Remarks by Sheryl Kennedy
Deputy Governor of the Bank of Canada
to the Adam Smith Seminar
9 March 2004
ADJUSTING TO A CHANGING WORLD: THE CANADIAN EXPERIENCE/
It is a pleasure for me to be back in Paris, taking part in the Adam Smith Seminar. It’s especially thrilling to meet at Le Procope, which I’m told played host to Adam Smith almost 250 years ago. As a student of the wealth of nations, he would undoubtedly appreciate the theme of this seminar, 2004 and Beyond: World Economic Prospects.
Canada is a relatively small, open economy, with many and complex links to the global economy. Because of this, we take a keen interest in what happens in the world economy—what happens beyond our borders, whether positive or negative, affects us strongly. I think our experience of recent years can also be of interest for other small, open economies. Despite the various global shocks that have hit us, we have done relatively well. Our strong performance over the past few years primarily reflects the extraordinary efforts we made during the 1990s to get our macroeconomic framework right.
Today, I’d like to address Canadian prospects and challenges as we look ahead. I’d like to begin by discussing our macroeconomic framework, and why we adopted the monetary and fiscal policies that we did. I’ll then take a look at our current economic situation before going on to describe some of the challenges we will have to meet in the future. Overall, I would like to suggest that, thanks to prudent policies, Canada is well positioned to take on the challenges presented by a rapidly changing worl
But let me start with the framework we have adopted for monetary policy.
Monetary Policy Framework
Since the early 1990s, the Bank of Canada has worked to create a more stable economy through a credible monetary policy framework focused on low, stable, and predictable inflation. This framework, based on an inflation-control target and a flexible exchange rate, has helped the Canadian economy to perform well and to adjust to various shocks stemming from both domestic and external sources.
Our goal is to keep consumer price inflation at the 2 per cent midpoint of a 1 to 3 per cent range.
In Canada, we explicitly run monetary policy in a symmetric way around our 2 per cent target; that is to say, we worry as much about inflation falling below 2 per cent as we do about it rising above 2 per cent. Thus, when strong demand threatens to push the economy against the limits of its capacity, and take inflation above target, the Bank will raise interest rates to curb excess demand and return inflation to the target within 18 to 24 months—the time horizon needed for monetary actions to have their full effect on the economy and inflation. By contrast, when demand is weak, threatening to take inflation below the target, the Bank will lower interest rates to breathe life into the economy and return inflation to 2 per cent. This symmetrical response to changes in demand helps smooth the ups and downs of the business cycle, promoting sustained economic growth.
An important characteristic of our inflation targeting is that it is forward-looking. Because the effects of monetary policy actions are indirect and spread over time, policy decisions are based on forecasts of where inflation is likely to be 18 to 24 months into the future, not on where it has been over the last 12 months.
Most central banks share the same goal of low inflation. However, their methods for achieving this differ somewhat. For example, the European Central Bank’s commitment is to keep inflation below 2 per cent, while in the United States, the Fed has committed to inflation low enough that it does not distort people’s behaviour.
Why did we in Canada adopt inflation targeting? Let me step back for just a moment to explain.
Canada’s monetary policy framework was developed in the early 1990s. At that time, inflation had come down from the very high levels seen through the 1970s and early 1980s, but it was still relatively high by today’s standards.
In February 1991, the Bank of Canada and the Government of Canada agreed on a series of explicit inflation-reduction targets. The agreement called for an inflation target—defined in terms of the annual rate of increase of the consumer price index—that would descend gradually to 2 per cent by the end of 1995. The targets have since been extended three times, each time retaining the 2 per cent midpoint.
From the end of 1994 to today, inflation has averaged almost exactly 2 per cent. Moreover, not only has inflation fallen, it has become more stable on average, over time. Indeed, the trend of inflation—as measured by what we call “core inflation”—has stayed within the target range for the past 10 years. More importantly, we found that, after a few years of inflation targeting, the inflation expectations of Canadians fell into line with the 2 per cent target. And expectations have remained close to the target in recent years.
This has had some very real benefits. For one thing, it has helped people to plan ahead with greater confidence. When inflation is low and stable, investors can better assess the future value of their investments; savers know that their purchasing power will be preserved; and labour disruptions tend to decrease, because workers and employers can agree on the medium-term outlook for inflation. In addition, with inflation expectations well anchored at 2 per cent, the economy is better able to adjust to supply shocks, such as changes in the world price of oil, because these changes do not raise expectations of generalized price increases. Long-term interest rates are also lower and more stable when people expect inflation to remain stable in the future. All this has led to greater stability in the economy. It has also enhanced the credibility of our monetary policy framework, as Canadians believe that their central bank will keep inflation low so as to maintain the purchasing power of their money.
In addition, this framework has allowed us to be more transparent in our actions, making it easier to explain more clearly to business, labour, and the general public what we are doing and why. This, in turn, helps the conduct of monetary policy, and gives citizens a measure by which to judge the performance of their central bank. While no single mechanism is perfect, our experience suggests that the outcomes of monetary policy are better with a clear, well-understood framework.
A key element of our monetary policy framework is a flexible exchange rate. If we want to target the domestic inflation rate, then we need a floating exchange rate. We cannot have two targets, one for inflation and one for the exchange rate, because we have only one instrument—the target for the overnight rate of interest.
A floating exchange rate helps facilitate the adjustment to major shocks. For example, in the wake of the free trade agreements of the early 1990s, Canada’s floating exchange rate helped businesses to adapt by sending signals about the kinds of adjustments that were needed. Firms that were efficient producers of traded goods and services were able to take advantage of free-trade agreements and strong foreign demand, and saw their profits increase. Because the depreciating Canadian dollar raised the cost of machinery and equipment relative to labour, businesses in expanding sectors of the economy were encouraged to absorb some of the excess labour that had been released by shrinking sectors. And the floating exchange rate helped on the macroeconomic side. The depreciating Canadian dollar in the late 1990s encouraged foreign demand, as demand from the government sector was being restrained.
To sum up, inflation targeting and a flexible exchange rate are the two basic elements of our monetary policy framework. And they have worked well for us.
Other Policy Adjustments
But getting the monetary policy framework right is only part of the story. In addition to low inflation, Canada has also made tremendous progress in three other areas: fiscal adjustment, structural reform, and trade liberalization.
In the middle of the 1990s, Canada was facing an unsustainable fiscal situation. Federal and provincial governments were carrying an extraordinarily high and unsustainable level of debt. Spending had to be put on a viable long-term course, and the ratio of public debt to GDP put on a steady downward track.
This was a very difficult task. Fiscal consolidation was painful, involving considerable sacrifices on the part of all Canadians. However, the effort proved worthwhile. The fiscal adjustment helped improve the credibility of Canada’s economic policies and reduced the risk premium that investors demanded on Canadian government bonds. Lower interest rates reduced debt-servicing costs and stimulated private-sector economic growth, which brought in more revenues for governments. As a result, instead of rising deficits and debt, we now have balanced budgets or better, and falling debt.
The fiscal improvement also meant that the Bank of Canada was able to lower interest rates more easily as economic circumstances warranted.
A third key change in the 1990s focused on the need to improve the structure of the Canadian economy. The goal was twofold: first, to increase the flexibility of our economies to adjust to changing world economic conditions; and second, to ensure the longer-run viability of our social and income security arrangements given the prospect of a rapidly-aging population.
Canada made progress on both fronts, but more is needed. In the public sector, governments took steps to reduce distortions in the economy by eliminating many industrial subsidies, lowering income taxes, and putting the Canada and Quebec Pension Plans on a sustainable basis. At the same time, the federal government made changes to its system of unemployment insurance, basing the program more on insurance principles and improving the employability of labour.
In the private sector, businesses and employees faced restructuring in the wake of the Canada-U.S. Free Trade Agreement and the North American Free Trade Agreement.
Despite initial misgivings, and in keeping with our long-standing tradition of being a “trading nation”, Canadian companies rose to the challenge of increased competition, taking measures to restructure their operations and become more efficient. Canadian exports flourished under the free-trade agreements.
None of these adjustments—inflation control, fiscal consolidation, structural adjustments, or trade liberalization—was easy. But they did leave Canada’s economy more flexible, and in a better position to handle economic shocks and, therefore, to grow more sustainably.
This is a brief summary of the efforts we made over the past decade to adjust to new global realities and lay the groundwork for a stronger economy in the future. A sound macroeconomic policy framework based on low inflation and a floating exchange rate, appropriate fiscal and structural adjustments, and trade liberalization, all did their part to help our economy adjust to the changing circumstances of the 1990s.
Current Economic Situation
Of course, for every challenge that we have met, there are always new ones to overcome. And Canada has certainly had its share over the past year. So, before going on to tell you about some of the challenges we face as we look ahead, let me give you a snapshot of our recent economic circumstances.
Canada was hit by a series of shocks in 2003: the outbreak of SARS, a case of BSE (mad-cow disease), last summer’s large-scale power outage, floods and forest fires, not to mention the Iraq war. And, of course, the U.S. dollar has depreciated sharply against major world currencies, including the Canadian dollar over the past year. With the pick-up in global economic growth, especially in the United States and in Asia, economic activity in Canada is expected to strengthen in 2004. But because of downward revisions to Canadian GDP data in the first half of 2003, lower-than-expected growth in the second half, and the appreciation of the Canadian dollar, the Bank has lowered somewhat its projection of output over the next year and a half. And we concluded that additional monetary stimulus would be required to support aggregate demand and return inflation to the 2 per cent target over the medium term. So in January we lowered our policy interest rate by 25 basis points to 2 1/2 per cent. And just a week ago, we…. [to be filled in after FAD]. In this way, Canadian monetary policy facilitates the overall adjustment process by helping to sustain aggregate demand.
The main risks to this growth outlook relate to the adjustment of the Canadian economy to an array of global economic and financial forces. These include higher prices for commodities, reflecting stronger world demand, adjustments associated with redressing global economic imbalances, including, notably, the large current account and public sector deficits in the United States, and the associated realignment of major currencies, including the Canadian dollar.
In light of the appreciation of our currency, we expect that, over the next couple of years, economic growth will come primarily from private domestic demand—that is, household spending and business spending—buoyed by monetary stimulus, increased confidence, and rising employment and incomes. The strength of the economy, the reduced cost of imported machinery and equipment, and generally favourable financing conditions should also contribute to increased business investment. Canadian exports should benefit from rising U.S. and global economic activity, although the lower value of the U.S. dollar is expected to continue to dampen Canadian export growth through 2004.
Overall, we now project that economic activity in Canada will pick up gradually through 2004, with average annual growth expected to be 2 3/4 per cent for the year. We are projecting a pickup in the pace of growth in 2005, which will likely result in growth of 3 3/4 per cent on an average annual basis. This scenario implies that the excess capacity in the economy would be eliminated for the most part by the third quarter of 2005.
Core inflation —a measure that removes the most volatile components of the consumer price index and thus provides a better reading of the underlying trend—is projected to fall to close to the bottom of our 1 to 3 per cent range, before gradually moving back towards the 2 per cent target by the end of 2005 as slack in the economy is absorbed.
Future Challenges for the Canadian Economy
That’s how the Bank sees the economy shaping up in the short term. But what of the longer term? I’d like to talk now about some of the forces we can expect to see at work in the Canadian economy in the years ahead and the adjustments that will likely be necessary.
Canada has an opportunity in the next few years to again register solid productivity gains. The information and communications technology sector is providing the general-purpose technologies that can drive sustained gains in productivity and incomes. Of course, the mere presence of technology is not enough to guarantee higher productivity. We also need investment, as well as training and organizational changes and flexibility. In the latter part of the 1990s, Canadians had begun to invest in productivity-enhancing technologies. After a pause at the beginning of this decade, such investments seem to have resumed. With changing demographics making labour harder to find, businesses will turn increasingly to productivity-enhancing investments to meet growing demand.
The most recent Statistics Canada survey of investment intentions shows that Canadian businesses and governments plan to increase spending by about 3 percent this year. In Canada’s private sector, strong increases are expected in manufacturing and mining, oil and gas, and the information industry, where plans are for an increase of close to 10 per cent.
As I said a moment ago, there are powerful forces at work in the global economy today. The significant imbalances that we now see in the world’s current- and capital-account flows need to be corrected. And emerging markets, particularly in Asia, are becoming increasingly powerful players in the global economy. China’s role in the global economy has been growing. Indeed, as the world’s fastest-growing economy, China has become a major source of demand in the current weak global economic environment. Canada is particularly well placed to take advantage of this demand, given our specialization in products that answer China’s current needs, such as housing materials, heavy equipment, metal products, and telecommunications.
Changes in information technology, global imbalances, and intensified competition from new and emerging players on the world scene will have an impact on the Canadian economy in the years ahead. And they will require significant economic adjustments. How will Canada respond to these challenges?
First, a floating exchange rate will continue to be an important part of our monetary policy framework, facilitating the necessary adjustments and sending important price signals.
A stronger Canadian currency is consistent with the adjustments that are going to be needed in our economy, even if the speed of the recent appreciation has made these adjustments more difficult. Because it makes machinery and equipment less expensive relative to labour, a stronger currency is in line with our need to increase productivity, as well as with the future demographic pressures on our labour force. A stronger currency is also consistent with the increase we have seen in commodity prices relative to those of manufactured goods and services. And it increases the price of non-tradable goods relative to that of tradable goods. This should encourage the shifting of labour and capital into those sectors that are oriented to meeting domestic demand.
There will need to be more high-productivity activities in the economy. But for significant gains in productivity to resume, Canadian governments must ensure that their microeconomic policies encourage flexibility and do not hinder innovation in the public and private sectors. Workers will need to have the training and skills to take advantage of new technologies. And businesses will need to ensure that their organizations and practices allow the potential of new technologies to be fully realized.
In terms of monetary policy, we will continue to maintain inflation at 2 per cent, by trying to keep the economy operating as close as possible to its full production capacity. And we will also take into account the forces that are driving adjustments in the economy in the years ahead. For example, we know that with a stronger currency, the economy will have to rely more on domestic demand and less on foreign demand for ongoing, solid growth. So we will take this into consideration as we set monetary policy.
Fiscal policy will also need to stay the course. Canada’s ratio of public debt to GDP will need to decline further, in order to support our aging population.
Finally, industry will have to adjust. This will not be easy. Indeed, for many firms and employees, it can be a painful and difficult process. But in today’s world, not adjusting is not an option. Fortunately, we have a relatively favourable climate in which to take the necessary steps. Many elements currently support investment: inflation remains low, stable, and predictable, and credit conditions are good. Business confidence and balance sheets are strong, and equity markets are performing well.
In conclusion, Canada has developed a sound macroeconomic framework, one that has eased the adjustment to changing circumstances. This has allowed us to weather shocks and to take advantage of the new opportunities that change brings.