Mr. Thiessen looks at flexible exchange rates in a world of low inflation
Remarks by the Governor of the Bank of Canada, Mr. Gordon Thiessen, to the FOREX '97
Conference held in Toronto on 30/5/97.
There is a good deal of discussion these days about Economic and Monetary
Union (EMU) in Europe -- about the benefits and difficulties of organizing such a union.
However, today I would like to examine a somewhat different issue, one that is at the other end
of the spectrum; namely, How is the international system of flexible exchange rates working
these days?
This is not to denigrate or deny the importance of the challenges surrounding the
EMU initiative, nor its relevance for those who will be directly or indirectly affected by its
debut. But while many European countries have operated under a fixed exchange rate regime
during the post-Bretton Woods period, most other industrial economies have chosen to operate
under a flexible currency arrangement. The three major currencies, those of the United States,
Japan, and Germany, float against one another. So I thought what I might do this morning is
focus on flexible exchange rates and discuss, in particular, how they have performed over the
past few years.
The main message I would like to convey to you is that, when all is said and
done, the flexible exchange rate system has not done badly over the past 25 years. And in the
last three or four years, it has done rather well in an environment characterized by low inflation
and improved fiscal performance across the major industrial countries. Exchange rates have, for
the most part, moved in the "right direction." And short-run exchange rate volatility has
diminished, notwithstanding some evident cyclical swings of the U.S. dollar.
Why are the major currencies floating?
The initial reason for adopting floating exchange rates was more a matter of
circumstance than a considered choice. The Bretton Woods system, which was established
shortly after the Second World War, collapsed in the early 1970s, forcing most industrial
countries onto a flexible exchange rate regime as an "interim measure." Attempts to rescue the
Bretton Woods system in the summer of 1971 and the fall of 1973 proved unsuccessful.
The reputed reasons for the collapse of the system were the inflationary
macropolicies pursued by the United States during the late 1960s and early 1970s and the
unwillingness of other countries either to inflate their economies to the same extent or to allow
the U.S. dollar to devalue. But the true reasons for its demise were more deep-seated. This
system, which had been viable, although prone to periodic crises, throughout the 1950s and
1960s, was clearly unable to cope in a world of liberalized trade and international capital
mobility. The Bretton Woods system, while laudable in concept, proved to be flawed in practice.
The main problem was that the imbalances that the system was supposed to
address, through discrete changes in the parity value of the affected currencies vis-à-vis the U.S.
dollar and gold, proved to be much larger and more intractable than the architects of the system
had ever envisaged. Moreover, countries were reluctant to adjust their currencies, even when the
problems were shown to be fundamental. Thus, authorities would often subvert domestic
economic objectives, such as price stability, economic growth and full employment, in order to
protect outdated parities. As a result, the system was in disequilibrium more often than not. And
its adjustable nature did not prove flexible enough to help countries deal with the shocks that
regularly hit the international financial system.
While the adoption of floating exchange rates may have been more a matter of
necessity than choice, floating rates did promise greater independence in the conduct of
monetary policy and better insulation from external shocks. Advocates of a floating regime,
partly influenced by Canada's favourable experience with such a system in the 1950s, suggested
that exchange rates would automatically adjust to correct external imbalances in an orderly and
continuous manner. And this would give domestic policymakers greater freedom than under the
pegged rate system as well as obviate the need for official intervention and large international
reserves.
Experience with the floating rate system
Needless to say, experience under the floating rate system has not been
problem-free. Events did not unfold quite as its proponents had suggested, and the past 25 years
have been characterized by volatile short-term movements and sizable long-term swings in most
of the major currencies.
The magnitude of these currency movements and our evident inability to explain
them in a comprehensive, precise manner, led many observers to presume that such movements
were driven by market speculation and that they were largely disconnected from economic
fundamentals.
There is no simple way to resolve this issue. Nonetheless, it is possible to identify
some of the forces that have influenced exchange rates through this period, either by shaping
their broad movements or, at times, by contributing to uncertainty and hence to excessive
volatility in these rates. I would stress, in particular, the uncertainty over the future course of
monetary and fiscal policies, which made it difficult for financial markets to cope with the
macroeconomic pressures of the day.
What forces am I talking about? In the 1970s, we had the two oil shocks, one at
the beginning and one at the end of the decade. These may have been precipitated by political
developments in the Middle East, but the initial shock was encouraged by the pursuit, among the
major industrial countries, of higher output and employment through monetary ease and a
willingness to tolerate increased inflation. Subsequently, the monetary accommodation of the
price effects caused by the oil shocks added to the turbulent environment that followed. The
1970s and early 1980s turned out to be a period of high and variable inflation in many countries.
High inflation, balance-of-payments difficulties arising from the oil shocks, and
the large fiscal transfers necessary to support economic activity in energy-dependent countries,
were the catalyst for much of what followed in the 1980s. Excessive government spending and
rising public indebtedness were coupled with tighter monetary policy, as authorities struggled to
maintain social services, restore full employment, and dampen the inflationary pressures that had
been allowed to grow in the 1970s. The effects of this uncomfortable policy mix hit the major
industrial countries with varying severity and triggered a debt crisis in the developing world.
Success on the inflation front was mixed, adding to the strains that the exchange rate system was
expected to cope with.
While the problems in the industrial countries were generally less severe than
those in the developing world, they nevertheless caused serious dislocations. Because of
differences in the mix of fiscal and monetary policies in the United States compared with
Germany and Japan, the U.S. dollar appreciated sharply against the deutschemark and the yen
through the first part of the 1980s. In turn, these developments led to an accumulation of very
large current account imbalances among these three major countries. In these circumstances, the
flexible exchange rate system did not perform as well as it might have. But it is not obvious that
any other alternative would have been practicable, and I doubt very much that a fixed exchange
rate system for the U.S. dollar, the mark, and the yen could have survived these strains.
The three major currencies were not the only ones subjected to tensions.
Uncertainty about whether and how fiscal imbalances might be corrected, and considerable
cross-country differences in actual and expected inflation contributed to major exchange rate
pressures among other currencies in the 1980s and early 1990s. By 1992-93, these pressures had
reached the breaking point in continental Europe and the United Kingdom, putting extreme
stress on the Exchange Rate Mechanism (ERM). As well as causing the United Kingdom and
Italy to leave the arrangement, the situation necessitated a widening of the ERM intervention
bands.
What is the current situation?
Although it is still early days, conditions in exchange and asset markets have
improved considerably since 1993. Short-term exchange rate volatility, and even the trend
movements in bilateral rates, while still significant, are much smaller than those of the previous
two decades.
I believe that this improved perfomance has a lot to do with the convergence we
have seen in recent years towards low and stable rates of inflation among the major industrial
countries. But progress on the fiscal front has also been essential, helping to reduce risk
premiums and stabilize expectations, both with regard to the long-run viability of the fiscal track
in many countries and the prospects for continued low inflation.
Thus, I would argue that consistently low inflation and improved fiscal positions
have brought about more stable, "better behaved" exchange rates, just as theory would have
predicted. This is not to say that exchange rates have remained absolutely stable over the past
four years. They have not. But movements have been more orderly, unlike those of the earlier
periods, and most of the observed trends can be explained by the different cyclical positions of
countries, the different monetary and fiscal responses, and by changes in world commodity
prices.
Exchange rate movements have, at times, appeared to contribute to trade
imbalances or exacerbate existing ones. But this should not be interpreted as evidence that
markets are pushing rates in the wrong direction. Indeed, imbalances often reflect the fact that
economies are at different points of the business cycle. For example, Japan has, until very
recently, seen the value of its currency decline, on balance, against the U.S. dollar, even though
the country is running a large and growing trade surplus. It is obvious that much of the recent
movement in the U.S. dollar/yen exchange rate has been driven by the different cyclical
positions of the two countries. Thus, the relatively low yen has been helping to rejuvenate
demand in Japan. Meanwhile, a strong U.S. dollar has been helping the United States to counter
inflationary pressures that would otherwise require stronger doses of interest-rate medicine.
Of course, it is possible for exchange rates to overreact, even in the benign
environment I described a moment ago. But the chances of a serious misalignment are much
lower when markets are operating in a climate of greater predictability, provided by a monetary
policy grounded in domestic price stability. When exchange rates are not anchored by a credible
commitment to price stability, it is difficult, if not impossible, for markets to perform the tasks
that are expected of them.
The operation of the flexible exchange rate system in Canada
As you know, Canada has been one of the strongest proponents of a flexible
exchange rate system. We were the only major industrial country to operate under such a system
in the 1950s and early 1960s, and we were the first major country to adopt it again in the 1970s.
As a medium-sized open economy that relies on exports of primary commodities more than our
principal trading partners, we are vulnerable to external shocks and appreciate the "shock
absorber" effect provided by a flexible exchange rate.
Let me tell you briefly how the Canadian economy has performed under the
flexible exchange rate system and describe the main forces that have been acting on our
exchange rate. The most significant trend movement occurred over the 1976 to 1986 period,
when the Canadian dollar experienced a large depreciation vis-à-vis the U.S. dollar, falling from
roughly parity to a low of 69 cents (U.S.) in February 1986. During this time, annual inflation
rates in Canada exceeded those in the United States by about one per cent, on average. While on
a yearly basis this may not sound like much, cumulatively the differential was rather significant
and can explain most of the trend depreciation in the Canada-U.S. exchange rate over this
period.
As for the cyclical swings that accompanied the trend depreciation of the
Canadian dollar, they reflected a number of factors. Among these, the most significant has been
the variability in the world prices of primary commodities, which remain an important
component of our exports. But the most worrisome factor during the 1980s and 1990s was the
growth of the fiscal deficit and the destabilizing effect that this had on financial markets,
including the foreign exchange market. Rising public debts and deficits contributed importantly
to the risk premiums in interest rates on Canadian dollar assets and were the catalyst, if not the
cause, of unsettling episodes in 1986, 1992, and 1994. Fiscal policy concerns, at times coupled
with political uncertainty, proved to be a volatile mix and led to serious financial market
turbulence and speculative pressures, complicating the task of monetary policy.
Fortunately, the situation has recently improved considerably. Inflation in Canada
is stable, at its lowest level in decades. And it has been somewhat below that in the United States
since 1992. This implies a potential appreciation of the Canadian dollar vis-à-vis the U.S. dollar
over time, if the inflation differential persists.
But other factors also tend to favour a stronger Canadian dollar. First, deficit
reduction by Canadian governments has eased the uncertainty that had pervaded financial
markets, thereby shrinking risk premiums in interest rates and reversing the currency weakness
caused earlier by these premiums. Second, Canadian industries are in a stronger competitive
position than they have been for years, and this has contributed to a sharp reduction of the
persistent deficit in the current account of our international balance of payments. Third, primary
commodity prices are firm and likely to move higher with the pickup in global economic
activity.
In light of all this, it is not surprising that several analysts, as well as the Bank of
Canada, expect a stronger Canadian dollar in the future and think that the currency is currently
undervalued relative to its longer-term fundamentals.
Why, then, has the Canadian dollar not been stronger? The explanation lies
mainly in the different cyclical positions of the Canadian and U.S. economies. The more
accommodative monetary conditions pursued in Canada during the past two years have been
consistent with the needs of an economy characterized by considerable excess capacity and an
inflation rate that has tended to be in the lower half of the current 1 to 3 per cent target range.
Thus, lower interest rates and a relatively low Canadian dollar have been temporarily
appropriate for economic reasons.
While no central bank ever wishes to have a weak currency, since late 1995, the
Bank of Canada has encouraged easier monetary conditions -- conditions that, at times, have
taken the form of lower interest rates and a somewhat softer dollar. Put another way, the Bank
did not purposely push the dollar lower, but simply aimed for the path of monetary conditions
that seemed appropriate given sluggish domestic economic conditions. The particular mix of
interest rate and exchange rate adjustments necessary to achieve the desired path of monetary
conditions is not under the direct control of the Bank of Canada. It is essentially determined by
the markets.
However, the Canadian economy has been gathering momentum lately, and
prospects are good for continued robust expansion through 1997 and into 1998, in response to
the substantial past monetary easing. With the margin of excess capacity in the economy still
fairly wide, there is ample room for strong growth in coming quarters without a resurgence of
inflation. However, as the slack is absorbed, the Bank will need to pursue less stimulative
monetary conditions, consistent with a durable, low-inflation economic expansion.
In other words, for cyclical as well as for more fundamental reasons, the
prospects are good for a stronger Canadian currency.
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In summary, I would say that the exchange market for the Canadian dollar has
worked rather well in recent years, interpreting and responding to both the fundamental trends in
our economy and the cyclical differences between Canada and the United States. I believe that
fiscal discipline and a credible commitment to low inflation are key ingredients of that good
performance.