Pierre Duguay: The conduct of monetary policy - dealing with changes in the
terms of trade
Remarks by Mr Pierre Duguay, Deputy Governor of the Bank of Canada, to the School of Business,
Okanagan College, Kelowna, British Columbia, 4 April 2006.
Charts for the speech can be found on the Bank of Canada's website.
* * *
Good evening. I'm delighted to be here in Kelowna, in the beautiful Okanagan Valley.
It's good to be back in a classroom, speaking to business and economics students. For those of you
who want to work in finance or the wider world of business, it is particularly important that you have a
solid grasp of economic issues and that you understand how monetary policy contributes to the
economic and financial well-being of Canadians. And as you will find out, economics is a way of
thinking, one that combines logic and pragmatism. The more you know about basic economic
concepts, the better you'll perform in whatever career you choose.
What I would like to do in the next 20 to 30 minutes is explain how monetary policy helps the economy
adjust to important shocks that occur from time to time, including sharp movements in our terms of
trade. I will start with the objective of monetary policy. Then I'll describe how monetary policy works
and where the exchange rate fits in. I will then explain what we mean by "terms-of-trade" shocks and
show how Canada's monetary policy framework helps to facilitate the adjustment to these shocks. I'll
leave plenty of time at the end of my remarks for questions.
Let me start with the objective of monetary policy.
The objective of monetary policy
The ultimate goal of Canadian monetary policy is to help our economy achieve its maximum
sustainable growth, and thus contribute to rising living standards for Canadians. The best way to
achieve this goal, we've learned from experience, is to keep inflation low, stable, and predictable.
Inflation, as measured by the annual rate of increase in the consumer price index (CPI), has been
running at about 2 per cent for more than a decade now. But in the 1970s and 80s, the rate of price
increases was a good deal higher, spiking twice to well over 10 per cent. I doubt that many of you here
tonight remember those days of high and variable inflation. High inflation exacted a heavy toll on
Canadians. Borrowers faced high and volatile interest rates. Incomes and savings were eroded by
rising prices. Speculation was rampant. And the economic booms that led to rising inflation ended up
in recessions.
One of the things we learned from this bitter experience is that high inflation injects additional
uncertainty into decision making. In a market economy, prices contain valuable information. When the
price of a product is rising relative to other products, it's a signal that that particular product is
becoming scarcer. Producers are then encouraged to increase its supply, while consumers are
encouraged to economize on its use, thus alleviating the scarcity. Conversely, a drop in the price of a
product is a signal that it is becoming more abundant. When this happens, firms are led to reduce their
supplies of the product, and consumers are encouraged to increase their demand for it.
But when inflation is high and variable, buyers and sellers are never quite sure what a price increase
means. Is it a sign that a specific good is becoming scarcer, or is it just a sign of more widespread
inflation? This uncertainty means that prices no longer convey as much useful information, and, as a
result, people find it difficult to make sound decisions about production and investment. They focus on
trying to protect themselves against the effects of inflation. Investors won't commit their resources for
lengthy periods; labour negotiations become more acrimonious; and the overall economy is not as
productive as it could be. Indeed, with the erosion of confidence in money comes an erosion of
confidence in the fairness of markets. As former Bank of Canada Governor Gerald Bouey aptly put it in
his 1981 Annual Report, "inflation melts the glue that holds free societies together."
The lesson we (and other central banks) have learned in the past 30 years is that low and stable
inflation is the best contribution that monetary policy can make to a strong economy. Since 1991, the
Bank of Canada has conducted monetary policy with an explicit numeric target for inflation, a target
that is set jointly with the Government of Canada. Since 1995, the inflation target has been the 2 per
cent midpoint of a 1 to 3 per cent range. It was last renewed 5 years ago, and is coming up for renewal
this year.
Having a clear objective has increased the Bank of Canada's accountability to Canadians. It has made
it easier for the Bank to explain its actions and easier for people to judge how the Bank is doing in
meeting its objective. Once Canadians believed that the Bank would take action to meet the target-
as we have done for some 15 years-they came to expect that inflation would remain low and stable.
This expectation helped people make economic decisions that are aligned with the objective of
monetary policy. And this facilitates the achievement of that objective.
Since the adoption of the target, inflation has been pretty close to 2 per cent. And this stable,
lowinflation environment has produced steadier economic growth, as well as lower and more stable
interest rates, than was the case when inflation was high and variable.
Now that I have described the objective of monetary policy, let me turn to how we go about achieving
it. I will start with what we call the "monetary policy transmission mechanism," which traces how
monetary policy actions work their way through the economy.
How monetary policy works
The Bank of Canada has only one tool at its disposal for carrying out monetary policy-its direct
overnight
influence on the rate. The overnight rate is the interest rate at which financial institutions
borrow and lend one-day (or overnight) funds among themselves. The Bank has a direct influence on
that rate because it controls the total amount of funds (settlement balances) available to these
institutions.1 The Bank sets the target for the overnight rate eight times a year on a pre-announced
schedule. That schedule reduces uncertainty in financial markets about the timing of policy actions
and helps direct attention to the medium-term perspective of monetary policy. The decisions are made
by the Bank's Governing Council-that is the Governor and five Deputy Governors-based on
consensus. They are informed by a thorough analysis, provided by Bank staff, of current and
prospective economic and financial developments.
Changes in the target for the overnight rate spread to other interest rates, which then affect borrowing
and spending decisions, and thus the overall level of demand for goods and services-what we call
aggregate demand. Imbalances between aggregate demand and the economy's capacity to supply
goods and services (referred to as the output gap) set off changes in inflation. That's a quick sketch of
the transmission mechanism, and I would encourage you to look up a fuller description on our web site
at: www.bankofcanada.ca/en/monetary_mod/index.html.
My key point here is that the whole process takes time. Monetary policy actions take 12 to 18 months
to have most of their effects on total spending, and another 3 to 6 months to have most of their effects
on inflation. This means that the Bank of Canada has to be forward-looking, taking actions based on
projections of future pressures on inflation.
Monetary policy aims to keep inflation low and stable by keeping overall demand in line with supply.
When demand is projected to rise beyond the economy's ability to meet that demand, threatening to
push inflation above target, the Bank will act to dampen some of that demand by raising interest rates.
Conversely, when demand is weak, threatening to take inflation below target, the Bank will lower
interest rates to stimulate demand. This symmetric, forward-looking approach to monetary policy has a
stabilizing influence on the economy, thus helping to prevent costly boom-and-bust cycles. If we
waited for inflation to increase or decrease before tightening or loosening monetary policy, we would
be too late, and there would be a risk that the economy would be less stable.
The role of the exchange rate
Except for a brief period from 1962 to 1970, when the exchange rate was fixed, Canada has had a
floating exchange rate since 1950.2 Today, the Canadian dollar is worth about 86 U.S. cents. Four
years ago, it was worth 63 U.S. cents.
Our flexible exchange rate regime is an essential ingredient of our inflation-targeting system. It allows
us to follow an independent monetary policy, suited to our own economic circumstances, which would
not be possible if we had to set monetary policy with the objective of maintaining a fixed exchange rate
for the Canadian dollar. At the same time, inflation targeting means that our floating exchange rate
acts as a "shock absorber," helping our economy adjust to changes with less pain and less disruption
than if the exchange rate was fixed.
So, we do not have a target for the external value of the Canadian dollar. With only one instrument-
the target for the overnight rate-to carry out monetary policy, we couldn't hit two targets, one for
inflation and one for the exchange rate. But saying that we do not have a target for the exchange rate
doesn't mean that we ignore it. On the contrary, we monitor the exchange rate closely to assess the
effects of currency movements on aggregate demand for Canadian goods and services, and the
consequences for future inflation. The fact is that the exchange rate is an important price in the
Canadian economy. It directly affects the Canadian dollar price of everything we import and export,
thus sending strong price signals to businesses and consumers.
Terms-of-trade shocks and the flexible exchange rate
As an open economy and a major producer of commodities, Canada is very much affected by swings
in the world demand for, and prices of, our products. Such swings cause our terms of trade-that is,
the prices we get for our exports relative to the prices we pay for our imports-to move around a great
deal. When the prices of the products we sell on world markets rise relative to the prices of those we
buy from abroad, our terms of trade are improving-and we are getting richer. When the prices of our
exports fall relative to those of our imports, our terms of trade deteriorate-and we are getting poorer.
So, improving terms of trade are favourable for a country. They result in gains in labour income, in
corporate profits, and in government revenues. But changes in our terms of trade-whether in a
favourable or unfavourable direction-can cause stress and dislocations. They can involve significant
shifts in production and employment among sectors of the economy. That means loss of jobs in some
industries and growth in others. In economic terms, it triggers a shift of resources from less profitable
to more profitable sectors. Thus, while the adjustments can be difficult, they are vital to our economic
prosperity. To make the most of our opportunities as a trading nation, we need to adjust to changing
global economic circumstances.
The key point I would like to emphasize here is that our low-inflation target and our flexible exchange
rate help facilitate the necessary adjustments. Of course, by its very nature, monetary policy is
national in scope, and while its effects are far-reaching, it cannot address the specific needs of a
sector or region. It can only address the needs of the nation as a whole.
Canada's terms of trade have moved around significantly over the past decade. To illustrate my point,
I'd like to focus on one episode when they were weakening and one when they were improving. I'll
describe the nature of the shock in each case, and explain the role of our monetary policy framework,
in particular, the role of the exchange rate, in facilitating the adjustment process.
The first episode occurred in 1997-98, when a financial crisis that started in Thailand spread to
Indonesia, South Korea, and other countries. Asian demand, which had accounted for a relatively
large share of growing world demand for commodities, weakened considerably. As a result, prices of
key commodities produced by Canada fell, and our terms of trade weakened.
Reflecting the downturn in world commodity prices, the Canadian dollar depreciated against the U.S.
dollar. The depreciation helped to mitigate the negative shock for commodity producers. And, more
importantly, it encouraged the manufacturing sector to expand and absorb the resources-labour and
capital-that were released from the commodity-producing sector. Thus, the depreciation of our
currency helped to offset the negative effects of the Asian crisis on aggregate demand for Canadian
goods and services and thus pre-empted downward pressures on prices and wages. In this way, the
flexible exchange rate acted as a shock absorber to mitigate the effects of the weakening terms of
trade on the overall level of economic activity, while encouraging economic adjustment.
Let me now turn to the second episode. In the past three to four years, Canada's terms of trade have
improved sharply. The basic story has been one of strong global economic growth, leading to a surge
in world demand and prices for oil and gas, lumber, metals, and other primary commodities. The
resulting rise in Canadian incomes has also boosted demand by Canadian households and
businesses.
Over this period, the Canadian dollar has appreciated by more than 30 per cent against the U.S.
greenback, and indeed significantly against many other currencies. This stronger Canadian dollar has
dampened the positive shock for commodity producers and made manufacturing less competitive. As
a result, resources have been reallocated from the manufacturing sector to the commodity and
services sectors. This adjustment has helped keep overall supply and demand in balance and inflation
pressures in check. In this sense, the past four years have been the reverse of the situation in
199798. Once again, the flexible exchange rate has helped to stabilize the economy and to encourage
adjustment-this time in the context of strengthening terms of trade.
It's useful to compare these two recent terms-of-trade shocks-which occurred when monetary policy
was anchored by an inflation target-with an earlier shock when monetary policy was not conducted
with an explicit target. During 1997-98, when our terms of trade were weakening, CPI inflation
averaged 1.3 per cent. Since the beginning of 2003, when our terms of trade have been
strengthening, inflation has averaged 2.6 per cent. Thus, during both of these recent episodes,
inflation has remained relatively close to target.
This is in sharp contrast to the 1972-74 period, when Canadian terms of trade improved dramatically
as a result of steep increases in energy and other commodity prices. Inflation rose sharply, spiking to
more than 12 per cent in late 1974. Inflation remained high and variable for quite some time after that,
causing severe economic disruptions, and great difficulty for people living on fixed incomes. Clearly,
the monetary policy framework at the time was not robust enough to contain the inflationary
consequences of rising energy and raw material prices and strong demand for commodities.
The comparison of these episodes illustrates how the two key elements of our current monetary policy
framework-the inflation-control target and the flexible exchange rate-work together to facilitate the
adjustment to terms-of-trade shocks.
To summarize: sharp changes in the terms of trade necessitate a reallocation of economic resources.
That adjustment process, while always a challenge, and sometimes painful, can be helped a great
deal by a coherent monetary policy framework. Of course, monetary policy is only one part-albeit an
important part-of the adjustment process. Also of great help in facilitating economic adjustment to
terms-of-trade shocks are the ingenuity of Canadian business people, the diversity and resilience of
the Canadian economy, and the flexibility of labour and product markets.
Over the past three years, we've seen strong growth in capital spending in commodity-producing
industries, as well as substantial gains in both capital spending and employment in sectors with low
exposure to international trade. Exports have continued to grow, despite the higher Canadian dollar.
And a surge in investment in machinery and equipment suggests that firms are, in fact, taking
advantage of the stronger exchange rate (which reduces the cost of imported machinery and
equipment in Canadian dollar terms) to improve their productivity and enhance their competitiveness.
There is also evidence that Canadians are more mobile, making the best of work opportunities in
strong growth areas such as the Athabasca tar sands. Indeed, it has recently been reported that Air
Canada is introducing an "Oil Express" pass to facilitate the movement of labour between Eastern
Canada and Fort McMurray, Alberta. And strong economic activity in Alberta is not only drawing in
migrant labour from other provinces; it is also generating large orders for goods and services produced
elsewhere in Canada.
Here in British Columbia, there has been solid growth in output in the construction, mining,
transportation, and the services sectors. Indeed, B.C. now enjoys its lowest recorded unemployment
rate. A Vancouver firm recently signed the largest licensing deal in Canada's biotech history.
In B.C. and across Canada, workers and investors have been quick to seize the new opportunities
presented by the improvement in our terms of trade.
Recent economic developments
The global economic environment has been particularly favourable to Canada in the past few years,
and our economy has adjusted remarkably well to large changes in relative prices, including the
marked appreciation of the Canadian dollar.
In our January 2006 Monetary Policy Report Update, we concluded that the Canadian economy was
operating at its production capacity and we projected that it would grow roughly in line with capacity
through 2007. We expected CPI inflation to stay slightly above the 2 per cent target in the first half of
this year and to ease to 2 per cent by the first half of next year. Core inflation-a measure of the
underlying trend in prices that excludes eight of the most volatile components of the CPI, and which
has been slightly below 2 per cent in the past two years-was also projected to return to 2 per cent by
the first half of next year.
Update
Our January also indicated that the risks to the Bank's projection were balanced for 2006, but
tilted to the downside through 2007 and beyond. These downside risks relate to the possibility that the
unwinding of large global current account imbalances could involve a slowdown in the world economy.
(By global imbalances, I mean the large current account deficit in the United States, mirrored by large
current account surpluses in other countries.) Consistent with this view, at the time of our last policy
decision on 7 March, we indicated that some modest further increase in the policy interest rate may be
required to keep aggregate supply and demand in balance and inflation on target over the medium
term.
Monetary Policy
We are now well into the preparation of our spring Report, which will be released on
27 April. If anything, the global economy may be a touch stronger in 2006 because of improved growth
prospects for Japan and Europe. In our upcoming Report, we will provide a full analysis of economic
developments, trends, and risks to the outlook.
Conclusion
Let me conclude. In a constantly changing and increasingly globalized world economy, the Canadian
economy will continue to be buffeted by various shocks. Our monetary policy framework-the inflation
target working in concert with a floating exchange rate-will continue to play an important role in
mitigating the effects of shocks, and in helping to facilitate the needed economic adjustments by
ensuring that the price system sends the right signals.
And of course, the ingenuity and adaptability of Canadian workers and business people will remain
critical to increasing our standards of living.
This is an exciting time to be in post-secondary education, preparing for a career in Canada.
Employment prospects are very good, and they will undoubtedly improve as the baby boomers retire. I
talked about the inevitability of economic shocks and of the adjustments that these shocks
necessitate. You will find that your studies will help you to prepare for, and to take advantage of, rapid
changes in our economy. I wish you all well in your studies.