David Dodge: Monetary policy and exchange rate movements
Remarks by Mr David Dodge, Governor of the Bank of Canada, to the Vancouver Board of Trade,
Vancouver, 17 February 2005.
* * *
Good afternoon. It is always a pleasure for me to return to Vancouver, a city I called home for a year.
And now that I live in Ottawa, I can tell you that it is particularly nice to get the chance to come here in
the middle of February.
Every year, the Canadian Press surveys news directors and editors to select the top business story of
the year. In 2004, they picked the rise of the Canadian dollar. That was not a surprising choice. The
dollar's appreciation drew a lot of attention from the media, from business people, from individual
Canadians, and indeed, from the Bank of Canada. Changes in the external value of the dollar are one
of the key factors that we scrutinize and work hard to understand. We watched the dollar closely as it
depreciated during the 1990s, as it fell to an all-time low against the U.S. dollar in early 2002, and as it
rose by roughly 25 per cent between January 2003 and January of this year.
With the rapid appreciation of our dollar has come an increase in public commentary about the
currency - its effects on the Canadian economy in general, and the Bank of Canada's monetary policy
in particular. There has been no shortage of stories broadcast or articles written. At the Bank, we
welcome this increased interest. Canadians should discuss important economic issues that affect their
daily lives. However, some of this commentary has oversimplified how movements in the exchange
rate affect the Canadian economy and monetary policy. I don't mean this as a criticism. The
relationship between the exchange rate, the economy, and monetary policy is complex. So today, I
want to talk about the various factors that influence the exchange rate, examine how these factors
affect the Canadian economy, and lay out how the Bank takes them into account as we conduct
monetary policy. In doing so, I will elaborate on the contents of a technical box in our latest Monetary
Policy Report Update, published on 27 January.
The exchange rate in an inflation-targeting framework
Let me begin with a brief review of Canada's monetary policy framework. At the heart of our monetary
policy is the idea that the best contribution the Bank can make to the Canadian economy is to keep
inflation low, stable, and predictable. By aiming to keep the annual rate of inflation at the 2 per cent
midpoint of a 1 to 3 per cent target range over the medium term, we lay the groundwork for the
economy to grow in a strong and sustainable way.
To keep inflation low and stable, we aim to maintain a rough balance between demand and supply in
the economy. When aggregate, or total, demand exceeds aggregate supply, the economy will push
against its capacity limits - and inflationary pressures will tend to build over time. If we see that inflation
is threatening to rise above target over the next 18 to 24 months, the Bank will tighten monetary policy
to dampen demand. Similarly, if there is too little aggregate demand relative to supply, the economy
will operate below its capacity. If this gap between aggregate demand and supply were to persist, the
projected trend of inflation would fall below target. The Bank would then ease monetary policy to
stimulate demand and close the gap. That's why it is important for us to understand how
developments in the Canadian and world economies affect the balance between demand and supply
in Canada.
Now let's bring the exchange rate into the picture. To understand the effect of exchange rate
movements, we need to understand why exchange rates are moving, and how these movements
affect the balance between demand and supply. Exchange rate movements tell us something about
economic developments that may be having a direct impact on Canadian aggregate demand. And the
movements themselves have their own impact on aggregate demand, by changing relative prices for
Canadian goods and services and by shifting demand between domestic- and foreign-produced
products. The challenge for the Bank is to evaluate these movements, together with other data, and
set a course for monetary policy that works to keep demand and supply in balance and inflation low
and stable.
Two types of exchange rate movement
With this general framework in mind, let me now talk in more detail about the forces that can influence
the exchange rate. Here, I want to emphasize a key point: From the Bank's point of view, the causes
of a movement in the exchange rate are just as important as the movement itself. I will spend the
balance of my time today explaining why this is so.
For monetary policy purposes, there are two basic types of exchange rate movement - and no, I don't
mean "up" and "down." I mean movements in the Canadian dollar that directly reflect changes in the
demand for Canadian goods and services, and those that do not.
Consider the first type of movement, which I'll call Type One. Growing world demand for Canadian
goods or higher world prices for Canadian products both prompt a direct increase in aggregate
demand in Canada. And both tend to cause an appreciation of the Canadian dollar. Put simply, when
demand for our goods and services increases, our currency tends to appreciate. Conversely, when
demand for our goods and services decreases, our currency tends to depreciate.
But not all exchange rate movements are Type One. Some movements, let's call them Type Two,
reflect the rebalancing of portfolios in financial markets, which may have nothing to do with current
demand for Canadian goods and services.1 One example of a Type Two movement would be a flight
to so-called "safe havens" during an international financial crisis. Another example is a movement that
relates to expectations of what might be necessary to resolve global imbalances. I'll say a bit more
about this later on. But for now, let me just stress the key point about Type Two exchange rate
not
movements. While they are more difficult to describe, their defining feature is that they do reflect
current changes in demand for our goods and services.
It's important for us at the Bank to try to distinguish between exchange rate movements that reflect
changes in demand for our goods and services and those that do not. That's because these
movements have different implications for aggregate demand and, hence, for monetary policy. This is
a complicated issue, all the more so because both types of currency movement sometimes occur at
the same time. So I want to spend some time talking about these two different types of exchange rate
movement. I'll give you some real examples and explain their different implications for monetary
policy.
Let me start with Type One. I've already noted that when global demand for Canada's goods and
services rises, the demand for our dollar also increases, so it tends to appreciate. Similarly, when
global demand for Canada's goods and services falls, so will the demand for our currency, which then
tends to depreciate. But the exchange rate, by reacting to these changes in demand, also acts as a
shock absorber. For example, when global demand for our goods and services weakens, and our
dollar depreciates in response, the lower dollar pulls down the relative prices of Canadian goods and
services, making them more attractive. And, of course, the opposite happens when global demand
rises for Canadian goods and services; the increase in demand is dampened by the associated
appreciation of our dollar.
Let me give you an example from here in British Columbia. In 1997 and 1998, the world economy was
dealing with the effects of economic crises in Asia, Russia, and other emerging markets. In this
environment, global demand for the primary commodities that Canada produces was very weak. That
weakness resulted in falling prices for many commodities, including some of the raw materials
produced in British Columbia or shipped through its ports. At that time, there was a sharp depreciation
of the currencies of countries that export raw materials - Canada, Australia, and New Zealand - while
the U.S. dollar appreciated. While there were other forces driving the exchange rate at that time, the
drop in global demand for raw materials was a direct, negative shock to Canadian aggregate demand,
and this shock led to a depreciation of the Canadian dollar. The lower dollar, in turn, helped to offset
the shock by making other Canadian exports more attractive to global markets, and by making foreign
products and services less attractive to Canadians.
Over the past two years, we have seen this movement work in the opposite direction. In 2003 and
most of 2004, both the demand for, and prices of, Canadian products rose. Once again, there were
other factors at work on the exchange rate during this time. But this direct, positive shock to Canadian
aggregate demand led to increased demand for our currency and an appreciation of the Canadian
dollar. The stronger Canadian dollar, in turn, increased the relative price of Canadian goods compared
with foreign products, and helped to restore the balance between demand and supply. In these two
instances, the flexible exchange rate helped to absorb positive and negative shocks to our economy.
That's the first type of exchange rate movement. Let's now turn to Type Two. You may wonder: if this
second type doesn't reflect changes in demand for Canadian goods and services, what does it reflect?
What are the forces behind this type of movement?
Quite often, it reflects changes in foreign demand for Canadian financial assets or changes in
Canadian demand for foreign financial assets.2 For example, if investors develop a greater appetite to
hold Canadian equities or bonds, this drives up the demand for our currency, which then tends to
appreciate. The reverse also holds true. A shift in investor sentiment away from our bonds and
equities reduces the demand for the Canadian dollar, and it tends to depreciate. But let's remember
equities and bonds
that these changes in demand for are not related to current changes in aggregate
demand for goods and services produced in Canada. The fact that these movements are not related
to changes in aggregate demand is the essential difference between a Type One and a Type Two
currency movement.
A textbook example of a Type Two currency movement occurred during the Mexican Peso Crisis of
1994-95. As a result of the Mexican situation, investors became less comfortable with holding the
financial assets of countries with governments that were heavily in debt - and this included Canada at
the time. As a result, investors sold the financial assets of those countries and sought the relative
safety of investments in the United States. This was one of the factors behind the sharp depreciation
of the Canadian dollar during this period.
Let me give you another example of an exchange rate change that is not driven by a change in
Canadian aggregate demand. The period near the end of the 1990s saw investors become
increasingly optimistic - some have said irrationally exuberant - about the prospects for the U.S.
economy. The associated financial flows into the United States helped to drive up the U.S. dollar over
this period - at the expense of other currencies, including the Canadian and Australian dollars, the
euro, and the yen. This optimistic view about the U.S. economy, combined with the decline in
commodity prices that I mentioned earlier, helped push down the value of the Canadian dollar from
71 cents (US) in March 1998, to about 62 cents (US) in January 2002.
Of course, the process also works in the other direction. During the past two years, investors have
become more concerned about the large and growing U.S. current account deficit - which has arisen
out of that country's large fiscal deficit and its very low level of private savings. While the United States
saves too little, Asian countries are saving too much, and this situation cannot be sustained
indefinitely. More domestic demand in Asia and some other countries, and more savings in the United
States, are needed to help restore global economic balance. Against this backdrop, market
participants have come to the view that further depreciation of the U.S. dollar will be needed to help
resolve these imbalances. The earlier "irrational exuberance" about the prospects for the U.S.
economy has been cooled by an increased focus on the risks facing that economy. And so we have
seen the U.S. dollar fall against many major currencies, including the Canadian dollar.
Let me stress the relevant feature that is common across all Type Two movements. These movements
do not reflect a change in the aggregate demand for our goods and services. However, the exchange
rate movements, by having the usual effect on relative prices, still lead to changes in Canada's net
exports and, thus, in Canadian aggregate demand.
The implications for monetary policy
At this point, it might be tempting to say, "So what?" After all, Canadians looking to head south for a
winter break probably don't care what is causing the exchange rate to move. They only want to know
how many U.S. dollars or Mexican pesos they can buy with their hard-earned Canadian dollars. But it
is important for us at the Bank, and for those who follow our actions, to understand what is causing the
exchange rate to move. This is because the monetary policy implications of a currency movement
depend on its cause, and on what other forces might be at work in the economy.
Let's look at examples of the two types of exchange rate movement that result in a stronger Canadian
dollar. In Type One, we start with an increase in foreign demand for our goods and services and,
hence, an increase in aggregate demand. The Canadian dollar strengthens in response, increasing
the relative price of Canadian goods. This increase offsets some of the higher foreign demand by
encouraging imports and dampening exports. In other words, the appreciation of the Canadian dollar
works to dampen the initial increase in aggregate demand. To the extent that the dampening effect on
aggregate demand exactly offsets the direct increase in demand, there would be no need for a
monetary policy response.
A Type Two appreciation is a different story. Consider the example where the U.S. dollar weakens,
driven by market concerns about global imbalances. In this case, there is no initial increase in
Canadian aggregate demand. But the stronger Canadian dollar still raises the relative prices of
domestic products and leads to a decline in net exports. The overall effect on Canadian aggregate
demand is clearly negative. And this decrease in demand - if it persisted - would likely lead to
undesirable downward pressure on inflation. All other things being equal, this would require monetary
policy to be more stimulative than it otherwise would have been.
I hope that this helps to clarify why these two different types of exchange rate movement have
different implications for monetary policy. However, I don't want anyone to think that we at the Bank
have a mechanical or formulaic approach to dealing with exchange rate movements. The truth is
exactly the opposite. Analyzing foreign exchange movements and determining the appropriate
monetary policy response is a complicated business.
Consider the sharp appreciation of the Canadian dollar against the U.S. dollar over the past couple of
years. Which type of movement drove this appreciation? How much of this movement was related to
stronger demand for Canadian goods and services, and how much was related to widespread
weakness in the U.S. dollar?
As we noted in our Monetary Policy Report Update last month, both types of exchange rate movement
seem to have been at play over the past year. However, their relative importance appears to have
shifted over this period. And that made it difficult to determine the appropriate monetary policy
response.
Looking at the economic data at the beginning of 2004, we saw that net exports had made a
significant negative contribution to Canadian economic growth in 2003. We were concerned that, on
balance, much of the exchange rate appreciation in 2003 was of the Type Two variety. This
assessment was one of the factors that led the Bank to lower interest rates in early 2004. However, by
late last summer and early last autumn, we had seen strong commodity prices and strong world
demand. And net exports had made a solid, positive contribution to Canadian growth in the first half of
2004 - a typical Type One effect. With our economy approaching its capacity limits, we raised interest
rates in order to reduce the amount of monetary stimulus in the economy.
But towards the end of 2004, the balance of Type One and Type Two forces appeared to shift again,
with Type Two dominating. The U.S. dollar weakened against all the major floating currencies, and the
Canadian dollar rose to a 13-year high of about 85 1/2 cents (US). This occurred despite the fact that
world commodity prices had declined somewhat and the outlook for the global economy had
weakened. The Bank's target overnight rate was therefore left unchanged at the fixed announcement
dates in December 2004 and January 2005.
Each monetary policy decision that we make is complicated by uncertainty about the persistence of
exchange rate changes and about the length of time it takes for both exchange rate and monetary
policy movements to influence the economy. This has been one of the Bank's major challenges in the
recent conduct of monetary policy. It's one thing to observe a movement in the exchange rate. It's
quite another to determine its implications for aggregate demand and, hence, for monetary policy.
We continue to struggle with the same complications today as we chart a path for monetary policy.
Canadian interest rates remain low by historical standards. Eventually, this considerable monetary
stimulus will have to be reduced; that is, at some point, interest rates will have to rise. But as I said,
the second type of exchange rate movement appears to have gained relative importance in recent
months, which means that aggregate demand in Canada will be weaker than we had expected last
autumn. That is why in our recent Update we slightly lowered our growth projection for 2005, to 2.8 per
Update
cent from 2.9 per cent. And it is why we said in the that: "...the pace of reduction in monetary
stimulus is likely to be slower than envisioned in the October Report." By slowing the pace at which we
will reduce monetary stimulus, we will continue to provide support for domestic demand to offset the
additional drag we expect from net exports.
Conclusion
Let me conclude by reminding you of what I said at the beginning of my remarks today. The
relationship between the exchange rate, the economy, and monetary policy is complex. And the
effects of movements in the currency are spread out over time. You can't look at one day's or one
week's performance of the Canadian dollar and pinpoint the reason behind the movement. There is no
precise way to measure the relative importance of the two types of movement that I have described, or
their likely persistence. So, in setting monetary policy, we at the Bank use an analytical framework
based on historical evidence, assess a lot of current data and, even then, we must apply a lot of
judgment to our analysis. And the analysis and the judgment can change over time as new information
becomes available.
Ultimately, the Bank of Canada's commitment to Canadians about monetary policy boils down to this:
We will continue to work at maintaining a rough balance between demand and supply in the economy,
in order to keep inflation low, stable, and predictable. And as we pursue this objective, we will continue
to explain the reasons behind our policy actions, and our view of the outlook for inflation and for
economic growth in Canada.