, as is the change in the fiscal balance for fiscal policy, both variables are highly endogenous to the rest of the economy. For example, a government may set out a balanced fiscal policy ex ante, but because of an unexpected weakening in the economy, the fiscal balance turns negative, which would be interpreted ex post as an expansionary fiscal policy when this was never the intention. In this sense, the mix of monetary and fiscal policy ex post is only partly a matter of plan or prior choice. In what follows, therefore, I use the term "policy mix" with the understanding that it is not truly a control variable, although of course it is possible for the monetary and fiscal authorities to exercise some degree of coordination of the policy mix ex ante, even if all they do is make clear what each is intending to do. Meanwhile, financial stability issues have become top of mind since the global financial crisis of 2007-08 as persistently low interest rates have been blamed for various financial imbalances, including rising household debt and hot housing markets. Indeed, the experience is spawning a new literature on how best to incorporate financial stability risks into monetary policy decision making (e.g., Poloz 2014). I will argue--and illustrate with concrete examples-- that the issues of financial stability and the monetary/fiscal policy mix are intimately related. I will begin by reminding you of some important policy history and then bring us to the present day, where I think the issues Doug loved to debate remain highly relevant. To fix ideas, it is worth spending a few moments describing the policy setting in which Doug found himself in the mid-1980s. In fact, it is better to start the narrative a bit earlier. When I was Doug's student in 1977, inflation was perceived as the paramount macroeconomic problem since it was fluctuating in the 8 to 12 per cent range ( deployed targets for the growth of the money supply as a means of reducing inflation over time. Experiments with wage and price controls had not delivered much. By 1980, breaking the inflation trend would take hikes in interest rates to around 20 per cent--first by the Chairman of the US Federal Reserve at the time, Paul Volcker, and followed by then Bank of Canada Governor Gerald Bouey. After a severe recession in 1981-82, inflation fell to the 4-5 per cent range and remained there for the next decade or so. Real interest rates stayed elevated Given this array of developments, fiscal deficits ballooned in the run-up to Doug's Innis ). The 1970s had witnessed persistent fiscal deficits of 2 to 5 per cent of GDP, but the deficit expanded during the 1981-82 recession and continued to widen even as the recovery gained traction, hitting 8 per cent of GDP in 1984. Doug's message was that the implications of those deficits for debt accumulation would someday matter. As it happens, deficits began to shrink in 1985, but it would take a full 10 years for budget balance to be achieved. As a consequence, the stock of fiscal debt continued to build over that period ( ). The macroeconomic situation was made even more difficult by a significant decline in Canada's terms of trade (the ratio of export prices to import prices) during the 1984-87 period, driven mainly by a significant drop in global oil prices ( ), which made the process of fiscal consolidation doubly challenging. As the fiscal debt ratio rose through the mid-1980s and early 1990s, consternation in global financial markets also grew. In 1994-95, federal debt as a share of GDP reached a peak of 67 per cent. Today, such a government debt ratio sounds high but certainly not catastrophic. Importantly, though, real interest rates were much higher in the mid-1990s, making the relative burden of servicing debt much greater than it is at today's rates. In any case, markets came to look negatively on Canadian sovereign debt, even describing the weakening Canadian dollar as Both monetary and fiscal policy-makers responded to this souring of investor sentiment with renewed urgency. The Bank of Canada had committed to inflation targets in 1991, and interest rates had been on a declining path, along with inflation. However, interest rates increased again during 1994-95, despite a slow economy caused in part by weak oil prices; to some extent, interest rates rose because markets perceived that the associated exchange rate depreciation would loop back into inflation pressures, forcing the Bank to tighten policy eventually. With the benefit of hindsight, it is likely that this market dynamic reflected the fact that domestic inflation expectations had not yet become anchored by the Bank's new inflationtargeting policy, which in turn made it difficult to keep one-time relative price effects on inflation distinct from the underlying trend in inflation. This is in sharp contrast to our most recent experience, where well-anchored inflation expectations have enabled the Bank to "look through" the temporary increase in inflation caused by a weaker currency and actually cut interest rates to cushion the blow to the economy from falling oil prices. Meanwhile, fiscal policy was tightened sufficiently to generate a surplus, and fiscal debt as a share of GDP began a long decline that would be interrupted only by the global financial crisis and the ensuing global recession. As a consequence, federal government debt as a share of GDP is around half what it was at its peak in the mid-1990s. Accordingly, at the risk of oversimplification, we can characterize the history of Canada's monetary/fiscal policy mix as follows. When Doug was preparing his Innis Lecture, we had tight monetary policy and easy fiscal policy. Over the following 10 years, fiscal policy gradually tightened, and monetary policy took this trend into account while pursuing its inflation targets. Then, from the late-1990s until the global financial crisis, fiscal surpluses were generally the norm, and monetary policy remained focused on keeping inflation close to target. In the aftermath of the global financial crisis, of course, the G20 countries undertook a coordinated fiscal easing, with many easing monetary policy as well. Starting in 2010, however, with the worst effects of the crisis behind us, Canada's fiscal policy gradually moved back into consolidation mode. Even so, the legacy effects of the financial crisis have lingered in many countries, and Canada's export recovery has been halting at best. Accordingly, monetary policy has remained very easy in order to keep inflation near its target. Thus, in broad strokes, over 30 years, Canada's policy mix moved from tight monetary/easy fiscal to neutral/neutral and then to easy monetary/tight fiscal, until the fiscal adjustments made in 2016, just at the time of writing. This quick historical sketch raises some obvious questions about the mix of monetary and fiscal policies and the consequences for debt dynamics, for both governments and the private sector. Intuitively, a tight monetary/easy fiscal policy mix means a relatively slow accumulation of private sector debt and relatively rapid accumulation of fiscal debt; an easy monetary/tight fiscal policy mix would deliver the opposite dynamic. Either dynamic can eventually give rise to financial stability risks, as was the case for rising government debt in the mid-1990s and for rising household imbalances over the past few years. In the following sections, we explore these linkages in greater depth. Economic Model) to investigate the significance of the policy mix for some key macroeconomic episodes. model that reflects the consensus view of the key macroeconomic linkages in the Canadian stock-flow dynamics for both government debt and household wealth (and therefore debt) that so preoccupied Doug Purvis. ToTEM represents some 30 years of research effort, beginning (not coincidentally) at about the same time that Doug began to work on these issues. ToTEM is essentially the mid-1980s. SAM incorporated for the first time fully articulated household and government debt dynamics, endogenous potential output and model-consistent (i.e., rational) inflation expectations. SAM was later made quarterly and elaborated in a number of respects to produce Bank's projection model from the mid-1990s until the mid-2000s. As its name suggests, ToTEM is the first model of its kind to have a fully developed commodity sector that captures economic and financial interactions with the terms of trade. This investment in modelling more than paid for itself in 2015, when the Bank was able to reach an early understanding of the plunge in global oil prices that took place in late 2014 and early 2015. I have no doubt that Doug would have enjoyed using ToTEM to explore the issue of the monetary/fiscal policy mix in Canada. Although his preference was to gain his insights from tractable theoretical models, the literature has progressed with more elaborate models mainly by going numerical. In what follows, we seek insights by examining alternative scenarios in known macroeconomic episodes constructed using ToTEM. As discussed above, Doug expressed considerable concern in 1985 about the medium-term debt implications of fiscal policies in place at the time. Although budget deficits began a slow decline around that time, these efforts really became aggressive after the emergence of international financial market pressures in 1994-95. As noted earlier, the headwind of declining oil prices posed a significant challenge for fiscal policy during the 1980s. Accordingly, in our first counterfactual, we ask what the implications for the economy might have been had Doug's warning been heeded immediately, with the federal deficit brought into balance over the five years from 1985 to 1990, about five years earlier than when it actually occurred. The historical and counterfactual budget deficits are shown in , along with a number of other simulation results. In this ToTEM simulation, monetary policy is modelled using a reaction function estimated on historical data that aims to keep inflation and therefore aggregate demand (or real GDP) close to their actual historical paths. Since neither fiscal nor monetary policy is modelled as truly optimal, we are abstracting from the possibility that different policies might have offered a different, potentially superior, set of macroeconomic outcomes. We are also abstracting from a key monetary policy issue at the time, namely, the lack of a well-defined policy target, as inflation targets were not formally introduced until 1991. ToTEM is built on a credible inflation target and a mixture of rules of thumb and rational expectations. Despite these caveats, the simulation is instructive. The shock we analyze is a series of cuts to government spending beginning in 1985 that brings the federal budget into balance by 1990 and holds it there. Notice that, given the importance of debt servicing to federal spending at the time, this would have meant a significant surplus of 4 to 5 per cent of GDP measured in primary terms (i.e., net of interest payments). Obviously, since we are basing our counterfactuals on actual history, starting points will matter to the simulations. According to our model, under this assumption of aggressive fiscal consolidation, the federal debt would have peaked at about 50 per cent of GDP in 1986- 89, instead of around 67 per cent in 1995. Indeed, the federal debt would have declined over the next several years, falling into the high 30s as a percentage of GDP, some 30 percentage points lower than actually occurred. Under this tighter fiscal scenario, interest rates would be lower by between 1 and 2 percentage points, since monetary policy would be cushioning the economy from the downside shock of lower fiscal spending. This lower interest rate profile would have had a significant impact on the Canadian dollar, which would have been lower by as much as 8 cents US. The currency would have peaked at around 80 cents US (measured in annual average terms), compared with the actual peak of more than 87 cents US on average in 1991. Canadian households would have responded to this lower interest rate environment by purchasing more durable goods and houses and therefore borrowing more. Household debt would have been higher in 1995, by more than 3 per cent of GDP. Clearly, with less government demand in the economy, there would have been more private sector activity, including consumption spending, housing construction and, given the lower Canadian dollar, more exports. What this counterfactual illustrates is that a shift in policy mix along the lines suggested by Doug in 1985 would have had predictable implications for the Canadian economy. Notice, however, that the lower trajectory for government debt would have had a mirror image, albeit more modest in scope, in household debt. Thus, even from this modest experiment, it is clear that the stocks of fiscal debt and household debt are interrelated. As for the desirability of one policy mix over another, hindsight is always 20:20 and such a discussion would have little meaning here. The Canadian economy was going through a very challenging period--recovering from the trauma of very high interest rates, falling oil prices and unanchored inflation expectations--and monetary policy and fiscal policy were both trying to achieve very important objectives. Here, and in subsequent sections, we will refrain from evaluating the pros and cons of alternative policy mixes. Having examined an interesting but fairly arbitrary counterfactual adjustment to fiscal policy in the late-1980s, we now turn to a more rigorous experiment around the policy mix. In our remaining counterfactuals, we hold fiscal policy in balance (moving the primary structural fiscal balance to zero) and allow monetary policy to adjust to produce the same level of economic activity that was observed in the historical data. The primary structural fiscal balance ( ) is estimated by adjusting budgetary components of revenues and spending to account for the effect of the output gap and the trading-gain gap, as estimated by the Bank of Canada (see Pichette et al. [2015] for information on the output gap and Barnett and Matier [2010] for information on the trading-gain gap). This approach is similar to the one used by the Parliamentary Budget Officer (Barnett and Matier 2010). Having estimated the primary structural balance, we then add fiscal spending shocks to the model to force that definition of fiscal balance to zero while constraining real GDP to follow its original historical path through a corresponding adjustment to the path of short-term interest rates. This allows us to investigate the policy issue purely in terms of a monetary/fiscal mix. The simulations are summarized in . Because the government ran persistent fiscal surpluses prior to the global financial crisis, this counterfactual would have implied considerably easier fiscal policy during the 2000- 07 period, with additional fiscal spending of about 3 to 4 per cent of GDP in primary terms in most years. Federal debt would have risen steadily throughout the 15-year period, including a sharp rise during the Great Recession of 2008-10. By 2015, federal debt would have been around 70 per cent of GDP and still rising--a higher level than the one that prompted market angst in the mid-1990s. Clearly, therefore, this counterfactual simulation could have tested the limits of policy mix flexibility. Indeed, such a policy might have proven technically unsustainable, given the starting point. Monetary policy in the scenario would have been much tighter under this easy fiscal policy profile because the central bank would be working to achieve the same path for real GDP as occurred in history, despite much higher government spending. In other words, monetary policy would be working to offset the fiscal stimulus. Short-term interest rates would have fluctuated between 5 and 10 per cent during most of the period, except during the aftermath of the global financial crisis when rates would have fallen to as low as around 2 per cent. But rates still would have risen to around 7 per cent again by 2012-15. Not surprisingly, the Canadian dollar would have been much stronger under this scenario. Already being pushed toward parity by the steady rise in prices for oil and other commodities during 2002-12, the dollar would have averaged about 6 cents US higher than its actual historical level but would have averaged around 10 cents higher during 2012-15. This would have meant even more long-term damage to the export sector and an even more laborious recovery from the global financial crisis. Clearly, this alternative scenario strains credibility in various ways, but our objective is not to derive a preferable policy path but rather to consider the implications of the shift in policy mix for debt and financial stability. While the federal government would be racking up a historically high stock of debt under the fiscal assumptions in our counterfactual, Canadian households would be doing the opposite. By 2015, household debt as a share of GDP would have been more than 20 percentage points lower than it is today, while government debt would be nearly 40 percentage points higher. Notice that there is not a 1:1 inverse relationship between the debt stocks of the public and private sectors. This reflects the empirical finding that household indebtedness is only modestly influenced by monetary policy, a characteristic embedded in our simulations. It also reflects the overall impact of monetary policy on real GDP, which extends well beyond its influence on household borrowing. The trade-off between the two debt stocks is highly dependent on the array of shocks hitting the economy at a point in time. Our third counterfactual scenario looks at the post-crisis period. After a significant easing of both monetary and fiscal policies from 2008 to 2010 across most of the G20, there was a fairly synchronized return toward neutral or tighter fiscal policy in the next couple of years. Monetary policy remained easy in many countries, particularly advanced economies, and in some cases was eased further as recoveries faltered. This has given rise to a debate around the monetary/fiscal mix--essentially asking what would have happened had fiscal policy remained easier for longer. In particular, the issue of rising household imbalances and the associated risks to financial stability have come to the fore. Accordingly, we use ToTEM to conduct a simulation with the primary structural fiscal balance constrained to zero, starting in 2011. The results are shown in . Because Canada's primary structural fiscal balance actually moved into surplus in 2011 and rose to about 2 per cent of GDP by 2015 ( ), this counterfactual would have entailed rising fiscal spending and persistent fiscal deficits through the 2011-15 period. By 2015, federal debt would have risen by about 6 per cent of GDP, to about 37 per cent. To therefore achieve the same level of real output, monetary policy would have been somewhat tighter, with interest rates fluctuating around 2 to 3 per cent instead of around 1 per cent, as actually happened. The Canadian dollar would have been stronger as well, by about 3 cents US, on average. It would be fair to argue that, in the context of a soft economy, monetary policy might not have been tightened as the scenario describes, especially since for most of 2012 and 2013 core inflation was around 1 per cent, about 1 percentage point below target. By forcing our model to replicate the historical GDP performance, monetary policy would have necessarily been tighter and would have clearly offset some of the effects of the increased fiscal spending in the counterfactual--an unlikely outcome, given the situation. With the higher profile for interest rates, household debt would have been lower than it actually was in 2015, by some 7 per cent of disposable income, or 5 per cent of GDP. Notice that the trade-off between private sector debt and fiscal debt in this shorter simulation is close to 1:1. Even if the financial vulnerability associated with household debt had been lower throughout the period, it would still have begun to rise again, beginning in 2014. Thus, although the counterfactual shift in policy mix would have mitigated financial stability risks, they would still have figured prominently in monetary policy deliberations by 2015. These counterfactual simulations offer a practitioner's glimpse into a difficult problem--how to define a guide for a monetary/fiscal policy mix that, if not optimal ex ante, at least works well on average ex post . The literature on this subject has employed increasingly complex DSGE models (see, for example, Gnocchi and Lambertini 2016). Despite those complexities, such models remain far more simple than the sort of elaborate model a policy-maker generally relies on, such as ToTEM. Thus, one can learn only so much from the conclusions that have been reached to date. A key finding in this literature relates to monetary policy's "commitment," or, in common parlance, inflation targets. In a model with government debt, the higher the level of that debt, the more incentive there is for government to create some surprise inflation, because surprise inflation erodes the real value of outstanding debt and reduces the need for future taxation. Such inflation surprises, of course, erode the value of private sector savings and, in time, lead to a de-anchoring of inflation expectations. Clearly, an inflation target committed to by the central bank (and, in the case of Canada, agreed to jointly with the federal government) can help offset this incentive. Accordingly, models with inflation commitments tend to predict a lower stock of government debt. As well, the credible inflation commitment gives both monetary and fiscal policy the ability to offset macroeconomic fluctuations. Because inflation stability emerges only when the economy is sustainably at full capacity, the coordination problem between monetary and fiscal policy is highly simplified when there is such a joint commitment to inflation targets. Where the issue of monetary/fiscal policy mix comes more to the fore is when the economy is far from equilibrium, and persistently so. As we saw in our simulations, starting points matter, and persistent disequilibrium gives rise to accumulating debt stocks in either the public sector or the private sector, or both. As is well known, so-called Ricardian effects are likely to become increasingly apparent as private sector debt rises--households know full well that they will have to pay the money back someday, so they will not accumulate debt ad infinitum . There is every reason to expect similar reactions to high and rising public sector debt: since households know that they will someday have to pay higher taxes to cover the debt the government is incurring, they might respond to increased government spending by increasing their savings today and, in so doing, partially offset the government's stimulus efforts. This suggests that there is a meaningful trade-off in the policy space between the medium-term consequences for debt of monetary and fiscal policies. An easy monetary/tight fiscal policy mix will lead to higher private sector debt and lower public sector debt, all other things being equal. Similarly, a tight monetary/easy fiscal policy mix will lead to lower private sector debt and higher public sector debt. In effect, for a given macroeconomic situation, policy-makers have the ability to choose the dynamics of those two debt stocks--they can't influence the two debt stocks independently, but their policy choices have simultaneous implications for both variables. What we lack at this time is a coherent framework for weighing the relative macroeconomic consequences of private sector debt versus public sector debt. For a given economic situation, what combination of public sector debt and private sector debt represents the best outcomes from the point of view of financial stability? On all counts, this trade-off is likely to be extremely complex, highly dependent on the economic situation and therefore likely to complicate significantly the choice of policy mix. The next generation of policy models will hopefully be enriched in this dimension, capturing the complexity of the underlying linkages between economic behaviour and financial variables in much the same way that ToTEM made such a significant advance with respect to terms-of-trade shocks. In addition to the stocks of debt, these enriched models would include other dimensions of financial stability risk, such as overvalued property or stock market prices, and the feedback these elements can have for consumers and financial intermediaries. A better understanding of the medium-term trade-off of private sector versus public sector debt will be helpful in developing stronger guidance around the monetary/fiscal policy mix. No doubt, over the next few years in Canada, we will learn more about this trade-off at a practical level. We have seen a lot in the 30 years since Doug Purvis gave his Innis Lecture. We have learned that there are limits to how much government debt financial markets will tolerate, as Doug thoughtfully predicted. We have also learned that, in unusual circumstances, private sector debt can reach levels that can similarly strain the tolerance of financial markets. These strains inevitably feed back into monetary policy deliberations, either because they have real effects on the economy or because central banks see the danger of making financial stability risks worse while trying to lessen macroeconomic risks. Central banks are actively engaged in determining how best to incorporate such financial stability concerns into the conduct of monetary policy. The analysis presented here has demonstrated that there is an intimate connection between the debt stocks embedded in financial stability issues and the monetary/fiscal policy mix. Objectives for monetary policy, such as monetary or inflation targets, have historically been seen mainly as a recipe for staying out of trouble; in other words, they are meant to manage macroeconomic risks in the face of uncertainty, while delivering a less uncertain environment for economic decision making. While experience shows that inflation targets have improved macroeconomic performance, the experience of the global financial crisis and its aftermath demonstrates well that such targets are not sufficient for preventing trouble. Clearly, there can be medium-term consequences that must be taken into account when formulating monetary policy, certainly in the presence of persistent shocks to the economy. This strongly suggests that the best mix of monetary and fiscal policy will depend on the economic situation, and any derived optimality condition is likely to serve only as a rough guide. Rather, policy coordination around an agreed goal seems to hold out more promise than seeking some optimality condition. Given the sanctity of central bank independence, the narrowest form of monetary and fiscal policy coordination would be for the central bank to take fiscal policy into account while pursuing its inflation target independently. However, within an institutional arrangement that enshrines central bank independence, there is scope for ex ante sharing of information and judgment between the two authorities. After all, the inflation target in Canada is agreed to by the central bank and the government. This institutional framework is a simple yet elegant form of monetary and fiscal policy coordination that may have anticipated some recent literature (e.g., Leeper and Leith 2016). My guess is that Doug Purvis already understood most of this. Certainly, he pointed us in the right direction 30 years ago. So, if I may paraphrase one of my late friend's most famous lines, the appropriate monetary/fiscal policy mix depends on the situation, but the medium term is still the message.

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Release of the Financial System Review

poloz

Governor of the Bank of Canada Press conference following the release of the Good morning. Senior Deputy Governor Wilkins and I are pleased to be with you today to talk about the June issue of the Bank's which we published this morning. The FSR identifies financial system vulnerabilities and monitors how they evolve. It then looks at how those vulnerabilities could become risks to the financial system as a whole. Turning vulnerabilities into risks requires a trigger--an event that interacts with the vulnerability and has a magnified effect on the financial system and the economy. So, we measure financial stability risk as a combination of the scale of the underlying vulnerability, the probability that a risk will be triggered and the estimated magnitude of the fallout if it is. Since our last FSR in December, the global macroeconomic environment first deteriorated but then improved. The US economic recovery gained traction, and accommodative monetary policies helped stabilize global financial conditions. Here in Canada, the economy continues to work its way through the implications of low oil prices, even though prices have recovered some lost ground. The export recovery remains uneven, and has yet to translate into stronger investment spending. Nevertheless, we remain confident that those forces are in motion in light of continued US expansion, past monetary policy actions and announced fiscal plans. More recently, the devastating wildfires in Alberta pose a significant downside risk for near-term economic growth, but estimated insurance claims, while large, do not suggest a threat to financial stability. Today's FSR focuses on the same three vulnerabilities as our December report: the elevated level of Canadian household indebtedness, imbalances in the Canadian housing market and fragile fixed-income market liquidity. We assessed these vulnerabilities in the context of four risk scenarios, namely: a large increase in Canadian unemployment brought about by a severe recession; a sharp jump in long-term interest rates driven by higher risk premiums, globally and in Canada; a sudden rise in stress from China or another major emerging economy; and a prolonged period of very low commodity prices. The first two vulnerabilities, household indebtedness and imbalances in the housing market, have both moved higher since our last report. However, in view of the improving economic outlook, there is now a lower probability that the risks stemming from these vulnerabilities will be triggered. This combination of higher vulnerabilities but lower probability leaves the financial stability risks related to those vulnerabilities roughly unchanged from our last report. Our view is still that a strengthening economy and rising incomes will reduce these vulnerabilities over time for the country as a whole. Nevertheless, it was the view of Governing Council that this conclusion merited a caveat, which is that the pace of house price increases in Toronto, and especially Vancouver, is unlikely to be sustained, given underlying fundamentals. This suggests that prospective homebuyers and their lenders should not extrapolate recent real estate price performance into the future when contemplating a transaction. Indeed, the potential for a downturn in prices in these markets, although difficult to quantify, is growing. A significant decline in house prices could have material consequences for some individuals and for some entities in the mortgage business. However, the financial system as a whole is resilient enough to handle the potential impact. The third financial vulnerability featured in the FSR is the fragility of fixed-income market liquidity. The empirical evidence is mixed, but there is considerable anecdotal evidence that fixed-income markets have become less liquid, in part as a consequence of regulatory reforms to safeguard the financial system. We believe that the system will eventually evolve in such a way as to make market liquidity more reliable over time. Nevertheless, we will continue to monitor and study this issue, both in Canada and with our international colleagues through All things considered, the Governing Council is of the view that financial stability risks overall have not changed materially since our last report. Let me also mention two very interesting reports included in this FSR. The first is a portrayal of Canada's pension business, focusing on the eight largest public pension funds. Canada is a global leader in pension fund management, and this article provides a comprehensive review of their activities. As major players in Canada's financial system, these entities warrant the Bank's interest, and I wish to thank those organizations for their co-operation as we prepared the article. The second report takes a look at the securities-financing market in Canada and the implications of recent developments in that space for bond market liquidity. With that, Carolyn and I will be happy to respond to your questions.

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The Canadian Economy: A Progress Report

poloz

Governor of the Bank of Canada It's a great pleasure to be here and see the Land of the Midnight Sun first-hand. The last time I was here it was mid-January, and the locals promised me I would see the northern lights--but it snowed the whole time I was here! This time, we get to take in the natural beauty of Whitehorse in the daylight while meeting with the business leaders of the region. Visits like these supplement the invaluable work done by the Bank's regional staff, who help keep us on top of how things look to the people who actually make the economy tick. I don't have to tell you that the Canadian economy has faced its share of challenges these past few years. Our exports plunged in the wake of the global financial crisis, and we lost many exporting companies and their jobs. The global recovery since 2010 has been disappointing and so has our export recovery. High oil prices boosted Canada's income growth and increased investment in the energy sector through 2014, offsetting some of the bad news. But over the past 18 months that growth engine, too, has throttled back. So, today we find ourselves partway through two distinct economic narratives. First, the resource economy is going through a painful and complex adjustment to low prices--an adjustment that will mean lower levels of income, investment and employment, as well as the migration of families within Canada. This process will take another couple of years to work itself out. Second, the nonresource economy is still healing from the post-crisis trauma, moving unevenly toward full capacity--two steps forward, one step backward. And then there are the wildfires in Northern Alberta, which devastated the town of Fort McMurray, forced 90,000 people from their homes and affected production in the oil sands. This has made a challenging situation even more so. The one constant in recent years has been the Canadian consumer. In part supported by low interest rates, Canadian consumers have been a steady source of economic growth, particularly through the housing sector. The result? Canadian households are carrying near-record debt loads, and we are growing increasingly concerned about risks in some housing markets. So, you might be wondering how Canada is really doing in the face of all these conflicting economic forces. Today I'd like to offer you a progress report. And let me say at the outset: we are making progress. Four times a year, the Bank publishes its containing our latest projections for the Canadian economy. Our model-based forecasts are complemented by judgment, which is supported by extensive consultations with companies and other contacts. Conditional on this economic projection, we choose a path for interest rates that will keep projected inflation on target or bring it back to target over a reasonable time frame. At the end of each MPR we highlight several risks to our forecast--issues that require the Governing Council to exercise judgment. In principle, if one of those risks were realized, projected inflation would deviate from the target, and an adjustment to policy might be indicated. The Governing Council spends a lot of time debating and forming judgments around these risks. So, I thought it might be interesting to invite you into our forecasting tent today and talk about how we have been seeing Canada's key economic risks evolve since our last MPR in April. For the past 18 months, the biggest issue for our forecast has been tracking how the Canadian economy is adjusting to low resource prices. In the first instance, this has meant a big drop in investment spending, especially in the oil patch. It has also meant a lower value for the Canadian dollar and two interest rate cuts during 2015. Our forecast in April saw the Canadian economy making its way back to full capacity during 2016 and 2017--a process that would see inflation sustainably at our target of 2 per cent by late next year. Without last year's interest rate cuts, it would have taken much longer to have inflation return to target. While the April projection was being developed, the Canadian economy appeared to be doing better than previously expected. However, our analysis suggested that we should not extrapolate that first-quarter surge in growth for the rest of the year--that some of the apparent strength represented a catch-up from a soft fourth quarter, and some other factors were probably temporary. Accordingly, our April forecast anticipated a significant slowdown in growth for the second quarter and a decent pickup in the second half of the year, in part due to the government's fiscal plan. Several risks played an important role in these discussions; I will now discuss four of the most important and consider how well the economic data have supported those judgments since April. We might as well start with the most obvious risk--the outlook for US economic growth, which, of course, feeds directly into our recovery narrative for Canada's non-resource economy. When we were preparing our forecast in April, the US economy was showing signs of faster growth, but we were skeptical that it would be sustained. The fact is we had been disappointed too many times in the past. As in all such debates, however, there was a risk that we were being too conservative and would be surprised on the upside as things unfolded. This would, of course, have been welcome, because it would have meant more exports for Canada. As it turned out, though, the first quarter in the United States was even softer than we had been expecting. US energy companies were cutting back on investment--much like they were in Canada--and US consumers slowed the growth of their spending. But the second quarter is looking better for the United States. We're seeing renewed strength in housing and auto sales, and consumer confidence is near a post-crisis high. America's job market stumbled in the latest monthly report, but we don't think this one month of data heralds a significant downshift in growth. Besides, some moderation in monthly employment gains and GDP growth is inevitable as the US economy approaches full employment. So, after tilting a little to the downside early in the year, the balance of risks around the US outlook now appears to be reasonably close to our view in April. A full reassessment of this risk is being done now, for our next MPR in July. Generally speaking, a stronger US economy will mean more export sales for Canada. But in recent years this link has proven less reliable than in the past. Accordingly, the second forecast risk that has been preoccupying us is the possibility that our Canadian export forecast would again miss the mark. Toward the end of 2015 and in early 2016, in fact, non-energy exports started showing surprising strength. While this was encouraging, more granular analysis suggested to us that some of that strength would be temporary--in auto exports, for example--and we judged that exports would slow. Therefore, the risk we set out in the MPR was that we may have been too conservative on the export outlook--that perhaps exports would continue to surprise us on the upside. Sure enough, exports have taken a step back in the past couple of months, validating our cautious analysis. Even so, the levels of several export categories have shown good progress. For example, exports of building and packaging materials are up 35 per cent since 2012 to levels last seen before the financial crisis. Furniture and fixtures exports are up 45 per cent over the same period and exports of pharmaceutical and medicinal products have grown by 70 per cent. And then there is tourism. I know the Yukon government has been actively working to draw visitors, both from Canada and abroad. Land border crossings, which are how most visitors enter Yukon, are up almost 9 per cent from last year. Accommodation and food services jobs were about 15 per cent higher in March than a year ago. These trends are being replicated in many parts of Canada. Data on day trips between Canada and the United States, where people cross the border but don't stay overnight, have shifted sharply with more Americans crossing the border to shop in Canada and many fewer Canadians travelling in the opposite direction. Given the past depreciation of the currency and our confidence in the US expansion, we expect our export sector to continue to heal. Many firms are close to their capacity limits, which augurs well for future investment spending and new job creation. So, while the whole process has been disappointingly slow and uneven, we remain confident that we have the right narrative. Risk 3: Deeper adjustment to low oil prices The third big source of uncertainty in our forecast is how our economy will ultimately adjust to a world of significantly lower oil prices. This basically comes down to the actions of individual firms and their investment plans, and we have managed to track this reasonably well through conversations with the firms themselves. In the energy sector, investment spending this year is expected to be about 60 per cent below 2014 levels. And, since the process began, companies have cut investment spending each quarter by more than we expected, so this has been framed as a downside risk. We've seen a similar phenomenon here in Yukon, as mineral exploration spending has fallen and is expected to drop further and several mines have closed in recent years. This includes the plans for a temporary shutdown at the Minto copper mine next year. The recent uptick in oil prices might lead some to expect an end to investment spending cuts. We are not persuaded of this, for two reasons. The first is that some of the recovery in prices is due to supply disruption that will probably be temporary, so we should reserve judgment. The more important reason, though, is that it's highly uncertain what price level will rebalance the oil market on a sustained basis. It certainly looks as though prices will not be returning to their old highs in the foreseeable future. Oil companies and their suppliers and service providers have found many ways to cut costs, and this is lowering break-even prices. This means that new oil supply can come back on stream profitably--especially in US shale plays--at lower prices than before, perhaps putting a lid on further price increases. The recent pickup in oil prices is, of course, welcome, because it means a boost to Canadian income for every barrel exported. But an extended period of oil prices at recent levels is unlikely to lead to greater investment spending in the Canadian oil patch. Indeed, market intelligence suggests there is further downside risk to investment at these still-low price levels. Accordingly, this remains a potential source of downside risk to our forecast. The fourth risk we've been giving special attention to is the possibility that Canadian households might become more cautious in their spending. At the heart of this uncertainty is the high level of household debt. It is natural to expect that, at some point, households will rein in their spending and put more effort into paying down their debt. There is no evidence of this downside risk so far, however. Indeed, data from the first quarter show that household spending, including big-ticket items such as motor vehicle sales and housing, has remained strong. Nevertheless, we will need to remain alert for signs that this risk is emerging. Low interest rates and a resilient job market have certainly helped sustain consumer spending, and the tax rate changes that the government introduced at the beginning of the year may also be playing a role. We also think spending is being supported by the impact of cheaper gasoline, since the average Canadian household is spending about $600 less per year to fill their tank. On the other side of the ledger, the decline in the Canadian dollar has raised the price of a wide range of imports. A strong consumer is, of course, a key contributor to Canada's strong housing market. However, a number of other factors are at play, as seen in the significant regional divergences in housing sales and prices. We continue to see very strong markets in British Columbia and Ontario, fuelled by strong population and employment growth, declines in energy-producing regions such as the Prairies and modest growth elsewhere in the country. Indeed, we noted last week in our that house prices in Vancouver and Toronto have been rising at a pace that probably can't be sustained. It's possible that self-reinforcing expectations of higher prices are affecting these markets, and the risk of a decline in prices, while difficult to quantify, is growing. So, after looking at those four risks, where do we stand? I have no doubt that the growth forecast numbers will change when we do our full analysis in July, and that will have implications for our projection of inflation and our policy deliberations. But it does seem that our core forecast narratives around the US economy and around Canada's exports remain intact. Investment plans in the energy sector, and the possibility that households will suddenly rein in spending to pay down debt, do still present downside risks that we will continue to monitor carefully. And of course, there may be a whole new set of risks to consider in July. Impact of the Alberta wildfires Unfortunately, there is still one major economic factor to consider that was not foreseen at all--the Alberta wildfires. The fires were brutal. Almost 90,000 people were displaced and about 2,400 buildings, mostly homes, were destroyed. Canadians rallied to support their neighbours, as you'd expect. Insurance claims are expected to be somewhere between $2 billion and $6 billion--the largest such event in Canadian history. It's difficult to estimate the impact of this disaster on the economy. Lost oil output amounts to around 1 million barrels per day, but since it is unclear when production will be fully restored, the cumulative loss of income remains uncertain. In addition, the vast majority of the local population wasn't working during the evacuation. From a GDP standpoint, there will be some offsets to these losses, from emergency services and the like. We estimate that the Alberta fires will reduce annualized growth in the second quarter by about 1.00 to 1.25 percentage points. Part of this decline in GDP, stemming from the oil production shortfall, will probably be made back sometime in the third quarter, but the net effect on the level of GDP over time will depend on the pace of rebuilding, which at present is difficult to foresee. This suggests that GDP growth will be very choppy in the second and third quarters. Growth will probably be flat or slightly negative in the second quarter and show an outsized recovery in the third quarter. That type of quarterly growth profile could yield average growth over the two quarters quite close to that set out in the Bank's forecast in April. But we will have to wait and see. We will bring a completely new analysis to the table in July, so all these estimates are subject to change, based on these risks or new ones. Just by way of illustration, the outcome of the Brexit referendum next week poses new risks at the global level that could mean a shift in view. Let me conclude. As I said at the beginning, the economic situation we face is very complicated and riddled with uncertainty. But I am confident that we are making real progress. The global economy retains the capacity to disappoint us, but it is gradually healing. The US economy appears to be doing well, despite the usual variability in the data. Our export recovery is proving to be very uneven, but several categories are encouraging. Many export sectors are operating near their capacity limits, which augurs well for future investment and job creation. The structural adjustments to low oil and other commodity prices are clearly under way and will persist for some time yet. Financial stability risks, especially in the household sector, remain an area of concern but should diminish as the economy strengthens. Continued patience is required, but we have the right to be optimistic. Let me acknowledge, though, that many of the macroeconomic processes that economists talk about sound impersonal, or even mechanical. I know they are not. Companies are run by real people, who risk real money in creating jobs and economic growth. Hesitating to do so in the face of uncertainty is only human. Workers who lose their jobs as a result of low oil prices may need to contemplate moving to another part of Canada, and layering the Alberta wildfires on top only increases the human burden. Economic adjustment processes that seem so ordinary in our models are painful, costly and take time at the human level. Still, there's a resilience and flexibility among Canadians that gives me confidence that we will get through these adjustments and our economy will return to natural, self-sustaining growth. My message is that the process has been uneven, and probably will remain so, but we are making real progress. Rest assured the Bank of Canada will keep doing its part to support Canadian workers and businesses along the way.

r160617a_BOC

canada

Fintech and the Financial Ecosystem: Evolution or Revolution?

wilkins

It is no exaggeration to say that we are in the midst of a defining moment for innovation in financial services. Some expect that new technology will cause a complete disruption of traditional financial institutions, giving businesses and households access to more convenient and customized services. Entrepreneurs are also finding applications well beyond finance, and these new technologies could transform other fields, such as humanitarian aid. Fintech, which is the term people use to refer to innovation in financial services, has created a lot of excitement, but also quite a lot of hype, depending on your perspective. Google searches for "fintech" have increased by more than 30 times in the past six years. Fintech has also attracted real money: over the same period, around 100 fintech start-ups in Canada have raised more than $1 billion in funding. At a global level, almost $20 billion was poured into fintech last year alone. There is a vast array of services being deployed in Canada and elsewhere. Many of you may be using Apple Pay or Google Wallet. You may also be getting investment advice from "robo advisors." There is peer-to-peer lending, such as the Lending Club, and even more services are in the works. I have had the opportunity to participate in a number of fascinating discussions about fintech in recent months--with my colleagues at the Financial Stability Board and other international organizations, as well as with fintech entrepreneurs and traditional financial institutions around the world. I can tell you that, despite the hype, no one knows yet what the social and economic payoff of these investments will be. And because it is early days, no one knows for sure what fintech developments will ultimately mean for business models or for the financial system more generally. But we are all trying to figure it out. I know this interest extends to all of us in the payments business, which is undergoing its own transformation. This conference is a great setting to offer a central banker's perspective on fintech. So I want to thank Payments Canada for the invitation to speak here today. The Bank of Canada is doing a lot of work in this area. Today I will explore three points with you that frame our thinking on the issues. First, fintech has the potential to transform the financial system across a broad range of services. And that is a good thing, because there is a lot of inefficiency that can be shed. Second, although some of the technology may be revolutionary, its overall effect on the financial system is likely to be evolutionary. Financial institutions that adapt will survive, and new service providers will become part of the financial ecosystem. In some areas, this evolution is happening fast, while in others, the most transformative technologies still have developmental hurdles to clear. Finally, now is the time for financial institutions, new entrants and policy-makers to work together. That is the best way to create the right environment for modernizing the financial sector and sensibly managing the risks that arise. This applies to many areas. For the Bank, the focus is on preserving financial stability and maintaining the safe and sound operation of core payment systems in My first point is that change is definitely in the air. In many cases, financial innovations are simply interesting twists on existing technologies and business models. They promise to lower costs, improve services and broaden access. Peer-to-peer lending is one example. As we have already seen with the taxi and hotel industries, peer-to-peer services challenge traditional intermediaries. This new competition could fundamentally change the relationship that traditional financial institutions have with their customers. From a regulatory perspective, the main issues relate to consumer protection, market integrity and rules that guard against money laundering and terrorism financing. Authorities are working to close significant gaps in these areas and are monitoring implications for financial stability. Then we have financial services enabled by fundamentally new technology. A prime example is distributed ledger technology (DLT). This technology has the potential to replace entire transaction systems, including core payment systems, and offer new products, such as smart contracts. Smart contracts are agreements written in computer code that do not need human intervention to be executed. This strand of fintech could take us into uncharted territory. As I will explain in a minute, regulators could face issues related to governance, legal environments and financial stability. One might argue that the financial sector is always changing and that fintech is a case of deja vu. We have seen important innovations in the past--such as credit cards, automated banking machines and online banking--that did not revolutionize the financial landscape, even if they provided huge advances in convenience for consumers. That is because financial institutions remained the dominant players and adapted to these changes, often by buying emerging competitors, adopting the technology and reducing access to legacy services to compel customers to adapt. I see a combination of factors that point to the potential for greater change this time. First, customers are more demanding than in the past. They are looking for more convenient and cheaper access to financial services that are well integrated with the rest of their online activities. Customers expect these services to be personalized, and faster, in part because of the widespread use of smartphones and the speed with which new apps can be pushed out. Given how accustomed people have become to instant access to goods and services, it is no surprise that they expect instant access to their money. That is why we see a push to implement real-time retail payment systems in nearly all major jurisdictions. will be an important point to consider for the modernization of the Canadian payments system. Second, we are seeing large, well-funded companies outside the financial space, such as Apple and Google, starting to offer financial services. One of the main advantages of traditional financial institutions is the trust they have built with their customers. Tech giants also have wide customer bases and brand loyalty that could help drive adoption. These companies are using their customers' information and their existing platforms to offer attractive and cost-competitive services and to pick away at the most profitable business lines of financial institutions. The range of services they offer could grow over time. Finally, some existing financial institutions and infrastructures have become relatively inefficient, while new technology has reduced barriers to entry in this space. Supporting systems can date back several decades and are often not interoperable, even within an institution. So the door for competition is open. This brings me to my second point, which is about the kind of change we can expect. Traditional players will have to adapt to survive, and there will be new players. And the new technologies that could be truly transformative have some way to go before they are ready for prime time. So I expect we are in for more of an evolution than a revolution. Since we are all talking about distributed ledgers--or blockchain--let me use that technology to illustrate my point. Ledgers may sound incredibly dull, but innovations in this space have been game changers in the past. Indeed, the invention of double-entry bookkeeping has been credited as one factor enabling capitalism. It makes me wonder what people will say about distributed ledgers 100 years from now. Let us first remind ourselves what this technology brings to the table. The exact features of DLT vary, depending on the needs it fulfills. At its core, it is a computer protocol that allows many participants to record information on a single ledger that is shared among users, so each one sees the same data. A consensus mechanism and modern cryptography ensure that stakeholders agree that entries to the ledger are authentic. The ledger's key benefit is that you do not need a trusted third party to guard against double-spending or expensive processes to reconcile information between ledgers. The best-known application of DLT is Bitcoin, which is a decentralized digital currency. The ledgers used for these currencies are "permissionless," which means that anyone with a computer can download the software, see the ledger and start authorizing transactions. The decentralized aspect of the technology is why some predict that widespread application of DLT could revolutionize entire industries. They contemplate alternative futures, such as one in which there is complete disintermediation of banks and even central banks, with state currencies being replaced by decentralized digital currencies. I see this as highly unlikely. People have not widely embraced digital currencies like Bitcoin because these currencies cannot outshine the competition when it comes to serving as a store of value and a medium of exchange. National authorities will want to run their own monetary policy, and so the most that could happen is that national currencies and digital currencies coexist. The Bank of Canada is studying digital currencies closely because of our role in issuing the nation's currency and the implications these currencies could have for monetary policy and financial stability. Like many other central banks, we are also researching the conceptual merits of issuing electronic money ourselves. In fact, the potential for DLT is actually stronger for applications outside of digital currencies. We have seen test cases related to payments and post-trade processes, including the clearing and settlement of financial instruments such as repos, bonds, derivatives and equities. One interesting application is in the syndicated loan market, where loans can take up to 20 days to go through the clearing and settlement process. DLT could reduce this to about seven days by providing a secure database that all participants share across a distributed private network. Looking at a single source of information would help reduce disagreements and make it easier to comply with legal requirements, speeding up the process at every stage. We may also see applications in areas such as trade finance and supply chains, where information cuts across jurisdictions and is difficult to centralize. One estimate suggests DLT could enable banks to save as much as $20 billion a year in global back-office costs if applied to cross-border payments, securities trading and regulatory compliance. So it is easy to see why private enterprise is investing a lot of money in this type of technology. If these ventures deliver on their promises, improvements could extend beyond efficiency and cheaper processing. Transactions could be settled almost immediately, which would reduce counterparty risk and free up capital for other uses. Transparency would be enhanced because a distributed ledger lets participants see the entire history of transactions. That said, several important issues with DLT must be resolved before its benefits can be realized. First on the list are technical issues related to scalability, the consensus mechanism, data privacy and cyber security. Second, proponents will have to agree on governance, which can be a challenge when stakeholders have divergent interests. Bitcoin's recent struggles are a clear illustration of this. Finally, standards and protocols, as well as a solid legal foundation, must be established to allow for interoperability. Protocols may be an area where governments can contribute. In the early days of the Internet, governments helped develop the first networking protocols. Like the Internet, many of the applications of DLT will require a global view. Applications of DLT will also need to become widely adopted. This means getting users to move away from the current networks and switch to DLT networks. Usually, the more people who join a network, the better the network becomes, which in turn entices even more people to adopt it. A social network like Facebook is a good example of this network effect--people flock to the service that their friends use--and it is no small challenge to compete with a system that is already established. The final hurdle DLT has to overcome is to gain regulatory acceptance and comply with domestic and cross-border laws and regulations. Authorities should support innovation, but the bar will be high, especially for core financial services, and appropriately so. Financial institutions, including Canadian banks, are working hard to test and adopt new technologies and adjust to new trends. So while banks may look different in the future, they will still play a major role in the financial system. It is true that some changes could seem revolutionary to some incumbents. To customers, however, it will likely seem evolutionary, and some changes will not be visible to them at all. In some dimensions, DLT is reminiscent of Voice over IP: here was a revolutionary advancement in technology that caused an evolutionary change in how we, as end-users, use the phone system. This brings me to my final point. Now is the time for financial institutions, new entrants and policy-makers to work together. The opportunity cost of sitting back and waiting for the dust to settle is too great. Financial institutions and infrastructure operators are making important strategic decisions about which parts of their businesses they want to defend and grow and which ones they want to scale back. This urgency is not only coming from fintech contenders. Banks are also dealing with a more demanding regulatory environment and exceptionally low interest rates around the world that are squeezing profit margins. Banks already spend close to $200 billion a year on IT globally, so replacing legacy systems will mean difficult and critical investment decisions. For the Bank of Canada, our priority is to see upgrades made to the core payment systems that the financial system relies on and that the Bank oversees: System (ACSS). These systems have served us well, but both require investments that are needed to fully meet our oversight requirements. Investment will also help the systems better meet the modern needs of participants and their customers. Take the ACSS, for example, which still handles most retail transactions today. It was implemented over 30 years ago, when everyone wanted a Commodore 64. The ACSS may have been at the forefront in 1984, but we are far from the efficient frontier now. Cheques take up to four days to clear, and some information needs to be re-entered manually. Now is the time to make our core systems more efficient and competitive. For consumers and business users, we need to move closer to real-time access to funds. In both the ACSS and LVTS, we need to collect richer data on transactions and, ideally, make them interoperable to avoid having to manually re-enter information. This effort is not change for change's sake. If we can leverage some of the existing infrastructure and still achieve our goals, that is all the better. For our part, policy-makers and regulators need to address innovation in financial services in a few proactive ways. The first is to develop a solid analytical framework to understand and assess the benefits and challenges of something so new. This is something the Financial Stability Board is working on. Authorities will make their assessments through many lenses, including consumer protection, financial inclusion, market integrity, competition policy and financial stability. That is why other international groups such as the Committee on Payments and Market Infrastructures, the Basel Securities Commissions are also involved. The Bank of Canada, together with our domestic colleagues, is actively contributing to these efforts. Since fintech is a global phenomenon, it is critical that this regulatory effort be global. We must also learn from emerging-market economies that are further along in some areas. While fintech innovations promise to solve some current problems, they could also create new ones. Let me give you an example: I worry that network effects, which underpin the success of many payment applications, could lead to an excessive concentration of payment service providers. If this happens, households and businesses may not benefit from cost savings. This is clearly an issue for competition authorities. It also is an issue for financial stability because "too big to fail" could emerge in a new form outside the current regulatory perimeter. Once again, payments are a great example. I worry that players not covered currently by regulation could become important to the system even if they never take on bank-like risks, such as maturity transformation or leverage, or become big enough to be considered systemically important. The move to increased direct access means that even smaller players could very well create critical dependencies within the financial system, particularly if they connect directly to core payments infrastructure. This could give rise to moral hazard. At a minimum, authorities need to put a large enough weight on operational dependencies when looking at systemic importance, particularly in light of cyber risk. When a payment system grows to be prominent or systemically important, the Bank of Canada's job is to oversee it. Even before we reach that point, regulatory measures should be considered to address specific issues, such as operational resilience and consumer protection. I also wonder how DLT-based infrastructures could affect the financial ecosystem. Ever-increasing automation through, say, smart contracts, could increase efficiency and certainty but could also increase financial volatility. Would that volatility be short-term, such as flash crashes? Or would it entail procyclical dynamics or new channels of contagion? There are also questions about whether the regulatory perimeter is adequate, given new entrants and risks of regulatory arbitrage. In my view, the field of inquiry should include the inherent risk and systemic importance of an activity, regardless of what entity is performing it. Even as we strive to implement a regulatory response that is proportionate to the risk, we need to keep in mind that maintaining a level playing field is important. Some of these issues are not too different from those that authorities face in their work on shadow banking, another area where new entrants are challenging traditional players. And, big or small, operational risk deserves much greater attention. The second way to address innovation in financial services is active engagement between authorities and the private sector. Some countries, such as the United Kingdom, Australia and Singapore, have created official regulatory These sandboxes allow start-ups to experiment with services without jumping through all the usual regulatory hoops. Here in Canada, we are consulting with fintech entrepreneurs. The Bank of which leads a consortium of financial institutions--to test drive distributed ledgers. Our only goal at this stage is to understand the mechanics, limits and possibilities of this technology. The plan is to build a rudimentary wholesale payment system to run experiments in a lab environment. Our experiment includes a simulated settlement asset used as a medium of exchange within the system. It is very much like the settlement balances in LVTS, except it is using DLT. Because it cannot be used anywhere else, it is a different animal altogether from a digital currency for widespread use. This is an experiment in the true sense of the word. I cannot think of a better way to understand this technology than to work with it. Other frameworks need to be investigated, and there are many hurdles that need to be cleared before such a system would ever be ready for prime time. The third way to address innovation proactively is to do fundamental research on the effects of new technology. The Bank of Canada's research over the past few years has focused on new payment methods, the adoption and competitiveness of digital currencies, and the essential benefits of private e-money. We are continuing this work and broadening it to include other developments, such as peer-to-peer lending and uses of DLT. We also want to understand how new financial technologies will address the underlying forces that created the need for financial intermediation in the first place. In theory, new technology could enable a different framework for addressing the same frictions, potentially one that does not require financial intermediaries at all. The names and faces may change, but I do not see technology changing the need for maturity transformation, loan monitoring, intermediation of borrowers and lenders, and trust. This is a good question for academics. Let me wrap up. While it is important to filter out the hype surrounding fintech, I am convinced that it could have a net positive impact on the financial system, provided the risks are adequately managed. Fintech will likely entail more of an evolution than a revolution. This is because incumbent financial institutions will adapt, new players will join the financial ecosystem and those with strong business models will survive. And the most fundamentally transformative technology so far--DLT--still has important hurdles to clear. Innovations may solve some current problems, but they could also create new ones. The regulatory framework needs to adapt so that the door is not opened to unmanaged financial and operational risks, unchecked critical dependencies within our financial system and moral hazard. Promoting financial stability is a core function of the Bank of Canada, and we take a system-wide perspective when we monitor risks. There is a lot of hard work ahead, and we need to get on with it. By working together, we can unlock the full promise of fintech to ensure a smooth evolution to tomorrow's financial system--safe, sound and serving the people who rely on it.

r160713a_BOC

canada

Monetary Policy Report Press Conference Opening Statement

wilkins

Press conference following the release of the Good morning. Governor Poloz and I are pleased to be here to talk about today's interest rate announcement and our turning to your questions, let me spend a few minutes highlighting the main points of discussion that took place within Governing Council. Our bottom line is that the underlying forces that underpin stronger growth in Canada are intact, and the adjustment of the economy to lower oil prices is well under way. That said, both international and domestic factors have led us to revise down our forecast for GDP growth. Most importantly for Canada, there is good underlying momentum in the US economy, even if the composition of US growth is somewhat less favourable for Canada than it was in April. We are seeing relatively strong labour market conditions in the United States, consumers are confident, and the rate of new firm creation is back near pre-recession levels. All of this suggests that the weak start to 2016 was largely temporary. The US economy remains a key driver for global growth, which we forecast will strengthen gradually to 3 1/2 per cent by 2018. However, the results of the referendum in the United Kingdom have clouded the global outlook. Governing Council carefully considered how best to incorporate the effects of the Brexit vote into the outlook. It is early days, and there will be a prolonged period of uncertainty as authorities work out how the United Kingdom will exit from the European Union. Governing Council decided to incorporate in the base case projection a 0.2 per cent reduction in the level of global GDP by the end of 2018. This reflects direct trade effects and some confidence effects on business investment. We are assuming that the Brexit process will proceed in an orderly fashion. Financial markets were resilient despite sharp adjustments in a wide range of global asset prices in the wake of the vote, and financial conditions are generally more accommodative. Now let me turn to the Canadian economy. Our discussions focused on how we should look through the choppiness in recent data to see the underlying trends, and what these trends mean for the inflation outlook. Among other factors, the fires in Northern Alberta, which have been costly for many, represent a sharp, but temporary, hit to the economy. We expect to see GDP fall by 1 per cent at annual rates in the second quarter, and then grow by 3.5 per cent in the third quarter as oil production resumes, rebuilding around Fort McMurray begins and the new Canada Child Benefit lifts consumption. In fact, fiscal measures, including infrastructure spending, provide an important support to growth over the forecast horizon. We have always said that the adjustment to the oil price shock would be a complex process. And we see evidence that these adjustments are happening, thanks to the resiliency and flexibility of the Canadian economy. On the energy side, firms have been quick to cut back investment plans and reduce costs. By the end of the year, we expect these reductions to be largely over. On the non-commodity side of the economy, we have also seen evidence of adjustment, but it has been more uneven. Export data have been particularly volatile, and it is very important for us as policy makers to assess underlying trends. What we see is that non-commodity exports over the past couple of years have been responding largely as expected to growth in foreign activity and the Canadian dollar. Businesses are telling us that they are benefiting from stronger demand and a lower dollar. We have a great chart in the MPR that shows that non-commodity exports have recovered almost to their pre-recession peak, which puts the recent volatility into proper perspective. Exports are projected to grow in line with the US economy over the projection period. We are being conservative by assuming that exports only make up part of the ground lost over the past four months. The past depreciation of the exchange rate will continue to support the level of exports, but its effect on export growth is projected to taper off over the course of this year. Growing demand for Canadian exports should lead to increased investment and new businesses being created. The question for monetary policy is when and by how much. Governing Council still believes that investment will be needed to expand productive capacity as both foreign and domestic demand increase. You can see that this rebuilding process is well under way in the United States, and we are seeing early signs that new firms are also being created in Canada. That said, our profile for investment, while still positive, is lower than in April. That is because investment data have continued to disappoint and some businesses are telling us that they remain cautious. Let me make a point about the lower investment profile. It does not just mean slower growth in GDP, it also means a reduction in the economy's potential, although to a lesser extent. When you add it all up, we project the output gap will close toward the end of 2017, somewhat later than we forecast in April. The uncertainty around potential output remains high because it is not clear how much productive capacity will ultimately be rebuilt as the economy strengthens. In terms of inflation, we project it will average 2 per cent in 2017, as the output gap gradually closes. Our judgment about the inflation process is supported by two staff papers published today. The first finds that wage pressures are subdued relative to historical experience, largely consistent with the existing slack in the labour market. The second focuses on structural factors that help explain recent movements in the prices of consumer energy products, food and services. Finally, as usual, we see a number of risks to our inflation outlook. We judge these risks to be roughly balanced. The overall climate, however, is one of heightened uncertainty. In a context of continued weak investment at the global level, any additional uncertainty has the potential to keep businesses on the sidelines longer. Not surprisingly, Governing Council also spent some time talking about housing. We continue to have the same concerns that we expressed in our June about household indebtedness and housing, particularly in the The circumstances that the Canadian economy is facing make the Bank's riskmanagement approach to monetary policy particularly valuable, because the types of uncertainties we see cannot readily be incorporated into projections. In light of all these considerations, the Governing Council maintained the target for the overnight rate at 0.5 per cent. With that, Governor Poloz and I would now be happy to answer your questions.

r160914a_BOC

canada

(S)low for Long and Financial Stability

wilkins

Let me first thank the Official Monetary and Financial Institutions Forum for inviting me here today. For policy-makers like me, the Forum's analysis and commentary are invaluable. Central bankers and fellow policy-makers around the world have dedicated the eight years since the global financial crisis to rebooting their economies and repairing their financial systems. Given the added challenges of a number of sovereign debt crises, an oil price shock and, most recently, the unfolding fallout from Brexit, it is understandable that we have devoted a lot of energy to avoiding another financial meltdown and keeping the recovery on track. It is perhaps not as epic a journey as in Homer's classic, but this odyssey has certainly proven long and perilous. Eight years into this journey, there is an urgent need for all of us to consult the map to see where we are headed over the longer run, and to take strategic decisions to help us avoid unnecessary trouble ahead. We all know that, cyclical factors aside, demographic trends and other structural factors are acting as a drag on the global economy's potential to grow. This surely worries all of you here, since growth is what ultimately drives the returns on your investments and your job prospects. And with economies expanding more slowly, having growth that is inclusive is more important than ever. Slow growth worries me as a central banker, not only because it reduces our room to manoeuvre to achieve our inflation target. It also worries me because slower potential growth materially increases risks to financial stability. To explain these concerns, I will start with a view on the long-term prospects for economic growth and real interest rates. I will then give you some examples of how these prospects could translate into increased financial system vulnerabilities. I do not believe we are powerless, though, so I will end by outlining some promising strategies that could lead us safely to a sustainable and solid growth path. Economic growth around the world since the crisis has repeatedly surprised economists on the downside and has led to the term: "serial disappointment." The Bank of Canada's own forecasts overestimated global growth by an average of half a percentage point each year in the past four. Private sector consensus forecasts were off by even more. The slow and halting recovery is partly the result of a number of cyclical factors that are taking years to sort out, including deleveraging in the private and public sectors. It is also the result of deeper structural trends that are driving down the global economy's potential to grow. Potential GDP growth at the global level declined from a peak of about per cent in 2005 to just over 3 per cent this year, according to Bank of Canada estimates. This is huge. A 2-percentage-point reduction in global potential growth translates into US$1 1/2 trillion in foregone output around the world in 2016 alone. If that pace is maintained, foregone output will rise to just under US$9 trillion five years from now. The slowdown has been widespread, although potential growth varies widely across countries. China's potential growth is estimated to be around 6 1/2 per cent, down from just over 10 per cent. In advanced economies, it is much lower-- around 1 1/2 per cent in Canada and around 1 3/4 per cent in the United for example. Potential output is made up of two parts--labour supply and labour productivity. Both are contributing to the slowdown in global potential growth. Labour force trends will continue and the numbers are striking: growth in the working-age population will fall at the global level from around 1 per cent to 0.6 per cent over the next two decades. It is difficult to precisely quantify the impact of demographic factors in terms of growth because a tighter labour market should, over time, drive wages up. Higher wages may persuade some workers to postpone retirement or join the labour force but are unlikely to reverse the tide. So far in Canada, demographic effects have been only partly mitigated by increased participation rates of older workers. The wild card here is the second component of potential output--labour productivity. Unlike the growth of the workforce, which is mostly driven by demographic trends that are predictable and evolve at a glacial pace, productivity growth can change more quickly. And big technological innovations that fuel sea changes in productivity--such as electricity and the semiconductor--are difficult to foresee. So far this century, productivity growth has been hardly encouraging. The effects of the information technology revolution on productivity growth are fading and the rate of adoption of new technologies is slowing. An additional source of drag has come more recently from a significant slowdown in business investment which is in large part related to lingering uncertainty and a steep decline in global trade growth. The medium-term outlook for potential output growth could be more positive if tighter labour markets do eventually lead to wage increases and incite more investment in productive capital, and if there are major advances in technology that we have not yet imagined. Without a meaningful rebound in productivity, population aging will lead to even lower potential growth than in past decades. Natural by-products of slower potential growth are not only weaker corporate profits and dividends, but also a lower average rate of return on investments. One way to gauge this effect is to estimate the neutral rate of interest; here I am referring to the risk-free real interest rate that would prevail over the medium term if the global economy were operating at its potential, after the effects of all cyclical forces had dissipated. This neutral rate would be just right to balance the full-employment level of savings and investment. In a lower-growth environment, businesses invest less and therefore have lower financing needs. This drives down the neutral rate, since a lower level of interest rates is required to equate savings with investment. is one of the key reasons why we have reduced our estimate of the neutral real rate for Canada over the past couple of years. It is about 1 1/4 per cent now, down from about 3 per cent in the early 2000s. Estimates are highly uncertain, so it is best to put a range of +/- 50 basis points around these numbers. Global potential growth is not the only determinant of the neutral rate. There is also the increase in global savings witnessed over the past decade and a half, the lingering effects of the financial crisis on investment demand and post-crisis financial reforms. And while we often talk about the existence of a "global" neutral rate, an array of factors like country-specific risk premiums push interest rates to different levels across countries. It is essential to keep an eye on where the neutral rate is, since the stance of monetary policy can be measured as the gap between the level of the policy rate and the neutral rate. Some economists, most prominently Harvard Professor Lawrence Summers, think there is a risk that the neutral rate is so low in some economies that the effective lower bound is preventing central banks from providing sufficient monetary stimulus. They argue that the structural factors that are responsible for the low neutral rate could persist well into the future, contributing to "secular stagnation." In Canada, with the target for the overnight interest rate currently set at 0.5 per cent, we judge monetary policy to be quite stimulative, although less so than it would have been a decade ago when the neutral rate was higher At the same time, as population aging continues, the neutral rate could fall further, unless productivity growth picks up or global savings fall. And the longer weak investment persists, the more important this risk becomes. While we typically link financial stability risks to unsustainably high growth, slower growth and lower returns can also add to vulnerabilities in the financial system through a number of channels. Let me talk about three. The first is a macroeconomic channel that works through households. Years of low interest rates have, by design, encouraged growth in household credit, leaving many highly indebted. In Canada, average household debt is around 165 per cent of disposable income. As average household income growth slows, we can expect that economic shocks-- such as foreign demand shocks that reduce demand for exports or changes in commodity prices that adversely affect a country's terms of trade--will result in more frequent and longer periods of shrinking incomes. This is due to two related factors. The first is just simple arithmetic: the lower the average growth rate of household income, the more likely it is adverse shocks will push it negative. The second factor is a bit more subtle. A lower neutral rate also makes it more likely that interest rates will be constrained by the effective lower bound, meaning monetary policy will have less scope to support income growth during periods of economic weakness. To get a better sense of the practical importance of these factors, we ran simulations with the Bank of Canada's main policy model. They show that, for Canada, the lower neutral rate means that the probability of being at the effective lower bound--which we assume to be -0.5 per cent--has gone up from around 1 1/2 per cent to around 7 per cent. Our simulations also confirm that there would be more episodes when the income of working-age individuals actually declined. And the median duration of those episodes would increase from three to six months, or perhaps more if low-income households bear the brunt of the growth slowdown. This would make households more vulnerable, particularly if they are already highly indebted. This is because the debt burdens of households, relative to incomes, would rise more frequently than in the past. And this would typically happen when growth is weak and businesses and financial institutions are also relatively more vulnerable. Of course, how worried we should be about indebtedness is related not only to income but also to the value of debtors' assets. When it comes to households, the most important asset in many jurisdictions is residential property. In Canada, housing equity represents about one third of total household assets. While demographic forces have been a source of upward pressure on house prices in the past, continued population aging and slower population growth going forward suggest a reversal of this trend. All else being equal, demographics will weigh on the demand for housing. Any price effect would directly impact the net wealth of households, at least in the transition period. Obtaining a reliable estimate of the impact of demographics on house prices is very difficult. Much will depend on the response of housing supply and the extent to which older households downsize. Other factors will also have an influence on housing markets in Canada and elsewhere, many of which could work in the opposite direction. For instance, it will also depend on how much urbanization and immigration bolster demand. The relative importance of these other factors will differ within and across jurisdictions. Nonetheless, there is no guarantee that relying on housing wealth will yield the expected payoff. The second channel through which slower growth and lower returns affect financial stability relates to risk taking. As households cope with shifts in the valuation of their main asset, they may also face lower returns on other investments because of the lower neutral interest rate. And since people are living longer, they may need more savings for their retirement years. Predicting the precise impact of lower interest rates on household savings is difficult because not all households will choose the same strategy. Empirical studies find that household savings will typically decline when interest rates fall. This suggests that workers, instead of saving more, generally choose to invest in riskier assets, work longer or earn lower retirement incomes. But these are not normal times, and with interest rates so low for so long, there may be a point at which we observe higher savings. Asset and pension fund managers also face increased incentives to take on more risk with a lower neutral rate. Defined-benefit pension plans are in a particularly difficult position: funding and benefit levels were set based on shorter lifespans, a smaller number of retirees relative to the working-age population, higher discount rates and higher expected asset returns. Not surprisingly, the funding status of major defined-benefit pension plans, both public and private, has deteriorated. Defined-contribution plans are also facing pressures--the amount that individuals need to contribute to fund a given level of nominal retirement income has increased substantially. Although they may turn to increased contributions or lower benefits over time, many pension funds are adopting strategies that include a larger share of alternative assets in an effort to generate higher returns. Some pension funds are also taking on more leverage. Large defined-benefit plans have the scale and expertise to diversify into less-liquid assets and into regions with higher expected returns, including in emerging markets that have relatively higher potential to grow. They also have a greater ability than many other investors to weather short-term market volatility--and even take advantage of it--because their liabilities are largely long term and their funding is secure. Nonetheless, pension funds are often large participants in the financial system, as they are in Canada, and so risks in this sector merit careful monitoring. Individual investors face similar challenges. As rates of return available from public bond and equity markets decline, they too are searching for alternative sources of yield. The investment industry has responded by creating fund products based on non-traditional, less-liquid underlying assets that expand the range available to individual investors but also carry risks. Alternative, open-ended mutual funds are an interesting example. They appear to offer daily liquidity for underlying assets that can be very illiquid, such as commercial real estate or commercial bank loans. In reality, this practice could result in redemptions being suspended, as we saw with some UK property funds in the wake of Brexit. Market participants investing in a wider universe of riskier assets may be desirable if it increases access to funding for productive projects. The crucial question is whether investors can properly price and manage the risks. History is rife with examples of when excessive and prolonged search for yield ended badly. The third channel relates to bank business models. In most economies, the banking system is integral to the provision of credit to households and businesses and therefore the efficient transmission of monetary policy. However, banks can also be the source of financial instability. In principle, a key determinant of a bank's level of profitability is net interest margin--the difference between what they charge on loans and what they pay for funding. At first glance, there is no theoretical reason banks could not achieve their desired margins even if the neutral rate is lower. In practice, however, problems arise when policy rates drop to very low levels. This is because banks do not always have the flexibility to reduce their funding costs in line with the declines in their interest income. In particular, banks have proven reluctant to pass lower interest rates--especially negative rates--on to their retail deposit base. In the United States, for example, net interest margins narrowed by about 20 per cent between 2010 and 2015. Without significant adjustments to expectations for returns on equity, these pressures on margins could prompt banks to change their business models and shift activity away from deposit-based lending toward other activities. That said, banks are limited by Basel rules on capital, leverage and liquidity in the amount of additional risk they can take on. The demographic trends and other factors that have contributed to the decline in the neutral rate will also likely have implications for how banks do business. As aging baby boomers switch from saving to dissaving, the mix of banking products will adapt. Weaker housing demand could reduce the demand for mortgage and consumer credit, including home equity lines of credit. In fact, housing itself is transitioning from being a savings vehicle to a dissaving one, through products such as reverse mortgages, and may even drive innovation in the provision of financial services. Pressures on bank business models come at a time when banks are also facing increased competition for profitable segments of the value chain, such as payments and data. Clearly, banks are adapting in response to these pressures. At the same time, important financial activities and related risks are migrating to the less-regulated sector. While financial reform has reduced the likelihood of instability coming from banks, these trends merit monitoring. These risks may at times be reminiscent of Odysseus's voyage back to Ithaca. Unlike Odysseus, though, we are not at the mercy of the gods. There are some promising strategies to mitigate the risks ahead. The first is to promote a sound global financial system. G20 countries have to complete the post-crisis financial reforms they have agreed to, whether those reforms are related to banks, financial market infrastructures or nonbank financial intermediation. We saw some of the benefits of increased bank capital and liquidity in terms of market functioning in the aftermath of the Brexit vote. It is still early days for financial reform, though, and we may not have gotten everything perfectly right. The Financial Stability Board is appropriately focused on measuring the effects of the reforms, including those on financial market functioning and cross-border financial market integration. Another important aspect that should be considered, where possible, is the impact on wealth and income distribution. A sound financial system also requires macroprudential tools to lean against credit cycles. The effects of downturns in these cycles can be very costly and difficult to clean up. Monetary policy is too blunt an instrument to fine-tune credit cycles. That is why macroprudential measures aimed at specific sectors are a better way to address financial vulnerabilities. The second strategy is to adopt policies that promote growth. You will not be surprised to hear that, as a central banker, I think that monetary policy best contributes to the overall health of the economy by keeping inflation low and predictable. In pursuit of this goal, monetary policy can at times ease the financial stability risks associated with negative shocks that reduce households' disposable incomes and their ability to service existing debt. This was the case in Canada when we lowered our policy rate twice in 2015 in response to the oil price shock. At the same time, the scope for monetary policy to offset negative demand shocks will be more limited as we face a lower neutral rate. As was discussed at length in Jackson Hole last month, central banks have developed other tools, like quantitative easing and productive uses of their balance sheets. The efficacy and long-term effects of unconventional tools will only be known over time. There is another reason we should not count on monetary policy to solve everything. Monetary policy is not well suited to deal with structural problems, and today's challenges go far beyond temporary shocks. Fiscal policy can be a powerful tool to boost growth, from both the demand and supply sides. Infrastructure spending can be particularly effective if it raises trend labour productivity, since it can help raise potential growth and ease pressures on the neutral rate. That said, government spending cannot solve everything either. We know that an aging population will put pressure on public finances through pensions and healthcare spending. When I was at the G20 meeting in Chengdu this summer, we reiterated the urgency of a comprehensive strategy to achieve a stronger trajectory for global growth. In addition to investment in infrastructure, countries agreed to raise potential growth by reforming their product and labour markets, as well as their tax systems, and to develop policies to support innovation and enhance trade. The last strategy I'll mention is crucial: we have to adapt to the new reality of lower potential growth. That means changing our investment strategies and risk-management practices to reflect lower rates of return for any given level of risk. For households, this may mean saving more before retirement or planning for a lower post-retirement income. It also means acknowledging a reduced capacity to grow out of existing debts. The faster we do this, the safer the financial system will be. Let me wrap up. At one point in their journey, Odysseus and his men come across an island inhabited by lotus-eaters. The fruit of the lotus makes those who eat it forget about their journey--so much so that Odysseus has to force a couple of his companions back on the ship to continue the trip home with him. It strikes me that we may be at a similar point: after what we have been through, it is tempting to enjoy some respite from our own long journey. We cannot. If there is one thing we have learned from the past decade, it is that imbalances can take a long time to develop and even longer to resolve. Investors and market participants have to adapt to lower neutral rates. Countries must continue to work to meet their G20 commitments and take fiscal and structural measures that will improve long-term growth. Authorities have to continue to solidify the global financial system and guard against emerging problems. It is a long road, but it is the one that will get us safely home.

r160920a_BOC

canada

Living with Lower for Longer

poloz

Governor of the Bank of Canada Association des economistes quebecois, the Cercle finance du Quebec and CFA Quebec It is not often that I get to speak to a room full of economists and, believe it or not, I consider it a privilege. People say that economists can never agree on anything, but I suspect that we can agree on at least one thing. What is the number one issue that people ask economists about today? It is ultra-low interest rates. You probably get questions from both sides, just as I do. Young folks with mortgages regularly thank me for keeping interest rates low. When I think about how much cumulative interest I have paid in my lifetime, it is no wonder that they are grateful. But I also hear from people, especially retirees, who are unhappy because they have saved their whole lives and are getting very little income from those savings today. Now, it is natural to give central banks the credit--or the blame--for ultra-low interest rates. Low rates have been with us since the global financial crisis. The G7 central banks implemented coordinated interest rate cuts in 2008--a sign of just how serious the situation was. Some of the hardest-hit economies, such as the United States, Europe and Japan, implemented unconventional policies to ease monetary conditions further. Without these efforts, the global economy could have fallen into a second Great Depression. We avoided that fate. But since that time, policy rates have generally remained extremely low, mainly because the economic headwinds that the crisis created have been slow to fade. Some central banks have even gone to negative interest rates, a bizarre concept for many, and bond yields across the curve are also ultra-low. In fact, more than US$10 trillion of government debt is currently trading with a negative yield. As economists, though, we can also agree that this is about much more than monetary policy. There are big, long-term, global forces acting on interest rates, and people need to understand them better. Senior Deputy Governor Carolyn Wilkins spoke about this same topic last week in London, focusing on the implications for financial stability. Today, I'm going to focus on the macroeconomic and monetary policy aspects of ultra-low rates and conclude with some thoughts on how other policies fit into the matter. As economists, we naturally think of nominal interest rates as a combination of expected inflation and the real interest rate. Under Canada's inflation-targeting regime, inflation expectations have been very well anchored, even during the global financial crisis and subsequent recession. It follows that a decline in real interest rates is the issue at hand, and a drop in the real neutral rate is a big part of this. The real neutral rate is a theoretical concept that can't be directly measured, and central banks don't control it. But it is extremely important to understand: it is the inflation-adjusted risk-free interest rate in an economy--the real interest rate that is neither stimulative nor contractionary when an economy is operating at full capacity without cyclical forces at play, thus balancing desired savings and investment. Presently, Bank staff estimate that the real neutral rate falls into the range of 0.75-1.75 per cent, which translates into a range for the nominal neutral pre-crisis period. The most important force pushing the neutral rate down has been a steady decline in the potential growth rate of the economy. In turn, this decline is being driven primarily by the aging of our population, which is slowing the rate of growth of the labour force. In effect, the baby boomers boosted potential economic growth significantly, starting in the 1960s. Since that force has been in place for some 50 years, it is easy to think of that boost as lasting forever. But in a demographic sense, it was temporary. Those folks have been entering retirement for the past few years, and potential economic growth has been slowing as a direct result. There are other forces acting, of course, including rising global savings rates as developing countries grow to represent a bigger share of global GDP. At the same time, global investment spending has moderated, in part because of lower potential economic growth; firms need to invest less than they did in the past to sustain that lower potential output. Technological change is also playing a role. But this combination of higher savings and lower investment means that the price of borrowing those savings in order to invest--the neutral interest rate--has ground even lower. Today, those forces seem permanent to people, but of course nothing is really permanent. Just as the 50-year boost to potential growth caused by baby boomers is ending, the forces acting today will unwind eventually. Put simply, we're dealing with lower for longer, not lower forever. Even so, these processes act so slowly that we must adapt to them today. We cannot just sit back and wait for these slow-moving forces to reverse. People and companies, investors and savers, all need to understand these forces and make adjustments. One group that has certainly been affected by lower for longer is savers, particularly seniors who planned to finance their retirement with interest income generated by a life of working hard to build savings. I have heard from many Canadians who are rightly worried about their ability to live off their savings and who are seeking a return to higher interest rates. I certainly can sympathize and understand these concerns. Demographic and economic changes, along with the low interest rates that followed the financial crisis, have upended the calculations that many Canadians made in planning for retirement. That is not their fault. But at the heart of this discussion is the level of the real rate of interest. Having higher nominal interest rates because of higher inflation would not help savers, because higher inflation would just erode the future purchasing power of those savings. Maintaining a low-inflation environment is the Bank's primary goal. We do this because we've seen that it is the best way to help bring about solid, sustainable economic growth. That growth benefits everyone, from business owners looking to expand, to workers looking for employment, to savers looking to protect their savings and find investment opportunities. In our most recent , in July, we said that our current policy rate setting of 0.5 per cent was consistent with the economy returning to full capacity toward the end of 2017 and inflation returning sustainably to its target. We'll update our forecast next month, but in our decision on September 7, we indicated that the risks to our projected inflation profile have tilted somewhat to the downside following recent data on investment in both the United States and Canada, and the recent data on our exports. It is quite evident that our economy is still facing strong headwinds, and we need stimulative monetary policy to counteract them and move us closer to full capacity. We also need to watch the full effects of the government's fiscal stimulus unfold. However, the decline in the real neutral rate means that any given setting of our policy rate will be less stimulative today than it was a decade or two ago. The current policy rate, while certainly providing monetary stimulus, is not as stimulative as it would have been before the crisis. By the same token, an immediate rise in our policy rate back to, for example, the 4.25 per cent that prevailed before the financial crisis would represent an extreme tightening of policy and would have significant consequences. This is just another way of saying that low interest rates are actually having big effects today, but the headwinds pushing back on that stimulus remain quite powerful. For some savers, ultra-low interest rates do have positive effects. In particular, the value of most assets rises when interest rates decline, supporting gains in household wealth. This effect may not be as obvious as the impact of low rates on savings. But lower interest rates generally mean higher stock and bond prices, as well as increases in the value of real estate, which has been another important source of wealth for many savers, particularly seniors. I realize this may be cold comfort to those people who have to adjust retirement plans to a lower-for-longer world. But the difficult reality is that savers must adjust their plans. That may mean some combination of putting aside more funds, working a little longer than planned or changing the mix of investments. There are no easy answers, particularly for some who have already retired. Compounding the challenge is the fact that people are now living longer--life expectancy has risen by about 6 years since the early 1980s. I hope you will agree that this is unambiguously good news. But combining longer life expectancy with low interest rates means that a person starting to save today would have to set aside much more to generate the same retirement income as a person who began saving 25 years ago, if both wished to retire at the same age. The other group I would like to talk about today is companies and, specifically, their decisions about business investment. Across the global economy, investment spending fell sharply during the financial crisis, and the recovery has been unexpectedly weak. The recent drop in oil and other commodity prices has lowered investment plans even further. When investment slows, it means an economy's potential output also grows more slowly, which can reinforce the trend toward lower interest rates. In contrast, raising potential output through increased investment can ease the downward pressure on global rates. With interest rates as low as they have been, the cost of capital certainly is not a problem for well-established businesses. But as economists, we know that credit provision will always be less than perfect in a financial system such as our own. And there is a risk that changes to global banking regulation, designed to make the system safer, could worsen any such imperfections. Put another way, it is likely that financing gaps continue to exist--and could easily have increased in importance--for new and young businesses, for small and medium-sized enterprises, and for trade finance and infrastructure. Given the importance of young company growth at this stage of the business cycle, the Bank is monitoring data on company formation and credit flows carefully. Still, we are seeing a number of firms in Canada's non-resource sector that are operating close to full capacity. Under normal circumstances, you would expect investment intentions to be rising, but so far that has not really been the case. Research done at the Bank of Canada and elsewhere, including conversations with business leaders, suggests that the main cause of weak investment is the high level of uncertainty that companies are facing, particularly about future demand prospects. And it is understandable that businesses would be uncertain. Companies have lived through the daunting experience of the financial crisis and Great Recession. On top of that, we have had all sorts of economic and geopolitical uncertainties across the global economy. In such an atmosphere, it's not surprising that business leaders would be reluctant to commit to major new investments. However, in my conversations with Canadian firms I have picked up on another possible investment impediment--hurdle rates for new investments do not seem to have adjusted to the new reality. The hurdle rate is the lowest acceptable rate of return that a company chooses for an investment to proceed. Generally, you calculate the hurdle rate by adding together the risk-free interest rate, a measure of inflation expectations over the life of the project and a premium to compensate for the investment's risk. Because the risk-free interest rate is closely related to the real neutral rate, and because the real neutral rate has been declining, it follows that hurdle rates should also be lower, all else being equal. I have had some business leaders tell me that they have been surprised to see, for example, companies in Asia pursuing investments with implicit returns of around 3 to 4 per cent, well below most companies' hurdle rates. My response has been to say that in the current and prospective environment, 4 per cent will probably turn out to be a pretty good return. If uncertainty is the main impediment to investment decisions, then it should subside over time as economies heal, improving the investment climate. But if companies are maintaining traditional hurdle rates, they are unlikely to invest any time soon, and we will not see the kind of growth, productivity and job creation we are looking for. And neither will the companies. So far, we've talked about the adjustments that are needed in response to powerful, slow-moving global forces. We know that these forces have reduced the real neutral interest rate here in Canada and will keep the growth of potential output around 1.5 per cent for the next number of years. In such a context, increasing potential output growth by even a few tenths of a percentage point would make an important difference to all the issues I have spoken about today. Raising potential output growth would boost the real neutral rate of interest and long-term interest rates, and it would increase returns on investments for savers and companies alike. So if there are policies that would boost potential output--the sum of labour force growth and productivity growth-- then we need to pursue them. Fortunately, there are many things that we collectively can do. The G20 has been discussing this for some time, describing it as the third leg of the policy stool-- structural reforms to complement monetary and fiscal policies. Here in Canada, one way forward is to identify and remove impediments to business growth. For example, new and young firms are often the ones that can do the most to improve an economy's productivity, create new jobs and raise potential output. So we need to make sure that our tax and immigration policies, as well as our ability to finance growth of young firms, are as enabling as they can be, so we can nurture those firms and see them flourish right here. One important impediment to business growth that is widely shared globally is weak infrastructure. We know that infrastructure projects spur growth in the short term by boosting demand. More importantly, infrastructure projects can support long-term growth by raising an economy's potential output. Among economists, there has been some debate over the size of the impact on potential output that infrastructure projects can deliver. Deputy Governor Sylvain Leduc did some research during his time at the Federal Reserve Bank of San Francisco. The research showed that, within six to eight years, US government spending on highway projects delivered at least one dollar, possibly two to three dollars, in increased output for every dollar spent. It would be helpful to have more research on the fiscal multipliers of infrastructure spending in Canada. But it seems likely to me that well-targeted infrastructure investments will yield more economic growth than just the first infusion of cash because they enable more growth to occur in the future. Another key avenue shared by all economies is trade liberalization. We all need to encourage this, both within Canada and internationally, since the world seems to be entering a phase of doubt about the benefits of international trade. Beyond the rhetoric, the future of the Trans-Pacific Partnership (TPP) has come into question, and the trade agreement between Canada and the European Union, while much more advanced, still must go through a long ratification process. We know from history that sliding into protectionism would be highly counterproductive. It is important for authorities to continually make the case for freer trade. Here at home, the announcement this summer of a preliminary agreement on interprovincial free trade is certainly welcome. There are many indications that interprovincial barriers are holding back the growth of individual companies and the economy as a whole. It is also important to recognize and understand the reasons behind rising antiglobalization sentiment. For example, people who have been affected by restructuring brought about by globalization often face difficult adjustments, including retraining and moving long distances. Policy-makers need to be sensitive to these difficulties and do what they can to facilitate those adjustments. At the same time, there is a role for economists to do compelling research that reminds people of the impact of trade. Increasing trade is a positive-sum game. Companies, too, could do more to demonstrate how globalization has made all kinds of goods and services more widely available at a lower cost, and how important trade is for their own employees. Making infrastructure investments, defending existing trade arrangements and pursuing new ones are certainly good candidates for boosting Canada's economic potential. But when we move from theory to practice, how big can those effects be? Well, bearing in mind that we start our analysis with a projection that Canada's economic potential is likely to grow by only around 1.5 per cent, which is not very inspiring, we need to take every decimal point of potential growth more seriously than we have in the past. Now, none of the structural initiatives I've mentioned is a silver bullet by itself. But together, they could make a large difference in our long-term economic prospects. Let's consider the possibilities in light of existing empirical evidence. Begin with the removal of interprovincial trade barriers. Conservative estimates suggest that removing interprovincial trade barriers could add one- or two-tenths of a percentage point to Canada's potential output annually. Some estimates are far larger. As for international trade, research conducted at the World Bank and elsewhere suggests that the TPP could add a further one- or two-tenths to our potential output growth. The Canada-EU trade agreement should also boost potential, though estimates suggest by less than the TPP. In a low-growth world, these three initiatives taken together could have a significant impact on economic growth, year after year. Now, let's add the impact of targeted infrastructure spending. A prudent estimate is that this could add another tenth or two of a percentage point to potential output over the medium term. When you consider how the benefits of these policies would add up over years, you'll see why every decimal point counts. A reasonable estimate is that these policies could raise the level of real GDP by 3 to 5 per cent by 2025, which would mean up to $100 billion more in income for Canadians every year. In a lower-forlonger world, these are opportunities we simply cannot afford to miss. This is especially true because other countries are not sitting still--in other words, we could actually lose ground as other countries become more competitive, so failing to take up these structural opportunities might still mean an erosion of the status quo. It's time to conclude. What I've tried to do today is be clear about the forces that have brought about this period of ultra-low interest rates and help identify the implications. While monetary policy actions played a role in the decline of interest rates, the Bank sets its policy rate to meet its primary mission: returning inflation sustainably to target, thus helping to get the economy back to full output. In this sense, ultra-low interest rates are a symptom of the conditions we face, conditions that we believe are improving over time. But some of the forces leading to low interest rates will persist for a long time, so we need to prepare for lower for longer. Individuals need to plan for retirement with different assumptions about longevity, interest rates and growth. Businesses need to make sure their expectations about investment returns reflect the current and likely future reality and reconfigure their investment plans accordingly. And policy-makers need to make sure they are working to increase the economy's potential output and reduce uncertainty--whether economic, political or regulatory--that may be holding back investment. What the Bank can, and will, continue to do is to provide certainty about the future value of money through inflation control. Together, we can make the necessary adjustments and boost confidence that will foster the economic growth we all want to see.

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Paul Storer was a special fellow. We met back in 1984 when he was fresh out of the Master's program at the University of Toronto, and I was fortunate that he chose to accept an appointment in my group at the Bank of Canada. I know I helped influence his decision to go back to school three years later for his PhD, and his choice of the University of Western Ontario, now known somewhat ironically as Western University. While he was there, I was able to visit him from time to time, and it was a pleasure watching him grow. Sincere, dedicated, thoughtful, skeptical--these are some of the words I would readily use to describe Paul. But most importantly, he was a very nice person, highly likeable and a joy to work with. It never seems fair when we lose someone like Paul, but, to me, this loss seems especially so, for we barely managed to stay in touch after he and his wife Tina moved to Bellingham. Email from time to time, and a beer or dinner when he and Tina were in Ottawa, it was always great to catch up, and now I treasure those memories even more. I'm very touched to have been invited to give today's lecture in Paul's memory, and I wanted badly to do something that Paul would have appreciated. Fortunately, Paul had wide-ranging research interests, so I had a lot to choose from. But he had clearly settled onto Canada-US relations, particularly trade issues, as a core interest. And, his first fulltime job was in monetary policy. So, today I have chosen to explore an issue he cared about deeply--cross-border trade integration--and to do so through the lens of a monetary policy practitioner. Let me offer a quick sketch of my narrative. Paul had a strong interest in whether the move to NAFTA, had actually led to increased integration of our two economies. His finds little definitive evidence of increased integration of the Canada-US economies in the wake of either CUSFTA or NAFTA. This seems to be the case whether you investigate trade flows, investment flows, labour mobility, or the convergence in prices or factor input prices. At the same time, some of their findings suggest that the issue may be too complex and the demands on the data too great to support rigorous empirical inference. In particular, there are some large shifts in trade patterns at the sectoral level, suggestive of increased specialization and more trade in components--in short, "supply chaining." Moreover, as Globerman and Storer themselves observed, periodic significant fluctuations in the Canada-US exchange rate, combined with a degree of domestic price stickiness, are likely to pose challenges for empirical work around integration. In what follows I will build on some of those observations and argue that there is more (albeit soft) evidence of increased trade integration when the definition of trade is broadened to embrace all the dimensions of international business. This includes widespread supply chaining and the establishment of foreign affiliates selling directly to host markets or third markets; in other words, globalization in its various forms. Indeed, it is important not to restrict attention to the three NAFTA partner countries, since additional countries (for example, China) may be important facilitators of integration within North America. Statistical agencies are still catching up to these business trends, so, by necessity, much of the evidence we will bring to the matter will be indirect. We make no rigorous empirical claims, especially related to the effects of specific trade agreements, but suggest that the evidence of increased integration is sufficient for monetary policy to take it seriously. This issue intersects with monetary policy along at least two dimensions. First, monetary policy formulation depends heavily on empirical economic models, and the evolution of international business is certain to have consequences for model structure and for key model parameters. For example, domestic inflation may come to be driven more by global demand and supply, and less by domestic forces. As well, the effects of fluctuations in domestic interest rates and exchange rates on the domestic economy may diminish as economies become more integrated. The second dimension relates to monetary policy strategy, including both the appropriate choice of target for the central bank to aim at and the time horizon over which it should attempt to exert control. In attempting to smooth real economic fluctuations--with the goal of achieving an inflation target--the central bank creates interest rate and exchange rate fluctuations. These fluctuations may need to be greater in a world where increased cross-border integration has weakened some of the key macroeconomic linkages relied upon by central banks. These shifting trade-offs need to be well understood in order to frame appropriate policy choices. We will explore these policy issues using a state-of-the-art macro model of the Canadian economy. We begin by describing the various ways in which trade has evolved in North America during the past 30 years. The concept of "trade penetration" is one useful proxy for the importance of international trade for the domestic economy since it goes beyond the traditional concept of exports. We use a country's nominal exports plus its imports as a share of nominal GDP to measure the importance or "penetration" of trade into domestic value creation, focusing on trade in goods for convenience. In a globalized world, where production processes are often geographically fragmented, the competitiveness of a country's exports depends increasingly on inputs imported from other countries, since that facilitates the division of labour between lower-wage and higher-wage workers. Clearly, this fragmentation boosts international trade for a given level of GDP. In effect, we trade parts, and then we trade the final products, which Chart 1 offers some data on trade penetration of goods for the world and for the three NAFTA economies. At the global level, trade penetration rose steadily from the early 1990s through to the collapse in trade after the global financial crisis in 2007-08. There was a recovery in trade penetration after the ensuing global recession, but since 2010 total trade has been flat or even declining slightly in importance to global GDP. The weakness of global trade growth in the past few years has attracted considerable globalization has happened in waves that cannot be expected to be repeated. Early development of global value chains (GVCs) was mainly the product of technological improvements and falling tariffs and other costs, such as transportation and logistical support costs. GVC development received a major boost when China joined the World 2014; Constantinescu, Matoo and Ruta 2015). A second reason is that the world has entered a phase of subdued business investment because of the weight of post-crisis uncertainty, and investment spending is a very trade-intensive activity. Accordingly, soft investment has a disproportionate effect on global trade flows (Morel 2015). A third reason, offered by Stratford (2015), is that emerging markets generally have lower import elasticities than advanced economies; consequently, as the relative contribution of emerging economies to global GDP growth rises, the global income elasticity of trade has been declining. It is therefore reasonable to expect global trade to pick up as the world economy gathers momentum; but it seems less likely to exceed global GDP growth to the same extent as in the past. This global pattern in trade penetration has been mimicked by the US economy. Canada and Mexico have had different experiences, however. Mexico has seen a steady rise in trade penetration for more than 30 years, with a big acceleration coming on the heels of NAFTA in 1994. There was a minor decline in trade in the wake of the global financial crisis, but the uptrend resumed right afterward. In contrast, Canada saw no rise in trade penetration in the immediate aftermath of CUSFTA in 1988 (indeed, trade penetration was in a downtrend) but then saw a rapid rise in trade penetration from 1991-2000. NAFTA may have contributed to this rise after 1994, but the fact that much of the 1990s increase in trade penetration was unwound during the following decade suggests that other forces may have been at work. One contributing factor was the global telecom boom and subsequent bust, in which certain Canadian companies were active participants. Another was the steady appreciation of the Canadian dollar from 2002 to 2008, and its persistent strength in the aftermath of the global financial crisis. This resilience was mainly the product of high oil prices, which led to considerable restructuring in many export sectors, including automobiles and forestry products, and the outright exit of large numbers of exporting companies. The US business cycle was also a contributor. Since 2010, a modest uptrend in trade penetration has resumed in By this simple measure then, one would conclude that the three NAFTA countries have become more integrated with the global economy during the past 30 years, especially Mexico. The latter observation fits one's priors that smaller countries tend to have the most to gain from trade liberalization. It is also consistent with empirical evidence in Romalis (2007), showing that export volumes between these countries increased significantly because of NAFTA. See also Caliendo and Parro (2015), who develop a calibrated model suggesting that NAFTA augmented intra-North American trade by 118 per cent for Mexico, 41 per cent for the United States, and 11 per cent for Canada. The implications of these trends for goods exports in the three NAFTA economies are illustrated in Chart 2. Exports as a share of GDP have almost doubled in the United States in the past 30 years but have been showing weakness recently. Mexico has seen a steady rise in exporting, particularly in the wake of NAFTA, and today has an export-toGDP ratio approaching 35 per cent. In contrast, the export sector trauma of the 2000s has taken Canada's export-to-GDP ratio from a high of 37 per cent to about 26 per cent--albeit resuming a modest uptrend--today. The concept of total trade penetration embodies the idea that countries trade not just in final goods but in the components that go into them. Indeed, this is the essence of the benefits of globalization. A given product can be fragmented into various components, some of which require highly skilled, highly paid workers and some which can be mass produced at low cost in lower-wage locations. Trade connects these fragments together into GVCs and permits better matching between skills and products and therefore lower overall costs and higher productivity. GVCs clearly boost conventional trade statistics for a given unit of GDP and make interpretation of those statistics more difficult. One way to tackle this issue and gain insight into the degree of cross-border integration is to examine the flow of intermediate goods between countries. After all, consumers are not interested in intermediate goods, only the finished product. Trade in intermediate goods is, therefore, business to business and productivity-enhancing. Chart 3 shows the trends in global trade in intermediate goods for the NAFTA countries. These data show that there has been a strong tendency for trade in intermediate goods to grow in all three countries. While all three have seen an uptrend since NAFTA, the large acceleration after 2000 suggests that the bigger influence may have been China's accession to the WTO. The level of intermediate goods trade for the United States dwarfs that for Canada and Mexico by factors of four and seven, respectively. The importance of intermediate goods trade to the US economy is consistent with its role as a global hub for multinational enterprises (MNEs) that develop GVCs spanning multiple countries, including its NAFTA partners. Although it would be difficult to disentangle these data, they are at least consistent with a rising degree of North American integration over the past 20 years. Trade in intermediate goods goes far beyond refined raw materials or minor parts to include full subsystems. Trade in automobiles provides an illustration: a very large portion of the total value added in an automobile comes from the parts and subsystems made by manufacturers in the supply chain, whether they are building engines, transmissions, electronic systems or even glass. Final assembly of vehicles is in fact a relatively low value-added activity today--amounting to well under 10 per cent of the final value of the automobile--with much more value added embedded in the parts and subsystems made by suppliers. Aircraft manufacturing is broadly similar in this respect. Supply-chain trade often happens within the same firm, the trade-facilitated version of vertical integration. Thus, the MNE creates (or purchases) entities that supply it, thereby increasing reliability, maximizing efficiency and perhaps internalizing the value added (and profitability) that lies in the supply chain. Such arrangements are very clear in the manufacturing sector of the NAFTA countries. For the United States, some 40 per cent of manufactured exports to Canada are intra-firm, and about 50 per cent of imports from Canada are also intra-firm. Similarly, around 40 per cent of US manufactured exports to Mexico are intra-firm, but a much higher proportion of US imports from Mexico--70 per cent--are intra-firm. These data point to a very high level of crossborder integration, at least in certain manufacturing sectors, including automobiles, aerospace and telecommunications equipment. As noted earlier, trade through a value chain creates some double-counting, or perhaps more appropriately multi-counting, of trade flows, because the same items cross borders more than once. Consider a mobile phone, designed and engineered in one country, assembled in another country from components produced in several other supplier countries and then sold to the entire world. Even in this relatively simple example, parts of the phone cross borders more than once, and each time that value is recorded as someone's export. What this means is that any change in the structure of global value chains can either inflate or depress normal "gross" trade flows. In an effort to understand these phenomena better, the Organisation for Economic Co-operation and Development (OECD) has developed indicators of "trade in valueadded terms," which attempt to capture the value added in each country's participation in a value chain. Viewed from the domestic lens, building a global value chain means outsourcing content of the final product, thereby reducing its domestic content. The OECD data show that 45 of 61 economies have seen a decline in the domestic content of their exports over the past 20 years (Chart 4). This includes Mexico, where the maquiladoras (suppliers clustered near the Mexico-US border) have captured considerable offshoring activity from US and Canadian firms. Indeed, the maquiladoras today account for over 25 per cent of manufacturing employment in Mexico (Bergin, Feenstra and Hanson 2009), while at the same time incorporating imported inputs from Asia and elsewhere in Latin America. While these observations fit our hypothesis of increased integration across a large number of economies, two exceptions are worth noting. One is Canada, where there has been a modest increase in domestic value added to total exports. The reason for this is that Canada's growth engine during much of the 2002-12 period was in the commodity sector--primarily oil--and this is of course largely domestic value added. Data from Canada's manufacturing sector clearly show a declining portion of domestic value added, reflecting a globalization trend (Chart 5). The other interesting exception is China, which has been by far the most important recipient of GVC business, often in very labour-intensive forms. This means that the explosion of global trade in the wake of China's accession to the WTO has contained a large share of Chinese domestic value added. Over time, however, China has been creeping up the value-added chain, particularly in manufacturing, as Chart 5 illustrates. Yet another indicator of rising cross-border integration is the growing importance of foreign affiliates in facilitating trade. A domestic company has a choice of producing at home and shipping abroad, or locating abroad and shipping directly to that host country and to third countries. Either arrangement may be supported by a global value chain. Importantly, both CUSFTA and NAFTA liberalized and offered legal protection of crossborder investment, so to understand the effects of these agreements we need to look beyond the cross-border flows of goods and services. Data on the operations of foreign affiliates with domestic majority ownership are less widely available and reported with a substantial lag. That being said, by 2013, sales by Canadian-owned foreign affiliates almost matched the amount of total exports sold from Canada, at Can$510 billion versus Can$573 billion, respectively. In effect, there is almost as large a Canadian economy operating in foreign countries as there is in the domestic export sector, creating jobs and GDP both domestically and abroad. Canadianowned affiliates operating in the United States account for about half of this total activity and employ some 600,000 people in the United States; Canadian operations in Mexico generate sales of about Can$15 billion and employ nearly 70,000 people in that country. The number of associated jobs in Canada is much more difficult to estimate. Importantly, the corresponding US figures are an order of magnitude greater. US affiliates operating abroad generate annual sales of some US$6 trillion, with over US$600 billion of that taking place in Canada, and over US$200 billion in Mexico. These are very large numbers; at a minimum, they imply that standard export and import data provide a very incomplete picture of the complexity of international business relationships. While these observations are not definitive, they collectively support the view that cross-border integration has increased in North America over the past 20 years. As mentioned above, deeper structural evidence of increased integration is harder to come by, especially related to specific trade agreements. This is probably because the effects of trade agreements are highly sector-specific, often even firm-specific, and there are always numerous other forces that affect macro statistics. For example, some sectors may have been more protected than others before a trade agreement, so outsized adjustments may be masked in the aggregate data. Shifts in industry composition or in factor intensity can easily distort micro phenomena when aggregated into macro statistics. And, there may be subsequent shocks that hit particular industries. Nevertheless, the literature has built a number of insights on the effects of specific trade agreements over time. For example, in the wake of CUSFTA, Canada's manufacturing sector saw a 5 per cent drop in employment and a 6 per cent increase in productivity. Looking at a finer level of detail, those industries with the deepest tariff cuts saw a drop in employment by some 12 per cent and a rise in productivity of around 15 per cent. Importantly, these employment effects were erased over the longer term, as job gains work, Lileeva and Trefler (2008) show that improved access to foreign markets induces evidence that US firms in the auto sector re-configured their GVCs in response to NAFTA. Mexico was an important beneficiary. Many of these changes are most dramatic at the firm level, which underscores the role of intra-industry reallocation in facilitating As for convergence in factor pricing, Caliendo and Parro (2015) find that NAFTA lowered the terms of trade for Canada by 0.1 per cent and for Mexico by 0.4 per cent, while raising the US terms of trade very slightly. Although real wages increased for all three economies, Mexico showed the largest gains--weakly suggestive of some degree of factor price convergence. The generally positive income effect of trade liberalization highlighted in the basic model of trade (Krugman 1980) receives surprisingly little attention. The main channel for this effect is falling import prices, and the positive effect of lower import prices on domestic purchasing power can be easily lost in the debate about how domestic producers will compete and how many domestic jobs may be lost. Job losses may not be well captured by import price indexes when a central result of trade liberalization is an increase in the number and variety of products that become complicating factor in this research is the possibility that profit margins may not be constant, which may weaken the pass through of decreases in costs that come from trade liberalization to domestic consumers (De Loecker et al. 2012). Summing up, a broad-brush review of data on international business and the empirical literature demonstrates substantial evidence that that cross-border trade integration has increased in the past 20 years. At the same time, it remains possible to be skeptical of the depth of the integration hypothesis, especially attempts to credit either CUSFTA or NAFTA specifically with the observed trends in the trade data, since definitive structural empirical evidence to support it is limited. Certainly, the impact of the two agreements on trade seems to have fallen short of predictions made by proponents during pre-agreement debate. Furthermore, some would point to recent evidence of integration reversals, as certain industries have "reshored" back to the United States. However, it is important to keep such anecdotes in perspective; globalization was never likely to take us to an idyllic endstate of pure integration, since the realities of international commerce continue to intrude. These realities include the limited availability of trade finance in many smaller countries, the costs of building and maintaining global logistics networks, geopolitical risks, the preference to have suppliers closer to buyers, and long-distance after-sales service and maintenance, just to name a few. Most importantly, perhaps, the trend to factor equalization--although not proven, it is easy to see rising wages in China or Mexico, for example--creates a new optimization problem for MNEs with GVCs whenever a company undertakes periodic strategic reviews of its cross-border structure. Such reviews can lead (and have led) to decisions to re-shore parts of the supply chain back to the home country--in short, the optimal supply-chain arrangement can vary considerably over time as underlying conditions evolve. This means that the degree of integration may also vary significantly over time, in both directions, making it risky to treat it as a permanent state of the world. My overall reading is that the evidence of increased international integration is sufficiently compelling for policy-makers to take it seriously, since it may affect their policy models and decision-making frameworks. These issues are explored in the next section. It is easiest to think about the implications of these trends in international trade in the context of a textbook open-economy model with inflation driven by a Phillips curve and the central bank targeting inflation. In this framework, a macroeconomic shock moves projected inflation off target and the central bank adjusts interest rates in a manner that brings inflation back to target over the next six-to-eight quarters. For ease of exposition, assume a negative shock to foreign demand, prompting the central bank to cut interest rates to keep inflation on target. The interest rate response of the central bank works mainly through intertemporal substitution by both consumers and firms, who borrow more and spend more on goods, housing and investments. Meanwhile, the cut in interest rates is associated with some depreciation in the domestic currency, which boosts exports and dampens imports, broadening the policy effect on aggregate demand. The weaker currency may also have partially offsetting effects on consumer spending and investment spending because of the higher cost of imports. The depreciation of the exchange rate boosts domestic inflation temporarily. However, the increase in domestic aggregate demand combined with these other effects offsets the drop in foreign demand and brings inflation sustainably back to target. The monetary policy transmission mechanism relies in the first instance on two key reduced-form parameters: the interest elasticity of aggregate demand and the exchange rate elasticity of aggregate demand. The issue to consider is how the evolution of international trade may have influenced these parameters over time, either directly, or through more subtle changes in the underlying structure of the economy. The ultimate effects on inflation will depend on the interaction between the domestic output gap and domestic inflation (the Phillips curve). Each of these relationships may be altered by an increase in cross-border integration. To illustrate, let's compare a world in which entire products are produced in individual countries and exported to others, with one that is "integrated" or "globalized," dominated by MNEs with suppliers scattered around the world. In both states, global demand for a given product is the ultimate demand shock variable. However, the investment decisions of an MNE will be driven more by global variables than individual domestic variables. This could include interest rate fluctuations--assuming the MNE has access to global capital markets, its decision making may be less influenced by domestic interest rates and more by global interest rates. To date, however, there is very little empirical evidence for or against this conjecture, so we have set it aside. Similarly, a fluctuation in an individual exchange rate may have a more muted impact on MNEs in a globalized world, because for any given MNE built on GVCs, the depreciation of one currency means an appreciation of another, both of which could be in the firm's portfolio of demand and supply. In concrete terms, as a country becomes more integrated into GVCs, a depreciation of the exchange rate improves its competitiveness by only a fraction of the value of final goods exports, rather than the whole bundle GVC involves increasing the degree of specialization at each point in the supply chain. This specialization presumably reduces the substitutability of producers across countries, thereby providing a second structural reason why the exchange rate elasticity of exports may decline with increased trade integration. In related literature, Caselli et al. (2015) show that sectors that are more open to trade are less exposed to domestic supply and demand shocks and tend to be less correlated with the rest of the economy. Further, sectors that are more open to trade tend to be more specialized and more volatile (di Giovanni and Levchenko 2009). And, countries that trade more tend to exhibit higher business-cycle synchronization (di Giovanni and Levchenko 2010; Liao and Santacreu 2015). Given these inferences, it is not surprising to find that globalization has made domestic inflation more sensitive to global demand developments and less sensitive to domestic disturbances (BIS 2016, 68). In other words, the global output gap may become a more important determinant of domestic inflation, at the expense of the domestic output gap. Another important structural channel to consider is the linkage between cross-border integration and income distribution. It is generally understood that increased trade penetration and specialization leads to the offshoring of labour-intensive, lowerproductivity fragments of the supply process. This leads to higher average productivity levels and higher incomes domestically. Logically, it may also lead to an increase in domestic income dispersion, a widely observed stylized fact of the past 20 years and much discussed in the United States. Based on a model developed by Krugman (2008), Bivens (2007) concludes that trade restructuring may account for about 15 to 20 per cent of the observed increase in income dispersion. Others have found evidence that this linkage may be even more pronounced for developing countries; for example, Mexico experienced a significant increase in income inequality soon after trade liberalization (Goldberg and Pavcnik 2007). It is evident that the situation varies tremendously from one country to another, in part because the implications of trade liberalization for a given country depend on what other policies are implemented concurrently or subsequently. Further, income distribution outcomes that are sometimes attributed to globalization are often driven by other factors, particularly technological change (Autor, Dorn and Hanson 2015; Chart 6 shows one summary income distribution statistic, the ratio of the income share of the top 10 per cent to that of the bottom 10 per cent, for the NAFTA countries. All three showed an increase in income dispersion during the 1990s. This trend has continued into the 2000s for the United States, but has partly reversed in Canada and has more than fully reversed in Mexico. Of course, since other elements of the policy architecture that affect income distribution have not remained constant through this period, we make no claim that these patterns are driven by trade. Shifts in income distribution could have implications for the standard open-economy models that policy-makers rely on. Since they may have less access to credit, lowincome groups are more likely to be credit constrained and therefore less likely to be influenced by intertemporal substitution than high-income groups. Meanwhile, highincome groups tend to make their spending plans independently of the level of interest rates. An increase in income dispersion, then, could increase the share of the population that is less influenced by interest rate fluctuations, perhaps pointing to a lower interest elasticity of consumption in aggregate. There is limited empirical evidence of this conjecture to date. However, it is important to acknowledge that the level of empirical confidence in estimates of the interest elasticity of aggregate demand is not high to start with. There is evidence that lowincome households have a higher marginal propensity to consume out of their disposable incomes than high-income households (Blundell, Browning and Meghir 1994; Guvenen 2006; Parker et al. 2013). While weakly supportive of the conjecture of a lower sensitivity to interest rate movements in partial equilibrium, this evidence also suggests that once the income effects from interest rate movements are factored in, low-income households won't necessarily adjust their spending by less than their high-income counterparts. Indeed, Kaplan and Violante (2014) offer a model in which increased income dispersion may actually increase interest sensitivity of consumption indirectly through a higher average income elasticity. In principle, the interest elasticity of aggregate demand represents an amalgam of a spectrum of actors, not a representative agent. The importance of this issue depends on how significant the underlying heterogeneity might be. A more promising line of inquiry might be to model income distribution explicitly, and to simulate the effects of an increase in income dispersion due to globalization in the model. A rough attempt to do so is explored in the next section. In this section we use the Bank of Canada's macroeconomic policy model, ToTEM (for may affect monetary policy transmission. model that reflects the consensus view of the key macroeconomic linkages in the sufficient detail to allow us to illustrate the range of possible interactions between cross-border integration and monetary policy. This includes separate modelling of the commodity and non-commodity export sectors and the production of domestic consumer goods and services. ToTEM also models consumption behaviour with two groups of consumers, one of them credit constrained. Members of the latter group consume all disposable income each period and therefore do not react directly to changes in interest rates, but instead react only to secondary movements in income that are induced by interest rate fluctuations. Although the trade literature does not suggest that increasing the share of credit-constrained consumers is an implication of increased trade integration, it can serve as a crude proxy for increased income dispersion and yield a preliminary insight into the matter. To study the effects of rising cross-border integration then, we compare a base version of the model with a version featuring five changes to the model structure. These changes reflect the conjectures of the preceding section and are as follows: A lower exchange rate elasticity of non-commodity export demand A higher share of imported inputs into the production of non-commodity exports, reflecting the development of GVCs A higher share of imported inputs into the production of domestic consumer goods, reflecting the development of GVCs A lower elasticity of substitution between domestic inputs and imported inputs into the production of non-commodity exports, reflecting increased specialization A higher share of credit-constrained consumers, to proxy for an increased dispersion of income We subject the two versions of the model to the same series of exogenous shocks and compare the model responses. Throughout, monetary policy is guided by the maintenance of the inflation target. Our conjecture is that increased integration will make the economy less responsive to both interest rate and exchange rate fluctuations, thereby making inflation targeting more challenging. In both versions of the model, the central bank is equally successful in offsetting fluctuations in inflation relative to its inflation target, so we compare the variability in interest rates, exchange rates and the output gap that are necessary to ensure this outcome. Our conjectures are shown in Chart 7 based on the response of the two versions of the model to an exogenous decrease in global demand. The specific form of the shock is a decline in foreign demand that builds to -1.2 per cent after six quarters and then gradually returns to control over the next five years. The deviations of inflation from target in the two versions of the model are very similar and modest, since the central bank policy objective is the same in both models. As expected, the central bank cuts interest rates in response to the shock somewhat more aggressively in the version of the model with higher cross-border integration. In contrast, the reaction of the real exchange rate to the shock is much greater in the high-integration version of the model, and the domestic real economic downturn much deeper and more prolonged. These observations are generally in line with our conjectures and are aligned with the results of Woodford (2007), that a more highly integrated global economy will make it more challenging for central banks to stabilize economic growth while pursuing inflation targets. In effect, rising integration loosens the connection between the domestic output gap and domestic inflation. Both versions of the model see a significant decline in exports when foreign demand falls, albeit more so in the high-integration version. This decline produces a deterioration in the current account balance, and the resulting wealth effects cause the path of consumption and therefore GDP to remain below control for an extended period of time. In short, it takes the economy several years to adjust fully to the shock, regardless of the level of cross-border integration. These insights may be generalized by calculating unconditional variances for the model's key variables for a given array of historical exogenous shocks. In effect, we generate macroeconomic data by running the same historical shocks through both versions of the model and compare the resulting variances of key variables between versions. Table 1 summarizes the results of this exercise. The results from ToTEM suggest that higher trade integration may be associated with higher variability of interest rates, real exchange rates and the output gap, although the effect on interest rate variability is quite modest. The relatively large increase in real exchange rate variability is related to the complexity of stock-flow interactions in the model. In ToTEM, any shock that leads to a deterioration of the current account will put downward pressure on the real exchange rate until the country's net foreign asset position stabilizes, and this process requires a bigger exchange rate movement when the economy is more integrated. ToTEM also suggests that the output gap will be more variable when trade integration is high. Since the variability of inflation is the same in both versions of the model, this means that greater trade integration also changes the nature of the trade-off between output and inflation stabilization, in effect making it more challenging to stabilize the economy while pursuing an inflation target. Increasing globalization, then, may be an argument for allowing more flexibility in inflation targets in order to produce less variability in the real economy. We also performed this exercise with versions of the model looking at the five model changes separately and then decomposed the changes in variance associated with globalization into the five components. These results are provided in Table 2. As expected, the reduction in the exchange rate elasticity of export demand plays an important role in generating higher variances in interest rates, exchange rates and the output gap. Comparatively speaking, increases in the share of imported inputs in domestic production of either non-commodity exports or domestic consumption goods has only modest effects on the variances. Increased specialization in domestic production, modelled as a lower elasticity of substitution between domestic and import inputs, generated significantly higher exchange rate variability but has limited effects on the variance of interest rates or the real economy. Finally, higher income dispersion-- modelled here crudely as an increase in the share of credit-constrained consumers--has its primary effect by reducing the economy's interest elasticity, as expected. This generates higher variability in both interest rates and the output gap but leads to very little change in exchange rate outcomes. The relative variances generated by ToTEM offer trade-offs that could be considered strategically when designing macroeconomic policies. In particular, the relative variances could be influenced through the complementary use of policy instruments other than monetary policy, such as automatic fiscal stabilizers or macroprudential policies. Alternatively, policy-makers could consider allowing additional flexibility in the central bank's inflation objective--a widening of inflation-target bands, for example, or allowing a longer period to pass before a complete return to target after a shock. Such a change would allow the variance of inflation to increase and the variances of the other key variables to decrease. Such trade-offs would be very difficult to formalize ex ante, however, and may best be considered within the risk-management problem faced by all central banks. This is especially true given that such risk management must occur in a forward-looking fashion in the presence of considerable uncertainty regarding model structure and the nature of shocks. It is an article of faith among most economists that trade liberalization will lead firms and households to reoptimize their behaviour and will manifest itself in increased integration of economies. The aggregate economic gains from such a shift are widely acknowledged, as are the potential effects on income distribution. Nevertheless, the real world is sufficiently complex, and so many things are not being held constant, that proving such conjectures empirically can be very difficult. My good friend Paul Storer held that faith but wore his skepticism like a comfortable suit, for a number of good reasons. I've argued here that seeking rigorous empirical proof may be too much of a burden for the data to bear. By taking a broader lens to international business activity, what we see is highly suggestive that trade liberalization has increased integration within the NAFTA economies--and this constitutes sufficient evidence for policy-makers to take the issue seriously. We conjecture that rising integration will appear in parameter bias or even structural misspecification in workhorse forecasting and policy models, posing a real issue for central bankers. Ultimately, policy models can be revised to capture these evolutions in behaviour, subject to the caveat that the degree of integration need not be constant through time. The Bank of Canada's model, ToTEM, is capable of capturing such shifts, in theory, but model respecifications need to be based on reliable empirical work, which is not extensive. For the present, it may have to suffice for policy-makers to acknowledge the risks posed by shifts in integration and consider how to insulate policy decisions from those risks. Our model simulations suggest that models that do not recognize rising integration are likely to predict that monetary policy actions will be more effective at stabilizing the economy and controlling inflation than they will prove to be in practice. In other words, a central bank that relies on a model that does not take rising trade integration into account when it should do so will tend to react too gradually and perhaps insufficiently to external shocks. This would run the risk of inflation deviating from target for longer than desired. On the other side of this risk is a modicum of comfort--by all counts, it would appear that trade integration is not headed for infinity. Rather, the optimal level of cross-border integration is a complex decision by individual companies that depends on logistics, transportation costs, geopolitical risk and evolving cost structures in foreign economies. As such, we have every reason to believe that the bias that globalization may be introducing into our models evolves gradually, probably in both directions, and has natural limits. Nevertheless, policy-makers need to acknowledge that international developments will have an influence on their economies and on the volatility of their financial markets. Review of Review of ,

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canada

Economic Trends and Monetary Policy

wilkins

It is a pleasure to be here in Trois-Rivieres. It is a city that has a long and vibrant history. It has also gone through profound transformation. For a long time, pulp and paper mills were the economic engine of the region. Today, Trois-Rivieres' economy is more diversified. You may be surprised to hear that Ottawa, where the Bank of Canada is based, was also at one time an important centre of Canada's timber trade. I am sure many of you may recall that the last one-dollar note the Bank issued even featured a tugboat amid logs on I mention this common past not to reminisce about the good old days, but rather to marvel at how much the Canadian economy has changed over the years. Industries have risen and declined, and new ones have appeared. These changes have at times been painful. Those who lived through hard times in the 1990s know it well. As mills closed, unemployment rose above 10 per cent. The unemployment rate in the region has fallen and is now close to the average for Quebec and for the rest of Canada. Trois-Rivieres has come a long way, with an unemployment rate that is below those averages. I know that the city is now counting on an expansion of its cultural and tourism sector and that your new amphitheatre has already had more success than expected. Today, the Canadian economy continues to face pressures to adapt. Not only has it been recovering from the global financial crisis of eight years ago, it has also been affected by headwinds from the European debt crisis, fiscal consolidation in the United States and, more recently, Brexit. These events have all undermined confidence. Further, Canada is still confronting the collapse in oil prices. Remember that oil was trading at higher than $100 per barrel in June 2014, compared with around $45 now. That directly affects roughly 10 per cent of our GDP. And the prices of other commodities that are important for Quebec, such as iron ore and nickel, have also fallen significantly. Anything that affects Canada's economy is important to us because, as you know, one of the Bank of Canada's main functions is to keep inflation low, stable and predictable. This provides the foundation for the economy to adapt as smoothly as possible to a new reality, such as a future with oil prices lower than in the past. We target an inflation rate of 2 per cent, inside a range of 1 to 3 per cent, so that families, investors and business owners can make long-term decisions with more confidence than if inflation were volatile and unpredictable. To make the right monetary policy decisions, we need to have a good sense of what is happening now in the economy and where it is headed over the next couple of years, because growth and inflation are connected. In simple terms, inflation tends to be higher when the economy is operating at a level higher than its potential. Why? Because firms facing capacity constraints tend to raise prices by more for their products and services. And because workers tend to demand higher wages when labour is scarce. Conversely, inflation tends to be lower when economic resources such as labour and capital are underutilized, as they are today. What I want to do now is to give you a window into how we analyze the Canadian economic situation as we seek to achieve our target for inflation. I will start by outlining the major shifts that have been affecting the Canadian economy. I will then go over the main adjustments we are watching closely as our economy returns to its potential. I will end by explaining how we incorporate all this into the decision-making process for monetary policy. If the years since the crisis have been difficult for the Canadian economy, it is largely because of two profound shifts that are taking place at the same time. The first shift is caused by population aging and a slowdown in productivity growth. These two factors are reducing how fast our economy can grow. Population aging slows the growth rate of the economy's potential because it reduces the number of workers entering the labour market. As well, people work less as they get older--either by retiring or by reducing the number of hours they work. The bottom line is that companies face a lower growth rate of available workers. To give you a sense of scale: in Canada, the annual population growth for prime-age workers was just below 3 per cent in the late 1980s, compared with barely more than zero today. In Quebec, this is happening a bit faster than in other provinces. At the global level, growth in the working-age population will be cut in half over the next two decades. Even China's labour force has started declining. So clearly, this is a worldwide phenomenon. At the same time, workers' productivity has been growing more slowly since the crisis began . Some of this slowing could be because companies are not investing as much as before to make each worker more productive. As well, the benefits to productivity growth from earlier developments in information technology are waning. Labour productivity growth has slowed Adapting to these underlying trends would have been a challenge at the best of times. Overall, potential output growth in Canada, as is the case in many other countries, is considerably lower than it was in the not-so-distant past. It is around 1 1/2 per cent today, compared with almost 4 per cent in 2000. That represents a lot of money, about $50 billion in foregone output in 2016. So, all things being equal, disinflationary pressures are lower because excess supply is lower than it otherwise would have been. The second shift is the steep decline in commodity prices, especially oil, which we have seen in the past two years. The result is a two-track economy. The industries that depend on commodities have suffered a considerable downturn. The other sectors that are not directly dependent on commodities and make up about 87 per cent of our economy have made steady progress ( . This improvement is due to a more accommodative monetary policy, US economic growth and the weaker Canadian dollar. Major structural adjustments are under way in Canada Economic models give us a framework for analyzing how the economy should be adjusting to these shifts. The framework tells us there are several interconnected adjustments that we should be seeing. In the face of the oil price collapse, we would expect firms to cut investment spending and employ fewer workers. Over time, this drop in activity would be felt by other companies and consumers in the region. Another adjustment concerns activity in the non-resource sector, particularly exports. We would expect the drop in commodity prices to cause the Canadian dollar to fall, which would support companies that export non-commodity goods and services. Of course, we are always looking to see how well the United States, our biggest trading partner, is doing. The final adjustment I will talk about relates to a further broadening in economic activity outside the resource sector. As firms see their business improve, we would expect them to invest and to hire workers to take full advantage of newfound opportunities. Government infrastructure spending would also be a contributing force. Let us see how each adjustment is unfolding. Stabilization in the energy sector Adjustments in the oil and gas sector have been dramatic . Investment in the sector is expected to drop cumulatively in 2015 and 2016 to about 60 per cent lower than it was in 2014. And tens of thousands of jobs have also been cut. When we talk to company leaders, they tell us that the pace of the investment cuts may be easing. And while it appears that oil rig activity has troughed, it is too early to say that the cuts to investment are behind us. The adjustment in employment and wages may also continue for some time as firms adjust to the reality of lower oil prices. The drop in investment in the oil and gas sector has decreased employment in the sector Sustained pickup in exports As the energy sector stabilizes, we have been expecting growth in other parts of the economy to start dominating. One area in which we are looking for growth is non-commodity exports. These sectors, such as aerospace, transportation equipment, and machinery and equipment, are all important sources of exports for Quebec. Here in the region, wood products manufacturing is particularly important. Exports should benefit from two factors: solid US economic growth and the past depreciation of the Canadian dollar. Our southern neighbour is important, since it buys around three-quarters of the goods and services we export. Now, relative to most other advanced economies, the United States has done quite well, with growth in the 2 to 2 1/2 per cent range for several years. And, let us keep in mind as well that the Canadian dollar has depreciated almost 20 per cent since the oil price shock. Our expectations were being realized as our exports were improving. While data can be uneven, there is a clear upward trend in non-commodity exports over the past six years . And, generally speaking, those that have improved the most are non-commodity exports that are more sensitive to the exchange rate. We can expect the weaker dollar to support the level of exports, even though its influence on their growth rate has faded for the most part. Meanwhile, we expect US activity to recover over the next few quarters, as household spending and the labour market remain robust. Non-commodity exports have been increasing steadily Unfortunately, Canada's non-commodity exports had an unexpected setback in the second quarter. This is explained in part by weaker-than-expected US growth, particularly in investment, which is significant for our exports. There was an uptick in July and August, which is encouraging, but uncertainty lingers. This uncertainty comes in part from the future growth of US investment. It is also possible that the effect of lower oil prices on the US economy is less positive than anticipated. It appears that the drop in oil-sector investment so far is largely offsetting the positive effects on consumption. We also cannot forget that competition effects are still playing an important role. We face stiff competition from other countries, such as Mexico, whose currency has depreciated by more than ours has. And, as Governor Poloz noted last week, some Canadian companies are growing their businesses outside of Canada to directly serve those markets. So it will take time to fully determine what is temporary and what is permanent for exports. That is why we noted in our September policy rate announcement that the risks to our inflation outlook have tilted somewhat to the downside relative to the July . Sustained non-resource growth Further broadening in economic activity should, over time, prompt existing firms to expand capacity and new firms to be created. This should happen as noncommodity exports, fiscal stimulus and a strong service sector create new sources of growth and take up some of the excess capacity that is now in the economy. We note that firms have not been inclined to invest in recent years. Last year, investment subtracted around 1 1/2 percentage points from growth, and we expect it to subtract another percentage point this year. The drop in nonresidential investment has been largely driven by the oil price shock--the 60 per cent drop that I mentioned earlier. At the same time, the lethargy in business investment is broad-based and started before the oil price shock. For example, intellectual property investment--such as research and development--has been declining for the past four years. Businesses tell us that uncertainty about global growth plays an important role here. Weaker-than-expected exports have also contributed, since business investment and trade go hand-in-hand. While the spotlight has rightly been on exports, I want to highlight other areas that will contribute to stronger and more balanced growth. In its most recent budget, the federal government announced roughly $25 billion of additional spending over the next two years. This includes infrastructure spending and measures for households such as the Canada Child Benefit. The effects of this stimulus will become more prominent as the year progresses. The service sector more generally has also been contributing to the stronger growth of household incomes. This is important, since services account for about 70 per cent of the economy and four of every five jobs. Some high-value-added sectors have grown quite nicely. The cultural sector is an interesting example, with more movies being shot in Canada. The air transportation sector is also improving, as new international routes are added. We export about $100 billion worth of services, or one dollar out of six from our export total. I know that tourism and professional and scientific services are two sectors that are expanding nicely in this region. As the composition of demand and production changes, many Canadians have to make hard choices, such as whether to move to find work. It is good news that we now are seeing interprovincial migration in line with the adjustment that is needed . In fact, the willingness of people to move to regions with more dynamic labour markets has increased over the past decade and a half. This has helped keep the overall unemployment rate relatively stable at around 7 per cent despite the oil price shock, although it still varies widely across provinces . Moreover, there continues to be more slack in the labour market than the overall unemployment rate would suggest. This is due to modest wage growth and involuntary part-time work, as well as the number of discouraged workers. Despite the weakness in the energy-producing provinces, nationally, the growth of household spending has held up . Growth in national household spending has held up despite weakness in energy-producing provinces Progress has been made with respect to the adjustments I have just described, but there is still material slack in the economy. In September, Governing Council decided to leave the Bank's target for the overnight rate at 1/2 per cent. We will revisit our projection when we release our quarterly , together with a rate announcement, on 19 October. We are currently working on this. As a matter of course, we monitor the data as they come in, but we prepare an update of our projection four times a year. This decision-making process serves us well. To achieve our policy objectives, we do our projections often enough to have a good sense of how the economy is evolving, but not so often as to become overly influenced by month-to-month fluctuations in the data. And when tragic events such as the Alberta wildfires inject volatility into the data, this longer perspective is doubly important. As our discussions take place, we always keep in mind that the economic adjustments under way are forcing people to make difficult, long-term decisions. The one thing they should not have to worry about is whether their money will lose its value. In this context, the best contribution the Bank can make to Canada's prosperity is to ensure that we have low and stable inflation. Empirical studies have shown that low and stable inflation helps create the necessary conditions for steady economic growth and job creation. Inflation has been remarkably stable The Bank of Canada has been successful at controlling inflation since we began targeting 2 per cent in 1995. Headline inflation may be variable, but it has averaged just shy of 2 per cent . While it has taken time for the economy to return to its potential since the financial crisis, we have managed to keep inflation within our target range, with the exception of a few brief episodes. The monetary stimulus we are providing has been helping with the adjustment. Inflation is now in the lower half of our target range in large part because of the temporary effect of lower consumer energy prices. We are mindful that low interest rates can lead to a buildup in financial vulnerabilities. As part of our financial stability mandate, we are monitoring very closely the high level of household indebtedness and housing sector activity. We think that, over time, the measures announced by the federal government on Monday will help mitigate risks to the financial system posed by household imbalances. Our approach to monetary policy is based on a risk-management framework. That is to say we consider both the risks to the outlook for inflation and those related to financial stability. Let me wrap up. My goal today was to give you the Bank's perspective on the conduct of monetary policy in the current context. Canada is going through important and complex adjustments. There has been progress, but also a few setbacks. As we said in September, with the recent setback in exports, the risks to the profile for inflation have tilted somewhat to the downside. The Bank is providing monetary stimulus in order to meet its inflation target. The adjustments are clearly under way. But it will take time before the economy has fully adjusted to the oil price shock, the US economy strengthens and the effects of fiscal stimulus take hold. Governing Council looks forward to providing you with an update on our outlook, as well as an interest rate announcement, in a couple of weeks.

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canada

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

poloz

Governor of the Bank of Canada Governor Wilkins and I are pleased to be back before you today to discuss the (MPR), which we published this morning. It has been six months almost to the day since we were last here, and several of the broad themes that we spoke about back in April remain in place today. The Canadian economy continues to adjust to low resource prices against a backdrop of weak global demand. This weakness, particularly in the United States in the first half of the year, has combined with ongoing competitiveness challenges to hold back export growth. In this environment, many businesses have continued to be reluctant to invest. These issues are not new. However, there have also been several developments over the past six months that affected the outlook for our economy. So, allow me to me fill in some details and outline the Bank's current economic forecast, before we turn to your questions. The second quarter of 2016 was a difficult one for the Canadian economy, which shrank at an annual rate of 1.6 per cent. The two main drivers of this result were a large, broad-based decline in goods exports and the impact of the Alberta wildfires. These factors more than offset the strength we saw in household and government spending. However, the economy is poised to rebound in the second half of the year. This reflects, in part, a return of oil sands production and rebuilding activity in Alberta. Indeed, we saw non-conventional oil output jump by almost 20 per cent in July. As well, exports of goods increased in July and August, pointing to a solid third quarter. A pickup in the US economy should help goods exports recover some-- but not all--of the ground they lost earlier this year. Let me spend a couple of minutes on the export story, because a revised export forecast was a central part of our deliberations. Even though exports of goods have more than fully recovered from their dramatic plunge in 2007-09, that recovery has persistently lagged our forecasts. The strong export performance of 2015 gave us new confidence, but this was shaken again in the first half of this year, when we experienced a sharp decline over five months. In our July MPR we advanced what we viewed as a conservative forecast for exports, in the sense that it assumed only that exports would grow roughly in line with the US economy. We have seen a significant recovery in exports since then, but the net effect of these choppy data is that the level of exports is well below where we thought it would be by now. It is true that international trade has been surprisingly weak globally, and we offer a box in this MPR discussing a range of interpretations. Also, the US economy was quite weak in the first half of the year in dimensions that are important to Canadian export demand. These factors explain about half of the shortfall in exports relative to what we were expecting. For the remainder, we are looking at a range of structural factors, including lost export capacity and competitiveness challenges. In our surveys, companies have mentioned a number of factors that can influence competitiveness or hinder exports directly. These include deficient infrastructure, regulatory uncertainty, rising trade barriers, relatively high electricity costs and the unknown status of current and future trade agreements. This analysis suggests that more of our export shortfall may be structural than previously believed, rather than cyclical. This is what led us to indicate in our September decision that the risks around our July inflation projection were tilted to the downside. Our latest projections incorporate a permanent shortfall in exports relative to our understanding of fundamentals in order to rebalance our forecast risks, reducing the projected level of GDP by about 0.6 per cent by the end of 2018 compared with our July projection. Such a reduction in our outlook for exports may sound odd, given the depreciation of the Canadian dollar against the US dollar. However, some of our competitors have also seen large depreciations in their currencies. For example, the Mexican peso has fallen by more than 30 per cent against the US dollar since mid-2014, while the Canadian dollar has slid by less than 20 per cent over the same period. So while the exchange rate will continue to support the current level of Canadian exports, most of its impact on export growth has probably already taken place. The export weakness is expected to lead to somewhat softer business investment. However, there are signs that the worst may be behind us in terms of investment. Our most recent survey of Canadian companies found that many businesses believe resource-related activity may be near a low point. Resource companies are expecting their sales to either level off or increase modestly over the next year. Overall, more firms than in recent surveys say they plan to boost investment spending over the next 12 months. Household spending has continued to support the economy, with employment and income continuing to grow outside of energy-intensive regions, particularly in service industries. The Bank's accommodative monetary policy will continue to buffer the impact on wealth and income stemming from the fall in resource prices. The rollout of the Canada Child Benefit should start giving an extra boost to households in the second half of this year. As well, the impact of the federal infrastructure spending that was announced in Budget 2016 should begin to be felt. We continue to project that these measures together will boost the level of Canadian GDP by about 1 per cent over the 2017-18 fiscal year. One other new development I'd mention is the government's measures to promote stability in the housing market. With house prices still elevated in the Vancouver area and resales and starts still robust around Toronto, these measures should dampen resale activity in the near term. Our analysis and historical experience suggest these measures will reduce the level of GDP by about 0.3 per cent by the end of 2018, although there is much uncertainty around that estimate. While household debt levels have continued to increase, these measures should, over time, help ease the growth of economic vulnerabilities related to household debt and housing. All told, we now expect growth over the third and fourth quarters to average about 2 1/2 per cent, which is lower than we anticipated in our last MPR in July. This reduction reflects the downward revision to exports, the pullback in housing and a shift in the timing of federal infrastructure measures that pushes some of the impact into 2017. We have reduced our growth estimate for this year to 1.1 per cent. The expansion in both 2017 and 2018 should be about 2.0 per cent, higher than the growth rate of potential. However, because the output gap is now somewhat larger than we projected and will close later than we expected in July, the profile for inflation is now slightly lower. We project that total CPI inflation will remain below 2 per cent through the end of the year, as disinflationary pressures linked to excess capacity and year-over-year price swings for gasoline will more than offset the inflationary pressure coming from a lower exchange rate. Total inflation should be close to the 2 per cent target in 2017 and 2018. As always, there are a number of risks surrounding our base case. These include the risks of sluggish business investment and weaker household spending, slower growth in emerging markets, stronger growth in the US economy and higher oil prices. We judge that the risks to our inflation profile are roughly balanced. I would point out, Senators, that we have changed the way we present these risks, beginning with this MPR. We are now reporting on how we see various aspects of the risks developing, as well as setting out the indicators we are watching in evaluating the risks. I invite you to take a look. With that, Mr. Chairman, Carolyn and I would be happy to answer questions.

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canada

Opening Statement before the House of Commons Standing Committee on Finance

poloz

Governor of the Bank of Canada Governor Wilkins and I are happy to be before you today. It is our normal practice to appear before this committee twice a year to discuss the Bank's week and are happy to answer questions about it and other economic topics. However, I suspect you may also want to ask about the agreement with the federal government that was announced this morning, which renews our inflationcontrol framework for another five years. So, before we respond to questions, allow me to say just a few words on both topics, beginning with the MPR. Since our last appearance, there have been two developments that led us to downgrade our outlook for the Canadian economy. The first is a lower trajectory for exports. After a sharp decline in goods exports over five months, we had a rebound in July and August. But that was not enough to make up for the ground that had been lost. We worked hard to determine the reasons for this shortfall. About half of it can be explained by weak global trade and composition changes in US demand, but the rest is unclear. So, in our outlook, we now assume that longer-term structural issues, such as lost export capacity and competitiveness challenges, are responsible for the remainder. This assumption led us to reduce the projected level of GDP by the end of 2018 by about 0.6 per cent, compared with our July projection. The second major factor behind our downgraded growth outlook is the federal government's macroprudential measures to promote housing market stability. These measures are welcome because they will, over time, ease vulnerabilities related to housing and household imbalances. That is important because such vulnerabilities can magnify the impact of negative economic shocks. We expect the government's measures will restrain residential investment by curbing resale activity in the near term and lead to a modest change in the composition of construction toward smaller units. We estimate that this will leave the level of GDP 0.3 per cent lower at the end of 2018 than projected in July. Given these developments, we cut our growth estimate for 2016 to 1.1 per cent. The expansion in both 2017 and 2018 should be about 2.0 per cent, which is above the growth rate of potential. However, because the output gap is now somewhat larger and will close later than we projected in July, the profile for inflation is now slightly lower. We project that total CPI inflation will remain below 2 per cent through the end of the year and be close to the 2 per cent target in The outlook is clouded by a number of uncertainties. These include the macroeconomic effects of the new mortgage rules, the likely path of our exports, the impacts of the federal government's fiscal measures and the effects of the US election on business confidence. Given the two-sided nature of these uncertainties, and with the flexibility inherent in our inflation-targeting framework, we judged that the current setting for monetary policy remains appropriate. Let me now talk about the renewal of the inflation-targeting framework. Today, the Bank and the government announced that we will continue to target inflation at the 2 per cent midpoint of a 1 to 3 per cent range for another five years. This is good news, as our framework has served Canadians well, in both calm and turbulent times, for 25 years. The framework's track record is impressive. Annual inflation has averaged almost exactly 2 per cent since 1991. Inflation has also been more stable, which has meant that unemployment and interest rates have become lower and more stable. In turn, this has helped households and firms make spending and investment decisions with more confidence, encouraged investment, contributed to sustained growth in output and productivity, and improved Canada's standard of living. As is the case at every renewal, a great deal of research and analysis went into the process, and we took on board the experiences and lessons of the past five years. Bank staff published dozens of research papers and worked with researchers from other central banks and academic institutions as well as private-sector economists. And, as usual, we asked some fundamental questions to make sure inflation targeting is still delivering its economic benefits effectively. We examined potential alternatives to inflation targeting to see if they provide even more benefits. That is one of the great advantages of our five-year renewal cycle--the framework is not set in stone; we are always looking for ways to improve it. Now, it is fair to say that even after years of very low interest rates, the recovery from the Great Recession in many economies remains weak. So it is not really surprising that some are wondering if monetary policy has lost its power. Low interest rates are actually doing a great deal to support the economy. To illustrate this point, if we were to raise interest rates to pre-crisis levels, say 3 to 4 per cent, there would be a significant contraction in the economy, and it is these contractionary forces that we are offsetting with low interest rates. But while monetary policy is still powerful, it is true that at the current setting, the impact of any interest rate reduction is less than it would be if rates were at historically normal levels. That is the case in a number of economies. In this environment, it is particularly important that all policies--monetary, fiscal and macroprudential--be working in a complementary way. This is why our agreement with the government is crucial. The government is making it clear that it also supports low, stable and predictable inflation, while leaving us the independence to pursue that goal as we see fit. It is a framework that has worked extraordinarily well for 25 years and, after looking at all the evidence, we could find no compelling reason to change it. With that, Mr. Chairman, Carolyn and I would be happy to answer questions.

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canada

25 Years of Inflation Targets: Certainty for Uncertain Times

poloz

Governor of the Bank of Canada These are uncertain times in the global economy, and anything that can be done to lessen uncertainty is welcome. Last week, the Bank of Canada and the federal government took an important step to provide some certainty, to both companies and consumers, by signing a five-year renewal of our inflation-targeting agreement. This year marks the 25th anniversary of inflation targeting in Canada. That is a long time--so long that a whole generation of business leaders and consumers has not had to deal with the uncertainty associated with high and variable inflation. It is human nature to take for granted things that have been around for a while. The Bank of Canada will never take for granted the benefits of inflation targeting, and last week's renewal makes it timely to remind people of the benefits that inflation targeting has delivered, as well as the difficult journey we took to get here. Twenty-five years is the silver anniversary, but inflation targeting has truly been golden. As an approach to monetary policy, inflation targeting has proven its worth repeatedly, both in good economic times as well as turbulent ones. Canada was just the second country to adopt this approach. Now, inflation targeting--narrowly defined--is being practised by 36 central banks representing 37 per cent of the world's economy. When you add the US Federal Reserve, which has inflation control as one of its mandates, and the European Central Bank, which has a mandate to keep inflation below 2 per cent, 64 per cent of the world economy is following some form of inflation targeting. But to understand how important an advance this system represents, you need to look back to the bad old days of the 1970s and 1980s. Inflation was not only much higher than today, but it was also much more variable. Annual inflation reached more than 12 per cent in 1974, dropped to less than 6 per cent two years later, then jumped back to over 12 per cent in 1981. It was impossible to predict with confidence what the inflation rate would be from one year to the next. From an employer's point of view, high and variable inflation made it extremely difficult to do the hard math required to run a business. High inflation meant companies constantly faced "menu costs" associated with having to regularly adjust prices. Those costs would typically be passed on to consumers, who also faced uncertainty about the future purchasing power of their savings. The situation was bad enough in the 1970s that the federal government implemented wage and price controls--a drastic measure usually reserved for times of war. They did not work. What ultimately did work were extreme monetary measures--interest rates that would make your head spin today. Mortgage rates rose above 20 per cent in the late 1970s. That must be hard to imagine for the current generation of borrowers, who are accustomed to five-year mortgages below 3 per cent and zero per cent financing at car dealerships. That necessary monetary medicine was painful, and it worked. By 1983, inflation had settled into a range of around 4 to 5 per cent. Back then, it would have been easy to proclaim the mission accomplished. Lowering inflation was no longer a high priority for governments, or for employees--particularly unionized workers-- who could protect themselves with cost-of-living adjustments built into contracts. It was about this time that I first came to work at the Bank of Canada. We knew that settling for 4 to 5 per cent inflation was not good enough. Canadians would still have their purchasing power eroded, just not as quickly. At an inflation rate of 5 per cent, prices still double in 15 years--which means that prices would more than double over someone's retirement horizon. Back in the late 1970s, there was a near-absolute consensus among economists and academics about how central banks should fight inflation. Control the supply of money and you control inflation, or so the theory went. Monetary targets would give clarity--a nominal anchor to help explain your actions--and provide the inflation outcome you want. Everyone understood that. The only problem was, it did not work quite as the theory predicted. We worked hard at the Bank to try to save the idea of monetary targets, but the economy was changing rapidly, and new types of bank deposits were being introduced. As a result, the relationship between money supply and inflation proved too unpredictable to rely on. It was quite a blow to the economics profession when, in 1982, then-Governor Gerald Bouey famously dropped the bombshell that we would no longer target the money supply. The Bank went off into uncharted academic territory, searching for a new way to control inflation. We knew all along that interest rates and inflation are connected through a complex series of relationships, with money somewhere in the middle. So, the Bank focused its efforts on refining its understanding of the linkages between interest rates, economic growth and, ultimately, inflation--in short, a monetary policy should aim at "achieving and maintaining stable prices." Although the precise definition of price stability was left open, the anchor for monetary policy would be inflation itself, not an intermediate variable such as money. It is fair to say that the concept of directly targeting inflation was met with a fair degree of skepticism, including from the government. After all, a central bank does not control how prices are set. What made us think we could achieve an inflation target? Well, we had done the research and improved our ability to use economic models, so we knew the logic was sound. In the end, the federal government was persuaded--we reached a formal agreement that said our monetary policy would be directed at controlling inflation and that gave us the operational independence to carry out policy as we saw fit. And so, in 1991, Canada became an inflation-targeting pioneer. Over time, the broad parameters of our approach have not changed. For the first three years, we had inflation-reduction targets, with a goal of bringing inflation down to 2 per cent. We succeeded. Since 1995, we have aimed to keep inflation at the 2 per cent midpoint of a 1 to 3 per cent range. Importantly, we approach the target symmetrically. Given the experiences of countries who have struggled with deflation, we are just as concerned about inflation below our target as above it. We want businesses and consumers to be able to make long-term plans with certainty. As it turned out, the framework worked better than we could have reasonably hoped. Check the numbers. Inflation averaged about 7 per cent between 1975 and 1991, including the 1983 to 1990 period when it stabilized around 4 to 5 per cent. Since then, inflation has averaged almost exactly 2 per cent and become much more stable, and expectations have become solidly anchored on the target. Inflation targeting has also provided economic benefits that went beyond those we were expecting. Canadian businesses and households have reaped the rewards of reduced uncertainty, helping them make spending and investment decisions with more confidence. It has also led to improved economic performance across a number of dimensions--both in terms of higher levels of activity and lower variability. The agreement, which has been renewed every five years since 2001, gives our approach legitimacy--that is crucial in a democratic society. And having an explicit number for a clear target like the inflation rate makes it easy to judge our work. Importantly, the agreement also gives inflation targeting additional credibility, which has made it more effective. This credibility has grown with our success in hitting the target. The combination of inflation targeting with a floating exchange rate has given Canada scope to pursue a truly independent monetary policy, suited to our specific conditions. The framework has also given us flexibility to respond to economic shocks. We could act aggressively during the global financial crisis, for example, because inflation expectations were so well anchored. And, during the crisis, our framework provided an anchor that helped explain our actions. It was not just Canada that benefited from improved economic performance. This outcome was shared by many countries as inflation targeting spread, contributing to a period known as the "Great Moderation." That success had a downside--the extended period of positive economic performance spawned rising financial imbalances. In short, we learned that while inflation targeting can bring about economic stability, that is not a sufficient condition for financial stability. Let me mention one more important benefit of our framework. Inflation targeting has made the Bank of Canada much more transparent. From the beginning, we knew that inflation expectations would be important. If people believed we would bring about low and stable inflation, they would behave in a way that would help make that happen. It has become clear over 25 years that it is easier to anchor inflation expectations when people understand what the central bank is doing, and why. This has led to a steady evolution in our approach to communications--in short, more and deeper communications around monetary policy decisions. In Governor Bouey's day, communication with the public was not a high priority. One or two public speeches a year was normal, with an occasional one by a Deputy Governor. So far this year, Governing Council members have given 17 public addresses, like this one, each broadcast live over the Internet and posted on our website for future reference. There have been many other changes that make us more transparent and accountable. Four years after moving to inflation targets, we began publishing our (MPR), which explains in detail how we interpret developments in the economy and spells out our economic and inflation forecasts. Senior Deputy Governor Wilkins and I hold press conferences after the publication of each issue of our MPR and , and we offer opening statements that highlight the key issues that figured in our policy deliberations. The two of us also appear before House of Commons and Senate committees twice a year. The Bank now publishes more research and has become active on social media. The overarching goal of all this activity is to help Canadians understand what we are doing, and why. Of course, Canada is not alone in this move toward transparency. My belief is that the additional accountability that comes with a formal inflation target has been the main driver of the transparency trend seen here and at other central banks. Now, just because inflation targeting has worked very well, that does not mean it cannot be improved. At each renewal, we have asked ourselves fundamental questions to make sure inflation targeting is delivering economic benefits most effectively. For example, in 2011, we clarified that the framework gives us the flexibility to adjust the time we need to return inflation to target, if moving too quickly or slowly would worsen financial stability concerns. During the five years leading up to this renewal, we looked into three issues. The first was about as fundamental as you can get: Is 2 per cent the right target? This has been a live issue throughout our experience with inflation targets. Five years ago, our research considered whether we should lower the target. This time, given our experience with low inflation and the risk of deflation, we took a good look at the idea of raising the target. We considered this possibility seriously because central bank policy rates in many economies have been near, or at, historic lows, reaching the effective lower bound in some places. The idea is that interest rates would generally be higher if we had a higher inflation target, so we would have more room to lower rates in the future before we hit that effective lower bound. However, we have learned from recent experience that there are unconventional monetary policies that give us more room to manoeuvre than previously believed. These include pushing interest rates below zero or buying longer-term bonds to compress long-term yields. A higher inflation target would mean higher nominal interest rates and more room to manoeuvre, on average, but also would entail imposing a higher inflation tax on the economy. I think of this as paying dearly, every day, for insurance against the low-probability risk that another very large macroeconomic shock could occur in the future. Besides, pushing inflation up from 2 per cent to 3 per cent might be quite difficult to do, and might require some significant economic fluctuations, given how well inflation expectations appear to be anchored at 2 per cent. The second issue we focused on was our measure of core inflation. Prices can move for reasons beyond the control of monetary policy. For example, a drought can lead to higher food prices. We try to look past those movements to focus on the underlying trend of inflation, so that we do not oversteer our policy. Previously, we used one particular measure of core inflation. Now, we will use three different measures that get at the underlying trend in different ways. You can find more information about these measures in the renewal document that is posted on our website. The third issue we took on is how monetary policy decisions should take into account concerns about the stability of the financial system. Once again, we drew heavily on the experience of the past five years. We have now seen successive moves by federal authorities to mitigate the threat posed by imbalances in our housing market and high levels of household debt. Our view is that these so-called macroprudential policies are best placed to deal with threats to financial stability because they can be designed to target specific financial vulnerabilities. In contrast, adjusting interest rates is a very blunt tool with widespread effects. Given all the work done to strengthen the global financial system over the past few years, it makes even more sense to separate monetary policy from efforts to stabilize the financial system. That does not mean our monetary policy ignores financial stability issues. For one thing, monetary policy is transmitted through the financial system, so we want it to work well. For another, we know that financial system vulnerabilities can magnify the impact of negative shocks, such as a large rise in unemployment. So, at the Bank of Canada, we take a risk-management approach to monetary policy. We acknowledge that there is always uncertainty around the outlook for inflation, and developments in the financial system bring uncertainties for financial stability. These uncertainties generate a zone within which we can tolerate variations in either the risks to our inflation outlook or risks to financial stability. Because there are many possible paths for monetary policy that can lead us to our inflation target, and because we have flexibility around the time it takes to hit the target, we can use monetary policy to manage those risks, while still keeping the pursuit of our inflation target as our main priority. For me, renewing the inflation target is a cause for celebration. And, I think Canada's inflation-targeting framework is stronger than those in many other countries, for a few reasons. First, the five-year renewal cycle gives us a regular opportunity to do a thorough examination of our policy in light of experience and new research, and to adjust it if necessary. Without the regular renewals, it would be much more difficult to introduce new thinking into the framework. Second, the renewal cycle brings an obligation to demonstrate to the government and to Canadians that we have the right policy. This requirement means that the framework has strong credibility. Third, because the framework takes the form of an agreement between the government and the central bank, there is an explicit commitment from the government to support our pursuit of low, stable and predictable inflation. The agreement therefore means that all economic policies--including monetary, fiscal and macroprudential--can work together in a complementary fashion. But at the same time, I recognize that even after years of very low interest rates, the economic recovery in many economies remains weak. So it is not really surprising that some are questioning whether policy-makers, including central bankers, are doing the right thing. Has monetary policy lost its effectiveness? Is inflation targeting passe? We take these debates seriously. We have studied the research and the theory behind frameworks such as price-level targeting and targeting the growth of nominal gross domestic product. But, to date, we have not seen convincing evidence that there is an approach that is better than our inflation targets. I am in no way suggesting that inflation targeting is perfect. We will never stop looking for ways to make our framework better, and to provide greater certainty to Canadian businesses and consumers. This goes beyond the targets themselves to include the tools we use to pursue them. Economic models remain at the core of the entire inflation-targeting process, and models require investments to capture many new complexities in today's economies. In short, the next generation of economic models needs to be under construction now-- after all, the main model used at the Bank today is the culmination of nearly 30 years of research effort. It is time for me to conclude. The renewal of our inflation-targeting agreement is good news. Whether you remember the bad times or not, high, variable and unpredictable inflation is deadly for confidence. It is a source of uncertainty that would be brutal in today's economic climate. We will not let that happen. We have a record of more than 25 years as a successful inflation-targeting central bank. This has helped businesses and individuals make financial decisions with certainty and confidence. It has led to an environment that is conducive to sustained economic growth. The renewal of the inflation-targeting agreement sets us up to extend this track record of success for another five years. But our framework is not set in stone. We will continue to observe and learn, ask questions, and make sure our monetary policy is truly doing its best until the next renewal in 2021. We will be looking for new ways to engage with Canadians in a discussion about our framework, and would very much like to hear your ideas as we continue to promote the economic well-being of Canadians.

r161108a_BOC

canada

Wood, Wheat, Wheels and the Web: Historical Pivots and Future Prospects for Canadian Exports

schembri

Thank you for that kind introduction. It's always a pleasure to visit Halifax. And thank you to the Atlantic Institute for Market Studies for the opportunity to speak here today. The research papers you publish on economic and social issues are thoughtful contributions to the public discourse. Since its founding in 1749, Halifax has served as a critical point of transit for Canadian trade. With its extensive port facilities, this city has supported the growth and evolution of Canadian exports from the early trading of fish and fur in sailing vessels to modern consumer and industrial goods in huge container ships. Inspired by the historic and ongoing contribution Halifax has made to Canada's international trade, my speech today is about the evolution of and prospects for our exports. The question I will try to answer is: What insights can we draw from the history of Canadian exports that will help us better understand our recent export performance and prospects for the future? This is a particularly important question today, given the slower-than-expected recoveries in global demand and Canadian exports since the Great Recession of 2008-09. While Canadian exports have grown over this period by approximately 4 per cent per year, their growth to date remains below the experience of past recoveries. For example, exports grew nearly 8 per cent per year over a similar length of time during the recoveries from the recessions of 1981-82 and 1990- 91. This difference is important because stronger export growth is critical to achieving a more sustainable growth path for the Canadian economy. Throughout our history, we have successfully relied on trade, both exports and imports, to support our rising standard of living. Exports have always been an important source of economic growth for Canada ( ). Today, exports and imports represent about 65 per cent of our output, which is one of the highest ratios among the G7 countries ( Exports are not a goal in and of themselves, however, but a means to acquire imports for consumption and investment. Furthermore, trade generates global benefits because it encourages countries to specialize in the production of those goods and services in which they have a comparative advantage--in other words, in the goods and services they are relatively more efficient at producing. Chart 1: Trade has always played an important role in the Canadian economy Chart 2: Canada remains a trade leader among advanced economies Because of our geography, which has given us an abundance of natural resources and proximity to the largest market in the world, resource-based products destined for the United Sates have dominated our export mix. Nonetheless, over our history, Canada has transitioned from being a primary goods powerhouse--principally, wood, wheat and other agricultural goods--with a limited set of trading partners to a well-diversified modern economy. Today, we export a broad range of manufactured goods, including almost anything with wheels--automobiles, trucks, airplanes and subway cars--and an expanding range of web-based services. To sustain our success as an exporter, we must continue to develop new exports and new markets. Our demonstrated ability to adjust flexibly, or "pivot" in response to a variety of external and internal forces, reflects, in part, our strong political and legal institutions and our commitment to policies that support economic activity and trade. These include well-defined property rights and legally enforceable contracts, as well as growth-promoting economic policies, such as trade liberalization, and prudent fiscal and financial policies. In addition, our inflationtargeting monetary policy and flexible exchange rate have helped us adjust to shocks and achieve low, stable and predictable inflation and strong and sustainable economic growth. I'll begin my presentation with a simple analytical framework that highlights the key factors that have influenced the evolution of our exports. I'll discuss how those factors shaped the changes in our exports and their destination over history. I'll review three phases in our recent export history. And, in the last section, I'll consider the prospects for Canada's exports and their contribution to the Bank's outlook for the economy. For the purpose of this analysis, I'll use a framework that focuses on three broad and often related factors that influence the volume, value, composition and destination of Canadian exports over time: economic growth and development in other countries, chiefly in our trading partners and competitors; trade policies, including tariffs and quotas, and other structural factors, such as changing technology and tastes; and natural resource or commodity prices and the exchange rate ( These factors affect what we sell, to whom we sell, how much we sell and at what price. Using this framework, let's look at how our export mix and trading partners have changed since Confederation in response to these key determinants. Since Confederation in 1867, the composition of our exports has evolved considerably ( ), as have the destinations to which we ship them. In Canada's earliest years, we exported what we extracted from our forests and produced on our farms. This pattern continued until the early 20th century, when commodities such as iron ore, nickel and copper became more prominent. The two world wars accelerated two important trends: the move from rural to urban life and the adoption of new technologies in the form of mechanization and electrification. These trends facilitated the transition to an industrial, export-driven economy based on new commodities, such as oil and gas and manufactured goods. Perhaps the most significant development following the Second World War was trade liberalization, a trend that continues to this day. The world learned a hard lesson about the cost of protectionism during the Great Depression, when trade collapsed, partly as a result of misguided policies such as the US Smoot-Hawley tariff. Chart 3: The composition of Canada's exports has evolved through history Trade agreements have been transformative for Canada. countries, including Canada, reduced or froze more than 45,000 tariff rates. agreement, together with subsequent GATT rounds, led to a more than sevenfold increase in world and Canadian goods exports between 1948 and 1972. commonly known as the Auto Pact, marked an even more important turning point for Canadian exports and the economy. The Auto Pact freed trade in autos and auto parts between the two countries and guaranteed Canada a share of total auto production. The auto industry in Canada expanded, became more efficient and was able to export on a large scale. Now, let's look at our trading partners ). Again, we see the flexible adjustment of Canadian exports in response to changing circumstances. Chart 4: The destination of our exports has also evolved After the Second World War, most of our exports were destined for the United Kingdom and the rest of Europe and the United States. You can see in the chart the spike in trade to the United States after the first GATT agreement in the late 1940s and the steady rise in the importance of the United States with subsequent trade agreements. In recent decades, we've seen an increase in the shares to Mexico and to China. Today, while the United States remains our dominant trading partner--it is the destination for about 75 per cent our exports--our markets have become more diverse relative to 15 years ago. I've compressed a great sweep of Canadian history into these charts. They illustrate three important points about our exporting history: first, exports have been critically important to our economic development; second, we have been able to flexibly adjust to shifts in demand for our exports, global shocks, new technologies and trade policies; and third, we have been able to sustain our economic success by developing new exports and new markets. Now let's consider the more recent forces that have affected our exports and their economic impact in greater detail. in 1994, continued the postwar trend in trade liberalization. Momentum at the multilateral level under the GATT process had been slowing, and the two new agreements were intended to maintain the pace at the regional level. They had a major impact on our exports, which grew strongly in volume and as a share of The agreements provided privileged access, and thereby increased exposure to, ), when it was one of the fastestgrowing economies in the world ( ). The 1990s was also a period when commodity prices were relatively low and our flexible exchange rate adjusted downward, which facilitated the expansion of the export of manufactured goods. As a result, the share of our goods exports to the United States increased steadily, from roughly 70 per cent in 1988 to just under 90 per cent in 2002. Non-commodities led the way. Within non-commodities, machinery and equipment experienced the strongest growth, while growth in motor vehicles and parts, which account for the largest proportion of non-commodity exports, was lower because trade in these goods had already been liberalized under the Auto ). Energy exports also grew rapidly as these agreements helped integrate the North American energy market. As a consequence, our exports became more diversified throughout the 1990s. Chart 6: ...and Canadian exposure to the US market grew Chart 7: Over this period, the United States was one of the fastest-growing economies Chart 8: Within non-commodity exports, machinery and equipment experienced the strongest growth Shortly after the turn of the millennium, China joined the World Trade Organization (WTO), which had a profound effect on global trade and on Canada's exports. While growth in export volumes slowed relative to the previous period, the value of our exports, primarily commodities, increased substantially China's rapid development as an industrial and export powerhouse and its rapid urbanization represented a large shock to the global supply of manufactured goods for export. More importantly for Canada, the changes in China greatly increased the global demand for commodities as inputs for the production of manufactured goods and the construction of transport systems, housing and other urban amenities ( The economic impact on Canada of these shocks was immense. Canada benefited from the lower prices for imports from China--whose share of our imports rose from under 4 per cent in 2000 to more than 12 per cent in 2015-- and from the higher prices for exports of commodities to China. The commodity price increases in turn caused a rise in the value of the Canadian dollar slowed the volume of Canada's exports Chart 10: China's share of global resource consumption increased Chart 11: Movements in commodity prices and the value of the Canadian dollar were closely linked The sizable increase in commodity prices spurred the expansion of our resourcebased industries and exports, particularly oil and gas. And the lower import prices and stronger export prices caused an improvement in Canada's terms of trade However, the substantial appreciation of the dollar and a broader opening to world trade among emerging-market economies (EMEs) led to significant structural adjustments in what we exported and their destination. US import demand was growing more slowly than global demand and Canadian exporters lost US import market share. merchandise imports fell by more than 4 percentage points. We were competing with China and other EMEs not just in the United States, but in markets all over the world. With these global shifts, Canadian goods exports once again transitioned. Our share of exports to the rapidly growing EMEs increased significantly. Our exports destined for China rose from 1 per cent in 2001 to just over 3 per cent in 2009. And the share of exports destined for the "rest of world" (i.e., not the European to 10 per cent in 2009. The strong global expansion of the 2000s came to a screeching halt with the global financial crisis of 2008-09 and the resulting Great Recession. Global trade and Canadian exports plummeted. Given the magnitude of the economic downturn, this decline in global trade and Canadian exports was not unexpected. What is now proving more difficult to explain is the weak recovery in exports, especially non-commodity exports, since recover in the wake of the financial crisis At the global level, trade has been held back by the slow recovery in demand, particularly in the United States and other advanced economies. And the ratio of trade to output at the global level has stopped increasing at the rate it had been before the crisis. At that time, global trade was rising twice as fast as global GDP and, more recently, the ratio has been essentially flat ( A number of explanations have been advanced to explain this shift, which are also relevant for explaining Canada's recent export performance. First, the composition of global demand has changed. The share of business investment, which is intensive in traded goods, has declined. A good part of Canada's slower-than-expected export performance can be explained by the weak recovery in US business and residential investment. This pervasive weakness in global business investment growth is also a challenge to understand, but the most compelling explanations are the combination of heightened uncertainty, especially about the profile for demand growth, which has been compounded by political events, and elevated risk aversion on the part of firms coming out of the Great Recession. Chart 13: Since the Great Recession, world trade has flattened relative to The second explanation for the recent weakness in global trade growth is that the pace of trade liberalization has recently slowed, if not reversed. Clearly, China can join the WTO only once, as it did in 2001. However, since the crisis, the WTO has recorded a troubling increase in the number of protectionist measures. Canadian exports, the most noteworthy concern being expressed by firms we The third global explanation is the diminishing impact of global value chains. Improvements in logistics technologies promoted an increase in production specialization and cross-border trade in intermediate inputs. The declining impact is most clearly seen in China, which has started to move up the value chain and produce intermediate goods domestically rather than import them. In terms of factors more specific to Canada that have held back our exports in the wake of the Great Recession, the most important are related to our ability to produce and export non-commodity goods, which represent about 60 per cent of our exports since the financial crisis. The remainder is split between energy and non-energy commodities. Our goods exports were severely affected by the sharp decline in global demand during the Great Recession. Our non-commodity goods exports were harder hit than in any post-war recession, decreasing by about 17 per cent between the third quarter of 2008 and the second quarter of 2009. A big part of that decrease was the shutdown of a substantial portion of Canadian auto production. In addition, from the peak in 2008 to the trough in 2010, the number of exporters fell nearly 20 per cent, dropping by almost 9,000 firms. This shock to non-commodity exports exacerbated an ongoing trend, discussed in the previous section, in which Canada was losing US market share, owing to the appreciation of the Canadian dollar, relatively weak labour productivity growth and the entry of new exporters. In our surveys, companies have also mentioned deficient infrastructure, regulatory uncertainty and relatively high electricity costs. All of these export competitiveness challenges suggest that our export shortfall may be more persistent than previously believed. While countries, most notably China, Mexico and other EMEs, have seen their exports of non-commodities to the United States increase over the past 15 years, Canada's exports have essentially remained unchanged in nominal terms ( ). The loss of US market share for our non-commodity goods exports was particularly concentrated in motor vehicles and parts, in which Canada had been historically strong. Chart 14: US non-energy goods imports from Canada have stagnated relative to imports from other countries These significant losses in US market share and the resulting decline in productive capacity are compelling explanations for why the recovery in noncommodity goods exports has been weaker relative to historical experience. In particular, such losses have likely generated hysteretic, or very persistent, adverse effects. In such circumstances, Canadian firms would have the incentive to re-enter these export markets and incur the sunk-cost investments associated with expanding productive capacity only when the outlooks for global and US demand are much stronger than they are currently. With respect to commodity exports, commodity prices and our dollar declined sharply during the Great Recession, but they both bounced back relatively quickly, supported by the strong recovery in Chinese demand. This rebound in commodity production and exports helped buffer the Canadian economy from the worst of the recession. However, this strong post-crisis recovery in commodity prices and exports helped mask the effects on the Canadian economy of the slowing in global trade and the losses in export capacity and export market share in the non-commodity sector. The commodity price collapse in 2014 exposed these structural weaknesses, which are now weighing heavily on the recovery of our exports. The drop in commodity prices and the associated depreciation of the Canadian dollar ushered in a complex adjustment within the Canadian economy. As a result, the exporting landscape is transitioning once again. Canada's resource sector is shrinking in economic importance as investment and employment shift toward the non-resource sector. Our simulations suggest that commodity exports could decline from the 2014 level of 50 per cent to roughly 40 per cent of total exports by 2020. At the same time, the depreciation of the dollar ( ) has helped the adjustment process by boosting demand for Canadian non-commodity exports and some domestically produced import-competing substitutes ( example, exports of pharmaceuticals and medicinal products, furniture and fixtures, and industrial machinery and equipment have grown strongly since the depreciation began. Chart 15: Real exports are expected to continue increasing Prospects for Canadian exports Looking ahead, Canadian exports will be underpinned by a US economy that is gaining momentum. US growth will be driven by rising employment, household income and private demand, although the composition of US demand is projected to be somewhat less favourable for Canadian exports. Taking this into consideration, the Bank revised downward, in its October its growth projections, particularly for goods exports. We expect US business and residential investment to grow more slowly than we had projected earlier in the year. In addition, because goods exports have been soft--their level is essentially unchanged over the past year--it is likely that structural factors, including lost export capacity and competitiveness challenges, are having a more pronounced impact. Our research on this issue is ongoing. Another relevant factor is that although the dollar has depreciated against the US dollar in recent years, the improvement in Canada's export competitiveness is less than expected because the currencies of competitors for US market share have also experienced sizable depreciations, in some cases by more than that of the Canadian dollar. We also know from past experience that our economy is flexible and can pivot in new directions to enhance and diversify our export performance. So while we have revised our projections for goods exports, we still see significant growth prospects for the production and export of services. This is an important element of our economic outlook. Financial, management, engineering, computer and information, and travel and transportation services currently constitute about 15 per cent of our exports ( ). Most notably, while the share of manufactured goods in Canada's exports has been falling since 2000, the services share has been rising. In particular, firms in the information technology service sector, which sells business solutions, software and entertainment services, are benefiting from strong foreign demand. The expansion of the production and export of services in Canada and other advanced economies is driven by a number of developments, including the trend toward outsourcing the provision of standardized services. Other contributions to service exports include technological breakthroughs, especially those related to the development of the web and the digital economy, and shifting tastes toward services consumption as households become more affluent and spend a larger proportion of their incomes on education, health and travel services, to mention a few examples. Chart 16: Services exports have been increasing steadily Given that the production of many of these services demands intensive use of skilled labour, Canada is well placed to provide and export such services. Another important element is that because tradable services generally entail lower costs to transport and deliver them than goods, they can typically be sold to a more geographically diverse set of customers. For example, web-based products can be transmitted to clients electronically. As a consequence, our export of services is more geographically dispersed than for goods ( particular, while the share to the United States is large, we export a sizable volume of services to other advanced economies and also to EMEs. One component of service exports that is showing strong growth is commercial services to affiliated companies. These exports flow in both directions: from a subsidiary in Canada to a foreign parent and from a Canadian parent to a foreign subsidiary. The latter case is becoming more prominent as Canadian firms outsource production of less skill-intensive activities (e.g., assembly) to lowerwage countries and retain highly skilled activities such as product design, marketing and management services with the Canadian parent. The production of services entails intensive labour input so exchange rate movements can have large effects on relative production costs. The most prominent example is travel services, whose net export position is very sensitive to the exchange rate. The bottom line is that given our projections of a pickup in US and global growth, a stable exchange rate at a lower level and ongoing technological change, especially in the digital economy, service exports will play an increasingly important role in our export growth. Chart 17: The destinations of service exports are more diversified than those of goods exports Let me wrap up. Although exports have contributed importantly to Canadian economic growth over the post-recession period, we have repeatedly downgraded their contribution, as we did again in October, for two important and related reasons. First, the recovery in global demand has been serially disappointing, with ongoing private and public debt deleveraging in the United States and Europe and numerous adverse shocks, both political and economic, which have served to increase uncertainty. Second, the structural export capacity and competitiveness challenges that we have discussed have had a more persistent and pronounced impact on Canadian export performance than expected. An important global economic shock that significantly affected our export projection is the sharp decline in oil and other commodity prices since 2014. The Canadian economy is making progress adjusting to this shock as economic activity in the energy sector seems to be bottoming out. The lower dollar has helped facilitate the adjustment of exports from the resource- to the nonresource-based sector, but most of its effect on overall export growth has likely already occurred. Going forward, there is good reason to believe our export performance will strengthen further as the US and global economies gain momentum. Let me leave you with three core messages: 1. First, throughout our history, the Canadian economy has been able to adapt and respond flexibly to large external forces, similar to those we have experienced recently, and to maintain the important contribution of exports to our economic well-being. 2. Second, this capacity for flexible adjustment should continue because our trade is largely determined by market forces and is supported by strong political and legal institutions and sustainable economic policies, including our monetary policy framework, consisting of an inflation target and a flexible exchange rate. These institutions and policies provide a stable environment for Canadian ingenuity, innovation and investment. 3. Third, Canada's commitment to trade liberalization over the postwar period has opened doors for our exports, made our production more efficient and supported economic and employment growth and rising living standards. That said, new trade agreements can result in adjustment costs for certain firms and their employees, and it is incumbent on policy-makers to buffer the transition by ensuring adequate safety nets for workers and facilitating retraining and relocation. While mindful of these concerns, our commitment to trade liberalization should remain as firm as it has been in the past. Efforts to liberalize trade externally as well as internally must continue in earnest. The signing of the new trade agreement with the European Union will support growth going forward, as would the TransPacific Partnership should it eventually come into force. Canada has one of the most diversified, trade-driven economies in the world. The global economy exposes us to shocks, but also to opportunities. Historically, Canadian exporters have overcome the challenges and seized the opportunities. We should have confidence that ships will continue to sail out of Halifax with our goods and commodities and that clients around the world will continue to value our services.

r161116a_BOC

canada

Follow the Money: A Canadian Perspective on Financial Globalization

lane

Thank you for inviting me to speak to you today. The movement of goods, services, people and money across international borders has always been controversial and seems to be becoming more so by the day. In this context, Canada needs to be fully engaged in the global dialogue. As a medium-sized country, we can only have an impact on this dialogue by bringing new ideas and careful analysis to the table. This is where the Centre for International Governance Innovation's contribution continues to be particularly vital. Today, I would like to focus on one aspect of globalization: international capital mobility. I'll start by opening up some basic questions associated with capital mobility and then review key trends in capital flows over the past few decades. I'll discuss the benefits and challenges of being open to capital flows and the policy tools that are being deployed by some countries to manage them. Finally, I'll take you through Canada's experience and the factors that have enabled us to conduct an effective monetary policy in the face of free capital mobility. It is striking how perceptions of international capital mobility differ across countries. In Canada, we take our ability to move funds across our borders for granted. Canadian investors hold US equities. Snowbirds open US bank accounts and run up bills on US credit cards. Canadian banks fund themselves in New York. Canadian companies borrow and issue shares in US markets. And our governments sell bonds to foreign central banks and other foreign investors. There are, of course, certain types of transactions that are periodically a source of controversy--notably, foreign investment in Canadian real estate and certain foreign acquisitions of Canadian companies. But for the vast bulk of the capital flowing across our borders, in both directions, most of us don't give it a second thought. To draw the bigger picture: capital flows in and out of Canada in response to broader economic trends. At the present time, Canada is going through a complex adjustment to lower prices for oil and other commodities in the face of persistently weak demand for our non-commodity exports. We have had to rely on domestic demand to keep our economy growing. In that context, Canada as a whole is spending more than it earns from the rest of the world--a current account deficit. Capital is flowing into Canada, in various forms, to finance that deficit. The inflows are accommodating the needed economic adjustments that are taking place. The experience of many emerging-market and developing countries has been quite different. Many of these countries have, at some time, faced the economic devastation of capital account crises, when sudden halts in foreign capital, often accompanied by capital flight by domestic residents, forces the economy through wrenching adjustments. In such episodes, capital flows take on a life of their own: they become a driver, rather than an enabler, of economic decisions. They can raise significant concerns for both economic and financial stability. In many of these countries, capital flows are seen as driven mainly by external forces, in particular, the monetary policies of the major advanced economies. In the eight years since the global financial crisis, ultra-low interest rates and unconventional monetary policy in the United States, the euro area and Japan have created incentives to search for yield, which have led to large surges of foreign investment in many emerging-market economies (EMEs). There are concerns that these flows are not sustainable--that when monetary policies in the advanced economies return to normal, the flows could reverse in a disruptive way, particularly for those EMEs with weaker domestic fundamentals. We had a hint of that with the "taper tantrum" in 2013. In the same vein, over the past week, market interest rates and capital flows worldwide have shifted sharply, along with changing perceptions of the direction of the economic policies of the Financial globalization raises another question: Can a central bank still conduct an effective monetary policy to fit its own circumstances and objectives? International capital mobility has given rise to a "global financial cycle" through which asset prices, longer-term interest rates and capital flows in many countries tend to move together. But long-term interest rates and asset prices are key transmission channels through which monetary policy affects the national economy. If these channels are compromised, policy could become less effective. In Canada, we have been living with an open capital account for several decades. But our flexible exchange rate gives us room to conduct an effective monetary policy that is consistent with domestic conditions and promotes the economic and financial welfare of Canadians. In many other countries, however, there are legitimate concerns that their monetary policies may be overwhelmed by the global financial cycle. In this light, some have even argued that capital controls are a precondition for monetary policy independence. In contrasting the Canadian experience with that of EMEs, we could conclude that capital flows are a good servant but a bad master. Being open to global capital flows is beneficial when it serves residents by creating a wider range of opportunities to save, invest and borrow. But it is harmful if it becomes a controlling influence on the economy and curtails the country's freedom to chart its own course. So how can a country learn to live with capital flows, to reap the benefits while insulating its economy from their effects and maintaining its policy Before I talk about recent trends, let's start with some basics--what we mean when we talk about gross and net capital flows. Gross private inflows refer to net purchases of domestic assets by foreign residents. They are defined as the sum of foreign direct investment, portfolio inflows, derivatives inflows and other investment inflows (which include trade outflows are the reverse, net purchases of foreign assets by domestic residents.) Gross flows, then, measure the extent and form of cross-border investment. They include foreign direct investment (FDI)--say, an American company buying a Canadian gold mine; portfolio flows--such as a Hungarian investor buying Ontario government bonds; and other flows--for example, a Canadian pension fund carrying out derivatives transactions in London. The net capital flow is the sum of these gross inflows and outflows and any change in the country's official reserves. This is a key macroeconomic variable: it is the mirror image of a country's current account balance, the difference between domestic savings and investment. Indeed, a net capital inflow is the way in which a current account deficit is financed. Now, let me turn to the global trends. For much of the past decade and a half, advanced countries ran current account deficits and received funding from emerging-market and developing countries ). This seems odd, since rapidly growing emerging economies surely had vast needs for investment--creating opportunities to earn much higher yields than those offered by investments in advanced countries. This counterintuitive flow of funds corresponds to large differences in national savings. In particular, while Chinese households and firms save a lot, those in the United States do not. These differences in savings rates, in turn, reflect a combination of factors, including the different stages of development of these countries' financial systems. Chart 1: Poorer countries lent to richer ones for most of the past 15 years Over the same period, we saw a massive expansion in gross flows, a testament to rapidly increasing global financial integration. This process has been anything but smooth. Global gross flows more than tripled in the early 2000s, from just fell sharply in 2008-09 during the global financial crisis, recovered somewhat in 2010 and remain well below pre-2008 highs. The composition of gross capital inflows also shifted considerably over this period ( ). FDI has been the most stable form of capital flows, since it tends to be driven by longer-term corporate decisions. Portfolio flows are easier to liquidate than FDI and thus are often more volatile. Other flows, mainly banking flows, have been the most volatile of all. Bank lending is procyclical, rising in good times and falling in bad times. This is not only because banks respond to the attractiveness of lending opportunities, which are themselves procyclical, but also because they typically lever up to increase lending during booms and de-leverage during downswings. After the global financial crisis, global bank lending dropped off sharply, since banks needed to repair their balance sheets and comply with more-stringent regulatory capital requirements. So how does Canada fit in? We have traditionally been a capital importer. Our current account balance--the difference between how much we invest and how much we save--has typically been in deficit to the tune of 2-3 per cent of GDP. We have depended on external financing to fund this gap. In the early 2000s, strong foreign demand and high commodity prices raised our national incomes, and we ran current account surpluses for a number of years. During those years we exported capital to the rest of the world ( ). Since the global financial crisis, foreign demand has been on a weaker track and commodity prices are lower. Our current account is again in deficit and, once more, we are relying on capital imports from the rest of the world. As I've already mentioned, opening up an economy to capital flows brings both benefits and challenges. The benefits of financial globalization are similar to those of free trade. Open borders create opportunities for transactions that benefit both parties because of their differences in endowments or preferences. For example, a country where a large share of the population is of working age can benefit from being able to channel its savings to other countries--a net capital outflow. As the country's population ages further and more of its citizens retire and start to draw on their savings, foreign assets are liquidated, generating a capital inflow from the rest of the world. Cross-border investments, which give rise to gross capital flows, enable investors to diversify risk. Canada's pension funds have, for example, used international opportunities to effectively provide more-secure retirement income for FDI brings other benefits, since it bundles financing and know-how. This helps residents of the investing country use these capabilities where they can be most productive and creates opportunities in the recipient country. Over the years, Canada has benefited from sizable flows of FDI in both directions. Chart 3: Banking flows are the most volatile capital flows Chart 4: Canada's current account balance is once again in deficit Being open to capital flows can also have collateral benefits. It can catalyze competition, promote the development of the domestic financial system and provide a force for better governance. For example, foreign financial institutions can bring a healthy dose of competition, boosting the quality and bringing down the cost of financial services. An open capital account can also lead to improved corporate governance as companies bring their practices in line with what is required to attract and retain foreign investors. In the same vein, some countries, including Poland, the Philippines, Thailand and Malaysia, have used foreign inflows as a tool to broaden their investor base and develop domestic equity and bond markets. To the extent that these forces are at work, they should contribute to stronger productivity growth and higher living standards throughout the economy. While these potential benefits of capital mobility are real, they are hard to pin down empirically. That is partly because they materialize over a longer time period. At the same time, the challenges associated with financial openness are only too easy to identify. Take the examples of Mexico and Thailand in the 1990s and of Greece in the mid-2000s. The experiences of these countries taught that financial flows from abroad can fuel macroeconomic and financial imbalances that later unwind in a destructive way. A capital inflow surge can encourage unsustainable spending by domestic households, companies and government; this unsustainable spending is mirrored in a current account deficit. A sudden stop in those inflows--particularly if accompanied by capital flight, where a country's own residents move their assets abroad--results in a crisis that forces an abrupt contraction of domestic spending. Inflows of capital are often associated with a buildup of financial system vulnerabilities, which can have important consequences for financial stability. This is particularly the case where the domestic financial system is lacking the ability to efficiently intermediate large gross flows. To the extent that there are weaknesses in a country's financial system, opening the capital account can feed those weaknesses and result in a larger buildup of imbalances. These can include currency, maturity and liquidity mismatches: in some instances, where liquid short-term banking flows denominated in foreign currencies are used to finance longer-term domestic currency lending, you get all three. Waves of foreign capital can also fuel credit booms, which are associated with mounting leverage and deteriorating credit quality. When the flows reverse, these vulnerabilities can amplify the effects on the domestic economy, in some cases triggering a wave of bankruptcies. In theory, exchange rate flexibility should mitigate the risks associated with large net capital inflows. This was framed by Robert Mundell as a trilemma: a country cannot have an open capital account, a fixed exchange rate and an independent monetary policy; but with a flexible exchange rate, it can use monetary policy to stabilize its economy in the presence of international capital flows. Consider the case of a country experiencing capital inflows. Its currency would rise in value, which--other things being equal--would have a negative effect on its net exports and on economic activity more generally. The country's central bank, tasked with stabilizing the economy, would typically respond with a lower policy interest rate. The combination of a stronger currency and lower domestic interest rates would make foreign investments in the country less attractive, thus attenuating the capital inflows. However, it doesn't always work this way. Many countries do not allow their currencies to adjust fully. Indeed, credit booms typically occur in countries with fixed and managed exchange rate regimes. It is also possible that, even with a floating exchange rate, appreciations can perversely encourage further capital inflows, exacerbating the problem. This occurs through the "risk-taking channel." If domestic borrowers have local currency assets and foreign currency liabilities, an appreciation increases the value of their domestic assets and makes their balance sheets look stronger. This increase in perceived creditworthiness could lead to the provision of more foreign currency loans as capital inflows through the banking sector increase. In a similar vein, it has been argued that, even with a floating exchange rate, a country's financial conditions depend primarily on a global financial cycle, limiting a central bank's ability to use monetary policy independently to influence its economy. One scholar thus argues that Mundell's trilemma boils down to a dilemma: "Independent monetary policies are possible if--and only if--the capital account is managed, directly or indirectly, via macroprudential policies." The most familiar examples of international capital flows enabling the buildup of domestic economic and financial imbalances come from EMEs. But this is not just a developing-country issue: think of the United States before 2008. The distorted incentives and regulatory weaknesses in the US financial system during that period are well known. In that context, the ability to borrow cheaply, at global interest rates reflecting high savings rates in China and other EMEs, contributed to a growing financial bubble. This pattern, and the ensuing financial crash in the world's most sophisticated financial system, had many elements that are familiar from EMEs in the past. To sum up, while there are known benefits to financial openness, a country can reap those benefits only if it avoids some important pitfalls. If a country has major distortions in its financial system, perhaps reflecting weaknesses in regulations, opening the economy to capital flows may just feed those distortions. To turn this around: a country may need to achieve a certain level of financial system soundness and standard of governance before it can fully reap the benefits of capital mobility. Based on this logic, a number of researchers have suggested that there is a threshold: capital flows are beneficial only once a country has reached a certain degree of institutional and financial sector development. Where those conditions are lacking--say, when financial regulation is inadequate or property rights are not fully protected--financial openness invites instability and, on the whole, can be detrimental to economic growth. Above that threshold, capital flows can provide broader benefits, which can support rising living standards. The threshold suggests that countries may choose two distinct strategies. One is to try to manage or control capital flows, or at least to cushion the economy and financial system from their impact. The other approach is to try to achieve the threshold. Of course, these strategies can be complementary if a country effectively manages capital flows to buy time to strengthen its domestic system. The international view of capital controls has shifted over time. Most advanced economies maintained pervasive restrictions on capital movements during the period following the Second World War, but they opened their borders to capital flows during the 1960s through to the early 1990s. Liberalization was generally seen as irreversible: as one observer said, "You can't put the toothpaste back in the tube." While many developing countries maintained capital controls, the Washington Consensus saw liberalization as the right destination--albeit with important issues concerning pace and sequencing. In contrast--and based on extensive international experience--capital control measures were viewed as distortionary and ineffective. The role of capital controls is being reassessed in light of the experience of both the crisis and the subsequent capital flow surges associated with the monetary policies of the major advanced economies. In this context, capital controls are often viewed as a type of macroprudential tool to limit the resulting buildup of vulnerabilities. Used in combination with other macroprudential tools, it could give monetary policy a freer hand in maintaining domestic macroeconomic and price stability. The reassessment is reflected in international discussions. In the autumn of 2011, G20 finance ministers and central bank governors drew up non-binding Experiences." These conclusions accepted that capital controls could be appropriate, provided they were temporary, targeted and transparent. This was an "institutional view" that characterizes the role of capital controls as part of the macroeconomic policy tool kit. However, capital controls, like tariffs on trade, have spillovers to other countries. This suggests a need for governance similar to that for trade restrictions. The have entered into a legally binding agreement--the Code of Liberalisation of Capital Movements--which is also open to adherence by non-OECD countries. The G20 has established a working group on international financial architecture, which is focusing on managing the risks stemming from capital flow volatility. This group has highlighted a need for better data on the composition of capital flows to better identify currency and maturity mismatches. It is also supporting analytic work that draws lessons from countries' experiences in capital flow management. A broader goal is to complete the global financial safety net--the set of financing arrangements available to countries faced with unexpected reversals of capital inflows. For example, the group is exploring the scope for contingent debt instruments such as GDP-linked bonds that would provide insurance to countries that may be faced with adverse shocks. measures to strengthen the safety net should make it less necessary for countries to resort to controls on capital outflows. The emerging global consensus is that capital controls can be used under some circumstances to mitigate the buildup of financial vulnerabilities. But they should not be used to compensate for inconsistent or inappropriate macroeconomic policies. Their effectiveness varies and typically diminishes over time. For example, research at the Bank of Canada has found that capital control actions have only a limited impact on net capital inflows, monetary policy autonomy or the exchange rate. Finally, if controls are used to shore up an unsustainable exchange rate peg, they may exacerbate rather than stem volatility. This is the classic "one-way bet" scenario: the strategy creates the expectation that the exchange rate will eventually adjust, thereby inducing additional speculative capital flows. To summarize the argument so far: capital controls are available as a tool to cope with volatile capital flows--but they are, at most, a second-best tool. Over the past 20 years or so, many EMEs have adopted a different approach: they have taken action to prepare their financial systems and economies to cope with the free movement of capital. They have put their fiscal deficits onto a sustainable track, established credible frameworks for fiscal and monetary policy, developed deeper and more-liquid domestic financial markets and stronger financial systems, and tackled structural issues that impede growth. All of these actions reduce their vulnerability to capital flows. In some respects, Canada's experience has been similar. Around the time of the Mexican peso crisis in the 1990s, our dollar was sometimes called the "northern peso." Our exchange rate and borrowing costs were buffeted by changing market perceptions of the financial strength of our governments and our banks. That wake-up call caused us to put our house in order. In the wake of the failures of some small financial institutions, Canadian policy-makers strengthened the regulation of our financial system, taking the prudent, principles-based approach that today underpins the soundness of the system. The federal government cut the deficit and now has fiscal room to manoeuvre. And the Bank of Canada has adopted a clear target for monetary policy and has established its credibility around this target. These actions have not completely insulated the Canadian financial system from the global financial cycle. Canada's market-determined interest rates are heavily influenced by global term premiums--as examined in recent Bank of Canada research. Despite that influence, however, the Bank of Canada retains the ability to affect those interest rates and other aspects of financial conditions in One key element is the country risk premium. The currencies and assets of many EMEs contain risk premiums that reflect their creditworthiness compared with that of the United States. These risk premiums can be time-varying and correlated with the global financial cycle: they rise during "risk-off" periods and they fall during "risk-on" periods. Canada's credit risk premium has been reduced to a very low level as a result of our strong economic and financial fundamentals, which underlie our AAA credit rating ( ). As a result, our asset prices and interest rates are less affected by the global financial cycle. Many of Canada's large gross flows of capital tend to be offset by other flows-- contributing to our overall resilience. IMF research has shown that such offsetting flows are characteristic of countries with sound policy, well-regulated institutions, flexible exchange rates and open capital accounts--all of which are features of In contrast, capital controls may reduce resilience by impeding such offsetting flows. Another factor that works in Canada's favour is that (unlike many EMEs) it is able to borrow in its own currency. This means that our national balance sheet does not have an excessive currency mismatch. Where such mismatches are important, exchange rate depreciations can be contractionary because the balance-sheet effects of a weaker currency inflate the size of national liabilities, overwhelming the expenditure-switching effects through the trade channel. In contrast, a depreciation of the Canadian dollar tends to support the Canadian economy. For example, the substantial depreciation of the Canadian dollar during the past few years has helped to cushion the Canadian economy by making our non-commodity exports more competitive. Being able to borrow in one's own currency, in turn, is a benefit of having a strong track record of sound macroeconomic and financial policies. Chart 5: Canada's risk premium has been reduced to a very low level The credibility of Canada's monetary policy framework, together with our floating exchange rate, also gives us more room to respond to shocks that are likely to have a differential impact on the Canadian economy than on the United States. For example, last year the Bank of Canada cut the policy interest rate twice, to help cushion the Canadian economy from the collapse of oil prices. We were confident that inflation expectations would remain well anchored despite the depreciation of the Canadian dollar that was occurring. The global financial cycle and policy actions by the Federal Reserve can have important implications for Canada. These are, of course, factored into the Bank of Canada's monetary policy decisions. As a concrete (but still hypothetical) example, suppose the Federal Reserve were to make an upward adjustment to its policy rate. Such a tightening in US monetary policy would affect Canada through two main financial channels. It leads to higher market interest rates globally and thus in Canada (in a sense, a tightening effect for Canada). But it also leads to a stronger US dollar, which increases the competitiveness of our exports (in a sense, a stimulative effect for Canada). It is important to note that the economic setting for such an interest rate move also needs to be taken into account: the Fed's rate move would likely be made in response to a strengthening US economy, which is itself typically favourable for our exports. The Bank of Canada would thus clearly need to take the net effects of the Fed's move into account, alongside many other factors, in making Canadian monetary policy. We could directly observe the effects on interest rates and exchange rates prior to making a policy decision. And certainly, we would not consider the implication of such a move by the Fed in any mechanical way. The Bank of Canada's track record--delivering low, stable and predictable inflation for the past 25 years, in the face of many shocks affecting our economy--attests to Canada's ability to pursue an effective monetary policy in a world of globalized capital flows. We are free to adjust our policy interest rate in the context of Canadian economic conditions--and, in particular, do not need to move in step with the Federal Reserve. And that policy rate is transmitted effectively to stabilize the Canadian economy. I began these remarks by noting that Canadians have learned to live with an open capital account. That goes for policy-makers, too. While global interconnections are a major factor in gauging the effects of our policies, they do not circumscribe our ability to set our own course. But the variety of international experience and our own past remind us that our resilience has been hard won; that, even now, not all countries are ready to benefit from financial globalization; and that we should be supportive of other countries as they take actions to safeguard their own economic and financial stability. A stable world is something from which we can all benefit.

r161128a_BOC

canada

From Hewers of Wood to Hewers of Code: Canada’s Expanding Service Economy

poloz

Governor of the Bank of Canada Some cliches never die. The last time the number of Canadians employed in the goods sector exceeded those working in the service sector was the mid-1950s. For about 60 years now, growth in services employment has persistently outpaced employment in goods production. We have been much more than a nation of hewers of wood and drawers of water for a long time, yet the cliche lives on. The same story of an expanding service sector has played out for all advanced economies. But that does little to allay an emerging sense of unease about the economic forces at work. Here in Canada, this sense of unease has been compounded by two significant shocks to the economy. The first was a steady loss of export capacity in the years prior to--and in the wake of--the global financial crisis. Our export recovery since 2009 has been impressive but remains incomplete, as at least $30 billion worth of export capacity was lost in the process and competitiveness challenges continue. The second shock was the sudden drop in resource prices, particularly for oil, which represented a significant loss of income for the nation as a whole--something in the range of $50 billion to $60 billion per year. Together, these two shocks have created an $80 billion to $90 billion hole in our economy, which is more than 4 per cent of GDP, and have set in motion a complex series of adjustments. It is natural to wonder: What will replace the economic losses due to these shocks? Where will the new jobs be created? These are difficult questions, so it is no wonder that people are worried about the future, particularly those employed in the goods sector. In the circumstances, skepticism about the benefits of technological change, globalization and international trade is understandable. We need a strong and open dialogue on these issues, and I hope to contribute to that conversation this evening. But let me start with my conclusion: I strongly believe that the continued expansion of our service sector is pointing the way toward full economic recovery and the return of sustained, natural growth. The phrase "hewers of wood and drawers of water" comes from the Bible, but it was the Canadian economist Harold Innis who used it in his 1930 book, , to describe our traditional economic dependence on resource production. Obviously, there has always been, and always will be, some truth behind the cliche. Resource production, particularly agriculture, dominated our economy in the years immediately after Confederation. But by the end of the 1920s, Canada had become primarily an urban, industrialized economy. By the mid-1950s, the share of manufacturing employment had reached about one-third of the workforce. This share has been declining ever since, while the service sector has continued to grow, both in absolute and relative terms. Today, more than 80 per cent of working Canadians are employed in services, while fewer than 20 per cent produce goods. Manufacturing now makes up less than 10 per cent of the workforce. The question is: How far can these trends go? Well, we shouldn't forget that Canada is fortunate to be endowed with a wide range of natural resources that represent an important source of future income. We all know that economic diversification is a good thing, but people sometimes seem to lose sight of the fact that it is much better for a diversified economy to have a significant endowment of natural resources than not. The fact is there will always be global demand for our food products, our forest products, our energy, our metals and minerals, and so on. And there will always be a market for innovative, high-quality manufactured products from Canada. Canadians are, and will continue to be, competitive in these markets. However, that leaves open the question of how many Canadians are likely to be working in the goods sector in the future. I am not sure we can forecast such things. Since 2001, total employment in goods production has fallen overall, even though output of goods has risen by 14 per cent within that time frame. Furthermore, for every job lost in the goods sector since January 2001, about 30 jobs have been created in the service sector. Here are the numbers: looking at the latest data, goods employment has dropped by about 100,000 since 2001, while service sector jobs have grown by nearly 3 million. Now, it is at this point in the conversation when we often hear some other cliches. One is that the only workers who actually create value are those who produce tangible goods--things that hurt when you drop them on your foot. Another is that service jobs are generally low-skill and low-paying. The reality, of course, is quite different. The service sector is widely diverse in both skills and pay, even though the average wage in services is lower than in goods production. It probably will not surprise you that the average wage in the finance and insurance industry is higher than that in manufacturing. But so is the average wage in the transportation and warehousing industry. And, together, those two industries employ more Canadians and produce more output than all of Canada's manufacturers. Economists' understanding of the evolution of economies is based on hundreds of years of history. Advances in technology lead to higher productivity and greater production, which in turn permit the development of new economic activities and increased specialization in jobs. Over time, the lion's share of these new activities has arisen in the service sector. Joseph Schumpeter called this process "creative destruction," because improving how we do things destroys the old while creating the new. And the key facilitator of this growth process is trade, both domestic and international; otherwise, we would all have to be jacks-of-all-trades. Let me illustrate with the Canadian experience. At the time of Confederation, about half of working Canadians were employed in agriculture in one form or another. Of course, technological advances led to enormous increases in productivity, creating opportunities for people to move away from farms and into cities. New technologies, coupled with the newly available workforce, sparked the creation of whole new activities, both in manufacturing and in services. By the 1920s, only one-third of Canadians were still involved in agriculture. By the 1950s, that figure was down to 15 per cent and, today, it is less than 2 per cent. And, yet, agricultural output today is more than three times what it was 80 years ago. Clearly, agricultural employment fell because technological advances and scale economies allowed for greater output with fewer employees. And this freed up the labour that allowed for the industrialization of Canada and fuelled the development of the service sector. The same process is continuing today with the decline in employment in goods production. New technologies, automation and robotics are allowing for higher productivity and output with fewer workers. Canadian factories are about five times more productive today than they were in 1955. This means more output per worker, not necessarily fewer workers. Indeed, improved productivity is essential to compete internationally, which is itself essential to maintaining or growing a business. In other words, without increases in productivity, the business itself and all of the associated jobs can be lost. This is the creative destruction process at work. Specific jobs lost to automation are gone. Exporting companies who closed their doors in the wake of the global recession in 2007-09 are unlikely to return. Rather, surviving companies will expand, and other, new companies will grow in their place. Naturally, I am oversimplifying the matter. The real world is far more complex than our economic models suggest. Even the distinction between goods and services is a blurry one. Consider the smartphone in your pocket. Yes, its manufacturer used circuits, wire, plastics and other materials. But it also needed research and development, engineering, design, software, transportation, trade, finance, legal, sales and accounting services. And certainly your phone would be totally useless without telecommunications services, not to mention after-sales service, including a call centre to help with problems. Rather than a dichotomy between goods and services, it is much more useful to think of a spectrum--from raw commodities at one end to pure services at the other. In general, the further up the value-added chain the manufactured product, the more services are embedded in it. There is reason to believe that the Canadian economy has a comparative advantage in some of the service categories I just mentioned, as well as others, such as tourism. We have the necessary ingredients: a highly educated labour force supported by strong universities and colleges; entrepreneurs with access to business incubators; a beautiful and interesting country that many would like to visit; a multicultural workforce that helps us to serve domestic and international markets. And, that comparative advantage has been strengthened by the decline in the Canadian dollar in the past couple of years--a symptom of falling resource prices, and a facilitator of the rotation of growth from resource production to other sectors. So, how can we fill the economic hole I spoke of earlier? Of course, monetary and fiscal policies are doing their part to support the recovery. But can growth in the service sector play a role? It already is, and we can expect its contribution to grow in the years ahead. Since the onset of the global financial crisis, growth in Canada's service sector has been stronger on average than in the goods sector. Most of the employment growth seen in Canada since late 2014 has been in service industries that pay above-average wages, helping to support national income. Services are also a bright spot in the export picture. Exports of services have continued to grow, both relative to goods and in absolute terms. In the first half of 2016, Canada was on pace to export more than $100 billion in services, almost $25 billion more than five years earlier. At a time of sluggish trade growth worldwide, exports of Canadian commercial services such as engineering, research and development, and financial services have grown by more than five per cent annually since 2000. And tourism exports are now generating about $17 billion per year, over $2 billion more than five years ago. We're particularly excited by recent developments in information technology (IT) services. We are seeing increasing numbers of foreign companies locating the IT service components of their supply chains in Canada. The publication reported that during 2015 and the first half of this year, 65 projects were announced or launched by foreign companies employed in knowledge-intensive services such as smartphone applications and custom computer programming. It is worth noting that last year, the average wage across highly digitalized industries, which includes IT services, was 17 per cent higher than the average Canadian wage. The Bank recently conducted an in-depth survey of about 50 exporting companies and industry associations in the IT service sector. Bank staff asked many of the same questions we ask in our . They found that IT service exporters were more optimistic than the average Canadian company. Many of these firms, which are located right across the country, reported double-digit sales growth. Most of them said they expected sales growth to continue to be strong, particularly export sales, and fully three-quarters of them are expecting to hire more people. None said they are looking to cut employees. A large majority said they are looking to invest in research and development. And nearly half said they are planning to boost spending on physical investment. But the companies are not typically planning to invest in what one would traditionally think of as industrial machinery; rather, they are investing in equipment such as computers and software. And, of course, the other place where these companies are planning to invest is in people. The companies in the survey who said they would have difficulty meeting an unexpected increase in demand almost unanimously cited a shortage of skilled workers. In fact, the idea of physical capacity is almost irrelevant in this industry. To increase sales, these firms need to hire, and possibly train, sales and support staff, programmers, developers and computer engineers. The data are limited, but evidence suggests firm creation in this industry is above the average of the rest of the economy. Output has grown by more than 15 per cent since the start of 2011--a faster pace than the rest of the service sector and more than double the pace of the goods sector. In the past five years, the industry has grown by close to $8 billion and now represents more than 3 per cent of our economy. This is the kind of creation that follows the destruction. These are just some of the channels of growth that we expect will replace what we have lost in the past few years. There will also be contributions from our more traditional exports. Agricultural exports, for example, have grown by more than 13 per cent in the past five years, including $2.4 billion in canola and pulse crops. Pharmaceutical exports have grown by $7 billion; machinery and equipment, $3 billion; furniture, $2 billion. Even the "other" export category is more than $1 billion higher than it was five years ago. When you put all of these examples together, you can see that we are making real progress in filling that hole I talked about earlier. This process has been gradual, more gradual than we would like, but based on the progress recorded to date, we have every confidence that the economy will find its way back to full output. As these new sources of growth add up, we will gradually absorb our excess capacity sometime around mid-2018, and inflation will converge on our 2 per cent target from below. Now, I'm not suggesting that this complex adjustment process is automatic, and that there's no role for policy-makers to facilitate the adjustment--on the contrary. The conduct of monetary policy must manage uncertainty as a matter of routine--uncertainty about the economic outlook, about unobservable variables such as potential output, and so on. It is the nature of economics and economic models that we should always express our expectations in probabilistic terms-- that is, a number surrounded by a margin of error--and make policy decisions that carefully weigh and manage those risks. In short, monetary policy is not like engineering. It is the job of the central bank to understand and monitor these new growth channels very carefully. Doing so is essential to providing a stable and lowinflation environment in which new businesses can thrive. The evolution of our economy poses issues for both economists and statisticians. The American economist Robert Gordon has written extensively about the challenges involved in measuring concepts such as output and productivity after advances in technology change the nature of work. Statistics Canada is devoting a great deal of effort and resources to these challenges, and I have no doubt that we will have the best data possible. In terms of economic models, it is worth considering whether the relationship between inflation and economic growth could change as the economy evolves. Certainly, the concept of an output gap is gradually changing, as services capacity depends mainly on people and skills rather than industrial capacity, while some parts of our old industrial capacity could become redundant in the face of major structural changes. The concept of investment is shifting away from plants and machinery toward human capital. Even the concept of inventories is changing. Economic models are just that--highly simplified constructs meant to capture the broad behavioural linkages in the economy. At the Bank, we are in a constant state of model redevelopment, adapting to evolution in the economy. The economics profession needs to be thinking hard about what the next generation of economic models will look like because it can take a long time to make a new model operational. From a broader policy perspective, we need to develop new ways to help people cope with technological and structural change in order to improve our economic performance over time and to allay the economic fear and skepticism we are seeing across the advanced economies. Historically, technological advances have always meant disruption as well as progress--creative destruction, as Schumpeter put it. And while the benefits of the advances are spread widely throughout the economy, the costs of the disruption are concentrated among relatively few people. These issues lie beyond the remit of the central bank. But our policy framework does help to put such issues into context. Policies that improve the ability of people to adjust to the demands of the new economy will help raise our economic capacity, our long-term potential growth rate and our productivity, and will make the job of maintaining our inflation targets easier. From the macroeconomic point of view, I can say that our economy is far more adaptable today than it has been in the past. But that performance can be enhanced by finding ways to ensure that our various educational, apprenticeship, immigration and employment insurance programs all work well together with the on-the-job training commitments of employers. Allow me to conclude. The rise of the new economy in Canada represents the latest chapter in a long story--the ascent of the service sector. Over time, this has been a good news story, with technological advances leading to rising incomes and higher standards of living. Every generation of Canadians has faced similar stresses--and similar opportunities. It is obviously the role of policy-makers like me to help people understand the economic forces they face and the importance of technology and international trade to their well-being. But no one understands the importance of these things to a typical Canadian worker better than their employer. I cannot think of an audience that understands these issues better than those who are here tonight. I ask you to join with me in helping explain these forces to your employees and the public at large. And I ask that you consider innovative ways of matching good people with good job opportunities. These are some of the ingredients of the confident future that Canadians all deserve.

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Engaging Canadians: a #bankNOTEable process

poloz

Governor of the Bank of Canada Distinguished guests, welcome. Welcome everyone. What a great day. A historic day. I would like to give a warm thanks to the young people who came this morning to take part in this event. I am very proud to be here with the Minister of Finance and the Minister of Status of Women to announce who will be the Canadian woman who will appear on one of our bank notes. The Bank of Canada is responsible for the design, production and distribution of Canadian bank notes. And on bank notes, we can celebrate the diversity of Canada's culture and society. Governor, I have long believed that it was time for a woman, in addition to Her Majesty, to be on one of Canada's bank notes. And we also heard from Canadians who told us that it was long overdue. So I was very pleased when the Minister asked the Bank to move forward in our search to find the iconic woman for our bank notes. We started by asking Canadians. And let me tell you. They told us. The response was amazing. Within two days we received more than 10,000 nominations. It became clear that this search for an iconic woman was engaging Canadians in a very personal way. Some people looked within their own profession: Engineers googled women engineers. Some of my economist colleagues searched for economists, computer scientists and statisticians. Some people looked at their alma maters-- notable women of Queens, or Mount Allison or the University of British Columbia. Other people looked geographically, finding women who represented their part of the country. Teachers used the nomination process as a way to teach children about Canada's history. School kids told us who they thought should be on the money. With every mouse click or turn of a book's page, with every kitchen table discussion or classroom debate, Canadians learned more about the women who built Canada. We received more than 26,300 submissions, resulting in 461 eligible candidates. Then we turned it over to an independent Advisory Council. This Advisory Council, made up of eminent Canadian academic, sport, cultural and thought leaders, carefully went through all the nominations. After much research and deliberation, they narrowed down the list of eligible Canadian women from 461 to What a task they had! Several of the members are here today, so please let me thank you for all your hard work. Your role in this process has been critical. With that list of 12, we consulted Canadians again. We then gave the Advisory Council another difficult task, whittling down the list to 5 extraordinary Canadian women. I was very proud of the list of finalists that we provided to the Minister. It was the result of a very extensive process of consultation. We engaged Canadians and we listened to them. I know that this new bank note will inspire us all, but especially young Canadians. They will be sure that the contributions of Canadian women and men are recognized and valued. And now let me turn it over to the Minister.

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Release of the Financial System Review

poloz

Governor of the Bank of Canada Press conference following the release of the Good morning. Senior Deputy Governor Wilkins and I are happy to be here to discuss today's remarks about Governing Council's deliberations. First, a brief reminder about our methodology. Most of the analysis in the FSR is about vulnerabilities here in Canada. These are pre-existing conditions that may interact with changes in our economic situation to present risks to the financial system. Macroeconomic shocks happen all the time and economies adjust to them. But if significant financial vulnerabilities are present, the effects of those shocks on the economy and on the financial system may be magnified through interactions with the underlying vulnerabilities. The metaphor we have used is that of a large tree with a crack in it--the situation may improve or worsen over time, but there's no immediate crisis until the wrong sort of storm comes along. Within this analytical framework, many possible shocks could, in theory, transform financial vulnerabilities into financial stability risks. We offer illustrative risk scenarios in the FSR. Of course, it is possible to draw logical links between almost any macroeconomic shock, anywhere in the world, and financial stability here in Canada, like a "butterfly effect." We make no attempt to catalogue all of these possibilities, the consequences of which would all look quite similar. Instead, we focus more of our analysis on underlying vulnerabilities in Canada. That being said, household financial vulnerabilities continue to rise in Canada. We separate these vulnerabilities into two areas, household indebtedness and housing market imbalances. This separation is important, since although they often go hand-in-hand, it is possible that over time one of them will diminish more than the other. This separation has always been present in our analysis, but Governing Council sought to sharpen the distinction in this FSR. This is because macroprudential measures have been introduced in recent months that will serve primarily to mitigate the potential consequences for the financial system of rising household debt. These measures relate to mortgage qualifying criteria, which will raise the underlying quality of household indebtedness over time, and to financial institutions' capital requirements and pricing criteria, which will make them more resilient to future shocks. Accordingly, these policies will help mitigate financial stability risks over time. When it comes to housing activity and prices, the measures will weigh on demand, especially for more expensive houses. But demographic demand remains robust, job creation and income growth have been strong in the greater Vancouver and Toronto areas, and housing supply constraints continue to bind. There is a box in the FSR that describes the macroprudential measures that have been taken and how they might be expected to affect housing fundamentals. The important takeaway is that one cannot judge the effectiveness of these policies simply by observing whether house prices continue to rise. This is because the measures are aimed at mitigating risks to households and to the financial system, not at house prices per se. The effects of these policies will be greatest in Vancouver and Toronto, because that is where the majority of high loan-to-income mortgages are being granted. In this context, Governing Council noted that price increases have begun to slow noticeably in Vancouver, but it is too early to determine the new trend. It is noteworthy that market activity began to slow before the imposition of the special tax on sales of homes to non-residents, which suggests that other factors may have begun to interrupt the cycle of extrapolative price expectations. However, the situation remains highly uncertain, and we have seen no signs of a similar moderation in the Toronto area. Again, we must emphasize that a moderating housing market, as we have seen in Calgary, for example, may ease financial stability concerns on one front, but leave the level of household debt at a very high level. Governing Council's discussions of these risks were also influenced by the backup in global bond yields since the US election. Canada's bond yields have responded, as is typically the case, albeit in less than a one-for-one fashion. This has led to some increases in Canadian mortgage rates. We will monitor these developments carefully in the months ahead. As we made clear in our recent interest rate announcement, we will continue to follow an independent monetary policy in Canada, one aimed at returning inflation to our 2 per cent target. Finally, there has been considerable discussion in financial markets about possible shortages of bond market liquidity. Many have pointed to regulatory changes as contributing to this. At the same time, markets functioned exceptionally well following the UK referendum on leaving the European Union and the US election. This issue continues to draw attention at the international level. In this FSR, we bring some new analysis to the table, which draws upon an in-depth market survey conducted by the Canadian Fixed-Income Forum, an industry group established by the Bank. Governing Council acknowledges that there are pockets where liquidity problems are more evident, such as corporate bonds, off-the-run government bonds and certain repo markets. But we also recognize that markets have yet to fully adapt to the new regulatory requirements. Further, the pre-crisis period may not be the best standard for comparison, because liquidity was excessive and virtually costless at that time. It is reasonable to expect that liquidity will be marginally more costly--and market-making less lucrative--under the new regulatory regime, and that market participants will continue to adapt against the backdrop of a more resilient financial system. We will continue to monitor market behaviour and to engage with market participants, while pursuing work on the impact of regulatory reforms at the international level. With that, Ms. Wilkins and I will be happy to respond to your questions.

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Monetary Policy Report Press Conference Opening Statement

poloz

Governor of the Bank of Canada Press conference following the release of the Good morning. Senior Deputy Governor Wilkins and I are happy to be here to answer your questions about today's interest rate announcement and our (MPR). Let me elaborate on some selected issues that were central to the Governing Council's deliberations. The uncertainty we face as forecasters and policy-makers remains undiminished. The MPR outlines a number of risks to our projection in both directions. In our discussions, Governing Council was particularly concerned about the ramifications of US trade policy, because it is so fundamental to the Canadian economy. But we cannot capture these in our projections because they are simply unknown at this point. We considered the possibility of not incorporating any US policy changes in our projection. However, Governing Council felt that some form of fiscal stimulus was likely over our projection horizon. Accordingly, we have made some reasonable initial assumptions about fiscal initiatives--specifically, corporate and personal tax cuts that would raise the level of US GDP by about 0.5 per cent in 2018. This assumption could be recalibrated in either direction, but doing the work now provides a framework for analyzing the situation as it evolves, while also giving us a better balance of risks over the projection horizon. According to our analysis, a US fiscal shock of this magnitude would probably have only small effects here in Canada, boosting GDP by about 0.1 per cent by 2018. This is because there are three important offsets that would limit the transmission of such a US fiscal shock to Canada. First, a corporate tax cut in the United States could adversely affect Canadian export competitiveness. This would mean lower exports and investment in Canada than otherwise. Although our stronger investment intentions, some of this may be coming from firms with cross-border operations considering new investments in the United States rather than here in Canada. Second, an important consequence of rising US optimism has been an increase in US bond yields, some two-thirds of which has been imported into Canada-- much more than in many other countries. While this reaction is consistent with past correlations, it is at odds with Canada's macroeconomic situation where there is material excess capacity, unlike the US economy. This divergence in economic performance is mainly due to the setback Canada endured when oil prices collapsed. Canadian 5-year mortgage rates have already risen in response to higher bond yields, which will act as an additional drag on housing demand in Third, the US dollar has moved higher against most other currencies. Because the Canadian dollar has held its own against the US dollar in this context, largely due to higher oil prices, it has also been rising against most other currencies. This combination creates two additional headwinds for Canadian exports: softer US exports will mean lower demand for Canadian components of those US exports; and Canada will lose more competitiveness in the US market compared with exporters from other countries. With respect to our export forecast, today we are publishing two new staff discussion papers on our modelling of exports. The main insight is that our previous model may have put too much weight on developments in the US economy and not enough on other economies, both in terms of demand growth and in terms of measures of competitiveness. Suffice it to say that the two new models both explain most of the missing exports we have been talking about-- amounting to some $30 billion to $40 billion--and predict slower export growth in the future than our previous model. The projections we are laying out today are similar to those from October, because we were already testing the new models then and used them to form our judgement. That said, our updated projection--which, I should remind you, is more conditional than usual--shows the Canadian economy experiencing above- potential economic growth for the next several quarters. This would imply a steady narrowing of Canada's excess capacity over the projection horizon. While some of the recent data have been encouraging--I am thinking in particular of the latest data on exports, employment and business sentiment in our BOS-- they do not support a forecast of above-potential growth by themselves. Rather, that projection continues to rely on the expected effects of domestic fiscal stimulus. We have already seen some early effects from the Canada Child Benefit on household spending, and there have been some new measures introduced at the provincial level. But the main ingredient in our forecast is the federal infrastructure program, which is well under way but not yet evident in the economic indicators we are tracking. In fairness, the best place to see this is in the national accounts data, which are so far available only through the third quarter of 2016. All of this matters because persistent excess capacity puts downward pressure on inflation, raising the risk that we will continue to fall short of our inflation target. We have recently introduced three new measures of core inflation, each with its own strengths and weaknesses. These are not target variables. Rather, they are analytical tools. They help us to see through shocks and give a better guide to what is happening to the underlying trend in inflation. In particular, they are much more correlated with excess capacity than total inflation is, simply because total inflation is constantly being buffeted by temporary price disturbances. Our new measures of core inflation are all below 2 per cent presently, weighed down by excess capacity in the economy. In addition, food prices have been running below expectations in recent months, due in part to enhanced competition at the retail level, something we will continue to monitor. Looking ahead, Governing Council expects inflation to move up to close to 2 per cent in the near term, mainly because of firmer energy prices. More importantly, our growth outlook would imply a narrowing of the economy's excess capacity over the course of 2017 and into 2018. So in the absence of any new shocks we would expect all inflation measures to converge sustainably on 2 per cent in the latter part of our projection horizon. To conclude, in the context of a projection that is largely unchanged, the Bank's Governing Council judges that the current stance of monetary policy is still appropriate and maintains the target for the overnight rate at 1/2 per cent. Governing Council will continue to assess the impact of ongoing developments, mindful of the significant uncertainties weighing on the outlook. be happy to take your questions.

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Opening Statement before the House of Commons Standing Committee on Finance

leduc

Good afternoon, Mr. Chairman and committee members. Thank you for the invitation to appear before this committee. My colleague Don Coletti, who is an advisor to the Governor, is joining me today. We are pleased to be able to contribute to your timely study on the Canadian real estate market. The Bank of Canada has a mandate to keep inflation low, stable and predictable. Given the importance of a well-functioning financial system in achieving our inflation goal, we provide our assessment of the stability of the Canadian financial system twice a year through our . Let me thus focus my remarks on financial stability. Our assessment starts by identifying the financial system's most significant vulnerabilities; this is important since financial vulnerabilities can help propagate and amplify shocks to the economy, leading, among other things, to larger deviations of inflation from our 2 per cent target. Over the past few years, we've highlighted two key vulnerabilities that are relevant to your study: high levels of household indebtedness and housing market imbalances. These two vulnerabilities clearly interact with one another, as households borrow more to buy more-expensive homes. Let me briefly discuss these two vulnerabilities in turn. The first one, indebtedness, is well known. The ratio of debt to disposable income in Canada is now approaching 170 per cent. This ratio has been rising steadily since the early 2000s. Additionally, the aggregate number masks worrisome patterns regarding how this debt is distributed. For example, our analysis shows that debt has become more concentrated over time in households with higher levels of indebtedness. Compared with their less indebted counterparts, these households tend to be younger and have lower incomes. The second vulnerability concerns house prices, which now stand at a record of almost six times the average household income on a national basis. What's most concerning here are the imbalances in some cities, most notably Toronto and Vancouver. The price increases we've seen in those cities have been caused by a number of factors, ranging from demographics to low interest rates to constraints on land use. We have also highlighted our concern that expectations of future price growth may be a contributing factor. Because these expectations can change rapidly, the imbalances that have emerged make it more likely that shocks to the economy could cause a drop in prices. In light of these vulnerabilities, the most important risk to the financial system remains a large and persistent rise in the unemployment rate across the country, which creates both financial stress for many highly indebted households and a correction in house prices. In this scenario, households significantly cut back their consumption spending, while a rise in defaults and a decline in collateral values exert stress on lenders and mortgage insurers. Although we see a low probability of this risk materializing, its impact would be substantial if it were to occur. This is why we judged this risk to be "elevated." That said, I hasten to add that we've conducted model simulations to analyze the effects of such a shock and found that the buffers in the Canadian financial system would be sufficient to absorb its impact. So while there would be stress, the financial system would remain resilient. As you know, the federal government made important changes to housing finance rules last fall. These changes should reduce the rise in highly indebted households over time by ensuring that borrowers are more resilient to potential future headwinds. We are not expecting the regulatory measures to lessen this vulnerability overnight because it will take time for the number of highly indebted households to decline significantly. It's also worth emphasizing that, under the new mortgage finance rules, the ability of all insured borrowers to make debt-service payments must now be assessed using an interest rate that is higher than the prevailing market rate. As well, applicants must show they can cover the costs associated with servicing not only their mortgage but also their total consumer debt. We expect this more stringent test will reduce vulnerabilities not only in Toronto and Vancouver, but also in cities where house prices aren't as high relative to incomes, such as Montreal, Halifax and here in the Ottawa-Gatineau region. The last point I'll make is that the Bank of Canada can best contribute to long-term financial stability by keeping inflation low, stable and predictable. To achieve our inflation mandate, we cut interest rates after the financial crisis and have done so twice since 2014, after oil prices collapsed. Our actions supported income growth and the economic recovery we've seen, helping mitigate households' financial stress along the way. This policy, coupled with other macroprudential tools aimed directly at financial vulnerabilities, is helping to preserve the stability of our financial system. Thank you. We will be happy to answer your questions.

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Models and the Art and Science of Making Monetary Policy

poloz

Governor of the Bank of Canada The Alberta School of Business sits a couple of hundred metres east of the Centennial Centre for Interdisciplinary Science, which houses a number of telescopes. When you look at a star through a telescope, you see it not as it exists today, but as it existed years in the past, when its light started heading toward Earth. In that sense, a telescope is something like a time machine. If only those telescopes could do the reverse and see into the future! Economic forecasting and policy making would be a snap. But since we do not have a machine that lets us see the future, we have to make do with the next best thing: the economic model. Models have become indispensable to the conduct of monetary policy. This is because central banks typically use monetary policy to target a variable, such as inflation, in the future. Policy actions take time to affect targets. For example, it takes up to two years for a change in interest rates to have its full effect on inflation. This means that there is little point reacting to the latest movement in inflation. Rather, central bankers need tools that can forecast where inflation is likely to be two years from now and tell them how to adjust policy today so inflation will hit the target. Of course, economic models are not crystal balls. They generally explain what happens in the economy on average--they always make errors, but the errors are expected to offset each other over time. The fact that models can deliver only an approximation of the truth means that conducting monetary policy is not a mechanical exercise. It is a complex blend of art and science--in effect, it is an exercise in risk management. Sooner or later, something extraordinary happens to the economy that a model cannot explain, pushing it persistently off track. A forecaster can rationalize a string of prediction errors for a while and adjust his or her judgment around the outlook accordingly, but eventually the time comes to rebuild the model. The global financial crisis of 2007-09 is one such event: a significant outlier in economic history. Models have struggled to explain the forces that led to the crisis and the behaviour that followed. This experience is now guiding the work of model builders. And in the Bank's most recent medium-term plan, we identified as a core priority the need to reinvent central banking, in part by refreshing and upgrading the tools we use. The cycle of modelling-forecasting-remodelling is as old as empirical economics. It is how we make progress. Today, I want to review the history of models at the Bank of Canada, illustrating how each new generation of models has built on the successes of the previous generation and adapted to the changing needs of policy-makers. I will describe how economic theory and computer technology have enabled this evolutionary process and speculate on what we can expect in the next generation of economic models. A key issue in building economic models is the trade-off that exists between forecasting ability and theoretical rigour. Forecasting models focus primarily on capturing empirical regularities. They work well when the economy and the shocks that it faces do not change much over time. In contrast, theoretical models built for policy analysis are based on a specific interpretation of how the economy functions. Their specifications may hold true on average, but not for every data point. So models with a strong theoretical base tend to underperform empirical models in normal times. However, they can be very useful in explaining behaviour when large shocks cause data-based models to break down. The two types of models have tended to be complementary, but that has never stopped economists from pursuing the holy grail of a single model that combines strong theoretical foundations with good empirical performance. Over time, advances in computing capability have made it possible to build more realistic behavioural assumptions into models, improving this trade-off. However, the history of model development at the Bank of Canada reflects both this quest for synthesis as well as the evolving needs of policy-makers. Each new model has drawn on the strengths of its predecessors while addressing their shortcomings. And throughout this history, advances in both economic theory and computer technology have played an important enabling role. The Bank began modelling in the 1960s, when staff and visiting academics built development of the mainframe computer was essential to this work, but not every institution had one. One academic involved in those early efforts at the Bank, John Helliwell of the University of British Columbia, tells of sending boxes of punch cards by bus to a computing centre at the Universite de Montreal and of inputting data by modem to a computer in Utah. Early models used by most central banks were based on Keynesian theory, with the demand side of the economy driving growth. However, the inflationary experience of the late 1960s showed the importance of modelling the supply side, which led to the successor model, RDX2. But after the oil price shock of 1973-74, the Bank wanted to use its model to examine alternative policies. The Bank actually began targeting the money supply as a means of reducing inflation and anchoring inflation expectations in 1975, but RDX2 did not have the ability to compare alternative policy paths. version of RDX2 was more amenable to policy analysis. Acquisition of an inhouse mainframe computer greatly facilitated this work. This is the model that was being used for quarterly projections when I arrived at the Bank in 1981. I can vividly recall my initial disappointment with RDXF. I was fresh out of graduate school, where the natural rate hypothesis and rational expectations were de rigueur . The natural rate hypothesis holds that there is no permanent trade-off between inflation and unemployment. Rather, the economy settles at full employment in the long run, and inflation reflects the impact of monetary policy actions and people's rational expectations. Rational expectations were seen as key to anchoring both models and economies as well as critical for properly analyzing alternative policy paths. The gaps between RDXF and the thinking of the day became even more real when the Bank dropped its monetary targets and began searching for a replacement policy anchor. We believed that RDXF would be vulnerable to the Lucas critique. The Lucas critique held that empirical models based on data generated under a given policy regime and expectations-formation process would prove unstable and forecast poorly when the policy regime shifted. By the late 1980s, the Bank was converging on targeting inflation directly as the central goal of monetary policy. This meant policy making would put much more focus on the future. We needed a model that would allow the Bank to make detailed projections--not just over the next couple of quarters, but for at least two years into the future--to reflect the lag between interest rate changes and their ultimate effect on inflation. This thinking led to the development of SAM, the Small Annual Model. SAM incorporated the natural rate hypothesis and also defined a steady state to which the model would converge after being hit with a shock. However, the flip side of these theoretical strengths was that SAM was unsuitable for short-term projections. So SAM was used to complement RDXF. The longer-term plan was to use SAM as a prototype to build a quarterly model with the same key properties to replace RDXF. Thus, QPM--for Quarterly Projection Model--was built. It incorporated forward-looking consumers and companies with rational expectations and a coherent steady state. Its short-run dynamics fit the data well enough to be used for projections. It also embraced all of the stock-flow dynamics necessary to analyze the significance of rising government debt, a prominent issue in the early 1990s. QPM represented a big leap in sophistication, and the desktop computers we had at the time were not up to the task. As the Chief of the Research Department, I had to make a special request of then-Governor Gordon Thiessen for money to buy more powerful computers just to run the experimental model--a process that nevertheless lasted all night. QPM served the Bank well for more than a decade. Its main shortcoming was that it could not deal with shocks to Canada's terms of trade--essentially, fluctuations in the prices of key commodities, such as oil--and these would become larger and more frequent. So adding a commodity sector to QPM moved to the top of our project list. At the same time, the economics literature was shifting to a new class of models: DSGE, for dynamic stochastic general equilibrium. DSGE models capture the idea that economic behaviours--such as decisions about household consumption and business investment--are perfectly informed, forward-looking and always optimal. These models also predict how an economy can evolve over time as expectations change. Furthermore, stochastic shocks are built into the model at the household and firm level, dealing completely with the Lucas critique. The model's solution describes an economy that has reached a state of general equilibrium, with individual decisions aggregated into economy-wide prices and production quantities. So the Bank decided to make the major investment to build ToTEM--the Termsof-Trade Economic Model. ToTEM kept all the functionality of QPM, while adding the commodity sector and using the DSGE paradigm. Again, this work proved to be too much for the standard workstations that staff had on their desks, despite their increased power. Calibrating ToTEM required an extremely complex series of mathematical problems that took up enormous amounts of computing power. The solution during the prototype stage was to buy some top-end gaming computers to crunch the numbers on nights and weekends when the heat and noise would not make people's offices unbearable. ToTEM continues to work extremely well for both projection and policy analysis. Of course, ToTEM's foundations represented a shift toward the theoretical side of the trade-off between forecasting ability and theoretical rigour. So Bank staff built a new model designed to complement ToTEM and guard against different types of forecast risks. This is the Large Empirical and Semi-structural model, known as LENS. It operates under a different paradigm than ToTEM does, is based more on what the data show and has only a loose set of theoretical constraints. LENS acts as a cross-check for ToTEM, and staff use the two models together to develop their projection and to facilitate a dialogue around policy options. In this way, the Bank is thus managing the trade-off by using two complementary models simultaneously, much as we did with RDXF and SAM. But ToTEM and LENS are much closer in performance than RDXF and SAM were, reflecting the improvements in the trade-off that I mentioned earlier. Our approach proved to be extremely valuable in late 2014, when Canada was faced with a collapse in the price of oil. In contrast to standard Keynesian models, ToTEM anticipated how serious the oil price shock would be, how the effects would endure and how the economy would adjust to lower oil prices. Our confidence in this analysis led the Bank to lower its policy rate twice in 2015, long before the negative effects of the oil price shock began to be widely felt. This put a cushion under the economy and made for a faster adjustment. Together, ToTEM and LENS represent a powerful, modern approach to economic modelling at a central bank. Nevertheless, they provide little insight into the forces that produced the global financial crisis or the behaviour that has come afterward. This is true for all major models previously used by central banks. The period since the crisis has raised related questions that these models are not well-equipped to answer. For example, how will the prolonged period of low interest rates affect risk-taking behaviour? How are business confidence and geopolitical uncertainty affecting business decisions? How do global value chains affect the way monetary policy is transmitted? To be clear, ToTEM and LENS have continued to do a good job, despite their shortcomings. And to complement them, we have developed a number of "satellite models" to deal with specific issues. For example, the Bank has built a the impact of financial shocks and macroprudential policies on the economy. Other models look at the ways inefficiencies in financial markets can lead to financial imbalances. There have also been ambitious efforts to model exports, at a very granular level, in light of extensive destruction of export capacity over the past decade. This multi-model strategy has allowed us to successfully mitigate the limitations of the current generation of models and appropriately manage the risks facing monetary policy. But the next generation of models at central banks will need to address these issues directly. While no one can say with any certainty what the next generation of central bank models will look like, we can expect them to stand on the shoulders of models One lesson we have learned over the years is that a single model is unlikely to satisfy all our needs. This is a consequence of the fact that models are, by construction, an abstraction from reality. Striking the right balance between theory and data fit is more an exercise in judgment than an empirical one, and those judgments are best formed by drawing upon complementary models. Another lesson is that central banks have traditionally stuck with their models until well after their "best before date." This is no doubt because greater realism in models means greater complexity, more computing power and big investments in research and people. Guarding against keeping a model too long may mean continuously investing in new approaches, even when there are no obvious shortcomings in existing models. Indeed, often it is the unforeseen advances in modelling paradigms--enabled by improved computer technology--that drive modelling progress. Today, the DSGE paradigm appears to have a long future, but no one was dreaming of this approach when we were building QPM only 25 years ago. To illustrate, an alternative approach worth exploring may be agent-based models. Unlike the DSGE approach, agent-based models assume that the economy consists of individuals who repeatedly interact with each other and adapt their behaviour based on what they learn from those experiences. Macroeconomic behaviour emerges naturally. Such models have their own limitations, but in a world of big data, where the advertisements you see online can be derived from what you type into your search engine, agent-based models could be a valuable tool. The next generation of models is also likely to take a more nuanced approach to rational expectations. In reality, people seem to behave in a way that falls somewhere between full rational expectations and simple rules of thumb. Hence the promising concept of "bounded rationality." Another potentially desirable attribute of future models is to allow for more forms of heterogeneity. We know, for instance, that different companies make different decisions about when to enter and exit markets and how to invest. We know that people with different income and wealth levels respond differently to interest rate movements, and these responses can change depending on the person's stage of life. Many financial transactions occur because people have varied risk tolerances. However, most current models assume uniformity among companies and individuals. And at a minimum, the next generation of models must capture the links between the financial system and the real economy. They should explain how the financial system can be a source of shocks and how those shocks can be propagated. They need to capture the possibility of nonlinearities that cause small shocks to have outsized economic effects. They should be able to show how debt that builds up in a specific sector can affect the entire economy. And we need models that capture risks and vulnerabilities within the financial system and can show how these interact with monetary and macroprudential policies. This is not an exhaustive list, but it illustrates the point. Bank staff have been given a licence to innovate on these issues because we know model evolution takes time, and we should invest continuously in it. Before I conclude, I want to return to an issue I raised at the beginning--the role of uncertainty in policy making. It is tempting to think that we can use today's sophisticated models to give us a precise numerical forecast for inflation two years from now as well as the exact policy response needed today to keep inflation precisely on target. In earlier speeches, I have likened this to an exercise in engineering. In fact, economists do exactly that with their models, but they express their predictions in probabilistic terms. They point to the many margins of error that exist around all the variables in their model, and all the assumptions they must make, and admit that their ultimate calculation contains all of these sources of error by construction. This creates uncertainty around both the model's inflation forecast and its recommended policy path. At the Bank, we think of this inherent uncertainty as creating a "zone" within which our interest rate setting has a reasonable probability of bringing inflation back to target over a reasonable time frame. So uncertainty exists even when models are performing well. But there are additional uncertainties, including those related to model-disrupting structural changes, such as those that were triggered by the global financial crisis. These additional uncertainties may introduce a bias in the model's projections, making it more likely that its suggested interest-rate path will lead to missed targets. And, of course, there is uncertainty generated by the risks to our inflation forecast. We begin our interest rate deliberations with the policy path recommended by our models, but we are always mindful of the uncertainties, including the range of risks that might cause us to undershoot or overshoot our target. All of these sources of uncertainty define the zone in which we can be reasonably assured that policy is on track. Factors that increase uncertainty-- such as geopolitical risks--can widen this zone temporarily. Conversely, resolution of uncertainties can narrow it. This is the essence of the Bank's risk-management approach to monetary policy. Interpreting, weighing and managing those risks approaches art, but the art is built on the science of our models. Allow me to make three related points. First, the starting point matters to a monetary policy decision. If inflation is on target and is projected to be on target in two years, then various risks can be interpreted and managed in an evenhanded manner. But our current situation serves as a counter example. While we project that inflation will be sustainably at target around the middle of next year, we are well aware that the lingering aftermath of the crisis has left the Canadian economy with persistent excess capacity, and inflation has been in the lower half of our target range for some time. Second, the uncertainty in economic models makes it ill-advised to reduce the conduct of monetary policy to a simple mechanical rule. The fact that there are so many sources of uncertainty, some of which cannot be quantified, makes the risk-management exercise highly judgmental. A corollary is that we need to explain our underlying reasoning very carefully to ensure that it is well understood. To this end, the Bank has taken a number of measures to increase its level of policy transparency in recent years. Third, uncertainty does not equal indecision. It is true that the notion of a zone generated by uncertainty can create a degree of tolerance for small shocks. At the same time, a large shock--or, perhaps, an accumulation of smaller shocks-- can tilt the balance of risks to projected inflation and prompt policy action. In early 2015, for example, ToTEM was showing how the oil price shock would play out and the downside risk to projected inflation became unacceptably large. The shock pushed us out of the zone in which the existing interest rate setting provided reasonable assurance of hitting our inflation target within a reasonable time frame. Accordingly, we reduced interest rates to bring projected inflation back into line with our target. It is time for me to conclude. The Bank has been pursuing inflation targets for 25 years, and the average rate of inflation has been extremely close to target over that period. This alone suggests that our models have done their job reasonably well. And while our current models continue to perform well, recent experience is pointing to some shortcomings that we need to address. Given how long it can take to develop a new model, investing in the next generation of models is one of the Bank's top priorities, and I want it to be a top priority for the economics profession as well. Better tools will mean a more stable and predictable rate of inflation, and an even better environment for economic decision making. It is an exciting time for economics and monetary policy. I can hardly wait to see what comes next. But economists have a tendency to get overly excited about their own issues, so let me leave you with an analogy to help you keep this in perspective. Today's macroeconomic models are as different from those of the 1970s as the latest film, , is from the first of the original trilogy, , released in 1977. No matter which film you prefer, it is clear that the tools and the technology available to the director have evolved dramatically. The state of the art today is light years ahead of what was state of the art 40 years ago. But ultimately, storytelling remains what is important. That has not changed. Our economic models will continue to evolve, becoming better and more sophisticated tools. But it will always be up to central bankers to use these tools, as well as their judgment, to conduct monetary policy, achieve their targets and offer a compelling narrative that everyone can understand.

r170209a_BOC

canada

Getting to the Core of Inflation

schembri

Thank you for the invitation to speak to you today. In October, the Bank of Canada renewed its agreement on the inflation-control target with the federal government for the sixth time since 1991. The target is a critical component of our monetary policy framework, which also includes a market-determined flexible exchange rate. It's not often that a policy performs better than expected. Our inflation-control target did just that and continues to do so. Over the past 26 years, we have reduced consumer price index (CPI) inflation and maintained it at a level close to our 2 per cent target, with no persistent episodes of inflation outside our inflation-control range of 1 to 3 per cent Because inflation has been low, stable and predictable, Canadians have been able to make better economic decisions and achieve better economic outcomes. Consequently, real output has expanded at an average rate of close to 2 1/2 per cent per year. In addition, there has been much less volatility in inflation, interest rates and real GDP growth. operating band That's a solid track record, so, as you can imagine, it would take some compelling evidence for us to consider major changes to the policy. Given its effectiveness, the renewals of the inflation-targeting agreement every five years have generally gone smoothly, but I can assure you they are not automatic. Because we are committed to having the best monetary policy framework for Canadians, we use the term of each agreement to conduct an intensive research and consultation program to critically examine aspects of the policy. For example, leading up to the 2016 renewal we investigated three 1. Is 2 per cent still the appropriate target for inflation? 2. How do we incorporate financial stability considerations into the formulation of monetary policy? 3. How should core inflation be used and measured? Our research led us to conclude that the 2 per cent target is still appropriate and that monetary policy should be adjusted to address financial vulnerabilities only in exceptional circumstances. Today, I want to focus on our findings on the third issue: the use and measurement of core inflation to assess the underlying trend of inflation. First, I'll explain the purpose of core inflation measures in our policy deliberations and what we look for in reliable measures. Lastly, I'll review the three new core measures we have adopted and what they are telling us about current inflationary pressures. Let's start with the basics. Inflation is simply a general increase in the average price of goods and services over a given time period, in other words, a trend increase in the cost of living. We measure inflation using the increase in total CPI, which is estimated and published by Statistics Canada and tracks the cost of a representative fixed "shopping basket" of goods and services over time. Bank of Canada officially targets the 12-month increase in the CPI because it is a broad gauge of inflation that is most relevant to Canadians. It is essential that the inflation target be widely understood and visible so that citizens can hold their policy-making institutions accountable. Our monetary policy framework posits that CPI inflation will be at 2 per cent on an ongoing basis when actual output equals potential output. This is the level of goods and services that an economy can produce and sustain without adding to inflationary pressures. The difference between actual and potential output is the output gap, which can be positive or negative. We achieve our monetary policy target by helping align demand for domestically produced goods and services with the economy's capacity to produce them. If aggregate demand is expected to exceed or fall short of the economy's potential output, we typically raise or lower the policy interest rate to close the gap and keep CPI inflation on target. As much as we aim for low, stable and predictable inflation, there will always be sharp movements in CPI inflation. These movements are generally driven by volatility in the prices of a small number of goods and services. This volatility typically has a transitory impact on the rate of inflation (most frequently, its effects dissipate within a year). Since the effects of monetary policy on demand have long and variable lags, the Bank must look ahead to achieve our inflation target over our policy horizon. Consequently, we "look through" short-lived price changes by forecasting CPI inflation and the output gap beyond the horizon of the impact of these price changes. If we reflexively raised our policy rate whenever inflation was above target and lowered it whenever inflation was below target, we would end up reacting to a lot of temporary factors. This would lead to what has been called "instrument instability"--like trying to steer a car by constantly overcorrecting one way and then the other. It would be counterproductive and would simply destabilize both inflation and real economic activity. For this reason, many central banks use core inflation measures, which are designed to help filter transitory deviations from CPI inflation and therefore serve as a useful operational guide for policy. Such measures help us estimate where the underlying trend of inflation is relative to the target in the current month or quarter. They also help to corroborate other indicators of capacity pressures (especially the output gap), which are uncertain. Given this purpose, what criteria do we look for in an effective measure of core inflation? We want a measure that (i) closely tracks long-run movements in CPI inflation (in other words, one that is unbiased); (ii) is less volatile than CPI inflation and captures persistent movements in inflation; (iii) is related to the underlying macroeconomic determinants or drivers of inflation, particularly the output gap; and (iv) is easy to explain and understand. Now, let me describe how we measure core inflation. A common approach to measuring core inflation is to exclude items from the CPI basket based on various criteria, such as their volatility. The measure we used as an operational guide from 2001 until October 2016 is CPIX, which strips out eight of the most volatile components of the CPI and adjusts the remaining components for the effects of changes in indirect taxes. In recent years, however, the usefulness of CPIX inflation as an operational guide for policy has deteriorated. Most notably, there have been large transitory shocks to CPI components not excluded from CPIX. Indeed, this highlights an inherent weakness in measures of core inflation such as CPIX, which include a fixed and pre-determined set of components. What to exclude is often evident only after the fact. In the span of 12 months in the early 2000s, for example, the inflation rate of automobile insurance premiums rose from 2.0 per cent to 30.6 per cent. At its peak, this one component of the CPI basket was adding a full percentage point to CPIX inflation. Other components, such as electricity prices, have also shown particularly high, but temporary, volatility, leading to noticeable movements in CPIX inflation, while auto prices have, at times, moved countercyclically, thereby obscuring the relationship between CPIX and the deviation of actual from potential output. These three examples illustrate the flaw in simply excluding a fixed set of components ex ante . In particular, adding more items to the list of exclusions based on their observed price volatility, which may only be temporary, would not solve the problem of how to account for unexpected spikes in the prices of other components in the future. Moreover, it would reduce the number of components tracked, rendering the core inflation measure less representative of household consumption. More flexible approaches to estimating core inflation are needed. The shortcomings in CPIX led us to evaluate the properties of a wide selection of alternative measures of core inflation. After studying these alternatives, we decided to replace CPIX with three new measures of core inflation--CPI-trim, CPI-median and CPI-common. They perform well across a range of evaluation criteria. In particular, they allow the data to "speak" and thereby more accurately identify persistent movements in inflation that reflect the evolution of macroeconomic variables important to monetary policy ( Still, each measure was judged to have limitations, so we decided to use a set of measures, instead of relying on a single one. This underscores our view that monetary policy decisions should not be based on the mechanical use of such indicators. As policy-makers, we grapple with a high degree of uncertainty in estimating trend inflation and the output gap. Using multiple measures of core inflation helps us manage this uncertainty. Let me describe the characteristics of each. excludes CPI components whose prices in any given month have exhibited the most extreme movements. In particular, it trims off 20 per cent of the weighted monthly price variations at both the bottom and top of the distribution of price changes. It therefore always removes 40 per cent of the total CPI basket. These excluded components can vary from month to month, depending on which experience extreme movements at any given time. A good example would be the impact of severe weather on the supply and prices of certain food components. captures the price change located at the 50th percentile (in terms of the CPI basket weights) of the distribution of price changes in a given month. It helps filter out extreme price movements specific to certain components. Similar to CPI-trim, it eliminates all the weighted price variations at both the bottom and top of the distribution of price changes in any given month, except the price change for the component that is the midpoint of that distribution. is based on trends in price changes that are similar across the various categories in the CPI basket, rather than focusing on increases to specific items, such as the prices of gasoline or fruit. It uses a statistical procedure called a factor model to detect these common variations, which helps filter out price movements that might be caused by factors specific to certain components. Such common movements in prices are more likely to reflect underlying inflationary pressures related to aggregate demand and supply forces than sector-specific disturbances. Chart 2: The three new measures of core inflation effectively filter out volatile but temporary price changes Of the various core measures we evaluated, we found CPI-trim, CPI-median and CPI-common all met three of our four criteria: they were found to be roughly unbiased, more persistent than CPI inflation and related to underlying macroeconomic drivers, notably the output gap. CPI-common was the top performer for two criteria: it was the most persistent and moved most closely with the output gap. In addition, all three were relatively effective at looking through sector-specific shocks. Two of the measures--CPI-median and CPI-common-- fell short on one criterion: they are relatively more difficult to explain and understand than CPIX. I hope this speech and the supporting documentation available on the Bank's and Statistics Canada's websites will help in that regard. Nonetheless, all the new measures performed better than CPIX for three main reasons. First, they are less influenced by sector-specific shocks and therefore more accurate. In episodes such as the sharp rise in auto insurance premiums in the early 2000s that I mentioned earlier, as well as the deflation in auto prices that started in 2007 and the run-up in meat prices in 2014, CPIX was unable to filter out these transitory shocks ( ). The new measures were relatively more effective at doing so. It is important to note, however, that no measure of core inflation can filter out every type of temporary shock that a central bank may wish to look through when conducting monetary policy. In an open economy like Canada, for example, currency movements can have a profound impact on consumer prices. A movement in the exchange rate would have an effect on the level of prices for imports and domestic import-competing goods and the persistence of this effect would depend on the duration of the exchange rate movement, but its impact on the rate of inflation would be much shorter. Thus, this exchange rate passthrough (ERPT) effect would not warrant a policy response as long as inflation expectations remain well anchored. The impact of ERPT does not typically reflect changes in the underlying trend of inflation, which is affected by the degree of excess capacity in the labour market and in the economy more broadly. At the same time, most measures of core inflation tend to be affected by ERPT in varying degrees because they are sensitive to the relatively broad-based price movements caused by ERPT in Canada. Still, on average, these measures were found to have somewhat lower pass-through from the exchange rate compared with CPIX. In particular, CPI-trim and CPI-common attach relatively more importance than CPIX does to the prices of services, which are largely not traded across borders. Second, the new core measures better capture persistent movements in inflation. In other words, their movements endure across a number of periods, whereas CPIX inflation shows no persistence. This implies that transitory price changes are more predominant for CPIX than for the three new measures ( And third, the new measures have stronger relationships with key macroeconomic drivers, such as the output gap For example, the correlation with the output gap is much higher for the new measures than with CPIX. Finally, it is important to note that, like CPIX, the three new measures are roughly unbiased estimates of CPI inflation. Their averages from 1991 to 2016 are very close to that of CPI inflation. Their outlooks will therefore converge to that of CPI inflation over the policy horizon, as transitory factors dissipate. Chart 3: The new measures of core inflation have shown they are more effective than CPIX at looking through sector-specific shocks Let's now look at how these new core measures have performed recently and what they are telling us about ongoing inflationary pressures. The three measures have generally evolved broadly in line over time, although there have been instances when their behaviour has differed. For example, in the fourth quarter of 2016 their range was relatively wide--between 1.4 and 2.1 per cent ( . To explore this behaviour, we based our analytical framework on the Phillips curve. We assume that core inflation depends on the degree of excess capacity in the economy and degree of ERPT. In the short run, inflation is also affected by relative price changes and other temporary demand and supply shocks. Chart 4: The new measures of core inflation have diverged recently These specific determinants are not included in the framework and are thus captured empirically by the residual term. The new core measures are constructed to minimize the impacts of temporary disturbances and relative price shocks, so they should, in principle, largely reflect movements in excess capacity. shows the deviation from average of the year-over-year percentage change in each measure since 2000 and the decomposition of this deviation into three causes: excess capacity (or slack), ERPT, and an unexplained residual term ("others" in the chart). Let me say a few words about each of these three elements. First, excess capacity in the economy has had a material and persistently negative impact on the three measures of core inflation since the Great Second, the depreciation of the Canadian dollar since mid-2014, largely driven by the decline in commodity prices, has had a positive impact on all core measures, although it has been diminishing since the beginning of 2016. In the absence of ERPT and other unexplained factors, all three preferred measures of core inflation would be below two per cent, broadly consistent with the Bank's assessment of the degree of excess capacity in the Canadian economy. Third, while these macroeconomic determinants shed some light on the recent evolution of all three measures, they are unable to fully account for the typically temporary divergence among them at different times, including the recent one. This can be seen in the positive residuals for CPI-trim and CPI-median in the fourth quarter of 2016 and the negative residual for CPI-common. To shed a bit more light on why the measures may diverge more markedly from time to time, let me focus on the last three major occurrences: at the time of the Great During the Great Recession, the widening range can partly be explained by the effects of the rapidly increasing excess capacity. In 2008Q4, all three were close to 2.6 per cent. CPI-trim started to ease in 2009Q1, bottoming out at 1.2 per cent in 2010Q1. CPI-common started a less pronounced descent a quarter later. This is likely because excess capacity has a larger impact in the near term on CPItrim than it does on CPI-common. The impact of excess capacity on CPIcommon tends to be more delayed. The two most recent episodes of a larger divergence are more challenging to while CPI-median and CPI-common have remained closer to 1.5 per cent. In the recent episode, CPI-common has been weakening more than the other two measures. A closer look at the distribution of the price changes for all 55 components used as inputs to compute these core measures offers some insights. The distribution of the monthly price changes has not been symmetric in recent years, particularly over these two periods, meaning that the negative shocks affecting inflation have been more prevalent and more pronounced than positive shocks. This likely reflects more-intense competition among Canadian retailers during these two periods as well as ongoing excess capacity, which has increased somewhat in the latest period, owing to the large negative commodity price shock Canada has experienced since 2014. These factors have likely lowered CPI-trim more than CPI-median over the past few years. CPI-trim, as a weighted average, would be more affected by the asymmetries of shocks while CPI-median would be more insulated from them. and CPI-common a. CPI-trim b. CPI-median c. CPI-common Let me quickly summarize. These measures have declined since mid-2016 to close to 2 per cent or below, in part, because of the diminishing effects of ERPT and persistent excess capacity. The wide divergence among them in recent years might reflect in some measure the prevalence of the negative price shocks that have hit the economy. In addition, let me say that as policy-makers, we view the divergence among the measures not as a weakness, but as an important insight that validates our decision to use all three. If we had focused on just one, we would have been led astray in our assessment of the underlying trend of inflation. Time to conclude. A key challenge we face as policy-makers working within an inflation-targeting framework is to distinguish the trend from the transitory --that's why measuring core inflation accurately is "core" to our approach. The better we are at separating the two, the better we will be at understanding the current state of the economy and capacity pressures, and the better we will be at achieving our inflation target. Our ability to keep inflation on target is the means by which the Bank and the target earn credibility and trust. That credibility gives Canadians confidence and helps anchor their inflation expectations. This is a virtuous circle. Having expectations solidly anchored is critical to conducting effective monetary policy and achieving the target, especially in turbulent times such as the recent Although we've had 26 years of success in hitting our target, we are anything but complacent. We are committed to learning from experience and from academic research--including work conducted here at Western University--to continuously improve our monetary policy framework. We used the period leading up to the renewal of our target last year to update the framework by replacing CPIX with three new core inflation measures, which give us a more effective reading of the underlying trend of inflation. Using these multiple measures will also help us to manage the measurement risk associated with any single indicator and to better communicate the uncertainty involved in gauging inflationary pressures. In our past quarterly s (MPRs), we provided projections of CPIX inflation and regularly described the extent to which movements in it were due to sector-specific factors. However, we have come to realize that the attention paid to CPIX inflation may have created the misperception that it was the target for monetary policy rather than a useful operational guide. Going forward, we have decided that only the projection for CPI inflation will be included in the MPR to reinforce its role as the target for monetary policy. In addition, we will focus our analysis on the key forces underpinning the inflation process. The new core inflation measures will contribute importantly to this analysis. In that regard, I want to emphasize that these measures are only one set of inputs into our broad and ongoing assessment of pressures on capacity and inflation. We also take into account a wide range of information, including responses to our and more informal conversations that we conduct with businesses and other Canadians. We use a combination of models and our own judgment to understand the underlying forces working on inflation. For many of you in this room, hearing about life in Canada before our inflation target--when inflation and interest rates were in the double digits--must be as difficult to imagine as life without laptops and smartphones. However, those of you who are old enough to remember when mortgage interest rates hit 19 per cent know first-hand how transformative the past 26 years of low and stable inflation have been for family finances and for our economy. We understand that Canadians want and expect low and stable inflation, and we are committed to ensuring that we meet those expectations through the successful conduct of monetary policy.

r170302a_BOC

canada

Thermometer Rising—Climate Change and Canada’s Economic Future

lane

It is my privilege to speak to you about the economic implications of climate change--one of the biggest challenges facing Canada and the world in the 21st century. Let me first congratulate the Finance and Sustainability Initiative for your leadership in promoting responsible investment for sustainable development. Your work is vital to putting finance at the service of environmental sustainability--helping the private sector to identify the risks and opportunities inherent in climate change and green finance. The connection between climate change and the Bank of Canada's responsibilities for the stability of prices and the financial system is not an obvious one. We are not experts on climate science, nor do we control the tools to limit global warming. However, climate change itself and actions to address it will have material and pervasive effects on Canada's economy and financial system. While many of these will play out over many decades, I will argue that they are already starting to become important. So, the Bank needs to consider these effects as we deliver on our mandate to promote the economic and financial well-being of Canadians. In the time I have with you, I would like to share the Bank of Canada's perspective on the economic effects both of global warming and of the tools and policies that can be deployed to address it. I will discuss some of the challenges--as well as the opportunities, because there are many--that lie ahead for Canada. I will also talk about how the work of the Bank connects with these issues. Here in Montreal in early March, it might be tempting to think that rising temperatures could be a welcome change for Canada. But, as we know, that would be wrong. Global warming is already having negative effects, with significant economic costs compounding a heavy human toll around the world, including in Canada. Climate scientists are convinced that global warming is, at least to a large extent, attributable to human activity. Climate systems, like economic systems, are complicated: the forces at work can interact in unforeseen ways, so there are some significant unknowns. But these unknowns are all the more reason to act, especially if they imply even a small risk of a truly catastrophic outcome. Correspondingly, while the economic costs of climate change are uncertain they are likely to be significant. In Canada alone, it has been estimated that, in the absence of action to address global warming, we would face annual costs of between $21 billion and $43 billion by the 2050s. Such costs would take a number of forms. Global warming is associated with more frequent extreme weather events--such as floods, droughts and forest fires--which often have tragic consequences at the human level. In economic terms, such events can have a very high price tag. Take, as an illustration, the wildfires in Alberta, which deducted about 1 per cent of Canada's GDP in the second quarter of 2016. While the economy subsequently rebounded, this event was a setback to Canada's return to full potential. We know that such extreme weather-related events are already more frequent than they were in the past. They will become even more so as average global temperatures continue to rise, even if action is taken now to address climate change. But in the absence of such action, the tab will be much larger. There are also risks to specific sectors associated with climate change--some of which have started to materialize. For example, the forestry sector has seen the epidemic infestation of the mountain pine beetle, the agricultural sector is facing more frequent droughts and the mining sector encounters infrastructure challenges when ice roads become impassable. It is likely that further implications, as yet unknown, will become evident as global warming progresses. In economic terms, such events have effects on both aggregate supply and demand. As a central bank, we can react to events as they occur. But we cannot build them into our economic forecasts or adjust our monetary policy in advance because each is unique and unpredictable. In the short run, they may be viewed as a downside risk to economic activity in Canada, which we would take into account in our risk management framework for monetary policy. Over a longer Such outcomes are discussed in National Research Council, Committee on Joint project of the Estimate from the National Round Table on the Environment and the Economy, 2011, using 2006 dollars. period, that downside turns from risk into near-certainty--that is, a lower growth track for the Canadian economy than we would otherwise achieve. Let me turn to discuss two important tools that are at our disposal to address climate change: carbon pricing and green finance. In economic terms, climate change is a negative externality. Any individual or company that engages in activities that generate greenhouse gases imposes a cost on everyone else by contributing to climate change. Establishing a price for carbon emissions forces polluters to bear those wider societal costs--thus internalizing the externality. Based on this logic, setting the right price for carbon is at the core of Canada's strategy to tackle climate change. In a market economy, prices are the mechanism through which decisions of individuals and companies are coordinated. Using that mechanism to address carbon emissions aligns environmentally sustainable goals with the self-interests of individuals and companies. Of course, the right pricing does not mean that greenhouse gas emissions and global warming would stop. It only means that environmental costs are properly weighed against the benefits of the activities that generate the emissions. We can set a price for carbon through a carbon tax or a cap-and-trade system. Either way, we create incentives to reduce greenhouse gas emissions in the most efficient way possible. These incentives motivate several kinds of changes in behaviour by encouraging the use of existing technologies to reduce carbon emissions, inspiring the development of new technologies, and helping shift consumption and investment toward those goods and services that require less carbon to produce. While some are skeptical that pricing will motivate changes in behaviour, experience confirms that price incentives work. An example is British Columbia's carbon tax, which is estimated to have reduced greenhouse gas emissions by 5 to 15 per cent below what they would have been otherwise. Other examples include the widespread switch to smaller cars, prompted by the oil price spikes of the 1970s, and the displacement of coal by cheaper natural gas for power generation in recent years. , 2017. Carbon pricing is discussed in a report by Canada's Ecofiscal Commission, www.ecofiscal.ca Properly aligned incentives can reduce the need for pervasive regulation. Of course, regulation has its place as a complement to pricing. But given how energy is used in a modern economy, and the magnitude of the changes required, regulation alone cannot possibly do as comprehensive and consistent a job of changing the behaviours and activities that generate greenhouse gases. Of course, carbon pricing has economic consequences: most directly, it is costly for households and businesses to transition to a smaller carbon footprint. But those consequences need not all be negative. They depend very much on how the revenues from carbon pricing are used. For example, the revenues from carbon taxation could be used to lower the burden of other taxes. That is the approach followed in British Columbia, where the carbon tax enabled the provincial government to reduce personal income taxes and corporate taxes by a roughly equal amount. Such revenues could also be used to smooth the transition for affected industries and households and to address concerns about how the cost of carbon pricing is distributed. Carbon pricing is more effective if the same price is in place everywhere in the world, so that the steps to lower emissions can be at the lowest economic cost. Further, a consistent global regime reduces incentives for high-emission activities to be relocated to another country rather than scaled back and encourages more effective long-range planning for carbon use. This is one reason why global agreements on climate change, such as the 2016 Paris Agreement, are so important. It has been pointed out, though, that even if there were no global agreement, it would be in the interest of a single country like Canada to set a meaningful carbon price. Emissions pose other health and environmental costs, even within Canada, that would motivate a public policy response. Concerns that carbon pricing could result in a loss of Canadian competitiveness can also be partly addressed through the use of the new revenue streams. For example, Alberta's carbon tax has been designed to help address competitiveness concerns in energy-intensive, trade-exposed industries. I've made the case that carbon pricing is a powerful tool for meeting climate change targets. So is green finance, which facilitates private-sector financial flows into environmentally sustainable investments. Similar issues arise if carbon pricing is achieved through cap-and-trade, depending on whether carbon permits are auctioned or granted to existing emitters. Green finance works hand-in-hand with carbon pricing. With the right pricing on carbon, more green investments become profitable. However, enhanced transparency and analytical tools are also needed to enable investors to exploit those opportunities, particularly when the benefits may accrue over a long period of time. In this vein, growing numbers of investors--including some of you in this room--have signed on to the Montreal Carbon Pledge for greater disclosure of climate-related risks. So why is transparency so important? Those investors who choose to make environmentally responsible investments need clarity on the environmental impact of the activities they are financing. All investors need to know whether and how companies are exposed to any risks associated with climate change, including the impact of policy changes. For example, will the shift to a lower-carbon economy affect an oil company's profitability, either through tax changes or reduced demand for oil? Will certain oil reserves become uneconomic--aka "stranded assets"? These questions are also important for regulators who assess whether vulnerabilities are building in the financial system. Physical, liability and policytransition risks could result in the repricing of financial assets--if that were to occur suddenly, it could potentially pose financial stability concerns. Disclosures is helping to address the information gap. The Task Force recently released a draft set of recommendations for private sector firms on the effective disclosure of their climate-related risks. I don't want to prejudge any of the specific recommendations that may end up in the final report, which is to be released later this year. But the new guidelines should be a helpful step forward in promoting more informed investment, credit and insurance underwriting decisions. While disclosure is an important piece of the puzzle, green investments face other financing challenges. For instance, their returns may accrue over a long-term horizon, which poses issues similar to those faced by many other infrastructure projects. As another example, green technology companies, like other tech companies, may face financing hurdles in growing to an efficient scale. Creditors and investors may also lack the sophisticated analytical tools needed to properly assess environmental risks and returns. Group, of which Finance Canada and the Bank of Canada are active members. The group issued a report last year with options to address green finance barriers at both the international and national levels. The study group will continue to build on this progress in 2017. These and other financial stability issues were addressed in M. Carney, Despite the challenges, green finance has the potential to become an integral part of mainstream finance. During the transition, there will be many opportunities for investors and financial institutions to find innovative ways of filling the gaps in the existing financial structure. Some of you are probably already working on those opportunities. Last year was a record year for global green bond issuance at US$81 billion. all issued green bonds in recent years. Just last week the Government of Quebec issued its first green bond. These are small steps in the grand scheme of things, but they will help catalyze greater market interest in this sector. Make no mistake: the move to a lower-carbon economy is a major structural shift for the global and Canadian economies. It is a change in the kind of energy that is used toward sources that emit less carbon. It is a change in in how goods and services are produced--lowering their energy-intensiveness. And it is a shift in what goods and services are produced and consumed--away from more energyintensive products toward other products and activities. While many countries will be undergoing a similar structural transformation, adapting to a lower-carbon economy will likely mean more profound structural changes for Canada than for many other countries. Canada is an important producer of fossil fuels. Our manufacturing sector is closely linked to energy-- notably our automotive and aerospace industries--and will be affected by measures to address climate change. And Canadians use more energy per capita than residents of many countries, given the size of our country as well as our climate, living standards and lifestyles. At the same time, Canada has certain advantages in facing this transition. It is already a large producer of renewable energy, notably hydroelectric power. And, given our highly educated population, Canada has the capacity to innovate in green technologies--while the magnitude of the transition itself provides a strong motivation for such innovation. While the coming shift does present some unique challenges, Canada has shown an ability to adapt. We have experienced major structural changes brought about by changes in relative prices. Think of the past two and a half years, when the drop in commodity prices drove production and employment away from resource industries toward other sectors of the economy. This shift represented a meaningful setback to Canadian economic growth and much economic pain to many families in the energy-intensive provinces. But the Canadian economy has proven itself resilient. Our flexible exchange rate helped provide a boost to our non-resource industries, including services and manufacturing. Our labour markets are adaptable--employment has kept growing at the national level in the face of job losses in the oil industry. Our financial system is strong and resilient and has been able to finance the transition rather than amplifying the resource downturn. Our governments' sound fiscal positions have given them room to provide support for aggregate demand. And at the Bank of Canada, we had room to ease monetary policy further to buffer the shock to the economy. Thus, as the effects of the oil shock have bottomed out, the Canadian economy is expected to return to its potential around the middle of next year. Of course, adjusting to a lower carbon economy will likely be more profound and involve different, more complex challenges. But the same factors that have made Canada resilient to the oil shock should serve us well as this adjustment proceeds. Through the adjustment and beyond, we also will rely on the innovative capacity of Canadians to recognize the many opportunities to develop new products and technologies for a lower-carbon world. Another important factor is that Canada's policy strategy for addressing climate change is being mapped out for the future--which will help in maintaining sustained growth and low, stable and predictable inflation through these adjustments. Indeed, this is in sharp contrast to a scenario where we do not succeed in staving off climate change which, as I have stressed, entails major downside risks and uncertainties. Now, how does the Bank of Canada fit into the picture? Obviously we are not at the front line dealing with climate change, but the issues I have been discussing have important implications as we carry out our responsibilities. Let me take a moment to talk about our mandate. The Bank has a role to promote a sound and efficient financial system, including robust markets. We share our financial stability responsibilities with other federal and provincial agencies. In contrast to some other central banks, the Bank of Canada is not directly responsible for regulating banks, insurance companies and similar financial institutions. It is therefore not for us to decide how these institutions should prepare for risks related to climate change or for those associated with the structural changes I have just discussed. We do not regulate financial markets and thus do not have the mandate to establish standards of transparency and disclosure in support of green finance. We do, however, have a broader set of responsibilities to support financial stability, including identifying, analyzing and assessing both imminent and emerging systemic risks. We bring this risk assessment into our discussions with other agencies that control the relevant policy levers. We also share our analysis with the public in our semi-annual and in various staff publications--not to mention in speeches like this one. Climate change also ultimately has implications for monetary policy. We will continue to pursue low, stable and predictable inflation amid the structural shift to a lower-carbon economy. The introduction of carbon pricing itself will have a transitory effect on inflation--indeed, such an effect is evident in the most recent monthly CPI figures. But since this effect is due to a one-off structural change, we look through it in making monetary policy--just as we have looked through the transitory effect of lower oil prices in the past couple of years. But the more profound structural changes that will be taking place are likely to have important consequences for both aggregate supply and demand, which we will need to consider carefully as we conduct monetary policy. By the same token, if rising temperatures were to bring increasingly frequent adverse shocks, we would need to factor that into our policy stance in the context of our risk management framework. Many of these forces are difficult to incorporate directly into our economic models, and we should be modest about the degree of precision we can bring to these issues. But models are nonetheless very helpful for characterizing the forces at work and capturing their interactions. We can also play an important role by being part of the policy dialogue, in Canada and internationally. I have already mentioned our contribution to the G20's work on green finance, one of a number of settings in which we can--and do--bring ideas and analysis to the table. All our efforts are guided by research to analyze the economic and financial forces at work. Indeed, the Bank of Canada's Medium-Term Plan includes an emphasis on "considering alternative futures." That label seems tailor-made for thinking about climate change--where we can envisage a lower-carbon future or another future where our economy is increasingly subjected to the shocks stemming from rising global temperatures. We are committed to analyzing the change that is here today and where it may take Canada's economy and financial system far into the future. In these remarks, I have been focusing on the future. But these changes are already in motion and are becoming increasingly important for decisions on a wide range of policies. The effects of climate change are already being felt, and action to address climate change is being taken now. If it is on a sufficient scale to address the problem, it is also on a sufficient scale to have a meaningful economic impact. The issues are complex, but basic economics can cut through some of the complexity. Putting a price on carbon is a core element of Canada's strategy for addressing climate change. And if we get the price right, we can do a lot right. Early steps are also being taken to make the financial system an effective tool for green finance, including here in Canada. There are signs that momentum is building. We at the Bank of Canada will do what we can, within our mandate, to help the Canadian economy through these changes. This is an integral part of our commitment to a better Canada. These modelling challenges, including those associated with the integrated models that seek to capture both environmental and economic forces, are vol.

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Getting Down to Business: Investment and the Economic Outlook

schembri

Thank you for the invitation to speak here today. My colleagues and I routinely consult the business community, and I welcome the opportunity to share our economic outlook with you and listen to your views. This consultation process is an important ingredient in our policy making. To achieve our monetary policy goal of low, stable and predictable inflation at the 2 per cent target rate, our economy should operate at, or close to, its productive capacity. However, most advanced economies, including ours, have been running well below full capacity since the Great Recession of 2008-09 owing to a persistent deficiency in demand. After years of serial disappointment, recent data suggest that the recovery in the global economy appears to be gaining traction. Notably, growth in the US economy is expected to remain solid, For the Canadian economy, estimates of the growth of gross domestic product (GDP) from Statistics Canada for the fourth quarter of 2016 came in somewhat stronger than we had anticipated in our January While the headline number is welcome news, a more detailed analysis suggests continued scope for caution. Exports continue to face ongoing competitiveness challenges. And despite recent gains in employment, subdued growth in wages and hours worked continues to reflect persistent economic slack in Canada, in contrast to the United States. In particular, one component of GDP that remains concerning is business investment. While investment in the energy sector now appears to be stabilizing after a painful adjustment to the decline in oil and other commodity prices that began in 2014, overall business investment in the economy remains weak. Statistics Canada also reported that non-residential business investment spending contracted by more than 15 per cent in the fourth quarter of 2016 and by almost 8 per cent for the year as a whole. The current elevated level of geopolitical uncertainty, and the related prevailing uncertainties around the economic outlook, are likely contributing importantly to this continued underperformance in business investment. Therefore, it is still too early to assume that the worst is behind us. So business investment is the topic I want to focus on today. It is, I am sure, top of mind for many of you, given the strength of business activity here in British Columbia. It is also top of mind for the Bank of Canada. Obtaining an up-to-date and better understanding of the investment intentions of the business community is critical for our outlooks for economic activity and inflation, which inform our monetary policy decisions. Although business investment represents a relatively small share of GDP--about 12 per cent, on average--it is a key economic indicator that we track closely for three main reasons. First, it reflects your expectations about the future. Therefore, it is an economic bellwether--you will invest only when you are relatively certain that the demand for your goods and services will remain firm or increase. Second, fluctuations in business investment can drive the business cycle--roughly 50 per cent of the movements in quarterly GDP during the Great Recession and its aftermath were due to shifts in business investment. And third, investment adds to our stock of capital and increases the level of "potential output" or productive capacity--the level of output our economy can produce sustainably without generating inflationary or disinflationary pressures. My talk consists of three main sections. I'll start with an overview of the cyclical and structural forces affecting investment. Then I'll review the impacts of these forces on investment in Canada since the 2008-09 recession, especially the period since mid-2014. Finally, I'll discuss our base-case or most likely outlook for investment and the economy and our assessment of the risks to inflation . Cyclical forces As I mentioned, business investment is a small and relatively volatile component of GDP, and investment across business sectors tends to crest and trough like the tides in response to shocks to demand. This ebb and flow reflects two related factors. First, investment projects are often large, require irreversible sunk costs, and take time to build and operate. Undertaking them depends on expectations of future demand. Second, the expectations of individual firms are often influenced by the behaviour of other firms and perceptions of overall business confidence. Consequently, common movements in expectations can become self-fulfilling. If many firms invest together, they will collectively boost demand for their products. The famous British economist John Maynard Keynes called these shared psychological forces "animal spirits," which he described as the "spontaneous urge to action rather than inaction." When these spirits are aroused and businesses start to see demand strengthening, economic momentum accelerates. As sales improve and profits rise, businesses become more confident. As a result, they invest in machinery, equipment and buildings to expand capacity. Investment expenditures raise employment, household income and spending, which, in turn, boost demand and further stimulate businesses to invest. The other factor that promotes the cyclical flows in investment spending is depreciation. Over time, capital assets depreciate or become obsolete and need to be replaced. During periods of weak or uncertain demand, firms typically delay their reinvestment decisions. However, they can do so for only so long. Thus, when it appears that the economic tide is turning, firms will take the opportunity to reinvest, and their collective actions will amplify the economic upswing. In practice, these psychological and economic forces often work in tandem and are self-reinforcing. Structural forces For the structural forces, or long-term determinants of the demand for capital and investment, it is useful to think about a typical firm's production process. Firms combine labour, capital and technology to produce goods and services. Therefore, demographic forces that affect the growth of the labour force will also affect the demand for capital. For example, faster labour force growth will encourage firms to invest not only to meet greater demand but also to equip these additional workers with machines and other capital to raise their productivity. The rate of technological progress is also a key factor, since a faster pace of innovation raises the return on each additional unit of capital, stimulating firms to invest more. Indeed, fresh investment often embodies new technology and serves to further increase productivity. The composition of investment matters too. The nature of the production process determines the amount and type of capital (and investment) required. Services, for example, generally require less investment than oil sands or motor vehicle production. Thus, the ongoing expansion of the service sector means we may see a shift from traditional forms of investment in structures, such as factories and heavy machinery, toward investment in intellectual property, such as software and research and development, as well as in human capital. And public investment can complement and thereby enhance the productivity of private investment. High-quality infrastructure in the form of transportation systems, power-generation facilities and, more recently, telecommunication networks (some of which may be provided privately) are essential to modern production processes, especially given the accelerating digital transformation of the global economy. As I mentioned earlier, business investment collapsed during the Great Recession, and its much-weaker-than-expected recovery since, despite historically low financing rates, has been a major source of disappointment in advanced economies. The challenge for policy-makers, including us at the Bank, is to assess how much of the weakness in business investment reflects the dynamics of the business cycle and how much is due to structural forces. This distinction is important for our projections for demand and for potential output or supply, which are critical to our monetary policy decision. Focusing on Canada, let's consider the possible impacts of cyclical and structural forces on investment over this period. Two key cyclical factors have affected business investment in Canada since the Great Recession: sharp movements in commodity prices and the subdued pace of the US recovery. Although the collapse in investment was as acute in Canada as it was in other advanced economies, Canadian business investment bounced back relatively quickly, as the oil and gas sector benefited from a sizable rebound in commodity prices ( ). Nowhere was this more apparent than in investments in nonresidential structures, which by the end of 2010 had already surpassed their precrisis peak ( ). Moreover, this had positive spillovers for investment in industries with strong connections to the commodity sector, even though we were continuing to see many firms in other industries closing their doors. By the middle of 2014, the level of Canadian investment had grown to 15 per cent above its pre-crisis peak. Then the oil price shock hit. Prices plummeted from above US$100 a barrel in the first half of 2014 to around US$35 a barrel by the end of 2015. This set off a complex set of adjustments to the Canadian economy, including a significant depreciation of the Canadian dollar, that are still at play today. The Bank estimates that over the past two years the level of investment in the oil and gas sector alone has declined by almost 50 per cent ( sectors linked to the oil and gas industry curtailed their investment decisions. Consequently, investment in Canada has declined by more than 20 per cent since the middle of 2014. The second cyclical factor that has had a major impact on our exports and business investment is the protracted recovery of the US economy--the slowest in the postwar period. When oil and other commodity prices rose in the years before the 2014 oil price shock, so did our dollar, making our non-commodity exports to the United States less competitive and reinforcing the ongoing shift from manufacturing to services. As I mentioned earlier, this is likely reducing the level of investment. Following the crisis, Canadian business investment recovered faster than in other advanced economies... ...because of strong growth in non-residential construction, primarily in the resource sector Investment in the oil and gas sector has contracted significantly since the decline in oil prices in mid-2014 Now, let's look at the structural factors that affected business investment during this period. I'll focus on two: demographics and productivity growth. Population aging under way across most advanced economies has led to a marked slowdown in labour force growth, and this has been a strong headwind to investment. In Canada and the United States, for example, the annual growth rate of the labour force slowed from around 1 1/4 per cent in 2006 to less than This decline has reduced potential output growth and investment demand. Low productivity growth since 2007 has also been a headwind on business investment. However, while demographic shifts are fairly predictable, it is less clear how much of the decline in productivity growth reflects a structural change and how much is a cyclical response to the subdued recovery. For example, the loss of existing firms and the low creation rate of new firms during and after the Great Recession have not only directly reduced investment but also impaired the dynamism of the private sector, causing persistent, adverse effects on productivity growth. All of these challenges have increased uncertainty about the strength of future demand and weighed on business confidence. As a result, Canadian firms have acted cautiously in their investment decisions, despite operating close to capacity in some industries. In some cases, they have met any increases in demand by hiring more labour. So that's how we got to where we are. Let me now take you through our most recent economic outlook for Canada. Let me start by making two important points from our January policy rate announcement. First, our outlook since mid-2016 for gradually increasing global growth is largely consistent with what we have seen in the data. Second, heightened concerns about prospective protectionist measures mean that we should not presume that the economic disappointments we have experienced since the Great Recession are over. That said, the adjustment to the decline in commodity prices is progressing, and activity in resource-related industries appears to have bottomed out. Real GDP growth is expected to pick up from 1.4 per cent in 2016 to slightly above 2.0 per cent in 2017 and 2018, with the expansion of the service sector underpinning rising employment, household incomes and consumption. The strengthening US and global economies and the federal fiscal stimulus in Canada are also expected to support exports and domestic demand. Financial conditions remain accommodative for investment, despite a modest increase in longer-term borrowing costs since October. Against this backdrop, investment is expected to slowly strengthen. Recent data on oil rig activity and the capital expenditure plans of oil and gas firms suggest that investment in the sector has begun to increase this year. Meanwhile, the growth of the service sector and a modest expansion in exports should continue to support moderate investment growth in other sectors in 2017 and 2018. Inflation is projected to be near 2 per cent through 2017 and 2018 as the temporary effects of higher consumer energy prices and lower food prices dissipate and economic slack is absorbed. The outlook for inflation is subject to a number of risks that the Bank identifies as important. Let's start with two risks that could raise inflationary pressures and that are particularly significant for investment. The ongoing US recovery, the new US administration's decision to restart the approval process for the Keystone XL pipeline and other energy projects, and further policy measures, including tax reform, deregulation and infrastructure spending, could boost both demand and business confidence, igniting animal spirits and leading to an acceleration in the rates of investment, firm creation and innovation. Stronger US household spending and public and private investment would have positive spillovers for Canadian exports and investment. Higher commodity prices Recently the prices of non-energy commodities have drifted higher, rising by roughly 2.7 per cent since we published our January . If they were to continue to strengthen, this would improve Canada's terms of trade, wealth, and hence household spending and business investment. Now, let's look at two risks that could exert downward pressure on inflation. A shift toward protectionist trade policies The new US administration and some political leaders in other jurisdictions have espoused policies that are inward looking, although precise measures remain to be determined. Such protectionist policies would dampen global trade and economic growth and either directly or indirectly reduce Canadian exports and business investment. They could also restrain or reverse the ongoing process of global economic integration, most notably the development of global value chains, which has supported growth in recent decades. Sluggish business investment in Canada The disappointing performance of business investment to date could reflect more sustained structural factors, such as slowing labour force growth, low productivity growth and regulatory obstacles. Over time, weaker investment growth would reduce capital deepening and lower potential output growth. Let me wrap up with three points. First, the decline in oil and other commodity prices since mid-2014 has dramatically altered the paths of business investment in Canada and the United States. The two countries are now at different points in their respective business cycles ( and ). Although the Canadian economy has made good progress adjusting to the oil price shock, material slack in our economy remains, in contrast to the US economy, which is approaching its productive capacity. In our March statement we indicated that our current monetary policy stance remained appropriate to achieve our 2 per cent inflation target on a sustainable basis by around the middle of 2018, whereas US authorities have now begun to tighten. Our economic projection will be updated in the April , and we will review the stance of monetary policy at that time. Second, recent economic data are largely consistent with our outlook of a gradual strengthening in global economic growth. However, uncertainty remains elevated because of prospective policies that put at risk the progress made in recent decades to liberalize trade and foster economic integration. Canada, however, has resisted this protectionist tilt. We have just concluded a major free trade agreement with the European Union and are working toward lowering barriers to internal trade. We view these measures, as well as the recent changes to immigration policy, as positive steps that will increase growth over the medium-to-long term. Third, and finally, I am sure many of you are considering whether this is the right time to invest and build your business. Such decisions are never easy, but at the Bank of Canada, we are committed to reducing the uncertainty you face and helping you make the best possible investment decisions by achieving our monetary policy goal of low, stable and predictable inflation. Chart 4: Business investment in Canada has been much weaker than in the Canada and the United States are now at different points in their respective business cycles

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Canada at 150: It Takes a World to Raise a Nation

poloz

Governor of the Bank of Canada It is a real pleasure for me to be back in my home town of Oshawa, particularly given that Durham College reaches its 50th anniversary this year. From 205 students in 1967, Durham has flourished. The college developed partnerships with both Trent and York universities and added the University of Ontario Institute of Technology as an educational partner on campus. Today, As we all know, Canada, too, is hitting a big milestone this year--150 years of Confederation. Let me ask you this: Where in the world would you rather live? Over the past 150 years--not long by global standards--Canada has progressed to become one of the wealthiest and happiest countries in the world. The average income, adjusted for inflation, is about 20 times higher today than it was at Confederation. It is worth thinking about how this progress arose. Essentially, Canada's economic growth up to around the end of the Second World War depended primarily on exploiting our natural resources. To accomplish this, we needed three things: foreign investment, immigration and access to foreign markets. Of course, being open to the world also meant that Canada would be affected by global events, including policies in other countries, and this occasionally caused us to question our commitment to openness. But over time, the evidence leads to a clear conclusion: Canada fares better when we are open. Today, I want to illustrate this by looking at six episodes in our history and talk about how our willingness to be open to trade, investment and people has ebbed and flowed over the years. The economic benefits of international trade have been understood for about 200 years. But trade itself has been going on throughout history, including here in North America. At numerous sites, such as the junction of the Gatineau and Ottawa rivers near what is now Parliament Hill, evidence of trading stretches back centuries. Goods--and better methods of producing them--spread via trade among First Nations--such as the Mississaugas of Scugog Island, on whose traditional territories Durham College sits. Trade grew even more following the arrival of Europeans. The colonial powers of Britain and France had a strong interest in Canada's natural resources. Trade in resources like fish, furs and timber, which was established long before Confederation, shaped how Canada would develop, as the economist Harold Innis clearly spelled out more than 80 years ago in his seminal studies of our economic history. Colonial resources So rather than start in 1867, let us set the scene by going back further, to see how Confederation actually happened. In the years following the War of 1812, the area that would unite at Confederation was still divided into four colonies: Upper Canada, part of today's Ontario; Lower Canada, part of today's Quebec; and the Maritime colonies of New Brunswick and Nova Scotia. At the time, our economic ties with the United States were frayed. No doubt that had much to do with the fact that the Americans had just tried to invade Canada, but they had also imposed high tariffs on our exports. In contrast, we had strong ties to Britain, which had a policy of preferential tariffs--very low taxes levied on imports--on goods from the colonies. Tariffs served a dual purpose in the 19th century. Until the First World War, governments relied on tariffs for most of their revenue. But the second purpose of tariffs was the protection of domestic business from foreign competition. Over the years, tension developed between those who sought higher tariffs to provide protection from import competition and those who advocated lower tariffs and open markets. In Canada, this tension has often had a regional component, with consumers outside the protected industries resenting paying higher prices. This tension has ebbed and flowed for the past 200 years. During the first episode of our story, economic growth for the colonies depended on shipping resources primarily, but not exclusively, to Britain. In Upper and Lower Canada, that meant building canals, such as the Welland and Lachine canals. Immigration from Europe was crucial to supply the labour needed for construction. And with little local capital to finance the projects, governments looked abroad--mainly to Britain--for foreign investment. The uniting of Upper and Lower Canada in 1841 was an important step in attracting the funds needed to build the canals that would allow ships to travel efficiently from the Great Lakes to the Atlantic Ocean. The new waterway allowed wheat shipments from Upper Canada to boom. It also attracted shipments of US grain, because Britain considered everything sent through the St. Lawrence to be Canadian, applying the same preferential tariff regardless of origin. So, by the early 1840s our colonies were making economic progress, aided by foreign investment, immigration and trade with the British Empire. But this business model was disrupted in 1846, when the British government eliminated all tariffs on grain imports to reduce food prices. That meant that grain shipped through the St. Lawrence no longer had preferential access to the UK market compared with, say, shipments from New York. The hard feelings from the War of 1812 had faded as our second episode began. The Canadian colonies reacted to the loss of preferential access to Britain by becoming more open to trade with the United States. After several years of negotiations, and after overcoming significant protectionist sentiment on both sides, the Province of Canada struck a reciprocity agreement with the United States in 1854--essentially, a free-trade agreement in resources. Meanwhile, the Irish famine touched off waves of immigration into the colonies and the United States, fuelling growth. The colonies actively sought foreign investment to support the construction of railways, so goods could move in winter as well as in summer. Most of the investment to finance these projects came from overseas, primarily from Britain. With growing trade, an expanding population, foreign investment and improved transportation links in the colonies, the years just before Confederation were generally a time of economic growth. However, the fiscal cost of supporting the railroads was high. The Province of Canada found itself forced to raise revenue, and it did so by imposing tariffs on some imported factory goods. Not surprisingly, this did not sit well with manufacturers in the northern United States. This resentment grew as Britain continued to trade with the southern states during the Civil War. After the war, with the northern states in the driver's seat, protectionist sentiment carried the day, and the United States backed out of the reciprocity treaty with Canada in 1866. Once again, Canada's business model was disrupted as we lost preferential access to a major market. This was a key driver to the event that we are celebrating this year: the founding of the Dominion of Canada 150 years ago. Back in 1867, we became a nation of 3.5 million people, with more than 80 per cent of the workforce involved in agriculture or other natural resources. Nation building and struggles after Confederation Our third episode begins at Confederation. With access to US markets restricted by high tariffs, Canada needed railways more than ever to move goods and people over long distances, East-West rather than North-South. It is no exaggeration to say that without railways, there would have been no Dominion. In the East, construction of the Intercolonial Railway was a condition for Nova Scotia and New Brunswick to join Confederation in the first place. In the West, amid American dreams of northern expansion, the Canadian government needed a railroad to assert sovereignty over the Prairies. And it enticed the colony of British Columbia to join Confederation with the promise of a transcontinental railway. When completed, Canada would have railways running from sea to sea. The nation, and its economy, would not have worked without them. However, building a railway with an all-Canadian route over the vast Canadian Shield would be tremendously difficult and expensive. To get this done, Canada again had to turn to foreign investment to help fund construction. Over its first 20 years, Canada was routinely running current account deficits of between 7 and 10 per cent of gross domestic product (GDP), financed by foreign borrowing. This was not a problem, of course, as the borrowing was being used to increase the economy's capacity. To complete the railroad, the government turned to a group that included Donald president of the Bank of Montreal and, as it happens, an ancestor of mine. (Stephen is my mother's family name.) Just as there would be no Dominion without the railroad, it is also fair to say there would be no railroad without the effort and skill of these early entrepreneurs and financiers who helped attract foreign capital and channel it where it was needed. The people who developed what has become the world's soundest banking system were vital to Canada's development. In fact, the Bank of Montreal served as fiscal agent for the Canadian government in the years after Confederation, a role the Bank of Canada now fulfills. West to flows of goods and people. This link may have been necessary for growth, but it would prove insufficient on its own. The world was in the grips of the Victorian Depression, a generation-long economic slump that followed the financial crisis of 1873. Looking back on the period, it is a wonder that the CPR was completed during such difficult times. Even though thousands of immigrants continued to arrive in Canada each year, a greater number of people were leaving Canada for the United States, where economic conditions seemed better. In these difficult circumstances, the Canadian government turned insular. Weak revenues and concerns about the future of manufacturing led it to raise tariffs. By 1890, the average Canadian tariff for manufactured goods had reached 23 per cent, with imported clothing subject to a 30 per cent tariff. However, growth remained modest until just before the end of the century. The tide turns with the century The tide turned in our fourth episode, which begins just before the turn of the 20th century. The railroads that now criss-crossed the land supported openness in both directions. They allowed the trickle of immigrants into the West to turn into a flood. And they were the conduit for rapidly growing exports. With rising grain prices, the country's income soared. On the tariff front, the US market remained essentially closed. And in the 1911 elections, Canadian voters rejected a renewed attempt at reciprocity with the United States. However, Canada's natural inclination toward open markets asserted itself. The government launched what became known as the Imperial Preference, which allowed for tariff rebates on goods of British origin. And over time, Canada pointed the way toward openness by negotiating lower tariffs through "most-favoured-nation" agreements with several other countries. Today, the concept of "most-favoured-nation" is at the heart of the global trading system. So, with tariffs starting to trend downward globally, market access rising and population growth accelerating, the Canadian economy boomed early in the century. Foreign investment remained a key ingredient, hitting a record 18 per cent of GDP in 1911. By 1913, more than $2 billion had been invested in railways alone, equal to about $43 billion today, in a country of just 7.5 million people. Another important trend began to emerge during this period--our economy was becoming more diverse. Canada's manufacturing sector, centred here in Southern Ontario, began to expand rapidly. Several factors helped this rise, including the development of technologies that raised productivity in agriculture, allowing workers to leave farms for new emerging jobs in cities. In the fledgling auto industry, Ford opened its first Canadian plant in Walkerville in 1904. In later merged with Buick and evolved into General Motors. This industrialization would, in time, help encourage a more open trading relationship between the Wars and the Depression Our fifth episode starts with the outbreak of the First World War and continues until the Second World War. The First World War led to higher tariffs as governments scrambled to raise revenue. Income tax was introduced in 1917, which finally gave governments another important source of revenue and made tariffs what they are today--purely a tool of protectionism. Foreign investment into Canada slowed sharply, immigration came almost to a halt and a major recession followed the First World War. Things improved briefly during the Roaring Twenties amid industrialization in both Canada and the United States. But the US stock market crashed in 1929, and shortly afterward, the Western world fell into the Great Depression. Foreign investment and immigration to Canada slowed again during the public sentiment turning against the banking system, then-Prime Minister R. B. Bennett set up a Royal Commission, leading to the establishment of a central bank to act in the public's interest. And since 1935, the Bank of Canada has been operating with a mandate to promote the economic and financial welfare of Meanwhile, in a bid to protect American workers and farmers from foreign competition, the US Congress pushed up the average tariff rate on dutiable goods to nearly 60 per cent by 1932. This policy backfired spectacularly. Most other countries, including Canada, retaliated with tariffs of their own. The trade war had no winners; everyone suffered as international shipments collapsed. Canadian trade fell by more than 50 per cent during the Depression; US trade, by 70 per cent. Unhappily, the Second World War is what happened next. Post-war success Our final episode follows the Second World War. After the Depression and war, many countries--including Canada--were determined to create international institutions aimed at preventing such disasters from happening again. At the 1944 international conference at Bretton Woods, Canadian economist and future Bank of Canada Governor, Louis Rasminsky, not only led the drafting of many of the documents but was also credited with breaking deadlocks between the British and American delegations. Canada would benefit greatly from this international push toward openness. A consensus emerged on the wisdom of an open trading system, and three years after Bretton Woods we saw the General Agreement on Tariffs and Trade (GATT). Over the next 50 years, successive rounds of GATT talks led to lower and lower tariffs, from the roughly 22 per cent average seen before the war to about 4 per cent following the Uruguay Round in the 1990s, reducing costs for consumers everywhere. Here in Canada, the government co-operated with the US government to invest almost half a billion dollars in the St. Lawrence Seaway, and it invested another billion dollars to build the Trans-Canada Highway. To get an idea of what these figures would be today, multiply them by roughly 10. The pattern of importing capital resumed, while the banking industry, along with the Bank of Canada, facilitated the development of domestic financial markets. These markets would provide a link to global financial markets and help attract and channel foreign capital. During the 1950s and 1960s, large numbers of people immigrated to Canada, and this has continued to be the case, more or less, until today. Simple arithmetic shows just how important immigration has been to Canada. Take away the force of international migration since Confederation, and Canada would be around 10 million people, not 36 million as we are today. With all of the right ingredients in place, Canada enjoyed years of sustained, strong economic growth in the post-war period. It is not a surprise that some of Canada's most famous economists made their mark during this time. I am thinking of Nobel laureate Robert Mundell, whose work with British economist Marcus Fleming led to a greater understanding of how small open economies such as Canada's function, and why flexible exchange rates are a key ingredient of success, especially for an economy reliant on foreign capital flows. Other Canadian economists who gained prominence around this time include John Kenneth Galbraith, with his international work and insights into economic cycles and financial bubbles, and Jacob Viner and Harry Johnson, both of whom did pioneering work on international trade. With industrialization continuing during the post-war period, Canada's economic ties with the United States strengthened. The 1965 Auto Pact created a single, tightly linked market for automobiles and parts between the two countries. This gave Canadian producers both the opportunity to develop economies of scale and the ability to specialize production. Over the agreement's first 40 years, auto production in Canada roughly tripled, while employment in the industry doubled. The next step in strengthening these ties was the Canada-US Free Trade Agreement (FTA) in 1988, which was expanded five years later to include Mexico earlier attempts at reciprocity, these agreements would not come easily. Many Canadians resisted continental free trade, fearing job losses, the possible loss of our health care system, and a general loss of Canadian economic or even political sovereignty. None of these concerns have come to pass, although heightened competition did result in job losses in some sectors. But these losses were more than offset by gains in other areas, and consumers have continued to benefit from lower prices and increased purchasing power as most tariffs were eliminated. Beyond the FTA and NAFTA, Canada has kept pursuing other opportunities for openness. Canada has continued to push for reduced barriers through the World Trade Organization--which succeeded the GATT framework--and through agreements with other individual countries or trading blocs. So what can we say about the lessons of our story, and how can we apply them today? Now, I know that I have greatly oversimplified matters and have not taken into account a host of other factors in Canada's development. But I find the correlation between economic progress and openness to be striking. When trade barriers are falling, when people are coming to our shores and when investment is rising, Canadians prosper. We saw this before Confederation, in the early 1900s and after the Second World War. The flip side is that responding to tough economic times by turning inward rarely succeeds. We saw this after Confederation and during the Great Depression. The bottom line of our history is that openness and economic progress go hand in hand. It is intuitive that a country like Canada would want open access to foreign markets. Indeed, given our abundance of natural resources, we have needed export markets to pay for the imports and the investment required for our development. Similarly, it is not hard to see how we have been bolstered by a growing population that includes immigrants who bring their skills, labour and demand. Canada is not unique in this. It is less intuitive to see the same point from the other direction. Historically, there has always been some resistance within Canada to lowering tariffs and exposing our businesses to foreign competition. But what experience has shown is that the fears of openness are misplaced. Protectionism does not promote growth and its costs are steep. First and foremost, higher tariffs and other trade barriers make things more expensive for people and limit their choices, while lower tariffs make things cheaper and increase choice. Specific companies might benefit from protectionism, but that imposes a cost on everyone else. Conversely, the gains from free trade are spread throughout the economy. Beyond this, exposure to competition has been an important driver of innovation. Through competition, companies are exposed to new technologies, which they can then adapt for their own use. And higher productivity leads to sustained employment and rising living standards. So there are compelling reasons why Canada should continue pushing for open markets, both here and abroad. Similarly, there are compelling reasons to keep our borders open to immigration. Last month, Statistics Canada issued a report projecting that in less than 30 years, Canada will rely entirely on immigration to keep its population growing. Along with productivity, we need continued labour force growth to keep our economic potential expanding. There are also compelling reasons to ensure that Canada remains open to foreign capital flows. Because of our vast geography and relatively small population, we have always had major infrastructure needs. Historically, our domestic savings base has not been large enough to finance these infrastructure projects, so we have needed foreign capital. A final, related point: this quick romp through our history illustrates the importance of dreamers and visionaries, leaders who can turn difficult odds into win-win outcomes. In short, success is not guaranteed, but the key ingredients must be there for the entrepreneurial to capitalize upon: open markets, immigration and foreign investment. Allow me to conclude. Canada's development owes much to people who had a vision of what it takes to build a great nation, and the willingness to take risks to achieve that goal. Our history shows that it takes a world to raise a nation, and nation building works best in an environment of openness for trade, people and investment. Canada has prospered by looking outward and being engaged, bilaterally and multilaterally. It can be hard to remember this in times of global stress such as we have seen in recent years. The quest for progress and higher productivity can disrupt people's lives. Automation has meant that workers in some specific industries have borne the cost of change in a very difficult and concentrated way, and we can expect this to continue. But remember that we have been through similar disruptions before, and turning inward has never been the answer. Rather, committing to openness has always been the right choice. What is crucial is that we deploy some of the benefits of being open to assist those who need help adjusting to global forces. Failing to do so invites doubt and puts everyone's progress at risk. Canada has prospered over its first 150 years. Mistakes have been made, and lessons have been learned. But overall, our openness to the world has helped us build a nation that I believe is the best place to live in the world. Imagine what we can build over the next 150 years.

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canada

Unveiling of Commemorative Bank Note Marking the 150th Anniversary of Canada

poloz

Governor of the Bank of Canada We at the Bank of Canada are proud to have produced this special note commemorating Canada's 150th anniversary. We've only ever produced three other such bank notes in our 82-year history, so believe me when I say this is a big deal. Developing any bank note is a long and involved process, especially so with this one. We've been working on it since 2014, and more than 5,000 individual Canadians have fed into the process. We asked them if they wanted to see the past, the present or the future on the note. In true Canadian form, the answer to The design was inspired by that input and carefully incorporates many of the ideas we heard on how to best represent the 150th anniversary of Confederation. Isn't it amazing how much history you can fit onto a little piece of polymer? All of the historical elements in the note's design show why this year calls for a big celebration! This bank note not only reflects the pride we feel about our country and its accomplishments, it also, we hope, instills in Canadians a different kind of confidence. The Bank is responsible for the design, production and distribution of Canada's bank notes. And while bank notes reflect Canada's society, culture and history, it's also our job to ensure that they are durable and difficult to counterfeit--in short, so that Canadians can have confidence in their money. From a design perspective, when we asked Canadians what they wanted to see, more than anything else, they said Canada's landscapes. So if we look at the back of the note, we will see several images of Canada's natural beauty, seamlessly woven together--from sea to sea to sea. From left to right, we start in the west with the Lions--or the Twin Sisters, as the Squamish people know them--the peaks of the North Shore Mountains, which overlook Vancouver. In the foreground, we can see Capilano Lake. Moving east, we come to the Prairies. We see wheat, the iconic crop of Canada's Prairie provinces and one of the most important cultivated crops in Canada. This image reminds Canadians of the importance of the role family farms played in the expansion of our country and of the Prairies as the breadbasket of our nation. Then the note takes us to the Canadian Shield, that ancient mass of rock that covers roughly half of the total land area of Canada. This is a view that many Ottawans may find familiar: forest, rock and water, minus the blackflies. The image used on this bank note is inspired by a photograph taken at the soon-tobe-created parc national d'Opemican in the Abitibi-Temiscamingue region of Quebec. The Kipawa River pictured here flows out of the park and into the Ottawa River. Those waters eventually run past our doorsteps here and down to Montreal, where they merge with the St. Lawrence. Moving right, we go to the east coast of Canada and an image of Cape Bonavista in Newfoundland and Labrador. This may very well have been the view that John Cabot saw when he landed in 1497. Above these images of Canada, we see the northern lights as they would appear if we were in Wood Buffalo National Park, home to the world's largest dark-sky preserve. Now some of you may be old enough to remember the Centennial bank note produced by the Bank of Canada in 1967. Many people still have some of them tucked away. I know I will be keeping one of these new notes. We have produced 40 million of them, just more than enough for every Canadian. They will be available as of As all of you celebrate Canada's big birthday this year, I encourage you to take a close look at this special note. It will be a little piece of history. I hope this bank note captivates your imagination and instills pride in who we are and how far we have come as a nation. It celebrates our land, our history and our culture. It's a bank note that reminds us of how much we have to celebrate as Thank you. Merci beaucoup.

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canada

Opening Statement before the House of Commons Standing Committee on Finance

poloz

Governor of the Bank of Canada Governor Wilkins and I are happy to be before you today to discuss the Bank's (MPR), which we published earlier today. When we were last here in October, I spoke about the factors that caused us to downgrade our outlook for the Canadian economy. Six months later, I'm pleased to say that I can discuss the factors that have led us to upgrade our forecast. For some time, we have been talking about how the oil price shock that began in 2014 set in motion a complex series of adjustments throughout the economy, including a significant restructuring in the oil and gas sector. What we are seeing now is that energy-related activity has stopped declining and is transitioning to a new level that is commensurate with the current level of oil prices. Because that large negative force is now essentially past, it is no longer masking the sources of strength that have been at work for some time, particularly the growth in output and employment that is being driven by the service sector. The expansion over the past six months has exceeded our earlier forecasts, and we have revised up our outlook for average annual growth in 2017 to a bit over 2 1/2 per cent, one-half percentage point greater than we projected in the January MPR. We project growth of just under 2 per cent in 2018 and 2019. A crucial question for the Bank now is whether the stronger economic data that we have been seeing are signalling increasing momentum. Some of the strength is coming from factors that are unlikely to continue at the same pace. For example, the very strong growth in consumption in the first quarter was supported by a temporary boost from the Canada Child Benefit. Housing activity has also been stronger than expected. While we have incorporated some of this strength in a higher profile for residential investment, we still anticipate slowing over the projection horizon. The current pace of activity in the Greater Toronto Area (GTA) and parts of the Golden Horseshoe region is unlikely to be sustainable, given fundamentals. House price growth in the GTA has accelerated sharply in recent months, suggesting that speculative forces are at work. In terms of the labour market, recent data have been mixed. While job growth has certainly been firm, both wages and unit labour costs have grown only slowly. The data suggest that material slack remains in the Canadian labour market, in contrast with the US labour market, which is close to full employment. At the same time, Canadian exports and business spending are still weaker than you would expect to see at this stage of the business cycle. Companies are telling us that while they plan to raise spending, the planned increases are modest, or tied to maintenance, rather than expansion. In short, the economy is not yet firing on all cylinders. In addition, Canadian companies are dealing with heightened levels of uncertainty related to US tax and trade policies. We still do not know what tax changes are coming, or when. And the range of potential trade measures under discussion is even wider now than it was in January. It includes a borderadjustment tax, increased tariffs aimed at specific industries or countries, nontariff barriers and even broader, multilateral measures. We do not know which of these will be enacted; their timing is uncertain; and each would affect the global and Canadian economies through a different, complex set of channels. With all of this uncertainty, we cannot reliably model the impact of changes to US trade policy. Instead, we have built in an extra degree of caution in our forecast for exports and investment relative to our January projection. Total inflation has been close to 2 per cent and is expected to dip to about 1.7 per cent in the middle of the year before returning to near its target. However, our core inflation measures are all in the lower half of the target band and have been trending downward. This supports the view that the economy continues to have significant excess capacity. Our current base-case forecast calls for the Canadian economy to absorb its excess capacity sometime in the first half of 2018, which is a bit sooner than we projected three months ago. We are certainly happy to see the recent strength in the economic data and want to see more of it in order to be confident that growth is on a solid footing. We judge that the economy still has material room to grow. And we remain mindful that significant uncertainty continues to weigh on the outlook. Given all of this, we judged that the current stance of monetary policy is still appropriate and maintained the target for the overnight rate at 1/2 per cent. With that, Mr. Chairman, Senior Deputy Wilkins and I would be happy to answer questions.

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canada

Monetary Policy Report Press Conference Opening Statement

wilkins

Press conference following the release of the Good morning. Governor Poloz and I are pleased to be here to answer your questions about today's interest rate announcement and our (MPR). There were a number of issues that were central to Governing Council's deliberations that I would like to elaborate on before turning to your questions. Many of the economic data that we have seen since our last MPR have been stronger than expected. That is certainly a welcome change. Given these positive surprises, and because monetary policy must be forward-looking to achieve our inflation target, Governing Council's discussions focused on three main issues: first, the extent to which recent strength is signalling stronger economic momentum in Canada and globally; second, how heightened levels of uncertainty, particularly about US tax and trade policies, should be incorporated in our outlook; and third, how much excess capacity the economy currently has, and the growth rate of potential output going forward. Let me start with the first issue. In our view, some of the upward surprises come from factors that are unlikely to keep adding to economic growth at the same pace. Energy-related activity has stopped declining and is transitioning to a new level that companies tell us is commensurate with the current oil price environment. This is good news. Consumption has also been more robust than expected as households have benefited from the Canada Child Benefit. This will continue to support the level of spending, but not the growth rate. Housing activity has also been stronger than expected. We have incorporated some of this strength in a higher profile for residential investment, although we still anticipate slowing over the projection horizon. The current pace of activity in unlikely to be sustainable, given fundamentals. That said, the contribution of the housing sector to growth this year has been revised up substantially. Price growth in the GTA has accelerated sharply in recent months, suggesting that speculative forces are at work. Governing Council sees stronger household spending as an upside risk to inflation in the short term, but a downside risk over the longer term. Meanwhile, exports and investment are still weaker than one would expect at this stage of the business cycle, even though growth in the global economy has also surprised on the upside. So, we do not yet see the well-balanced base that would give us assurance that growth is on a solid footing. This brings me to the second issue. Given the performance of exports and investment, the uncertainty regarding the tax and trade policies of the US administration again factored prominently in our discussions. The Bank of Canada is quite used to dealing with uncertainty, and we were very deliberate in choosing how to incorporate it into our projections and policy decision. In terms of potential US tax measures, we judged in January that there was enough information available to make some initial assumptions. There are now signs that suggest implementation will be delayed, and so we have updated these assumptions. We took a different approach to uncertainty about potential US trade policies. We now have a better sense than in January of the extremely wide range of possibilities: they include a border-adjustment tax, targeted tariffs on some products and countries, non-tariff barriers and even broader multilateral trade measures. We do not know which of these will be enacted; their timing is uncertain; and each would affect the global economy and Canada through a different, complex set of channels. Take a look at Box 1 of the Report for a discussion of this. Although it is fair to say that the possible outcomes are almost certainly negative for Canada, we cannot reliably model them at this stage. Instead, we have incorporated an extra degree of caution in our forecast for exports relative to our January forecast, including the potential implications of the softwood lumber dispute. We have also been cautious with our forecast of business investment. While businesses are becoming more confident, they remain wary. When we talk with companies, many tell us that planned increases in investment are modest, or related to maintenance, rather than to expansion. Overall, we project economic growth in Canada to slow from an annual pace of 3.8 per cent in the first quarter to just over 2 per cent for the remainder of the year. We project growth of just under 2 per cent in 2018 and 2019. Given the stronger profile of economic activity relative to January, Governing Council was very focused on the third issue: how much excess capacity remains in the economy. We use a couple of different methods to gauge the amount of excess capacity, which gives us a range of estimates of excess supply. Evidence from inflation data is also consistent with material excess capacity remaining. Although a number of temporary factors are keeping headline inflation near its 2 per cent target, our measures of core inflation are in the lower half of the target band and have been trending downward in recent quarters. Evidence from the labour market has been mixed. Employment growth has been firm, yet both wages and unit labour costs have risen only slowly, supporting the view that the amount of excess capacity could be greater than the midpoint of the range of estimates. Finally, there is the related issue of how quickly the economy's potential will grow. We still expect potential output growth to increase, but by less than we did a year ago, when we last updated our estimates. You can see from the Staff Analytical Note that we published today that this is mainly due to weak investment. That said, as the economy gains momentum and approaches full capacity, greater investment--including through new firm creation--could lead to potential output growing faster than we assume in the base case. Some of the tools used by the Bank have tended to underestimate growth in potential output during periods of expansion, leading to upward revisions later on. If potential growth turns out to be greater than we expect, the economy could expand further before generating inflationary pressures. Under our baseline outlook for growth and potential, the economy will absorb its excess capacity sometime in the first half of 2018, a bit sooner than we projected in January. I would also point out that we now judge that the neutral interest rate in Canada is lower than we thought previously. While financial conditions are still very supportive of growth, this implies that they are somewhat less stimulative now than we judged in January. This brings me to our policy decision in pursuit of our inflation target. Governing Council welcomes the recent strength in economic data and wants to see more of it in order to be more confident that growth is on a solid footing. We judge that the economy still has material room to grow. And we remain mindful that significant uncertainty continues to weigh on the outlook. Given all of this, we judged that the current stance of monetary policy is still appropriate and maintained the target for the overnight rate at 1/2 per cent. Governor Poloz and I would now be happy to answer your questions.

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canada

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

poloz

Governor of the Bank of Canada Wilkins and I are pleased to be back before you today to discuss the Bank's At the time of our last appearance in October, I spoke about the factors that caused us to downgrade our outlook for the Canadian economy. Six months later, I'm pleased to say that I can discuss the factors that have led us to upgrade our forecast. For some time, we have been talking about how the oil price shock that began in 2014 set in motion a complex series of adjustments throughout the economy, including a significant restructuring in the oil and gas sector. What we are seeing now is that energy-related activity has stopped declining and is transitioning to a new level that is commensurate with the current level of oil prices. Because that large negative force is now essentially past, it is no longer masking the sources of strength that have been at work for some time, particularly the growth in output and employment that is being driven by the service sector. The expansion over the past six months has exceeded our earlier forecasts, and we have revised up our outlook for average annual growth in 2017 to a bit over 2 1/2 per cent, one-half percentage point greater than we projected in the January MPR. We project growth of just under 2 per cent in 2018 and 2019. A crucial question for the Bank now is whether the stronger economic data that we have been seeing are signalling increasing momentum. Some of the strength is coming from factors that are unlikely to continue at the same pace. For example, the very strong growth in consumption in the first quarter was supported by a temporary boost from the Canada Child Benefit. Housing activity has also been stronger than expected. While we have incorporated some of this strength in a higher profile for residential investment, we still anticipate slowing over the projection horizon. The current pace of activity in the Greater Toronto Area (GTA) and parts of the Golden Horseshoe region is unlikely to be sustainable, given fundamentals. House price growth in the GTA has accelerated sharply in recent months, suggesting that speculative forces are at work. In terms of the labour market, recent data have been mixed. While job growth has certainly been firm, both wages and unit labour costs have grown only slowly. The data suggest that material slack remains in the Canadian labour market, in contrast with the US labour market, which is close to full employment. At the same time, Canadian exports and business spending are still weaker than you would expect to see at this stage of the business cycle. Companies are telling us that while they plan to raise spending, the planned increases are modest, or tied to maintenance, rather than expansion. In short, the economy is not yet firing on all cylinders. In addition, Canadian companies are dealing with heightened levels of uncertainty related to US tax and trade policies. We still do not know what tax changes are coming, or when. And the range of potential trade measures under discussion is even wider now than it was in January. It includes a borderadjustment tax, increased tariffs aimed at specific industries or countries, nontariff barriers and even broader, multilateral measures. We do not know which of these will be enacted; their timing is uncertain; and each would affect the global and Canadian economies through a different, complex set of channels. With all of this uncertainty, we cannot reliably model the impact of changes to US trade policy. Instead, we have built in an extra degree of caution in our forecast for exports and investment relative to our January projection. Total inflation has been close to 2 per cent and is expected to dip to about 1.7 per cent in the middle of the year before returning to near its target. However, our core inflation measures are all in the lower half of the target band and have been trending downward. This supports the view that the economy continues to have significant excess capacity. Our current base-case forecast calls for the Canadian economy to absorb its excess capacity sometime in the first half of 2018, which is a bit sooner than we projected three months ago. We are certainly happy to see the recent strength in the economic data and want to see more of it in order to be confident that growth is on a solid footing. We judge that the economy still has material room to grow. And we remain mindful that significant uncertainty continues to weigh on the outlook. Given all of this, we judged that the current stance of monetary policy is still appropriate and maintained the target for the overnight rate at 1/2 per cent. With that, Mr. Chairman, Senior Deputy Wilkins and I would be happy to answer questions.

r170418a_BOC

canada

Blame It on the Machines?

wilkins

In the 150 years since Confederation, the average income per person in Canada has increased about 20-fold after adjusting for inflation--all because we have adopted better ways of doing business. This illustrates the basic economic reality that productivity growth is the only game in town when it comes to raising the economic and financial well-being of people over a long period. The arithmetic is simple. Productivity growth, combined with growth in the labour force, determines how fast activity can expand without stoking inflation pressures--something we call potential output growth . The Bank of Canada updated its estimates of potential output growth in last week's . Our best estimate is that potential output will rise by an average of 1 1/2 per cent per year over the next few years--that is not very impressive relative to history. We are counting on gains in productivity to deliver fully two-thirds of that growth. And we are not alone; productivity performance in other industrialized countries is also underwhelming. The good news is that Canada has the opportunity to make up for lost time. The world is on the brink of a new industrial revolution. Innovations in artificial intelligence, robotics and other fields could give productivity a big boost by automating an expanding range of tasks. Some analysts predict that close to half of all jobs in some advanced economies will be profoundly affected by automation in the next 20 years. That leaves many of us wondering about the future of work. And it's personal. We wonder what will happen to our own jobs or those of our friends, or what our kids should study to succeed in tomorrow's workplace. Business people like you share a stake with the Bank of Canada in these matters. So I am pleased to have the occasion to speak on this subject today, and I thank the Toronto Region Board of Trade for the invitation. In my remarks, I will speak to three main points: We can expect a future with work for people, not just for machines . Innovation is always a process of creative destruction, with some jobs destroyed and, over time, even more created. We have seen this process in action throughout modern history. What will change is the types of workers that will be in demand. We will need people with highly technical skills to program and repair the technology. We will also need people to perform tasks that may never be replicated by a machine because they require creativity, intuitive judgment, inspiration or simply a human touch. Canada should embrace new technologies and their benefits, while proactively managing their more harmful side effects. Policies that help businesses and workers manage what could be a difficult transition are essential. So are policies that address the potential for amplified income inequality and, in some cases, increased market power. The Bank's job in all of this will be to foster the macroeconomic conditions that will help Canada adapt and grow. Let me dive right into my first point. In the past couple of centuries, the world has seen revolutionary innovations like the steam engine, the combine, the jet engine and the assembly-line robot. The resulting increases in productivity gave us a 20-fold increase in real income per capita in Canada over the past 150 years. Our underwhelming productivity performance since the early 2000s has cost us dearly. If productivity had continued to grow at the pace it did in the late 1990s, our gross domestic product (GDP) would have been 23 per cent higher in 2016, meaning an extra $13,000 for every Canadian. Even as we see the benefits of technology, many of us feel uneasy about what automation could mean for workers. Fears of technological progress are as old as technological progress itself. Now, there is no doubt that technological improvements have eliminated jobs at the sectoral level. Take manufacturing, for instance. Innovations such as industrial robots have reduced the need for workers in that sector. If we were to roll back the clock on Canadian manufacturing productivity to what it was 20 years ago, three-quarters of a million more people would have been needed to produce today's level of output in that sector. But the manufacturing jobs lost were offset with gains elsewhere. Roughly 82 per cent of the prime-age population is now employed, about 13 percentage points higher than 40 years ago. Other past technological advances did not lead to a sustained rise in overall unemployment either. Let me use agriculture to illustrate the economic mechanisms that have helped us adapt and thrive in the past, which are often underemphasized. Factory farming and the combine harvester increased labour productivity in the farming sector and reduced the need for agricultural workers. Higher farm productivity also made food cheaper for all consumers, leaving them with more money to spend on other goods and services. These positive effects on income led to higher consumer demand, which helped spur the creation of new jobs outside of agriculture. Rising productivity in manufacturing also led to widespread industrialization, which attracted labour from farms to higher-paying factory jobs. This is how agriculture went from representing more than one-third of all jobs in Canada a century ago to less than 2 per cent today, without creating a permanent jump in unemployment. Governments helped ease the transition away from agriculture by making some bold decisions. One example is promoting education in the late 1800s and early 1900s through publicly funded schools. This helped prepare the next generation for jobs outside the agricultural sector, although the period of adjustment could not have been easy. This leads me to my second point. Technological advances have always been a key driver of growth and rising income per capita, yet some fear that this time will be different. In the past, automation was largely restricted to simple manual or procedural tasks. Today's technology makes it possible to automate an increasing number of cognitive and non-routine tasks across a wide range of industries. Machine learning is one way to do that. Feeding computers large sets of data teaches them to mimic the human brain's ability to infer rules from previous experiences and adapt to changing circumstances. Artificial intelligence (AI) allows computers to read scans and x-rays with precision and self-driving cars to react to any number of unique situations on the road. AI also allows businesses to automate many of the routine cognitive tasks performed by accountants, investment advisors and lawyers. This has raised the spectre of technological unemployment--the dystopian vision of an economy in which machines make many workers obsolete. You have probably heard estimates that suggest that around 40 per cent of tasks performed by humans in Canada and the United States could be automated using current technology. Even so, it is difficult to imagine that the adjustment mechanisms I described earlier are now obsolete. An intuitive way to think about it is to observe that people's spending appetite tends to grow along with productivity. With 20 times more income, people would only have to work 20 times less than they did before to earn the same amount. The reality is that people generally work a little more than half the time that they used to, with the rest of the gains going toward increased consumption. This phenomenon is observed not only in Canada but also in other advanced economies. As technologies raise productivity, labour market dislocations occur over the transition period, but eventually new jobs are created to supply the goods and services that people buy with the extra income. The fact is that we do not know exactly which new sectors will be important employers 50 years from now. Who in the early 1900s could have imagined the boom in health care, tourism and software development jobs? There are also many tasks that machines will not be capable of doing any time soon. An academic expert in this area of economics, David Autor, maintains that humans will likely retain an advantage in jobs that require interpersonal interaction, flexibility, problem solving and common sense. These include personal care workers, plumbers, consultants and, I am hoping, central bankers. What is particularly important to consider this time is the impact that technological progress could have on income inequality. advances may lead to higher incomes for workers whose skills are complemented by the technology, but not for those whose skills are substituted by it. The first wave of information technology in the 1980s and 1990s is a case in point. Educated professionals like scientists and architects could use their skills more productively, while many less-educated workers, like bank tellers and travel agents, saw their jobs being displaced by technology. This led to bigger employment shares for high- and low-skilled jobs at the expense of middle-skilled jobs in Canada, along with a modest increase in income inequality. The hollowing out of the middle could be further accentuated by automation. Moreover, the polarizing effect of technology on income distribution could be heightened by a winner-takes-all effect--this comes from the market power that new technologies can often bestow on their inventors. In parts of the information and communication technology (ICT) sector, economies of scale such as network effects are already prominent. That said, for all the hype around the current wave of automation, we have yet to see the kind of productivity growth that is consistent with a technological revolution. While we sometimes see fast technological change in specific industries--fracking in the oil sector is one example--economy-wide technological transitions often play out over long periods. After the first central power station opened in the 1880s, electrification took four decades to have an impact on productivity in the United States. Power grids had to be built, machines had to be replaced and new applications took years to develop. For similar reasons, it could take many years for self-driving vehicles to completely displace human-driven taxis, trucks and buses. The length of the transition will depend on how fast existing vehicles depreciate, prices for the new technology decline, and required infrastructure is updated. What does all of this mean for the Bank of Canada's economic projections? It is simply impossible to quantify the impact of these innovations before they happen. That is why the Bank assumes no additional boost from automation. While the Bank is projecting a rebound in trend labour productivity growth from 0.6 per cent in 2016 to 1.1 per cent in 2020, this mainly reflects a cyclical pickup in investment spending from the lows witnessed following the oil price shock. Our work to date suggests the greatest productivity benefits will occur in firms with high-quality people-management and decision-making processes and high levels of human capital. With big data, smart contracts and robo advisors, financial companies could be at the head of the pack. The Bank of Canada has a research program to better understand these issues. We have created a new digital economy team that focuses on how automation is unfolding and affecting the economy, including inflation dynamics and the transmission of monetary policy. We are reviewing the measurement issues that are exacerbated by the proliferation of digital and services-oriented technologies. We are also developing our macroeconomic models to better account for changes in the distribution of income and wealth. Let me now turn to my final point. Canada is well positioned to succeed in a digital world, and we should embrace it. Canada has a flourishing information technology sector and is becoming an important player in the AI field. Canadian firms have teamed up to provide funding for the development of AI start-ups through a program called NextAI. And some international companies are moving their AI divisions to Canada. To get the most out of the new technologies, we will need to work together to proactively mitigate the more harmful side effects that I have mentioned: the transition period and the potential effects on the distribution of income. There are many promising approaches to managing the first side effect--the transition period. Let me highlight just one. As with previous technological transitions, education, skills training and continuous learning will be key. Universities across Canada are working with students and businesses to bring the best ideas in science, machine learning and AI to market. A great local positive aspect is that students will gain practical experience early on. Canada and its fellow G20 countries have committed to supporting strong, sustainable and inclusive growth. Today more than ever, it is important to preserve the gains that have been made. Trade is a great driver of productivity, and so the risk of growing protectionism concerns me. More open trade with the United States and Mexico in the 1990s gave Canadian firms access to much bigger markets and therefore greater incentives to invest--in both physical and human capital. Disrupting supply chains and reducing incentives to compete will not create more jobs and income in the long run. Canada remains committed to free trade and the most recent example of that is the interprovincial agreement that was signed earlier this month. While we will not know its full impact for some time, we flagged it as an upside risk to productivity in our April . The second side effect, distribution of income, is equally important. While gains in productivity will increase the size of the pie, there is no guarantee that these gains will be evenly distributed. This is the purview of governments, who can use tools such as taxation and transfers to address these issues. And they involve difficult trade-offs related to preserving the incentives to invest while also avoiding increased polarization of income. Cross-border taxation will also be challenging, given how easy it can be to move intellectual property to low-tax jurisdictions. Aside from taxation, increased market power for some players may raise important systemic issues, many of which are cross-border in nature. These issues are likely to arise in sectors where barriers to entry or economies of scale are prominent. An example that is top of mind from my work on fintech issues is related to cloud computing and storage. As we move away from decentralized on-site storage and computing systems, we may see a trend toward greater concentration in market structure. These service providers are largely outside the regulatory framework, and this raises issues related to adequate legal foundations, governance, transparency and risk controls. All of these are critical to a stable economic foundation for workers and businesses. As a central banker, I care about income inequality, even if we do not control the tools to address it. Worsening income inequality can lead to weaker macroeconomic outcomes and financial instability. It is more difficult for people with low incomes to weather economic shocks. If we see an increasing proportion of people at the lower end of the income distribution, recessions and other negative events could result in more financial stress. Shifts in income distribution can also affect the transmission of monetary policy since interest rates do not affect everyone in the same way. For example, people with lower incomes are likely to be sensitive to interest rate changes because of the potential effects on their employment income and their debt-service costs. These effects may be less prominent at the other end of the income scale. That said, people with higher incomes and higher net worth tend to be sensitive to the impact of interest rates changes on asset prices. An increase in income dispersion, then, could alter the channels through which monetary policy actions affect the economy. The Bank of Canada's monetary policy accomplishes a simple, yet vital, task: it manages the level of demand over the business cycle in order to meet our inflation target. In turn, an environment of low, stable and predictable inflation allows productivity-enhancing investments in physical and human capital. This is the perfect complement to the structural policies that governments at all levels in Canada are working to strengthen. Time to wrap up. If we want to continue to prosper, we have to improve our productivity. Clearly, blaming the machines is not the way forward. If we seek out and embrace new technologies while successfully managing their harmful side effects, we will create inclusive prosperity. That means proactively managing the transition period and the longer-term implications for the distribution of incomes. In many respects, we have a head start in Canada. Our policy-makers are working to implement measures that will achieve strong, sustainable and inclusive growth. What you can do on your side is equally ambitious: keep building competitive and dynamic businesses; keep the collaboration going between educational institutions and companies; and keep sharing your good ideas with policymakers. The Bank of Canada will continue to focus on what it does best: supporting the economic and financial well-being of Canada by achieving low, stable and predictable inflation; by keeping core financial market infrastructure safe; and by giving sound advice on financial sector policies so that vulnerabilities do not get in the way of sustainable, productive growth for all Canadians.

r170504a_BOC

canada

Canada and Mexico: Common Issues in Uncommon Times

poloz

I would like to thank Rose Cunningham and Tatjana Dahlhaus for Governor of the Bank of Canada I am thankful for the opportunity to speak with you today, as it is a good time for our two countries to be talking. It is true that nobody will ever confuse Mazatlan with Manitoba, particularly in February. But it is also true that Canada and Mexico have more in common than is usually appreciated, especially on the economic front. A good deal of our commonality stems from the fact that we are both relatively small open economies that trade heavily with the economic powerhouse next door, the United States. But we share much more than a common neighbour. Resources, particularly oil, are an important part of both of our economies. The automotive industry plays a vital role in our manufacturing sector, along with high-tech manufacturing such as communications and pharmaceuticals. And while we may be at different stages of our economic history, we are following a similar trajectory. In both countries, the service sector now makes up the majority of output--more than 60 per cent in Mexico and 70 per cent in Canada--and the shares are rising. Finally, we are both committed to rules-based free trade, and we both maintain a floating exchange rate within an inflation-targeting framework for monetary policy. Since we have so much in common, it is not surprising that shocks in the global economy have hit us in similar ways. Now we are facing similar economic challenges. More important, we have similar opportunities that we can capitalize on by using our strengths. So today, I want to discuss recent developments in, and prospects for, the Canadian economy, in a way that will hopefully resonate for the audience here in Mexico. Let us start by looking back at the second half of 2014 and the collapse in oil prices. Various benchmarks saw declines of more than 50 per cent. Given the importance of oil to both Canada and Mexico, the shock represented a serious blow to our economies. It had a substantial impact on the terms of trade--the ratio of the prices a country receives for its exports relative to the prices it pays for its imports. Canada's terms of trade fell by roughly 11 per cent from the middle of 2014 though the first quarter of 2016. This meant a significant hit to our national income, about $70 billion in that period, or roughly 3.5 per cent of income declined by about 500 billion pesos, or about 2.5 per cent of annual GDP. In response to the shock, our currencies depreciated--the peso dropped by 28 per cent against the US dollar during the same period, while the Canadian dollar declined about 20 per cent. Of course, some amount of depreciation was not surprising. It was a natural consequence of the shock, and it helped economic adjustments happen by sending signals that prompted shifts in investment and employment. Although both currencies rebounded early in 2016, the peso then began to fall again, while the Canadian dollar more or less stabilized. Global capital flows were likely one important factor. Historically, flows in and out of Mexican capital markets have been closely tied to investor sentiment about emerging markets. Capital flows into Mexico fell sharply in 2015 and remained low in 2016, as the US Federal Reserve prepared to raise interest rates and eventually began tightening monetary policy. This put additional downward pressure on the peso, on top of the pressure coming from lower oil prices that both Canada and Mexico faced. In terms of output, though, the oil price shock hit Canada harder than Mexico. The Canadian economy contracted outright early in 2015, while growth in Mexico remained fairly stable. This reflected, in part, the fact that Canada is a bigger oil producer than Mexico is--at the end of last year, Canadian output was about twice as large as Mexico's. For Canada, the oil price shock meant a significant shifting of capital and workers out of the oil and gas industry. It established a two-track economy: while the nonresource sector continued to expand, it was not enough to offset the sharp decline in the resource sector. From the start of 2015, the negative impact of the resource track dominated. While the adjustment process in Canada has been complex, and very difficult on a personal level for many, we are seeing encouraging signs that the worst may be over. Activity and investment in the oil and gas industry have stopped declining and are coming back to a level that is commensurate with current prices. And because that large negative force is now essentially past, it is no longer masking the sources of strength in other sectors. There is still a way to go, but the two tracks of the economy are gradually converging to become a single track for sustainable growth. Now let me say a few words about monetary and other policies in the aftermath of the oil price shock. Both the Bank of Canada and Banco de Mexico dealt with the impact through our shared framework--inflation targeting with a flexible exchange rate. To set the scene, it is worth noting that Canada was a very early adopter of both aspects of the framework. After experimenting with a floating currency in the 1950s, we allowed the dollar's value to be set in financial markets as early as 1970, and we have not looked back. In contrast, Mexico moved to a truly freefloating system only in 1994. In terms of targeting inflation, Canada adopted the practice in 1991, 10 years before Mexico officially did. I mention this only because the experience of central banks worldwide is that inflation targeting builds credibility and improves an economy's resilience to economic shocks. And the longer this policy framework is in place, the greater this impact becomes. There is no doubt that the predictability and certainty that come from inflation targeting helped Canada's economy respond as quickly as it has to the oil price shock. The response demonstrated our economic resilience and flexibility, certainly when compared with shocks of past decades. I do not mean to dismiss how difficult it has been for many individuals. But at the aggregate level, the economy has shown its ability to adapt quickly. Other structural factors, such as Canada's relatively flexible labour market, have also contributed. Mexico's inflation-targeting framework helped make its economy relatively resilient to the shock as well. Indeed, it is worth noting that since Mexico adopted inflation targeting, the country has not seen the type of domestic financial crisis that it regularly experienced in previous decades. Mexico's tax collection has improved, and it has also made notable progress with other structural reforms. While some of these have been politically difficult, such as the measures to open the oil sector to private and foreign participation, they have been important for increasing Mexico's resilience and competitiveness. In both countries, the inflation-targeting regime framed the monetary policy response. Recall that the oil price shock led to a contraction in Canada's economy, while in Mexico growth continued at a slower pace. The drop in income caused by the shock raised the clear risk that Canadian inflation would fall below the Bank of Canada's target. So, we lowered our key policy interest rate twice in 2015 to help offset the fall in income and facilitate the adjustment from resource industries to the non-resource sector. By the end of 2015, the US Federal Reserve began normalizing its monetary policy, and it has raised its key policy rate three times amid strengthening US inflation and a labour market that is near full employment. But in Canada, given that core measures of inflation have drifted downward in recent quarters and slack in the economy and labour market remains, we have kept our policy interest rate unchanged. Importantly, longer-term expectations of Canadian inflation have remained anchored at 2 per cent. Mexico's experience has been somewhat different. The oil price shock was less of a downside threat to the inflation target. Indeed, the greater depreciation of the peso led to concerns about upward inflationary pressure. So, the central bank has tightened policy, by a total of 350 basis points, to counter inflationary pressures on consumer prices from the depreciation of the peso and other factors, as well as to ensure the impact of the exchange rate did not de-anchor inflation expectations. As I said earlier, the worst of the restructuring in Canada's oil sector appears to be over. After the shock hit, we expected a natural sequence to take hold; that is, stronger global demand--particularly from the United States--would lead to stronger exports. The depreciation in our currency would support gains in nonenergy exports. All of this would spark increased business confidence and investment, which would increase growth and ultimately help bring the economy back to full output with inflation sustainably at target. However, this sequence has yet to play out fully. A major part of the problem has been a continuing shortfall in Canadian exports relative to what one would expect historically. We have looked at this closely and found both a permanent loss of export capacity that started more than a decade ago and ongoing competitiveness challenges for some of our exporters. And now, we have another challenge to deal with--uncertainty about the future of US trade policy. Clearly, this uncertainty is a significant issue for both Canada and Mexico. Both of our countries' trade is dominated by the United States. Last year, fully 75 per cent of Canada's goods exports went to the US market. For Mexico, the number was even higher, at 81 per cent. Similarly, the biggest share of both of our imports comes from the United States. These numbers reflect the traditionally open trading relationship among the three neighbours. This uncertainty has real consequences for companies. It increases the risks companies face, which can raise their cost of capital and restrain investment. The Bank's most recent survey of Canadian companies showed that many see negative risks from potential US policies. These risks include increased protectionism, reduced competitiveness of Canadian firms if US corporate tax rates are lowered and possible delays in implementing pro-growth US policies. To be clear, the outlook for investment in machinery and equipment in the Bank's has continued to improve, and many companies are saying they are maintaining or modestly increasing their level of investment. However, some are also saying this spending will be limited to maintenance work, rather than the type of expansion that supports economic growth. When you consider that the painful memories of the global financial crisis are still fresh, it is not surprising that companies would continue to hesitate to expand in the face of this uncertainty. The situation is similar in Mexico. Both producer confidence and investment intentions fell after the US election, reaching their lowest levels since the global financial crisis. In concrete terms, we have seen several announcements by companies in the auto industry to cancel or delay plans for major investments in Mexico. The picture is certainly not uniformly poor, and we have seen auto companies based outside the United States announce plans to invest in Mexico. Still, the ongoing uncertainty represents a clear challenge for both of our countries. This naturally leads to the question of what can be done. Any economist will tell you that open trade supports economic growth and employment. We know the predictable effects of protectionism. We have seen throughout history how efforts to shield industries and workers from foreign competition have been counterproductive. Increases in tariffs lead to higher inflation and a stronger real exchange rate, as well as potentially higher interest rates. Work done at the Bank of Canada shows that a broad-based increase in US tariffs would ultimately lead to lower US output after about five or so years, whether or not other countries retaliate. Basic economic theory also suggests that protectionism leads to slower productivity growth and slower rates of innovation and technology adoption. But while it is one thing to make theoretical economic arguments about the benefits of open trade, it can be more helpful to have concrete examples. Consider the auto industry. We can talk about how it is responsible for 18 per cent of Canada's goods exports and about 30 per cent of Mexico's. We can talk about how many times a single auto part might cross a national border during the assembly process. And we can talk about the intricate supply chains that have been developed over more than 50 years. Or, we can show how building a single, integrated North American auto industry has led to jobs in all three countries. The Automotive Parts Manufacturers' Association has done a good job putting the numbers together. In Canada, 81,000 people are employed in the automotive supply sector, by both Canadian and foreign-owned firms. Those Canadian companies operate 150 plants in the Mexico, providing jobs for roughly the same number of workers there. It is hard to imagine how interfering with open trade or implementing other protectionist policies would benefit these people and their families. It would be helpful to hear many more examples from other industries. Policymakers, business leaders and labour leaders all have a role to play in showing how open trade has meant jobs for workers across North America and around the world. Nobody can explain the importance of trade to an employee better than their employer. Regardless of what evolves, though, there is no shortage of potential sources of growth for both of our economies. The first order of business should be to keep working on opening trade elsewhere in the world. In this respect, Canada has been playing catch-up to Mexico, which has successfully negotiated access to many more markets than Canada. The numbers tell a clear story. As of today, Canada has free trade agreements in force with 15 countries that represent about 22 per cent of global GDP. Mexico has agreements in force with 47 countries that represent 44 per cent of global GDP. But if you take the United States out of the picture, Canada is left with free access to just 6 per cent of the world economy, compared with 28 per cent for The good news for Canada is that this gap will close significantly once the agreement between Canada and the European Union comes into effect. It is unfortunate that the Trans-Pacific Partnership, with its ground-breaking coverage of intellectual property and services, has been shelved for now. Still, the work that was put into those areas could prove useful for both Canada and Mexico in future trade agreements. The bottom line is there is still scope for both countries to improve access to markets outside of North America. Within Canada, we had the positive news last month of the agreement to lower barriers to interprovincial trade. Perhaps the most encouraging part of the agreement is that instead of listing the few areas that are subject to open trade, the provinces are now listing the areas that are exempt. This makes open trade the default position, and it means the provinces will be under continuous pressure to justify any exceptions. Beyond pushing for open markets, governments can pursue structural policies that allow our economies to be as flexible as possible. Canada is taking some welcome steps in this direction--for example, by investing in infrastructure that can increase our economic potential and by helping workers develop new skills to take advantage of a changing labour market. I hope policy-makers at all levels of government will continue to focus on measures to improve Canada's flexibility. I have already spoken about the moves by the Mexican government over the past five years to introduce some major structural reforms. Besides energymarket reforms, there has been good progress in such areas as tax policy, competition policy and regulatory reform. These and other measures are all investments in flexibility that will improve economic potential and give Mexico a better chance to succeed and grow in the future, no matter what is happening in the global economy. In terms of central banking, the Bank of Canada has been working on the implications of heightened uncertainty for the economy and the conduct of monetary policy. More fundamentally, the Bank renewed its five-year inflationtargeting agreement with the Government last year. After a thorough look at all the evidence, we concluded that setting interest rates to aim inflation at a target of 2 per cent remains the best policy. Amid all the uncertainty, we can provide Canadian businesses and consumers with certainty about the future value of their money. Allow me to conclude. For both Canada and Mexico, the oil price shock represented a significant economic setback. Sound economic policies in both countries are supporting a return to more balanced growth. But now, again, we face a common challenge. Even though trade liberalization and increased economic integration have generated prosperity across North America, we are now faced with the threat of new protectionist policies from our largest trading partner. We know that with protectionism, everybody loses eventually, including the country that puts the policies in place. And the uncertainty around this threat of increased protectionism is holding back growth. However, in these times it is important not to lose sight of the bigger picture. There is much that Canada and Mexico can do to support growth and employment in our economies. We have faced obstacles before, and have overcome them. Back in the 1860s, the United States pulled out of a free trade agreement with the colonies of British North America. This provided the impetus for Canadian confederation 150 years ago, which turned out pretty well. The antidote to uncertainty is certainty. The Bank of Canada will continue to provide certainty around the future value of our money through our commitment to inflation targeting. This is the best contribution we can make to Canada's economic welfare. And more broadly, Canada and Mexico's shared commitment to open trade means both of our countries are well placed to thrive, whatever the international environment.

r170525a_BOC

canada

Upgrading the Payments Grid: The Payoffs Are Greater Than You Think

leduc

On the morning of November 21, 1985, officials at the Federal Reserve Bank of New York received a routine phone call from staff at a large bank they supervised. The call informed them that they were still preparing their settlement accounts from the day before and would not be in position to process transactions until later that morning. The New York Fed officials were not too concerned, since such delays happened occasionally. It was only later in the day that they realized the gravity of the situation. The financial institution in question was $30 billion in the red; that's billion with a "b." This extraordinary situation was caused by a computer glitch the day before that had impaired the bank's internal payments processes. That glitch meant it was unable to receive payments for securities it had bought on behalf of clients. By the end of the day, signs of liquidity pressures on the wider interbank market were developing, and the Fed had to lend $23.6 billion to this bank through its discount window. At the time, that was by far the largest loan of its kind. The loan was necessary to avoid the possible failure of what was then one of the largest banks in the United States, which likely would have spread the stress throughout the entire financial system. Of course, there is a significant difference between the internal systems of any one bank and the wider payments infrastructure that supports the financial system as a whole. But I'm recounting this story because it clearly highlights the link between payment systems and financial stability, the topic I want to touch on today. This is a timely subject since, as you well know, our payment systems are showing their age. While they are constantly being upgraded and still function, technology is changing rapidly and improving, offering better and smoother ways to move funds. We've got to keep pace. The good news is that our conference host, Payments Canada, which operates our core large-value and retail payment systems, is making steady progress on a modernization plan. The goal is to develop a payments system that is fast, flexible and secure, one that will be fully aligned with global regulatory standards and that will become a platform for future innovations. This modernized system will certainly lead to gains in payment efficiency. It will also strengthen the stability of our financial system. While problems such as the one I just described are rare indeed and have never occurred in Canada, we still need to be vigilant and keep improving our systems. Because the Bank of Canada is responsible for promoting the efficiency and stability of the financial system, which includes oversight of our core payment systems, we are working closely with Payments Canada on the modernization plan. Our staff of experts is providing input at all levels. I have confidence that with the collaboration of the Bank, financial institutions and other stakeholders, the modernization program will help strengthen the stability and efficiency of our financial system. Today I want to focus on the payoff from payments modernization for financial stability, a benefit that is often overlooked. I'll set the stage by discussing the main risks that participants in payment systems may face. Against this background, I will focus on designs for payment systems that address those risks as well as the demand for greater efficiency. I will conclude by discussing why this is important for the Bank's conduct of monetary policy. Let me start by taking you back again to 1985, the year that computer glitch occurred. As a fan of the Montreal Canadiens, that year is memorable because the Habs were midway through their 23rd Stanley Cup win, with a rookie named Patrick Roy in the net. System (ACSS), was also in its rookie year. This system still processes some 30 million retail transactions a day. Payments cleared in ACSS are then settled on a multilateral net basis the next day in our Large Value Transfer System Despite its age, ACSS still performs reliably. So did Patrick Roy, but he retired in The LVTS, which was introduced in 1999, is also showing its age. It is the core of Canada's national payments system. Transactions in the LVTS ultimately settle on the books of the Bank of Canada at the end of the day. Modernizing our core payments infrastructure is long overdue. Payments Canada has set out a roadmap for modernization that includes changes to both LVTS and ACSS and the introduction of real-time retail payments. This is an ambitious goal, but Payments Canada has developed a necessary and credible staffing plan to achieve it. In addition, Payments Canada has hired the services of a wellestablished consulting firm with expertise in payments to manage the complexity of this process, which will take several years to complete. While this is a costly project that will affect industry participants as well as the Bank of Canada, given that we are a direct participant in LVTS, the modernization process will nonetheless bring our payment systems in line with state-of-the-art systems introduced abroad. Indeed, recent joint research by Payments Canada and the Bank of Canada documented that 19 countries have made major changes to their core payment systems since 2004. These countries faced challenges similar to those we are now confronting. For one, adopting new technologies can be daunting. Given the rapid pace of technological change, designing with an eye to the future is critical. Modern systems must be flexible and adaptable. For example, newer systems are modular in nature, meaning that specific functions are built into separate modules. Although both of our core payment systems have been upgraded several times since their respective launches, their legacy architecture often makes it difficult to introduce new features that would facilitate a more modern approach to risk management. They were written in COBOL, an old, inflexible programing language that is no longer used except in legacy systems, which makes maintaining or changing our systems difficult. This is important because payment systems are exposed to various forms of risk. For instance, a payment may fail to settle because an institution is unable to fully meet its financial obligations when the payment is due or at any time in the future, thus posing credit risk. As we saw in the example of the bank with the computer glitch, operational risk can trigger gridlock in payment systems. Payments are also associated with liquidity risk, which arises because an institution may find itself temporarily short of funds to make a payment at the time needed. More broadly, because participants in certain payment systems are interconnected, systemic risk can arise when the inability of one institution to settle a payment produces a domino effect, or financial contagion, by triggering a similar inability at other institutions. Financial contagion is intimately related to the risk of market failures and externalities in certain payment systems. A bank that defaults or experiences a technical failure will not bear the costs of these events on its own. Other financial institutions will also be affected. Such externalities can lead to decisions that are suboptimal from a social perspective. If left to the private market alone, both theory and experience show that the resources devoted to the safety of payment systems may be less than is socially warranted, raising potential operational, liquidity and credit risks. To guard against this possibility, central banks are typically mandated to operate or to oversee their country's main payment systems. An important aspect of designing payment systems is developing infrastructure that can appropriately address these sorts of credit, liquidity, systemic and operational risks. In addition, because of their systemic importance, high-value payment systems, like the LVTS, must be particularly designed to ensure their safety and resilience. Now that I've alarmed some of you by enumerating the principal risks, let me reassure you that the Bank of Canada has in place strict risk standards that Canada's core payment systems must meet. Payment systems have also evolved through the years to mitigate these risks. In high-value payment systems, this evolution reflects the fact that increasingly large sums are transacted every day. In our LVTS, $175 billion is now processed daily. So one of the big concerns for central banks is the potential for payment systems to put financial stability at risk through the exposures that participants might have to each other. In response, many central banks have adopted realtime gross settlement (RTGS) systems. These systems eliminate credit risk between participants by requiring the final and irrevocable settlement of each payment. In contrast, deferred net settlement (DNS) systems are typically designed so that payments are settled periodically on a net basis, typically at the end of each day. Credit risk still arises in DNS systems because an institution may fail between the time a payment is made and the time it is settled. As a result, in most jurisdictions the main large-value payment system operates as an RTGS, although many retail systems and even other, secondary wholesale systems may operate on a DNS basis (as in the United States, for example). Research conducted at the New York Fed a few years ago shows that while only 3 countries had RTGS systems in 1985, 20 years later that number had increased to 90. However, as is typical in economics, there are trade-offs, in this case between credit and liquidity risks. Because each payment must be settled on a gross basis, RTGS systems are costly in terms of liquidity. An institution needs to have the necessary funds on hand, or must be able to borrow them, before it can make a payment. If the cost of liquidity is high, financial institutions have an incentive to delay making payments, waiting until they, in turn, receive payments from other institutions. Therefore, to avoid the possibility of gridlock in these systems, the central bank typically offers direct participants free, though fully collateralized, intraday liquidity. While credit risk is higher in DNS systems, the liquidity requirements are lower, since payments are settled on a net instead of a gross basis. Over time, however, hybrid systems that combine the best of the RTGS and DNS systems have emerged to achieve a better trade-off between credit and liquidity risks. Our existing LVTS has a unique hybrid framework. As in DNS systems, payments are settled on a net basis at the end of each day, thus economizing on liquidity needs. But the system also shares features with an RTGS framework, since payments are final and irrevocable. The finality of payment is achieved through a pool of collateral from participating institutions that covers the single largest possible default. A residual guarantee from the Bank of Canada fully protects against any remaining credit exposures. The Bank's guarantee is akin to disaster insurance, since the probability that more than one of our large financial institutions will fail on a given day is, of course, extremely remote. This design has the benefit of providing payment finality in a collateral-efficient manner, although at the cost of the public sector bearing a contingent liability. While this approach was appropriate at the time the LVTS was created, international experience has shown that other hybrid systems can also provide efficiencies and finality without the need for a public sector backstop. We envisage that the new high-value payment system that will be deployed as part of the modernization plan will be a fully collateralized, defaulter-pays system. While we are ready to consider different designs consistent with this vision, an RTGS system with liquidity-saving mechanisms may provide a relatively simpler and well-tested framework. Naturally, end-users of payment systems care not only about the resilience and security of the system, but also about its efficiency. The desire for greater efficiency is particularly acute for retail payments. Customers are more demanding than in the past. They are looking for more convenient and cheaper access to financial services that are well integrated with the rest of their online activities. We have seen an explosion of innovations that are making it easier and faster for parties to exchange payments both at the point of sale and online. PayPal, Interac e-Transfer and Apple Pay are among the new innovations that are quickly becoming familiar modes of payment. To be in tune with these innovations and with consumers' expectations, our modernized retail payment system will need to allow more open, but risk-based, access that will promote innovation and an improved end-user experience. Designing an efficient retail payment system that fulfills these needs and expectations is essential because the volume of transactions flowing through it is large, putting a premium on efficiency. However, since the values of transactions in retail payment systems are relatively small, the risk that a failure of one participant would trigger financial contagion is more remote than for our largevalue payment system. Even so, disruptions in retail payment systems can still bring about important losses to the economy. To address this risk, the ACSS was recently designated a prominent system and is now overseen by the Bank of Canada. But failure to keep pace with user expectations may lead to the adoption of alternative, potentially unregulated forms of payment that could end up posing risks to the economy as they grow over time. Because of its impact on financial stability, the soundness of our payments system is also crucial for the conduct of monetary policy. Our key policy objective at the Bank of Canada is to keep inflation low, stable and predictable so that Canadians can make better economic decisions and achieve better economic outcomes. As the 2007-09 global financial crisis showed, financial stability is clearly needed to achieve this mandate. This presupposes a well-functioning payments system. Our monetary policy decisions are partly transmitted through the economy via long-term interest rates, exchange rates and asset prices more generally. So the conduct of monetary policy depends on well-functioning financial markets. Disruptions in payment systems could ripple through financial markets and impair the transmission mechanism. In Canada there is an even more direct and explicit link between the operation of the LVTS and the implementation of monetary policy. Some of you may remember your first "Money and Banking" course, where the central bank changed interest rates by buying or selling government securities for money, thus affecting the money supply and interest rates as a result. In practice, that's not exactly how we implement monetary policy. Since 1999, when the LVTS was first introduced, we have been implementing monetary policy by managing the interest rates on accounts used to settle payments at the end of the day in our high-value payment system. To reinforce the target for the overnight interest rate, our main policy instrument, we use an operating band, with the deposit rate at the bottom of the band and the Bank rate--that is, the lending rate--at the top of the band. In a nutshell, settlement banks that have excess funds after all payments have been settled earn the deposit rate on those funds, which is typically 25 basis points lower than the target for the overnight rate. Meanwhile, settlement banks that are short of funds to settle their accounts can borrow from the Bank of Canada at the Bank rate, which is typically 25 basis points above the overnight rate target. The spread between the deposit and Bank rates gives commercial banks an incentive to trade with each other at an interest rate within the band, typically at the target rate in the middle of the band. The changes that we envision to the high-value payment system will not affect our ability to implement monetary policy. We will continue to do so through the system using the target rate and the operating band. We do not expect the changes to the high-value payment system to alter our ability to control the overnight rate, which should closely track our target policy rate, as is the case today. Given the implications for financial stability and monetary policy, we take a comprehensive view of payment systems. That means we look at modernization not only in the near term but in the long term as well. So keeping up with the latest technological advances, such as distributed ledger technology, or DLT, is imperative. While we're a long way from adopting DLT, as my colleague Senior Deputy Governor Carolyn Wilkins explained in her speech to you last June, we still want to be forward-looking and study its possible impact. Later today you'll be hearing about an experiment called Project Jasper that we have embarked on with Payments Canada and a number of Canadian financial institutions. To investigate the costs and benefits of a high-value payment system based on DLT in the interbank market, we set up a rudimentary payment system to run experiments in a lab environment. One interesting finding is the tensions that arise between the fully decentralized and transparent payment systems that DLT could provide and the requirements for confidentiality of wholesale payments. While our project is still in its infancy, there is still no better way to understand a technology's strengths and shortcomings than to work with it in a controlled setting. For more information on Project Jasper, you can check out the paper we will post on our website later today. Modernizing systems when technological advances and other changes in the payments environment are occurring at such a fast pace is not only challenging, it is potentially paralyzing. The fear of adopting systems that quickly become technologically obsolete is natural. However, we all know that inaction is not without costs. More importantly, the modernization process provides a truly amazing opportunity to reshape an essential part of our financial infrastructure for the benefit of all Canadians. As I've explained, the Bank of Canada is closely involved in all aspects of this transformation. Making payments more efficient and secure will benefit all Canadians. A sound payments system is as important for the stability of the financial system as a reliable electrical grid is for the economy. And a stable financial system is essential for the effective conduct of our inflation-targeting monetary policy.

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Release of the Financial System Review

poloz

Governor of the Bank of Canada Press conference following the release of the Good morning. Senior Deputy Governor Wilkins and I are glad to be with you today to talk about the June issue of the Bank's which we published this morning. Let me start with a quick reminder about the purpose of the FSR. It identifies vulnerabilities in the financial system--pre-existing conditions that can interact with economic shocks--and monitors how they are evolving. It also looks at the potential impact on the financial system and economy if a shock were to interact with, and be magnified by, these vulnerabilities. Canada's financial system remains resilient, and this resilience has increased because the Canadian economy has strengthened since our previous FSR in December. Still, the two most important vulnerabilities for Canada's financial system--the elevated level of household indebtedness and imbalances in the Canadian housing market--have moved higher over the past six months. On the first, the level of household indebtedness in Canada continues to rise. A good portion of this increased debt consists of mortgages and home equity lines of credit located in the greater Toronto and Vancouver Areas. Last year, the federal government introduced changes to housing finance policies aimed at improving the quality of borrowing. And there is evidence that these changes are working. This is particularly true for insured mortgages, where more than 80 per cent of the cost of the home is being borrowed. We have seen a drop in the proportion of insured mortgages being issued to highly indebted borrowers, that is, people whose debts are more than 450 per cent of their income. This is a positive development. However, we are now seeing more uninsured mortgages being issued, particularly in places such as Toronto and Vancouver, where prices are the highest in Canada. In part, this is to be expected, given that insurance is not available for mortgages on homes with a price greater than $1 million. Still, some of these uninsured mortgages are showing riskier characteristics. A growing share is going to people who are highly indebted, and these borrowers are amortizing the mortgages over longer periods. As well, we see some evidence that people are borrowing from other sources to put together enough of a down payment to avoid the insurance requirement. This could be a concern, depending on the source of the borrowing. Imbalances in housing markets, the second vulnerability, have also grown since December. Policies aimed at cooling the Greater Vancouver Area market appear to have had only a temporary effect, as sales and prices are rising again. Similar While the most recent average home sale price in the GTA has declined, that followed significant price acceleration over the previous year, across dwelling types. There is a map in the FSR showing that large price increases are now being seen across the region, from Niagara to Peterborough. We expect macroprudential and housing policy measures to help mitigate this vulnerability over time. And I would point out that housing market fundamentals remain very strong in the greater Toronto and Vancouver areas, with solid growth in population and employment. However, fundamentals alone cannot explain the price movements we have seen, and there is evidence that extrapolative expectations continue to play an important role. This is important because there is a greater chance of a correction when prices rise at a faster pace than fundamentals would imply. And where extrapolative expectations are at work, there is always a risk that expectations can turn quickly, amplifying the drop in prices. So, given the evolution of these two vulnerabilities, the Bank looked at the most important risk scenarios for the Canadian economy. Specifically, we once again looked at a risk scenario where a severe recession triggers a correction in house prices. And we took a narrower look at a different risk scenario, where a house price correction in specific regional markets occurs on its own, rather than being caused by some external shock. Under the first scenario, a severe recession would lead to widespread job losses and declining income, which would hurt highly indebted households in particular. The ensuing house price correction would worsen the impact of the recession, which could lead to widespread stress in the financial system and economy. The Canadian economy has been strengthening in recent months, so the chance of this scenario happening is decreasing. However, its impact could now be more severe because the underlying vulnerabilities have grown. The second scenario we looked at involved a significant house price correction in the greater Toronto and Vancouver areas. Such a correction would hit the British Columbia and Ontario economies, affecting spending on housing and related goods and services. There would be some spillovers to other regions and sectors of the economy. Bank balance sheets would also be affected in this scenario, leading to tighter lending standards. The likelihood of this second scenario occurring is greater than the first. However, its impact would be less severe, and we don't anticipate that a house price correction would trigger the widespread rise in unemployment assumed in the first scenario. Given recent events, some people might naturally wonder if there is a connection between the two vulnerabilities we've described and the situation at Home Capital. While we don't generally discuss individual financial institutions, I can say our assessment is that the situation reflected firm-specific factors. The regulatory and supervisory system worked as it is designed to do, and we are not seeing signs of broader stress. Indeed, those recent events were a pretty clear indication of the resilience of Canada's financial system as a whole. Let me close by pointing out that the FSR includes a section that describes how we measure the resilience of the Canadian financial system. It shows that capital, leverage and liquidity ratios in the Canadian financial system are all well above regulatory minimums and have improved over the past year. We are seeing early signs of a recovery in business investment. The process of adjustment to the oil price shock is mostly behind us, having been facilitated by the monetary policy actions we took in 2015. This improving economic backdrop will add to the resilience of Canada's financial system. And as such, we decided to drop the risk of prolonged weakness in commodity prices from our risk assessment. With that, Senior Deputy Governor Wilkins and I are happy to respond to your questions.

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Canadian Economic Update: Strength in Diversity

wilkins

I am very pleased to join you here in Winnipeg. Thank you to the Associates of the Asper School of Business for the invitation. I was able to get out for a run this morning at The Forks. It is a beautiful area, and I was struck by the impressive architecture of the Canadian Museum for I am looking forward to visiting it this week. The museum reminds us that all people are worthy of respect and dignity, regardless of their differences. The 150th anniversary of Confederation of Canada is the perfect opportunity to reflect on the strength that comes from diversity. Just a couple of weeks ago, the Bank of Canada issued a commemorative bank note that celebrates the diversity of our nation builders and of our landscape. Diversity comes in many forms, and today I will speak about economic diversity and the strength that comes from having multiple sources of growth. As you will remember, the Canadian economy was hit hard by the collapse in oil prices in 2014. The adjustment to lower oil prices is now largely behind us, and we are looking for signs that the sources of growth are broadening across sectors and regions. As I will explain, the signs are encouraging. My colleagues and I spend a lot of time poring over data to see how the economy is evolving. Data rarely tell the whole story, though, which is why we also spend a lot of time talking to people, firms, financial market participants, industry associations, labour groups and others. We do this through formal surveys on important economic issues and through outreach discussions. And, for years now, the Bank has held one of its Board of Directors' meetings outside Ottawa every year. In fact, there is a Board meeting in Winnipeg this week, and we will have an opportunity to exchange views with local business people and other community members. We are looking forward to these discussions because this province is a vibrant microcosm of the Canadian economy. While Manitoba has a number of unique dimensions--ranging from world-class ballet to world-class winters--it shares almost the same structure as the overall Canadian economy when it comes to sources of gross domestic product (GDP) Manitoba's diverse economy has been a source of strength over the past decade. Its economy has expanded by slightly more than 2 per cent a year on average since 2006. That is about half a percentage point higher than the Canadian economy overall for the same period. As I talk about economic diversity today, I will first explain why it matters to a central bank whose main goal is to achieve low, stable and predictable inflation. I will then walk you through what key sets of information are telling us. Finally, I will outline some of the issues that we are considering as we prepare for our next economic update. This will be published in our on July, along with our interest rate decision. Diversity comes in many forms. Let me mention two that relate to the Canadian economy. The first is diversity with respect to our nation's industrial structure, in other words, the range of goods and services produced in Canada. This is important because sectoral diversity makes the economy more resilient-- although not immune--to shocks. It is the economic equivalent to not putting all of our eggs in one basket. Anyone who has attended business school or managed an investment portfolio will be familiar with the benefits of diversification. Let us remember, Canada has benefited over history from its wealth in natural resources. But when oil prices fell from their highs in mid-2014, the regions of Canada that rely on the oil and gas sector were hit hard. As these regions underwent a difficult adjustment process, sectors in other parts of the country were able to help absorb the slack that was created. The service sector was a primary force. That demonstrates the benefit of diversity in the Canadian economy. Monetary policy stimulus and a lower dollar together provided critical support to aggregate demand and facilitated the adjustment of labour and capital. You will remember that the Bank of Canada reduced the policy rate by 50 basis points in 2015, to near-historical lows. The second form of diversity--which I will focus on today--relates to the sources of economic growth. Generally speaking, while growth might bounce around from quarter to quarter, it is more likely to be sustainable over the medium term if its sources are broad-based. For example, growth in exports helps generate the income required to sustain growth in household spending without the need to borrow from abroad. Similarly, demand growth is more likely to be sustainable if matched by growth in capacity-enhancing business investment. There are also important sectoral and geographic aspects to sustainability. While broad-based growth is desirable, it is not under the direct control of monetary policy, and it is not our objective. We target a 2 per cent inflation rate. That means that it is the outlook for overall inflationary pressure and related risks that matters most when we consider the appropriate stance for monetary policy. So even if only a few sectors were expanding enough to absorb the excess capacity in the aggregate economy, we would need to take the appropriate monetary policy action to meet our inflation target. So let us look at how the economy has been performing recently. When we assess the extent to which the sources of growth are broadening, we look at the economy from a number of perspectives. These include the progress made in adjusting to lower oil prices, the range of industries that are growing and the evolution of the labour market. As I discuss each in turn, I will point to some signs that growth is broadening across regions and sectors, although not to the same extent. Adjustment to lower oil prices Let us start with the adjustment to lower oil prices. In 2015 and 2016, the starkest effects of the drop in oil prices on GDP were in business investment. Firms in the oil and gas sector cut capital spending in half, shutting down oil rigs and cancelling investment plans. Investment in the rest of the economy was also subdued, in part as a result of the weakness in non-commodity exports, especially last year. The economy kept growing, thanks to household spending, and activity was concentrated in regions where the energy sector was not as important. Today, as we move past the adjustment to lower oil prices, we are seeing the economy pick up. A couple of weeks ago we got the national accounts data from Statistics Canada for the first quarter of this year. It was pretty impressive, with growth at 3.7 per cent. And the figures show business investment growing again. This is in large part because capital expenditures in the oil and gas sector have bounced back. That is good news. That said, investment growth in this sector is likely to moderate if oil prices stay around where they are today. More generally, ongoing uncertainty about the policies of the US administration is weighing on investment plans. And, given how business investment has declined in the past two years, we flagged it as one of the downside risks to the outlook in our April . Growth in the first quarter was also fuelled by the usual suspects--consumer spending and residential investment. However, growth in the housing sector is expected to slow from exceptionally high rates, and we are already seeing this in the most recent data on housing starts and resales. It is too early to tell how the recent housing measures introduced in Ontario will ultimately affect activity and prices in and around Toronto. In Vancouver, when similar measures were introduced last year, we saw the market cool for a period of time. But it is picking up again. So, given we expect household spending to slow somewhat, it could surprise us and provide an unexpected boost to growth in the near term, which is another risk we mentioned in April. Higher-than-expected spending, if funded by credit, could add to the vulnerabilities in the household sector. We have been monitoring these for some time and highlighted them in last week's . In this regard, the recent policy measures taken by federal and provincial governments are welcome. If there was one disappointment in the first-quarter figures, it was exports. We actually saw a decline of exports of services, which had been performing very well. At the same time, goods exports were flat. We have been working hard to understand the forces behind the data. Stepping back from the quarterly data, there are other signs of adjustment. We see indications that demand in energy-intensive provinces is strengthening, after having fallen in 2015 and the first half of 2016. You just need to look at motor vehicle sales and housing resales ( One challenge we have when assessing the geographic diversity of growth is that it takes longer for provincial data to be published--this year's data on growth by province will not be available until well into 2018. That is why Bank of Canada staff recently developed models to get a timelier read on provincial GDP. models point to a broadening in provincial activity this year, in contrast to the lopsided growth we have seen over the past couple of years ( We also see a regional broadening of demand in the results of our most recent . This survey asks 100 businesses every quarter about things like sales, employment and investment intentions. Executives across the country responded more optimistically about their future sales and their investment plans than they were just a few quarters ago. Range of growing industries We also see a broadening when it comes to growth across industries ( We can see the adverse effect the oil price shock had on goods production in 2015 and the first half of 2016. The fact that growth was positive overall was due to a resilient service sector. As the oil and gas and related sectors stabilized, the goods sector as a whole started contributing again. What is encouraging is that this growth is not being driven by just a few key industries. The data show that more than 70 per cent of industries have been expanding--a rate we have not seen since the oil price shock. That is the kind of diversity that helps support strong and sustained overall growth. When we think about the main drivers of economic growth, many of us picture industries like mining, motor vehicles or aerospace. While these sectors still matter a great deal to the economy, many service industries are increasing in importance. Computer systems design and related services have been growing nearly 10 per cent in the past year. This sector is now as big in Canada as motor vehicles and aerospace combined. It is not all about computers--more areas of the service sector, such as financial services and air transportation, are engines of growth. This is helping to support the household spending we have seen. Labour market developments Let me turn now to labour markets. Developments here are largely consistent with the evolution of economic activity I just discussed. It is not surprising that job growth in the past couple of years had been concentrated in services, offsetting significant losses in goods employment. Jobs in goods-producing industries are now on the rise, and the share of sectors adding workers is growing. Some sectors stand out. The technology sector has been creating a lot of jobs, many of which are very well paid. Other sectors that have seen strong job growth include finance and insurance, health care and education. As sources of growth become more diverse, gains in employment are spreading across the country ( ). Now, we know that the adjustment in the labour market is still under way in some regions, and this is difficult for many people and their families. Alberta and Newfoundland and Labrador, in particular, have not recovered all the jobs lost in the aftermath of the oil price shock. Being able to judge the sustainability and evolution of growth is critical for a forward-looking central bank that targets inflation over the medium term. To meet this objective, we use our policy interest rate to stimulate or slow economic activity, depending on how we judge the evolution of inflationary pressures. Once inflation reaches our target, maintaining it there requires growth to be sustained at the economy's speed limit--what we refer to as "potential output growth." Low, stable and predictable inflation, in turn, allows people to make financial decisions with more confidence. Monetary policy actions influence financial conditions and economic decisions right away but can take as long as two years to have their full effect on inflation. To ensure that inflation gets back to target on a sustainable basis, we must consider not only current economic conditions but also how they will evolve. If you saw a stop light ahead, you would begin letting up on the gas to slow down smoothly. You do not want to have to slam on the brakes at the last second. Monetary policy must also anticipate the road ahead. Right now, slack in the economy is still translating into inflation that is below our target. Headline inflation stood at 1.6 per cent in April, in part because of the transitory effects of competition among food retailers. We look at several measures of core inflation to see past the transient volatility in headline inflation. These measures have drifted down in recent quarters and range from 1.3 to 1.6 per cent. This is consistent with the lagged effects of excess supply in past quarters. Other indicators also point to ongoing spare capacity. We have seen moderate growth in wages, and the number of hours that people work has only recently picked up, although employment growth has been strong. Our base-case projection in the April was for the output gap to close sometime in the first half of 2018 and inflation to return sustainably to target around the same time. We are in the process of doing our next projection, which will be released in July. We will digest all the new data since the April Report and update our assessment of inflationary pressures. We will also look at how the main risks we highlighted in that report have evolved. I have already mentioned the risk of slower investment growth and the risk of stronger growth in household spending. We also underscored the risk that even stronger growth in the United States could lead to a big jump in business confidence, igniting "animal spirits" as John Maynard Keynes would have put it. And, given that we do not know how much capacity might be rebuilt as the economy expands, we pointed to the possibility that potential growth may be stronger than assumed in our base-case projection. We are all acutely aware of the uncertainty around the policies of the US administration--whether it is about trade, tax or the regulatory environment. We already factored in some of the effects of that uncertainty in our April outlook. Until we get more information, it will be difficult to gauge the impact of any proposed policy changes more precisely. This will likely remain an important uncertainty in our projection, but life goes on and decisions must be made in the meantime. Our judgment on the appropriate stance of monetary policy will continue to be based on the outlook for inflation and on the full range of risks--both upside and downside--to that outlook. An important aspect of our inflation assessment is that the economic drag from lower oil prices is now largely behind us. And the 50 basis point reduction in our policy rate in 2015 has facilitated this adjustment. As growth continues and, ideally, broadens further, Governing Council will be assessing whether all of the considerable monetary policy stimulus presently in place is still required. Time to wrap up. There are still risks to the Canadian economic outlook. That said, when you look at the economy from different perspectives, there is reason to be encouraged. Growth has been robust in recent quarters. As we celebrate Canada's 150th birthday and the strength that comes from the diversity of its people, we are seeing the benefits of its economic diversity as well. The strengthening economic activity in regions and sectors that rely on energy is working to diversify the sources of growth across the country. And, while there is still room for improvement in the labour market, stronger growth is translating into job gains across a wider range of regions and sectors. At present, there is significant monetary policy stimulus in the system. As we work toward our interest rate decision on 12 July, we will be focusing on the data and talking to many people like you to get a better sense of what is happening on the ground. One thing that remains clear is the Bank's commitment to achieving its inflation target so that Canadians can make their financial decisions with more confidence.

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Markets Calling: Intelligence Gathering at the Bank of Canada

patterson

Good afternoon. Thank you for that kind introduction. As participants in today's marketplace, you are likely experiencing how quickly technology and markets are evolving. And I can relate. The changes that I saw during my years in fixed-income and equity markets were remarkable. Shortly before I began working in fixed-income markets, if you wanted to sell a bond, you would make a phone call and follow up with a teletype message with all the details. Then, someone in your back office would physically descend into a vault to pull the bond and have it delivered to the buyer by hand. Imagine how sluggish that process would seem to today's traders who transact and settle securities worth millions of dollars with a couple of taps on the keyboard. The shifts in market function and participation that we are seeing globally today are as dramatic. Some stem from central bank actions in certain jurisdictions, such as quantitative easing and negative interest rates. Others are the result of regulatory reform, new technologies and investor preferences. Think, for example, of the influx of investors in the commodity space using indexed and compressing bid-ask spreads in the futures and equity markets. Or the development in Canada and globally of central counterparties for over-thecounter (OTC) derivatives and repos. Keeping up to date on new trading practices and how the markets are functioning is important to the Bank of Canada. Our mandate is to "promote the economic and financial welfare of Canada." So we closely monitor the vigour and health of the financial system. My responsibilities at the Bank include the oversight of our activities in financial markets. This includes market intelligence, which is my topic today. Now market intelligence can take many different forms, including--in its broadest sense--the macroeconomic insights we gain from talking face to face with businesses operating in the real economy. This includes the important work done by our regional teams on a quarterly basis for our . I can't emphasize enough how critical these real-time perspectives are to our overall understanding of economic developments, particularly during periods of heightened uncertainty. They provide us with timely insights that we wouldn't have been able to see in the data until months later. In my remarks I will highlight an example of how this feeds into our policy decision making. But my focus today will be on the intelligence we gather from financial markets. Let me start by expanding on the significance of the Bank's market intelligence. I will then explain how we gather it and how that has evolved. Finally, I will share with you what we are learning and how we use what we learn. The market intelligence we gather is a critical complement to our analytical work. Often, in interpreting data, or through our modelling, we develop a view about the future direction of the economy or inflation. Our intelligence work then offers us an opportunity to corroborate or, occasionally, refute what we see in the data. It helps us fill in the pieces of the puzzle that may be missing or that need greater clarity so that we can refine our judgment surrounding the outlook. It can give us new insights into how markets are functioning and responding to regulatory or other changes. All of this helps us shape Bank policies and is integral to our core functions. Let me say a few words here about those functions. First is the conduct of our inflation-targeting monetary policy. We have successfully maintained inflation close to our 2 per cent target since 1995. The policy's effectiveness depends on the efficient transmission of our rate decisions through to capital markets. It is therefore essential that we have a solid understanding of how those transmission channels function and are evolving. Second, we act as fiscal agent for the federal government, managing its reserves, auctioning its bonds and managing its cash. And that is why it is important for us to assess how market developments could influence these activities. Third, we are responsible for promoting the efficiency and stability of the financial system. We do this in a number of ways. We consider financial stability issues in our decisions and operations. We provide liquidity facilities and serve as lender of last resort. And we oversee the key payment clearing and settlement systems that support the Canadian economy and financial markets. So we need to understand how market developments could affect the financial system, vulnerabilities to it or the effectiveness of our tools. I should underline that, payment and settlement systems aside, we do not have regulatory responsibilities for financial market participants. This is actually helpful and conducive to open, two-way exchanges. At the same time, we maintain regular and open dialogue with the federal and provincial authorities that do exercise such responsibilities. And we share with them our analysis of potential vulnerabilities and risks. Our intelligence gathering supports these functions by ensuring that we remain well informed of market activity and structure. This is by no means a new activity for us. The Bank has been observing markets since it opened in 1935. However, until the 2007-09 financial crisis, intelligence gathering by the majority of central banks, including the Bank of Canada, tended to focus on operations and monetary policy formulation. But the crisis made it clear that central banks missed some areas where risk was building. We were familiar with traditional markets, such as those for government bonds and foreign exchange, but much less knowledgeable about other areas, such as markets for structured credit and OTC derivatives. Those were some of the areas where leverage had risen to dangerous levels. In 2009, the G20 called for new regulations to strengthen the stability of the global financial system. The measures that have since been put in place range from structural reforms to capital enhancements. They include new solvency and liquidity standards and new risk requirements for products such as OTC derivatives. These regulatory reforms have strengthened the global financial system. Today, the institutions at the heart of the system--the banks and other financial intermediaries--are safer and have lower levels of leverage. However, we all know that risk remains. It may now reside in some areas that are not subject to as much or any regulation and, as such, is not easily observed. The regulations have also affected the intermediary function that banks have long performed. As they look to optimize their use of capital, they are allocating less balance sheet to certain asset classes, such as corporate bonds. This has affected liquidity in these products and altered the way investors execute and trade. In response to these evolutions in market functioning and behaviour, we have adapted how we track the health of the financial system. We've increased the frequency of our checkups, are making contact with a broader set of players and have added new diagnostic tools. We now devote more resources to the who, what, how and why of the vulnerabilities we identify and their interplay with markets. To undertake these new tasks, we have expanded our team at the Bank of Canada. Because communication is key--not by email, or tweets, but with inperson meetings and discussions with a wide range of market participants. We augment our conversations with analysis, research and surveys. To facilitate our exchanges, we maintain and, in some cases, have expanded our presence in Toronto, Montreal and New York. We make regular trips across the country as well as to London and other key international financial centres. Across Canada, and around the world, we also hear from participants at our speaking engagements. And while we are committed to communicating new information on the outlook and policy only in public settings, the insights we garner in both public and private are invaluable for our policy making. Internationally, we collaborate closely with other central banks, and many of us sit on committees of various global institutions. For example, I'm a member of the Committee on the Global Financial System of the Bank for International Settlements. My participation allows me the opportunity to discuss market functioning from a Canadian perspective, while hearing about developments in other parts of the world. Another important source of intelligence, one that helps us understand developments in foreign bond markets, is our reserve-management operations, which total roughly US$75 billion in assets denominated in foreign currency. And, along with other central banks and monetary authorities, we conduct regular surveys of turnover activity in the foreign exchange and OTC derivatives markets to obtain information on their size and structure. Domestically, our own operations are an important source of intelligence on funding and liquidity. Our traders maintain a continuous dialogue with participants in our Receiver General auctions and repo operations. We combine what they learn with other sources of market intelligence in a framework we developed several years ago to assess financial system vulnerabilities and risks. Some of you will be familiar with this framework from our biannual us explicitly identify underlying weaknesses, such as high leverage, asset price misalignments or maturity and funding mismatches that could amplify and propagate shocks. For example, a few years ago we increased our focus on ETFs, particularly those related to fixed-income instruments, given their increasing popularity among investors. While ETFs are still relatively small in Canada, if they were to grow substantially, they could, in some circumstances, propagate liquidity shocks, especially where the underlying assets they hold are less liquid. We currently have no concerns about the sector but will continue to monitor its functioning and growth. Our assessments are augmented by meetings with market participants that help deepen our understanding of the vulnerabilities we have identified as well as the underlying drivers of market activity. These meetings are a two-way exchange. We learn about market behaviour from them, and we have an opportunity to explain our policy framework. With the expansion of our intelligence gathering, we have developed a wider network of contacts. Still, we know the financial sector is dynamic and our work will never cover all of the playing field. Nonetheless, we now capture a broader sweep of market segments and participants. This allows us to gather information when significant events that could affect Canadian markets occur, such as the commodity price collapse, Brexit or the recent US election. The expansion helps us track more closely how markets are positioned going into such events, gauge how they will react, and, in the aftermath, understand the short- or long-term repercussions. Let me get to that example that underscores why multiple sources of broader market intelligence are so helpful for us, particularly at times when there is a great deal of uncertainty in markets. You may remember that in the months following the commodity price collapse in 2014 the outlook for oil prices was cloudy. The futures curve out to six months was upward sloping. This implied that either market participants were expecting oil prices to rebound or, more negatively, the cost of storage was increasing, given the high level of inventories, and oil prices would remain low. To obtain a better picture of what was happening, colleagues from our domestic economy department, in particular, staff from the Bank's office here in Calgary, interviewed some of their contacts in the oil industry. Those discussions led us to conclude that market expectations were likely too optimistic. It was clear that the path to higher oil prices was not assured in the medium term and that the negative real effects on capital spending were going to be larger than what had been suggested by the data. This would have a major impact on the economy. That knowledge fed into our judgment and, ultimately, our decision to lower our policy rate in January and July 2015. Two years later, it is our view that these cuts have helped facilitate the economy's adjustment to the oil price shock and that the economic drag from lower prices is largely behind us. We will be updating our outlook over the next few weeks, and it will be released on July 12 in our . Lastly, we have established a forum for gathering fixed-income market intelligence. We wanted to better understand the shift in risk taking that we were seeing and its impact on market functioning. So, some two years ago we created senior professionals from both buy- and sell-side firms across the country. I cochair the committee, which meets quarterly. Its goal is to explore developments in the fixed-income market by tapping into the collective expertise of the membership, including areas such as trading practices and changes in market infrastructure. The committee's efforts involve research and analysis to identify potential enhancements and raise awareness of these issues. All of our meetings, presentations and minutes are published on the Bank's website. As the G20 financial system reforms were being put into place there was a lot of concern among market participants about how these reforms could affect bond market liquidity. That's why one of the first initiatives CFIF undertook was a survey of investors active in the Canadian fixed-income market. We wanted to hear first-hand whether there had been changes in liquidity and, if so, whether that had altered the trading, execution and portfolio-management practices of participants, including active domestic issuers. We learned a great deal from the survey. Participants confirmed that most fixed-income instruments have experienced a slight decline in market liquidity over the past two years. They also told us that liquidity for certain products, such as investment-grade corporate bonds, has deteriorated the most. One key takeaway was that many participants have adapted to the change in liquidity by adjusting how they manage their portfolios. Those adjustments include taking more time to execute by breaking up their trades into smaller pieces, holding more on-the-run securities, holding less liquid assets for longer periods of time and reducing the turnover in their portfolios. These changes in strategy are especially evident in the corporate bond space. Some buy-side participants also told us that they were willing to provide liquidity by acting in a countercyclical fashion to take advantage of market distortions caused by temporary illiquidity in certain markets. The survey results are providing CFIF with a foundation for further work in areas where improvements in market functions may be made. Discussions at CFIF meetings are also inspiring new areas of research. Last year, members commented on the increased use of Canadian bond futures for hedging by the dealers. In analyzing the data, we noted an increased level of participation by high-frequency traders in this space. In response, we undertook a study of HFT in the Government of Canada bond futures market. We used data provided by the Montreal Exchange to understand the impact of HFT on market functioning. Our analysis showed that its average effect on market pricing was slightly positive. Both effective and bid-ask spreads, as well as price volatility, declined, while the average depth of the market increased. HFT had a small beneficial impact on the all-in cost of the execution of smaller trades. However, no effect was found on the cost of execution for larger trades (greater than $10 million). It was also clear from the data that many participants now split their trades into smaller blocks, something we have been hearing through CFIF and in discussions with market participants across a range of asset classes. So what's on our horizon these days? As we outlined in the recent FSR, changes in mortgage rules late last year have led to important shifts in mortgage activity. Because of significant growth in house prices in some of Canada's largest cities, we have seen an important increase in the uninsured mortgage space. This has highlighted the potential need for market participants to develop additional sources of funding, particularly for the smaller lenders in this market. To diversify funding sources, one solution would be the development of a private mortgage securitization market. This option has come up in several of our recent conversations. If poorly structured, securitization markets can have significant vulnerabilities. However, if appropriately developed, private-label securitization could benefit the economy by helping lenders fund assets while broadening available collateral to promote market functioning. We will continue to monitor developments in this space. Another initiative we are working on is a new systemic risk survey that we will launch next year. We plan to conduct the survey biannually to seek views on key financial system risks and developments, as well as measure overall confidence in the Canadian financial system. The survey will support our surveillance of the financial system, inform policy decision making and help strengthen our network. We are finalizing the details and expect to launch in early 2018. The results will be published in the As a central bank, we rely heavily on our excellent models and incoming data for our forecasts. Yet we know that the intelligence we gather is a critically important complement to them, particularly during times of transition or when sentiment is playing a bigger role. This information gives us a deeper understanding of how the economy is performing and how markets are functioning and evolving. And what we learn from all of it--our models, the data, our analysis and intelligence from our contacts--feeds into our judgment on policy actions. I want to emphasize that although our policy judgments are guided, in part, by our intelligence gathering, we know that financial markets are dynamic and that we will never have a perfectly complete, up-to-the-minute picture of all activity. We are realistic about this and are constantly learning and seeking to know more. So it is essential that we communicate regularly with participants across all dimensions, be they investors or issuers, the operators of financial market infrastructures, regulators or other capital market facilitators. And we share much of what we learn. While we are committed to transparency, we are mindful of the need to respect the confidentiality of what we hear from individual firms. We publish our findings broadly in the FSR and other Bank publications and in CFIF minutes posted on our website to educate and raise awareness both domestically and internationally. So let's talk. Our ultimate goal is to promote a stable and resilient financial system that serves all market participants. We need and value your collaboration and feedback.

r170712a_BOC

canada

Monetary Policy Report Press Conference Opening Statement

poloz

Governor of the Bank of Canada Press conference following the release of the Good morning. Senior Deputy Governor Wilkins and I are pleased to be here to answer your questions about today's interest rate announcement and our Today, we raised our key policy rate by 25 basis points, in the context of an economy that is approaching full capacity and with inflation expected to reach the 2 per cent target within the next year. Before we turn to your questions, let me offer some insights into the deliberations Economic data have been encouraging over the past few months, globally and especially for Canada. We acknowledged this positive trend in our April MPR and in our May 24 press release, while noting concern about the sustainability of growth because of its composition, as well as US-based policy uncertainties. While uncertainties remain, delays in decision making in the United States seem to have moved some of those concerns more into the background. The Bank's latest , for example, finds very strong business sentiment, particularly for investment and hiring intentions, despite a lack of clarity about future US policies. Since April, we have also seen further evidence of a broadening of growth in Canada. Along with stronger-than-expected growth, this has bolstered Governing Council's confidence in the outlook for the economy and inflation. The economy is absorbing excess capacity more rapidly than we projected in April, and it now appears that the output gap will close around the end of this year. That will nevertheless leave some slack in the labour market. As output growth continues to exceed potential, we expect companies to invest in additional capacity and draw from this slack in the labour market, thereby expanding potential output further. This process is difficult to forecast but is likely to become increasingly evident as we approach full potential. This is an important reason why monetary policy is not on a predetermined path. It will remain highly datadependent as we move forward. One key indicator of progress will continue to be wage inflation, which has shown signs of a pickup in recent months but remains restrained by the lingering effects of the adjustment to low oil prices. Meanwhile, inflation has continued to fluctuate in the bottom half of our target range. This has prompted a lively debate, not just in Canada but in many other countries, about the appropriate interest rate setting when economic growth is rapid but inflation is low. Governing Council examined this issue closely from two perspectives. The first asks whether there are special factors that are temporarily pushing inflation lower, and we discuss this issue in a technical box in the MPR. Generally speaking, central banks prefer to look through temporary factors. Of course, our new core measures of inflation were developed to help us see through the noise in inflation data, but even these are not immune to temporary fluctuations. After careful assessment of the evidence, Governing Council agreed that a significant portion of the recent softness in our measures of inflation should prove to be temporary. Nevertheless, even a one-time price change affects inflation for a year, simply because we gauge inflation on a year-over-year basis. Some temporary factors are themselves gradual rather than one-off, such as increased competition in retail food stores. This all serves to underscore the datadependent nature of monetary policy. All things considered, Governing Council judges that in the absence of temporary factors, inflation would be running at around 1.8 per cent, as excess capacity in Canada is estimated to account for an inflation shortfall of about 0.2 per cent. Accordingly, as the gap closes in the months ahead, we expect inflation to head toward 2 per cent, with the rate of convergence determined by how quickly these various temporary factors unwind. Our projection shows a modest overshoot of the 2 per cent inflation target in 2019. This is a product of the dynamics of our model, but it is an important reminder that, while our target is 2 per cent, our control range is a symmetric 1 to 3 per cent. Having a target range acknowledges the uncertainty inherent in economic forecasting and inflation control. The chances of an overshoot will depend on how investment and potential output respond to tighter capacity constraints, a process that the Bank will monitor closely. The second perspective on the low-inflation issue concerns the lags between monetary policy actions and their ultimate effects on inflation. It is worth remembering that it can take 18 to 24 months for a monetary policy action to have its full effect on inflation. This means that central banks must target future inflation by anticipating future deviations from target. And because inflation is measured with a lag, reacting only to the latest inflation data would be akin to driving while looking in the rear view mirror. In contrast, imagine a world where the Bank was able to anticipate all future movements in inflation, and adjust interest rates in advance to offset them and keep inflation exactly at 2 per cent. In such a case, it might appear to the casual observer that interest rates were being adjusted up or down for no reason. Taking together the approaching closing of the output gap and our understanding of recent soft inflation readings, today's increase in interest rates is clearly warranted. That being said, we will of course monitor the details of inflation carefully to determine the extent to which it remains appropriate to look through fluctuations in inflation. Interest rates were lowered in 2015 in order to help the economy adjust to lower oil prices, and much of that adjustment is now behind us. While lower rates contributed to greater household financial vulnerabilities, enhanced macroprudential policies helped to mitigate these and will continue to do so. As the economy approaches full capacity, a higher policy rate in pursuit of our inflation target also serves to reinforce efforts to mitigate financial system vulnerabilities. Governing Council acknowledges that the economy may be more sensitive to higher interest rates than in the past, given the accumulation of household debt. We will need to gauge carefully the effects of higher interest rates on the economy. Future adjustments to the target for the overnight rate will be guided by incoming data as they inform the Bank's inflation outlook, keeping in mind continued uncertainty and financial system vulnerabilities. With that, Senior Deputy Governor Wilkins and I will be happy to take your questions.

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canada

Bank of Canada Workshop “Monetary Policy Framework Issues: Toward the 2021 Inflation-Target Renewal”

schembri

Good morning everyone, et bonjour a tous. Bienvenue a la Banque du Canada. Je m'appelle Larry Schembri. Je suis un sousgouverneur ici a la Banque. It is a great pleasure for me to open this workshop on issues central to the monetary policy framework and its implementation. Given the significant challenges central banks have faced in achieving their monetary policy goals since the global financial crisis, this is a propitious moment to step back and re-examine these fundamental issues from a variety of perspectives. As many of you know, the current monetary policy framework in Canada consists of two a consumer price index (CPI) inflation target of 2 per cent, the midpoint of a control range of 1 to 3 per cent; and a flexible, market-determined exchange rate. While the second component has been in place for almost 60 of the past 70 years, our inflation-targeting regime was implemented in 1991 and the current specification has existed since 1995. This framework has served Canada well in the face of significant movements in commodity prices and Canada's terms of trade, as well as other shocks, including the Great Recession. Inflation has averaged just below 2 per cent since we implemented the target, and both output growth and inflation have been much more stable relative to before 1991. In addition, two important features of our inflation-targeting regime have drawn favourable international recognition: first, the price stability policy goal of the regime is founded on a joint agreement between the Bank of Canada and the Government of Canada; and second, the agreement is reviewed regularly on a five-year basis. The joint agreement with a democratically elected government enhances the legitimacy of the price stability objective and thereby boosts its credibility. It also gives the Bank of Canada operational independence to achieve this goal. The regular five-year review, meanwhile, affords the Bank the opportunity to revisit many important aspects of our monetary policy framework and its implementation. While the framework has worked well in the past, improvements should always be considered--especially given the changing economic environment, the lessons learned from experience in Canada and elsewhere, and pertinent research findings. In the past, the Bank has used this opportunity to organize and give visibility to its monetary policy research program, which has examined various dimensions of our monetary framework--well beyond the relatively narrow scope of the joint inflationcontrol agreement and the goal of price stability. The regular five-year review also presents the opportunity to engage various stakeholders in this process to provide us with helpful ideas and useful feedback on our work. This workshop is a case in point. It has been organized early in the current fiveyear review cycle, so we can draw from a wide range of perspectives--from academics, economic journalists and other central bankers and policy makers--well before we begin to develop the key questions for our research program that will culminate in the 2021 renewal and publication of our background document. In addition to striving to obtain a wide range of perspectives, the workshop has been organized in a fairly open-ended manner to stimulate dialogue on a broad span of issues. And in keeping with our desire to be open and transparent about this process, and to include all Canadians, today's conference is being webcast and we will post running commentary on our social media channels. We have divided the workshop into four panels: one on the role and objectives of monetary policy in Canada; two panels on more operational issues, namely the scope and effectiveness of monetary policy tools, and monetary policy communication; and a panel on lessons learned from other central banks. In the past, we have considered several important framework questions, most notably: whether to lower or raise the inflation target; whether to adopt a price-level path target, instead of an inflation target; and what would be the implications for monetary policy of financial stability vulnerabilities and risks. These issues were considered primarily during the last two review cycles, which ended in 2011 and 2016, respectively. In recent years, discussions of monetary policy frameworks have focused on the impact of a number of significant economic developments. These include: the decline in the equilibrium real interest rate and thus in the "neutral" policy interest rate, which limits the scope for use of countercyclical changes in the policy interest rate; the decline in potential output growth--especially in advanced economies--driven by demographic trends and lower labour productivity growth, forces that monetary policy has limited or no ability to counteract; and the elevated level of indebtedness of both the private and public sectors, which raises concerns about financial stability, fiscal space and central bank independence. And, looking ahead, new financial technologies could affect the implementation and transmission of monetary policy. So, we are most fortunate to have with us today a very distinguished group of speakers to enlighten us with their thinking on these and other challenging issues. Please let me close by thanking them, and all conference participants, especially those who have come some distance to be with us today. It promises to be a very stimulating workshop, and my colleagues and I are very much looking forward to listening and discussing with you. Bonne journee.

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canada

Monetary Policy Framework Issues: Toward the 2021 Inflation-Target Renewal

wilkins

Closing remarks This has been a lively and constructive day. I am not surprised many of us agree that inflation targeting has been, on balance, a successful foundational element of solid and sustainable economic growth--not only in Canada, but around the world. At the same time, few of us in this room would say that the inflation-targeting regime is perfect, or that we would be wasting our time to seriously consider alternatives. The beauty of Canada's regime is that we renew the agreement on the inflation-control target with the federal government every five years. This gives us a mandate to step back, get out of the day-to-day frame of mind and think about fundamental issues. Is inflation targeting as we know it still the best thing the Bank of Canada can do to support the economic and financial well-being of We invited you, experts from Canada and abroad, to put diverse points of view on the table and start a conversation. On that metric alone, this workshop has clearly been a success. I will not attempt to summarize everything that we talked about today. I do want to highlight three broad issues that came up, because they are particularly important to pursue further: The choice of the monetary policy framework How monetary policy should dovetail with other policies, notably macroprudential and fiscal policy The appropriate form and degree of transparency and communication for central banks When we started this morning, many could not resist the temptation to take a walk down memory lane. This is understandable, since some of the people in the room may still have been in school in 1981, when inflation in Canada peaked at just about 13 per cent. Clearly, the dragon to slay in the 1980s was inflation. Many of us were dedicated to finding a better monetary policy framework or improving the one we had. Governor Poloz was one of those people, but there are many others that we are fortunate enough to have with us today as well. When we settled on inflation targeting, I can tell you that no one was 100 per cent sure it would work. We worried about, among other things, the uncertainty surrounding the strength and timing of the transmission mechanism. While today we know the power of credibility and expectations, that was also a source of worry at the time. So there was some element of a leap of faith in the analysis that had been done. This leap was easier to take because there was a clear sense that something was broken and needed to be fixed. I did not get the sense today that anybody believes there is presently a similar dragon to slay. But I did hear several concerns that have gained in importance since the financial crisis: Inflation targeting, especially strict inflation targeting, can contribute to a buildup of financial imbalances. The low neutral interest rate we have today may make a 2 per cent target difficult to achieve. Supply shocks, such as those we may be experiencing with the digital economy, could make it more difficult or unwise to try to achieve a 2 per cent target at all costs. Some of the alternatives discussed today were aimed at addressing one or more of these concerns, and I think that many of the ideas are worth pursuing in our research program. The first idea is related to the flexibility of our current inflation-targeting regime. Although we haven't changed the target over the last 25 years, we did introduce greater flexibility in the framework for how fast we should aim to return inflation to target. We thought this flexibility might be particularly useful in circumstances where returning inflation more slowly could help support financial stability-- recognizing that financial stability is part of our risk-management approach. Right now, the important question is: what are the costs and benefits of making greater use of this flexibility, particularly when it comes to anchoring expectations? Similarly, what are the costs and benefits of putting less emphasis on the midpoint of the 1 to 3 per cent target range? These are interesting research questions. A second idea that was put on the table relates to alternative frameworks that could reduce the chances of hitting the effective lower bound. One alternative discussed was to change the level of the inflation target; another was to switch to price-level targeting (PLT). We heard many pros and cons for each. One of the dominating worries, especially with PLT, relates the effectiveness of the regime if it proved to be too complex for people to understand. Those worries are real. And, since the bar to make a change is very high, we need more research on how inflation expectations are actually formed. Research in this area would help make the debate more productive. We should also ask ourselves whether we can leverage the credibility we have built up over the past 25 years to make the transition to a new regime smoother. Some believe that a digital currency issued by a central bank could help address issues related to the lower bound of on nominal interest rates by making it easier to implement a policy of negative nominal rates. In theory, this makes sense, but I wonder how much of the issue about the effective lower bound would go away in practice if we had a central bank digital currency. That is an open question for research, and the answer depends on how much power there is in negative nominal interest rates. Other complex issues related to central-bank-issued digital currencies that merit study also came up today, such as who should have access to the central bank balance sheet. Of course, the Bank will continue looking at these questions. We also talked about the idea of broadening the mandate to include a realeconomy objective--what is known as a dual mandate--or some version of nominal income targeting. These approaches could be useful when the so-called divine coincidence--low and stable inflation occurring in tandem with low and stable unemployment--doesn't hold. Even there, it's not simple, because the regimes could create tensions related to the independence of the central bank. But there may be other benefits associated with such approaches that should be studied further. Think of how disinflationary effects of positive supply shocks can lead to low interest rates that could reinforce financial imbalances under strict inflation targeting. We have seen such a shock with inexpensive imports from China in the 2000s. Targeting nominal GDP might help in those cases. Since nominal GDP growth is the sum of inflation and real GDP growth, weaker inflation that is offset by stronger economic activity would leave nominal GDP growth at the target. Choosing the right framework is serious business. I was happy to hear people's views on the considerations that should guide our research. Clearly, we want a framework that stabilizes the economy without worsening inequality and that performs well when the neutral rate of interest is low. This brings me to the second set of issues. A low neutral interest rate raises the question of the optimal policy mix. There has been much research on the effectiveness of fiscal policy at the effective lower bound. We heard a great deal today about how important macroprudential and microprudential policies are to guard against excessive credit growth and the buildup of financial imbalances, well before we start thinking about using monetary policy. It is difficult to disagree with that. This line of research is an important building block to a more fundamental issue that was raised today--the optimal mix of monetary, macroprudential and fiscal policies to get the economy back to its potential. I am taking an expansive view of fiscal policy to include countercyclical policies, automatic stabilizers and structural policies. Different mixes of policy may be able to achieve the same macro outcomes in the short to medium term, but the outcomes could differ in some important respects over a longer horizon: whether indebtedness builds up in the private or public sectors, or whether the distribution of income and wealth widens or narrows. It can matter when the time comes to choose between unconventional monetary policy measures, such as quantitative easing (QE), and fiscal policy measures. The optimal mix of fiscal and monetary policy was a hot topic in economic journals in the 1970s and '80s. Interest tapered off because we thought we had the problem solved. The consensus was that you had a monetary anchor with inflation targeting, which meant that the monetary authority could simply take fiscal policy as a given. And that may work very well in normal times, but several factors discussed today support doing more research in this area. The first factor, which I already mentioned, is the low neutral rate and the limits of monetary policy in the face of negative shocks. We can discuss whether the neutral rate of interest will rise or fall in the future, but it is clear that it is currently lower than it was before. The power of negative interest rates, QE and other unconventional policies is still being debated, as we saw today, and so questions around an increasing need for fiscal stabilization may become more important. The same is true for structural government policies to raise the rate of potential growth of the economy. As several people correctly observed today, monetary policy--which is neutral in the long run--cannot fix structural problems. The issue of the optimal policy mix is made more pressing by the reality that "low for long" and unconventional monetary policies may give rise to vulnerabilities in the financial system because they work through credit. This point was made several times today. It seems to me that the debate around the role of monetary policy in leaning against financial imbalances can only move forward through a better understanding of the effectiveness of macroprudential policies. What we need to know is how macroprudential policies interact with monetary policy and how authorities with different mandates can coordinate effectively. Policy coordination in real time raises governance issues for policy-makers who have clear and independent mandates. How can we support this clarity of mandates as we explore policy-mix options? One way would be to focus research on the coordination of framework design, rather than on the coordination of responses to cyclical shocks. Complementary frameworks could deliver better outcomes while maintaining the central bank's instrument independence. Most economists would recognize that we need better models to answer the questions I just raised. There has been important progress over the years, but more is needed. Better modelling of the linkages between the real economy and the financial sector will be crucial. Understanding how expectations are formed will be just as important, as will be measuring the importance of heterogeneity in household incomes, wealth and the size of businesses. The third set of issues, and one that permeated the workshop, relates to transparency and communications. We all agree that central banks must be clear and transparent. Indeed, communication in and of itself has become a policy tool for many central banks. The debate today was around the form and the degree of this transparency. We heard some very strong and helpful advice in that area. Some advised central banks to publish the path for their policy interest rates or to at least give regular conditional forward guidance on interest rates. Others recommended that central banks should repeat their messages more often and provide more information on their reading of the economy. Still others cautioned that too much information could cloud the incentives of market participants to do their own analysis. We saw survey evidence today that showed academics tend to favour more transparency than practitioners. The discussion helped to shed light on where the points of disagreement may be most important. First, there is no consensus on the gravity of the problem to begin with. It would be useful to know whether increasing transparency along the lines discussed today would improve outcomes for inflation, output, jobs and other variables that matter to us. There is also disagreement on how much clarity can be achieved by more transparency about the potential future path of interest rates in an environment that is constantly evolving. Practitioners know their forecasts will not always be right and that they will have to adapt as new information comes in. To be sure, economic models can help analyze the effects of developments, but they cannot do away with uncertainty. One question here is how well market participants would understand the conditional nature of forward guidance. The last point of divergence relates to the trade-off between the benefit of additional clarity and the cost of the information you lose from markets when you telegraph your expected actions in advance. We are constantly seeking new ways to innovate in our communications, and this workshop gave us a great deal to think about. We have heard today from you, experts from many countries and fields of expertise, about what you think are the key monetary policy framework issues. You have given us many good ideas to consider on the best way to fulfill our mandate to support the economic and financial well-being of Canada. There are many tough questions related to the framework itself, policy coordination and transparency. I want to thank those who participated in person and those who watched the webcast. I also want to thank Larry Schembri for organizing this workshop. We will use this workshop and other discussions to articulate our research agenda, and we will get started this fall. From there, we will be able to narrow down the questions that are pertinent for the inflation-target renewal in 2021. We are not going to rush this because we want to keep it broad for now. You will be able to see our progress over time because we will post the research we do on our website. Now that we've reached out to you, you might be wondering how you can contribute in a constructive way. Stay connected; do research and analysis on the issues, if that is your thing; and send us comments on our work. We are doing our homework, and we are listening.

r170918a_BOC

canada

How Canada’s International Trade is Changing with the Times

lane

My theme today is international trade, which is the lifeblood of the Canadian economy. Throughout our history, we have successfully relied on our exports and imports, particularly during the vast expansion of global trade in the decades following the Second World War, to support our rising standard of living. Today, exports and imports represent about 65 per cent of our output, one of the highest ratios among the G7 countries. Few places in Canada illustrate the importance of trade and innovation as vividly as Saskatchewan. Historically, people living on the Prairies relied on exporting grain--and, more recently, potash and oil--to markets outside Canada's borders. They imported many of the products they consumed and the tools they used, from T-shirts to tractors. In the first several decades of Confederation, they often chafed at the trade barriers that were put in place to protect and nurture the growth of the manufacturing industries of central Canada. What is remarkable is how nimble businesses in this province have been. They have adapted and innovated not only to grow market share but also to develop new products and markets for them. In recent years, the pattern and drivers of trade both nationally and in Saskatchewan have evolved dramatically in response to forces that have been acting at the global level. Innovations in many areas, notably information and communications technologies (ICTs) and logistics, have given rise to the development of new products and new ways of producing and trading them. A particularly important trend has been the emergence of global value chains (GVCs), with various stages of production located in different countries. In this context, the progressive lowering of trade barriers worldwide has had outsized effects. Trade agreements have enabled much closer economic integration, and trade flows have burgeoned, leading to increases in productivity and living standards. These trading relationships are now being called into question. Populist movements in some of our major trading partners are demanding new trade barriers. However, such protectionist measures would undoubtedly mean less trade, which would reduce economic growth. While I can't comment on the specifics of any particular agreement, we have certainly been assessing this shift toward protectionism, how it might affect the outlook for growth in Canada and its trading partners and ultimately what it would mean for the conduct of our monetary policy. In my presentation today, I'll review the changing nature of international trade, the factors, such as innovation, that are propelling it and the benefits to Canada. I'll discuss the challenges Canada faces in its international trade and how they affect our economic outlook. I'll conclude with what this means for monetary policy. We used to think that the greatest benefits of trade accrued to countries with market dominance in specific industries. Think of Switzerland and watches or France and wine. Historically, Canada exported what we had in abundance--raw materials such as fur, fish and timber--and imported manufactured goods. Of course, this is still the case for much of our trade. But the biggest increase in world trade in recent decades has been intra-industry--that is, two-way trade within a given industry ( ). Some of that simply reflects product differentiation: Canada exports rye whisky and imports scotch and bourbon. But, even more importantly, the expansion of intra-industry trade has been enabled by the unbundling of different stages of the production process. Consider the automobile industry: Canada both exports and imports auto parts at different stages of production as well as the finished product. The potential for this kind of unbundling was unleashed by technological innovations, particularly advances in ICT, which enabled the logistics needed to manage a supply chain that criss-crosses international borders. Bank of Canada research has shown that the separation of production into stages significantly increases the economic gains from trade. In a world of GVCs, easing trade restrictions can also have outsized, positive effects on the economy and on trade flows. This has been described as "leveraging" because every unit of the final product--say, every car-- incorporates a great deal of trade in the intermediate products and any reduction in costs imposed on trade can have cascading effects. Lower trade barriers also make it less expensive for firms to allocate different stages of production to countries where they are most efficiently produced. Chart 1: Two-way trade is important within several industries What are the benefits to Canada of barrier-free, intra-industry trade within GVCs? Within any given industry, lowering trade barriers enables more efficient producers to expand to supply a wider market. That further lowers their costs as they move to a larger scale. Other, less efficient producers or plants may shrink or fail. (NAFTA) are good examples of the economic impact of lowering trade barriers. The North American market opened in the wake of the agreements ( Employment in manufacturing declined in the short term, but productivity rose and, in the longer term, the number of jobs in the economy increased. Efficient plants were able to expand to a scale that allowed them to capture even greater efficiencies. The improvement in productivity supported the growth in the overall earnings of workers. Exports and imports are a two-way street--and both help deliver the benefits of barrier-free trade. Canadian firms can compete in foreign markets partly by making use of lower-cost imported inputs, which raises their productivity. their exports of intermediate products are linked to their trading partner's trade performance. For example, when we export machinery to the United States, it is an efficiency-enhancing input into their exports. Benefits from opening trade may also come from increased competition. This is the result of both opening one's home market to imports and gaining access to foreign markets. Chart 2: Canada's exports expanded rapidly in the years following the adoption of NAFTA More generally, innovation drives changes in trade patterns. This is economist Joseph Schumpeter's idea of creative destruction. The new replaces the old. Firms inventing new products may expand their exports by penetrating new markets. They can also develop new production processes that enable them to produce at lower cost. There are many such examples throughout the economy--in the high-tech industry as well as in many other sectors. For example, 45 years ago here in Saskatchewan, pulses such as lentils and peas were a small part of the province's farm economy. In the 1970s, however, researchers at the University of Saskatchewan began searching for a protein crop to complement wheat, which was suffering from an oversupply and low prices. They saw the opportunities in lentils and developed new varieties suitable to the climate and soils of Saskatchewan. Today, the province is the world's largest exporter of green lentils and the world's second largest producer ( of the crop generated more than $2 billion in sales. Chart 3: Lentils have become one of Saskatchewan's largest export crops Innovations in the production process can also drive export growth. Historically, this has been a major part of the history of Saskatchewan. New technologies, such as farm machinery and seed varieties, drove the consolidation of Prairie farms to take advantage of the greater ability to cultivate and harvest crops on a larger scale. Saskatchewan's farm production and exports expanded massively, even while its population steadily declined. That freed up workers to move into job opportunities opening up elsewhere in the economy, while increasing the productivity and incomes of those who remained ( and b ). This is a story that has a personal connection for me: half of my great-grandparents were farmers in the Prairies, but none of their descendants is still farming. I've been talking about how innovation drives trade, but the reverse is also true: trade openness drives innovation, too. This happens for two reasons. First, access to foreign markets exposes firms to new technologies and provides incentives for them to invest in producing more efficiently. And second, competition from trade encourages firms to innovate and invent new products to maintain market share. Trade is also an important channel for knowledge to spill over across borders: an operation in one country can become competitive by combining its home advantages with the best techniques developed elsewhere. Chart 4: Employment in agriculture and manufacturing continues to decline but output is increasing While trade and innovation have always been interconnected, the nature of these interconnections is changing rapidly with recent advances in digital technology, touching virtually all sectors of the economy. We are only beginning to appreciate how new fields, such as artificial intelligence, cloud computing, additive manufacturing and big data, may play out in new trade patterns. Even calculating their economic impact is challenging. Returns from patented intellectual property (IP), such as software, are an increasing part of value added in electronic products, and these are hard to measure. That's also true of trade in IP services, which is becoming increasingly important. Google Chrome and Dropbox-- distributed worldwide across the Internet--are good examples. Since they do not physically cross the border, there is no customs paper trail, and they are difficult to track. They are also provided free to many users, so it's hard to place a value on them. This whole process of expanding two-way trade and technological advancement is playing out in myriad industries. It is one of the most important drivers of Canada's growth potential, which, in turn, underpins rising living standards for Canadians. While these are basically positive developments, they do pose important challenges for society and for policy-makers. Both trade expansion and innovation are by their nature disruptive for firms and individuals. They spur growth by enabling more advanced and efficient activities and encouraging producers to expand, displacing less efficient activities and producers. This is an integral part of the whole process. Improved productivity is essential to compete internationally; without increases in productivity, the business itself and all of the associated jobs can be lost. Historically, these changes have created many more job opportunities than they have eliminated. In particular, Canada's service sector, which has become an increasingly important source of exports, has created many new jobs paying above-average wages. But still, some workers have been left behind. Moreover, the rewards for innovation, particularly in the digital economy, often accrue to the few who own the related IP. Can public policy help smooth the transition? I should make it clear that this is not part of the Bank of Canada's monetary-policy remit, which is to keep inflation low, stable and predictable, allowing Canadians to make spending and investment decisions with confidence. But the disruptive effects of trade and innovation have been major topics of discussion internationally. These are very challenging issues that do not offer easy solutions. Clearly, we can't turn back the clock on technological innovation; nor is the answer to try to limit its scope by closing our borders. What we can try to do is focus on supporting workers as they adapt to changing economic realities. That requires investments in retraining and lifelong learning as well as social safety nets. Another priority is to make sure that profits, including those derived from IP, can't be shifted to avoid taxation. This includes stronger international co-operation--an area where the G20 has made meaningful progress. Now let me discuss the part international trade plays in Canada's current economic situation. The period since the early 2000s has been challenging for Canadian exporters. The commodity supercycle not only created opportunities for resource exporters but also put upward pressure on the Canadian dollar, undermining the competitiveness of Canada's non-commodity exports. Then, during the Great Recession of 2007-09, foreign demand for our products collapsed, and our exports plunged by about 20 per cent. They rebounded quickly but then hit a long stretch of lacklustre growth. This was part of the broader global pattern: before the crisis, global trade had been expanding by more than 7 per cent a year-- about twice as fast as the world economy. Since then it has been growing at a much more modest pace, closer to the rate of GDP growth. Because Canada's relatively weak export performance has been a central aspect of our economic situation, the Bank of Canada has examined it in increasing detail. New measures of external demand for Canadian exports have been constructed, which better take into account how Canadian industries are positioned in GVCs. Our staff have also constructed new measures of Canada's effective exchange rate that better capture Canada's competitiveness, not just relative to our export markets but also relative to third countries ( This analysis contributes to a better diagnosis of Canada's loss of competitiveness. Moreover, in keeping with the new concepts in international trade that I have been describing, our researchers have been examining Canada's exports at an increasingly disaggregated level, down to the individual firms involved. During the recession and its aftermath, many Canadian exporters went out of business. With those firms went many of their supply-chain linkages. Another complex set of adjustments have been playing out during the past three years, with the plunge in prices of oil and other commodities. The economic and human costs to the resource-producing regions were huge. For Canada's economy to continue growing, the non-resource sectors--manufacturing and services--needed to grow faster and export more. Increasing foreign demand and the 25 per cent decline in the value of the Canadian dollar were forces supporting this adjustment. While this expansion of non-commodity exports did take place--exports of services were especially robust--the expansion was smaller than expected based on previous experience. Regaining market share was not just a matter of getting foreign customers to switch to a Canadian product. It often depended on a reassessment of where to locate production within a GVC--decisions that are typically not made often. To support the continuing growth of our international trade, many new linkages may need to be constructed as both new and existing firms emerge with new ideas and expand their activities to a sufficient scale. This process inevitably takes time and is still not complete. The prolonged weakness of Canadian exports has meant that Canada's economy has needed to rely on other sources of demand to drive its growth. In particular, we have depended heavily on household spending, supported by very low interest rates. Now, economic data show that growth in Canada is becoming more broadly based and self-sustaining. We are seeing widespread strength in business investment and exports, in conjunction with a global economic expansion that is becoming more synchronous ( ). Imports are also expanding; the increases we are seeing in imports of machinery and equipment and of various intermediate products are early signals of rising business investment. It was in this context that the Bank of Canada decided, in July and again earlier this month, to raise our policy rate. We will be paying close attention to how the economy responds to both higher interest rates and the stronger Canadian dollar. Looking ahead, Canada's openness to international trade is an important determinant of Canada's economic growth potential--that is, of how fast the Canadian economy can grow without giving rise to inflationary pressures. That growth potential could be greater than we think--if businesses find new ways to engage with GVCs and develop new products and processes to make them more productive and competitive. As in the past, further expanding Canadian firms' access to markets and to imported inputs could unlock more opportunities. An Agreement, most of which will be implemented in the next few days. But some other developments are more concerning. With the rise in protectionist sentiment in some parts of the world, we have been entering a time of heightened uncertainty about the rules of the game on international trade. The possibility of a material protectionist shift--particularly regarding the outcome of negotiations on possible changes to NAFTA--is a key source of uncertainty for Canada's economic outlook. Given the nature of international trade in the 21st century, the stakes are very high. As I discussed, the economic benefits we have experienced from trade liberalization were not only in expanding the markets for Canadian exports. We also benefit from the greater efficiencies that can be achieved by those exporters that do expand, the heightened competition and better access to imported inputs that come with greater openness to imports, and the resulting spur to innovation throughout the GVCs. If trading rules are changed in a way that undermines these benefits, the result would be both lost external demand for exports and lower potential growth for Canada as well as for the United States and other trading partners. Chart 5: The Bank has developed a new measure of Canada's effective exchange rate Exports are projected to benefit from stronger global demand The Bank of Canada is not, of course, at the negotiating table. But the outcomes, when they materialize, could have important implications for the Canadian economy, which we would need to consider in the conduct of monetary policy. For example, lower potential would mean that the expansion of the economy generates inflationary pressures sooner, and so policy would have to respond to that. Given the complexity of the effects of material changes, and the fact that they would likely affect both actual and potential economic growth, we cannot adjust monetary policy in anticipation of these risks. But we will be watching these developments, and their implications for Canadian exports and business investment, very closely. As an open economy, Canada's fortunes will continue to rise or fall with trade, as they have throughout our history. Global economic forces--the sharp movement of commodity prices; the Great Recession and the lacklustre global economy in its aftermath; and, for much of the past decade, a strong Canadian dollar-- battered many of our export industries and splintered their supply chains. Rebuilding them requires the emergence of brand-new industries and the development of new linkages to international trade networks. While it will take time for many of these adjustments to play out, we are now seeing encouraging signs that exports and business investment are broadening and strengthening. At the Bank of Canada, we have made a lot of progress in understanding the changing nature of world trade and especially why it has taken so long for our exports to recover. But as the dynamics of trade continue to evolve with technology and other forces, we will closely monitor and analyze these developments. This is essential, given the importance of trade to the economic well-being of Canadians.

r170927a_BOC

canada

The Meaning of “Data Dependence”: An Economic Progress Report

poloz

I would like to thank Russell Barnett and David Amirault Governor of the Bank of Canada I am always happy to be here in St. John's, a unique corner of our country. Given the city's geography, its history and rich culture, those of you who get to call St. John's home are fortunate, indeed. The idea of "home" is a preoccupation for us at the Bank of Canada. We have been working since the global recession almost a decade ago to bring the Canadian economy home. What I want to do today is give you a sense of how far the economy has come and how much further it has to go, and talk about some signs to watch for along the way. The goal of our monetary policy is to keep inflation low, stable and predictable. Under the terms of the agreement between the Bank and the federal government, we aim for an annual rate of consumer price inflation of 2 per cent. Of course, unforeseen events can always push inflation up or down. So, our agreement sets out a target band of 1 to 3 per cent. What do I mean by "home"? For us, home is at the intersection of full capacity and 2 per cent inflation. We expect that when the economy reaches full capacity, inflation will converge on the 2 per cent midpoint of the target band. That is why we are so preoccupied with the idea of home. Our adjustments to interest rates affect economic activity, which affects the gap between the level of output and full capacity, which in turn affects inflation. However, there is an important consideration that sometimes gets lost: this process takes time. Any change in interest rates will not have its full impact on inflation for about a year and a half to two years. So, when we make our monetary policy decisions, we are less concerned about the latest inflation numbers--which are already a month old--than we are about where inflation will be in the future. That brings us to the question of how to forecast future inflation. The place to start is with economic models. Models are indispensable for developing forecasts of inflation and the rest of the economy. However, no central banker would ever base a monetary policy decision solely on a projection from an economic model. Models provide us with a coherent starting point, but we need to apply real-world judgment before reaching a policy decision. A lot of this judgment comes from conversations with people. Earlier this year, spoke about how the Bank gleans intelligence from financial markets. Equally important are efforts to gauge business sentiment--sometimes called "soft data"--and to gather intelligence about the real economy from business leaders. We need to understand the view from both Main Street and Bay Street to help inform our outlook for growth and inflation. This is where our regional offices, staffed by people who routinely visit companies across the country, play a vital role. One of the most important vehicles for these efforts is our anniversary this year. The informal process for these visits began when I was at the Bank in the early 1990s. In fact, the first time I visited St. John's was to do some of those consultations. Through our surveys and conversations with business leaders, we regularly get clues about economic trends before they show up in the official economic statistics. Let me illustrate. The roughly 50 per cent drop in oil prices during 2014 represented a cut of roughly $60 billion per year in export revenue for oil producers. Some of the impacts of this cut were immediately obvious and predictable. We knew oil-intensive regions would be hurt by the drop in income and that oil companies would reduce their spending. Certainly, the people of this city and province are aware of the pain caused by the oil price shock. However, the BOS taken late in 2014, together with additional discussions we had with energy companies, revealed warning signs that went well beyond the decline in business investment. For example, companies in this region told us that they were being flooded by resumes of workers returning from Alberta. Service firms, such as hotel and trucking companies, told us about bookings being suddenly cancelled. Energy-service companies told us that previously signed contracts for construction and exploration work were being renegotiated, or even terminated. So, well before the shock started to show up in the statistics, we could see that it would have a significant negative effect on the Canadian economy and the outlook for inflation. This was crucial to our decision to lower interest rates in January 2015. And, as companies cut their investment intentions further, we lowered interest rates again the following July. To be clear, our economic models correctly predicted that the collapse in oil prices would be a serious blow. Specifically, our main policy model gave us invaluable insights into how the shock would affect the economy and how the subsequent adjustments would unfold. But the fact that everything we were hearing was supporting these insights increased our confidence that cutting rates was the right course of action. Obviously, the drop in oil prices was a significant detour for the Canadian economy. We knew that the shock would trigger a complex series of adjustments and create significant hardship for many people. Basically, our models projected that the economy would go through the reverse of its experience in 2010-14, when high oil prices led to strong increases in business investment and national income. Provinces where the energy sector is relatively more important, such as Newfoundland and Labrador, would feel these effects most acutely. This underscores one of the fundamental challenges for policy-makers, that economic shocks can have very different effects across Canada's regions. In terms of adjustments, we anticipated that lower oil prices would mean not only a decline in the energy sector, but also a pickup in growth in the non-energy sector. We expected exports to be boosted by a lower Canadian dollar. And, as exporting companies reached their capacity limits, we expected to see business investment increase. Stronger exports and investment would complement household spending, and growth would become more broadly-based and selfsustaining. Certainly, adjustment in the energy sector has been painful. Beyond cuts to investment spending, oil companies restructured operations and laid off workers. Employment in the resource sector fell by roughly 50,000 jobs from the beginning of 2015 to the middle of last year. Despite this, companies boosted production and exports of crude oil as earlier investments were completed and as they found greater efficiencies. And, since oil is priced in US dollars, the decline of the Canadian dollar also helped cushion the impact of the shock. The increased output and weaker currency helped to offset almost half of the $60 billion decline in revenue from oil shipments, boosting exports by about $25 billion. That said, Canada's other exports took longer to recover than we anticipated. Exporting companies had taken a significant hit both during and after the global financial crisis. Many disappeared, to be replaced over time by new firms exporting new goods and services. As a consequence, the composition of Canada's exports has also changed since the crisis. Exports of services in categories such as technical, travel, financial and management services, have taken the lead, while some traditional goods, such as motor vehicles and parts, have seen their shares decline. By mid-2016, non-energy exports had fully recouped their previous drop, and today, total exports are almost 10 per cent above their pre-crisis peak. Monetary policy has played a key role in this adjustment. We estimate that if we had not lowered our policy rate in 2015, the economy would be roughly 2 per cent smaller today--a difference of almost $50 billion--and there would be about 120,000 fewer jobs. Government fiscal stimulus measures also contributed importantly to growth, and this has meant a better mix of monetary and fiscal policy. Without this fiscal stimulus, interest rates would have had to have been even lower than they were. All things being equal, this would have meant even more household debt and an increased longer-term vulnerability for the economy. As we look ahead, we project that business investment will be a key driver of economic growth. Business investment has also been slower to materialize than we expected, but it has been strong across the board over the first half of this year. Further, in our most recent BOS, our regional staff found that companies were more focused on expanding capacity than they were previously. Indeed, businesses across an increasing range of sectors say they expect sales growth to improve further, and hiring intentions have reached a record high. Given all this evidence, we could see by the beginning of summer that the economy's adjustments to lower oil prices were essentially complete. To be clear, the impact of the shock was still visible in energy-intensive areas of the country. But this was being offset at the macro level by greater strength in other areas. So, in July, and again earlier this month, we raised our key policy interest rate. Between those two rate hikes we saw a long string of stronger-than-expected economic data, culminating in the GDP report at the end of August that showed an annual growth rate in the second quarter of 4.5 per cent. As we noted in our most recent interest rate announcement, this pace is unlikely to be sustained, and recent data point clearly to a moderation in the second half of the year. Still, the expansion is becoming more broadly-based and self-sustaining, and it is important to remember that it is the level of output relative to potential that drives inflation, not the growth rate. We are in the process of developing an updated forecast for growth and inflation, and it will be published in next month's Despite the recent news about economic growth, the story of inflation in Canada over the past few years has been dominated by downside risks. Indeed, for most of the past five years, inflation has been in the bottom half of the target band. Bearing in mind the long lags between economic activity and inflation, much of this low inflation has been due to slow economic growth in the past. More recently, it has also reflected temporary factors such as weakness in food and electricity prices. In fact, inflation has been surprisingly soft recently in much of the developed world, not just Canada. I will have more to say about this in a few minutes. Since inflation has been so consistently in the lower half of the target band, our risk-management approach to monetary policy led us to pay greater attention to forces pushing inflation down. This is because when inflation is already low, a negative shock to the outlook for inflation has more significant policy consequences than a surprise on the upside. Throughout, we wanted to be sure our policy would be sufficiently stimulative to get the economy home. As the expansion continues, we will continue to manage the evolving risks to the inflation outlook. The temporary factors that have been holding inflation down should dissipate in the months ahead, although recent exchange rate developments could affect this timing. In our July projection, we forecast that inflation would reach close to 2 per cent by the middle of next year. Since that projection, the Bank's measures of core inflation have edged higher, as expected. We expect the downward pressure on inflation to shift to upward pressure as economic slack is used up. Indeed, our models forecast a very slight overshoot of our 2 per cent target in 2019--a product of our model's dynamics. The appropriate path for interest rates in this situation is very difficult to know, because there are a number of important unknowns around the inflation outlook. These unknowns are unusual, as they are mostly the product of the unusual nature of the situation we find ourselves in--the legacy of the global financial crisis, the protracted period of slow economic growth and extremely low interest rates, and so on. Accordingly, we need to keep updating our understanding of the economy in real time. That is why we say that the outlook for inflation, and therefore monetary policy, is particularly data dependent right now. What does it mean, in practical terms, to say that monetary policy is "data dependent"? After all, central banks always depend on data to measure their economy's progress relative to expectations. What I mean in this context is that in a period of heightened uncertainty about how the economy is evolving and the implications for inflation, we need to pay very close attention to all the information we receive, including data, sentiment indicators and intelligence, and make continuous inferences about not just how the economy is evolving, but how its behaviour may be changing. Let me give you four examples of the issues we will be monitoring. The first, and most important, is the evolution of economic capacity . I said that our version of "home" is at the intersection of full capacity and 2 per cent inflation. But full capacity can be a moving target. This is because when companies increase investment, they augment their capacity to produce through some combination of raising their productivity and increasing their workforce. This is a welcome development because, as the economy approaches full capacity, investment spending can have the effect of pushing out those capacity limits, giving the economy more room to grow in a non-inflationary way. In short, this is something worth encouraging. To some extent, this happens at this point in every economic cycle, but the protracted cycle we have been through makes this issue particularly relevant this time around. A second issue is the question of inflation and technology . Some economists have cited technology as contributing to the weakness in global inflation. The digital economy may be allowing goods and services to be produced and delivered more efficiently, helping to keep prices down. We may also be seeing stronger competition through e-commerce, which affects how retailers set prices. It is worth emphasizing that this type of disinflation increases everybody's purchasing power and therefore is also a positive development. The Bank would want to estimate the impact of technological developments on trend inflation and, assuming the impact was temporary, see through it, provided that inflation expectations remained well anchored. There is a lot more work to be done to understand both the size and persistence of these effects. A third issue is wage growth , which has been slower than would be expected in an economy that is approaching full output. Hourly wages increased at an annual pace of 1.7 per cent in the second quarter, and growth has been subdued for months, although there were signs of an increase in the latest monthly employment report. The slow growth is likely due in part to employment shifting from higher-paying jobs in the oil sector to lower-paying jobs elsewhere. How long this effect will continue is not clear, and other phenomena may be at work. Again, we must work hard to understand the data, and the underlying shifts in behaviour they may be pointing to. The fourth issue is elevated household debt . There is reason to think that interest rate increases may have more of an impact on the economy and inflation than they did in the past. Further, we do not yet know the full extent of the economy's reaction to various macroprudential measures aimed at imbalances in the housing market. So, the Bank will be looking closely to see how the economy's adjustment to changes in interest rates may differ from that in previous economic cycles. This is not an exhaustive list. There are also many external risks and uncertainties around our outlook, including geopolitical developments and the rise of protectionist sentiment in some parts of the world. The evolution of the neutral rate of interest is also a topic of significant debate in the profession. We have been talking about these uncertainties for some time. In such an environment, we simply cannot rely mechanically on economic models. This does not mean we are abandoning our models. It does mean we need to use them with plenty of judgment, informed by data, sentiment indicators and intelligence, as we go through the delicate process of bringing inflation sustainably to target. We will continue to watch all the data closely, as well as developments in financial markets, in terms of their impact on the outlook for inflation. We recognize that the economy may act differently than in previous cycles. We will not be mechanical in our approach to monetary policy. Let me quickly make one final point. Among the financial market developments that we watch closely are movements in longer-term interest rates and the exchange rate. Changes in interest rates naturally lead to movements in the Canadian dollar. However, currencies can move for many other reasons, including external factors, and these movements can affect our inflation outlook, depending on their cause, size and persistence. It is time to conclude. I hope I have given you an appreciation of just how far the economy has come on its way home. And although we are confident that the economy has made significant progress, we cannot be certain of exactly how far there is left to go. The economic progress we have seen tells us that the moves we took to ease policy in 2015 were the right thing to do. At a minimum, that additional stimulus is no longer needed. But there is no predetermined path for interest rates from here. Monetary policy will be particularly data dependent in these circumstances and, as always, we could still be surprised in either direction. We will continue to feel our way cautiously as we get closer to home, fostering economic growth and keeping our inflation target front and centre.

r171003a_BOC

canada

Seeking Gazelles in Polar Bear Country

leduc

You are probably all familiar with the inventor of the snowmobile, he merits a place in our history books just as much as Maurice Richard and You may be less familiar with Montrealer Arthur Sicard, who also had an idea that had a profound impact on the Quebec and Canadian economies. Born in 1876, Sicard spent his childhood working on the family farm. He was often prevented from delivering milk in the winter because of the snow blocking the roads. Observing combine harvesters at work in the fields in summer gave him an idea for a snowblower. Sicard's invention was launched in 1925, and the City of Outremont bought the first model two years later. The snowblower not only improved the lives of city dwellers by making car travel easier in winter, it also had a major and unexpected impact on Canadian economic activity, facilitating winter road transport between Montreal, New York and Toronto. When we think of innovation, we think of people like Sicard and Bombardier, who start from scratch, invent new products or processes, and create companies that soon become drivers of the economy. These innovators help increase our productivity. In recent decades, advanced economies have experienced a sharp decline in productivity growth. This trend is worrisome because, in the long run, productivity growth determines the evolution of our standard of living. To give you an idea of how much it matters, last year Canadians would have earned an additional $13,000 if our productivity had increased at the same pace as seen in the late And since productivity determines the level at which the economy can operate without creating inflationary pressures, understanding its evolution in an inflationtargeting regime like ours is vital to us at the Bank of Canada. Economists who are studying this trend are naturally asking whether there are fewer innovators like Bombardier and Sicard today than in the past. They are also trying to explain why productivity is weak in all advanced economies. To answer this question, we have to look beyond the usual macroeconomic indicators and examine the innovation process at the firm level. Today, I would like to highlight some of the major trends in firm behaviour that have given rise to vigorous debate among economists. First, I will describe how the data point to declining dynamism in the Canadian economy. I will then offer some possible explanations for this trend and will review how dynamism and other factors affect economic growth. I will conclude by briefly discussing the implications for monetary policy and achieving our inflation target. Let's start with a simple intuition: in a dynamic economy, innovative companies are expected to emerge and replace companies with older business models. Think of Sicard, whose invention clearly brought huge long-term benefits but also led to job losses, especially the jobs of workers who cleared roads using horsedrawn snowplows. As such, a strong and dynamic economy should be driven, in part, by the entry of new firms and the exit of less-viable firms. This renewal involves a needed reallocation of labour toward growing industries. This dynamic process of innovation was called "creative destruction" by the economist Data collected by Statistics Canada show that there has been a surprising and sustained decline in the entry rate of new firms since the early 1980s. Relative to total active firms, the entry rate of new firms was 24 per cent in 1984. It has decreased by half since then, which is a considerable drop ( exit rate has also declined--but by less--from almost 17 per cent in 1984 to about 11 per cent, according to the most recent data. The decline in entry and exit rates is also reflected in the weaker rate of labour reallocation. For the past 10 years, new firms have created fewer jobs than before. Simply put, the data seem to point to a loss of dynamism in the Canadian economy. This decline in dynamism is especially striking because it is broad-based. It can be seen in almost all industries and across the country, showing up, for example, in rates of entrepreneurship ( ). This trend has also appeared in most OECD countries. Chart 1: Aggregate entry and exit rates of new firms have been declining The main concern about a loss of dynamism is that it will lead to less innovation and diminishing long-term growth. The estimated potential growth rate of the economy is about 1.5 per cent, adjusted for inflation. Compared with previous decades, when potential output sometimes rose to more than 3 per cent per year, this is a significant drop. And this is the context in which the loss of dynamism must be considered. To better understand the possible effects of a loss of dynamism, we need to understand its causes--a more difficult task than it sounds. Some leads are more promising than others. The fact that we see this loss of dynamism not only in Canada but also in most OECD countries suggests that its causes are not unique to Canada and that there may be common factors. A first factor to consider is population aging. The younger you are, the more likely you are to become an entrepreneur and start your own company. The appetite for risk is perhaps more intense when you have less to lose and the expected benefits are spread out over a greater number of years. However, our data show that the rate of entrepreneurship has dropped for all age groups. Indeed, we even see that the decrease in entrepreneurship is greater among people aged So population aging can explain only part of the decline in entrepreneurial activity. On the other hand, this decline may be because emerging entrepreneurs face greater opportunity costs than before; that is, the shortfall in income they would suffer if they quit their job to launch their company is now higher. In fact, since the 1980s, the most significant decrease in entrepreneurship rates that we've seen has been among those whose wages have increased the most; namely, university graduates. New technologies, which often benefit those with more technical skills, have likely contributed to this trend. In many cases, these new technologies also generate significant economies of scale and network effects that lead to greater industrial concentration, in turn leading to a loss of economic dynamism. On the one hand, the expectation of positive benefits is what encourages business innovation. On the other hand, if the largest companies constantly increase their share of the market, it is increasingly difficult to compete with them. In fact, industrial concentration figures are quite astonishing. In the United States, industrial concentration since the early 1970s has increased in 75 per cent of its industry sectors. There are now fewer US firms listed on the stock exchange than there were 40 years ago, while US GDP is three times higher. In line with this trend, markups in several industries have been steadily increasing over the past three decades. Here in Canada, the rate of industrial concentration is historically high. Estimates from economists at Innovation, Science and Economic Development Canada tell us that the median concentration of Canadian industries in the early 2000s was about 75 per cent higher than in the The economies of scale and network effects in several sectors put new firms that produce at higher costs at a disadvantage. You must be very optimistic and have a great deal of confidence in your business model to launch a retail business these days, when giants like Walmart and Amazon are making life difficult for established companies. For example, with its diverse network of producers, Walmart can change its source of supply to minimize operating costs a lot more easily than a newly launched company can. However, the effects of concentration and declining entry rates on innovation and productivity are not unequivocal. Many large companies use leading-edge technology and are pushing boundaries as never before--such as the firms developing self-driving cars. Today, large companies know that they must continually invent new products or services to stay one step ahead of their competitors. A good example of this is Apple, with the introduction of its iPhone in 2007 and the different versions the company has introduced since then. Competition is therefore essential to innovation and can certainly come from established companies. But the possibility of new companies revolutionizing an industry encourages established firms to innovate. Viewed in this light, the loss of dynamism could be symptomatic of a decline in innovation and long-term productivity, paradoxically during a period when technological advances seem to be increasing exponentially. Indeed, this question may warrant further investigation so that we better understand which new firms are most likely to contribute to growth. Statistics show that the shelf-life of new companies ranges between two extremes. About half of firms close their doors within five years of their creation. But younger companies that do make a name for themselves tend to grow very rapidly. It is this propensity to grow by leaps and bounds that inspired the term These young, transformative companies that are growing at dizzying speeds have a good chance of developing new technologies that increase productivity. However, the impact of innovation on productivity is difficult to assess. Breakthroughs in robotics, artificial intelligence or financial technologies are phenomenal, but are still not reflected in our productivity measures at the national level ( ). And the impact of an innovation is very uncertain, which is why many new companies go bankrupt after only a few years. Predicting whether an innovative company will revolutionize markets is just as risky as guessing if a first-round choice in the hockey draft will become a new superstar goalie like Carey Price. Most of the time, you get another very ordinary player. Nevertheless, among OECD countries, firm productivity is operating at two speeds. Firms at the cutting-edge of technology--big guns such as Google and Tesla--are three to four times more productive than other companies. the declining dynamism we are seeing, this gap is not being reversed by the exit of less-productive firms, which probably feel less need to adopt cutting-edge technology. These firms therefore contribute to reducing national productivity. In this context, encouraging the adoption of new technologies is essential. Given that about a quarter of productivity growth is driven by innovations from new firms, gazelles play an essential role, particularly in the high-tech sector. So it's worrying that the share of gazelles in the Canadian economy has declined markedly since 1997 ( ). Surprisingly, we see this decline in the information and technology sector. Chart 4: The rates of entry of both new firms and gazelles have declined That said, the entry and exit rates of new firms also follow the business cycle, and the Canadian economy has performed a lot better than expected over the past five quarters. For example, productivity has increased significantly since mid-2016, especially in the goods sector. It is also encouraging to note that the most recent data show that the rate of entry for new firms appears to have stabilized over the past few quarters ( The economy's growth rate is expected to decline over the next few quarters, but it should still exceed that of potential output. We therefore expect an increase in entry rates and a decline in business exits over the coming quarters. the contribution of new firms to increasing the productive capacity of the economy could give rise to a virtuous circle of growth. For the Bank, understanding how the productive capacity of the economy evolves is crucial. Indeed, our monetary policy is based on the fact that the rate of inflation tends to stabilize near our target of 2 per cent when the economy is running at capacity. When the economy operates at a level higher than potential output, inflation tends to accelerate and, conversely, decelerates when the economy operates below its potential output. An increase in productive capacity resulting from new firm creation would therefore allow the economy to grow faster without creating inflationary pressures. In concrete terms, higher potential output would lead to a long-term improvement in the standard of living of Chart 5: The rate of entry for new firms may have finally stabilized In recent quarters, Canada's economic growth has been strong, exceeding that of all the other G7 economies. The sharp depreciation of the Canadian dollar following the drop in oil prices may have contributed to the growth of gazelles by facilitating access to external markets and increasing the benefits of greater economies of scale. What I find encouraging is that, despite the decline in dynamism, the sectoral adjustment required as a result of the fall in oil prices happened within the anticipated time frame. This episode shows that the Canadian economy is still flexible enough to absorb a major shock. That said, significant challenges remain, as our productivity is still well below that observed south of the border. Productivity growth could certainly be increased by reducing the barriers that future gazelles may face, which would further stimulate the Canadian economy. A report from the World Bank notes that Canada is one of the easiest countries in which to start a business. On the other hand, it is nevertheless more difficult for businesses to grow beyond a certain point, possibly because of the size of our markets. The free trade agreement with Europe is an encouraging example, because it can help our gazelles grow. Here in Canada, the agreement signed earlier this year on reducing barriers to interprovincial trade is also a good sign, although several areas are still excluded. In addition, new gazelles are likely to have more difficulty financing intangible investments, which they increasingly need, than tangible investments, which, unlike the former, may be offered as collateral. I would be remiss if I did not mention a Sherbrooke initiative that is addressing these challenges. I'm talking about Sherbrooke Innopole, an organization dedicated to accelerating business development in five new areas. In collaboration with the city, Innopole three years ago founded Espace-inc, a business incubator whose results have exceeded initial expectations. So far, it has helped launch 24 companies. Similar initiatives are under way elsewhere in Canada. We hope they will be successful and that they will help entrepreneurs of the calibre of Sicard and Bombardier to emerge. In the meantime, the best contribution the Bank of Canada can make in this regard is to promote economic stability by keeping inflation at 2 per cent, thereby facilitating investment decisions.

r171025a_BOC

canada

Monetary Policy Report Press Conference Opening Statement

poloz

Governor of the Bank of Canada Press conference following the release of the Good morning. Senior Deputy Governor Wilkins and I are pleased to be here to answer your questions about today's interest rate announcement and our As you know, Governing Council decided to raise interest rates at each of its July and September meetings, in the context of stronger-than-expected economic growth and a very strong labour market. Furthermore, over the course of the summer, we saw a firming of inflation indicators and a rapidly closing output gap. As we predicted in July, the economy is showing signs of moderating in the second half of the year. Nevertheless, we expect the economy to continue to grow at an above-potential pace. Today, we left our policy rate unchanged at 1 per cent. We regard this level as appropriate in light of our updated projection for the economy and inflation--in particular, we expect inflation to reach our 2 per cent target in the second half of 2018. This is a little later than we projected in July, primarily because the Canadian dollar has strengthened in 2017. Before taking your questions, let me offer a few comments around Governing Council's deliberations. Governing Council agreed that the economy is likely to require less monetary stimulus over time, but we will be cautious in making future adjustments to our policy rate. Four key issues are adding uncertainty to the projection. These are the same four issues that I highlighted in my recent speech in St. John's, and they played an important role in our deliberations for today's decision. Discussion of these issues features strongly in today's MPR. The first issue on which Governing Council spent considerable time is around inflation itself. In this MPR, we investigate a number of conjectures around the apparent softness of inflation in several advanced economies. I refer you to Box 1 of the MPR. These conjectures include a role for technology, specifically digitalization, which may be putting downward pressure on inflation; a role for imported disinflation from lower-cost countries; or more generally, a role for the forces of globalization. Suffice to say that for the Canadian data, this work has generally confirmed our faith in our model of inflation, in which inflation depends mainly on the degree of excess demand or excess supply in the economy, and this process operates with a lag. In short, we believe that we understand how Canada's inflation rate has been evolving. If we have been surprised in the past, it has been either because of sector-specific shocks, or because economic growth was slower than expected and there was more excess capacity than we previously believed. Indeed, the second issue that preoccupied Governing Council was the degree of excess capacity in the economy. The economic growth we experienced in the first half of the year has been sufficient to bring the level of production close to our estimates of capacity. Let me reiterate, inflation has always been and remains a question of supply and demand. Therefore, one might expect continued above-potential economic growth--which we are forecasting for the next few quarters--to cause inflation to rise over time. However, the economy builds new capacity every day, through new companies and through investment and increased employment. We note that there is still some excess capacity in the labour market: there are people who are working part time who would prefer full-time work, there is still below-trend participation in work by youth, and hours worked are lower than we would expect. Accordingly, what we expect to see-- and what occurs at this stage of virtually every economic cycle--is capacityaugmenting investment and the creation of new jobs at existing firms or at new firms, along with rising productivity. All of this could mean higher potential output than we have built into our projection. Because this process is highly uncertain as to timing and size, we build it into our projection conservatively. But the bottom line is that the economy could be capable of generating more non-inflationary growth than we are assuming. The third issue is the continued softness in wage growth in the context of an unemployment rate that is now about the same as it was prior to the global financial crisis. While employment growth has certainly been strong, wage increases have not kept pace. This softness is due in part to the excess capacity in the labour market that I just mentioned, and the link between excess demand and higher wages also operates with a lag. But it is also possible that other factors, including globalization, may be affecting wage dynamics. The fourth issue that preoccupied Governing Council was elevated household debt and how that might affect the economy's response to higher interest rates. We have enhanced our main macroeconomic model used for projections to capture relevant details around housing and debt, and we have re-estimated all of our model's parameters using advanced methods. You can find details in the appendix in the MPR. We do find that the economy is likely to respond more to higher interest rates at today's debt levels than historically. Even so, we have to allow for the possibility that these improved estimates fall short of the mark. Furthermore, we have to watch how the household sector reacts to the new rules around mortgage underwriting. It will take time to understand the impact of these changes as well as the economy's sensitivity to higher interest rates. Governing Council expects that incoming data and new research will shed more light on these four issues as we move forward. There is also a range of other risks that we outline in the MPR, which, taken together, give us a balanced outlook for inflation. As well, there is uncertainty surrounding the possibility of a significant shift toward more-protectionist trade policies in the United States, which we have chosen not to incorporate in our projection. Given our recent history with inflation running below target, we continue to be more preoccupied with the downside risks to inflation. The bottom line is that Governing Council will be cautious in considering future interest rate adjustments and will be guided by incoming data to assess the sensitivity of the economy to interest rates, the evolution of economic capacity, and the dynamics of both wage growth and inflation. With that, Senior Deputy Governor Wilkins and I will be happy to take your questions.

r171031a_BOC

canada

Opening Statement before the House of Commons Standing Committee on Finance

poloz

Governor of the Bank of Canada Governor Wilkins and I are happy to be before you today to discuss the Bank's (MPR), which we published last week. When we were last here in April, we were celebrating the fact that we had upgraded our economic forecast following a long period of disappointment. I am happy to tell you that many of the positive trends that we saw then have continued. Sources of economic growth have broadened across sectors and regions, and the process of adjustment to the oil price shock is essentially complete. The Bank raised its policy interest rate twice since our last visit, in July and September. We did this in the context of very strong economic growth over the first half of the year and solid progress in the labour market. Over the summer, we saw evidence of firming inflation and an economy that was rapidly closing its output gap. With these two rate increases, we have taken back the cuts we made in 2015, which were crucial in helping the economy adjust to the oil shock. Growth in the first half of the year averaged just over 4 per cent at an annual rate. This reflected strong consumer spending backed by rising employment and income, together with increased business investment and a jump in energy exports. We are now starting to see signs of moderation in the second half, which we forecast in July. Growth in consumption and investment is expected to ease, and growth in housing is projected to slow further, in part because of the measures introduced by the Ontario government in April. All told, we forecast that the economy will expand by 3.1 per cent this year, before slowing to 2.1 per cent in 2018. This is still faster than the growth rate of potential. We estimate that the economy is now operating close to its capacity. Inflation should reach our 2 per cent target in the second half of next year, a little later than earlier projected because of the temporary impact of the stronger Canadian dollar this year. We are at a crucial spot in the economic cycle, and significant uncertainties are clouding the way forward. In our MPR, we identified the four most important sources of uncertainty. I will touch on these now. The first issue is inflation itself. There have been several conjectures about the apparent softness of inflation in Canada and many other advanced economies. Some have argued that globalization is restraining inflation. This could be due to increased imports from lower-cost countries, for example, or the effect of Canadian companies participating in global supply chains. Others point to the impact of digitalization on the economy. They suggest that digital technologies could lower barriers to entry in some sectors and lead to more competition. The rise of e-commerce may be changing price-setting behaviour. And digital technologies could promote innovation and higher productivity, which could create disinflationary pressure. The second issue is the degree of excess capacity in the economy. We note several signs that point to slack remaining in the labour market. For example, the participation rate of young workers is still below trend, and average hours worked are less than we would expect. With the economy now operating close to capacity, we expect to see investment by companies, together with job creation by new and existing firms, and rising productivity. This should serve to raise the economy's potential output, increasing the amount of non-inflationary growth that is possible. However, this process is highly uncertain and not at all mechanical, so we have built it into our projection in a conservative way. The third issue is the continued softness in wage growth. While employment growth has been strong in Canada, wages have not kept pace. The slack in the labour market is certainly responsible, in part, for this effect, and there will be a lag between the time this slack is used up and when we see stronger wage growth. However, other factors, including globalization, may also be affecting wage dynamics. Finally, the fourth issue is the elevated level of household debt and how that might affect the sensitivity of the economy to higher interest rates. Bank staff have recalibrated our main economic model used for projections to capture key information about housing and debt. This work tells us that the economy is likely to respond to higher interest rates more than it did in the past. However, we will watch incoming economic data closely for evidence to support this idea. We will also look to see how the household sector is responding to the new rules about mortgage underwriting. We also outline several other risks in the MPR. Taken together, these give us a balanced outlook for inflation. We have not incorporated into our projection the risk of a significant shift toward more-protectionist trade policies in the United States, given the range of potential outcomes and the uncertainty about timing. However, we acknowledge that uncertainty about future US trade policy is having some impact on business confidence and investment spending, and this impact is reflected in our outlook. In this context, Governing Council judged that the current stance of monetary policy is appropriate. We agreed that the economy is likely to require less monetary stimulus over time, but we will be cautious in making future adjustments to our policy rate. In particular, the Bank will be guided by incoming data to assess the sensitivity of the economy to interest rates, the evolution of economic capacity, and the dynamics of both wage growth and inflation. to answer questions.

r171101a_BOC

canada

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

poloz

Governor of the Bank of Canada Governor Wilkins and I are pleased to be back before you today to discuss the (MPR), which we published last week. When we were last here in April, we were celebrating the fact that we had upgraded our economic forecast following a long period of disappointment. I am happy to tell you that many of the positive trends that we saw then have continued. Sources of economic growth have broadened across sectors and regions, and the process of adjustment to the oil price shock is essentially complete. The Bank raised its policy interest rate twice since our last visit, in July and September. We did this in the context of very strong economic growth over the first half of the year and solid progress in the labour market. Over the summer, we saw evidence of firming inflation and an economy that was rapidly closing its output gap. With these two rate increases, we have taken back the cuts we made in 2015, which were crucial in helping the economy adjust to the oil shock. Growth in the first half of the year averaged just over 4 per cent at an annual rate. This reflected strong consumer spending backed by rising employment and income, together with increased business investment and a jump in energy exports. We are now starting to see signs of moderation in the second half, which we forecast in July. Growth in consumption and investment is expected to ease, and growth in housing is projected to slow further, in part because of the measures introduced by the Ontario government in April. All told, we forecast that the economy will expand by 3.1 per cent this year, before slowing to 2.1 per cent in 2018. This is still faster than the growth rate of potential. We estimate that the economy is now operating close to its capacity. Inflation should reach our 2 per cent target in the second half of next year, a little later than earlier projected because of the temporary impact of the stronger Canadian dollar this year. We are at a crucial spot in the economic cycle, and significant uncertainties are clouding the way forward. In our MPR, we identified the four most important sources of uncertainty. I will touch on these now. The first issue is inflation itself. There have been several conjectures about the apparent softness of inflation in Canada and many other advanced economies. Some have argued that globalization is restraining inflation. This could be due to increased imports from lower-cost countries, for example, or the effect of Canadian companies participating in global supply chains. Others point to the impact of digitalization on the economy. They suggest that digital technologies could lower barriers to entry in some sectors and lead to more competition. The rise of e-commerce may be changing price-setting behaviour. And digital technologies could promote innovation and higher productivity, which could create disinflationary pressure. The second issue is the degree of excess capacity in the economy. We note several signs that point to slack remaining in the labour market. For example, the participation rate of young workers is still below trend, and average hours worked are less than we would expect. With the economy now operating close to capacity, we expect to see investment by companies, together with job creation by new and existing firms, and rising productivity. This should serve to raise the economy's potential output, increasing the amount of non-inflationary growth that is possible. However, this process is highly uncertain and not at all mechanical, so we have built it into our projection in a conservative way. The third issue is the continued softness in wage growth. While employment growth has been strong in Canada, wages have not kept pace. The slack in the labour market is certainly responsible, in part, for this effect, and there will be a lag between the time this slack is used up and when we see stronger wage growth. However, other factors, including globalization, may also be affecting wage dynamics. Finally, the fourth issue is the elevated level of household debt and how that might affect the sensitivity of the economy to higher interest rates. Bank staff have recalibrated our main economic model used for projections to capture key information about housing and debt. This work tells us that the economy is likely to respond to higher interest rates more than it did in the past. However, we will watch incoming economic data closely for evidence to support this idea. We will also look to see how the household sector is responding to the new rules about mortgage underwriting. We also outline several other risks in the MPR. Taken together, these give us a balanced outlook for inflation. We have not incorporated into our projection the risk of a significant shift toward more-protectionist trade policies in the United States, given the range of potential outcomes and the uncertainty about timing. However, we acknowledge that uncertainty about future US trade policy is having some impact on business confidence and investment spending, and this impact is reflected in our outlook. In this context, Governing Council judged that the current stance of monetary policy is appropriate. We agreed that the economy is likely to require less monetary stimulus over time, but we will be cautious in making future adjustments to our policy rate. In particular, the Bank will be guided by incoming data to assess the sensitivity of the economy to interest rates, the evolution of economic capacity, and the dynamics of both wage growth and inflation. to answer questions.

r171107a_BOC

canada

Understanding Inflation: Getting Back to Basics

poloz

I would like to thank Patrick Sabourin and Louis Morel for Governor of the Bank of Canada Inflation targets have been the centrepiece of monetary policy in Canada for over 25 years now. Every Canadian has benefited. The high and volatile inflation and interest rates of the 1970s and 1980s are a distant, though painful, memory. Recently, however, inflation targeting has come under increased scrutiny. Many advanced economies have seen inflation either slow down or remain weak, even while economic growth has been strengthening. This has led some to question whether central banks can still target inflation effectively. Some have even suggested that central banks may be losing the ability to understand the processes that drive inflation. I hope to persuade you today that this is not the case. I've been at this for a long time, having been part of the team that developed the Bank of Canada's policy framework back in the 1980s. Inflation targeting, supported by a flexible exchange rate, is the product of an enormous cumulation of thought and research spanning an entire generation. In my speech today, I intend to show that the Bank has a solid understanding of the inflation process and retains the ability to guide inflation to our targets over time. I will start with a quick review of the fundamentals. We implement monetary policy through our key policy interest rate. Changes to this rate influence other interest rates, such as mortgage rates. Through this channel and others, policy rate changes affect decisions about spending, saving and investment. These adjustments work through the economy and eventually have an effect on inflation. Importantly, it takes one and a half to two years for a change in our policy rate to have its full impact on inflation. The goal of our policy is to keep the annual rate of CPI inflation at the 2 per cent midpoint of a 1 to 3 per cent range. The idea of a target range has been a key feature of our framework from the beginning. It serves to recognize that inflation targeting is an imprecise business. First, the transmission from monetary policy to inflation contains several economic linkages, each of which is complex and highly uncertain. Second, the inflation data themselves are subject to short-term fluctuations that make it difficult to hit the target exactly. A central bank can do little about fluctuations in gasoline prices, for example, yet these transitory movements have a large influence on inflation movements from month to month. Given these uncertainties, it is not realistic to expect our policy instrument to control inflation down to tenths of a percentage point. In fact, the two-percentagepoint inflation-control range is a reasonable approximation of the degree of precision that we can expect to achieve. It is much like piloting a boat in rough water: the boat is buffeted in one direction or the other, and the pilot must continuously adjust the heading so that the fluctuations average to zero in order to arrive at the desired destination. To help steer through these short-term fluctuations in inflation, we make use of various measures of core inflation. These measures help us judge the underlying trend of inflation--the rate we would see if no sector-specific or one-off factors were at work. Put another way, these measures help us separate inflation's signal from its noise. The underlying trend in inflation is driven by the laws of supply and demand, which are as applicable today as they ever were. Excess demand pushes inflation up; excess supply pushes inflation down. Central banks exploit this relationship, working to create excess demand or excess supply in the economy, to target the inflation rate. A central role in this relationship between the economy and inflation is played by inflation expectations. The more anchored those expectations are, the more quickly the economy will find its way back to normal after an economic shock. This is known as the credibility dividend: a credible central bank will see inflation expectations well anchored at the target level and will have a relatively easy time restoring normality after a shock. What this means is that the underlying trend in inflation may become more stable as expectations become more anchored. In short, the more successful the inflation target is, the less obvious the relationship between economic shocks and inflation will become. But that does not mean that the relationship is no longer there. The relationship between inflation and excess demand or supply really represents a summary of a number of more complex underlying linkages between companies and the labour market. Consider a company that finds itself running at full capacity. If it sees increased demand for its product and expects that demand to persist, the company is likely to invest in new capacity and expand its workforce. If unemployment is already low, the company may have to increase wages to attract new employees. Over time, higher wages can add to inflationary pressure. This is how excess demand works its way through the system and translates into higher inflation. In addition to these domestic drivers of inflation, a couple of key external factors can also play a role. For example, exchange rate movements can have both direct and indirect impacts. If the value of the Canadian dollar falls, that directly raises the price Canadians pay for imports. Inflation may tick up immediately, albeit temporarily. At the same time, the lower dollar can boost export sales, and this impact on demand may work its way through ultimately to the inflation rate. The same analysis holds for movements in global commodity prices--they affect inflation directly right away, albeit temporarily, but can also have a more gradual impact via adjustments in the economy. When oil prices plunged in late 2014, we saw both types of shock hitting the Canadian economy simultaneously. To sum up, in the absence of shocks coming from external factors, we can expect the trend of inflation to be sustainably around the midpoint of the target range when the economy is operating at full capacity and inflation expectations are well anchored on the target. That is why I have said that "home" for the economy is at the intersection of full capacity and 2 per cent inflation. As I said at the outset, inflation in a number of advanced economies has been running short of expectations recently. Consider a prime example, the United States. There, the Federal Reserve looks at core personal consumption expenditure (PCE)--an index of prices consumers pay for goods and services that is adjusted to remove the volatility caused by food and energy prices. Core PCE had climbed close to the Fed's 2 per cent target around the end of 2016, following a prolonged period of weakness. However, it has slipped by 0.6 percentage points since the beginning of this year and now sits at 1.3 per cent on a year-over-year basis--all while economic growth has been steady and unemployment very low. While this may raise doubts about our ability to explain the trend in inflation, when you dig a bit deeper you discover that there have been some special factors affecting US inflation. In particular, as mobile phone carriers began offering more unlimited-data plans, there was a significant drop in the cost of data. Staff at the Bank of Canada estimate that special factors such as these account for roughly two-thirds of the decline in US core inflation since the start of this year. The impact on inflation of these relative price changes should not persist--in other words, the underlying trend in US inflation is higher than it appears. In many other advanced economies, core inflation was soft throughout 2016, even as excess supply was being absorbed. And unlike in the United States, this softness has come mainly from goods prices. Bank staff have identified exchange rate movements and low export prices in emerging-market trading partners as factors acting as a drag on core inflation in these economies. Here in Canada, total inflation slowed over the first half of this year and has stayed in the lower half of the target range, even as our output gap has been closing rapidly. Both total and core inflation have firmed in the past couple of months. Still, since the middle of last year, an average shortfall in inflation of 0.7 percentage points has been unexplained by fundamental drivers. The factors behind this weakness include below-average food inflation, caused by a combination of abundant crop supplies and increased competition in the retail sector. Another special factor is the impact of the Ontario government's reduction in electricity prices. Like the United States, these one-off factors account for roughly two-thirds of this year's shortfall in total inflation in Canada. The bottom line is that the fundamental drivers of inflation, along with some special factors we can identify, can explain the recent behaviour of inflation reasonably well. Certainly, the remaining shortfall is well within a reasonable margin of error, given that we are working with statistical relationships. Furthermore, the underlying trend in inflation is well within the target range we have committed to. In short, we understand inflation well enough for policy purposes. Nevertheless, like all central banks, we would prefer to understand inflation perfectly and are not content to leave even a few tenths of a percentage point unexplained. We are working hard on this, and this research agenda is what I turn to now. Bank staff have examined 20 years' worth of inflation data from 10 advanced economies and the euro area. They used statistical techniques to look for inflation factors that these countries might have in common. The first factor they found in common is fluctuations in food and energy prices across countries--as it turns out, these can explain almost half of the movements in total inflation. This makes sense, as food and energy prices are driven by global commodity prices. But we generally look through movements in food and energy prices when we are assessing the underlying trend of inflation. So, this common factor does not add much to our understanding. Looking beyond commodity prices, Bank staff found evidence of a second factor common to all countries that can explain around 15 per cent of the remaining variation in core inflation. As it turns out, this factor is correlated with the recent softness in inflation shared by a number of countries, including Canada. While we do not yet know exactly what is driving it, several ideas have been advanced. Generally, these are related to either globalization or the digital economy. Let me review some of these ideas. Globalization could affect prices in a few ways. An obvious one is linked to the movement over the years toward more open trade. When companies are exposed to increased competition in global markets, they face pressure to cut costs and hold down prices. Similarly, consumers have access to a greater supply of imports from lower-cost, emerging-market producers, also dampening inflation. This impact became particularly important for manufactured goods early in the 2000s, after China joined the World Trade Organization, and it could still be at work. A related idea is that global economic slack is becoming more important for domestic inflation, and domestic slack less so. Since the global economy has become more integrated, excess global supply might hold down inflation, particularly of some goods, regardless of the supply-demand balance in any individual economy. Companies need to worry about competition from other countries, not just local competitors, when deciding whether to raise prices. The integration of companies in global value chains could also dampen inflation. Since various production stages can be moved to where costs are lowest, companies and their workers face additional competitive pressure to keep down prices and wages. The digital economy Another set of factors that may be acting as a drag on inflation is related to digitalization of the economy. This could affect inflation in at least three ways. First, there is the direct impact of price changes for information and communications technology (ICT). Given how computer and home electronics prices have plunged over the years, it seems intuitive that lower ICT prices could push down inflation. Second, digitalization has an impact on competition and market structure. In many sectors, digitalization has lowered barriers for the creation of new firms and increased competition. We have seen the disruptions caused by companies such as Uber and Airbnb. There is also the impact of e-commerce--the so-called Amazon effect--which can certainly affect how firms set prices. Think of how easy it is to check a competitor's price on your phone while you are in a store, considering a purchase. Third, digitalization can make business processes more efficient, improving productivity and leading to slower price increases. Indeed, productivity has increased more quickly than wages over the past year, roughly coinciding with the weaker inflation that we have seen. However, Bank staff have yet to find rigorous empirical evidence to show that these factors add to our understanding of Canadian inflation beyond what the basic drivers tell us. To be clear, all I am saying is that the evidence does not pass the formal test for statistical significance. Common sense tells you that globalization and digitalization are affecting prices. Over time, as we accumulate data, we may be more able to identify and statistically quantify these effects. That said, it seems that, so far at least, the cumulative impact of digitalization is not large enough to challenge our basic understanding of inflation dynamics. The Amazon effect appears to be smaller than the impact of the rise of big box stores about 20 years ago--the so-called "Walmart effect"--and even that was not large enough to force a rethink of the inflation process for policy purposes. So, if we cannot prove statistically that globalization and digitalization are restraining inflation, what else could be going on? Let us take a deeper look at the linkage I mentioned between unemployment and wages, which economists refer to as the Wage Phillips Curve. The fact is, despite strong economic growth and plenty of job creation, wage growth has remained relatively low. Possible explanations for this are not that hard to find. Even though Canada's unemployment rate has returned to its 2007 lows, suggesting the labour market is at full employment, other indicators suggest that a fair amount of slack remains. In particular, youth participation rates still seem low, and a lot of people are still working part-time when they would prefer full-time. As well, we know that many workers who lost high-paying jobs during the oil price collapse in 2014-15 may be moving to employment in other, lower-paying sectors. Similarly, younger workers may have lower wages than the retiring older workers that they are replacing. And certainly, the perception that companies or workers are facing increased foreign competition could lead to slower wage increases. The fact that wage growth has been slower among goods industries than services--which can be more easily insulated from globalization--supports this idea. Another conjecture I will offer, which is difficult to test empirically, is that prolonged very low interest rates have lowered the relative cost of capital equipment compared with the cost of labour. Firms may be restructuring their operations, making greater use of capital equipment and thereby limiting the scope for wage increases. Some can do this without even buying equipment, instead buying capital services in the cloud. Even the threat of increased automation may be sufficient to keep wage rises in check. This conjecture is worth exploring in more depth. Given all these potential factors that may be holding back wage inflation, it is simply premature to conclude that there is something amiss in the traditional inflation process. At a minimum, we need to monitor measures of slack in the labour market to see how it is being absorbed. Over time, this can be expected to lead to a pickup in wage growth, which in turn will feed its way through to inflation. In short, we believe that there is still a link between labour market slack and wages, just as there is still a link between inflation and the balance of total supply and demand. What this means is that the closer we get to full output and employment, the greater the risk that inflation pressures will appear. This is just one of the many risks that the Bank will need to manage as we conduct monetary policy. As we said last month, while the economy is likely to require less monetary stimulus over time, we will be cautious in making future adjustments to our policy rate. In particular, the Bank will be guided by incoming data to assess the evolution of economic capacity, the dynamics of both wage growth and inflation, and the sensitivity of the economy to higher interest rates. A lot of pieces need to fall into place before we can be certain that the economy has made it all the way home. Allow me to conclude. The popular perception that inflation has become inexplicable has been greatly exaggerated. In part, this perception reflects a misunderstanding of the accuracy with which economists can predict inflation, and a misunderstanding of the precision with which central banks can control it. Fundamentally, we know how inflation works--the laws of supply and demand have not been repealed. Yes, Canada's inflation rate has repeatedly fallen short of our 2 per cent target in the past few years. For the most part, this may be explained by the drag related to the surprising persistence of excess capacity in the economy, and the fact that inflation reacts to excess demand after a lag. This drag can persist until all slack in the labour market is absorbed as firms build additional capacity through higher investment with the economy approaching potential. Beyond these factors, there have been repeated relative price fluctuations--in electricity prices and from increased competition in food retailing, for example--which have temporary effects on inflation and should be looked through. Moreover, there may also be some drag on inflation from globalization and digitalization. When we put it all together, we see that inflation has been behaving well within the normal zone of statistical and policy tolerance. I am not claiming that our understanding of inflation is perfect, complete and unchanging. Far from it. We will continue to look closely at forces such as globalization and digitalization so that we can better understand how they are influencing the inflation process. There are always uncertainties in economics. That is why forecasts are best thought of as ranges, rather than points, and why our inflation-control framework is based on a target band. The bottom line is that inflation targeting has worked, through good times and bad, for more than 25 years. It continues to work today. And Canadians can be confident that it will continue to work for years to come.

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canada

Embracing Uncertainty in the Conduct of Monetary Policy

wilkins

Uncertainty is top of mind for many people. This is the case whether it is related to the future of trade agreements, job security--as economies become more automated--or threats from geopolitical tensions in many parts of the world. Actually, economic news in several advanced economies has recently been surprising people on the upside. At the same time, many feel like the world is becoming more and more uncertain. Canada is no exception. For central bankers like me, there is nothing particularly new in this, even though the sources of concern are changing over time. This is evident to those who remember the oil price shock in the 1970s or Black Monday in the 1980s, among other turbulent events. Our job has always been to steer the right course for monetary policy in the face of uncertainty. Today, as some central banks contemplate shifting gears, it will be critical to understand how uncertainty is factored into monetary policy decisions if you want to understand and anticipate policy actions. In my remarks this evening, I will dig into this set of issues in the context of Bank University, is dedicated to fostering discussion of relevant policy issues. So, it is the perfect place to do this, and I would like to thank you for the invitation. I will structure my remarks around three observations that are explored in a discussion paper I worked on with my colleagues Rhys Mendes and Stephen Put simply, the three observations are the following: 1) Uncertainty is a fact of life. 2) Monetary policy can become asymmetric when uncertainty is embraced. 3) Uncertainty is not a reason for paralysis in decision making. It is no surprise that our work uncovered areas where further research is most needed to improve the framework for dealing with uncertainty. I will get to that as well. So, let us start with my first observation. Uncertainty has always been a fact of life for everyone. And, like many businesses and households, central banks have established techniques to reduce, where possible, the level of uncertainty they experience. The Bank has devoted considerable effort to reducing uncertainty by being clear about the objectives of monetary policy and the framework for achieving those objectives. The inflation-control agreement with the Canadian federal government has been in place for the past quarter of a century. It provides a clear objective for monetary policy and operational independence for the Bank. We also invest continuously in state-of-the-art forecasting models. For example, we recently updated one of our main projection models to include a richer role for indebted households in the transmission of monetary policy--a timely innovation, given that household debt has increased notably in Canada in recent years. use competing models to inform our deliberations when possible. This is like getting your investment advice from more than one broker. We are also exploiting multiple sources of information, such as surveys of businesses, to improve our reading of the economy. It would be fabulous if these efforts could eliminate uncertainty altogether, but the real world is not so obliging. The reality is that researchers are aiming at a moving target, given ongoing structural change in the economy, such as the aging of the population. And there is also the possibility of the truly unexpected, such as natural disasters. That means a considerable degree of uncertainty is irreducible at any given time. In the current context, the Bank is particularly focused on data that indicate how wages and potential output are progressing, as well as the effects of the two interest rate increases we made over the summer. And we are following trade negotiations closely. So how does the Bank deal with this irreducible uncertainty in practice? Like many other central banks, we use projection models that capture key economic relationships to produce a forecast. This forecast includes the monetary policy actions likely to be needed to bring inflation back to our 2 per cent target over the projection horizon. The necessary policy actions are generated by what we call a simple "monetary policy rule." This policy rule captures the Bank's average historical behaviour and does not change with the level or sources of uncertainty. Because of that, it is as if uncertainty has been set aside. This is closely related to "certainty equivalence" in the monetary policy literature, which is akin to aiming for the bull's eye, even though you know there are winds that may move your arrow in some unknown direction. While this is a useful starting point, it is insufficient. In fact, there is a rich economic literature that shows why this framework applies only in a limited set of circumstances that do not look very much like the real world. The market participants here will know first-hand how much volatility can affect investment behaviour, even when expected returns are unaffected. And some investors, to avoid tail risks on the downside, may decide to forgo higher expected returns. Quantifying how best to respond to uncertainty requires knowledge of the type and degree of uncertainty. It is manageable in some cases, but it is a tall order in others. In practice, we are faced with uncertainty about the retreat from globalization and threats to peacetime relationships. We are also faced with uncertainty of a more positive nature, like the promise of digitalization for productivity growth and structural reform in emerging economies. And, we are faced with scenarios in which even the range of outcomes is unknown. In these cases, statistical estimates based on the past are obviously of little help. The current uncertainty around the future of the North American Free Trade Agreement (NAFTA) and related policies is a case in point. We have incorporated an estimate of the effects of uncertainty on business investment and exports to better balance the risks. At the same time, we have assumed no change to trade agreements in the base case. And, aside from the estimated uncertainty effects, we have not factored possible changes in trade relations into our current stance of monetary policy either. Instead, we are following developments very closely. We have mapped out the main channels of transmission of a rise in protectionism. And we are sharpening our modelling tools so that we can incorporate any concrete developments into the projection, should they occur. This approach is consistent with how we've treated uncertainty surrounding other trade agreements in the past, such as the CanadaEuropean Union Comprehensive Economic and Trade Agreement (CETA) and So, in practice, central banks start with a formal framework that is consistent with certainty equivalence. We then apply judgment to account for the main sources of uncertainty considered to be missing from the framework. This leads me to my second observation. Monetary policy can become asymmetric when uncertainty is taken seriously in policy design. This can lead policy-makers to deviate substantially from the simple world of certainty equivalence. It is here that our understanding can greatly benefit from cross-checking our logic with the economic literature on how to conduct monetary policy under uncertainty. To illustrate, let me discuss two situations that are particularly relevant in the current context--the first leads to more-aggressive policy actions and the second leads to what is often referred to by central banks as "caution" or When uncertainty can motivate aggressive policy action The first situation is best illustrated by considering how to conduct monetary policy when interest rates are close to the effective lower bound (ELB). We all likely remember when central banks, including the Bank of Canada, reduced interest rates aggressively when financial markets seized up in 2008. Knowing what we know today--that the biggest global recession since the Great Depression was about to begin--these policy actions seem self-evident. I can tell you, they were less evident in real time. When we compare our policy actions with what would have been prescribed based on our past behaviour, we can see that the response was exceptional. The Bank eased monetary policy significantly more than usual, by as much as 2 percentage points more at one stage. This increased aggressiveness is a textbook example of optimal policy when there is the possibility of being constrained by the ELB. While this constraint is mitigated by the availability of unconventional monetary policy tools, it is not eliminated, because there is considerable uncertainty about their effectiveness. The Bank's actions 10 years ago reduced the chance that this constraint would bind by generating additional economic momentum going into the recession. So even though gross domestic product and inflation fell, they fell by less than they would have if the pace of cuts had been slower. As a result, the only unconventional tool the Bank needed to use at the time was communicating extraordinary forward guidance in the form of a conditional commitment to keep interest rates unchanged. A principle we can draw from this experience is that policy should respond more aggressively to negative shocks when rates are near the ELB than when they are far from it, all else being equal. Policy is also asymmetric in that it responds more aggressively to negative shocks than to positive shocks. And the reality is that we will be closer to the ELB more often than in the past because of a lower neutral rate of interest. Based on our assessment that the ELB in Canada is around -50 basis points, the probability of being at the ELB is around 8 per cent, approximately five times higher than it was 15 years ago. While this may be the optimal strategy, central banks could potentially achieve lower volatility of inflation and less buildup of financial vulnerabilities from credit if they were more confident about the effectiveness of unconventional policy tools. That is why it is so important that we refine the design of unconventional policy tools such as quantitative easing and deepen our understanding of the strength of their transmission to the real economy. When uncertainty leads to caution There are also times when uncertainty can lead to caution or patience. This is my second example. Just three weeks ago, the Bank decided to leave the policy rate unchanged. We said at the time that while less monetary policy stimulus will likely be required over time, Governing Council will be cautious in making future adjustments to the policy rate. One of the motivations for caution is that inflation has been in the lower end of the inflation target bands of 1 to 3 per cent for quite some time. To see why this might matter, it helps to recall why the inflation target bands were chosen in the first place. The 1 to 3 per cent range primarily reflects the recognition that there is a degree of imprecision associated with inflation targeting. While some normal fluctuations can be expected within the target range, central banks may become disproportionately concerned about the prospect that inflation might fall outside the range. This is referred to in the economic literature as a "kinked loss function." In plain language, it means that the central bank puts a greater weight on the downside risks when inflation is low to begin with. What is important to note about this line of reasoning is that it also applies to situations in which inflation is close to the upper part of the range. Even if inflation were closer to the middle of the range and the ELB was not a consideration, caution might still be in order. In Canada, one reason for caution is that there is currently greater uncertainty about the strength of the monetary policy transmission mechanism. While higher household debt has likely heightened the sensitivity of spending to interest rate increases, it is difficult at this juncture to know by how much. There is also uncertainty about the interaction of interest rate increases with the recent tightening of macroprudential rules. The logic behind caution in this case is often referred to as Brainard's principle of attenuation: policy should change less than it would if the central bank were more sure of the effect on spending. Another reason for caution--in this case more of a "wait-and-see" approach--is related to a desire to avoid having to reverse policy direction abruptly in the future. Since the adoption of fixed announcement dates in November 2000, the Bank of Canada has changed its policy interest rate 46 times, and only four of these were reversals within a six-month window. If you look at the behaviour of other central banks, it is very similar--so it is not much of a surprise that other central banks have also cited uncertainty as a rationale for waiting. For the business people in the room who have considered large capital expenditures, this reasoning must sound familiar. It can be useful to have the option value of waiting until you are more sure of the returns. This is particularly true if the investment is largely irreversible. As with investment, fixed costs of changing policy direction may explain a central bank's aversion to reversals and motivate a wait-and-see approach to policy. That said, it is unclear how costly policy reversals are for the real economy. It is possible that the perceived costs are self-reinforcing because reversals are so rare that they are viewed as policy errors when they do occur, rather than as a sensible reaction to new information. Now for my final point. Uncertainty is not a reason for paralysis in decision making. Whether it is about how aggressive or how cautious policy should be, getting the dosage right demands sound judgment about complex trade-offs. Just think about my last example about the wait-and-see approach. In central banking, there is no equivalent to the "late-mover advantage." But even for a business, delaying investment too long leaves it vulnerable to the competition. Checking the logic of this judgment through formal modelling exercises is good practice to inform our assessment of these trade-offs and to support decisions that stand the test of time. That is why research efforts at the Bank are focused on some key areas. In particular, we are working to better model the dynamics between the real and financial sides of the economy, particularly the triggers for financial instability. This continues to be a blind spot. Related to this is work to measure the effectiveness of macroprudential measures and unconventional monetary policy tools. There is also significant work under way studying inflation and wage dynamics, as Governor Stephen Poloz spoke about last week in Montreal. A longer-term objective relates to incorporating the effects of uncertainty that households and businesses face in their own decision making. These efforts will help improve base-case projections. We supplement these projections with model-based risk scenarios. For example, Bank staff recently published an alternative scenario in which the economy's potential output grows faster than projected. We are also focusing our efforts on designing policy rules that are more robust to the types of uncertainty we encounter every day. Strengthening the policy framework will support not only sound decision making, but also transparency. If you want to understand why policy actions were taken and what actions might be in store, you need to understand both the Bank's base-case projection and how the Bank has factored uncertainty into its policy decisions. We have numerous ways to explain these two elements. These range from discussion in the risk section of the Bank's quarterly (MPR) to the opening statement at the press conference that follows its release. We also have speeches like this one today. We have decided, starting next year, to advance the timing of speeches providing economic updates to align them more closely with the fixed announcement dates between MPRs. These speeches will be given by Governing Council members and will be followed by a question-and-answer session with media. Of course, no communications tool will be effective if we do not reach our audience. That is why we continue to advance our digital strategy to communicate in ways that match how people prefer to receive information these days. It is time to wrap up. Uncertainty is a fact of life for all of us. Central bankers have well-established methods to deal with uncertainty in the conduct of monetary policy. When uncertainty is taken seriously, it can lead to asymmetric monetary policy responses. I explained why policy may respond to negative shocks more aggressively than usual when near the effective lower bound on interest rates. I also explained why, during periods of uncertainty like today, a cautious approach may be prudent. Caution has its limits, because there are complex trade-offs involved, including those related to financial stability. The Bank of Canada is investing heavily in research that will help better quantify these trade-offs and the interaction with macroprudential policy measures. As we move forward, it will be critical that people like you and other central bank watchers stay engaged and share your own ideas on how to further strengthen the monetary policy framework under uncertainty.

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Release of the Financial System Review

poloz

Governor of the Bank of Canada Press conference following the release of the Good morning. Thank you for coming here to the Bank of Canada. Senior Deputy Governor Wilkins and I are happy to be with you to talk about the latest issue of the Bank's I will start with a reminder about the purpose of the FSR. In it, we identify key vulnerabilities in the financial system, which can interact with and magnify economic shocks. We monitor the evolution of these vulnerabilities, and we look at their potential implications for the financial system and economy if a significant shock were to occur. The most important vulnerabilities for the financial system remain the high level of household indebtedness and imbalances in housing markets. These vulnerabilities continue to be elevated and it will take a long time for them to return to more sustainable levels. A stronger economy and sound policies are working in the same direction to help bring about a gradual easing of these vulnerabilities, and this trend should continue. Let me give you some details. Since our last report in June, household debt has continued to rise more quickly than household income. Borrowing for mortgages and home equity lines of credit is driving this growth. Further, we see that households with the highest debt relative to their income are carrying a growing share of the total. That said, new and pending rules for housing finance should help mitigate this vulnerability. Last year, the government introduced stricter rules for high-ratio mortgages--that is, where the down payment is less than 20 per cent of the value of the home. These rules are continuing to improve the quality of new high-ratio mortgages. Fewer of these mortgages are being issued, particularly among highly indebted households. However, we have become increasingly concerned about low-ratio mortgages-- those where the down payment is more than 20 per cent of the value of the home. We are continuing to see an increase in new low-ratio mortgages that have riskier characteristics. More of these are being taken out by highly indebted households, and a growing share of borrowers is choosing an amortization period longer than 25 years. Last month, the Office of the Superintendent of Financial Institutions announced enhanced guidelines for low-ratio mortgages that are similar to the changes announced for mortgage insurance last autumn. There will be restrictions on borrowing from multiple sources to finance a purchase, and borrowers will have to show that they could handle higher interest rates. That is just good practice for anybody who is taking on new debt. While we can be confident that the new rules will help mitigate this vulnerability, their precise impact will depend on how both borrowers and lenders respond. We will be watching this closely when the guidelines come into effect next year. Another important development since June is the Bank's tightening of monetary policy through two interest-rate increases, which came in the context of improving economic fundamentals. The effect of these moves on mortgages is complex. Roughly 15 per cent of borrowers have floating-rate mortgages, and they felt the impact immediately. However, interest rates on fixed-rate mortgages only change when they are renewed, and about half of all mortgages will not reset for more than a year. Some of those that will reset next year could even see their interest rate decline, depending on their term. Improvements in the labour market, particularly stronger wage growth, should help households adjust to higher interest rates. But clearly, this is another area we will watch closely. The second vulnerability, imbalances in the housing market, has also been affected by recent changes in government policy. Price growth has slowed in the Greater Toronto Area after the Ontario government introduced policies aimed at housing affordability. This slowing pulled down national house price growth to an annual rate of 10 per cent. The Toronto-area market is following a pattern similar to what took place in the Greater Vancouver Area last year, where resales fell sharply and new listings rose after the B.C. government announced a tax on non-resident buying. It is worth noting that prices in the Vancouver area are once again growing more quickly than the national average. The Bank will continue to monitor housing market imbalances closely, particularly for signs of extrapolative expectations. Higher interest rates and stricter mortgage-finance rules should also help mitigate this vulnerability. However, the economic fundamentals of the Canadian housing market remain strong. Demand is being supported by increases in employment and population, and supply is being held back by basic geography and restrictions on land use. The third vulnerability I will quickly mention is related to cyber security. There has been a worldwide increase in the frequency, severity and sophistication of cyber attacks. Because our financial system is so interconnected, a successful attack on one institution can potentially lead to widespread disruptions. We are working with our partners in the banking industry and public sector to ensure the system is robust and that institutions can recover quickly should any disruptions occur. To better understand the potential implications of all these vulnerabilities, we examined the same risk scenarios as we did in June. The risks are essentially unchanged. However, the policy changes affecting housing finance are clearly a step in the right direction. Still, it will take time for these, as well as the effects of recent interest rate increases, to significantly reduce the vulnerabilities. Meanwhile, our financial system continues to be resilient and is supported by improving economic fundamentals, in particular, by strength in the labour market. With that, Senior Deputy Governor Wilkins and I are happy to respond to your questions.

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canada

Three Things Keeping Me Awake at Night

poloz

Governor of the Bank of Canada The holiday season is traditionally a time to reflect on the events of the past year, and to look ahead at what may be in store for next year. Speaking from an economic perspective, I think we can look back at 2017 with considerable satisfaction. And 2018 is looking positive, too. The Canadian economy is on pace for about 3 per cent growth in 2017, which would be the strongest among the Group of Seven economies. Most sectors and regions are now participating. Over 350,000 full-time jobs have been created so far this year, and wages have recently shown signs of picking up. This is supporting robust consumer spending. Exports and business investment have long been the laggards in our recovery story. Encouragingly, though, business investment has grown for the past three quarters in a row. As well, the government's infrastructure program is becoming increasingly evident in the data. In contrast, exports have not been stellar. They started the year strong, but faltered during the summer. Nevertheless, the most recent data show a broad-based upturn, supporting our forecast that--after looking through all the noise--exports will continue to be pulled along by rising foreign demand. That brings me to inflation, our policy anchor. Inflation spent the year within our 1 to 3 per cent target band, although it has tended to fall a little short of the 2 per cent midpoint. We did a lot of work this year to satisfy ourselves that our fundamental understanding of inflation remains valid. It does, once you take account of short-term effects in the data. I have talked before about the process of bringing the economy back home--at the intersection of full capacity and 2 per cent inflation. Our return home was made even longer by the detour we took when oil prices collapsed back in 2014. But, today, we find ourselves quite close to home, and getting closer, with the economy now running close to full output and inflation expected to be around 2 per cent later in 2018. That is all good. But as an economist, and as a central banker, I find myself preoccupied with a number of slower-moving, nagging issues that I expect will be with us for a long time. They keep me awake at night because I wonder if we have done all we can to address them. I have chosen three of these things to talk about today. These personal preoccupations are a little different from the more pressing, immediate risks to the economy that economists usually think about. I can assure you that the Bank is fully engaged on a wide range of such issues, from the effects of technology on inflation to uncertainty over the future of the North to mortgage rule changes, to cite just a few. I am not trying to spoil everyone's holiday cheer with my topic today. Rather, I have found over the years that issues that appear daunting often become less so when we understand them better. What is more, a better understanding of the issues helps everyone--from the various government authorities to the public at large--determine what should be done to resolve them. So, with that, let me share with you three things that are keeping me awake at night, and bring you up to date on developments surrounding them. The first issue I want to touch on is the potential for a cyber attack that leads to a major disruption of our financial system. People take for granted the efficiency and convenience of today's financial system, as they should. It was not all that long ago that your choices for making a retail purchase were a personal cheque, a credit card or cash--and cash was an option only if you remembered to get to your bank branch before it closed. Today, e-commerce is pervasive. People can have electronic access to their accounts instantly, almost anywhere. The infrastructure that underpins our financial system is a public good, every bit as important to the health of Canada's economy as our roads, bridges and airports. I am not exaggerating. Every day, Canada's major payments systems process millions of transactions, large and small, and billions of dollars change hands. These transactions happen so routinely and with such accuracy that it is easy to overlook how critical these systems are. The process looks completely risk-free, but it is not. And to be without these systems for any length of time could have a significant impact on the economy. Our financial system is as good as it is today because of major advances in communications and financial technology, and a high degree of connectivity between institutions. However, this connectivity also creates a vulnerability. It means that a problem in one institution may spread to others and be amplified. As such, a successful cyber attack on one institution can become a successful attack on many. These attacks can be launched from anywhere and spread across global networks. The good news is that all the major participants in the financial system are taking this threat very seriously. They are collaborating with each other by sharing information and best practices. As for the key payments systems that connect everyone together, the Bank of Canada has the legislative authority to oversee them and to ensure that they follow strong risk-management practices, including those aimed at preventing cyber attacks. We are also collaborating with partners in the federal government who are working to ensure that Canada is resilient to cyber threats. However, we cannot assume that our financial system is immune, despite bestin-class cyber defences. We need to be prepared to recover our systems should a cyber attack succeed. The Bank is working closely with our financial institutions and payments systems to ensure that we have robust joint recovery plans in place. Further, the Bank is making significant investments in its own operational redundancies, increasing the resilience of our systems and our people. It is vital that we be able to "fail over" quickly so our key functions will be maintained in the event of a major disruption, be it a cyber attack, natural disaster or some other crisis. This is a matter not just of operational continuity, but of maintaining confidence in our financial system in stressed situations. The bottom line is that I am confident that we are doing everything we can on this issue. Still, the system may be only as robust as its weakest link, and that keeps me thinking. My second preoccupation is the state of Canada's housing markets and the associated level of household debt. The Bank said in last month's that these vulnerabilities are showing early signs of prospective easing, which is good. However, these vulnerabilities are elevated, and are likely to remain so for a long time. Remember, it took years for these vulnerabilities to build up in the first place. It is not just the amount of debt; it is also its composition and distribution. More than 80 per cent of household debt is composed of mortgages and home equity lines of credit (HELOCs). Increasingly, mortgages are being combined with HELOCs, to the point where about 40 per cent of all housing-backed loans are blended with a HELOC component. HELOCs have been a very convenient tool for many households. They give borrowers flexibility to finance renovation projects or handle emergencies--such as when your furnace dies on a cold February night. Their popularity shows how useful these lending arrangements are. However, there are some potential risks that borrowers need to manage. HELOCs usually allow the borrower to pay only the interest on the loan each month, leaving the principal amount unchanged. Indeed, about 40 per cent of HELOC borrowers are not regularly paying down their principal, which means that debt loads may persist longer than in the past. Furthermore, some may be using their HELOC to speculate--for example, to fund a down payment on a second house with the intention of flipping it. Given the potential for volatility in house prices and for higher interest rates, such activity may be adding to the overall vulnerability of the system. We have seen several rounds of macroprudential measures to tighten mortgage finance rules. These include measures last year that were aimed at high-ratio mortgages--those where the down payment is less than 20 per cent of the value of the home. Since then, there has been a sharp drop in the number of highly indebted Canadians obtaining these mortgages--and by highly-indebted we have in mind people with a ratio of debt to income that is more than 450 per cent. But we have also seen an increase in low-ratio mortgages with risky characteristics, such as extended amortization periods. New lending guidelines for low-ratio mortgages, which will come into effect next year, should work to limit the number of low-ratio mortgages going to highly indebted households. These mortgage rule changes will help build up the resilience of the financial system over time, as each new mortgage will be stress-tested to ensure that the borrower can manage a higher interest rate at renewal time. It is important to remember that the purpose of these rule changes is not to control house prices. Ultimately, the laws of supply and demand will determine the direction of house prices. At the same time, there is little doubt that these rule changes will mean less growth in our housing sector. In the wake of the global financial crisis, ultra-low interest rates have helped our economies weather the storm, but an important by-product has been exceptional growth in housing. For some time now we have been expecting a rotation away from housing and toward other engines of growth, such as exports and investment. We are seeing signs of that fundamental rotation now. A key issue for the Bank, then, is understanding how people will react when they are told that, under the new rules, they do not qualify for the mortgage they would like. Staff examined data from new mortgages issued last year by federally regulated lenders. They found that about 10 per cent of low-ratio mortgages-- around 36,000 loans, representing about $15 billion worth of borrowing--would not have qualified last year under the new stress test. Of course, there is more than one way for people to respond. The most likely response is for people to look for a less-expensive house with a smaller mortgage so they qualify under the new rules. Others might try to boost their down payment, or delay the purchase until they can do so. But people might also look for a lender that is not bound by these new mortgage rules so they can avoid facing the stress test. No doubt, certain non-federally regulated lenders will step up to compete for that business, although other regulators may choose to impose the same guidelines. In any event, to those people who hope to avoid the rules, I offer this advice: testing yourself to make sure you could handle your mortgage payments if interest rates were higher at renewal is a very good idea, whether it is a rule or not. One final issue related to indebtedness--we expect that high levels of debt will make the economy as a whole more sensitive to higher interest rates today than in the past. This issue has obvious implications for monetary policy, so we have done a lot of work this year to enhance our models to capture it. As we said in our October and in our interest rate announcement last week, this is one of the key issues we will be monitoring in real time as we consider the appropriate path for interest rates. My third long-term preoccupation is the state of our labour market; specifically, how hard it has been for so many young people to find work. I mentioned earlier that more than 350,000 full-time jobs had been created this year. However, only about 50,000 of those have gone to young workers. A decade ago, the proportion of people aged 15 to 24 participating in the workforce peaked at almost 68 per cent. That figure hit a trough earlier this year at nearly five percentage points lower--the lowest in almost 20 years. If we could return the youth participation rate to its level before the global financial crisis, more than 100,000 additional young Canadians would have jobs. Of course, this is not only a problem for youth. We know of people in all age groups who are working part-time when they would prefer a full-time job. We also know people who cannot find jobs that match their skill set and are underemployed. And we know there are people who have lost the job they held for years when their factory closed, and have faced extreme difficulty in finding new work in a similar field. These are all serious concerns. But I want to concentrate on young people, for whom a long period of unemployment can leave a scar that could last a lifetime. I know there are legitimate explanations for why more young Canadians are staying out of the labour force. Enrolment in post-secondary schooling has increased in recent years, and we expect some of this rise will be permanent. Some of these youth are looking to gain the skills that will match what employers are demanding. There are more than 250,000 job vacancies in the economy today, the highest on record. Canadian business leaders say that most of these vacancies are unfilled because they cannot find workers with the right skills. Let me suggest that responsibility for addressing this skill mismatch rests with all of us, not just the students and the education system. There surely is room for more ambitious on-the-job training programs in this picture. This issue is taking on greater urgency because the economy is reaching the stage where more-efficient job matching and increased workforce engagement will be our main means of building economic capacity. With more economic capacity comes the opportunity for more non-inflationary growth and a permanently higher level of Canadian GDP, and more income for everyone. Clearly, that is something worth having. Let me elaborate. Right now, we are at a point in the economic cycle that I think of as the "sweet spot." We know that a majority of Canadian companies are running flat out. They may have been hesitating to invest in new capacity until now, perhaps because of lingering economic uncertainty, or concerns over the future of NAFTA, for example. But, despite these uncertainties, companies are moving to expand their capacity now, which augurs well for the future. Most expansions of capacity have two elements--more capital equipment, and more people. Attracting the right people to new jobs may require higher wages, and this in turn can cause people to re-enter the workforce. We may be seeing early signs of this happening. I mentioned earlier that measures of wages have turned higher over the past couple of months and, in November, the participation rate for young people jumped back to more than 64 per cent. These are encouraging signs, but it will take awhile before they become trends. The Bank is watching these indicators very carefully at the moment, for they will help us manage the risks that monetary policy faces at this point in the business cycle. Our current policy setting clearly remains quite stimulative. With the economy operating near potential, a mechanical approach to policy would suggest that monetary policy should already be less stimulative. However, as we said in last week's interest rate announcement, we still see signs of ongoing, albeit diminishing, slack in the labour market. Fundamentally, this is an exercise in risk management. The facts that the economy is operating near its capacity, and that growth is forecast to continue to run above potential, together pose an upside risk to our inflation forecast. At the same time, our belief that there remains some slack in the labour market poses a downside risk to our inflation forecast. Given the unusual factors at play, the Bank is monitoring these risks in real time--the term we use for this is "data dependent"--rather than taking a mechanical approach to policy setting. So there we have it, three preoccupations that are keeping me awake at night. I could give you even more, but these are my top three, and you do not have all afternoon. Actually, there is one more thing keeping me awake at night, which perhaps I should mention, and that is all the noise I keep hearing about cryptocurrencies, especially Bitcoin. There is a lot of hype around Bitcoin, and markets are evolving quickly to allow wider access, including to retail investors. So perhaps you will allow me to make a couple of points. To begin with basics, the term "cryptocurrency" is a misnomer--"crypto," yes, but "currency," no. For something to be considered a currency, it must act as a reliable store of value, and you should be able to spend it easily. These instruments possess neither of these characteristics, so they do not constitute So, what are cryptocurrencies, exactly? Characteristics vary widely but, generally speaking, they can be thought of as securities. The Canada Revenue Agency agrees. That means, if you buy and sell them at a profit, you have income that needs to be reported for tax purposes. What their true value is may be anyone's guess--perhaps the most one can say is that buying these things means buying risk, which makes it closer to gambling than investing. To be absolutely clear, I am not giving investment advice. I never do. All I will say to people intending to buy a so-called cryptocurrency is that you should read the fine print and make sure you know what you are getting into. The Bank of Canada does not regulate these instruments and their markets, just as we do not regulate traditional securities and their markets. But one question that does preoccupy me is, what does the arrival of cryptocurrencies mean for the cash in your pocket? Supplying the Canadian dollars you need to carry out your business is one of the Bank's most important mandates. It is often forgotten that the cash provided by a central bank is the only truly riskfree means of payment. With cash, buyers and sellers can be certain that payment is final. This is an absolutely vital public good, which has always been provided by the central bank. All other payment types, from debit cards to credit cards to cheques, work through intermediaries in the financial system. Yes, of course, they are safe. But, fundamentally, they can never be quite as risk-free as cash. Just ask yourself--if you were concerned that an imminent cyber attack was about to hit the financial system, would you not want to carry some extra cash until everything was back to normal? Nonetheless, it is natural that transactions using electronic payments, such as debit and credit cards, continue to grow in volume and value relative to cash. It is certainly possible that the demand for digital cash could grow over time. If so, there could be very strong arguments for the central bank to provide it, given its obligation to fulfill the public good function. Bank staff are exploring the circumstances under which it might be appropriate for the central bank to issue its own digital currency for retail transactions. All central banks are researching this. We will have more to say about the subject in the months ahead. Now I am ready to conclude. Cyber threats, elevated household debt, youth underemployment--these are all long-term issues that will continue to be major preoccupations for myself personally, and for the Bank of Canada. I hope I have not spoiled your festive, pre-holiday mood by talking about my preoccupations. In case I have, let me repeat that the economy has made tremendous progress over the past year, and it is close to reaching its full potential. We are very encouraged by this, and we are growing increasingly confident that the economy will need less monetary stimulus over time. Nevertheless, a number of uncertainties remain around our outlook, many of in an important speech last month, it is critical that we take these uncertainties on board in our policy-making. So, allow me to repeat what we said in our interest rate announcement last week: We will continue to be cautious in our upcoming policy decisions, guided by incoming data in assessing the economy's sensitivity to interest rates, the evolution of economic capacity, and the dynamics of both wage growth and inflation. By sharing my preoccupations with you today, I hope that I have also raised your understanding of them, so that they appear somewhat less daunting. The Bank will continue to work on these issues while doing our part to help bring about a strong and stable economy. This has been the Bank of Canada's role since our beginning. And it will remain our role for years to come. Let me wish you all the best for the holidays, and for a prosperous 2018.

r180117a_BOC

canada

Monetary Policy Report Press Conference Opening Statement

wilkins

Press conference following the release of the Good morning. Governor Poloz and I are pleased to be here to answer your questions about today's interest rate announcement and our The Canadian economy is operating close to its potential level of activity, and inflation is close to the 2 per cent target. In this context, Governing Council decided to raise the policy interest rate by one quarter of a percentage point to The data we have received since October have been generally stronger than expected. Growth around the world continues to strengthen and broaden, supporting the expansion here at home. We have upgraded the outlook for the US economy due to greater momentum and the new tax legislation passed late last year. In Canada, economic growth is expected to average around 2 1/2 per cent in the short term, before slowing to a more sustainable pace over the projection horizon. This outlook remains clouded by uncertainty related to the future of the In coming to our decision, there were three issues that Governing Council spent a lot of time discussing. Let me walk you through them. The first issue was related to how much slack remains in the economy, and how that will evolve. Obviously, this is always an important question for an inflationtargeting central bank, but it is particularly so at this point in the economic cycle. Back in October, we said there were still signs of slack in the labour market. We also said that, even though we judged the economy was operating close to capacity, there was the possibility that more capacity would be created over time through business investment and an increase in labour market engagement. The data we have seen suggest that labour market slack has indeed been narrowing, and somewhat more quickly than we had been expecting. The national unemployment rate has fallen to historic lows, average hours worked are recovering and our points to signs of more intense labour shortages . That said, wage pressures remain modest. This could indicate that some capacity remains in the labour market. It could also indicate that wages have become less sensitive to pressure in the labour market, given the impact of global competition. Either way, wages do not appear to be a source of inflation pressure at this point. We published a staff analytical note today about wages, and will continue to monitor this issue. In terms of new capacity creation, we have also seen positive signs. Business investment has continued to grow, our shows that intentions remain positive, and historical data revisions imply that capacity is greater than we previously thought. New companies are typically a key source of capacity growth, and while it is still too early to determine the trend, recent data on firm creation have been encouraging. We will update our views on the economy's potential in the April MPR. The second issue was how the evolution of capacity pressures will affect the outlook for inflation. As the Governor noted in a speech last November, a number of economists and policy-makers have been struggling to explain weaker-thanexpected inflation in many jurisdictions. This has not been the case here in Canada, where core inflation measures have been increasing and behaving largely as we would have expected. Inflation was actually a bit stronger than we projected in October, rising to just above our 2 per cent target near the end of last year. This was due to the temporary impact of higher energy prices. We expect a bit of a dip in inflation in the near term, largely because of the base-year effects of gasoline prices. The big picture is that we project inflation to fluctuate relatively close to target throughout the projection horizon. That said, there is still the risk of a drag on inflation coming from global trends, such as digitalization in the economy. This will continue to be something that we watch closely. The final key issue we discussed is how best to account for the uncertainty surrounding the renegotiation of NAFTA in our policy decisions. Where trade policy decisions have already been taken, such as in the case of softwood lumber, we have built in their expected effects. In addition, while the results from the were positive, an increasing number of firms told us that uncertainty surrounding the outcome of the talks is weighing on their investment decisions and, to a lesser extent, trade. Because of this, we added some more negative judgement to our profile for both business investment and exports. Consistent with this approach, our outlook is based on the premise that current trade agreements will remain in place over the projection horizon. There are still a wide range of possible outcomes, which could play out over many different timelines. We do not know how the talks will conclude, and we do not know how governments will react to whatever outcome is reached. This means that trying to quantify any particular scenario would not be useful at this point for monetary policy purposes. However, Bank staff have been working to determine the channels through which our economy could be affected by changes to trade policy. It is a subtle exercise. Economic theory tells us that there can be both upward and downward pressure on inflation. That is because changes to trade policy can work through multiple channels that affect both demand and supply in the economy over time. Such changes can also affect asset prices and the exchange rate. Whatever the outcome, we will be ready to assess the impact as it unfolds, and adjust monetary policy in a timely way, if required. Taking all of these issues into account, Governing Council judges that while the economic outlook is expected to warrant higher interest rates over time, some continued monetary policy accommodation will likely be needed to keep the economy operating close to potential and inflation on target. Continued stimulus is likely to be required for a time to take into account a number of factors. These include the effects of uncertainty related to trade negotiations, the expected effects of recent adjustments to mortgage lending policies, and the greater sensitivity of the economy to interest rates given high household indebtedness. In this context, raising the policy rate too quickly would risk stalling the expansion, and cause inflation to fall back below target. At the same time, raising the policy rate too slowly would risk a buildup of inflation pressures. Governing Council will therefore remain cautious in considering future policy adjustments, guided by incoming data in assessing the economy's sensitivity to interest rates, the evolution of economic capacity, and the dynamics of both wage growth and inflation. With that, Governor Poloz and I would now be happy to answer your questions.

r180208a_BOC

canada

At the Crossroads: Innovation and Inclusive Growth

wilkins

Welcome to Canada--and to a snowy Montebello. This day is dedicated to a discussion about innovation and inclusive growth. It is great to have so many experts with us today. Thank you. We know that technological advances are key to improving an economy's potential to grow. They have raised living standards in G7 countries and across the globe, and have helped lift more than one billion people around the world out of extreme poverty since the Second World The current wave of innovation--digitalization and automation--promises to raise trend growth in the economy even more. However, as we are discussing today, technological advances can leave people behind. It is perhaps only in the last decade or so that mainstream macroeconomists have sharpened their focus on how income distribution may affect long-term growth and macro dynamics. There is compelling evidence that innovation has been an important reason behind rising income inequality in advanced economies in recent decades. Research also finds that rising inequality can result in weaker and less-stable macroeconomic outcomes. This places us, as policymakers, at a crossroads. Do we choose to stay on the same road and repeat the past? Or do we apply fresh thinking to policy and choose a new road where innovation delivers even stronger and more-inclusive growth? This is the challenge that the G7 countries have set for themselves for 2018. Canada is proud to lead the G7's work this year to better understand the issues so that we can set priorities for policy. The context we are working in matters. The global economy is enjoying the most robust and synchronous growth we've seen in close to a decade. Businesses and consumers are feeling more confident. Yet, we know that many people in advanced economies are also anxious about what digitalization and automation might bring. They are worried about being left behind. For workers in some industries, such as manufacturing, this may seem like old news. For drivers, lawyers, investment advisors and many others, it's new. By some estimates, close to half of the tasks done by workers could already be automated using current technology. This anxiety has real costs. It has eroded trust in the framework for international co-operation in areas that have served us well in the past: trade policy and financial sector regulation are good examples. As a way of spurring discussion today, I will cover three points: (i) Technological progress will raise economic growth, although the channels through which it contributed to rising inequality in the past are still forces to be reckoned with. (ii) It doesn't have to be this way--if we apply fresh thinking in some key areas, we can make policy choices that manage the side effects of innovation, without stifling it. (iii) Policy-makers themselves need to dig into the technology--the better we understand it and the underlying business incentives, the better policy choices we will make. Technology has transformed our daily lives at an astonishing pace. Google is not yet 20 years old. Who knew, even 5 years ago, that some people would be making a small fortune as professional video-game players? And, while parents have been worrying about how much screen time their kids should have, a growing number of professions--from firefighters to surgeons--have embraced the "gamification" trend, integrating video exercises into their training programs. Let's remember that per capita output has increased around five times in since the early 1950s. Our average life expectancy during this period has risen from 67 to 81 years. bad. Yet, recent voting behaviour and public discourse make it clear that many people question what is in it for them and their families when it comes to technology and globalization. A study here at home showed that the more pessimistic people were about technology, the more worried they were about their own prospects. Many of us would agree that the data point to a concerning trend. The share of income going to labour has been declining in many economies, including the G7. The share of income going to the top 1 per cent has nearly doubled since 1980 in some of our countries, amounting now to as much as 20 per cent. If we want to find a better road forward, identifying the underlying issues is the right place to start. One question is, what is it exactly about innovation--and, to a lesser extent, globalization--that opens the door to these outcomes? There's a lot of good research, including by people in this room, pointing to many possible forces at play. I think three stand out: Technology has benefited skilled workers more than other workers because it has made them more productive. People in more-routine jobs have tended to be replaced entirely. Digitalization will likely reinforce this dynamic. Machine learning and other technologies mean that tasks requiring routine cognitive skills, such as reading medical scans or preparing legal and investment advice, can now be automated too. That said, I do not share the dystopian view of a world without workers. People will still have an absolute advantage in tasks that require common sense and a human touch. And they will also find employment in areas where they have a comparative advantage. The question is not so much whether there will be jobs for people, but, rather, how well they will pay, and what the working arrangements will be. Some types of technology lead to market concentration and the rise of "superstar" firms. These firms tend to have fewer employees than conventional companies and can earn impressive monopoly profits. Market concentration happens quite naturally in industries with prominent network effects and other scale economies. There is nothing new in that. Phone companies are traditional examples, and social media companies and online marketplaces are more-modern examples. What is new is that the "winner-takes-all" effect is magnified in the digital economy because user data have become another source of monopoly power. Data from a large network create a formidable barrier to entry. Another barrier to entry can come from firms using their position as gatekeepers to crucial online services to impede their competitors. And, it's easier to avoid taxes when production is not tied to a large factory with a fixed physical location. Technology has helped to separate work into discrete tasks, allowing businesses to make more use of short-term, temporary jobs to maintain flexibility or respond to changing needs. Workers in these types of jobs tend to have less bargaining power than regular employees. They usually earn lower incomes, get fewer benefits and have less job security. This may be one reason why we have seen relatively weak wage growth in Canada and other G7 countries despite improving labour market conditions. With the current wave of innovation, the "gig economy" is likely to keep growing. We do not have to be hostage to these forces. That's my second point. Canada's priority as G7 host is to find ways to embrace technological progress while handling the challenges of digitalization and automation. Adequate income and equality of opportunity are critical to handling the challenges of the digital economy. Adequate financial incentives to innovate and take ideas to market are critical to embracing technological progress. Trade-offs need to be made between these two objectives, and there are different views about what "adequate" means in practice. It is the job of governments to make these important choices, not central banks. In any case, central bankers do not have the mandate or the tools to directly influence the pace of technological progress or the distribution of income. We do have a stake in supporting strong and sustainable growth, and that is why we play an important advisory role and help shed light on some of the trade-offs at play. There are many policy areas to consider. Let me talk about a couple that I think should be priorities: developing skilled workers through inclusion, and keeping market power in check. Developing a skilled workforce Developing a skilled workforce is about education, training and continuous learning. It's also about reducing the barriers to participation in the workforce. We know that the fields of science, technology, engineering and mathematics (STEM) are an important part of the equation. Businesses in Canada tell us that it is increasingly difficult to find the right people in these areas, and I imagine this is the case globally. The obvious implication is that we need to find better ways to make these fields of study more accessible and interesting to students, starting at an early age. Improving our track record in terms of gender balance would add to the pool of STEM skills, but this will require some new ideas. We also know that on-the-job training and reskilling will become even more important because of the accelerating pace of change. Even a recent graduate may not have the exact skills needed to be a perfect match for the job. An increasing number of mid-career employees may find that their skills have become obsolete and that retraining is needed. As Governor Stephen S. Poloz mentioned recently, we will need more engagement from businesses to tackle this issue. They are best placed to know their own people and their own business needs in real time. The question is, how can public policy and academic institutions encourage and complement any new efforts by businesses? Each of our countries has interesting approaches to build on. Germany's apprenticeship program is well known and established. It has been successful in giving students valuable vocational training while also meeting business needs. Destruction Lab in Canada is a lesser-known example in the tech field of universities working with students and businesses to bring the best ideas in science, machine learning and artificial intelligence to market. Let's not forget that technology itself can be used to better match people with jobs, and to attract people into the labour force and keep them there. This will strengthen sustainable economic growth while supporting inclusiveness at the same time. Finding ways to include more women in the labour force, and empower them, is a priority for the G7 this year. Another promising avenue to explore is how to adopt technologies that remove barriers for people with disabilities. Right now, just over 10 per cent of the labour force across the G7 consists of persons with disabilities. If their employment rate were raised to the same level as that for the rest of the labour force, we could add up to 12 million workers. Chat and email functions on our phones have already transformed workplace accessibility for the hearingimpaired. Entrepreneurs in Canada and elsewhere are developing technology to help people who are visually impaired see far-away details. Soon, driverless cars will help make people with a range of disabilities more mobile. As governments work to nurture innovative tech start-ups, they could emphasize technologies to enhance workplace and social inclusion. Keeping market power in check We are not going to get the full benefits of innovation if we leave market power unchecked. I'm focusing on the tech industry because the discussion is about digitalization, but some of my points could apply elsewhere. The five biggest global technology companies have a market capitalization of about US$3.5 trillion. That's almost one-fifth of the size of the US economy. The tech industry is making a valuable contribution to our economic performance. That said, the size and market dominance of some of the tech firms raise many of the usual concerns about the potential effects of monopoly power on prices and competition. A new source of market dominance relates to data. Access to and control of user data could make some firms virtually unassailable. They can easily drive out competition by combining their scale with innovative use of data to anticipate and meet evolving customer needs, at a lower price (and sometimes for free). This has a couple of undesirable consequences. First, firms operating in less-competitive environments innovate less; we need the dynamism from firm entry and the contestability of markets to raise the trend line on growth as much as possible. Second, the biggest firms may well return to monopoly pricing in the long run. These consequences get in the way of stronger, more-inclusive growth. That is why we should prioritize the modernization of anti-trust and competition policy, as well as the relevant legal frameworks. There are many unanswered questions, especially about how best to remove barriers to entry. If user data are the primary source of monopoly rents in the digital age, how should we regulate who owns these data and how they are shared? Some interesting ideas include giving users control of their data--perhaps even making firms pay users for their data--and regulating tech platforms as utilities. Intellectual property rights present similar issues. Patents are a key way to protect the return on valuable research and development. Given that they create barriers to entry and that the pace of technological change is accelerating, do we need to rethink our approach? It is good to see authorities across the G7 countries looking at all these issues. International collaboration is necessary because of the ubiquity and cross-border nature of many digital services. New technologies pose additional regulatory and legal questions. For example, the sheer complexity of algorithms used for data analytics makes them difficult to interpret, audit and govern. In some cases, algorithmic pricing could lead to tacit collusion--price fixing without the quiet glass of scotch between commercial rivals. Even if it were identified, tacit collusion would not meet some current legal definitions of collusion. Legal clarity is also required in many jurisdictions with respect to data privacy, information security and consumer rights. We also need to determine how best to manage the risks that concentration in digital services can pose for the financial system. Top of mind for me are the growing operational risks (including cyber risks) from a very concentrated set of third-party service providers that our financial institutions use--cloud services, data aggregators and related analytics. How concerned should we be about these third parties--telecommunications companies and tech companies--given that they typically fall outside the current regulatory perimeter? This is another question that would benefit from concerted attention at the international level. Good progress is already being made on issues related to international taxation to avoid base erosion and profit shifting. This brings me to my final point. Policy-makers need to dig in and be proactive. Good policy decisions can only come from a clear understanding of the new technologies and the related business incentives. Let me give some examples from my own backyard. At the Bank of Canada, we are focused on understanding the many ways in which digitalization and automation are affecting the economy and the financial system. For example, as nontraditional pricing models become more prevalent, we are rethinking how best to measure inflation. We are looking at how digitalization might be affecting labour markets and the transmission of monetary policy, and how a global digital marketplace for goods and services changes the ways in which domestic inflation pressures are generated. Our researchers are also studying emerging technologies in financial services to understand how the ecosystem is evolving, and to spot new risks as they emerge. The workforce needs to have the right skills for the digital economy. So do public policy-makers. The Bank of Canada has several irons in the fire that take a learning-by-doing approach; one example is the work staff are undertaking to apply machine learning and techniques such as distant reading to analyze vast amounts of unstructured information. The goals are to increase the range and depth of skills of our staff, improve our projections and reduce the uncertainty we face when making policy decisions. We are also working on how we could use machine-learning applications to increase efficiencies and manage operational risks in all parts of our business. All the institutions represented in this room are doing interesting work in this area. Public sector institutions need to innovate in their business cultures. We should be open to more-diverse perspectives and expertise, work more often with private sector experts and take manageable risks. The Bank of England and the Monetary Authority of Singapore are leaders in exploring fintech with the private sector. The Bank of Canada also has several experiments under way. One is in partnership with the TMX Group and Payments Canada. It uses distributed ledger technology to build a delivery versus payment settlement system for securities. experience with these types of partnerships so far is that we can quickly harness deep subject matter and business expertise, define realistic yet ambitious objectives and make faster progress than if we were working alone. It's good to see that G7 central banks, among others, have already been comparing notes on our work in these areas. It is time to conclude. I do not need to convince you that the digital economy is a promising way to raise trend growth and overall living standards. We cannot be satisfied, though, if some of the potential gains are left on the table, because many people will be left behind and important markets will be virtually uncontestable. It does not have to be this way if we choose a road for policy that effectively manages the downsides of innovation without stifling it. Of all the areas where we could develop and implement a better strategy, here are my top three: (i) develop a dynamic workforce with the skills to match the jobs, and encourage more labour force participation; (ii) keep market power in check, particularly the power that comes from control of consumer data, to encourage competition and limit monopoly profits; and (iii) manage the growing operational risks associated with the digital services that are provided by a concentrated set of firms to systemically important financial institutions. We will need to judge wisely when it is best to use public policy tools to manage risks and when to let private enterprise work its magic. We'll need to work together and in the field to inform these judgments. I am confident that, together, the G7 will show leadership and will build with the private sector a shared sense of responsibility for the future.

r180215a_BOC

canada

Anchoring Expectations: Canada’s Approach to Price Stability

schembri

Thank you for the invitation to speak to you today here in the hometown of Mr. Coyne, who died in 2012, was the governor of the Bank of Canada from 1955 to 1961. As governor, he stressed that price stability should be the primary function of monetary policy. That principle--price stability--is now the cornerstone of monetary policy frameworks around the world. In practice, it is achieved by maintaining inflation at a low, stable and predictable level. Our mandate at the Bank of Canada's is to "promote the economic and financial welfare of Canada." And, like former Governor Coyne, we believe that inflation control is the main contribution monetary policy can make to achieving that goal. Our current monetary policy framework consists of an explicit inflation target and a flexible exchange rate. It was established in an agreement with the federal government in 1991 and, since 2001, has been renewed every five years. With this framework, we have anchored inflation expectations, achieved low and stable inflation, and promoted sustained employment and economic growth. Three main factors have contributed to the framework's credibility and success. First, we have a clear, simple and well-understood inflation target, whose focal point is 2 per cent. Second, the framework has political legitimacy, is coherent with other public policies and is implemented with effective tools. And third, we have a formal review process for continually improving the framework that is widely admired by many of our peers and was cited as one of the factors that earned us the Central Bank of the Year Award we received recently. My speech today is the first in a series that my colleagues and I will be delivering over the next four years as we embark on our review of the framework leading up to the 2021 renewal of the inflation target. I'll start with some background on our experience--and that of many other central banks--with inflation in the 1970s and 1980s and on the lessons we learned trying to control it. I'll discuss how and why the Bank adopted an inflation target for its monetary policy. I'll review the impact of the policy on inflation, why it works so well, and the unique and innovative process we follow to ensure that it remains effective. Finally, I'll conclude with a discussion of important economic developments affecting economies worldwide. Strengthening the framework to manage the potential risks these developments pose to the Canadian economy is the key objective of our research over the next four years. Monetary policy needs a nominal anchor or a fixed point of reference to help tie down the expectations people have about inflation. During the 1960s, that anchor in most countries was a pegged nominal exchange rate that linked the value of domestic currencies to the US dollar. This exchange rate arrangement, known as the Bretton Woods system, collapsed in the early 1970s, largely because of unsustainable inflationary pressure in the United States. Without an anchor for monetary policy, inflation and inflation expectations rose rapidly, exacerbated by large oil price shocks. In some years, inflation hit double-digit levels in Canada and in other advanced economies. Economist Milton Friedman's great insight into inflation is that it is always and everywhere a monetary phenomenon, which led him to claim that low inflation could be achieved by controlling the growth rate of money. He also emphasized that inflation expectations are influenced by monetary policy and that they eventually adjust to actual inflation. For this reason, he argued, there is no longrun trade-off between inflation and output. Thus, central banks should focus on controlling inflation. In 1975, the Bank adopted a money supply target. But, by 1982, we were forced to abandon it--or, rather, it abandoned us, as former Governor Gerald Bouey once quipped--after it became clear that financial innovations had weakened the Bank's ability to control the money supply and overall spending with its policy interest rate. Unfortunately, by then inflation and inflation expectations had risen and the expectations had become so entrenched that inflation declined only when the Bank of Canada and most other major central banks boldly increased interest rates in the early 1980s. It worked, but at the cost of a severe global recession. After this disinflation, the Bank renewed its search for a viable nominal anchor and considered various options. We tried to identify one that would be effective, straightforward to operationalize and easy to communicate, and that the public would trust. In the late 1980s, then-Governor John Crow delivered several speeches in which he laid out an argument in favour of price stability itself as a long-run goal for monetary policy. The inflation rate was then running at roughly 5 per cent. No one knew with certainty what rate best represented price stability. And economic theory was not yet developed enough to confidently predict the outcome of such a policy, if implemented. Still, the idea of using the policy rate to directly target the rate of inflation held promise. At the time, only one other country in the world had attempted such a policy approach: New Zealand adopted inflation targeting in 1990. Canada became the second the following year when the Bank and the Department of Finance announced an agreement on a monetary policy framework that set a path for reducing inflation. The agreement gave the Bank operational independence to use its statutory tools to achieve the inflation target, while at the same time acknowledging that "a range of public policies, besides monetary policy, can make a significant contribution" to controlling inflation. Since 1995, our inflation-control target has been 2 per cent, the midpoint of a 1 to 3 per cent range. Central banks in many other countries--37 in total--have now also adopted an inflation target and most, especially in advanced economies, have chosen 2 per cent as their target. Experience suggests that 2 per cent is sufficiently low that it does not materially distort economic decision making and behaviour, but still leaves the central bank adequate room to lower its policy rate in response to a significant adverse shock to the economy. Because a 2 per cent target balances these offsetting considerations, it is symmetric. In other words, we care equally about deviations above and below 2 per cent. The 1 to 3 per cent range reflects normal variations in consumer price index (CPI) inflation, since it is subject to a wide variety of temporary shocks. These ongoing shocks make it impossible to hit the 2 per cent target consistently. We aim to achieve the target by adjusting our policy rate, which directly influences interest rates for household and corporate borrowing. Doing so helps align demand for domestically produced goods and services with the economy's capacity to supply them. If aggregate demand is expected to exceed or fall short of the economy's potential output, we typically raise or lower the policy interest rate to close the gap and keep inflation on target. As I mentioned earlier, the other central pillar of our monetary policy framework is a flexible, market-determined exchange rate. It serves two important functions: it allows Canada to have an independent inflation target; and it helps the economy adjust to external shocks, most notably, movements in commodity prices. It's not often that a policy performs better than expected. Our inflation-control target did just that, and continues to do so. Over the past 27 years, we have reduced inflation as measured by the CPI and maintained it at a level close to our 2 per cent target, with no persistent episodes outside our control range ( Because inflation has been so close to the 2 per cent target, it has served as an anchoring and coordinating mechanism, allowing Canadians to make better economic decisions and achieve better economic outcomes. In addition, there has been much less volatility in interest rates and output growth. We have learned some key lessons from this experience. First, the clarity and simplicity of the 2 per cent target has facilitated its communication and broad acceptance, and that has helped enhance the target's credibility. Second, as inflation expectations have become firmly anchored at the 2 per cent target, the effectiveness of the policy has increased ( For example, during the global financial crisis of 2007-08, the Bank was able to aggressively reduce its policy rate and provide substantial monetary stimulus because inflation expectations were so well anchored. As a consequence, a reduction in the policy rate translated directly into a similar reduction in the real interest rate, which is necessary for stimulating demand. Third, the more successful we are at hitting the target, the more credible the policy is and the more confident Canadians are that inflation will remain on target This self-reinforcing feedback loop has been instrumental in our ability to keep inflation on target. Chart 1: Since 1991, inflation has remained mostly within the control range We also recognize that the credibility and success of our inflation-targeting regime depends critically on the coherence of the macroeconomic and financial policy framework in Canada. For monetary policy to be effective, it must be complemented by sustainable fiscal policy, as well as strong financial regulation and supervision that promote financial stability. Because inflation targeting has worked so well, it is easy to lose perspective. We now discuss inflation in decimal points rather than the percentage points we were worried about in the 1980s, when inflation was running, in some years, above 10 per cent. At the same time, we must also understand that when inflation is persistently away from the target, as it has been in recent years, we run the risk that inflation expectations will drift away from 2 per cent. Chart 2: Inflation expectations have become well anchored in Canada Figure 1: Anchored expectations and the success of inflation targeting While inflation targeting itself was very innovative, even more so is the joint agreement and its renewal process. For each renewal, the Bank conducts a deliberate, rigorous and transparent research program to critically examine important issues related to the policy framework. Based on this analysis, we adjust and improve the framework. We examine two types of issues in the renewal process: fundamental and operational. Fundamental issues include whether the target for monetary policy should be changed, and to what extent monetary policy should consider financial stability concerns. Operational issues include how to measure underlying or core inflation. Given the policy's effectiveness, the renewals have gone smoothly. But, I can assure you, they are not automatic. The issues we research are based on monetary policy experience, primarily in Canada, but also in other jurisdictions, and on academic and policy-related discussions and research. We also consult widely, most notably with the Department of Finance, as well as other central banks, policy institutions and the private sector. All our research, as well as a comprehensive background document, is published on our website. The renewal process has evolved over time as our experience and understanding of inflation targeting has broadened and deepened. Although we haven't made many changes to the framework, we've gotten better at operationalizing it. Most notably, having a well-understood and credible inflation target has facilitated--and indeed demanded--more transparent communications, since the public can more easily hold the Bank accountable for monetary policy outcomes. To this end, we decided in November 2000 to announce adjustments to our policy rate on eight fixed dates throughout the year. Four of these announcements are accompanied by our , which sets out our outlook for the global and Canadian economies as well as the risks to our projections. Starting this year, the four other decisions will be followed by a public speech by a member of Governing Council. Finally, let me give you a quick overview of some of the questions we addressed in previous reviews. In 2011, we asked whether the 2 per cent target should be lowered, and in 2016, whether it should be raised. Decisions to alter the target rate of inflation require that we balance two considerations. On one hand, higher inflation is economically costly. It distorts the price mechanism and is socially unjust because many people, especially those with lower or fixed incomes, cannot adequately hedge their financial situation against higher inflation. On the other hand, higher inflation, if it were credible (which is a big "if"), would give the central bank a higher neutral policy rate. That's the interest rate consistent with the economy growing at its potential and inflation staying on target. It serves as a benchmark for us to gauge the degree of monetary stimulus in place and provides a medium- to long-run anchor for the policy rate. The level of the neutral rate is important because, in the event of an adverse shock, we would prefer to have sufficient room to lower our policy rate to provide stimulus without the risk of dropping it to zero or below. In some jurisdictions, policy rates have been lowered to slightly negative levels, but these negative levels appear to be less effective in stimulating economic activity. For both our 2011 and 2016 reviews, our research found that the 2 per cent target roughly balances these two considerations, especially since our target is clearly understood and is very credible. In both reviews we also examined to what extent the conduct of monetary policy should take account of financial stability concerns. We concluded in both reviews that monetary policy should be used only in exceptional circumstances because it is most effective at achieving the inflation target, while macroprudential policy has proven useful for mitigating financial vulnerabilities. In addition, we found that post-crisis reforms have made the financial system much more resilient. We know financial stability is necessary for achieving the inflation target on a sustainable basis. Therefore, central banks must be mindful of the impact interest rate changes might have on financial stability and consider adopting a more flexible horizon over which to return inflation to target. Moreover, well-anchored inflation expectations provide more scope for central banks to implement a flexible horizon. Finally, in 2016, we re-examined how we should measure core inflation. Our search led us to adopt three new measures. None of them is perfect but, together, they are giving us a much better reading of underlying inflation than previous measures did. As I mentioned, our next renewal is in 2021. At this early stage in the process, we are examining recent economic developments that could affect the resilience of the Canadian economy. We are also assessing possible measures to strengthen the monetary policy framework to respond to adverse shocks and increase overall macro resilience. Three important developments in advanced economies could pose a challenge to our framework. First are higher levels of household and public debt ( interest rates have encouraged households to take on debt, and the elevated level of government debt is largely a legacy of stimulus policies pursued during the Great Recession of 2008-09. Now, there is less space, on average, across the G7 for more borrowing to stimulate demand. Second, over the past 25 years, we've seen a gradual decline in interest rates, including long-term bond yields and, most importantly, estimates of the neutral interest rate ( This reduces the scope of central banks to adjust their policy rate. And, third, the trend rate of economic growth has been decreasing, owing to fundamental forces: lower labour force growth, reflecting an aging population, and declining labour productivity growth, which is more difficult to explain. The underlying growth in the economy is expected to remain low or to slow further. Therefore, the cyclical forces that normally help to propel an economy out of an unexpected downturn, namely business and residential investment as well as purchases of large durable goods, may be less powerful, especially if debt levels are high and confidence is slow to rebound. In such circumstances, policy might have to be more aggressive to boost confidence and increase demand. The policy implications of these developments were the focus of our discussions in September 2017 at a public workshop we hosted at the Bank to launch our 2021 research agenda. We invited Canadian and international academics, journalists, and economists from the private sector, think-tanks and unions to suggest ideas for our research agenda for the renewal. These ideas can be grouped into three broad sets of issues regarding our monetary policy framework: its objective, the available tools to achieve the objective and the potential role of policy coordination. Let me say a few words about each. On our objective, one alternative that participants discussed was a switch to price-level targeting (PLT). Under PLT, monetary policy would seek over time to keep the price level, rather than the inflation rate, on a predetermined path. This would imply that past deviations from this path would have to be reversed, likely gradually, with higher or lower rates of inflation. We researched PLT for the 2011 renewal and, in the end, we concluded that its benefits did not clearly outweigh the costs and risks of making the shift. But we also said that our assessment of PLT could change. Chart 3: Household debt has risen to elevated levels in Canada and the G7 Chart 4: High levels of G7 public debt are a legacy of post-crisis fiscal stimulus What about our tools? In recent years, central banks have used various tools to ease monetary conditions and stimulate demand when their policy rate was at the effective lower bound. For example, in 2009 we issued a conditional commitment to keep the key policy rate unchanged for a year, as long as the outlook for inflation didn't change. Other central banks also used such explicit forward guidance as well as large-scale asset purchases, typically of government securities, for this purpose. Further research is needed to examine the effectiveness of these tools and how best to use them. Finally, the experience during the crisis, when both aggressive monetary and fiscal stimulus were used, highlighted the benefits of simultaneous policy action. Although monetary policy is normally seen as the most effective countercyclical policy tool because it can respond flexibly and nimbly to adverse shocks, it may need support from other policies more frequently in the future. Indeed, studies have shown that when rates are at the effective lower bound, countercyclical fiscal policies, such as automatic stabilizers, and discretionary policies, such as infrastructure spending, are highly effective. Our agreement with the federal government includes a commitment by both the Bank and the government to the inflation target. That means all economic policies--including monetary, fiscal and macroprudential--can work together in a complementary fashion for this purpose. More explicit coordination of fiscal and monetary policy would raise governance issues for both the government and the Bank, given our respective mandates. One interesting suggestion that came up at the workshop was to focus our research on ex ante mechanisms to coordinate policies, because complementary frameworks could deliver better outcomes. Let me conclude. Canada's experience with inflation targeting has been much more successful than originally expected. In hindsight, we underestimated how powerful anchored inflation expectations would be in helping to keep inflation close to target. Our policy framework continues to work, and work well--inflation and inflationary expectations remain firmly anchored. The framework's strengths are the It features a clear, simple and well-understood target--a focal point. The agreement with the government underpins its credibility. And, finally, it is continually improved through the renewal process to ensure that we are able to meet future challenges. A strong framework enhances the resilience of the economy, making it better able to weather adverse shocks. An important recent example of such a shock was the sizable oil and commodity price declines in 2014 and 2015. The policy rate reductions we made in 2015 in response to this shock were effective in facilitating the economy's adjustment and returning inflation to target. In coming speeches in this series on the review of our framework, we will finalize and share with you the research questions we will be working on leading up to the 2021 renewal. We continue to believe that the best contribution the Bank can make to improving the performance of the Canadian economy is to ensure that inflation remains low, stable and predictable.

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canada

Central Bank of the Year Award

poloz

Governor of the Bank of Canada It is an honour for me to accept the award for Central Bank of the Year on behalf of the staff of the Bank of Canada. And it is a real pleasure to be here to celebrate the successes and achievements of central bankers from around the globe, such as my Back in January, when announced this award, you published an extensive write-up that detailed the reasons why we were judged to be worthy of it. I am very glad that you did so, because the article illustrates just how important teamwork is at the Bank of Canada. In that article, every employee in every department can see how their own work contributes to a central bank that is operating at the top of its game. From the model developers, to the currency designers, to the people who got us settled back in our renewed headquarters--everyone contributed to an outstanding body of work with remarkable skill and dedication. So, this award belongs to all the members of our incredible team. I would like to particularly thank for recognizing the work we have done in terms of conducting monetary policy in an era of heightened uncertainty. We have been working on the theme of uncertainty since the global financial crisis revealed the limits of our models and our knowledge. And we have learned that it is far better to be open and honest about the uncertainty we face, as well as how we deal with it, rather than to just assume the uncertainty away and project a false sense of confidence. Because profound uncertainties are everywhere, we began talking about monetary policy as an exercise in risk management, as opposed to the precision engineering that many believe the practice of monetary policy to be. To be truly honest about the uncertainties we face, we stopped providing routine forward guidance, which observers and market participants had come to rely on. We took some grief for this decision. But I am certain that the best and most honest approach is to communicate openly about the Bank's reaction function, and the key risks we see. This leaves market participants to interpret the data and make their own forecasts about the future path of interest rates. It has taken time, but markets and observers are increasingly adapting to our approach. This experience shows that open communications are vitally important--even more so in a world where public institutions are increasingly viewed with suspicion and distrust. We embrace transparency--as you recognized last year--and embed communications in all our plans at the start of the planning process, rather than tacking them on as an afterthought at the end. This approach led us to take on some of the projects that you have highlighted. We hosted a conference on the most fundamental questions about our monetary policy framework, and broadcast it on the web. We encouraged unprecedented public engagement in our bank note design. And we gave our researchers freedom to publish their best and most interesting work without worrying about whether it follows Bank orthodoxy. So, let me just conclude by again thanking for this recognition. It means a lot to everyone at the Bank of Canada. I know I would not be here without the hard work of everyone on our team. The best employees in the world are the ones who made it all happen, and I'm grateful to them all. Thank you.

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canada

Canada’s Economic Expansion: A Progress Report

lane

I am delighted to be spending International Women's Day here in Vancouver, a city that has long been a leader in fostering diversity, tolerance and inclusiveness. unveiled the new $10 bank note , featuring a portrait of the late Viola Desmond. businesswoman, refused to leave a whites-only area of a movie theatre in New Glasgow and was jailed, convicted and fined. She confronted this discrimination with grace and courage. And she made history, bringing forth the first known legal challenge against racial segregation by a Black woman in Canada. Her case was an inspiration for change and part of a wider set of efforts toward racial equality across the country. The bank note will begin circulating later this year. I hope you'll agree that its imagery and symbols reflect the progress we have made as a nation--and the road still to be travelled--in the pursuit of human rights and social justice. Now, I will turn from these lofty themes to the main topic of my speech today: Canada's continuing economic expansion, which has brought the Canadian economy close to its full potential. This is the setting for the monetary policy decision that we announced yesterday. For those who may not know, we make eight decisions on the policy interest rate each year. Four of these come with the publication of our quarterly , which provides a complete forecast and detailed explanation of how we see risks to our inflation outlook evolving. The Governor and Senior Deputy Governor hold a press conference the same day. Until now, the other four decisions would come with only a press release--about one page long. We've decided that, starting today, one member of the Bank's Governing Council will also give a public speech--an "economic progress report"--a day or so after each of these four interest rate announcements. The idea is to shed further light on how we see the economy evolving and the considerations that figured most prominently in our deliberations. So, this speech kicks off a new initiative--another step in our ongoing efforts to help Canadians better understand our actions and decisions as Canada's central bank. Now, let me begin. Global and Canadian economic developments The Canadian economy is progressing well. Following a decade of many setbacks, 2017 was a year of robust economic growth--3 per cent for the year as a whole. After many years in which the growth was uneven, it has become more balanced. The material slack that existed in the economy, and especially in the labour market, has been largely absorbed. Inflation is running close to our target rate of 2 per cent. While the future is subject to some notable uncertainties, which I'll discuss, trends over the past few quarters have been quite encouraging. The trends have been broad-based across regions and sectors, but these favourable economic conditions are particularly evident in some parts of Canada, including British Columbia. Global developments Of course, Canada is a very open economy, and its growth is supported by what is now a synchronous global expansion. This too is encouraging. We are now seeing solid growth not only in the United States and China but also in Europe, as well as in many other emerging-market economies. The US economy has been on a path of mostly solid growth and job creation for a few years. At the beginning of 2018, the data indicated stronger momentum for the United States, and the tax cuts announced just before Christmas were expected to boost demand further. Developments since then have largely supported this story. US economic growth remained robust, at an annual pace of 2.5 per cent during the fourth quarter of 2017, and the US economy is essentially at full employment, with the jobless rate at a 17-year low. Wage growth has also edged up in recent months. Meanwhile, US business confidence remains high. And increases in government spending legislated in February are likely to provide a further boost in the next couple of years. The US economic picture still has upside potential. The current expansion could create a virtuous circle, triggering "animal spirits" among businesses and consumers and driving even faster growth than expected. If that happened, stronger business investment and household spending in the United States would likely benefit our economy. So, as always, we are watching developments in the United States closely. On that note, we saw some sharp movements in US and global stock markets a few weeks ago, ushering in increased market volatility ( ). While these shifts were clearly amplified by technical factors--and, of course, markets are prone to overreaction--the repricing reflects a shifting economic outlook. Market expectations about the path for inflation in some major advanced economies have been shifting upward--in the United States, for example, where inflation had persistently been running short of target. The shift in expectations about inflation and the strength of the global economy brings forward, to some degree, market expectations of less stimulative monetary policy. Over time, rising bond yields in the United States can be expected to put upward pressure on yields elsewhere, including in Canada. In effect, as markets digest what the changing dynamics could mean for central banks, Chart 1: Market expectations of US inflation have risen, and volatility spiked markets themselves are bringing about some of the tightening that would be consistent with an improving world economy. The rise in volatility came after a long period of exceptional calm in global financial markets--not just in stock markets but also in fixed-income markets. That tranquility reflected, at least in part, the influence of monetary policy: in many advanced economies, policy interest rates have been constrained by their effective lower bounds, and their central banks have relied on unconventional tools, including quantitative easing and forward guidance. As the global economic expansion becomes more secure, we may be reaching a turning point where the volatility-suppressing effects of monetary policy are diminishing and more normal levels of volatility are returning to markets. At the same time, the global outlook remains subject to considerable uncertainty, notably around geopolitical developments and increasing protectionism. I'll talk more about this uncertainty a little later. Canadian developments Turning back to Canada, as I've said, 2017 was a year of robust growth for our economy. We were expecting growth to moderate to a more sustainable pace going into 2018, and the latest National Economic Accounts data confirm that it has. In fact, growth of real gross domestic product (GDP) during the fourth quarter of 2017 slowed more than we anticipated in our January forecast. Yet, even as the annual pace of growth came in at 1.7 per cent, under the 2.5 per cent pace in our projections, the underlying details suggest that the economy is progressing much as we thought it would. Specifically, what we economists refer to as "final domestic demand" increased at around a 4 per cent pace for a fourth consecutive quarter ( The slower-than-expected headline GDP growth number was largely due to higher imports, while exports made only a partial recovery from their third-quarter decline. The gain in imports mainly reflected stronger business investment, which adds to the economy's capacity. There were also some temporary factors influencing imports in the fourth quarter. In addition, housing and government spending contributed more than expected to economic growth. On that note, we'll incorporate the implications of the recent federal budget for the outlook for growth and inflation in the Bank's April projection. growing global trade tensions will need to be watched, for their possible impact on the outlook. Recent developments with respect to steel and aluminum, alongside increased protectionist rhetoric, carry potentially serious consequences. We do not know how or when the NAFTA talks or other trade disputes will conclude, and we do not know how industries, or governments, will react. The range of possibilities is wide, which means that trying to quantify any scenario in advance would not be useful for monetary policy purposes. For now, our working assumption is that existing trade arrangements will stay in place over our current two-year projection horizon. As and when concrete outcomes emerge, we will be in a better position to assess their impact on the Canadian economy. adjusted annual rates) But even with no changes in our trading arrangements, the uncertainty around them is affecting business investment decisions. The US tax reforms may further reduce the relative attractiveness of investing in Canada. For both these reasons, firms may decide to redirect some of their planned investment spending from Canada to the United States. Our economic projections have been incorporating the judgment that such effects are likely to dampen business investment--as discussed in January. As we prepare our April forecast, we'll assess whether the degree of caution we've applied is still appropriate. An important indicator will be our spring There are a couple of additional points to note on the export and investment picture. First, with respect to energy exports, spot prices for crude oil have fallen since we published our January forecast, but remain relatively high compared with 2017 ). However, Canada is not seeing the full benefit of oil's recovery because of wider-than-average differences between benchmark global oil prices and prices for Canadian heavy oil. To the extent that these differences stem from ongoing transportation bottlenecks, we expect them to persist. This could have a dampening effect on investment in the energy sector. In addition, although Canadian manufacturing activity has been solid in recent quarters, non-energy goods exports could disappoint, given ongoing competitiveness challenges. Indeed, in 2017, these challenges meant Canada was unable to benefit fully from a strengthening in global trade. Monthly data Another key element of our economic outlook is household spending--consumption and residential investment. In our January projection, this spending was expected to remain solid, while contributing less to growth as we go forward. But there are a lot of moving parts. The effects of various provincial government measures in British Columbia and Ontario are still working their way through major housing markets. Federal authorities introduced new mortgage underwriting guidelines, which came into effect on January 1. And higher interest rates are also expected to dampen household spending. This effect is likely to be stronger than in the past, since the average household is now more heavily indebted. The timing of these effects can vary and is hard to predict. For example, we expected that some home resale activity would be pulled forward into the last quarter of 2017 as buyers and sellers tried to book transactions before new underwriting guidelines took effect. The strong pace of resales late last year and the recent sizable drop ( appear consistent with that pull-forward idea. But it's too early to tell how all these measures--not to mention measures that the BC government announced two weeks ago--will affect housing markets over the longer term. We will continue to watch the data closely. We will also continue to assess how sensitive consumption is to higher interest rates, given high household debt. On that front, it's worth noting that household credit growth has been decelerating in recent Chart 4: Toronto, Vancouver home resales down after recovering from lows months. It's still too early to firmly call it a trend, and credit data can be volatile, but it's what one would expect to see. Turning to labour markets, despite a fall back in January, Canada has made considerable progress in job creation over the past year, notably with strong gains in full-time employment. The jobless rate is consequently near a historically low level ). Wage growth has firmed, although it remains slower than would be typical in an economy with no labour market slack. Going forward, we will be monitoring the extent to which minimum-wage increases in key provinces may be affecting broader wage pressures. For now, it is a bit early to say. Meanwhile, even as regions such as British Columbia experience wage pressures and intensifying labour shortages, the elevated long-term unemployment rate and relatively low youth participation rate nationally suggest that there is still some slack in the Canadian labour market. Reflecting this, the Bank's composite labour market indicator--which is designed to capture broad labour market developments--has fallen by less than the unemployment rate. Now, I'd like to go into a bit more detail about inflation, both globally and in Canada. Global and Canadian inflation dynamics I mentioned earlier that recent developments in global financial markets would seem to reflect shifting expectations about the path for inflation in some advanced economies. Only a few months ago, the fact that inflation in advanced economies, including the United States, the euro area and Japan, was either slowing down or remaining weak, despite material slack being absorbed, caused some to question whether the inflationary process may have structurally changed. At a global level, there are a number of possible explanations for why inflation has been slow to pick up. For instance, there may be more leftover economic slack. Inflation expectations may have drifted lower in response to persistently low inflation. The competitive effects of the rise of the digital economy and ongoing globalization may be playing a role in holding down prices. Or it may simply be a matter of time: inflation never picks up smoothly and does not follow a mechanical process. Our staff have been working hard to assess these possible explanations. To date, they've found no compelling evidence that the underlying inflationary process has changed globally. That's not to say it hasn't--we need to continue to study this. But for now, our view remains that key relationships remain intact. Given the depths of the post-crisis recession and varying degrees of slack in different economies, inflation has taken longer in some countries than others to materialize on a sustainable basis. Meanwhile, here in Canada, inflation has lately been running close to our 2 per cent target. The Bank's core measures of inflation are also edging up, as we expected. Still, inflation in Canada will be influenced this year by temporary factors related to gasoline, electricity and minimum wages. For example, we expected that inflation would drop temporarily below 2 per cent in January because of effects from gasoline prices a year earlier ( ). But the decline in inflation, to 1.7 per cent, was a bit less than we had anticipated, reflecting a number of factors. Inflation is expected to climb back to around our target in the coming months as gasoline prices pick up on a year-over-year basis. Our latest policy decision That brings me to yesterday's decision to hold our policy rate, the target for the overnight rate, at 1.25 per cent. This decision, as always, is grounded in our assessment of developments in the Canadian economy and what they mean for the outlook for inflation. In that regard, global and Canadian economic data have come in much as we expected. That confirmation gives us greater confidence that inflation will remain sustainably near our 2 per cent target. Our decision yesterday also takes into account some important context. First, our policy rate remains appropriately below what we call the normal, or neutral, rate--the policy rate that would balance the economy in the longer run. We've estimated the neutral rate to be in the region of 2.5 to 3.5 per cent. I say it's appropriately below because accommodative monetary policy is working to offset several factors weighing on demand: persistent competitiveness challenges facing Canadian exports, the chilling effect of heightened uncertainty about future US trade policies, and the burden of high household debt levels. The second piece of context is that, starting last summer, we increased our policy interest rate three times, for a total of 75 basis points. In these moves, we've been balancing the risk of undermining the economic expansion by moving too quickly with the risk of delaying too long and needing to raise rates sharply later to rein in inflation. By moving gradually, we've been able to take in new data and conduct analysis on four key issues. First, when an economy is running close to full capacity, it can actually create more capacity as firms invest and discouraged workers are drawn back into employment. Second, as I've already discussed, inflation dynamics could be changing in the new economy, and it's important to understand those dynamics. Third, despite strong employment gains and an economy operating close to capacity, wage growth has been slower than would be expected. And, finally, with household debt at high levels, the economic effects of interest rate increases could be different than in the past. In our deliberations for yesterday's decision, we took stock of recent developments related to these issues. As job creation has absorbed slack in the labour market, we have started to see wages pick up. With respect to the impact of higher interest rates on housing markets and the economy, although it is still too early to make a full assessment, we have seen a deceleration in household borrowing. And while it's also too early to tell how much additional potential output in the economy is being created, last week's strong investment figures are encouraging. We will be providing a fuller assessment of potential growth, as well as of the neutral interest rate, in our April Allow me to conclude. All things considered, we decided yesterday that the current policy rate remains appropriate. While the economic outlook is expected to warrant higher interest rates over time, some continued monetary policy accommodation will likely be needed to keep the economy operating close to potential and inflation on target. My Governing Council colleagues and I will remain cautious in considering future policy adjustments, guided by incoming data in assessing the economy's sensitivity to interest rates, the evolution of economic capacity, and the dynamics of both wage growth and inflation. Rest assured that, as always, the Bank of Canada will continue to do our part to ensure that we safeguard, and build on, the progress that has been made so far.

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Unveiling of New $10 Note

poloz

Governor of the Bank of Canada It is the Bank of Canada's job to design, produce and distribute bank notes that Canadians can use with confidence and pride. Bank notes are designed to be not only secure and durable, but also works of art that tell the stories of Canada. I am confident that you will agree that this new $10 note fits the bill. Trust is vital to everything we do as Canada's central bank. And the most tangible way we earn Canadians' trust is by supplying the highest quality bank notes. You handle them every day, trusting that they are durable, safe and easy to use. Even though people have more ways than ever to make electronic payments, the number of bank notes in circulation continues to climb. And thanks to past innovations, such as the introduction of polymer, counterfeiting rates remain low, and our bank notes last longer and wear better. But at the Bank of Canada, we continually strive to innovate and improve. I am immensely proud to say that a great deal of innovation went into the note you are about to see. For starters, there was the question of whose portrait would appear on the front. Both the Minister of Finance and I agreed that it was long past time for a bank note to feature an iconic Canadian woman. That has been a goal of mine since I became Governor. But with so many excellent choices, we took a new approach to involve Canadians directly in the decision-making process. And boy, did Canadians get involved. We received over 26,000 nominations from coast to coast to coast. A great national conversation took place--in schools, in the press, and in social media--about the important contributions so many iconic women have made to our history. I thank all Canadians for their engagement--it made the journey to develop this bank note truly unique. I would also like to give a special thanks to the independent advisory council that we set up to help us narrow down the nominations. This eminent group of academics, as well as sports, culture and other thought leaders, were invaluable throughout this process. Several of them are here with us today--so thank you once again. As you know, Nova Scotian Viola Desmond was ultimately chosen to appear on the new note. With that choice made, our designers and scientists and historians then went to work. As you will soon see, they brought together beautiful design, cutting-edge security features, and meaningful symbolism in an exquisitely balanced way. The job they did was nothing short of brilliant. I could spend hours thanking all the people who worked so hard to bring this innovative note to life - many of whom are with us today or watching this webcast. But there is one person we all owe a debt of gratitude to, and that is Viola's Wanda, you worked tirelessly to raise public awareness of the injustice done to your sister. And you made sure that ultimately, justice was done. Thanks to your actions, Wanda, this important Canadian story of your sister's courage will never be forgotten. Developing a new bank note is a huge undertaking, and I am happy and grateful that we got this one done as quickly as we did. And I cannot wait any longer to show it off. It is time for all Canadians to see the new $10 note.

r180313a_BOC

canada

Today’s Labour Market and the Future of Work

poloz

I would like to thank Russell Barnett for his help with this speech. Governor of the Bank of Canada I am delighted to be back at Queen's, where I earned an undergraduate degree in economics some 40 years ago. I remember this time of year well. It is a stressful time--whether you are stressed about starting your career, getting into your next degree program, or just getting this year's work done. Those of you who hope to join the workforce may be feeling both excitement and nervousness about an uncertain future. At least the macroeconomic situation you face is a positive one. The economy has created 283,000 jobs over the past 12 months, and the unemployment rate is as low as it has been in more than 40 years. However, this may still leave you wondering about the future. We have all heard stories of people struggling to get a foot in the door, of being overqualified and underemployed, and of the challenges of building a stable career in the "gig economy." Meanwhile, automation and digitalization are disrupting entire industries and threatening to make some jobs obsolete. Given this backdrop, I will use my time today to talk about Canada's labour market--why the central bank pays such close attention to it, and what role monetary policy can play in its performance. I will also take the risk of speculating a little on what lies further ahead for you--on the future of work. Let me start with why the Bank of Canada--whose central objective is to target low and stable inflation--cares so much about the labour market. Simply put, it is because inflation is driven by the balance of demand and supply in the economy, and the labour market is the heart of that balance. When demand is less than supply, inflation tends to fall, and vice versa. When supply and demand are roughly in balance, inflation tends to stabilize around the level where people's inflation expectations lie--in Canada's case, our target of 2 per cent annual inflation. To maintain this balance, a central bank needs to understand all the elements that make up supply and demand. At the top of the list for supply is labour. The more people available to work, and the more productive they are, the greater the contribution that labour makes to supply. In every economy, demographic forces and immigration determine the available workforce. A complementary role in supply growth is played by investment. Investment spending expands or improves an economy's capital stock--the machinery and equipment available to workers, as well as infrastructure such as roads, ports or information technology networks. New investment can give existing workers updated tools that raise their productivity. Or, it can mean an expansion of the firm, which is accompanied by new job creation. Both channels raise the economy's potential output. Canada has reached the phase of the economic cycle where investment usually takes over as the lead engine of growth and this capacity-building process becomes central. I think of this phase of the cycle as the "sweet spot," where rising demand actually drives the creation of new supply. With many companies operating near their capacity limits, growing their sales further means increasing investment, leading to the creation of new jobs and increased aggregate supply. Obviously, this is a phase worth nurturing. By far the most potent form of business investment is the creation of brand new companies. New firms apply the latest technologies in novel ways, sometimes creating completely new industries. As successful new firms exploit new technologies, they can grow very rapidly. Their sales growth chart sometimes looks like a hockey stick, or the left side of the Eiffel Tower. You can imagine how the creation of numerous new companies might affect the overall performance of our economy. Each firm that sees hockey-stick growth adds disproportionately to the overall productivity of the economy. Indeed, historically, a large share of an economy's gains in productivity and new job creation have come from young companies. This is why a period of slow productivity growth is usually associated with slow rates of new company formation. We are--at long last--finally seeing some encouraging signs in these data. This follows a long lacklustre stretch in the wake of both the global financial crisis and the period of high oil prices and exceptional Canadian dollar strength from 2010 to 2013. Importantly, this process of rapid growth generates higher incomes that people spend in every sector of the economy, benefiting everyone. However, newly created economic growth is disruptive, sometimes destroying existing companies and jobs along the way. This may sound like today's issue, but it has been a characteristic of economic growth for all time. It was aptly described a long time ago by Joseph Schumpeter as "creative destruction." I will say more about this process in a few minutes. However, none of this highly desirable economic growth can happen unless there are people available to fill the newly created jobs. Accordingly, a healthy, wellfunctioning labour market is critical, particularly at this stage of the business cycle. There are many ways to measure labour market health. We start with the unemployment rate because it is intuitive and the most commonly reported indicator. It is also as low as it has been since 1976 when Statistics Canada started tracking it this way, which is good. But the unemployment rate does not tell the whole story. To illustrate, imagine someone whose company closed back in 2010 and who gave up looking for work after months or years of unemployment. This person is no longer participating in the labour market and so is not counted as unemployed. But he or she could still be pulled back into the workforce if the right opportunity came along and so represents a potential source of new supply. Furthermore, no analysis of the labour market is complete without considering the impact of demographics, specifically, the impact of the Baby Boom generation. The first Baby Boomers began to enter the labour market in the early 1960s and fuelled labour force and economic growth for the next 50 years. This demographic support is now fading. Immigration can help provide an important offset, but we should also be doing everything we can to develop untapped sources of labour supply within our existing population. After looking at a much wider range of labour market indicators, the Bank has concluded that there remains a degree of untapped supply potential in the economy. This is important, for it means that Canada may be able to have more economic growth, a larger economy, and therefore more income per person, without generating higher inflation. So, let me turn to a deeper analysis of that issue. Young people represent one source of untapped potential. Yes, the unemployment rate for people in the 15 to 24 age group has declined to around 11 per cent. However, youth are not participating in the workforce as much as they did 10 years ago. Traditionally, labour force participation rates decline during recessions and rebound during periods of economic growth. But while most other population groups have seen their participation rates recover from the Great Recession, that has yet to occur for young Canadians. Some have argued that this should not be a concern, because it reflects an increasingly popular choice to remain in school and get more education. In cases where that is true, I certainly agree. School enrolment has increased over the last decade. However, the full story is more complex. For one thing, many students historically have chosen to work and go to school at the same time. I am sure that many of the students in this room have a parttime job, not just to earn money but also to gain valuable work experience. I know I did. However, the current participation rates of all student groups--males and females, 15 to 19 years old and 20 to 24 years old--are all below pre-crisis levels. Further, while young people who are not at school have higher labour force participation rates than students do, their rates are all lower than they were before the crisis. Because this drop in youth participation coincided with the crisis and Great Recession, I cannot believe that everything we are seeing today simply represents people choosing to stay out of the workforce. Clearly, a good part of the decline is tied to the economic cycle, and a shortage of opportunities. Other forces, including demographics, may be acting here as well. The key point is that youth represent an important untapped source of potential economic growth. If the youth participation rate were to return close to its level before the crisis, more than 100,000 additional young Canadians would have jobs. An even more significant source of economic potential is higher labour force participation by women. While about 91 per cent of prime-age men participate in the labour force, the rate for women is only about 83 per cent. History suggests that this gap can narrow. Consider Quebec, where, 20 years ago, the prime-age female participation rate was about 74 per cent. The provincial government identified barriers keeping women out of the workforce and acted to reduce them, particularly by lowering the cost of child care and extending parental leave provisions. Within a few years, proportionately more prime-age Quebec women had jobs than women in the rest of Canada. Today, Quebec's prime-age female participation rate is about 87 per cent. If we could simply bring the participation rate of prime-age women in the rest of Canada up to the level in Quebec, we could add almost 300,000 people to our country's workforce. The recent Federal Budget introduced some new measures in this direction. There's more. Employment rates among indigenous peoples--one of the youngest demographic groups in Canada--remain well below those of the rest of the country. And, as Senior Deputy Governor Carolyn Wilkins pointed out in a speech last month, technological advances are breaking down barriers that have been keeping some of the millions of Canadians who live with disabilities out of the workforce. Finally, much could be done to speed up the integration into the workforce of the growing number of recent immigrants. This would allow their important contribution to the workforce to increase more rapidly over time. Put it all together, and it is not much of a stretch to imagine that Canada's labour force could expand by another half a million workers. To put this thought experiment into perspective, this could increase Canada's potential output by as much as 1.5 per cent, or about $30 billion per year. That's equal to a permanent increase in output of almost $1,000 per Canadian every year, even before you factor in the possible investment and productivity gains that would come with such an increase in labour supply. Clearly, that is a prize worth pursuing. The central bank has no role in implementing specific policies aimed at breaking down barriers to labour force participation. However, that does not mean we have no role to play at all. The Bank can certainly use its monetary policy to help bring about a stronger, better functioning economy while still pursuing our inflation-targeting goal. This is particularly important in the current phase of the economic cycle, with demand prompting investment that can pull more people into the workforce. Statistics Canada data show that job vacancies have been rising quickly, reaching a record 470,000 last autumn. And we hear from business leaders that many of these vacancies are going unfilled because they cannot find workers with the right skills. To have companies looking for so many skilled workers is surely a sign of a strong economy. It shows the need for more targeted education, as well as on-the-job training programs that the employer tailors to fill a specific need. But another important way to fill job vacancies is a process that economists call labour market churn. Basically, churn describes the way people switch to jobs that better match their skills and experience. Churn falls sharply during recessions, because people are less likely to take a chance on a new opportunity and companies are more inclined to hold onto their skilled workers. However, in periods of strong growth and rising wages, we often see people who are already employed become more willing to leave their current position and switch to a higher-paying job. When one person takes that step, he or she leaves an opening that needs to be filled. A period of job switching follows, where people move into better employment. Ultimately, people who have been outside the labour force then see more opportunities and can be drawn back in. Of course, we will never have a perfect matching of all workers and jobs. The regional nature of our economy means the perfect job to match a person's skills and experience might be thousands of kilometres away. Further, there are still too many barriers that prevent workers in one province from moving to a job in another province. Labour market churn is a highly complex process that is difficult to predict. So is the creation of new economic supply through investment prompted by strong demand or new firm creation. But it should be clear that there are likely to be significant economic benefits associated with allowing the economy to find its way to a higher, more productive economic equilibrium, if this can happen within our inflation-targeting regime. We cannot know in advance how far the capacitybuilding process can go, but we have an obligation to allow it to occur. This is why the Bank has been careful to explain that it cannot take a mechanical approach to policy in this context, even though we believe that interest rates are likely to move higher over time. In fact, we have described this as a riskmanagement process. If the economy builds more supply than usual, that will put downside risk on inflation; if less, that will create upside risk to inflation, and it is our job to balance those risks. Of course, these are not the only issues we are watching closely. My colleague, Deputy Governor Tim Lane, listed many of these in his progress report speech last week. The issues include heightened uncertainty about future US trade policies, changes in inflation dynamics, wage behaviour and the impact of interest rates on the economy, given high levels of household debt. In this situation, we will remain cautious in considering future policy adjustments and dependent on incoming data to guide our assessments. So far, I have been talking about the untapped potential in today's economy. Let me now say a few words about the future of work, and what theory and history suggest may be in store. We are at the start of what has been called the fourth industrial revolution. The integration of digital technologies in virtually every part of our lives is just getting started. Like all revolutions in human history, we can expect it to cause some significant dislocations. And like all economic progress since the beginning of time, it will involve creative destruction. The first industrial revolution saw the introduction of the steam engine and led to the first factories and urbanization. This spawned the Luddite movement--textile workers who fought against the technology that threatened their livelihood. In the second industrial revolution, electricity and the internal combustion engine changed the way goods could move around the globe. Countries began to specialize more, and international trade became key to connecting supply and demand. In the third industrial revolution, advances in computing power and communications technology led to breakthroughs in the way information could be stored, processed and transmitted. The associated advances in global logistics enabled even greater specialization in production--the development of global supply chains--making the world even more dependent on trade to connect supply and demand. Importantly, all of these revolutions caused hardship for people in industries that were disrupted. Yet, the enormous gains in productivity and the advances these new technologies spawned form the basis of our modern economy. Whenever a groundbreaking technology arrives, a predictable pattern follows. The technology disrupts existing industries, leading to job losses. Governments can, and do, have in place safety-net policies to cushion the blow for people directly affected. And, as I mentioned before, new companies will exploit these technologies to create new types of jobs and entirely new industries. The hockeystick growth and productivity gains help boost income, which flows throughout the entire economy. This in turn increases demand in every sector of the economy, creating new job opportunities and raising living standards. Let me give an example from Canada's history. At Confederation, 151 years ago, about half of working Canadians were employed in agriculture in one form or another. As new technologies disrupted farming, fewer people were needed on the farm, yet farm output continued to expand. The same technologies created new opportunities for those who moved to cities. By the 1920s, only one-third of Canadians were still involved in agriculture. By the 1950s, that figure was down to 15 per cent and, today, it is less than 2 per cent. And, yet, agricultural output has more than tripled over the past century. Here at the start of the fourth industrial revolution, new applications are creating jobs that were unimaginable just a few years ago. When most of us were kids, we did not dream about what we would create with a 3-D printer, because 3-D printing had not been invented yet. Ten years ago, there were no smartphone app developers, or cloud computing engineers or social media managers. It is human nature to focus on the negative. So, when we think about autonomous vehicles, for example, people tend to dwell on the jobs that will begin to disappear for truckers and taxi drivers. Clearly, governments need to support people who bear the brunt of technological change. At the same time, we need to remember the positives--all the new jobs that will be created and the people who will be needed to build these vehicles, to write their software, to maintain the fleets once they are built, to redesign and construct roads, to coordinate traffic and so on. What is more, truly creative entrepreneurs will think about new ways to apply this technology, for example, to boost independence and productivity for many people living with disabilities. Beyond this, we also need to remember the income-generating effect of these new jobs. The higher incomes that are generated create demand, not just in the new sectors but also for other goods and services throughout the economy, including such ordinary things as housing and home renovations. This incomegenerating effect is likely one factor behind Canada's strong job growth last year in sectors such as manufacturing and construction--jobs where the required skills are not too far removed from those required in sectors of the economy that are being disrupted. The bottom line is this: throughout history, technological advances have always led to rising productivity and living standards, and they have always created more jobs than they destroyed. This is not to understate the pain that disruption can cause for individuals--we owe it to them to work hard to create pathways forward, so all can participate in the evolving economy. It is time for me to conclude. The Bank of Canada has plenty of reasons to care about the state of the labour market. It has become a good deal healthier over the past year or so, but we still see some slack remaining. We expect to see increased investment--both in existing and brand new companies--as well as labour market churn create more supply through higher productivity and employment. However, these uncertain processes entail both upside and downside risks to inflation, and our monetary policy remains particularly data-dependent as we balance those risks. Of course, we are watching issues other than the state of the labour market and the evolution of supply. Yet, even with all the unknowns, there is good reason to be optimistic about the Canadian economy. These are exciting times. New opportunities, new technologies and new industries are all waiting right around the corner. The students here today will be the ones who will shape the future, with the tools developed through their imagination and ingenuity. I cannot wait to see how it turns out.

r180322a_BOC

canada

Financial Stability: Taking Care of Unfinished Business

wilkins

Here we are, 10 years after the financial crisis, still tallying the costs, studying causes and drawing lessons from it. The outcome would have been worse in 2008 and the following years had it not been for the swift and coordinated efforts of policy-makers around the world to boost demand and repair the financial system. Even so, it has been estimated that the crisis cost the global economy 62 million jobs and more than US$10 trillion in lost output. Canada's recession was less deep than experienced in countries at the epicentre of the crisis, it was still painful for many people. It took more than a decade--and a series of aftershocks--to get to a place where we feel that emergency measures, such as ultra-low interest rates, may at last no longer be needed. While uncertainty about trade polices continues to cloud the global and Canadian outlooks, for a central banker like me, this moment feels like it has been a long time coming. We responded to contagion from abroad with aggressive monetary policy actions. We have estimated that without these actions, the recession might have been a year longer and an additional half a million jobs would have been lost. We worked with our Canadian and international colleagues--and some of you here--to put critical programs in place to ensure liquidity in core funding markets during the crisis. And, we co-operated on a series of global financial reforms. Having been personally involved on several fronts, I know just how much of a collective effort this was. Many of you here today have worked hard in your own institutions to comply with new rules and shore up risk management. We have all accomplished a lot. But, let's face it, the job is still not done. Winston Churchill once said, "All men make mistakes, but only wise men learn from their mistakes." So, it is wise to have conferences like this one, where we can continue to reflect on what went wrong. That is why I am pleased to be here; I would like to thank the organizers for the invitation. The experts who spoke before me gave us insights into the genesis of the crisis and the subsequent lessons. My intention is to push the conversation forward and spark discussion in three areas where I believe we have unfinished business: Understanding the role of monetary policy in financial stability --if there is one thing we have learned since the turn of the century, it is that price stability does not guarantee financial stability. Keeping policy current as risks to the system evolve-- leverage and liquidity are important usual suspects , but the trickiest part may be understanding the risks that stem from interconnectedness in an ecosystem that is changing rapidly. Being ready for when things go wrong --being well prepared will help keep the financial damage to a minimum, especially for people who did not take the risk in the first place. Central banks, along with other authorities and financial system participants, have a strong role to play in all these areas. Let me start with the role of monetary policy in financial stability. Monetary stability-- low, stable and predictable inflation--is at the heart of a solid macroeconomy and financial stability. Since the Bank of Canada adopted its inflation-control target in 1991, there has been a reduction in the variability of economic growth by more than one-third and in unemployment by 40 per cent, even when accounting for the crisis. This has been particularly beneficial for younger people and workers with a lower level of education, who tend to have more precarious employment. Successful inflation targeting in Canada and elsewhere is considered one of the factors behind this "Great Moderation," together with some helpful changes to structural policies and a little good luck. We know that many factors contributed to the crisis--including inadequate regulatory safeguards and global macroeconomic imbalances. That said, the crisis made clear what some economists had previously suspected: price stability alone is not enough to ensure financial stability and could, in some circumstances, contribute to the buildup of financial vulnerabilities. Central bankers were of course already aware that vulnerabilities could build up via the traditional channel of monetary policy that works through asset prices and credit markets. But we learned the hard way that another channel--the risk-taking channel--could be a powerful amplification mechanism. In fact, it is now evident that low interest rates encourage people not only to borrow more but also to make riskier investments to get better returns. Hindsight is 20/20, but we can all think of an episode that fits the risk-taking narrative. For me, it is the substantial rise in the issuance of structured credit in the mid-2000s that facilitated a huge increase in subprime mortgages and leveraged buyouts driven by private equity. The unfinished business here is coming to a consensus about what monetary policy can and should do about financial vulnerabilities, and about how monetary policy fits into the rest of the policy framework. Clearly microprudential and macroprudential regulations are on the front lines, and inflation targeting is the central bank's primary mission. Nevertheless, we take financial stability into account in our decisions, consistent with our risk-management approach. The current situation offers an example. With high levels of household debt and the Canadian economy operating close to capacity, monetary policy actions to achieve the inflation target and support financial stability are currently complementary. The Bank of Canada has underscored that there is nonetheless a fine balance to be struck here: while moving too slowly would allow more time for financial vulnerabilities to build, moving too quickly could have outsized effects, given the high level of household indebtedness. There may be, in different situations, a case for taking longer to bring inflation back to target than the usual six to eight quarters. That was something we considered in late 2013. Inflation was running below target and the economy had excess capacity, which might have warranted an easing in policy. However, we judged that the best course of action was to leave our policy rate at 1 per cent to avoid exacerbating financial vulnerabilities in the household sector, while still returning inflation to target over a reasonable time horizon. There is still debate about how best to integrate financial stability considerations into monetary policy. I would like to highlight a couple of promising avenues to help advance this discussion. The first is to invest in policy models that do a better job of capturing the interlinkages between the financial system and the economy, such as those that can lead to defaults on loans, asset fire sales and other real-world events. I don't think any model will ever be perfect, so we will always be operating with a heavy dose of uncertainty. Yet, this research will yield insightful answers to the question of how monetary policy should respond to a buildup of financial vulnerabilities, if at all. The second avenue is to strengthen our framework for macroprudential policies, which are better suited to target financial system risks. Taking a page from the inflationtargeting regime, there is a benefit to clarity about objectives, governance and tools for the job. The focus in Canada has understandably been on macroprudential policies related to household finance to improve the quality of debt and limit its growth. Many of these policies, such as recent changes to mortgage underwriting rules, are aimed at increasing the resilience of the financial system on an ongoing basis. Authorities could use other tools to dampen financial cycles and boost the resilience of the banking system when bank credit has been growing rapidly. An example is the countercyclical capital buffer introduced as part of the Basel III reforms. The Bank of England has put such countercyclical measures in place, and the Office of the Superintendent of Despite the promise of macroprudential policy, we need to be humble about what we know in practice. As we gain experience with these tools, in Canada and abroad, we should sharpen our understanding of their effectiveness. And we should continue to strengthen the framework in which monetary policy and macroprudential policies reinforce each other. A solid framework is essential to reduce the likelihood of undue pressure for monetary policy to lean against the build-up of financial vulnerabilities. Interest rates are a blunt tool, so using them to achieve financial stability could have suboptimal outcomes from the perspectives of both monetary policy and financial stability. That is why it is imperative that academics and central banks focus our efforts on a number of areas. At the Bank of Canada, we are exploring new sources of microdata to better understand vulnerabilities and monitor the effectiveness of macroprudential tools and monetary policy. We are developing policy models that have relevant institutional features and rich heterogeneity in income and wealth to get a better handle on the efficacy and impact of macroprudential policy tools. Even with improvements in these areas, we know that monetary and macroprudential policies will be insufficient to fully safeguard financial stability. This brings me to the second area of unfinished business, which is that our regulatory and supervisory practices need to stay current as risks evolve. The key issues that got us into the crisis--leverage, illiquidity and interconnectedness--are still the right ones to look at. We have taken great steps to identify, manage and mitigate these vulnerabilities in financial institutions. Basel III is largely in place globally, which has tightened banks' capital and liquidity requirements and set a limit on leverage. We have enhanced bank resolution tools and shifted the largest portions of over-the-counter derivatives to central counterparties (CCPs). And, many of the weaknesses in market-based financing that made the system vulnerable before the crisis have been addressed. The job is never done, however, because risk is constantly shifting. We learned from the crisis that, while trouble is a complex brew, financial innovation is usually a key ingredient. Financial innovation has not slowed since the crisis. It can often help improve our financial system, yet it can also carry risks. That's why risk management needs to become more nimble. A couple of areas worry me right now, and they need concerted attention. Both relate to interconnectedness and trust in the system. My first concern is one that I know is shared by many here in relation to your own activities: cyber risk. In fact, a recent survey conducted by Risk.net found that disruption in information technology leads the list of the top 10 operational risks for 2018. When it comes to cyber risk, and many other operational risks, we are all connected. Now, some new technologies, such as cloud computing, may be safer than legacy systems. Yet cyber risk is heightened in other ways because of an increasing number of points of access to core parts of the financial system and the growing sophistication of those launching cyber attacks. It is part of our digital world. The Bank of Canada is responsible for oversight of critical financial market infrastructures (FMIs). We already impose strong requirements to support the stability of these infrastructures, such as payment systems and CCPs, and we are working to further contain and respond to cyber risks. The systems that underpin all financial transactions in our economy are highly interconnected, and a cyber attack on one could quickly propagate and cause major disruptions. The costs might not stop there. Households and businesses typically do not think about these systems because they operate smoothly behind the scenes. However, trust in core systems could be undermined if participants felt that their information or assets were vulnerable. That is why we are working with Payments Canada and the six largest Canadian banks to reduce the chance of a serious cyber event, and to mitigate the impact and recover quickly if such an event were to materialize. My second area of concern is related to the rapid pace of financial innovation. Such innovation can bring lower costs and increase the range of investment strategies. Exchange-traded products, for example, offer investors relatively easy access to illiquid, complex strategies. The issue is that some of these strategies rely on derivative structures that have counterparty and collateral risks. These products can be surprisingly troublesome if they are not well understood, yet become popular, particularly with retail investors. This hearkens back to Canada's experience with thirdparty asset-backed commercial paper leading up to the crisis. A recent--albeit more contained--example is inverse volatility exchange-traded products. Many investors were attracted to the high returns earned on these products in the low-volatility environment of recent years. At the beginning of February, however, these products lost nearly all their value in one day when US equity volatility spiked. The good news is that markets were resilient to this event. The unease is because, aside from the obvious suitability issue, many were unaware of the extent of the underlying interlinkages between products, in this case, leveraged long and short volatility products. These interlinkages, or dynamics, worked to amplify the volatility by creating a one-way market in VIX futures. Even further along the risk spectrum are private crypto assets. I do not refer to the existing products as currency because they do not perform any of the key functions of money. While activity may be too small right now to be systemic, at some point they could have financial stability implications. The crypto world is moving fast, and is largely unchecked. This certainly raises concerns about investor protection, market integrity and the use of crypto assets in illegal activities. In fact, there is evidence of widespread use of some crypto assets for money laundering and other illegal activities, and some rather spectacular incidents of theft and fraud have occurred. And we have seen significant financial risk, given the volatility and illiquidity of the assets. Authorities should work toward a coherent set of policies for crypto assets that is aligned internationally. This strategy will need to cover risks in both cash and derivatives products, as well as in the related ecosystem. The Canadian Securities Administrators (CSA) launched work on offerings of crypto assets last year, noting that--where appropriate--they are treating these as securities. I just returned from the G20 meetings in Buenos Aires and am pleased that the G20 is increasing its focus in this area, given the global nature of these products. My bottom line here is that we need a sharpened focus on consumer and investor protection, and market integrity. These are foundational elements of a sound financial system because they support trust. The last area I want to highlight is readiness: we need to be prepared for when things go wrong. It is impossible to be rid of all risks, and undesirable as well. A modern economy advances because people work hard and are willing to stick their necks out. That means that some risk will materialize. That said, the system should be able to withstand some failures without imposing huge costs on those who did not take the risk in the first place. We have made a lot of progress in a number of areas, but more needs to be done. For example, we identified the financial institutions and FMIs that could have outsized impacts on the financial system if they failed, and we are subjecting them to more stringent regulation and supervision, including recovery and resolution planning. Central banks and international policy organizations have also worked to develop earlywarning indicators of risks to the global financial system. While these are helpful as a starting point, we need to recognize their limitations, particularly if they rely on deviations from historical trends or threshold values. That is why it is important to push the analysis further to properly gauge the risk. Stress tests are an excellent way to help us understand what could happen if financial institutions were subject to adverse events, such as a steep house price decline or a Brexit vote. They also provide practical information about what might be needed to withstand and recover from these events. The Bank of Canada works with other organizations, such as OSFI and the International Monetary Fund, to conduct regular stress-testing exercises of financial institutions and to improve our modelling techniques. The unfinished business here is that models used for stress testing capture mainly firstround effects, with limited ability to identify spillovers that we know can end up being even more important. For example, while the Bank's current framework does capture second-round effects that could come from interbank exposures and asset fire sales, it could be improved. The Bank, and others who conduct stress tests, could introduce behavioural aspects, such as the reactions of bank managers and other financial market participants, and feedback to the real economy. This would require mapping a broader range of interconnections among financial players, which is not a trivial exercise. We would also need to keep this mapping fresh by considering changes in the financial system that might affect the results. An example would be potential changes in the stickiness of retail deposits in an environment of open banking. Of course, it's not all about banks. Stress-testing frameworks have been designed for CCPs to test their capacity to absorb losses stemming from the default of a participant. More work is being done here as well. Many CCPs have clearing members in common, and so international standard-setting bodies are developing a framework for supervisory stress tests of multiple CCPs across jurisdictions. We know that being well prepared will increase the odds that financial institutions will recover from stress events; we also know that recovery is not always possible. Effective resolution regimes and credible plans are needed to resolve systemically important financial institutions if they fail. Together with other members of the Financial Stability Board, Canada has committed to establishing effective resolution regimes for its As part of this effort, Canada introduced the legislative framework for a bail-in regime to ensure that people who invest in long-term bank-issued debt, along with equity holders, share in the financial burden of resolving systemically important banks. Aside from protecting the taxpayer, this kind of regime will help avoid adverse implications for the distribution of wealth that can follow a bailout. It will also support market discipline on banks in good times. Development of the rest of the framework is also under way. Canadian banks are working hard with the Canada Deposit Insurance Corporation on their resolution plans. These plans are particularly complicated for those with significant cross-border activities, because home and host regulatory authorities need to develop a clearer sense of how financial institutions with global footprints would collaborate in stressful times. With respect to Canada's systemically important FMIs, this year's federal budget included plans to implement a resolution framework, although it still needs to be operationalized. Rest assured, we will not be satisfied until all these plans meet an appropriate standard. It's time to wrap up. Janet Yellen said in 2009 that an imperative "for sustained economic recovery following a financial crisis is a thoroughgoing repair of the financial system." On this front, we have accomplished much over the past decade, and we are now reaping the benefits. They might not be durable, though, unless we focus on some unfinished business: refining our understanding of the role of monetary policy in supporting financial stability, keeping regulatory and supervisory policies current as risks evolve, and planning for recovery and resolution when things go wrong. The Bank of Canada is committed to playing a strong role in all of these areas, both domestically and at international tables. And let us remember, whether it is through our own financial decisions, our advice to policy-makers or our policy actions, we all play a role in the health of the financial system, and in the trust that people place in it.

r180418a_BOC

canada

Monetary Policy Report Press Conference Opening Statement

poloz

Governor of the Bank of Canada Press conference following the release of the Good morning. Senior Deputy Governor Wilkins and I are happy to be with you to answer your questions about today's interest rate announcement and our (MPR). Before taking your questions, let me briefly offer a few insights into Governing Council's deliberations. Inflation is on target and the economy is operating close to potential. That statement alone underscores the considerable progress seen in the economy over the past 12 months. That said, interest rates remain very low relative to historical experience. This is because the economy is not yet able to remain at full capacity on its own. Furthermore, the sustainability of this level of activity is not assured; although we expected the economy to moderate in the second half of 2017, that moderation has extended into early 2018 and has been more pronounced than expected. Governing Council considered recent economic data very carefully and concluded that the softness early this year was due mainly to two temporary factors. The first relates to changes to mortgage rules that went into effect at the start of the year. These caused house sales to be pulled forward into the fourth quarter of 2017. Although we are still expecting the housing sector to moderate in 2018 compared with last year, we can expect a partial recovery of activity in the second quarter. The second factor is the unexpected drop in exports during the first quarter, much of which was related to transportation bottlenecks. This points to a partial recovery in the second quarter and later in the year. Notice that we are expecting only a partial recovery in the level of exports--an issue I will return to in a moment. Accordingly, we expect a strong rebound in the second quarter after a lacklustre first quarter, with an average growth rate of about 2 per cent in the first half of the year and a return to near-potential growth thereafter. Fiscal stimulus, both provincial and federal, is playing a role in this forecast. We will be monitoring the data for the second quarter very closely in the weeks ahead. Assuming our forecast remains on track, it is Governing Council's view that interest rates will need to move higher over time to keep inflation on target. We acknowledge that the forces weighing on the economy mean that monetary policy is likely to remain stimulative to some degree, even if it is less stimulative than today. By this, we mean that interest rates may need to remain below the neutral range until various forces have dissipated. These would include, in particular, the uncertainty around trade conflicts and escalating geopolitical risks. We have reviewed our work on the neutral interest rate and concluded that it still lies somewhere in the range of 2.5 to 3.5 per cent, given a 2 per cent inflation rate. Another useful benchmark that entered our discussions was the real policy rate, which takes into account the rate of inflation on the policy rate. Today, this benchmark is at minus 0.75 per cent. It is the view of Governing Council that the need for a negative real policy rate continues to diminish steadily, albeit gradually. Most of our deliberations, therefore, concerned the appropriate pace of interest rate increases. As we have said repeatedly in the past, this is an intensely datadependent process of risk management. We continue to be faced with four key sources of uncertainty around the outlook for inflation. Each of these represents the potential for either upside or downside risk to the inflation outlook, and therefore needs to be assessed to ensure that our risks remain balanced around the 2 per cent target. First is the issue of economic capacity. We have done our extensive annual reassessment of economic potential and revised its profile higher, both in terms of its level and growth rate. This means that we have a little more room for demand growth within our 2 per cent inflation target than we believed before. Related to this, it is becoming increasingly evident that Canada's international competitiveness challenges are hampering our export performance. Many firms are operating at or above their capacity, but are hesitating to invest in new capacity given the uncertain future of the North American Free Trade Agreement, transportation bottlenecks and a shortage of skilled workers, to name a few issues. This reluctance to expand capacity, in turn, also serves to limit growth in our exports. It is possible that this represents a structural change in the Canadian economy, and the resolution would lie beyond the capability of monetary policy. For the central bank, the net effect on the inflation outlook will be our guide. The Bank is continuing to work on these issues and will offer more research in time for our next MPR in July. The second issue is the dynamics of inflation itself. Recent data have been very reassuring. Indeed, the convergence of our three core measures around 2 per cent, as we forecast last year, has helped buttress confidence in our inflation models. Our forecast now shows inflation rising modestly above 2 per cent due to temporary factors, and then easing back to about 2 per cent during 2019. In this respect, it is worth underscoring that our target is a range of 1 to 3 per cent and that the average rate of inflation in the last few years has been below the midpoint of the range. The third issue is wage dynamics. Recent data have been encouraging. Our summary measure of various wage series, called wage-common, shows that wage growth has picked up significantly in the last 18 months. We have noted before that we would expect wages to be growing by around 3 per cent in an economy operating close to capacity. We are approaching that zone now, although the latest figures have been boosted temporarily by minimum wage increases in some provinces. Furthermore, Governing Council acknowledged that these data can be difficult to interpret after a prolonged period of labour market slack. For example, wages tend not to decline during periods of high unemployment as much as our models might predict, and when the economy recovers, there is a lag before average wages respond. All things considered then, we continue to believe that there are elements of excess capacity in the labour market, as well as the possibility of productivity-enhancing labour market churn, that will add to the economy's capacity. Fourth, Governing Council has been monitoring the data for evidence that the sensitivity of the economy to interest rates has risen with household indebtedness. This issue will take longer to assess, especially given that the housing market and mortgage lending have also been affected by the new mortgage guidelines. However, we did note that household credit growth has continued to moderate, an important signal that is consistent with the idea that households are beginning to adjust to higher interest rates and the new mortgage rules. Some progress has been made on the key issues being watched closely by Governing Council, particularly the dynamics of inflation and wage growth. This progress reinforces our view that higher interest rates will be warranted over time, although some degree of monetary policy accommodation likely will still be needed to keep inflation on target. The Bank will also continue to monitor the economy's sensitivity to interest rate movements and the evolution of economic capacity. In this context, Governing Council will remain cautious with respect to future policy adjustments, guided by incoming data. With that, Senior Deputy Governor Wilkins and I would be happy to answer your questions.

r180423a_BOC

canada

Opening Statement before the House of Commons Standing Committee on Finance

poloz

Governor of the Bank of Canada Governor Wilkins and I are pleased to be with you today to discuss the Bank's (MPR), which we published last week. At the time of our last appearance in October, we saw signs that the Canadian economy was moderating after an exceptionally strong first half of the year. That moderation turned out to be greater and to last a bit longer than we expected. Still, it is important to recognize that inflation is on target and the economy is operating close to potential. That statement alone underscores the considerable progress seen in the economy over the past year. The slower-than-expected growth in the first quarter reflected two main issues. First, housing markets reacted to announcements of new mortgage guidelines and other policy measures by pulling forward some transactions into the fourth quarter of last year. That led to a slowdown in the first quarter that should naturally reverse. Second, we saw weaker-than-expected exports during the quarter. This weakness was caused in large part by various transportation bottlenecks. Some of this export weakness should also reverse as the year goes on. So, after a lacklustre start to 2018, we project a strong rebound in the second quarter. All told, we expect that the economy will grow by 2 per cent this year, and at a rate slightly above its potential over the next three years, supported by both monetary and fiscal policies. The composition of growth should shift over the period, with a decline in the contribution from household spending and a larger contribution from business investment and exports. Inflation should remain somewhat above the 2 per cent target this year, boosted by temporary factors. These factors include higher gasoline prices and increases to the minimum wage in some provinces. Their impact should naturally unwind over time, returning inflation to 2 per cent in 2019. Of course, this outlook is subject to several important risks, and a number of key uncertainties continue to cloud the future, as was the case in October. In terms of risks to the outlook, the most important remains the prospect of a large shift toward protectionist trade polices around the globe. I should be clear that our forecast already includes the negative effect of increased uncertainty on companies' export and investment plans. Otherwise, it assumes that the trade agreements now in place will continue. The range of possible outcomes is far too wide to incorporate into an economic projection. The four main uncertainties around the outlook for inflation are the same as six months ago, but good progress has been made on some of them. First, in terms of economic potential, our annual review led us to conclude that the economy currently has more capacity than we previously thought. As well, this capacity is growing at a faster pace than we expected. This means we have a little more room for economic demand to grow before inflationary pressures start to build. That said, some firms, particularly exporters, are operating at their capacity limits but are hesitating to invest. This hesitation may be due to trade uncertainty, transportation bottlenecks, shortages of skilled workers or other reasons. Regardless, it is limiting growth of our exports and economic capacity. The second source of uncertainty concerns the dynamics of inflation. Here, recent data have been reassuring. Inflation measures, including our various core measures, have been behaving very much as forecast and are consistent with an economy that is operating with very little slack. This gives us increased confidence that our inflation models are working well. The third area of uncertainty is about wages, and data here are also encouraging. Wage growth has picked up significantly over the past 18 months, approaching the 3 per cent growth rate one would expect from an economy that is running at capacity. However, the most recent figures are being boosted temporarily by the minimum wage increases in some provinces. The fourth source of uncertainty is the increased sensitivity of the economy to higher interest rates, given elevated levels of household debt. The concern is that as interest rates rise, the share of household income going to service debt will also rise, leaving less to spend on other goods and services, and putting downward pressure on inflation. It will take more time to assess this issue, particularly because new mortgage guidelines are currently affecting the housing market and mortgage lending. However, the growth of household borrowing is slowing, which is consistent with the idea that consumers are starting to adjust to higher interest rates and new mortgage rules. So, as you can see, there has been some progress on these four key areas of uncertainty, particularly the dynamics of inflation and wage growth. This progress reinforces our view that higher interest rates will be warranted over time, although some degree of monetary policy accommodation will likely still be needed to keep inflation on target. The Bank will continue to monitor the economy's sensitivity to interest rate movements and the evolution of economic capacity. In this context, Governing Council will remain cautious with respect to future policy adjustments, guided by incoming data. to answer questions.

r180425a_BOC

canada

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

poloz

Governor of the Bank of Canada Governor Wilkins and I are pleased to be back before you today to discuss the (MPR), which we published last week. When we were last here at the beginning of November, we saw signs that the Canadian economy was moderating after an exceptionally strong first half of the year. That moderation turned out to be greater and to last a bit longer than we expected. Still, it is important to recognize that inflation is on target and the economy is operating close to potential. That statement alone underscores the considerable progress seen in the economy over the past year. The slower-than-expected growth in the first quarter reflected two main issues. First, housing markets reacted to announcements of new mortgage guidelines and other policy measures by pulling forward some transactions into the fourth quarter of last year. That led to a slowdown in the first quarter that should naturally reverse. Second, we saw weaker-than-expected exports during the quarter. This weakness was caused in large part by various transportation bottlenecks. Some of this export weakness should also reverse as the year goes on. So, after a lacklustre start to 2018, we project a strong rebound in the second quarter. All told, we expect that the economy will grow by 2 per cent this year, and at a rate slightly above its potential over the next three years, supported by both monetary and fiscal policies. The composition of growth should shift over the period, with a decline in the contribution from household spending and a larger contribution from business investment and exports. Inflation should remain somewhat above the 2 per cent target this year, boosted by temporary factors. These factors include higher gasoline prices and increases to the minimum wage in some provinces. Their impact should naturally unwind over time, returning inflation to 2 per cent in 2019. Of course, this outlook is subject to several important risks, and a number of key uncertainties continue to cloud the future, as was the case in November. In terms of risks to the outlook, the most important remains the prospect of a large shift toward protectionist trade polices around the globe. I should be clear that our forecast already includes the negative effect of increased uncertainty on companies' export and investment plans. Otherwise, it assumes that the trade agreements now in place will continue. The range of possible outcomes is far too wide to incorporate into an economic projection. The four main uncertainties around the outlook for inflation are the same as six months ago, but good progress has been made on some of them. First, in terms of economic potential, our annual review led us to conclude that the economy currently has more capacity than we previously thought. As well, this capacity is growing at a faster pace than we expected. This means we have a little more room for economic demand to grow before inflationary pressures start to build. That said, some firms, particularly exporters, are operating at their capacity limits but are hesitating to invest. This hesitation may be due to trade uncertainty, transportation bottlenecks, shortages of skilled workers or other reasons. Regardless, it is limiting growth of our exports and economic capacity. The second source of uncertainty concerns the dynamics of inflation. Here, recent data have been reassuring. Inflation measures, including our various core measures, have been behaving very much as forecast and are consistent with an economy that is operating with very little slack. This gives us increased confidence that our inflation models are working well. The third area of uncertainty is about wages, and data here are also encouraging. Wage growth has picked up significantly over the past 18 months, approaching the 3 per cent growth rate one would expect from an economy that is running at capacity. However, the most recent figures are being boosted temporarily by the minimum wage increases in some provinces. The fourth source of uncertainty is the increased sensitivity of the economy to higher interest rates, given elevated levels of household debt. The concern is that as interest rates rise, the share of household income going to service debt will also rise, leaving less to spend on other goods and services, and putting downward pressure on inflation. It will take more time to assess this issue, particularly because new mortgage guidelines are currently affecting the housing market and mortgage lending. However, the growth of household borrowing is slowing, which is consistent with the idea that consumers are starting to adjust to higher interest rates and new mortgage rules. So, as you can see, there has been some progress on these four key areas of uncertainty, particularly the dynamics of inflation and wage growth. This progress reinforces our view that higher interest rates will be warranted over time, although some degree of monetary policy accommodation will likely still be needed to keep inflation on target. The Bank will continue to monitor the economy's sensitivity to interest rate movements and the evolution of economic capacity. In this context, Governing Council will remain cautious with respect to future policy adjustments, guided by incoming data. to answer questions.

r180501a_BOC

canada

Canada’s Economy and Household Debt: How Big Is the Problem?

poloz

I would like to thank Jing Yang for her help with this speech. Governor of the Bank of Canada Shakespeare wrote, "Neither a borrower nor a lender be." Well, that may have been reasonable advice back in Hamlet's day, but it is hard to imagine a modern economy like ours functioning under that dictum. For most Canadians debt is a fact of life, at least at some point. Borrowing can help someone get a higher education, or buy a new car, or purchase a home. Simply put, debt is a tool that allows people to smooth out their spending throughout their life. The amount of debt held by Canadian households has been rising for about 30 years, not just in absolute terms but also relative to the size of the economy. At the end of last year, Canadian households owed just over $2 trillion. Mortgages make up almost three-quarters of this debt. While debt is indispensable for our modern way of life, it has been a growing preoccupation for the Bank of Canada for several years now. That is because high debt levels can make us vulnerable to negative events--individuals as well the entire economy. There are two ways to look at this. Traditionally, our focus has been on the vulnerability of Canada's financial system arising from elevated indebtedness. This means analyzing how our banks would manage a serious economic recession with high unemployment and increasing debt defaults. But the Bank is also focused on the vulnerability of our economy to rising interest rates, given high household debt. There is little doubt that the economy is more sensitive to higher interest rates today than it was in the past, and that global and domestic interest rates are on the rise. So, today I want to talk about household debt in Canada--the dynamics that led to its buildup, how big a problem it is for Canadians now, and how we can manage the risks in the years ahead. Two trillion dollars of debt is a big number. Let us try to put some context around it. A common way to measure household debt is to compare it with the amount of disposable income people have. In Canada's case, household debt is around 170 per cent of disposable income. In other words, the average Canadian owes about $1.70 for every dollar of income he or she earns per year, after taxes. That ratio is a Canadian record, and up from about 100 per cent 20 years ago. Although this ratio is on the high side, other economies such as Sweden, Norway and Australia have even more household debt relative to disposable income. This international comparison reveals some common factors. Like Canada, the countries I just mentioned have all seen decades of steadily rising house prices. They all have high rates of homeownership and deep, well-developed mortgage markets. Like Canada, mortgages in Australia are typically amortized over 25 to 30 years. In Norway and Sweden, you can find mortgages where the homeowner is only making interest payments, and the principal is passed on from one generation to the next. Aspiring to own a home is part of our culture. It is also a way to build wealth for the future, as house prices have tended to rise faster than incomes. My colleague, Deputy Governor Larry Schembri, took an in-depth look at the drivers of house prices in a speech in 2015. He found many factors working on both supply and demand to push prices up. On the supply side, Canada is a highly urbanized country, and many of our cities have land-use constraints that limit supply, such as green belts and other zoning restrictions. Geography, in the form of mountains and water, also helps to limit supply and support prices. In terms of demand, several factors have reinforced an extended trend toward higher prices. These include demographics and a long period of low long-term interest rates. But the point I want to stress here is that when you combine a strong desire for homeownership with rising house prices, you will naturally find increasing levels of debt. The connection between low interest rates, rising house prices and increasing debt levels is worth considering in more detail. The goal of our monetary policy is to deliver low and predictable inflation by keeping supply and demand in the economy in balance. If inflation is too low, we can lower our key policy interest rate and expect to stimulate demand for goods and services. When we raise interest rates, we expect to cool demand. You would expect, then, that relatively low interest rates would lead to strong demand for housing. Looking back, mortgage rates shifted into a lower range in the late 1990s. In part, this reflected a global trend toward lower inflation and interest rates. But it also reflected the fact that the Bank of Canada had built some credibility around its inflation-targeting policy, which began in 1991. Canadians had come to expect that inflation would remain low, and interest rates moved lower accordingly. This is when our long-term rise in household debt took root. The situation took another dramatic turn in the wake of the global financial crisis in 2008. Central banks slashed interest rates, in some cases to zero and beyond, and kept them at historically low levels for an extended period. Internationally coordinated fiscal and monetary actions from 2008 to 2010 provided stimulus and helped the world avoid a second Great Depression. But our economy has struggled to gain traction in the last 10 years, not least because our recovery was interrupted by the collapse in oil prices in late 2014. Today, inflation is on target and the economy is operating very close to potential. However, given the lingering effects of the shocks we have faced, the economy still requires stimulus. Let me make a very basic and important point here. Policy stimulus has a cost, whatever form it takes. Whether delivered by monetary or fiscal policies, stimulus encourages growth by bringing forward household spending and business investment, financed with debt. I spoke about these debt dynamics in the Purvis lecture two years ago. If fiscal policy takes the lead in stimulating the economy, this can result in a buildup of government debt. If monetary policy takes the lead, this brings about a buildup in household debt. In both cases, stimulus leads to a buildup of debt over time, whether public or private. And excessive debt levels create a vulnerability, making the economy less resilient to future shocks. This is why policy-makers need to consider the debt consequences of the mix of fiscal and monetary policy. Ultimately, what matters most is the burden of servicing debt relative to income. In other words, the lower the interest rate, the more debt a given household can afford to carry. For this analysis, we look at the debt-service ratio, which is the required payments of interest and principal expressed as a percentage of income. Remarkably, the aggregate debt-service ratio on mortgages for Canadian households has been very stable, remaining within a range of 5 to 7 per cent since the early 1990s. What this means is that Canadians have taken advantage of lower interest rates to carry a higher level of debt, thereby keeping the debtservice ratio fairly constant. You can see how this would arise. Financial institutions are mainly interested in a borrower's ability to service his or her debt out of regular income. So, lower interest rates make it possible to purchase a more expensive home. Further, with improved access to credit--in particular, the widespread use of home equity lines of credit, or HELOCs--it becomes largely a matter for households themselves to choose their overall level of mortgage debt, and to use that debt for a wider range of purposes. Indeed, Canadians, regardless of their age group, are increasingly relying on mortgages. Among people under 35 years old, the percentage of homeowners with a mortgage has edged higher from about 85 per cent in 1999 to 90 per cent in 2016. For people in the 55 to 64 age bracket, the increase was more dramatic--from 34 per cent to 46 per cent. This casts a new light on that 170 per cent debt-to-income ratio I cited before. Notice that the 170 per cent figure represents an average across Canadian households. It includes all those who have little or no debt, which means, to make the average level of debt so high, it also must include some very highly indebted Canadians. In fact, about 8 per cent of indebted households owe 350 per cent or more of their gross income, representing a bit more than 20 per cent of total household debt. These are the people who would be most affected by an increase in interest rates. We are closely watching the vulnerability represented by this group and the debt they carry, and how it poses a risk to both the financial system and the economy. And it is important for these households to understand how personally vulnerable they may be. In this context, recent changes to mortgage regulations are particularly welcome--including those that require people to show that they can service their debt at higher interest rates. These regulations are helping reduce the economy's vulnerability, since new borrowers will be more resilient than existing borrowers. There are signs that these and other rules are working, as we are already seeing a significant reduction in the issuance of very high loan-to-income mortgages. However, these regulations apply only to new mortgages. The stock of household debt, including the $1.5 trillion in existing mortgages, will persist. And this debt has increasing implications for monetary policy. As I said at the beginning, a significant issue for us now is gauging how much more sensitive consumers, and the whole economy, have become to changes in interest rates. This is particularly important right now because the economy will require higher interest rates over time to meet our inflation goals. Given current levels of household debt, we expect that moves in our policy rate will have a stronger impact in cooling demand than they did in previous years. But this is a significant uncertainty--the sensitivity could be larger or smaller than we expect. Since last July, the Bank has raised interest rates three times, taking the policy rate from 0.5 per cent to 1.25 per cent. However, it is still too soon to know just how strong an impact these moves will have. There are many reasons why interest rate changes take time--up to two years--to fully work through the economy. For example, consider that the majority of mortgages in Canada have a fixed interest rate, which is usually adjusted only at the end of the term--most often every five years. Those fixed-rate mortgages that have not been renewed since last July have yet to be affected by the interest rate increases. Some of the people renewing in the last few months may have been given a rate similar to the one they received five years ago. Of course, those who have opted for a floating rate--some 25 per cent of mortgages--have already seen their rate resetting higher. That said, we are seeing some other evidence of the impact of higher interest rates. Banks have increased the interest rates on new loans--not just mortgages, but also other forms of consumer and business borrowing. We have also seen signs that the growth rate of borrowing has begun to moderate. You may be wondering where interest rates are headed. We know there is some level for our policy rate that is considered neutral--where it will neither stimulate nor cool the economy. This neutral rate cannot be observed, and we do not control it. What is more, it can move around over time as the global and domestic economies evolve. Despite this uncertainty, it is a useful reference point for central banks, for three reasons. First, the further the policy rate is from the neutral rate, the greater the impact on the economy. Second, because the neutral rate does change, any given policy setting can become less or more stimulative over time, even if the central bank keeps it unchanged. And third, if the neutral rate in an economy falls far enough, it may be difficult for a central bank to provide enough stimulus in the event of a serious downturn. In our (MPR) last month, we published our latest estimate of Canada's neutral rate, saying it falls in a range between 2.50 and 3.50 per cent, assuming that all shocks affecting the economy have dissipated. At 1.25 per cent, our current policy rate is still well below our estimate of the neutral rate. With supply and demand in our economy currently close to being balanced, you might expect our policy rate to be much closer to neutral. But several forces appear to be still acting to restrain the economy. We talked about these in the MPR. They include the new mortgage rules, ongoing uncertainty about US trade policy and the renegotiation of the North American Free Trade Agreement, and a range of competitiveness challenges affecting Canadian exporters. These forces will not last forever. As they fade, the need for continued monetary stimulus will also diminish and interest rates will naturally move higher. Another benchmark for measuring monetary stimulus is the real rate of interest, defined as our policy rate, less the rate of inflation. Today, our inflation-adjusted policy rate stands at -0.75 per cent. As the economy progresses and the forces acting against it fade, the need for an inflation-adjusted policy rate below zero is steadily diminishing. All this to say that we are becoming more confident that the economy will need less monetary stimulus over time. Still, as we approach every interest rate decision, we need to consider all the risks the economy is facing relative to our forecast, including those related to household debt. If we raise rates too quickly, we risk choking off growth and falling short of our inflation target. If we move too slowly, we risk a buildup of inflation pressures that would cause an overshoot of our inflation target. At the same time, moving too slowly would mean a further accumulation of household debt and rising vulnerabilities, while moving too quickly could trigger the sort of financial stability risk we are trying to avoid. As you can imagine, getting the path of monetary policy right involves a lot of judgment. Bank staff have recently developed an important new way to evaluate these trade-offs and help inform this judgment, and we are publishing a staff analytical note today on this work. Briefly, the framework uses our models to calculate the risks to the economy associated with various hypothetical interest rate paths. By examining many such paths, we are able to sketch the trade-offs involved in choosing any particular path. Intuitively, higher interest rates will mean slower economic growth; but they will also mean reduced financial vulnerabilities. As a result, the impact on the economy of a major financial stability event would be less. From this starting point, the framework then allows for the inclusion of macroprodential policies, such as the new mortgage guidelines. By reducing financial vulnerabilities directly, macroprudential policies improve the trade-off policy-makers face in choosing when to adjust interest rates higher. Put another way, macroprudential policies allow monetary policy to deliver similar results for growth and inflation without exacerbating financial vulnerabilities. It is time for me to conclude. If Shakespeare were writing today, he might say that our financial system gives Canadians more choices than ever in deciding whether to be, or not to be, in debt. Today's record level of household borrowing reflects the evolution of the financial system and the comfort level of Canadians in taking on debt. But it also reflects a prolonged period of very low interest rates and rising house prices. At the Bank of Canada, we have been watching these debt levels closely because of the growing risks they pose to financial stability and the economy. We know that a portion of Canadian households are carrying large debts, and the concern will become larger for them as interest rates rise. Of course, higher interest rates would likely reflect an economy that is on even more solid ground and less prone to a major economic setback. Furthermore, our financial system is resilient, and the new mortgage rules mean that it is becoming progressively more so. Even so, our economy is at risk should there be an unexpected increase in bond yields or a global slowdown, because both effects would be magnified by their interaction with high household debt. Ultimately, the Bank's job is to look at the economy as a whole and judge the outlook for inflation. Today, the view is quite good, even with the shadow cast by household debt. This debt still poses risks to the economy and financial stability, and its sheer size means that its risks will be with us for some time. But there is good reason to think that we can continue to manage these risks successfully. The economic progress we have seen makes us more confident that higher interest rates will be warranted over time, although some monetary policy accommodation will still be needed. We will continue to watch how households and the entire economy are reacting to higher interest rates. And we will be cautious in making future adjustments to monetary policy, guided by incoming data.

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canada

Strengthening Our Cyber Defences

dinis

Thank you for the invitation to speak here today. The ability to control your home appliances or deposit a cheque with a few clicks on your phone is hardly a novelty anymore. These innovations were introduced and widely adopted in record time. More are in the pipeline, and the speed of technological change is most certainly not slowing. I see that in my own family. Before I was even able to master some of the new payment methods, my three children--including my 12-year-old daughter--were referring to them as "old fashioned." The modernization project launched by our host, Payments Canada, is designed to strengthen the underpinnings of the payments system and facilitate innovation and competition in retail payments. But delivering a faster retail payments system will be pointless if users don't have confidence that the system will be better able to protect their account information and their own payments. That applies to the entire financial system. Maintaining the trust of Canadians is essential. We need strong protections within each institution and collaborative partnerships between public agencies and the private sector to share information on cyber threats and strengthen our defences on every front. Despite our best efforts, some attacks will inevitably succeed. Given the sophistication and frequency of cyber incidents, we need Canadians to know that in the event of a successful attack, we have recovery mechanisms in place. Limiting the damage and quickly getting the system back up and running is critically important. That's my topic today--cyber security defences and recovery plans. I'll start with a short overview of the cyber risk environment. I'll explain the Bank of Canada's mandate and the role we play in cyber security for the financial system. I'll describe the three main areas where we are concentrating our efforts and the partners we work with in Canada and internationally. And I'll outline the actions we are taking. Think of all the ways that you can access your bank accounts, aside from standing in line waiting for a teller. You can use your watch, cell phone, tablet, automatic-teller machine and point-of-sale terminal. And think of all the places that accept electronic payments these days. All of this works relatively seamlessly and will become even more so with payments modernization. The real-time retail system that is part of the modernization program means that payments will be final and in your account in seconds rather than days. Yet in many ways we're just getting started. The digital economy is expanding rapidly, with artificial intelligence, robotics, biometrics and other emerging technologies. The number of electronic devices that you can use to connect to the Internet is multiplying exponentially. Each has broadened the web of connections between users and available services. The financial industry is keeping pace with these changes by investing in innovations that are reducing their costs and improving the customer experience. We all want better and faster banking services. But the more the industry adopts new technologies and amasses larger libraries of customer information, the greater the incentives for, and risk of, cyber attacks. Banks, credit unions and other players in Canada's financial system process daily cash payments of $175 billion and more than $500 billion in trades of stocks and bonds . These kinds of numbers have made the financial system worldwide a favoured target of cyber criminals. Canada's financial institutions have strong defence mechanisms in place to repel attempts to steal money, grab information or simply disrupt their operations by causing damage. Our concern is not with individual firms but with the interconnections among them. Institutional protections are an excellent first line of defence, but they need to be complemented by effective sector-wide action, because a rare, successful breach at one institution could quickly morph into a broader disruption of the financial system. Let me now turn to the role the Bank of Canada plays in enhancing the cyber security of the financial system. One of the Bank of Canada's responsibilities is fostering a stable and efficient financial system. With the steady increase in the scope and seriousness of cyber attacks worldwide, we are devoting more time and attention to the threats to financial stability that they pose. How are we helping to mitigate the risk? Our focus is on three main areas. First, we invest to ensure that the Bank itself is resilient to cyber threats. Second, we ensure the financial market infrastructures overseen by the Bank are taking appropriate steps to mitigate cyber threats. And third, we collaborate domestically and internationally with financial system participants, regulators and oversight bodies to improve the resilience of the financial system. Let me give you more detail on each. said in a recent speech that one of the things that keeps him up at night is cyber threats. If they keep him up at night, then I can assure you they keep me up at night as well. Within the Bank, we are constantly investing in and augmenting our own cyber security program to prevent, detect and respond to a rapidly evolving array of threats that may compromise the confidentiality, integrity and availability of our digital information. Our security measures are multipronged, aligned with international standards and always up to date. To protect our internal systems, we have conducted network-penetration tests, enhanced the controls governing access and deployed vulnerability-scanning tools. We ensure our data is encrypted and perform regular security updates. We regularly communicate to staff best practices in online and email safety to make them aware of the risk of cyber attacks and encourage and reinforce appropriate responses. We've seen a significant improvement in the ability of employees to identify phishing e-mails, but we know we can't let our guard down. We monitor the external environment to detect and respond to cyber threats. This includes the collection of threat intelligence and assessment information, a comprehensive review process for any third parties we interact with, a robust access-management program and implementation of enhanced controls. We are also making significant investments in our operational redundancies to ensure the resilience of our systems and our people. It is vital that our key functions can be maintained in the event of a major disruption, be it a cyber attack or natural disaster. Finally, we are putting in place strategies to contain and recover from any damage such attacks might cause. More about this in a minute. The Bank is responsible for the regulatory oversight of financial market infrastructures, or FMIs, that we determine have reached a critical mass where their disruption could affect our entire system. These FMIs include the Large which are owned and operated by Payments Canada. FMIs are hubs for financial transactions. Their connections allow for the safe and efficient exchange of funds, securities and other financial products. Given the central role that FMIs play in the financial system, a prolonged interruption, compromised data integrity or a loss of confidence in them could have a far-reaching impact on the financial system and the real economy. Protecting them from cyber-related threats is of the highest importance. The Bank of Canada helped draft international guidance on cyber security. We use it in our work with the FMIs to assess whether they are taking appropriate steps to mitigate cyber threats. The FMIs internally assess their cyber resilience and also have outside experts conduct independent reviews. We evaluate these assessments to ensure that appropriate cyber security tools and practices are in place. One area that we are concerned about is the growing operational risk from thirdparty providers such as the concentrated set of firms that provide many of the new technologies to the financial sector. Some of these firms offer critical data services and cloud computing and fall outside the purview of system regulators. As the , reliance on these same third parties and the interconnections between institutions could pose a systemic risk to the financial system. Greater global coordination is essential for addressing this issue. We are also active participants in Payments Canada's modernization program. We want to ensure that cyber resilience is top of mind as payment and settlement systems are being redesigned. An important initiative Governor Poloz launched recently--and that I am leading--is collaboration with the six largest Canadian banks to test and enhance the cyber resilience of the wholesale payments ecosystem. The goal is to have a rapid, collaborative approach to recovery should a key participant be affected by a serious cyber security event, such as the corruption of critical data that results in a prolonged operational outage. The financial system's domestic and global interconnections mean it is important that we communicate, coordinate and align our work with what other participants are doing. Within Canada, we study and assess vulnerabilities and risks to the financial system. In our we listed cyber attacks on the financial system as a critical vulnerability and discussed how the Bank is working with industry, international bodies and federal and provincial authorities to enhance information sharing and improve policies. We work to ensure that Canadian FMIs are speaking to the relevant security In that regard, the National Cyber Security Strategy outlined in the recent federal budget is an important step forward. The government is allocating $507 million over five years, with almost $110 million per year afterward, to build an innovative and adaptive national cyber ecosystem. The strategy is designed to support effective leadership and collaboration among government, the business community, academia and trusted international partners. An equally important part of the government's strategy is the creation of a new Canadian Centre for Cyber Security. The centre will become a single source of expert advice, guidance, services and support on operational matters related to cyber security. We are looking forward to building on the Bank's already strong relationship with the CSE and the new Centre. To improve not just cyber readiness but the operational resilience of FMIs and the broader financial system, we helped create and are chairing a partnership includes the Department of Finance, Canadian FMIs, large Canadian banks and the Canadian Bankers Association. Last year, JORM conducted a day-and-a-half long exercise that took 20 months to plan and involved more than 180 participants in three different cities. We wanted to assess escalation and communication protocols and public messaging at a national level during a systemic crisis. To do so, we simulated the operational failure of a key FMI, which would have halted major Canadian debt and equity markets for more than 30 hours. We learned some key lessons from the exercise and are working to improve the financial sector's ability to coordinate actions in the event of such a major disruption. Perhaps the most important lesson we learned is the value of trusted relationships and partnerships among regulators, financial system participants and other sectors. Individual firms in the financial system know their own business but don't always understand all their connections with others. This can lead to decision making that ignores threats to the system. We also discovered--and this is certainly not unique to this exercise--the importance of coordination and communication protocols in the event of a systemic crisis. At such a stressful time, the last thing we want is confusion and ambiguity. We are now developing improved protocols to address this shortcoming. On the international front, we participate in organizations that keep us up to speed on strategy, such as the development of regulatory and supervisory policies and the promotion of financial system resilience. For example, we are active in the G7 Cyber Expert Group, which was created to strengthen cyber security in the international financial system. Cyber threats cut across borders so we coordinate with the expert group on policies such as thirdparty risks and penetration testing. We participate in the SWIFT Global Oversight College. The college oversees the cyber resilience of SWIFT's messaging services. Our participation helps improve our own cyber security as well as that of the financial system in general. We also work with other G7 countries, the Bank for International Settlements and numerous central banks to discuss emerging threats, our responses to threats, security monitoring and other related topics. Let me sum up. Cyber threats aren't going away, so our job will never be done. The threats are constantly evolving and the digital economy is rapidly expanding. It is no longer enough for each institution to maintain its own alarm system. While doing so provides a certain level of protection and comfort, we need to invest in system-wide defences. To achieve that, we need close collaboration and coordination between the public and private sectors in Canada and abroad to share information and develop effective detection, response and recovery strategies. We can only do this by building and maintaining trusted relationships with partners who know that the information they share with us will be protected. Thank you.

r180516a_BOC

canada

The (Mostly) Long and Short of Potential Output

schembri

Thank you for inviting me here today. An important, if sometimes underappreciated, purpose of central bank speeches is to help the public understand what we are trying to achieve, and why. A greater understanding of our monetary policy actions helps make them more effective. And as a public institution, we have an obligation to highlight and demystify the concepts that guide our thinking in a way that all interested citizens, not just the experts in this room, can grasp. Few in the public likely give much thought to potential output, for example. Yet this somewhat abstract notion is vital to how most central banks evaluate inflationary pressures and conduct monetary policy. At the Bank of Canada, being able to estimate and project potential output has contributed notably to our strong track record of meeting our inflation objectives. At the same time, the dynamics of potential output are primarily shaped by slow-moving forces that can take time to have a material impact, such as demographic shifts, capital accumulation and technological change. Equally important, many of these same forces influence a country's standard of living. A significant development in recent decades is that growth in potential output has been on a generally downward trend in most major advanced economies, including Canada, largely owing to the aging of our populations. This trend has important implications for our macroeconomic policy frameworks and for our economic prospects. My remarks today are organized around four separate but closely related questions: How do we measure it? Why is it important for policy? What policies have supported potential output growth in the past and could again in the future? The answers to these questions should help you better understand not only our policy in the near term, but also our thinking about policy-making over a longer horizon. Turning to the first question, we usually refer to "potential" in the context of individual achievement, as in "realizing one's potential." When I was much younger, for example, my aspirations for my own potential included growing as tall as my favourite player on the Dallas Cowboys, becoming a pitcher for the Toronto Blue Jays, and obtaining a PhD. My immigrant parents placed more value on education than sports, so they were quite relieved that I only managed two out of three. Central banks apply "potential" in a similar way--to assess what an entire economy, rather than a single person, can achieve on a sustainable basis. So "potential" can be viewed as a measure of aggregate, or total, supply in an economy. Essentially, it refers to an economy's capacity to produce goods and services when all available productive resources--specifically, labour and capital--are used to their fullest. In practice, we pay close attention to the growth rate of potential output as well as to its level . An economy's productive capacity is normally always growing as available resources and their productivity expand. But the speed at which potential output grows has important short- and long-run implications. In the short run, the rate of potential output growth indicates how quickly an economy can grow on an ongoing basis without stoking inflationary pressures. In the long run, potential output growth is a useful gauge of an economy's prospects, namely the outlook for national income and standard of living, because these are largely determined by the forces of supply. Digging a little deeper, most central banks including the Bank of Canada-, interpret an economy's actual output growth, its gross domestic product (GDP), as being determined in the short run by the forces moving aggregate demand. An economy's potential output growth, meanwhile, reflects the evolution of aggregate supply over a longer horizon Aggregate demand growth tends to move with short-term factors--such as shocks to foreign demand and exports--which may trigger cyclical movements in, for example, inventories and consumer purchases of durable goods. Aggregate supply growth is affected more by the slow-moving forces that I noted earlier. So, a central challenge in pinning down potential output growth is disentangling the short-term fluctuations in GDP caused by demand shocks from long-term fluctuations that are due to the underlying forces that affect aggregate supply. Since the forces that determine aggregate supply tend to change slowly, we focus on trends when thinking about and measuring potential. Now, it's rarely as simple as just separating short-term phenomena from long-term. The Great Recession was a once-in-a-lifetime shock to aggregate demand that, because of its severity, also affected aggregate supply. Consequently, a decade later, this experience continues to have an impact on potential output in advanced economies. So, the disentanglement challenge is two-fold: first, identifying the trend movements, as opposed to temporary or cyclical ones; then, identifying the forces driving the trend movements, which also helps us predict how long they'll persist. I'll go into more detail shortly about how we measure potential output growth. But one way to look at it is to break it into two components: the long-run growth rate of total hours worked in the economy--known as trend the long-run growth rate of how much output is produced per hour of work-- known as trend labour productivity (TLP). shows each component's respective contributions to Canadian potential output growth since 1992. The chart reflects the findings of the Bank's annual reassessment of potential output growth, which we recently published as an appendix to our April Two observations are important. First, the chart shows a secular, or persistent, decline in TLI and, thus, in potential output growth. Population aging is the biggest reason, and it is only partly offset by immigration. Second, TLP's contribution to potential output growth has also declined somewhat from the period before the global financial crisis. TLP growth is expected to increase modestly in the coming years. This is mainly because the slowdown in investment and productivity growth that followed the sharp decline in commodity prices in 2014-15 turned out to be less pronounced than we initially expected, and the economy's adjustment from it is now mostly behind us. That is good news because TLP growth is expected to play a larger role in potential output growth over the projection and beyond. There is, however, considerable debate about how much we can expect productivity growth to rise in the future, even as the emerging digital economy promises to transform how firms operate and how they use their workforces. Canada's experience is similar to that of other advanced economies. shows that potential output growth in Japan, the United States and key countries in the euro area is also much lower now than it was in the 1980s, largely due to the same forces causing the slowdown in Canada. For Canada specifically, the Bank's reassessment found that annual potential output growth from 2009 to 2021 would average 1.8 per cent, much lower than the 2.7 per cent average from 1982 to 2008. With all of this in mind, let's tackle the hard question of how to measure potential output. The main challenge in measuring potential output is that it is hypothetical, so it is not directly observable. We can only estimate it. Over the years, though, the Bank has put a lot of research effort into refining our methods for assessing this very important variable. Techniques for estimating potential output growth can be viewed as being along a spectrum ( ). At one end are simple statistical models that aim to capture underlying trends in output growth by mechanically filtering out short-term fluctuations. The problem with these techniques is they are essentially a "black box"--the data going in and the estimates coming out are known, but there's little economic explanation of how they are connected. At the other end of the spectrum are structural models that rely primarily on relationships between variables, based on economic theory, to identify and quantify the impacts of different sources of potential output growth. For example, higher levels of investment will cause the capital stock to rise faster, leading to more rapid TLP and potential output growth. However, structural models may produce inaccurate estimates if the economic theory on which they are based is incorrect or incomplete. To help manage the uncertainty around measuring potential output growth, the Bank uses a variety of models along this spectrum that combine statistical filters and theorybased structural approaches. This is done so that we can cross-check the estimates from each model and then combine them to get a reasonably robust assessment. , for example, displays estimates for potential output growth from four separate models along the spectrum that are part of the Bank's staff tool box. Models that incorporate an economic structure are especially useful for projecting TLP growth, since TLP is based on variables and relationships that are difficult to measure and predict. TLI growth is comparatively easier to forecast because it is based on accurately observed labour market outcomes: the employment rate, the working-age population and average hours worked. In contrast, TLP growth depends on two variables that are less concrete and therefore more challenging to observe precisely. The first of these, capital deepening , is a measure of growth in the ratio of capital per hour worked. The second is a more elusive concept called trend total factor productivity , or TFP. While we have some observable measures of investment and capital stock growth, we do not have the same for trend TFP--which essentially includes everything affecting firms' productivity that isn't captured by capital stock growth. These "residual" factors include, for example, technological improvements and the impact of education and training. Another way that the Bank manages the uncertainty around potential output growth is by conducting an in-depth review of our projections on an annual basis. First, economic data are regularly revised, so for that reason alone an annual review makes sense. Also, our empirical techniques are "living" in a sense--we are continually improving them as we learn from experience and ongoing research. Plus, in the annual reassessment, we further account for uncertainty by publishing ranges around our estimates and projections that expand with time . We also list the factors that could lead potential growth to be lower or higher within those ranges. I would like to stress that the Bank recognizes the difficulties associated with measuring potential and the related uncertainty, and so takes a deliberate and rigorous approach to managing this uncertainty. We work hard to ensure that our models evolve in line with prevailing best practices. And on top of using multiple techniques, we corroborate the models' results against other measures of capacity and inflation, and then apply wellinformed judgment. Finally, the uncertainty around these estimates is taken into account in the formulation of monetary policy. This helps us ensure that our estimates and our policy decisions are consistent with our broader economic outlook. Now, let me expand on why potential output is important for policy. The conduct of monetary policy For the conduct of monetary policy, the difference between the level of actual and potential output--the "output gap"--is a critical element. It indicates how much slack there is in the economy, and so it is an important determinant and useful gauge of underlying inflationary pressures. As an inflation-targeting central bank , the Bank of Canada's assessments of both the current output gap and its projected evolution have direct bearing on our inflation outlook and policy decisions. Because monetary policy operates with a well-known lag, the Bank must be forward-looking as we set the policy interest rate to affect aggregate demand, close any output gap and return inflation to target on a sustainable basis. A higher level of potential output for a given level of GDP will mean a more "negative" output gap--implying (other things being equal) inflation below the 2 per cent target, greater economic slack and a possible need to ease the policy rate--and vice versa. Along with the output gap, expectations of inflation are also important in explaining current inflation. As inflation targets have become more credible, expectations have become better anchored at the target rate and, in turn, have had a larger influence on inflation itself. To illustrate the relationship between the output gap and inflation, consider . It shows that the Bank's three measures of core inflation all increased steadily over the past year following, with a short lag, the narrowing of our measure of the output gap. This demonstrates how we use other data to corroborate our estimates of the output gap, which helps ensure a coherent economic outlook. The higher the projected growth rate of potential output, the faster the economy can grow without inflation rising persistently above our target. For example, our 2018 reassessment revised the profile for potential higher than it was in the 2017 reassessment, both in terms of its level and growth rate. That means that, in the near term, we have a bit more room than we thought to support demand without sparking undue inflationary pressures. Challenges to the monetary policy framework Although the inflation-targeting framework has been very successful in the past, looking ahead, the decline in potential output growth in many advanced economies represents a notable challenge and has prompted central banks in those countries to revisit their monetary policy frameworks. Let me explain. Lower potential output growth in advanced economies is one of the factors likely contributing to a decline in global real interest rates. For monetary policy, this implies that the policy rate that is considered neutral--where it will neither stimulate nor cool the economy because GDP is growing at its potential level, inflation is at target, and the effects of any shocks have faded--is lower than it would be otherwise. lower neutral rate has important implications for monetary policy. To effectively buffer the economy in response to a harmful shock, it's desirable that a central bank has sufficient room to lower the policy interest rate without going to zero or below, thus being forced to use unconventional tools such as large-scale asset purchases (i.e., quantitative or credit easing) or negative interest rates. Our next inflation-target renewal with the Government of Canada, which represents an opportunity to review our monetary policy framework, is slated for 2021. As part of that process, we will examine ways to meet this challenge and strengthen the framework to enhance the resilience of the Canadian economy. Lower potential output growth also has implications for fiscal policy because it implies less tax revenue than otherwise. Less revenue could limit governments' abilities to implement countercyclical fiscal policy when needed, particularly as demands for public expenditures rise with an aging population. This aspect is important for monetary policy, too. The credibility and success of our inflation-targeting regime depends critically on the coherence of the overall macroeconomic policy framework. To maintain solid potential output growth and rising living standards in the future, what policy lessons can be drawn from the past? Historically, Canada has benefited from strong growth and rising living standards. Great economic opportunity has stimulated employment and investment in capital, while also encouraging investment in individuals through accessible, quality education and an inclusive social safety net. We also have benefited from robust political, legal and economic institutions, and from openness to trade, investment and immigration. Despite those advantages, developing the appropriate policies to maintain solid potential output growth in the face of an aging population is a formidable challenge. Moreover, even the most effective policies can take some time to have a meaningful impact. That said, I'd like to touch on three policy areas that have been successful at promoting potential output growth in the past: education --I have benefited from the opportunity created by my own access, and my parents' commitment, to good-quality education at all levels; immigration --which is something I know a bit about since my parents arrived in Canada from Europe during the 1950s; and trade liberalization --which I have studied and analyzed for my entire professional life. As Alfred Marshall--a founder of neoclassical economics--emphasized more than a century ago, education is critical to economic progress. In a period of accelerating technological change, boosting skills and the flexibility of the labour supply may be as important for potential output growth as the size of the workforce. Improvements to education and training will help make workers more productive, which should in turn boost their employers' overall productivity and lift the economy's potential. In Marshall's era, the main impediment to the quality of the labour force was illiteracy. This was a huge obstacle to lifelong learning and self-improvement. The vast majority of Canadians, of course, can read and have basic numeracy skills. But this wasn't always the case. Our economy's transition around the turn of the 20th century from agriculture to industry was facilitated by promoting public and private investment in education that provided broader access. The question today is whether education and training can equip a growing share of the workforce with the right skills for an increasingly technology-driven economy. While the challenge today may seem more daunting, it also appeared insurmountable in Marshall's time. Yet, the expected private and social returns were great, so investment followed. History needs to be repeated. New technologies should be harnessed to provide broad access to the types of education and training that will help Canadians prosper amid rapid change. This would also help to address rising income inequality, much of which is due to technological change that favours those with greater skills. Higher immigration levels offer an obvious avenue for boosting potential by increasing the supply of labour, given that immigration already accounts for two-thirds of the growth in Canada's workforce. Canada's immigration policy has long been considered a success because of its record of attracting immigrants with the necessary skills to be absorbed into the labour force and to make important economic contributions. This approach will be particularly crucial going forward as the workforce gets older. An important challenge, though, is whether Canada's immigration policy can raise the levels accepted each year while continuing to be as successful as in the past at matching immigrants' skills to the jobs that are available. recently, more could be done to speed up immigrants' integration into the workforce, particularly given the elevated number of job vacancies in Canada. Trade liberalization Given demographic constraints, the most promising remedies for lifting potential may be measures that stand to increase productivity. This speaks not only to the importance of education, as I mentioned, but also to that of creating a climate that encourages capital investment. This can be done through, for example, infrastructure spending and other efforts to ease transportation constraints. Perhaps most helpful in this regard, though, is trade liberalization. Our experience with past and existing trade arrangements demonstrates the benefits of lowering barriers, both external and internal, including improvements in productivity that supported growth in the overall earnings of workers--a direct boost to living standards. Council colleague Tim Lane noted in remarks last September, expanding Canadian firms' access to overseas markets spurs them to invest, innovate and increase their productivity. As in other advanced economies, there is renewed focus in Canada on ensuring that we help the workers who are displaced by trade agreements. Again, education and training can help people adjust. Still, there is no question that Canada has benefited from being one of the world's most diversified, trade-driven economies. Even as uncertainty about US trade policy currently weighs on business investment and export growth, Canada's recent agreements with the European Union and with countries in the Pacific region, in addition to efforts at the interprovincial level, are helping reduce barriers and create opportunities for Canadian companies. Our history tells us that our firm commitment to trade liberalization will remain important for supporting solid potential growth in the future. Allow me to conclude with three key messages. First, potential output is an indispensable input into the formulation of monetary policy, because the output gap is important in determining inflationary pressures in the economy. Using the output gap as our guide has helped underpin the success of the Bank of Canada's inflation-targeting regime, which has, on average, delivered inflation roughly at the 2 per cent target on a consistent basis for more than a quarter-century. Second, the Bank's multifaceted approach to measuring and using potential output-- drawing on diverse tools and on different sources of information--helps to manage uncertainty and ensure reasonably robust estimates. This deliberate and regularly updated approach has also contributed to our success. Third, like other advanced economies, Canada faces important challenges to our policy frameworks and to our economic prospects from lower rates of potential output growth. Nonetheless, we have a rich history of generating economic opportunity and supporting growth, and we should draw from past successes in developing future policies. In closing, I mentioned earlier that although potential is mostly a function of longer-term, slow-moving forces, the Great Recession had a severe and protracted impact on potential output. With the economy now operating close to potential, solid demand growth is spawning business investment, firm entry and improved labour-market conditions--all of which are helping to repair that damage. As noted in recent policy statements, we are closely monitoring this expansion in economic capacity. It will help guide us in achieving our goal of low, stable and predictable inflation, which is the best contribution monetary policy can make to support sustainable growth and rising living standards in Canada.

r180531a_BOC

canada

A Progress Report on the Economy

leduc

Association des economistes quebecois and I am very happy to be here in Quebec City. People come from all over to visit this city, not only for its beauty, its fine dining and its hospitality, but also for its historical significance to North America. There is a lesser-known anecdote from this region that I quite like because it teaches us a lesson on monetary policy that is still relevant today. In 1685, as New France faced a shortage of coins, Jacques de Meulles--the intendant of the colony--decided to use playing cards as paper money by writing a value on them. And when I say "playing cards," I really do mean cards like the ones we use to play hearts or bridge. I would say that gives a whole new meaning to the phrase "play money." These playing cards were the first form of paper money distributed in North Although this series of cards was repurchased only three months later, it marked the beginning of a tradition that would last more than half a century. So why did people agree to get paid in playing cards? Because they trusted the authorities would manage them rigorously. While monetary policy has changed dramatically over the past 300 years, one thing remains the same: trust is key. Today, this trust is buttressed by explaining--in a way that is transparent--what the Bank of Canada is doing and why. I would like to thank the Association des economistes quebecois and CFA Quebec for allowing me to do that here today. My speech is part of an initiative the Bank launched at the beginning of this year. The Bank makes policy interest rate decisions eight times per year. On four of these occasions, we accompany our rate decisions with the (MPR) and a press conference. The other four times, the rate decision is now followed by an economic update speech, where a member of our Governing Council explains how we considered the key elements related to the economic outlook in our decision-making process. Yesterday, the Bank maintained its policy interest rate. The ongoing backdrop for these policy rate discussions is a Canadian economy that, after some challenging years in the wake of the oil price shock, is operating near its potential and inflation that is very close to our 2 per cent target. Here in the province of Quebec, growth was above 3 per cent last year--its best performance in more than 15 years. The broad-based growth since the beginning of 2017, and its implications for inflation, has led us to raise the policy interest rate three times since July. With the economy facing uncertainty on a few fronts, each decision, including yesterday's, is less straightforward than the picture I just painted might suggest. Before diving deeper into the economic environment we are operating in, let me remind you what we are trying to achieve and how we do it. The Bank targets an inflation rate of 2 per cent, within a band of 1 to 3 per cent. It is worth noting that inflation has averaged close to 2 per cent in the past 25 years, and that this success can be attributed in part to our policy, adding to its credibility and increasing public trust in our framework. To reach our goal sustainably, aggregate demand in the economy must be in balance with aggregate supply. Our main tool for achieving this is the policy interest rate, which allows us to stimulate or temper demand. The policy interest rate is currently below our estimate for the "neutral" rate--that is, the equilibrium interest rate when inflation is at target and the economy is growing at potential, once the effects of any shocks have faded. That means our policy stance remains accommodative. Another way to see this is by noting that once adjusted for inflation, our real policy rate is -0.75 per cent. Our accommodative stance reflects the presence of some factors that continue to weigh on the economy and, in turn, on our forecast for inflation. For example, two such factors are the uncertainty surrounding trade policy, which is restraining business investment, and the impact of the new mortgage financing guidelines on housing activity. With this context in mind, I will share our assessment of global and Canadian economic developments and elaborate on the issues that we are watching closely. Global economic developments and exports First, let me talk about the global economy. It plays an important role in our forecasts because we rely on exports for one-third of our gross domestic product Our main trading partners--including the United States, the euro area, China and other emerging markets--continue to show solid growth. Such synchronous growth across these regions has not been seen in many years. Data we have received since mid-April, notably with respect to the US economy, continue to suggest the global economy is expanding roughly as expected. And while global financial markets continue to function well, financial stresses have recently developed in some emerging-market economies as well as in Europe. Though global growth will eventually moderate over time as excess capacity is absorbed, the world economy is nonetheless expected to remain strong and to contribute to our export growth. Despite a rather slow start to the year, the growth of our goods exports jumped to 3 per cent in March. Their contribution to Canadian GDP in the first quarter should be greater than what we had forecast in the April MPR. This is encouraging. That said, we know that our exporters are facing increased foreign competition. As we noted in April, the market share of Canadian non-energy goods in the United States has shrunk by almost half since the early 2000s. We see this competition in many sectors--from automobiles to electronic goods to forestry-- which is why we are monitoring competitiveness very closely, and expect to publish further analysis on this issue in the months ahead. We also know that international trade has undergone some significant changes in the past 10 years. Before that, international trade was growing at roughly twice the rate of the global economy. It is now growing at the same rate as the global economy. This, together with more competitive world markets, has been restraining our exports. Another important factor is the fact that many of our exporters are already operating at full capacity. At an industrial level, three-quarters of the sectors are at their highest capacity utilization rates since 2003. So investments would be needed to meet rising demand. Given ongoing trade policy uncertainty, some firms are waiting to invest in new capacity, while others are deciding to expand outside of Canada. This could limit exporters' ability to grow further even as foreign demand rises. For their part, Canadian oil exports are likely to be stronger than expected in April, following pipeline outages last year. Large upward revisions to oil exports in January suggest that oil exporters recovered much faster from these outages than suggested by earlier data. Canadian economic developments Turning now to the domestic economy more broadly, in April we forecast that activity would grow at roughly 2 per cent over the next two years, a little higher than our estimate of potential growth. Over this horizon, we expected the composition of growth to shift, with a higher contribution from exports and investment, alongside a decline in the contribution from household spending. Despite some short-term fluctuations, we also expected growth to average about 2 per cent in the first half of the year. Overall, the data we have received since April support our near-term projection. Recall that we saw some weak data at the beginning of the year, but the tenor of the more recent data has improved. In addition to the growth in exports I mentioned previously, manufacturing output was especially robust and investment appears to have been stronger than expected. This good news was partly offset by declines in housing resales and retail sales, which suggest that household spending could be a bit weaker than expected in the first quarter. Taken together, all these factors point to growth for the first half of the year around what we forecast in April. This continued growth of the Canadian economy is contributing to strong labour markets and higher wage growth. Indeed, recent data from the Labour Force Survey show that wages in April were 3.6 per cent higher than a year earlier. However, the signal we get from this reading is muddied by the high volatility of this series and the fact that last year at the same time wages were surprisingly weak. Because our different wage indicators are all volatile and sometimes send conflicting signals, the Bank developed a wage measure to help us better capture the trend: the wage-common. According to this measure, wage growth has strengthened considerably from its low in mid-2016, reaching about 2.6 per cent in the first quarter of this year. This stronger wage growth is consistent with what firms surveyed in our quarterly have been telling us. They have indicated that it is becoming more difficult to hire, although firms in energy-producing regions still see little wage pressure. Still, at this point in the business cycle, wages would be expected to increase at an annual rate of around 3 per cent--which is the sum of the inflation rate, about 2 per cent, and trend productivity growth, which is close to 1 per cent. And, given that the recent increase in minimum wage in Ontario is temporarily contributing to their growth, wages are rising somewhat more slowly than we would expect to see in an economy operating at capacity. This may indicate that some slack remains. For example, the share of workers who have been unemployed for more than six months remains significantly higher than it was before the Great Recession. So a key question is to what extent wage growth could increase as further tightening of the labour market takes place, given that some sectors and regions already face a shortage of workers. Historically, wage growth accelerates only after a large and sustained period of excess demand, often with a de-anchoring of inflation expectations. We are not expecting such a situation to develop. Indeed, empirical work by Bank staff shows that, in the past, when the economy was operating only slightly above its potential, wage growth did not increase substantially. What is more, in many sectors, persistently high unemployment in the wake of the financial crisis and subsequent oil price shock has had a profound effect on the labour market. Workers may have also become more concerned about the impact on their jobs from greater automation and outsourcing. As a result, they may be more reluctant now to ask for bigger raises, even when the economy strengthens. We can look at regional data to examine how labour markets are adjusting in situations of excess demand. The strong economic growth in British Columbia is a valuable example. While rising labour shortages there should eventually put upward pressure on wages, our regional wage-common measure still shows only moderate wage growth in that province. This evidence is consistent with labour supply adjusting to strong demand. Indeed, higher inbound migration and participation rates among youth and prime-age workers have increased the labour supply in British Columbia in the past couple of years. Similarly, Quebec has also seen strong job creation, a historically low unemployment rate and sustained wage increases in recent quarters. But the growth in Quebec's labour force is slower than that in British Columbia, contributing to relatively stronger wage growth. Interestingly, we also see the impact of labour supply adjustment in regional housing markets. How the labour supply adjusts in the face of rising demand conditions is an issue we are watching closely because it affects the evolution of our economic capacity. For example, given revisions to past investment and our anticipation that trend labour input will rise over the next three years, we increased our estimate of potential output growth in April to 1.8 per cent. Still, with the uncertainty inherent in measuring potential output, we carefully monitor our measures of underlying inflation to ensure they are consistent with our assessment of economic slack. As such, core measures of inflation remain essentially at 2 per cent, consistent with the economy operating at close to capacity. However, higher crude oil prices, on average, relative to our April forecast are expected to lead to a higher headline inflation rate in the near term. Monetary policy typically looks through transitory fluctuations such as this, as we did last year when inflation was held down by other temporary factors. This brings me to our decision yesterday to leave our policy rate unchanged at As we have emphasized several times in the past, our policy decisions remain guided by incoming data, since they inform our outlook for growth and inflation. As such, in reaching yesterday's decision, we carefully weighed the information we have received since our April MPR. Let me take a few moments to summarize the developments that factored the most into our deliberations. First, I want to reiterate that the economy is evolving largely as expected, with inflation roughly at our 2 per cent target and economic activity near potential. Given this context, we began by acknowledging the better-than-expected tenor of many recent economic indicators. As I outlined earlier, manufacturing and investment activity has been solid, and exports are proving to be stronger than we expected in April, helped by increased energy exports. Another positive sign is the 11 per cent increase in nominal service exports in the first quarter, which reinforces our view that services will continue to lead export growth, as they have in recent years. Similarly, higher prices, on average, for Canadian oil since April should be positive, on net, for the Canadian economy. These higher prices help boost profits of Canadian oil producers and improve our terms of trade--the price we receive for our exports relative to the price we pay for our imports. That said, given the uncertainties the oil sector faces, the prospect of substantial increases in investment are not likely to be as high as in past cycles. We also noted in our discussions that housing resale activity remained soft into the second quarter, as the housing market continues to adjust to new mortgage guidelines and higher borrowing rates. With other measures of activity in the housing sector more generally holding up, we are still expecting resale activity to pick up over the second quarter. More data from a range of sources in the coming weeks will help further inform our understanding of this adjustment process. As I discussed earlier, the labour market continues to improve and wages are rising at rates closer to what would be expected in an economy operating at potential. Together with sustained high levels of consumer confidence, this should continue to support housing construction and consumption growth more generally. Finally, Governing Council still sees elevated trade policy uncertainty as a factor restraining business investment. We expect business investment to increase, but not by as much as it could without this uncertainty. That said, business sentiment and investment intentions remain positive, suggesting that firms are getting on with business and adjusting to this more volatile environment. As such, the greater-than-expected increase in imports of machinery and equipment in the first three months of the year bodes well for business investment growth. This is encouraging because it is consistent with our broader narrative of a rising contribution coming from investment and exports, and it is important to the evolution of economic capacity. A final point before I conclude. Uncertainty is everywhere and can come from many sources. Regardless of the source, it's important to note that households and businesses continue to make economic decisions as they plan for the future. And so does the Bank of Canada in setting monetary policy. Monetary policy decisions are always made with an imperfect picture of the future, and they must be forward looking, always with our mandate--the inflation target--in mind. Allow me to conclude. Yesterday, we decided that the current policy stance remains appropriate. Overall, developments since April further reinforce Governing Council's view that higher interest rates will be warranted to keep inflation near target. Governing Council will take a gradual approach to policy adjustments, guided by incoming data. In particular, the Bank will continue to assess the economy's sensitivity to interest rate movements and the evolution of economic capacity.

r180607a_BOC

canada

Release of the Financial System Review

poloz

Governor of the Bank of Canada, Press conference following the release of the Good morning, and thank you for being here today. Senior Deputy Governor Wilkins and I are pleased to be with you to talk about the latest issue of the Let me quickly remind everyone about the purpose of the FSR--to identify key vulnerabilities in the financial system, which can interact with and magnify economic shocks. We monitor the evolution of these vulnerabilities, and then apply a set of risk scenarios to look at the potential implications for the financial system and economy if a significant shock were to occur. The main vulnerabilities that we see today are the same as those in the last FSR in November. I will begin with a few words about two of these: elevated household debt and imbalances in housing markets. These vulnerabilities are expected to persist for some time, although we have seen continued signs of easing. Several factors are helping to lessen the vulnerability related to household indebtedness. Importantly, there has been a series of changes to mortgage lending guidelines. We have also seen a slowdown in credit growth along with higher interest rates. As well, a solid expansion in the Canadian economy is leading to strong growth in employment and income and, over time, this will support Canadians' ability to manage their debt, even at a time of rising interest rates. The changes to mortgage lending guidelines are driving a steady improvement in the quality of new loans. We have seen a decline in the share of mortgages that have a loan-to-income ratio above 450 per cent. In fact, the share of new insured mortgages that have a ratio above this threshold has been cut in half since the middle of 2016. This is an important improvement, because we know that households with this level of debt are more vulnerable to an economic shock, such as a recession. However, I will point out two reasons for continued vigilance. First, because the total amount of debt carried by Canadian households is so large, we know that it will be with us for a long time. Second, it is still too soon to fully assess the impact of the newest changes to mortgage lending guidelines. These guidelines, which came into effect at the start of the year, were aimed at tightening standards for uninsured mortgages. It is not yet clear whether the guidelines are driving a significant amount of activity away from federally regulated institutions and toward private lenders and credit unions, who may not follow the federal guidelines. This is an issue that we will monitor. We are looking forward to lending data from the second quarter, as well as the latest information from the Canada Mortgage and Housing Corporation about mortgage underwriting practices, which we will receive later this year. In terms of housing market imbalances, we have also seen some lessening in this vulnerability, though it remains elevated. The annual rate of house price growth peaked in April 2017, at just under 20 per cent on a national basis, and is now below 2 per cent. This slowdown is due to the declining affordability of housing in some markets, as well as the combined impact of higher interest rates, macroeconomic policies such as the new mortgage lending guidelines, and housing policy measures taken by various provincial governments. Of course, that figure is a national average. Outside of Toronto, national house price growth remains above 5 per cent. A decline in prices for single-family homes in Toronto is a major factor pulling down this national average. In contrast, prices for condominiums are still growing rapidly, particularly in the greater Toronto and Vancouver areas. This is a reverse of the dynamics that we saw until early 2017, when price growth for condos trailed the pace for singlefamily homes. It is possible that the guidelines are having an impact here by limiting the amount some buyers can borrow and increasing the demand for condos relative to single-family homes. It is also possible that speculative activity is helping to push prices higher. The third main vulnerability we are watching is the possibility of a major successful cyber attack on a financial institution or market infrastructure, such as the payment systems that we all rely on every day. Given how interconnected our financial system is, there is concern that a successful attack on one institution could have wide-ranging effects. The Bank has been working with major banks and Payments Canada to make sure our country's key payment systems can recover quickly from a successful cyber attack. Overall, when we look at the three vulnerabilities and our risk scenarios, we judge that the overall level of risk is roughly unchanged from November, and our financial system remains resilient. I also want to point out that in this FSR, we report the results of a survey we conducted with financial system participants. Respondents identified the threat of a cyber attack, geopolitical events and a pronounced decline in property prices as among the most important risks facing their firms' own activities and the broader financial system. Before we answer your questions, I will turn it over to Senior Deputy Governor Wilkins, who will say a few words about the Bank's plans for communications on financial system issues. As many of you know, for over a decade, the biannual has been our main vehicle for communicating our analysis and research on developments related to stability of the financial system. The financial crisis taught us, the hard way, just how important it is to keep on top of financial system risks. That's as true today as it was then. I am pleased to tell you about some changes we are making to improve the accessibility and timeliness of our work in this area. The first is that this autumn, we will launch the Bank of Canada's financial system hub on our website. The hub will offer up-to-date analysis and articles on financial system issues, presented in an engaging way and aimed at a broad audience. The goal is to help more Canadians better understand developments in the financial system without having to wait for publication of the full FSR. The second change is that we will publish the FSR once a year, in June. This recognizes that the main vulnerabilities facing the financial system tend to evolve very slowly. As the Governor said, the top three vulnerabilities in our financial system are unchanged from the previous report, as is the overall level of risk. The third change is that we will introduce a speech each autumn by a member of Governing Council that will give an update on the Bank's views about the evolution of the main vulnerabilities and risks to the financial system. This speech will draw from the analysis that is published on the hub. The concept is similar to the regular economic progress report speeches that we have begun doing. We will also use our quarterly to discuss relevant financial system issues when they have a bearing on the outlook for economic growth and inflation. The bottom line is that we are modernizing our financial system communications, to be more nimble and to give these issues the greater visibility that they deserve. With that, Governor Poloz and I would be happy to answer your questions.

r180618a_BOC

canada

Rebooting Reference Rates

patterson

Thank you and good afternoon. My topic today is interest-rate benchmarks or reference rates and the work under way here in Canada and globally to strengthen them. Before I plunge in, let me take you back to the 1980s. Aside from the monstrous shoulder pads in my suit jackets, the decade gave us several important innovations. One of the most widely used was Windows. Not the kind you put in your house, but the operating system for your computer. Microsoft released improved functionality and reliability. has undergone only one material change in the past 30 years and was certainly never originally designed to support what has become a . it is difficult to imagine modern financial markets without derivatives enabled by benchmarks. However, just as Windows 1.0 isn't versatile enough to support new computer programs that have been introduced over the past 30 years, many benchmarks are no longer suitable for the wide array of derivatives markets they support. In addition, the scandals and mistrust related to the manipulation of benchmark rates for the financial benefit of individuals and institutions have made their future use unpalatable. Not surprisingly, then, these problems with benchmarks have undermined confidence in their reliability and robustness. In response, global authorities are working closely with the private sector to address them. For many of you in this room, benchmark reform is probably a familiar topic, and you understand the significant role these rates play in the functioning of markets. But benchmarks, like Windows, are part of our day-to-day lives in one way or another. How they function and how they may change matters a great deal not just to your industry but also to most Canadians. Our financial wealth is connected to benchmarks. For example, exchange-traded funds and mutual funds may invest in products linked to benchmarks. And mortgage costs are based on bank funding costs, which, in turn, include inputs priced off derivatives contracts using benchmarks. So, reforming this foundational element of our financial infrastructure is critical to both the financial industry and the broader economy. Indeed, we're long overdue for an upgrade. In my remarks today, I'm going to discuss the work afoot to either validate, enhance or transform various widely used benchmarks or create new ones. I'll start with an overview of the work under way globally and then focus on what is being done in the United States and Canada. Aside from our primary role in setting monetary policy to meet our inflation target, our mandate at the Bank of Canada includes fostering the stability and efficiency of the financial system. Benchmarks contribute to the efficient functioning of markets and the stability of the system. Getting them right matters. The Bank of Canada is playing a role in these changes through our active the global effort to coordinate benchmark reform . Central banks are trusted by market participants and they keep a watchful eye on risks to financial stability, so it's important that we be involved in this work. To be effective, a benchmark should be robust, reliable and resilient to any market stress. It also needs to be transparent and consistent with the principles for financial benchmarks set out by the . These principles cover governance, quality and accountability. They stress that the data used to construct benchmarks "should be based on prices, rates, indices or values that have been formed by the competitive forces of supply and demand and be anchored by observable transactions." The major upgrades that have taken place since 2014 have been guided by the IOSCO principles as well as by improvements to LIBOR and other benchmarks recommended by the FSB. The FSB is also urging countries to develop new benchmarks based on shortterm, risk-free (or near risk-free) observable rates or, where they already exist, to promote more active use of them. Such benchmarks would be a better fit for many derivatives transactions. Market participants, together with central banks and other authorities, have been actively pursuing this "twin track" approach of strengthening existing benchmarks and developing alternatives. A risk-free rate would help accomplish two goals. First, it would reduce the dependence on any individual benchmark. Second, it would allow counterparties to select benchmarks that might more closely match the exposures they want, enabling them to better meet the needs of some derivatives markets. For example, LIBOR is meant to represent a bank's cost of funding. It can vary according to a number of factors, such as an increase in underlying rates or a deterioration in the creditworthiness of banks--as we saw during the global financial crisis. Imagine a sovereign issuer wanting to take a fixed-rate bond and swap it to a floating-rate liability. Since such an issuer's creditworthiness does not fluctuate with that of the banking system, using a benchmark with a shortterm rate that is not influenced by the creditworthiness of banks would be more appropriate. Some of the alternatives that have been identified are new, while others are existing rates that are being, or have been, enhanced. In all cases, they are overnight rates. Now, many jurisdictions are exploring whether they need to develop term risk-free benchmarks, say for one- or three-month maturities, for use in mortgages and cash markets and perhaps also for some derivatives. This might help the transition from LIBOR-type benchmarks, where term rates are more widely used than overnight rates. For this to happen, such benchmarks would have to be consistent with the IOSCO standards. The pace of all this work accelerated last summer thanks to Andrew Bailey, Chief announced that LIBOR might be sustainable only until the end of 2021. After that date, the FCA will not persuade or compel banks to submit LIBOR rates. This means markets need to be ready to transition to alternative benchmarks. This announcement came as a surprise to those who had not been closely following benchmark developments. Now, roughly a year later, there appears to be wider market acceptance of what needs to be done, and progress is continuing despite the significant complexities. I'll focus on recent developments in the United States because the US-dollar LIBOR is one of the most widely used benchmarks, and Canadian investors and issuers have material exposure to it. Consider the sheer size of the market that references USD LIBOR. In 2016, notional contracts priced off USD LIBOR totalled nearly US $200 trillion . The lion's share of that exposure--95 per cent--was in derivatives, primarily interest rate swaps. Another US$8 trillion in cash products was based on USD LIBOR-- everything from floating-rate notes to consumer loans. The work to develop an alternative to LIBOR in the United States is being led by dealers, asset managers, issuers, exchanges, regulators and official institutions. Overnight Financing Rate (SOFR), which it concluded is a reliable benchmark for new US-dollar derivatives. SOFR is an overnight rate based on the Treasury repo market. It covers multiple segments of this market, including tri-party, dealer-to-dealer and centrally cleared bilateral repos. Based on US$800 billion in daily transactions, SOFR adheres closely to the standards set out by IOSCO. To establish SOFR as a widely used benchmark, an entire ecosystem of products needs to be built around it to encourage trading and generate liquidity in SOFR-related products. This work has begun. Futures contracts for SOFR started trading in May, with all primary dealers pledging to support that market. Trading has been light so far but is expected to increase as more market participants revamp their systems. Some time this summer, overnight index swaps referencing SOFR will begin trading, and they will be accepted for clearing through central counterparties later this year. Of course, greater market adoption will require buy-side involvement--the engagement of asset managers and issuers is critical. The next step may be the identification of a term rate based on SOFR. It is possible that this could be developed through the futures market. Many trade groups are collaborating in this work, which goes beyond just selecting a new benchmark and developing markets that reference it. For example, fallback provisions are an important transition element. These provisions are a contingency written into financial contracts in case the current benchmark is no longer viable. Fallbacks, or contingency plans, are a feature of many things we consume in everyday life--everything from backup electrical generators in case the power goes out to a guaranteed rental from your dealership if your new vehicle needs repairs. Given the uncertainty that LIBOR will continue to exist beyond 2021, it just makes sense to have appropriate fallback provisions written into financial market contracts to allow these products to transition smoothly to new benchmarks. The International Swaps and Derivatives Association is working on fallback language for derivatives contracts, while ARRC is helping to draft appropriate language for cash products. Although considerable progress has been made, reform still has a long way to emphasized in a recent speech , we have a compressed time frame to get the work done, so "we need aggressive action to move to a more durable and resilient benchmark regime." In 2014 my colleague Timothy Lane gave a speech on benchmark reform that highlighted the work being done in Canada and the rationale for it proceeding at a different pace from that of our global peers. This is partially due to differences CDOR is used for derivatives, floating-rate notes and loans. At the end of 2017, it was referenced by more than $13 trillion in financial instruments. Like LIBOR, CDOR is based on submissions from a panel of banks, but there are major differences between the two. Just to remind you, LIBOR is a borrowing rate based on estimates of the cost of unsecured borrowing transactions between banks. The volume of this borrowing has been declining, which means that LIBOR has become more reliant on the judgment of experts rather than actual transactions. In contrast, CDOR is a bank lending rate and was originally developed by the banks themselves to facilitate the calculation of a benchmark rate for the CDOR is the rate at which submitters are willing to lend their balance sheet to corporate clients with existing BA lines of credit. These BA lines are being drawn down daily, and BA volumes have been continuously growing. BAs were first developed in 1962 as an alternative source of short-term funding for corporate borrowers. They are an unconditional order from a corporate client to draw funds against their established line of credit at a Canadian bank to be paid back in full at a fixed date in the future. Now, BAs make up the largest portion of money market instruments issued by non-government entities, accounting for around 25 per cent of the total money market. In 2017, an average of about $76 billion in BAs was outstanding. paper we published today on our website reviews the evolution of the BA market. Since 2014, and in keeping with the IOSCO principles, CDOR has been strengthened in a number of ways. Thomson Reuters has been appointed the administrator and is responsible for the calculation and distribution of the rate. Thomson Reuters has also formed an oversight committee for CDOR to regularly review its definition, scope and methodology. And the Office of the Superintendent of Financial Institutions is now supervising the governance and risk controls surrounding the submission processes at the panel banks. Although CDOR does not have the same vulnerabilities as LIBOR, it is being used in derivatives markets where the notional value of contracts is a multiple of volumes in the underlying BA markets and where a risk-free rate may better suit the needs of many users. Fortunately, we already have a risk-free overnight rate. Let me introduce you to CORRA, the Canadian Overnight Repo Rate Average, which has been in place since 1997. It measures the average cost of overnight collateralized funding and is an important reference rate for overnight index swaps , which investors use if they want, for example, to hedge interest rate risk related to Bank of Canada rate decisions. CORRA is based on actual transactions and is calculated from on-screen trades through interdealer brokers. As with CDOR, CORRA is now administered by So, in Canada, we have a different starting point and have made further enhancements to comply with the IOSCO principles. Should we be satisfied that this is enough? We don't know the answer to this question yet, but to help work through the issues we recently set up the . We know a risk-free rate is a better fit for most derivative-related exposures. Recall the example I mentioned earlier of issuers who want to hedge their interest-rate liabilities from a fixed to a floating rate. If other currencies move primarily to using risk-free rates as their benchmark, specifically term risk-free rates, market participants may want to have the same option in Canadian dollars. CARR is co-chaired by the Bank and a private sector participant. The group will look at potential enhancements to CORRA, such as whether the rate could be calculated using a wider range of transactions, instead of just those occurring on interdealer broker screens. These enhancements might include dealer-to-client trades. We expect that CARR will have a recommendation to bring forward on enhancements to CORRA by the end of the year. From the outset, we wanted a diverse group to participate in CARR, people active in the marketplace, with deep expertise. We now have 21 members, some of whom are from banks, pension funds and investment firms. Because of the importance of ancillary products and exchanges where transactions are cleared, and the Montreal Exchange are observers. We feel this provides a full perspective on the market. The working group is currently meeting monthly. In addition, we want and need feedback from a wide range of stakeholders, including various Canadian regulatory authorities. We will likely set up targeted round-table discussions and other subgroups to solicit broader input. We will be exploring a range of topics, from the type of products that use interest-rate benchmarks to the wording of the fallback provisions in Canadian cash products referencing CDOR. All of this will give us a greater appreciation of the impact these changes will have on multiple stakeholders. The demands will be high over the balance of this year and next as we assess appropriate options for Canada while keeping informed of international developments. We will share our findings widely. If a new risk-free term benchmark is developed, market adoption will be critical. For that to happen, we need pension funds, asset managers, banks and infrastructure providers to use it. Just as new functionality in each Windows upgrade prompts the development of new computer programs, a new benchmark will gain broader acceptance with the development of other ancillary products, such as futures. Let me turn now to the challenges that lie ahead, some of which are related to the global interconnectedness of markets. Like our economy, where cross-border trade plays an important role, there is a large volume of cross-border financial flows, which are critical to our financial system. So we have to work in lockstep with authorities elsewhere. Many crosscurrency products reference benchmarks like LIBOR and CDOR. How quickly can markets for them adapt to using these new benchmarks or curves based on them? And if some benchmarks survive and others don't, will there need to be common approaches governing the use of interest rate benchmarks in foreign exchange markets? There are also major issues around transition. Many contracts using benchmarks expire relatively quickly. But some have much longer maturities. For those, the transition could be much more complicated because the nature of their exposures might change. Then there are the challenges we all face within our organizations. Transitioning to new benchmarks means adapting our trading and risk systems and back-office processes. We all know how long systems changes can take. That means starting work relatively soon, or as soon as we know what reference rates we will be using in the future. As we begin to trade in these products, we will need to be patient--liquidity may take some time to build. The work under way on benchmarks is complex and requires a great deal of coordination among countries, central banks and market participants. The Bank of Canada is committing significant resources to this effort, as are private-sector market participants. The stability of financial markets is an important part of our mandate, and benchmarks play a key role in the efficient functioning of markets. My goal today is to ensure we're all on the same page in terms of the work on benchmarks here and globally. The Bank of Canada's website has a page where you can follow our work as we post key findings and updates from our meetings. I hope that those of you who are not already involved will participate in some of our subgroups and comment on our work. You will also want to think about the readiness of your own organizations. The LIBOR deadline isn't that far away. I realize I am giving you more work to do, but it is important that you keep up with these developments and ensure you are operationally prepared. Reference rate reform is a necessary and huge global undertaking. Getting this right is critical for maintaining trust in the financial system. While we certainly don't anticipate the need to reform benchmarks as frequently as Windows is updated, we are clearly in need of new versions. Ongoing monitoring by regulators, central banks and market participants alike will ensure that this cornerstone of our financial market infrastructure remains robust and resilient for years to come.

r180627a_BOC

canada

Let Me Be Clear: From Transparency to Trust and Understanding

poloz

Governor of the Bank of Canada I am happy to be here in Victoria, a city with a beautiful natural setting and an economy that successfully blends old and new. You have the benefits of being a provincial capital and a natural tourist destination. And, today, the high-tech sector is your largest private industry. The Bank of Canada is also a blend of old and new. For those who have not seen our Ottawa headquarters, at its centre is the original granite building, which was completed in 1938. Its classical architecture projects a sense of security. Its aim was to establish trust in challenging times. The building also embodies the approach that central banks took toward communications back then--meaning it is basically impenetrable. This approach can be summed up in a phrase explain, never excuse." But times change. By the mid-1970s, trust in central banks was low as inflation was high and rising. That was when renowned British Columbia architect Arthur Erickson designed the expansion of our headquarters. Erickson created two glass towers to flank the original granite building, linked by a towering glass atrium. All that glass foreshadowed the modern idea that central banks needed to be transparent to be trusted. As usual, Erickson was ahead of his time. The Bank rarely felt obliged to explain its actions to Canadians. This remained true even after moving from a fixed exchange rate to a floating one in 1970, which meant that the Bank no longer had an obvious anchor to guide its policy. During the 1970s and 1980s, Bank governors typically gave one public speech per year, while deputy governors gave none. A big step toward increased transparency came in 1991 with the first inflationcontrol agreement between the Bank and the federal government. That agreement gave us a clear focus for our monetary policy. It also gave people a simple, easily understandable way to judge our performance over time. Many other important advances in transparency followed. We started publishing a regular (MPR) to detail our economic forecasts and explain our policy. We moved to a system of fixed dates for announcing interest rate decisions, with press releases that explained our rationale. Governors and deputies began speaking in public much more often--going from one speech a year to dozens. We started webcasting the audio of public appearances, and added video in 2011. In 2014, we began to offer frank opening statements at press conferences to help people understand our policy deliberations--explaining how the information contained in the MPR contributed to the decision itself. This year, we began offering four economic progress report speeches per year. They happen the day after each interest rate decision that is not accompanied by an MPR. This innovation means that the media can now ask questions of a member of Governing Council after every interest rate decision. Now, I am not suggesting that more is always better when it comes to transparency and monetary policy. Transparency is not about the volume of communications, it is about clarity. We should always give our straightforward, honest views of the economy and interest rates. We believe that these efforts help build Canadians' trust in us. Importantly, our policy framework holds the Bank publicly accountable. At least twice a year, Senior Deputy Governor Carolyn Wilkins and I make public appearances before committees of the House of Commons and of the Senate, which are webcast. Parliamentarians grill us on our track record on inflation and the Bank's other functions. Furthermore, the inflation-target agreement is subjected to a thorough review every five years. During this time, anyone can offer new thinking on our framework. This consultation process ensures widespread buy-in. But perhaps the most important way to build trust is through results. Because we kept successfully reaching our inflation goals, by the late 1990s, inflation expectations had become solidly anchored on our 2 per cent target. Those expectations even held steady through the trauma of the global financial crisis a decade ago. This level of trust has meant that fluctuations in economic growth and unemployment have become less severe than before the inflation-targeting era. To illustrate, consider our experience in late 2014, when oil prices collapsed. We knew this would hit the economy hard, leading to cuts in investment spending and layoffs. We needed to respond to prevent inflation from undershooting the target, so we cut interest rates twice, starting in early 2015. The combination of lower oil prices and lower interest rates caused a significant decline in the Canadian dollar, and this pushed up prices of imported goods. Inflation quickly moved higher, but we explained that it would be temporary, and inflation expectations remained well anchored at 2 per cent. As a result, the economy adjusted to lower oil prices much more quickly than it otherwise would. All that being said, transparency is only helpful if people can understand what we are saying. As a central bank, we have multiple audiences. They all go about their daily lives making economic and financial decisions in the environment we create for them. Yet, not everyone has the same level of interest or familiarity with economics. The father rushing to pick up the kids and get dinner on the table before soccer practice is not as focused on our interest rate announcements as, say, a bond trader on Bay Street. So, we need to tailor our communication to various audiences and deliver consistent messages through the right channels. These audiences include business leaders such as yourselves, business economists, financial market participants, academics, students and, of course, that soccer dad and other members of the general public, regardless of their occupation. Consider how we communicate with the academic community. We have hundreds of economists on staff publishing cutting-edge research. This work must be credible with academics, because we rely on them to do research that complements ours, and to train the next generation of central bankers. So, the Bank is making its data and models more open, in multiple digital formats that let researchers more easily verify, enhance and challenge our findings. But, believe me, if the Bank were to communicate with non-specialists the same way we do with academics, we would not seem transparent at all. If you doubt me, just browse a few of the research papers on our website. We recently commissioned some public opinion research to help us tailor our communications. It showed that about half of Canadians are interested in economic issues. But only about one-third say they understand how the economy works. This means there are roughly 6 million Canadians who are interested in the economy, but who are having trouble understanding economic issues. The challenge for us is to make sure that when we have a message to deliver, you will not need a degree in economics to understand it. by Bank staff shows that we have some work to do on this front. We have been using software to analyze the readability of our speeches and other communications. It turns out that most of our speeches score at university reading levels. That is fine for many people, but not for everyone. This is also true for our interest rate announcements, the MPR and the Only a handful of our public speeches over the past couple of years had a readability score at the high school level--in other words, a level that would be accessible to the majority of Canadians. Of course, our subject matter is complex. But we can, and we will, make our communications more widely understandable. We want our content to be accessible to everyone who wants to understand our issues. We want those already reading our content to read even more of it. And we want the media to continue to report on our issues accurately and to engage us in constructive commentary. This speech, in case you are wondering, rates at about a Grade 12 level in terms of vocabulary and sentence structure. Even so, not everybody will read this speech or hear about it on the news. We have to be creative to reach more people who are interested and help them understand what we do. Social media is an important element in this effort--through Twitter, LinkedIn and other platforms. But it is only part of the effort. Last year, we re-opened the Bank of Canada Museum in Ottawa. The museum helps Canadians understand all the work we do. It takes a hands-on approach--encouraging people to interact with the exhibits. Plus, it is the best deal around, because admission is free! The museum is working with educators across Canada to help develop material for classrooms. Tied in with that effort is the museum's website , aimed at the whole country. The bottom line is that we want Canadians, especially youth, to understand what the Bank does as part of a solid grounding in basic economics. We are also replacing one of our regular publications, the , which has always been aimed at a specialized audience. In its place, we will be launching a new digital-only publication: . It will explain key economic concepts and issues in an understandable way for the general public. We want this publication to stand out for its use of plain language, infographics and other visual content that will make what we do more accessible. In fact, you will see more visual elements--including videos and interactive charts--in the digital versions of all our publications. And as we announced earlier this month, we are changing how we communicate about financial stability issues. Starting this autumn, a new financial system hub on our website will offer clear and up-to-date reports on the financial system, also aimed at a broad audience. Let me make one last point about connecting with the general public. Yes, we want people to understand our views on the economy and its prospects. But it is equally important that we get out across the country and listen to people. These two-way conversations help fill in the gaps that economic statistics leave behind. We organize this effort around our which is based on conversations between our regional representatives and business leaders. Members of Governing Council also engage in these conversations. I am here in British Columbia not just to give a speech--I am also here to meet with business leaders and with students. Given the subject matter, getting people more interested in the Bank's work may be a challenge. But there is no shortage of interest in what we do and say from financial market participants. Financial market participants trade securities based on their understanding of the economic outlook and the Bank's monetary policy. The Bank controls only one interest rate--the overnight rate--so its policy actions are transmitted to the economy through financial markets. This means that market expectations for monetary policy and the economy are embedded in market prices and interest rates. As a result, fluctuations in financial markets provide very useful signals about the future--they summarize the views of a multitude of market participants. In recent years, many central banks have tried to enhance their impact on financial markets and the economy by giving explicit direction about future policy, or what we call forward guidance. Since this is a speech about transparency, let me be absolutely clear what I mean by that. Central banks make forward-looking statements all the time because monetary policy takes time to affect inflation. I could say something like: "The economy is running close to capacity, so higher interest rates will be needed to keep inflation on target." That does not meet the textbook definition of forward guidance. Forward guidance is more specific than this. It usually ties future interest rates to an explicit condition, such as a specific time frame or an economic statistic. The most definitive form of forward guidance in Canada's experience came in 2009, during the global financial crisis. We cut our policy rate effectively to zero, but we believed that the economy required more stimulus than that. So, we committed to keep the policy rate at the lower bound for an extended period, provided that the outlook for inflation remained unchanged. Because this anchored expectations for the overnight rate for some time, it caused longer-term interest rates to decline, too. This stimulated the economy even more. Today we think of this kind of forward guidance as an unconventional policy tool, to be deployed only in extraordinary times. Some central banks routinely offer financial markets forward guidance about interest rates that is less specific. The Bank of Canada has done so at times in the past. Back in 2005, for example, our interest rate announcements mentioned the need to lower the policy rate "in the near term" and "over the next four to six quarters." The most complete form of this routine forward guidance is to publish a projection for the future path of policy rates. This is the practice of Sweden's central bank, for example. Similarly, the US Federal Reserve publishes so-called "dot plots" to indicate how its Federal Open Market Committee views the likely future path of interest rates. Offering routine forward guidance obviously makes it easier for financial market participants to predict the actions of the central bank. Arguably, this makes markets more efficient by reducing uncertainty about future policy. However, this comes at a cost: by anchoring financial market expectations, forward guidance reduces the reaction of markets to economic news. In short, it suppresses the signalling role of financial markets. As Canada recovered from the global financial crisis, the Bank gradually moved away from the most definitive form of forward guidance to a softer form. By 2013, though, we were becoming increasingly uncomfortable with offering even soft forward guidance to markets. The economy was struggling to return to full capacity, and we could not fully explain why exports and business investment were weaker than our economic models were projecting. We wanted markets to appreciate the uncertainty we were facing, and were concerned that providing forward guidance was giving participants a false sense of certainty. Therefore, during the second half of 2013 we gradually toned down the forward guidance that we were providing in our interest rate announcements. This had the effect of shifting the Bank's uncertainty back out into the marketplace, which caused some market volatility. By 2014, we had stopped providing routine forward guidance altogether. Not everyone was happy about this. But we have seen signs that financial markets have become more responsive to data surprises as a result, particularly over the past year. In other words, market signalling has become stronger. Since 2014, we have begun drafting each interest rate announcement on a blank page. This is to avoid getting locked into repeating specific language that, when changed, can create big market disruptions. We choose the words that best communicate our expectations for the economy and monetary policy. Our latest interest rate announcement at the end of May is a case in point. Some observers noted that instead of repeating that we would be cautious about future policy adjustments, we said that we would take a gradual approach to raising interest rates. In fact, this shift in language represented increased confidence that the economy was performing as we expected, and that higher interest rates will indeed be warranted. Financial markets understood our message. Let me stress that the Bank's decision not to offer routine forward guidance does not mean we want to keep markets in the dark. Indeed, we want markets to understand very well the relationship between how the economy is evolving and the likely future of monetary policy. Economists call this the policy reaction function. Economic models will not work without one. Our model specifications are documented on our website, and our policy reaction function is a form of what economists call a "Taylor Rule," named for the economist John Taylor. According to the Taylor Rule, the policy interest rate depends on projected inflation and economic growth. Our version is calibrated for the Canadian economy. We use it each quarter to calculate a path for interest rates that is predicted to keep inflation under control within our economic model and given the numerous assumptions we must make. But this exercise gives us only a starting point for our interest rate deliberations. We cannot mechanically follow the rate path provided by our models because there is simply too much uncertainty in the world. We consider it misleading to pretend that uncertainty does not exist. There is always a degree of uncertainty when using economic models, but these days there is a litany of things we simply do not know. These include the degree to which uncertainty about trade policy is holding back business investment, how new guidelines for mortgage lending are affecting the housing market, and how sensitive the economy is to higher interest rates given the accumulation of household debt. With all these uncertainties, setting monetary policy is a matter of risk management. We need to understand the upside and downside risks to the outlook for inflation and determine how best to manage and balance those risks. Over time, we learn more about some of these issues as we receive new data. This is why we say that the Bank is particularly data-dependent right now. Providing routine forward guidance in such a setting would not, in my view, enhance our credibility. Rather, it would put it at risk. We have taken many steps to be more transparent about our decision making. We explain in detail the reasons for our interest rate decisions, both in statements following the publication of our MPR and in our economic progress report speeches . In the MPR, we now provide details on the most important risks to our projections. We spell out how we have seen these risks evolving and what we will watch so that we can judge their continuing evolution. Of course, there will always be a desire for the Bank to be more forthcoming about our own interest rate expectations, including by publishing a projected interest rate path. Ironically, the case for doing so is usually based on economic models that are so simple they exclude most financial markets. This means that they cannot even consider the idea that forward guidance might suppress the signalling role of financial markets, which we consider of high value. Given the complex uncertainties we face today, market signals have never been more valuable to policy-makers. To continue to benefit from those signals, we must be honest and transparent about what we know and what we do not know. We are committed to explaining what issues we are looking at and how we are thinking about them. Today, as we approach our next interest rate decision, we are working to incorporate in our projections the effects of the recently announced US steel and aluminum tariffs, along with retaliatory measures, both in Canada and globally. We are also analyzing individual-level data to understand how the new lending guidelines in Canada are affecting the housing market and mortgage renewals. We expect these issues to figure prominently in our upcoming deliberations. It is time for me to conclude. I hope that my talk about transparency has clarified our work at the Bank. We realize the importance of transparency, along with accountability and credibility, in building understanding and trust among all our audiences. We have worked hard at being transparent, and these efforts have been recognized as world-leading among central banks. But we acknowledge that we have more work to do. We can be clearer in our communications with the general public. And we will be as clear as we can be with financial markets, always guided by what we know and by what we do not know. My bottom line is this: being transparent is not only the right way to operate in a modern democracy, it also helps us meet our inflation-control target and our commitment to a stronger, more resilient Canadian economy.

r180711a_BOC

canada

Monetary Policy Report Press Conference Opening Statement

poloz

Governor of the Bank of Canada Press conference following the release of the Good morning. Senior Deputy Governor Wilkins and I are pleased to be here to answer your questions about today's interest rate announcement and our (MPR). Before taking your questions, let me offer some insight into Governing Council's deliberations. Our discussion began with the big picture: inflation is on target and the economy is operating close to capacity. Our outlook published today is that this situation will continue. Governing Council believes that higher interest rates will be needed to keep inflation on target, and that is consistent with our actions today. Monetary policy is, of course, always conditioned on new data, particularly when they do not align with the Bank's projections. A few data points over the past few weeks have seemed out of step with those projections, but when all the data are taken together, the economy seems to be on track. Given the various uncertainties we face, the Bank is particularly data dependent at this time. However, that does not mean that monetary policy will react to every data fluctuation. A better way to think of this is that it takes hundreds of data points to make a complete picture, and each new one helps the picture come into sharper focus. So, when a data point comes in differently than what the Bank or other forecasters expect, it matters to the big picture, but it is almost never decisive on its own. As we have previously discussed, an important issue we face is to understand how the economy reacts to higher interest rates, given the high debt loads being carried by Canadian households. We are monitoring this situation closely. We have seen a moderation in credit growth and the debt-to-income ratio has begun to edge lower. At the same time, the housing market is also dealing with the revised B-20 Guideline for mortgage lending, and the data do not yet permit a sharp distinction between the impact of the guideline and the effects of higher interest rates. Governing Council did take some comfort from an analysis of the renewal process for five-year mortgages taken out in 2014 and 2015 and up for renewal in 2019 and 2020. This analysis shows a very modest increase in debt-service ratios compared with the date of origination. Keep in mind that many households have had some income growth during these past five years, and these households may have grown accustomed to higher income levels. They may face an adjustment as their debt-service ratio rises once again, with consequences for their consumption spending. Of course, this issue is most important for highly indebted households. We also know that the jump in payments will be greatest for those who took out mortgages when interest rates were at their lowest levels, in 2015 and 2016, so the mortgage renewal process is likely to weigh on the economy more in 2020 and 2021. All that being said, Governing Council concluded that the economy should be resilient to higher interest rates, provided that labour income continues to grow. The biggest issue on the table was trade tensions. As discussed before, uncertainty around the future of the North American Free Trade Agreement has caused some companies to delay investment spending or to move their investments to the United States. This channel was identified and captured in our projection some time ago. The recent imposition by the US government of actual tariffs on Canadian exports has made the situation more concrete. In the projections we are presenting today, we have added more negative judgment to our business investment forecast in recognition of this. We have also incorporated the effects of the US tariffs on steel and aluminum, and the various countermeasures implemented around the world. Box 2 in the MPR gives a flavour of the complex effects such actions will have on the economy. Let me summarize briefly. A US company importing Canadian steel must now pay a 25 per cent tariff. They may instead buy steel made in the United States or in some other country. Or, if no obvious substitutes are available, they may just pay the higher price. Or, the Canadian company may offer to reduce its price in order to absorb some of the tariff's impact. Or, it may look to other markets to sell its products. The response of companies will depend on how long they think the tariffs might be in place--for example, it appears that if NAFTA is successfully renegotiated, those tariffs would no longer be in effect. The point is, the outcome depends on individual reactions, which depend on the circumstances. And then there are countermeasures. Canada has imposed a 25 per cent tariff on steel imported from the United States. This would seem to level the playing field, but many of the same complexities enter the analysis. All things considered, our analysis suggests that Canadian exports would fall, as would Canadian imports. Prices would rise at a time when the economy is already operating at capacity, so inflation would rise at least temporarily, but the effect could persist. Consumers would have less purchasing power, so demand would slow. Meanwhile, the potential of the economy would be eroded as companies invest less and become less competitive. So, the economy would see shocks to both demand and supply, resulting in two-sided risks to future inflation. Furthermore, the net effect on the economy might be buffered by any fiscal actions that governments might take. Now, as we said in the MPR, these various effects are likely to be small for the measures already taken. In contrast, a large tariff on Canadian-made automobiles and parts would have a much greater effect on trade and the economy through these same channels. People are understandably concerned about this sort of escalation and want to know how monetary policy might react to it. Indeed, there was speculation that the Bank would not move interest rates today because of the possibility of further trade measures. The Bank cannot make policy on the basis of hypothetical scenarios. We felt it appropriate to set aside this risk and make policy on the basis of what has been announced. Given the multiple channels through which protectionist measures affect economies, it should be clear that monetary policy is ill-suited to counteract all of their effects. It may, of course, play a supporting role, in conjunction with other policies. But, to put it bluntly, the economy would slow, inflation would rise, and the exchange rate would depreciate, adding further to near-term price pressures in the Canadian economy. Therefore, the implications for interest rates of an escalation in trade actions would depend on the circumstances. Let me emphasize that monetary policy by itself could not undo the long-term damage to jobs and income that could result from rising protectionism. All this being said, it is important to remember that our economy is in a good place. We are operating near capacity, companies are investing even if some are hesitating, the labour market has been strong, and, most importantly, inflation is on target. In this context, higher interest rates will be warranted to keep inflation near target. Governing Council will continue to take a gradual approach to adjusting rates, guided by incoming data. With that, Senior Deputy Governor Wilkins and I would be happy to answer your questions.

r180825a_BOC

canada

The Fourth Industrial Revolution and Central Banking

poloz

Governor of the Bank of Canada discussions here in Jackson Hole have been wide-ranging, but a common theme throughout has been digital disruption. Just about everything is being disrupted--from production, to consumption, to financial intermediation. We are in the early stages of what many are calling the fourth industrial revolution. That is because the deployment of digital technologies will alter the economy as fundamentally as did the steam engine, the internal combustion engine and the computer chip. I will use my time today to offer some preliminary thoughts on what all this might mean for monetary policy. Let us begin with the obvious. The deployment of digital technologies will be very positive for economic progress. Over time, these new technologies will find their way into everything--transforming existing firms and creating new ones. This will lead to new types of jobs in entirely new industries. Where firms are successful, productivity will rise, and economic growth will be more concentrated in those sectors. The positive spillovers will spread throughout the economy. Holistically, this is a predictable process, but the details are of course quite unpredictable. It is worth reflecting on an insight on economic growth offered by Arnold Harberger some 20 years ago. He argued that economic growth has always been more like mushrooms than yeast. In other words, economic growth is uneven, popping up here and there. This metaphor aligns well with Joseph Schumpeter's notion of creative destruction. This insight is important in today's context. As Peter Howitt has argued, it means that economic growth is naturally contentious, which introduces politics into the equation. If growth were evenly spread, in the way yeast causes dough to rise, everyone would be a winner. But because it is like mushrooms, the associated disruption means that some will lose out while others win. In certain conditions, the winners can even become superstars; hence, the term "winner takes most," as described in John Van Reenen's paper here. It is human nature to focus on the negative. In the process of creative destruction, destruction gets more headlines than creation does. This is because the threats to individuals are concrete and easily identifiable--whether manufacturing workers, call centre workers, truck drivers, investment advisors or radiologists. Modern social media enable grievances to be amplified many times over. By contrast, the opportunities being created by the application of new technologies--and the broad, positive spillover benefits to the rest of the economy--are much harder to identify and measure. This brings me to my first policy implication: it falls to policy-makers to explain the process, and offer concrete evidence that it is unfolding as usual. We need to demonstrate that beyond the initial negatives are many positives, which are likely to dominate over time. We need to acknowledge that real people and businesses are being disrupted and require policy support. And we need to point to the new and different jobs that are being created and explain that the new incomes are being spent in a wide array of traditional economic sectors. In other words, when mushrooms grow, they have yeast-like second-round effects as the growers spend their incomes. We can do this now because the narrative around technological disruption is not much different from the disruption associated with globalization, which has been with us for some 20 years. But beyond explaining and documenting these complex dynamics, we also need to be attentive to potential pitfalls, such as those connected with the rise of so-called superstar firms, as we discussed earlier here. These and other legitimate public policy concerns make it imperative that policymakers reallocate some of the benefits of growth to cushion the impact on those who are directly affected by disruption, and help them adjust. All that being said, let us consider the possibility that we are living in a profound, global, positive expansion of aggregate supply--the product of digital disruption. As with all major supply shocks in the past, it could take a long time for us to truly understand that it is happening. Still, we must conduct monetary policy in the meantime. We can start by measuring growth in the digital economy itself. One rough proxy for the digital economy--the computer system design and related services sector--accounts for close to 2 per cent of Canadian gross domestic product today and has been growing by about 7.5 per cent annually for the past five years. But that growth is likely to be only the tip of the iceberg--what we need to know is how it is spreading through other sectors and affecting aggregate supply. For example, in the automobile industry, advances in computer technology are driving improvements in quality and represent significant value added from one model year to the next. Another example would be the financial services industry, where fintech is driving gains in productivity. Statistical agencies are hard at work on this. As discussed in the paper by Crouzet and Eberly, digitalization has led statistical agencies to underestimate investment, particularly in intangibles. A consequence is that central banks are working with estimates of potential output today that may be revised up in the future. The recent historical revisions to US GDP data, which improved the measurement of investment in intangibles such as software, indicate that this could be important. A similar exercise in Canada has delivered a large upward revision in investment, and, hence, potential output, beginning in 2014. This makes one wonder about what revisions may be forthcoming for 2015, 2016 and, of course, today. The spread of digital technologies may also help explain the slow, measured growth of international trade. We know that cross-border supply chains have complicated the task of gathering accurate data on trade. Digital technologies are making it even easier to fragment production globally. And digital ordering, payments and service delivery are making it easier for transactions to occur that fall below customs reporting thresholds or are missed altogether. The point is that our ability to measure the impact of digital technology is continually playing catch-up with the technology. At the same time, the diffusion of digital technologies to other sectors is itself a gradual process. We have seen a similar scenario before--it was several years before we could measure the rise in aggregate productivity that followed the increase in spending on information and communications technology in the 1990s. Positive revisions to the history of potential output could help explain the underperformance of inflation over the past five years. This underperformance has occurred in a wide swath of economies, both advanced and emerging. These countries have, on average, a high level of Internet penetration--a possible proxy for the pace of adoption of digital technologies. Related to this, empirical evidence of the so-called Amazon effect on inflation, like the Walmart effect of 20 years ago, has so far been limited. But we need to bear in mind that this work relies on estimates of potential output that may be revised up in the future. Of course, it would be considered risky to conduct monetary policy based on an assumption that we were enjoying a pickup in aggregate supply. Central bankers would generally require empirical evidence of the phenomenon before embracing it, because the consequences of being wrong could be significant. However, that does not prevent us from treating digital disruption as a risk to the inflation outlook like any other. Arguably, this has already been happening in practice. Our economies have begun to return to normal after the trauma of the global financial crisis. But the process of interest rate normalization has been much more gradual than traditional models with embedded Taylor rules would advocate. Taking a gradual, data-dependent approach to policy is an obvious form of risk management in the face of augmented uncertainty. Importantly, this approach does not mean keeping interest rates unchanged until inflation pressures emerge. That would virtually guarantee falling behind the inflation curve. Rather, it means following a more gradual approach to normalizing interest rates than traditional models would advocate, thereby balancing the risks around future inflation. The central risks that affect that balance are, on the one hand, the possibility that inflation could accelerate as we approach full capacity and, on the other hand, the possibility that digitalization of the economy is boosting aggregate supply and holding inflation pressures at bay. The bottom line is that digital technologies are disrupting central banking along with everything else. Digital disruption is likely to be a major preoccupation of central bankers for the foreseeable future.

r180906a_BOC

canada

An Update on Canada’s Economic Resilience

wilkins

It is great to visit Regina during the waning days of summer. I would like to thank to give an update on Canada's economic performance, and discuss the Bank of Canada's interest-rate announcement yesterday. The big picture over the summer has been that the global economy is doing well, despite some troubling developments on the trade front. Many countries around the world are continuing to grow and put people back to work. Here in Canada the economy has shown its resilience, operating near capacity for the past year--the first time that has happened since the global financial crisis. Next week marks 10 years since Lehman Brothers failed; and, after many fits and starts, this period of sustained growth seems like it has been a long time coming. Since the crisis, people in Saskatchewan have also been forced to deal with the consequences of the plunge in oil prices that started in 2014, and lower prices for many other commodities. The Saskatchewan economy returned to growth last year, and it is good to see the expansion here is continuing. The Canadian economy is now on a solid footing, although we are feeling some headwinds from the trade environment. The recent US tariffs on steel and aluminum mean losses on both sides of the border. Trade disputes between the United States and China are affecting Canadian commodity producers too. And number of businesses are wary of making investments in capacity that would help them take advantage of improved global demand. I know that these issues are top of mind for many here today. For any business, facing the challenges that come with uncertainty is crucial. Farming in Saskatchewan is now an impressively high-tech business. Yet, to succeed, business leaders in this sector still need to deal with the vagaries of Mother Nature and global commodity prices. Decisions must still be taken and followed through on. It is surprisingly similar for the Bank of Canada's Governing Council. We have some finely honed economic models to guide us, yet we must take decisions about the policy interest rate amid many unknowns to meet our inflation objective. We also must follow through by communicating with Canadians and with financial markets about our outlook for the economy and inflation. With that in mind, my remarks today will cover three points: First, how the Canadian economy has evolved since our quarterly (MPR) in July; next, how we have factored developments on the trade side into our outlook; and, finally, I will give you a sense of Governing Council's deliberations that led to our decision yesterday to hold our policy rate steady. When it comes to economic developments, Canada has been thrown several curve balls over the past decade: the financial crisis; lower commodity prices; and now, trade tensions. It was only a little over a year ago that we could see that the adjustment to lower oil prices was sufficiently behind us to begin withdrawing the monetary stimulus we had put in place in 2015. We have raised the policy rate four times since July 2017, to 1 1/2 per cent. During this period, overall Canadian economic performance has been solid and broad-based. Growth has been running close to potential, the rate at which the economy can grow on a sustained basis without sparking too much inflation. And core inflation measures are now around 2 per cent. Today, the policy rate is still relatively low--by that I mean that it is lower than what we would consider to be a "neutral" rate of interest. The data and other information we have received since July reaffirm Governing Council's view that higher interest rates will be required to achieve our inflation target. In fact, the global economy is performing largely as we expected, and that is a good thing because it will support growth here at home. Our neighbour to the south has seen particularly strong demand, driven by household and business spending. Some jurisdictions, though, are showing signs of weaker momentum, which may be partly linked to trade measures and uncertainty about trade policy. Meanwhile, the most recent data for Canada indicate that growth should average near potential over the next couple of years. Some of you might recall that in our July forecast we were counting on a quick rebound from the marked slowdown in gross domestic product (GDP) growth that we saw during the first quarter of this year. This was an important call because it lent support to our view that July was the right time to raise interest rates by 25 basis points. The GDP data released last week by Statistics Canada show that we were right on the money; the economy grew at an annual pace of 2.9 per cent between April and June, twice the pace we saw earlier this year. Growth was fuelled by consumption and exports and, to a lesser extent, business investment and government spending. The data support our view that the shift in demand toward exports and investment is continuing. Healthy growth in consumption and home renovations also indicates that households are generally adjusting well to higher interest rates. A wide range of sectors are contributing to these developments. The resource sector continues to expand after a few tough years. The services sector is also growing in many high value-added areas. For example, in the second quarter computer system design and related services grew more than 10 per cent from a year earlier. We expect the quarterly profile of GDP growth to be volatile for the rest of 2018, but to still average around 2 per cent. Temporary factors that pushed up exports in the second quarter are expected to unwind, and there have been some outages in the oil sector. Those factors will likely weigh on growth in the third quarter, but do not point to weaker underlying momentum. All of this is encouraging. And we are making progress in understanding some of the issues that have been on our minds for a while. The first relates to the housing market and household debt, and how they are responding to a wide range of policy changes. These include the tighter guidelines for mortgage financing that came into effect in January, some provincial measures to target specific housing markets and, of course, higher interest rates over the past year. We saw resale activity in the housing market slow markedly at the beginning of 2018, particularly in the greater Toronto and Vancouver areas. This swing was amplified by the fact that many households had rushed to secure their financing and complete transactions ahead of the new rules coming into effect. Recent data show that in Toronto resales are rebounding and prices are stabilizing too, although in Vancouver activity and price growth remain subdued. Other urban markets that had weakened, such as Regina and Saskatoon, have steadied or shown some recovery. So, on a national basis, sales and prices appear to be stabilizing. This suggests that borrowers and lenders are adjusting to the range of policy changes as anticipated, and that financial vulnerabilities are beginning to ease. Growth in household credit has slowed, and the household debt-to-income ratio is edging lower. We see an improvement in the quality of new uninsured mortgages, resulting in a smaller proportion of these households becoming highly indebted. What I mean by highly indebted is households with loan-to-income ratios above 450 per cent. These are early positive signs, and we will have an even better view of developments as the data come in. A second issue that we are always working to better understand relates to developments on the inflation front. The companies that participated in our (BOS) during the second quarter told us that capacity pressures and labour shortages were intensifying. Yet, wages were rising less quickly than we would expect in an economy that is near capacity. The latest data indicate that this is still the case: Our preferred measure of wage gains was up by just under 2 1/2 per cent in the second quarter. That said, inflation data for July surprised us on the upside by coming in at 3 per cent. We had expected that inflation would average around 2 1/2 per cent in the third and fourth quarters, rising toward the upper end of our target range because of temporary factors such as gasoline prices, rather than pressure from excess demand. Since much of the July surprise was due to a jump in the airfare component of the consumer price index (CPI), we continue to hold this view. Here is where our measures of core inflation are particularly valuable as operational guides, because they strip out a lot of the noise. Those measures have remained around 2 per cent, supporting our assessment that the inflation increase will be temporary. Factoring the trade policy environment into the outlook Let me turn now to the final issue--the trade environment--which has been top of mind for some time given its importance to economic prospects here at home and abroad. And, while Canadian officials have been working hard to resolve the issues, a lot of uncertainty remains. Canadian businesses are telling us that trade tensions are among several factors keeping them from investing in new capacity, even though both demand and investment intentions are strong in many sectors. Here in Saskatchewan, we have spoken with firms whose investment plans are in flux pending more clarity about NAFTA. Others are exploring whether to invest across the border instead of in Canada. These kinds of responses to uncertainty are not adequately captured by our economic models, so we need to apply judgment. This judgment is informed by our quarterly BOS, as well as by other discussions we have with business people across Canada. Canada is not alone in this--we expect that investment in many other jurisdictions is suffering from similar effects. To assess the impact of the tariffs that have been announced, we followed two steps. The first step was to look at the potential long-term effects of the recent tariff changes. We used a new model developed by staff that is described in a staff analytical note published this morning. It provides an excellent framework for mapping how trade flows might change and how resources might shift across sectors over a long period of time. The second step was to consider the shorterterm effects--what might happen as businesses and workers adjust over the transition period. This is a process that is too complex for models to fully capture, yet is important to understand for monetary policy. Of course, we also accounted for the effects of countermeasures implemented by the Canadian government. Taken together, the Bank estimates that the combination of reduced confidence and trade measures already taken will shave about two-thirds of 1 per cent from We are seeing the effects already. June trade data showed steel exports fell the most since 2008, with little movement in July. Moreover, the value of consumer goods subject to a 10-per cent import tariff fell almost 23 per cent in July, following a run-up in the previous months. Regarding inflation, we estimated that Canada's countermeasures would temporarily boost inflation by about 0.1 percentage point until the third quarter of 2019. The most recent inflation report from Statistics Canada showed no impact from the tariffs on prices to date. Still, some beer and pop manufacturers have announced plans to raise prices in response to the rising cost of aluminum cans. The outlook for growth and inflation in Canada is also affected by tariff disputes between big players such as the United States and China. These disputes can cause shifts in global markets that affect the prices of many of the commodities we produce. Reflecting this, the prices of base metals and some agricultural products have softened. Saskatchewan was among the provinces to experience this effect earlier in the summer. It is important to recognize that the challenges facing Canadian exporters are not only about NAFTA and tariffs. Concerns about weak business investment, firms building new capacity outside our borders, and declining market shares existed long before the current trade tensions emerged. Competitiveness issues have been hampering Canadian businesses for some time, even while foreign demand has been growing. Market share in the United States for Canada's non-energy goods has, in fact, been declining over the past 15 years. The effect has been particularly acute in the manufacturing sector. This trend has meant a much lower share of employment for most manufacturing industries, including automotive and parts and clothing. Regardless of what transpires on the trade policy front, the Bank will still need to better understand the competitiveness issues to assess the extent to which Canada has permanently lost market share and export capacity. Let me now turn to Governing Council's policy deliberations that led to yesterday's decision. It will not surprise you to hear that the implications of the current trade environment were front and centre. As I just outlined, we have already incorporated into our forecast the expected negative effects of uncertainty on business investment and exports, as well as the effects of US tariffs and Canadian countermeasures imposed so far. These estimates are highly uncertain and may need to be adjusted as we get more information about the NAFTA negotiations and how businesses are adjusting their plans. Our practice is to not incorporate scenarios that have yet to occur, even though they may be the subject of ongoing discussions. That said, the risks to growth related to trade policies are not just on the downside, particularly in light of the ongoing negotiations. There is some significant upside as well. Nonetheless, it is important to understand that certain trade developments can result in complex trade-offs for monetary policy. On the one hand, protectionist measures can be costly in terms of growth and incomes, particularly as businesses and people adjust. A recent study by the Canada, Mexico and the United States could expect lower real wages if these countries reverted from NAFTA to World Trade Organization tariff rates. On the other hand, protectionist measures create risks to the upside for inflation, especially when the economy is operating near full capacity. In weighing these trade-offs, you can be sure that Governing Council will not lose sight of our primary mission. Low and stable inflation will help reduce at least one source of uncertainty for companies and households. Of course, there are a number of structural and other policies that are better suited than monetary policy to help manage what would be complex adjustments. Governing Council also discussed whether the gradual approach to raising rates that we have been taking over the past year remains appropriate. It is a natural question to ask, given that the economy has been operating at potential for the past year and it is in this part of the cycle when interest rates typically rise to preempt a buildup in inflation pressures. As I mentioned earlier, the factors that are pushing inflation to the top of our target band appear to be temporary and not signs of excess demand. These factors mean that inflation could turn out to be higher over the next couple of quarters than we had expected in July, but will most likely fall off afterward barring any new price shocks. We will need to do a full update of our inflation outlook for the October MPR, but we already have a good idea of when the effects of the temporary factors at play right now are likely to dissipate. For example, the increases in gasoline prices from earlier this year are contributing 0.7 percentage point to above-target inflation today. This effect will largely recede by the first quarter of next year. We have seen this in the past, since fluctuations in energy prices have accounted for about three-quarters of the overall movement in inflation. To do our job without causing undue volatility in growth, we look through these factors, while remaining alert to signs of underlying inflation pressures. Furthermore, we still acknowledge that there may be more room to grow without causing inflation than we have built into our forecast. We also know that high levels of household debt have made the economy more sensitive to interest-rate increases than in the past. That is because people must commit more of their income to servicing their debt when borrowing cost rise, leaving less for other spending. The fact that the job market has been particularly strong, and that average household incomes are rising, helps this adjustment. Consumer confidence has also been relatively high. All this suggests that the economy is adjusting well and can adapt to higher interest rates. The bottom line is that Governing Council agreed that the gradual approach we have been following is still appropriate. Finally, we discussed how much momentum remains in the global expansion. Few would disagree that the United States is showing considerable strength, but some commentators see a relatively flat US yield curve as a sign of trouble ahead. While there are downside risks to any outlook, Governing Council prefers to look at a broader range of indicators. For one thing, the yield curve is not currently inverted, and is therefore not pointing to significant slowing. that, the shape of the curve may not be a reliable signal in the current environment anyway. This is because longer-dated bond yields are being distorted by a combination of central bank quantitative easing programs and strong private demand for long-dated safe assets. Other indicators to look at include credit spreads, which remain narrow. There may be some downside risk to our July outlook for the global economy coming from trade tensions, and cracks have appeared in certain emerging economies with financial vulnerabilities, but with limited spillovers to other countries. It is time for me to conclude. In terms of momentum in Canada, we are encouraged that the economy is adjusting well to higher borrowing rates and tighter guidelines for mortgage financing. We are also pleased with the continued shift in the composition of growth toward exports and business investment. Recent data reinforce Governing Council's assessment that higher interest rates will be warranted to achieve the inflation target. We will continue to take a gradual approach, guided by incoming data. In particular, the Bank continues to gauge the economy's reaction to higher interest rates. The Bank is also monitoring closely the course of NAFTA negotiations and other trade policy developments, and their impact on the inflation outlook.

r180908a_BOC

canada

Investing in Monetary Policy Independence in a Small Open Economy

poloz

This paper explores the limitations that global financial cycles bring to monetary policy in small open economies, even under a flexible exchange rate. It then suggests ways to overcome those limitations to buttress monetary policy independence. The argument that global financial integration has reduced the ability of central banks to pursue independent monetary policy is surely self-evident by now, at least episodically. This amounts to a shortage of policy instruments. This paper develops a menu of ways in which small open economies can invest in strengthening policy independence. Having a menu of policy instruments available permits customization of responses to the circumstances that arise. The paper focuses on three sets of instruments that may not fall under the purview of central banks. The first set of instruments comes under the rubric of macroprudential policy. For example, adjusting countercyclical capital buffers in both directions can dampen the procyclicality of capital flows. Similarly, tightening or easing rules around mortgages-- leverage or debt-service restrictions, in particular--can blunt foreign interest rate shocks passing through the domestic bond market. These tools have so far been used only for macroprudential purposes, but if authorities were willing to adjust them in both directions, they could serve as a powerful way to buttress the independence of interest rate policy. The second set of instruments is based on direct public sector financial intermediation. Public sector financial intermediation--such as providing export credit, small business lending or mortgage underwriting--is generally designed to address credit gaps left by an oligopolistic banking sector. But it may also be used to counter procyclicality in credit creation, even if it is being driven globally. Tapping these tools was one key reason why Canada was able to weather the global financial crisis as well as it did, as public sector institutions were able to offset considerably the credit crunch that emerged. In turn, this allowed the central bank to maintain its focus on inflation. The third set provides a promising avenue in the development of additional automatic fiscal stabilizers. It is widely recognized that fiscal policy becomes relatively more powerful when monetary policy is approaching its limits. Calibrating fiscal parameters to become more active at that time, and less so in normal times, can promote an appropriate mix of fiscal and monetary policies, reduce output volatility and help preserve monetary policy independence. In all three areas, it is not possible to simply flip a switch in the heat of the moment. The paper argues that, to become effective policy tools, these instruments all require up-front investment and a demonstrated willingness to adjust them in both directions. The benefits of doing so are clear--the risk of losing the domestic monetary policy independence generally associated with a floating exchange rate can be significantly reduced.

r180927a_BOC

canada

Technological Disruption and Opportunity

poloz

Governor of the Bank of Canada The Canadian economy has been doing quite well overall for the past year. Yes, growth has been a bit choppy and regionally uneven. But the economy as a whole has finally recovered from the global financial crisis of 2008 and the 2014 collapse in oil prices. Inflation is close to target, the economy is operating at capacity, and unemployment is very low. I know that this assessment will sound too rosy for some Canadians. Oilproducing regions continue to adjust to low prices and deal with shipping constraints. We face daily uncertainty around the future of NAFTA. And people are nervous about digital technology, and about how it will disrupt industries and lead to widespread job losses. This is what I would like to talk about today--digital disruption, and how it is affecting our economy and monetary policy. Given the pace of change, it is no surprise that people are concerned. But I hope that helping people understand the process of technological change will allay some of those fears. The fact is, we have been through this many times, to our considerable benefit. Perhaps the pace of change is unprecedented, but the process of adjustment is very familiar. Now, I am not here to deliver an academic lecture. The Bank of Canada is trying to use plain and simple language as much as possible. In fact, we are launching a new publication called . It aims to explain important economic concepts in a way that is accessible for anyone who is interested. And I invite you to check it out, on the Bank's website, starting tomorrow. There will be an article on how international trade works to the benefit of Canadians that I hope will be widely read. When using the term "technological disruption," we have in mind how technological breakthroughs can literally revolutionize the way people work, with implications for the entire economy. Consider the changes that arrived with the internal combustion engine or electricity. Or, to take a more recent example, consider the disruption over the past 20 years caused by the globalization of manufacturing. Companies fragmented their production processes, making their parts in various countries. Then they connected those suppliers together into cross-border supply chains. Globalization meant lower prices for goods in advanced economies, which boosted purchasing power. And it lifted more than a billion people out of extreme poverty worldwide. There is no question that on balance, globalization was a significant positive for the majority of people. Overall, Canada's economy did well because of this disruption, not in spite of it. And there is no reason to expect the disruption due to digital technology to be any different. Technological change tends to follow a predictable pattern. At the outset, entrepreneurs and business leaders find ways to apply a new technology in the workplace. Consider, for example, robots on a manufacturing assembly line. A disruptive breakthrough such as this tends to spread throughout an industry. In the year 2000, Canadian companies were using about 1,000 industrial robots. By 2016, that number had jumped to more than 25,000, most of which were used in automobile manufacturing. The process that follows technological change was aptly summarized by Josef Schumpeter when he used the term "creative destruction." On the destructive side of the coin, new technologies clearly make certain jobs obsolete. Today's robots are doing what some assembly-line workers used to do. This entails a significant human cost for the people directly involved. Even those who are not involved worry that their job or their industry will be the next to become obsolete. It is crucial to keep this human cost in mind. I will come back to this point in a few minutes. First, however, let me talk about the other side of creative destruction--the creative side. New technologies allow companies to produce more at lower cost and can lead to the creation of entirely new industries. In doing so, the technologies create value that is distributed throughout the economy through several channels. One channel is higher profits. Investors certainly see that potential in today's digital disruption. The market capitalization of five of the most powerful technology companies is now US$4.2 trillion. That is almost double the market capitalization of the entire TSX exchange. These gains accrue to many people through their pension plans or retirement savings plans. The second channel is higher real (or inflation-adjusted) wages. Because new technology makes companies more productive, it can lead to higher wages. It may also mean lower prices for goods and services. Think about how inexpensive a quality television is now compared with 10 years ago--the price index for video equipment has fallen by an average of 9 per cent per year for the past decade. Companies might instead produce a better product for the same price, which means a lower quality-adjusted price. Consider all the digital technology that now goes into a new car, making each model year more sophisticated than the last. Whether through higher wages or lower prices, our purchasing power rises. The third channel is the creation of new types of jobs. Before you can put robots on an assembly line, you need people to design, build, program and maintain them. Driverless cars will also need designers and maintenance workers, as well as people to create systems to control the traffic. These new jobs tend to be very well-paying, and the workers earning these salaries spend them on everything you might expect: food, cars, clothes, housing, travel. This spending creates a fourth channel of distribution by supporting jobs and growth in other unrelated sectors of the economy, such as construction, renovation, maintenance, manufacturing and tourism. And then there is the fifth channel through which technological benefits are distributed, and it may be the most powerful. As new technologies become widespread, they create opportunities for growth far beyond their original setting. Today, digital technologies are spreading rapidly throughout the Canadian economy, enabling growth in all kinds of industries. From this brief illustration, you can see that the effects of new technology on the economy are quite complex. Certainly, they go far beyond the initial disruption experienced by a displaced worker. So, let us look at some of the ways that Canadians are embracing digital technologies. One way to get a rough measure of this process is to look at the sector called "computer system design and related services." Over the past two years, the number of jobs in this sector has grown by more than 20 per cent--five times faster than total employment for Canada as a whole. Output from this sector has expanded by more than 7 per cent every year for the past five years. Today, it accounts for close to 2 per cent of output in the Canadian economy. To put this into context, the computer system design sector is already more important to the economy than the auto and aerospace sectors combined. That is because in many of these digital jobs, labour and brain power make up almost all the value of the product--there is very little automation involved. These jobs are showing up throughout Canada. Earlier this year I was in Victoria, where there are as many people working in information technology as there are in government. British Columbia, along with Ontario and Quebec, is also a hub for Canada's video game industry, one of the largest in the world. More than 21,000 people work directly in this industry, with an average salary of more than Canada now has the world's third-largest concentration of researchers in the field of artificial intelligence. And foreign direct investment projects coming into Canada are increasingly skewed toward high-tech activities such as research and development and information and communications technology. Even individual households are embracing the opportunities from digital technology. Preliminary estimates from Statistics Canada show that the business of offering household accommodation--through a service such as Airbnb--has grown roughly seven times over the past two years to around $1.8 billion. Many of the jobs in the digital sector are located in Canada's three most populous provinces. However, the digital nature of the work means that places like New Brunswick, with its high quality of life, relatively low cost of living, skilled workers and growing number of innovative firms, can also compete. As many of you know, Fredericton has become a hub for cyber security research. Large international companies and domestic firms are attracted to the researchers and ecosystem in and around the University of New Brunswick. New Brunswick's population recently began increasing again as people find opportunities here, including in the tech sectors. Since the end of 2014, New Brunswick has seen solid gains in the employment rate among youth and primeage (age 25 to 54) workers. And the youth participation rate--an indicator I watch particularly closely--has risen here even while it has fallen in other provinces. Wage growth is also encouraging. The Bank's wage measure has shown even stronger growth in New Brunswick than in many other provinces since the end of 2014. All these signs show that the province is taking advantage of the opportunities provided by a strong economy and digital disruption. However, we know that these statistics only scratch the surface of the effects of new technology on the economy. That is because the technology is enabling growth everywhere, including in industries that have not traditionally been considered high-tech. Here are a few examples: It is becoming common to see driverless trucks at oil sands operations. Almost all large-scale farms in Saskatchewan use tractors guided by satellite. Drones can now assess the health of crops, or monitor assets at the bottom of the ocean. And jet engines can report performance data in real time, allowing airlines to maintain the aircraft more efficiently and maximizing its time in the air. These examples show how new technology can create value in diverse industries. Now, let us go back to the other side of the coin, and talk about the workers whose jobs become obsolete through technological change. Their immediate concern is to find a new job. Many will look to some sort of training or education to help them become qualified for another line of work. Unfortunately, the skills gap is often portrayed in exaggerated terms--how can a long-term factory worker be trained to write computer code, for example. This only serves to discourage people. Recall my earlier description of the process of technological change, and the channels through which the benefits are distributed throughout the economy. Yes, technological change creates brand-new jobs in the high-tech sector, but the new incomes that are generated there create new jobs across the whole economic spectrum. Right now, there are 462,000 job vacancies in Canada. The details might surprise you even more. Over the past two years, the number of vacancies in the sector that includes computer system design has grown by about 8,000. But over the same time frame, construction job vacancies have increased by almost 10,000, transportation and warehousing vacancies have grown by 14,000, while manufacturing vacancies are up by more than 14,000. These numbers suggest that technological advances are driving growth and creating opportunities broadly. They also imply that we need to do a better job of matching people with job openings. I often hear from business leaders about how hard it is for them to find workers with a specific set of skills. Yes, Canada needs more people who can write code. But we also need people with skill sets that may not be too far removed from the ones that are being displaced. A displaced factory worker has valuable skills that can be used in many different jobs where there are vacancies. Much is already being done by governments to make it easier for people to retrain throughout their working life. There are programs that allow displaced workers to receive employment insurance while they are retraining. Grants and loans are available for people who want to become an apprentice for a trade. There are tax credits and deductions for both people and employers who start an apprenticeship. No doubt, Canada's geography poses a challenge. A worker laid off in Alberta needs a lot of confidence to pull up stakes and move to Ontario for a new job, especially if their spouse already has a good job. Perhaps more could be done to facilitate such adjustment. More importantly, companies could take more responsibility for training their workers. Companies are best placed to know what skills they are looking for in their employees. Schools can adapt their curricula only so often. Indeed, given the pace of change we are facing, a company that is willing to take smart graduates and train them in-house will establish an extra competitive edge in their marketplace. After all, their competitors are finding it difficult to find the workers they need to help them grow. So far, I have tried to illustrate the ways that the digital revolution is affecting the economy. It is one more factor that we at the Bank of Canada are watching closely as we set monetary policy. The goal of our monetary policy is to keep inflation near the 2 per cent midpoint of a 1 to 3 per cent range. This preserves your purchasing power over time, and makes it easier for households and businesses to make long-range plans with confidence. To keep inflation near its target, we use our key policy interest rate to influence demand so that the economy runs close to the limits of its capacity. If the economy is operating above capacity, inflationary pressures tend to build. And if the economy is operating below capacity, inflation tends to fall. I do not want to give you the impression that this is an exact science. The economy's capacity is estimated based on our understanding of the number of workers available and their productivity. Productivity depends on investments by companies, and can rise significantly when new technology is deployed. Our economic models are saying that the economy is operating essentially right around capacity. The recent behaviour of inflation backs this up. Our core measures of inflation have been trending very close to 2 per cent, which is what you would expect from an economy operating at capacity. The latest inflation reading was above target at 2.8 per cent, but 0.5 percentage points of that came from the temporary impact of higher gasoline costs, and 0.3 points came from the cost of air travel, which should also affect inflation only temporarily. Still, there is a great deal of uncertainty about the state of the economy and the prospects for growth and inflation. And digital disruption is adding to that uncertainty. Let me explain how. First, technological improvements can directly affect prices and inflation. We know that e-commerce is changing the ways that companies set prices. This is the so-called "Amazon effect," as digital technology makes it easier for consumers and businesses to compare prices. While common sense tells you that this is happening, it has not been easy to measure this effect. So, this adds a layer of uncertainty to our inflation outlook. More fundamental, however, is the way digital technology is changing total supply and demand in the economy. For example, consider a company that is planning to expand. Traditionally, you would expect this company to make investments such as the construction of new buildings, the purchase of machinery and equipment, or the hiring of more staff. But today, this investment might take on whole new forms. A company that needs more computing power might decide to buy cloud-computing services rather than purchase new physical equipment. Or, the investment might be concentrated in intellectual property or in retraining workers. There may be a lot of investment, but it may not show up in the economic statistics the same way it has in the past. In short, new digital technologies are making it harder to accurately measure the components of supply and demand. Our ability to measure the impact of digital technology is constantly playing catch-up with the technology itself. This is not just true for investment. It is also becoming more complicated to measure how much households spend and import. Digital technology makes it easier than ever to make purchases online, from anywhere in the world. When I was a teenager, buying albums for my record collection, it was easy to determine the cost of the purchases and say whether they were imports. It is much more complicated today when people download digital music purchased from iTunes or stream songs from Spotify. The point is that the emergence of new technologies is another source of uncertainty at a time when the Bank is trying to get a handle on many others. We are still assessing how new guidelines for mortgage lending are affecting the housing market. We believe the economy has become more sensitive to higher interest rates, given the accumulation of household debt, but we are not sure how much. And we cannot know to what extent the NAFTA negotiations and global trade policy uncertainty are slowing business investment decisions. In the face of such uncertainties, we cannot operate monetary policy mechanically. Rather, policy becomes a matter of risk management. We must assess carefully the upside and downside risks to the outlook for inflation, and decide how best to manage and balance those risks. Today, we continue to judge that higher interest rates will be warranted to achieve our inflation target. And we know that if we move too slowly to raise interest rates, the economy could move firmly above its capacity limits and inflation could establish significant momentum. We certainly want to avoid this outcome. At the same time, there are risks in the other direction. In particular, new digital technologies could be giving the economy more room to grow before inflation pressures emerge. Raising interest rates too quickly could choke off this economic growth unnecessarily. The situation makes monetary policy decidedly data dependent. Of course, being uncertain about the future does not justify inaction. It does not mean keeping interest rates on hold until inflation momentum begins to build. What it does mean is that we will move rates toward a more neutral level gradually, continuously updating our judgment on these key issues in real time. It is time for me to conclude. I hope I have shown you why technological advances represent opportunities to be seized, not a force to be resisted. Of course, we must always remember that the associated disruption will be difficult for people whose jobs are affected. However, we know that in the long term, these advances will create more jobs than are lost, and create enough income to ensure that those who are affected can adapt and access new opportunities. Digital disruption is also posing challenges to the Bank of Canada as we conduct monetary policy. It is adding more layers of uncertainty at a critical time in the economic cycle. Given all the uncertainty, the Bank will continue to follow a gradual approach to raising interest rates, and remain dependent on incoming data and other sources of information to guide our decisions.

r181001a_BOC

canada

Decrypting “Crypto”

lane

Good afternoon. Some of you here today may have purchased bitcoins or one of the other cryptocurrencies or products that have launched in recent years. I'm not here to give you investment advice about them. Rather, I want to share with you our current thinking about these virtual products. Investors worldwide have taken an increasing stake in them over the past few years, even as their market values have fluctuated widely. Around 2,000 crypto products are now available, with dozens more launching every month. volumes have grown almost 100-fold in just the past two years. Media interest in them has inflated at a similar pace, often including a thick layer of hype. The recent collapse in the market valuations of many cryptoassets--almost 40 per cent of those originally launched are now worthless--seems to have done little to dampen enthusiasm. Some investors see these products as potentially world-changing; others as an example of "popular delusions and the madness of crowds." Possibly both are right. New financial or technological innovations often ignite market bubbles as users race to discover their most popular and profitable applications. Think of the "dot-com" bubble of the late 1990s, when prices of many Internet-related stocks shot into the stratosphere. While that period ended in tears for many investors, a handful of new companies that rose at that time, such as Google and Amazon, have brought about profound changes in the way we work, play, shop and live. The Bank of Canada is not responsible for regulating these crypto products. Indeed, the term "cryptocurrencies" is a misnomer. We prefer to call them "cryptoassets" because, as I will discuss in a moment, they don't do a good job of performing the basic functions of money. But as they evolve, they may touch on the Bank of Canada's core functions: monetary policy, financial stability, payments and currency. In my remarks today, I'll put these crypto developments in context, discuss the need for globally harmonized regulations and highlight the Bank's research and responses to public interest in cryptoassets. Bitcoin and many similar products were created in the hope that they would become the money of the future. How well do they stack up against the money of the past and present? This includes bank notes as well as bank deposits that can be accessed with a debit card or--for your parents' generation--by cheque. Let's consider bank notes. One of our core functions at the Bank of Canada is to provide bank notes that Canadians can use with confidence. This is perhaps the most visible aspect of our work. We all take for granted that if you want to buy a coffee you can pay with cash. The coffee shop deposits the cash in the bank and uses the funds to pay for beans and baristas' wages. The cash is universally accepted by all parties. Why is that? First, bank notes are a simple but effective technology for keeping track of who is paying how much to whom. Because a bank note is a physical thing, you can't spend the same note twice. Many Canadians still prefer the simplicity of cash for small transactions. And cash works even when systems are down. Second, bank notes offer privacy for your transactions. You can use them without giving anyone your personal or banking information. Using cash avoids the risk of being hacked or having your card compromised. Privacy is a controversial attribute given that bank notes are a preferred medium of exchange for all kinds of illicit transactions. But for entirely legitimate reasons, most people place a high value on the privacy of their financial transactions. Third, we incorporate into our bank notes the most advanced security features to ensure they are difficult to fake and easy to authenticate. We also work closely with law-enforcement agencies to deter counterfeiting. Fourth, the acceptance of money is a matter of social convention. People accept cash as a means of payment because they know that others will do the same. This convention is enshrined in law: Canadians understand that we and the Royal Canadian Mint have a monopoly on the issuance of what's called legal tender, the official money used in Canada. Finally, bank notes are denominated in dollars that offer stable purchasing power. The Bank of Canada helps preserve their value by keeping inflation low, stable and predictable. Since the early 1990s, when we adopted our inflation- targeting monetary policy framework, we have maintained inflation close to the midpoint of our 1 to 3 per cent target range. This has allowed Canadians to make spending and investment decisions with the confidence that the future purchasing power of their money is secure and predictable. After a quarter century of successful inflation control in Canada, overall price stability has become the new norm. But some of us can recall the impact on households of spiralling inflation during the 1980s, when the interest rate on mortgages hit 20 per cent. Even today, while many countries have tamed inflation, some like Venezuela are coping with hyperinflation that is causing widespread hunger and hardship. The trust and confidence that Canadians have in our notes and in their purchasing power is based on our track record and reputation. So where do cryptoassets fit into this picture? Their proponents argue that the great benefit of Bitcoin and other forms of crypto cash is that they eliminate the need for public institutions like a central bank or large commercial banks. People using this system, they argue, don't have to trust an individual or institution. That's true, but they do have to trust the technology. Cryptoassets are so called because they use cryptography to validate transactions and prevent fraud. Records are kept through blockchain technology--a digital ledger stored on thousands of computers worldwide that keeps track of every coin or token issued. Anybody trying to fraudulently use their crypto cash multiple times will likely be caught by the validation process on all these computers. The use of encryption gives cryptoassets a similar level of privacy as bank notes. And they are as light and borderless as air. You can transfer them across town or across continents much more easily than you can a suitcase filled with $100 bills. A key feature of most cryptoassets is that their value is not tied to the dollar or other national currencies but has its own unit. Blockchain provides a mechanism for creating new tokens that makes it difficult to generate more in any way other than as prescribed by its underlying software. To create new units of value, cryptoassets must typically be "mined" by running energy-intensive computer computations. This is, in effect, a form of preprogrammed monetary policy: the purchasing power of the crypto tokens is determined by supply and demand, where the supply is limited by the enabling software. This pre-programmed mechanism for creating cryptoassets was originally a key selling point. Those who believed that central banks could not be trusted to maintain the value of money were attracted by the idea of a money that is untouched by any public institution or individual. Ironically, this very mechanism has turned out to be its fundamental flaw. When the limited supply of tokens meets large flows of demand from enthusiasts, the result--as we have seen--is wild fluctuations in the value of cryptoassets. These fluctuations have drawn in even more speculative money, which has further amplified the price movements. Indeed, many Canadians who purchased bitcoins in 2017 reported that they did so for "investment" purposes--and that really means speculation. The implication of these price movements is that the purchasing power of cryptoassets is far less stable than that of almost any sovereign money. The value of a bitcoin in US dollars topped $20,000 in the last year and is now down to around $6,000. Such wide price movements make it unlikely that the current crop of cryptoassets would ever be used as money for ordinary purposes when there is a stable national currency. Cryptoassets are also very expensive to use. Transaction costs were high in 2017--as much as $55 per transaction--compared with almost zero for cash. These costs have come down since then, but if transaction volumes push the limits of the network again, costs will jump back up. In short, the current crop of cryptoassets is not about to replace the Canadian dollar or other national currencies. They are products that may be largely of interest to three kinds of users: investors, who should be fully aware of the risks they are taking; residents of countries where there is no trustworthy national currency; and those undertaking illicit transactions, including tax evasion, money laundering and terrorist financing, for which the property of pseudonymity makes them an ideal way to move funds. So far, I have been talking about digital tokens launched with the ambition of becoming a form of currency. Now, many digital tokens are being created without any such ambition. Every month, dozens of new crypto products are launched through initial coin offerings (ICOs). In an ICO, investors purchase a new digital token in exchange for cash or for other, more established cryptoassets. Some of these resemble the initial public offerings that private companies use to raise capital by offering their stock to the public for the first time. In this way, they are like crowdfunding--a means to raise equity capital without jumping through all the regulatory hoops needed to issue publicly traded securities. Other ICOs offer the purchaser the right to use services on a platform that has yet to be built--and are thus more like the economic equivalent of a gift card. In yet other cases, the promised benefits to the purchaser are more nebulous. Those ICOs that function in a similar way as shares in a new company raise all the same issues as any other stock offering. Their value is based on the profits from some enterprise, so investors need to be able to verify that the enterprise actually exists and keep track of what it is doing with the funding it raises. In practice, ICOs have not always met that standard. For example, failure to meet funding targets hasn't always resulted in the return of money to investors. And in cases where funding targets were exceeded, it's not always clear how ICOs are using the extra money. Thus, while there are certainly advantages to a flexible, technologically advanced method of funding innovative enterprises, investors in ICOs need to be wary of fraud and misrepresentation. Given the steady introduction of new types, crypto products are often hard to classify. Many will prove to be short-lived. Yet it would be a mistake to dismiss all these innovations as fleeting fads. Some products may turn out to be smart and useful--by finding better, cheaper, more competitive ways of filling an actual need. If they do that, they could also challenge the existing business models of established financial institutions. For example, if the risks are properly managed, cryptoassets could potentially serve as a new funding tool, allowing small businesses to find the capital they need. Some also argue that cryptoassets could deliver financial services to segments of the population that are underserved by existing financial institutions. Even if the products themselves ultimately fail, they advance the development of technologies that are likely to be useful for a range of other purposes. Cryptoassets spurred the development of distributed ledger technology (DLT), which may have many valuable applications. At the Bank of Canada, through our Project Jasper, we have been exploring the potential use of DLT to streamline the settlement of financial transactions and the associated back-office activities. This technology may have many other uses, such as registries for anything from land to commodities, trade finance and parolees in China. Although cryptoassets themselves exist only in cyberspace, they connect with the real economy and the financial system at various junctions--comprising a kind of crypto ecosystem. One point of contact is the direct use of these products to pay for goods and services over the Internet. A second is ICOs. Third, certain investment products in the mainstream financial system are linked in some way to the valuations of cryptoassets. These include derivatives contracts that have been launched on some commodity exchanges and exchange-traded funds. A fourth important point of contact is crypto exchanges, where cryptoassets are traded for money or for other cryptoassets. Crypto exchanges have been set up in different ways, which makes them hard to classify. Some exchanges have an economic function similar to banks: they hold cryptoassets on behalf of their clients, so the client gives up direct control of the cryptoassets themselves and has a claim on the exchange. Other crypto exchanges function more like electronic trading platforms for cryptoassets. The newness of crypto products and the fact that they claim to be delivering some of the same services provided by regulated financial institutions raises key questions. What risks could they pose? Should they be regulated? If so, how? As I mentioned earlier, the Bank of Canada is not responsible for regulating crypto products. Nonetheless, we have been examining their potential impact on the stability of Canada's financial system. We've also been participating in Regulators need to examine cryptoassets from a number of angles: the potential risks to the stability of the financial system, the integrity of markets and protection of investors, and protection against abusive financial flows such as money laundering and terrorist financing. The consensus of policy-makers is that crypto products do not yet pose financial stability risks. This is in part because, despite their rapid growth, crypto products have a relatively small footprint in the financial system. The market capitalization of all cryptoassets was recently estimated at $230 billion and the volume of trading in these products at about $15 billion annually. While these seem like big numbers, they are dwarfed by other global financial markets: global equity markets alone have a market capitalization of around $100 trillion. Moreover, crypto products are not deeply interconnected with the mainstream financial system. For example, there is little evidence that commercial banks are investing in cryptoassets or accepting them as collateral. In this context, the immediate priorities are to address the other two issues I mentioned: investor protection and abusive financial flows. In these areas, the relevant regulators are working hard to adapt their frameworks to cover these new products. But things are evolving rapidly. Cryptoassets are growing in size, complexity and interconnectedness. As the underlying technologies and the design of crypto products evolve, we need to be ready to reassess how they might affect financial stability. Some potential aspects include the integrity of payment systems, bank business models, and the exposures of financial institutions and infrastructures. The FSB and related bodies are monitoring this evolution closely. Regulators also have to be forward-thinking about what kind of action may be required. That means putting in place a framework that is sufficiently adaptable so when new products emerge that potentially pose new risks, regulatory agencies will be ready. Crypto products are already regulated in many countries at the national or regional level. But in many jurisdictions the regulatory framework is far from complete. Also, given that cryptoassets are global in scope and not confined by borders, an emerging problem is the gaps between regulatory regimes. Different jurisdictions have adopted different regulatory approaches, depending on how they have defined these assets. When a new product is launched, is it classified as a payment instrument, a security, a commodity or none of the above? Should crypto exchanges be called banks, financial market infrastructures or something else? These classifications differ across jurisdictions and in some cases remain nebulous. Beyond these differences in classification, the regulatory treatment of these assets differs. In China, the response has been to ban them. In Japan, authorities are creating a framework to manage the risks associated with their growth. Such differences among regulations globally, together with the incompleteness of regulation in many jurisdictions, open room for promoters to engage in regulatory arbitrage, developing new products to exploit them. Regulators must decide how far they need to go in harmonizing their approaches with other countries. Differences in the regulatory treatment of these products for controlling money laundering and terrorist financing are a particularly pressing concern. Such factors pose key challenges for regulatory agencies. Data and a consistent means of collecting them are required to assess emerging risks. And an agreed system is needed to classify new products by their attributes and economic functions. At the same time, we need to avoid regulation that is so heavy-handed or cumbersome that it stifles innovation. New crypto products could deliver more of what the public wants and bring more competition and financial inclusion to the system. Developments in this space could spur the growth of technologies that have important positive spinoffs. These concerns must be carefully balanced. The regulatory framework in Canada is still a work in progress, but a number of steps have been taken by the federal and provincial governments, which share jurisdiction in this area. In 2014, the federal government amended Canada's anti-money laundering legislation to include businesses dealing in cryptoassets. based on the legislation are now being finalized. The Canada Revenue Agency also published a note on the tax laws that apply to cryptoassets. And the Financial Consumer Agency of Canada has a useful backgrounder on the risks and tips for using cryptoassets. At the provincial level, the Canadian Securities Administrators issued a staff notice in 2017 on crypto offerings, warning investors about issues such as volatility, transparency, valuation, custody and liquidity, as well as the use of unregulated cryptocurrency exchanges. The notice also offers guidance on the applicability of securities laws and what steps businesses should take if they are raising capital through ICOs. At the Bank of Canada, we are also considering the potential implications of these developments for our own core functions. In particular, we are assessing how we could respond if cryptoassets were to evolve in a way that undermines our ability to provide Canadians with a means of payment with stable purchasing power that they can use with confidence. This is related to our ability to implement effective monetary policy as well as to the security and finality of settlement we provide through our bank notes. While we do not have any doubts currently about our ability to fulfill our mandate, contingency planning is important: the changes driven by technology may be rapid. In this context, one of our priorities is to explore under what conditions, if any, we might recommend to the government that we issue our own digital currency. At the same time, we are studying key design questions related to a central bank digital currency (CBDC), such as what form it might take and whether it would be anonymous like cash. As it turns out, the questions of "under what conditions" and "in what form" are closely intertwined. The design of a CBDC has important implications for its risks and benefits. For example, some major reasons for caution about a central bank digital currency are concerns that it could become a vehicle for illicit transactions or that it could have significant negative implications for financial intermediation. Unless such risks could be managed through appropriate design, the Bank would not recommend issuing such a currency. Ultimately, then, this exploration is going to require a unique combination of economics, technology and business strategy as well as thorough consultations with all stakeholders. We have assembled a multidisciplinary team to do this work and will provide more details as the research unfolds. We are also exchanging information with other central banks, notably the Swedish Riksbank, which is well along in examining CBDCs. The results of our work in this area are available on a special page on our website. It's important that Canadians benefit from financial products and services that are better, cheaper and more flexible. At the same time, we will continue to keep a close eye on the risks associated with cryptoassets. We are working with our domestic and international partners to ensure they do not pose a risk to the Canadian or global financial system. Canadians need universal access to means of payment that they can trust. As advances in technology open up new opportunities and transform the financial system, we at the Bank of Canada will continue to do what is needed to maintain that trust.

r181024a_BOC

canada

Monetary Policy Report Press Conference Opening Statement

wilkins

Press conference following the release of the Good morning. Governor Poloz and I are pleased to be here to talk about today's interest rate announcement and our turn to your questions, let me take a couple of minutes to give you an idea of the most important issues that came up during Governing Council's discussions. We started by noting some very positive developments. The Canadian economy continues to operate near its capacity, and growth is relatively broad-based across sectors and regions. Meanwhile, inflation is close to our target. What stands out is that, even with today's increase in the policy rate to 1.75 per cent, monetary policy remains stimulative. In fact, the policy rate today is still negative in real terms; that is, once you adjust for inflation. Given this context, it is natural that our discussion centred on the main factors driving economic activity and inflation over our projection horizon, and the appropriate pace for returning the policy rate to a neutral stance. Let me remind you that our estimate of neutral is in a range--currently 2 1/2 to 3 1/2 per cent. It is a range rather than a point estimate because the neutral rate is unobservable and can change over time. Let me talk about our assessment of inflation developments. Inflation was running near the upper end of our 1 to 3 per cent target range in July and August, a little higher than we had expected in our July MPR. As we said at our last interest rate announcement in September, the staff assessment was that most of this surprise came from one component of the consumer price index: airfares. They judged that this component would be volatile over the coming months because of methodological changes by Statistics Canada. Staff were right. The most recent data, released just last Friday, show that inflation fell back to 2.2 per cent in September, due in large part to a reversal of the airfare component. We could see further volatility from this component in coming months. Importantly, our core measures of inflation remain firmly around 2 per cent. This is consistent with an economy that is operating at capacity. This episode shows just how critical it is to distinguish between the volatile elements of inflation and more persistent, underlying pressures. Labour markets are so far showing little signs of wage pressures. Even with the unemployment rate near its lowest point in 40 years, underlying wage growth is running at around 2.3 per cent. This is a backward-looking indicator, and we project wage growth to pick up in the year ahead. Companies that we spoke to in our autumn (BOS) expect wage gains to pick up over the coming quarters. They also told us that capacity pressures remain elevated and that labour shortages are increasing. Governing Council spent a considerable amount of time discussing the USMCA is good news because it will reduce an important source of uncertainty that has been holding back business investment. Remember that we have been marking down our investment outlook because of this uncertainty. We know from our latest BOS, which was completed before the agreement was reached, that business investment plans were already quite positive. Firms told us they were looking to increase capacity and productivity to take advantage of a strong US economy. So, given the agreement, we have reversed some of that mark down of investment. To be prudent, we did not remove all of it, because we want to see how firms actually adjust their investment plans. This prudence is also because we know that competiveness challenges are also weighing on investment. The approval of the LNG project on the West Coast adds to the good economic news, although its impact is somewhat offset by lower commodity prices. Overall, the projected investment profile is higher than it was in July, increasing both actual growth and the economy's potential to expand in a non-inflationary way. However, the protectionist trade actions, particularly those involving the United States and China, were also top of mind for us as they are still weighing on the global outlook. We have incorporated in our forecast the expected effects of tariffs imposed to date, as well as the dampening effects on confidence from threats of future measures. All told, we estimate that this amounts to a drag on the global economy of 0.3 per cent by the end of 2020. That is a big cost - it adds up to more than US$200 billion. This represents a two-sided risk for Canadian monetary policy. There is a possibility that the United States and China find a path to ease or resolve this trade conflict. This would be positive for global trade and investment, and for Canada. However, the conflict could worsen, jeopardizing important global value chains. This would surely reduce long-term growth and prosperity globally, although the overall implications for inflation would be uncertain. Closer to home, Governing Council has been assessing how people are adapting to both higher interest rates and the changes to mortgage underwriting guidelines implemented earlier this year. We have seen that households are adjusting their budgets largely as expected. We understand that this can be difficult, particularly for those who are highly indebted. At the same time, employment and incomes continue to grow, which can help to cushion the adjustment process. Further, the quality of new debt is improving and housing activity is moderating to a more sustainable level. All of this is making the economy more resilient, and reduces the chances of painful outcomes for many people further down the road. The rule changes also appear to have helped take the wind out of the sails of speculators in some markets, which reduces the pressure on housing affordability. Overall, while financial system vulnerabilities are still elevated, the fact that they have stabilized and edged down in a number of respects is positive. There is an updated analysis of these household issues in Box 4. More detail will be published about the effects of the underwriting guidelines on borrowing on the Financial System Hub that we will launch in a couple of weeks. The Hub is designed to be a place on our website where we can post our analysis of current financial system vulnerabilities and risks in a manner that is accessible to a wide audience. Given all these factors, Governing Council agrees that the policy interest rate will need to rise to a neutral stance in order to achieve the inflation target. You may have noticed that we have not used the word "gradual" to describe the pace of policy adjustments. This is to avoid the impression that we are following a preordained, mechanical policy path. The appropriate pace for interest rate increases will depend on Governing Council's assessment at each fixed announcement date of how the outlook for inflation and related risks are evolving. In particular, Governing Council will continue to take into account how the economy is adjusting to higher interest rates, given the elevated level of household debt. While the focus of many commentators tends to be on the downside risks, it is also possible that strong consumer confidence builds on solid job and income growth, and leads to greater-than-expected consumption. We will also pay close attention to global trade policy developments and their implications for the inflation outlook. Again, we need to bear in mind that this risk is two-sided. With that, Governor Poloz and I would be happy to take your questions.

r181025a_BOC

canada

Money for Nothing? A Central Banker’s Take on Cryptoassets

wilkins

I - a FI - b FI - n bankofcanada.ca bankofcanada.ca bankofcanada.ca bankofcanada.ca bankofcanada.ca bankofcanada.ca bankofcanada.ca

r181030a_BOC

canada

Opening Statement before the House of Commons Standing Committee on Finance

poloz

Governor of the Bank of Canada Appearance before the House of Commons Governor Wilkins and I are pleased to be with you today to discuss the Bank's . At the time of our last appearance in April, our message was about the considerable economic progress that we had seen. We explained that after a lacklustre start to 2018, growth would rebound in the second quarter, coming in at around a 2 per cent pace for the rest of the year. We also said inflation would stay somewhat above our 2 per cent target this year, boosted by temporary factors whose impact would unwind over time, returning inflation to target in Six months later, we have seen some very positive developments. The Canadian economy has solid momentum and continues to operate near its capacity. Growth is relatively broad-based across sectors and regions and it is more balanced, as the composition of demand shifts toward business investment and exports and away from consumption and housing. The economy will grow at a rate slightly above its potential over the projection horizon, supported by both foreign and domestic demand and favourable financial conditions. Meanwhile, inflation is close to target after running a little higher than we expected in July and August due in large part to changes in the way Statistics Canada measures airfares. While there could be further volatility in inflation in coming months, our core measures remain firmly around 2 per cent. Of course, the outlook remains subject to important risks and uncertainties. Let me highlight two issues: trade and household indebtedness. In April we said the most significant risk to our inflation outlook was the prospect of a large shift toward protectionist trade policies around the globe. We also reminded members that our forecast included the negative effect of increased uncertainty on the export and investment plans of companies. Naturally, we spent a considerable amount of time ahead of last week's interest rate decision discussing the implications of the recent US-Mexico-Canada trade agreement (USMCA). The USMCA is good news because it will reduce a considerable source of uncertainty that has been holding back business investment. We know from our latest business survey, completed before the agreement was reached, that investment plans were already quite positive, as firms looked to take advantage of a strong US economy. Given the agreement, we reversed some of the markdown of our investment outlook. To be prudent, we did not remove all of it, for two reasons. First, we want to see how firms actually adjust their investment plans. Second, we know that competitiveness challenges are also weighing on investment. Protectionist trade actions, particularly those involving the United States and China, were also top of mind for us, as they are already affecting the global outlook. We have incorporated in our forecast the expected effects of the tariffs imposed to date, as well as the dampening effects on confidence from threats of additional measures. All told, we estimate that this will amount to a drag on the global economy of 0.3 per cent by the end of 2020. That is a big cost--it adds up to more than US$200 billion. The US-China trade issue represents a two-sided risk for Canadian monetary policy. The United States and China could find a path to ease or resolve this trade conflict, which would be positive for global trade and investment, and for Canada. Or, the conflict could worsen, jeopardizing key global value chains. This would surely reduce long-term growth and prosperity globally, albeit with uncertain implications for inflation. For more information on the potential impact of US-China trade tensions, I refer you to Box 1 in the MPR. As for household indebtedness, we have also been assessing how people are adapting to both higher interest rates and the changes to the B-20 mortgage underwriting guidelines implemented earlier this year. Box 4 in the MPR goes into some detail on the impact of these policy changes on mortgage lending. Overall, the data tell us that households are adjusting their budgets largely as expected. We understand that this can be difficult, particularly for those who are highly indebted. At the same time, employment and incomes continue to grow, which can help cushion the adjustment process. Further, the quality of new debt is improving and housing activity is moderating to a more sustainable level. All of this is making the economy more resilient and is reducing the chances of painful outcomes for many people further down the road. The rule changes also appear to have taken the wind out of the sails of speculators in some markets, reducing the pressure on housing affordability. While financial system vulnerabilities are still elevated, the fact that they have stabilized and edged down in a number of respects is positive. Let me conclude by pointing out that, even with last week's increase in the policy rate to 1.75 per cent, monetary policy remains stimulative. In fact, the policy rate today is still negative in real terms, that is, once you adjust for inflation. Our estimate of neutral is in a range--currently 2 1/2 to 3 1/2 per cent. The policy rate will need to rise to neutral to achieve our inflation target. That said, the appropriate pace of increases will depend on our assessment at each fixed announcement date of how the outlook for inflation and related risks are evolving. In particular, we will continue to take into account how the economy is adjusting to higher interest rates, given the elevated level of household debt, and whether strong consumer confidence builds on solid job and income growth and leads to greater-than-expected consumption. We will also pay close attention to global trade policy developments and their implications for the inflation outlook. Again, this risk is two-sided. to answer questions.

r181031a_BOC

canada

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

poloz

Governor of the Bank of Canada Governor Wilkins and I are pleased to be with you today to discuss the Bank's . At the time of our last appearance in April, our message was about the considerable economic progress that we had seen. We explained that after a lacklustre start to 2018, growth would rebound in the second quarter, coming in at around a 2 per cent pace for the rest of the year. We also said inflation would stay somewhat above our 2 per cent target this year, boosted by temporary factors whose impact would unwind over time, returning inflation to target in Six months later, we have seen some very positive developments. The Canadian economy has solid momentum and continues to operate near its capacity. Growth is relatively broad-based across sectors and regions and it is more balanced, as the composition of demand shifts toward business investment and exports and away from consumption and housing. The economy will grow at a rate slightly above its potential over the projection horizon, supported by both foreign and domestic demand and favourable financial conditions. Meanwhile, inflation is close to target after running a little higher than we expected in July and August due in large part to changes in the way Statistics Canada measures airfares. While there could be further volatility in inflation in coming months, our core measures remain firmly around 2 per cent. Of course, the outlook remains subject to important risks and uncertainties. Let me highlight two issues: trade and household indebtedness. In April we said the most significant risk to our inflation outlook was the prospect of a large shift toward protectionist trade policies around the globe. We also reminded Senators that our forecast included the negative effect of increased uncertainty on the export and investment plans of companies. Naturally, we spent a considerable amount of time ahead of last week's interest rate decision discussing the implications of the recent US-Mexico-Canada trade agreement (USMCA). The USMCA is good news because it will reduce a considerable source of uncertainty that has been holding back business investment. We know from our latest business survey, completed before the agreement was reached, that investment plans were already quite positive, as firms looked to take advantage of a strong US economy. Given the agreement, we reversed some of the markdown of our investment outlook. To be prudent, we did not remove all of it, for two reasons. First, we want to see how firms actually adjust their investment plans. Second, we know that competitiveness challenges are also weighing on investment. Protectionist trade actions, particularly those involving the United States and China, were also top of mind for us, as they are already affecting the global outlook. We have incorporated in our forecast the expected effects of the tariffs imposed to date, as well as the dampening effects on confidence from threats of additional measures. All told, we estimate that this will amount to a drag on the global economy of 0.3 per cent by the end of 2020. That is a big cost--it adds up to more than US$200 billion. The US-China trade issue represents a two-sided risk for Canadian monetary policy. The United States and China could find a path to ease or resolve this trade conflict, which would be positive for global trade and investment, and for Canada. Or, the conflict could worsen, jeopardizing key global value chains. This would surely reduce long-term growth and prosperity globally, albeit with uncertain implications for inflation. For more information on the potential impact of US-China trade tensions, I refer you to Box 1 in the MPR. As for household indebtedness, we have also been assessing how people are adapting to both higher interest rates and the changes to the B-20 mortgage underwriting guidelines implemented earlier this year. Box 4 in the MPR goes into some detail on the impact of these policy changes on mortgage lending. Overall, the data tell us that households are adjusting their budgets largely as expected. We understand that this can be difficult, particularly for those who are highly indebted. At the same time, employment and incomes continue to grow, which can help cushion the adjustment process. Further, the quality of new debt is improving and housing activity is moderating to a more sustainable level. All of this is making the economy more resilient and is reducing the chances of painful outcomes for many people further down the road. The rule changes also appear to have taken the wind out of the sails of speculators in some markets, reducing the pressure on housing affordability. While financial system vulnerabilities are still elevated, the fact that they have stabilized and edged down in a number of respects is positive. Let me conclude by pointing out that, even with last week's increase in the policy rate to 1.75 per cent, monetary policy remains stimulative. In fact, the policy rate today is still negative in real terms, that is, once you adjust for inflation. Our estimate of neutral is in a range--currently 2 1/2 to 3 1/2 per cent. The policy rate will need to rise to neutral to achieve our inflation target. That said, the appropriate pace of increases will depend on our assessment at each fixed announcement date of how the outlook for inflation and related risks are evolving. In particular, we will continue to take into account how the economy is adjusting to higher interest rates, given the elevated level of household debt, and whether strong consumer confidence builds on solid job and income growth and leads to greater-than-expected consumption. We will also pay close attention to global trade policy developments and their implications for the inflation outlook. Again, this risk is two-sided. to answer questions.

r181105a_BOC

canada

Making Sense of Markets

poloz

Governor of the Bank of Canada Making sense of financial markets is supposed to be easy. Stock prices, bond yields and exchange rates are all expected to behave in line with economic fundamentals. We know the reality is more complicated than that. Yes, financial markets react to new information--in fact, they usually overreact. Today's overreaction becomes tomorrow's retracement, and so on. It can be very difficult to reconcile high-frequency financial market action with slower-moving economic fundamentals. Often this process of reconciliation is just a matter of time, since economic data arrive with a lag while financial markets live in the moment. But therein lies the essential problem: our view of today's economic fundamentals is actually a forecast because the data have not arrived yet. If financial markets appear to diverge from those forecasted fundamentals, they may be telling us that our forecast is wrong. The fact that financial market prices are formed with the discipline that comes from putting real money on the line means that central bankers ignore them at their peril. To illustrate the difficulty, consider some of the market action we have seen in 2018. Yield curves were on a flattening trend in the first half of the year, raising questions about whether they were pointing to slower economic growth ahead. At the same time, stock markets were on a steady march upward, which we would normally associate with a positive economic outlook. This fall, we have seen the reverse--higher yields and widespread stock market declines. While it may not always be possible to make sense of all this, the effort itself is generally worthwhile. Today, I want to touch on some of the main points of our latest outlook, and offer some reconciliation of recent financial market action with that view. Of course, there are always risks in trying to interpret what financial markets are saying. Markets are not monolithic--their prices represent the average of a diverse distribution of views. Moreover, markets evolve over time. Still, we glean what we can from markets and use the information to cross-validate the signs we see in the economy. Let us discuss the economic outlook briefly. The big picture is that the world has made considerable progress in shaking off the effects of the 2007-08 financial crisis. Some countries have made more progress than others, but, taken as a whole, the world economy is operating close to potential, and monetary policy has begun the process of normalization. In our latest , we noted that the global expansion, which had been quite synchronous across regions, has become less so recently. The US economy is now setting the pace among advanced economies, primarily due to the additional fiscal stimulus that has been applied. We forecast that global growth will moderate from about 3 3/4 per cent this year to 3 1/2 per cent next year, with the US strength expected to ease back by 2020. Of course, various trade actions--and the threat of more--have already begun to affect the global economy. The escalation of tariffs between the United States and China is of particular concern, weakening investment and the overall growth outlook, and putting downward pressure on various commodity prices. A key implication of the divergence of growth between the United States and the rest of the world is an appreciating US dollar. This has led to strains for certain emerging economies, and we expect these to continue. Thus far, however, we have seen few signs of the strains becoming generalized across all emerging markets. As for Canada, our forecast is a positive one. We project the economy will continue to operate close to its capacity limits, with annual growth around 2 per cent over the next couple of years. The successful conclusion of North American trade negotiations reduces a key source of uncertainty for the Canadian economy. Meanwhile, we project that inflation will continue to move back toward the 2 per cent midpoint of our target range, after having peaked in the summer. Fixed-income markets Now, let us look at what fixed-income markets are saying about all this. These are the markets most directly relevant to central banks because bond yields can tell us what investors think about the prospects for both growth and inflation. In particular, the slope of the yield curve is often seen as a reliable predictor of economic growth. Specifically, when the curve inverts--when short-term bond yields move higher than long-term yields--this is often seen as a sign that a recession is imminent. Of course, no indicator is ever perfect. To adapt the old quip, the yield curve has inverted before 10 of the last 6 Canadian recessions. But it is important to recognize that a number of factors have held down long-term yields in recent years. That means short-term yields do not have to rise as far as in the past to flatten or invert the yield curve. One of these factors is that the neutral interest rate has been drifting downward for about 15 years, contributing to a long-term trend toward lower bond yields. A second factor is that years of successful inflation targeting by central banks have reduced inflation risk steadily. A third factor has been the buying of bonds by central banks as part of efforts to mitigate the effects of the global financial crisis. In light of these factors, it seems that the more important signal coming from the bond market is not a flattening of the yield curve, but the reversal in the longstanding downward trend in long-term yields. Indeed, since the start of the year, the US 5-year yield has risen by more than three-quarters of a per cent, to over 3 per cent, while the 10-year yield has climbed by a similar amount, to about This trend reversal is consistent with the view that a decade of massive monetary policy intervention is finally taking the risk of deflation off the table. Higher bond yields may reflect that the market is becoming two-sided again, as central banks shift interest rate risk back out into the marketplace. Investors can no longer expect yields to be suppressed by extraordinary monetary policies. Within this big-picture theme, some important sub-themes are emerging. One is a worrying tendency among some emerging markets to encroach on the independence of their central banks. Another is the consequences for the corporate bond market. Corporate yields and spreads have for some time been compressed by the post-crisis provision of central bank liquidity, and the trend shift is leading to modestly wider spreads now, as we would expect. Importantly, though, these effects are not uniform across the market--debt issued by companies most exposed to international trade actions is underperforming other sectors. Specifically, since the start of the year, the spread on debt issued by basic materials and industrial companies has widened two to three times as much as that on the debt of technology companies. These differences in spreads can be seen globally and tell us that investors see growing risks for these firms in light of international trade actions already taken or in prospect. I mentioned that most countries are not as far advanced in post-crisis recovery as the United States. However, because bond markets are so globalized, movements in US yields will be reflected in bond markets elsewhere, particularly in countries where central bank bond purchases are not distorting yields. Canada is a case in point. Traditionally, Canadian 5-year yields will import about twothirds of any movement in US 5-year yields. This can affect Canadian mortgage rates even with an unchanged stance of Canadian monetary policy. Equity markets Time now to turn to stock markets. Recent action has some commentators questioning whether many economic forecasts, including ours, are too rosy. As I mentioned at the beginning, such a divergence between the economic outlook and market action needs to be taken seriously. Part of the reconciliation must come from taking a longer-term perspective on equity market performance. True, the S&P 500 Index has fallen about 7 per cent from its highest level earlier this year. But even with that decline, the index is still about 35 per cent higher than it was three years ago. Several factors drove this performance over the past three years. Part of it reflected the strong outlook for the US economy and, by extension, company earnings. Part of it was due to a small number of technology companies--the socalled FAANG (Facebook, Apple, Amazon, Netflix and Google) stocks, as investors saw the potential for tremendous earnings growth. Even though the total assets of these companies equal about 1 per cent of US economic output, their total market capitalization is almost 10 per cent of the entire US equity market. Over the past three years, the increases in these companies' stock prices were responsible for 17 per cent of the rise in the S&P 500 Index, after accounting for reinvested dividends. As we saw with the bond market, the era of extraordinary central bank liquidity helped make stock markets more one-sided, naturally suppressing their volatility. Investors could borrow money cheaply and take leveraged positions in stocks. Now, this liquidity is becoming more expensive, so it is only natural to expect more volatility in stock prices as this support is removed. But there is a more fundamental point to make if, as I suggested, the long-term downward trend in bond yields is over. If investors are coming around to the view that expected earnings, as good as they are, need to be discounted by higher interest rates, it naturally lowers the price they are willing to pay for a given stock. Qualitatively, then, it is logical to expect stock prices to retrace some of their earlier increases and to exhibit a more normal level of volatility. The present situation is made even more complex by the overlay of international trade actions. When we break down recent stock performance by sector, we see a message similar to the one coming from corporate bonds. The 2 per cent rise in the S&P 500 Index for the year to date masks some very divergent performances. The companies most exposed to international trade actions have done the worst. Materials companies are down 12 per cent on the year, while industrials are down 7 per cent. Technology companies, in contrast, have risen 8 per cent over the same period. The same basic pattern holds in Canadian stock markets. The main Canadian stock index has declined by 7 per cent this year because the TSX is so heavily weighted with companies that rely on trade. It is evident, therefore, that rising interest rates can explain only part of what we have observed in stock markets--trade actions are playing a central role. Commodity markets Concerns about the impact of ongoing international trade actions by the United States, and China's retaliation, can also be seen in commodity markets. One common interpretation of commodity markets is that rising prices signal future global economic strength, and a slump--along the lines of what we are seeing in many commodity markets--signals weakness in demand. But a nuanced look at certain markets gives a more focused interpretation. Of course, oil is the global economy's most important commodity and Canada's largest export. However, movements in the oil market tend to reflect more the impact of unexpected changes in supply or demand than shifts in global shortage of pipeline capacity has been weighing on prices. The WCS discount has been especially large of late, due to maintenance shutdowns of some key US refineries, which will be temporary. Although most of Canada's exports move by pipeline and see relatively modest price discounts, the newest barrels are discounted the most, and this is suppressing capacity investment in the sector. Looking beyond oil, we have seen particular weakness in base metals. A generic index of base metals prices has fallen 13 per cent since the start of the year. This reflects, in part, concern about the prospects for China's growth amid ongoing trade disputes. We are also seeing investors taking fewer speculative positions on copper--a commodity closely associated with prospects for Chinese growth. Another contributor to the slump in commodity prices is the fact that they are generally priced in US dollars. So, a period of US-dollar strength relative to other currencies can lead to lower prices for those commodities, all else being equal. Foreign exchange markets This brings me to currency markets, which can give another perspective on prospects for economic growth. Many factors affect exchange rates on any given day. Still, at the root, exchange rates signal expectations for the relative strength of economies and differences in interest rates. So, it is not a surprise that the US dollar has outperformed virtually every major currency since the start of the year. This reflects both the prospects for continued US growth and policy-rate increases by the Federal Reserve. The prospect for higher US interest rates is slowing or reversing capital flows to emerging markets. In previous years, this would have raised fears of capital flight, leading to sharp increases in interest rates and significant currency weakness across many emerging markets. So far, at least, the message from currency markets is somewhat more encouraging. Virtually all emerging markets have seen their currency decline against the US dollar, as you would expect. And while several emerging-market currencies have shown significant weakness this year, extreme movements have been confined to two currencies--the Argentine peso and the Turkish lira. In fact, the weakness in the currencies of those two countries may well reflect a risk I mentioned earlier--among other risks, of course--that the independence of those central banks has been put into serious doubt. It can be perilous for an economy if investors come to believe that the outlook for inflation is coming under political influence. By the way, this highlights one of the best attributes of Canada's monetary policy framework. Every five years, after extensive research and consultation, the government agrees in writing on the Bank's inflation target, and gives us the operational independence to pursue that goal. And finally, to the money markets. Expectations for Canadian short-term interest rates are best captured in the overnight index swap market, or OIS. Participants in the OIS market can use the swaps to hedge exposure to future Bank of Canada policy rate changes, or to speculate on them. We watch this market closely because it provides the average forecast of market participants for the path of our policy rate. When the market shifts with some event or the release of economic data, this tells us how participants think our monetary policy will react. As such, the OIS market is crucial for telling us when there is a disconnect between expectations in the market for the economy and interest rates and our own expectations. This is an important reason why we are generally reluctant to fine-tune market expectations about our interest rate decisions through our communications. If we tried to guide market views so they were always aligned with our own, we would lose the cross-validation that financial markets provide. It is time for me to conclude. When you take a broad look at financial markets, the messages they are sending appear to be generally consistent with our economic outlook and our understanding of the main risks to that outlook. After a decade of extraordinary effort by central banks to flood markets with liquidity, the global economy has reached the stage where stimulus can be steadily withdrawn. Investors are now confronting two-sided risks to inflation, as central banks are shifting those risks back out to the marketplace, and the longstanding trend toward lower bond yields seems to be over. This, in turn, is producing a recalibration in equity markets, both overall and in the details, and creating a more normal level of market volatility. The US economy is leading the way, and this is strengthening the US dollar. These characteristics do not point to a gloomy economic outlook by any means-- rather, they are welcome symptoms of normalization. On top of this, market action shows considerable evidence of investors' preoccupation with the downside risks associated with international trade actions, both actual and threatened. This preoccupation is understandable, but we must not lose sight of the fact that trade risks are two-sided. Yes, trade disputes may escalate, with obvious negative consequences. But it is also possible that resolutions will be found, in which case the world economy will enjoy a new source of lift. We have seen exactly this dynamic play out in Canada, as fears that NAFTA would be torn up have been replaced with relief after agreement on In general, it is not appropriate for a central bank to formulate policy based on only one side of a risk distribution. Rather, the Bank of Canada must attempt to weigh both the upside and downside risks and take a middle, risk-balanced path. Given our outlook for growth and inflation, the Bank's policy rate will need to rise to a neutral stance to achieve our inflation target. In determining the appropriate pace of interest rate increases, we will continue to monitor the economy's adjustment to higher interest rates, given the elevated level of household debt. And we will pay close attention to new developments on the international trade front.

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canada

Launch of New $10 Note

poloz

Governor of the Bank of Canada We are here today to celebrate the end of a long journey. A Canadian journey. Today, we celebrate the launch of this incredible new $10 note. Bank notes are more than secure means of payment that Canadians can use with confidence. They also tell the stories that have shaped our country. Now, each time this new vertical $10 bill changes hands, it will remind us of our continued pursuit of human rights and social justice in Canada. Bringing a new bank note from concept to reality is a remarkably complex process. Few people realize just how long the process is--work on this note started 2 1/2 years ago and the planning for it goes back twice as far. And the process involves a wide range of people. Some have an obvious role--the historians, researchers and graphic designers, for example, who make the note beautiful and meaningful. Photographers and engravers also play an important part. But others involved in the process aren't quite as obvious--the chemists, physicists and engineers who do the research on the polymer and help develop the features that make our notes so secure. And then there are all our partner groups, many of which are represented here today, and the Bank staff who work closely with them. We truly appreciate the assistance of the financial institutions who distribute the notes across the country. We expect that they will be available at local branches throughout Canada over the next few weeks. And we appreciate the help of the retailers who handle the notes and the law enforcement agencies that work to make sure that counterfeiting remains very low. So yes, it's a long and involved process and a lot of hard work. But it's the hard work that makes the process so worthwhile and the celebration so sweet. I want to highlight a couple of things that made bringing this note to reality so special. The first is the public's involvement in designing the note. Finance Minister Bill Morneau agreed with me that it was long past time to feature an iconic Canadian woman on the front of a regularly circulating bank note. So, the Bank asked Canadians to tell us who that woman should be. And that invitation unleashed a flood of nominations--over 25,000 of them. An expert panel helped us comb through them all. This turned into a tremendous opportunity to learn about all these great Canadians and to give their stories some well-deserved and long-overdue recognition. The second thing about this note, of course, was the ultimate choice of Viola Desmond, the successful businesswoman from Nova Scotia's Black community, who took a stand for human rights, and against discrimination, in the 1940s. With this inspired and inspiring choice, the note's themes of human rights and social justice fell naturally into place. And what better embodiment of this theme than this remarkable location--the Canadian Museum for Human Rights. I am so pleased that this building as it stands, and everything it stands for, are being recognized on this note. The choice of Viola Desmond has touched off conversations about human rights across Canada, as well as celebrations of the life of this remarkable woman, especially in the North End of Halifax, where she lived and grew her business. I know events are taking place in Halifax to honour this great Canadian, where people can spend their brand-new vertical notes and even see an original musical production about her. Right here in this museum, there is an exhibit where you can learn more about Viola. And starting at the end of the month, our own Bank of Canada Museum in Ottawa will have a special exhibition-- --that will explore the story of Viola and this new vertical note. The choice of Viola Desmond brought her story of dignity, courage and human rights to the fore. And, it brought one other remarkable person to our attention. That is, of course, Viola's incomparable sister, Wanda Robson. You may know that Wanda was pursuing her dream of getting a university degree at a time in life when most of us would be planning for a quiet retirement. In her studies, Wanda heard her sister's story being told by her professor, Dr. Graham Reynolds, who is also with us today. At that point, Wanda realized the importance of sharing her sister's story with the world. It was Wanda who worked tirelessly to make sure that her sister's story wouldn't be forgotten. And Wanda, we all owe you a debt of gratitude because, thanks to your hard work, your sister's story won't be forgotten.