Mark Carney: Capitalizing on the commodity boom - the role of monetary
policy
Remarks by Mr Mark Carney, Governor of the Bank of Canada, to the Haskayne School of
Business, Calgary, Alberta, 19 June 2008.
* * *
Everyone here remembers the bumper sticker. For two decades, Albertans promised not to
waste the next boom if one were granted. With US$130 oil, US$10 natural gas, US$200 coal,
and US$8 wheat, the next one has clearly arrived. The question now is how to make good on
that promise. This evening, I will concentrate on one aspect of the answer: how monetary
policy can help to create the conditions that will allow all Canadians to benefit from sustained
high commodity prices. I am grateful for this opportunity because monetary policy is more
effective when it is well understood. Seldom is this understanding more important than when
our economy faces the types of supply and demand shocks engendered by a series of sharp
increases in commodity prices.
Outlook for commodity prices
We are experiencing a commodity super cycle. Throughout the current boom, the scale of
price increases has been higher, and the range of affected commodities broader, than in
previous upturns. Since 2002, grain and oilseed prices have more than doubled, base metals
prices have tripled, and oil prices have quadrupled. Beyond the breadth and magnitude of
these price increases, the current boom is also unusual in that it began earlier in the global
economic cycle and has lasted longer. While booms usually herald a downturn, this one
appears to be evidence of unusually robust momentum in global growth.1
These dynamics suggest that a combination of very favourable and mutually reinforcing
factors are at work. These include burgeoning demand, a subdued supply response,
important links among commodity markets, and supportive financial conditions. An
environment for a secular increase in commodity prices has been building since the middle of
the 1990s. That said, we can expect considerable volatility around this longer-term trend and
must remember that while supply and demand may be inelastic in the short term, they are
decidedly more flexible over longer periods.
Current commodity-price dynamics are intimately linked to the globalization process. In
particular, rapid growth in emerging-market demand is driving most prices. Positive
underlying demand fundamentals in emerging markets include sustained growth in per capita
income, rapid industrialization, and a more intensive use of commodities in production.
Research at the Bank of Canada and elsewhere suggests that while oil and metals prices
have historically moved with the business cycle in the developed world, this relationship has
broken down over the past decade. For example, industrial activity in emerging Asia now
appears to be the dominant driver of oil-price movements,2 and China alone is expected to
become the world's largest consumer of energy by 2010.3 Emerging markets and developing
economies have accounted for nearly 95 per cent of the increased demand for oil since
2003.4 As recently as the 1990s, marginal demand was roughly split between OECD and
non-OECD countries.
In the face of this demand, the supply response has been disappointing. Consider oil.
OPEC's annual production has declined by 2 per cent since 2005 and, with a few exceptions,
non-OPEC supply has failed to meet expectations. Among OECD countries, oil output has
fallen by 8 per cent since 2002. As a consequence, inventories remain very tight at 31 days,
and spare capacity is limited. With inelastic demand in the short term, actual or perceived
supply disruptions can lead to sharp price spikes and continued volatility.
There are many reasons why the supply response has been limited thus far. First, access to
many of the world's most promising regions is often tightly controlled or wholly restricted to
state-owned enterprises. Second, while nominal investment has surged, so too have costs.5
Many in this room know from direct experience how hard it is to find skilled workers, drilling
rigs, and pipeline capacity. Exploration and development costs for conventional crude have
doubled, and oil sands costs have tripled. Across the global industry, surging investment
costs have meant that real investment has remained flat. The net result is that a 70 per cent
nominal increase in non-OPEC capital expenditure since 2003 has barely replaced declining
production from existing fields.6
Over the medium term, high prices will encourage the development of new supplies and
energy alternatives. Canada will be one of the most important marginal suppliers of oil. With
more than $150 billion of new investment in the oil sands proposed or under way,7 output
from the oil sands is expected to grow by 3 million barrels per day by 2020, representing
about 15 per cent of expected marginal global demand.8 Other supplies can be expected to
come on stream, and alternative energy sources should be developed. Although there will be
lags, it would be a mistake to assume that the market has ceased to function.
Demand will also be more responsive over time. SUV sales in the United States have fallen
by nearly one-third so far this year - an important early indicator. Oil demand in OECD
countries has been essentially flat since 2003, and the International Energy Agency projects
it to remain weak for the next few years.9 As a result, the extent of continued upward
demand pressure will depend almost exclusively on emerging markets. There are several
considerations. First, we are about to find out the extent to which slowing domestic demand
growth in the G-7 will affect growth in emerging Asia. Second, the stance of monetary policy
in emerging markets will be an important determinant of prices in the short term. Monetary
policy remains highly accommodative in a number of fast-growing economies that are major
marginal consumers of commodities. The combination of accommodative monetary policy
and overheating economies will eventually be reversed, either through policy action or
generalized inflation. In either case, aggregate demand in emerging markets will likely slow
relative to current trends.
A third consideration is that the demand response in many economies is currently being
muted by the prevalence of administered food and energy prices. These efforts to protect the
most vulnerable are usually poorly targeted and, as a consequence, highly distortionary. By
keeping domestic commodity prices artificially low, the authorities are simultaneously
encouraging consumption, which leads to higher prices elsewhere, and discouraging the
internal supply response that would normally occur. In addition, by interfering with the price
signals, these policies delay necessary economic adjustment and increase the risk of a
dramatic and difficult reversal in the future. Encouragingly, in recent weeks, several countries
have taken important steps to ease such controls. Demand can be expected to follow.
As in the wake of previous commodity-price spikes, this demand response will ultimately
include the adoption of new technologies. Indeed, commodity-intensive economies will likely
replace energy-inefficient capital more rapidly than their peers did three decades ago. With
today's major marginal commodity consumers operating at levels well below peak efficiency,
the question is how quickly they will adopt more efficient, existing technologies once they
have determined that the relative price adjustment will be sustained.
There has been much discussion about the contribution of financial factors to the commodity
boom. It does appear that low long-term interest rates and past weakness in the U.S. dollar
may have played minor supportive roles. The impact of outright speculation and index
investment is less clear cut.10 If speculation were keeping the spot price of a commodity
substantially higher than the level where supply and demand naturally intersect, inventories
should build as the incentive to increase supply outstrips the desire to increase consumption.
However, there is little evidence of this in commodities as diverse as crude oil, wheat, or
aluminum.
At this point, the bulk of the evidence suggests that the increase in most commodity prices is
due to the fundamentals of strong demand and weak supply. This appears to be a durable
relative price shift. That does not necessarily imply persistent price increases. Demand and
supply will adjust, particularly as prices are passed through. In the short term, low inventories
suggest continued price volatility, which may be amplified by trend-following speculation.
What the current boom means for Canada
Although natural resources as a whole represent only 6 per cent of direct employment and
12 per cent of GDP, the sector has an important influence on Canadian economic activity
through a number of channels. Resources account for roughly one-third of all business
investment and about 45 per cent of our exports. As such, the benefits of the current
commodity boom can be felt across Canada - not just in resource-heavy sectors and
regions.
Above all, rising commodity prices have made Canada wealthier as a nation. Since 2002,
rising commodity prices have fuelled a 25 per cent improvement in our terms of trade, which
alone has been responsible for roughly two-thirds of the 15 per cent gain in real per capita
disposable income recorded over that period. These income gains have helped reduce
corporate leverage to its lowest level in a quarter of a century and have helped our
governments to record consistent fiscal surpluses. Higher commodity prices bring increased
investment, which entails direct and indirect benefits not only for the sectors in question, but
also for the service sectors that support them. As well, many individual Canadians - and their
pension funds - have benefited greatly from the gains in the value of their own investments
in commodity-producing firms.11 Finally, the rise in our terms of trade has brought with it an
associated appreciation of our currency that has benefited everyone by lowering the cost of
imported goods and services. With this downward pressure on import prices, productivity-
enhancing machinery and equipment - much of which is imported - has become less
expensive for all firms, not just commodity producers.
These benefits are important. However, it is unavoidable that large, sustained changes in
terms of trade - whether favourable or unfavourable - will cause stress and dislocation
because of significant shifts in production and employment among economic sectors. In
macroeconomic terms, terms-of-trade shocks trigger a shift of resources to activities
generating higher income. From that perspective, postponing adjustment would mean
forgoing the potential income gains that the reallocation of resources can bring. Adjustment
is always difficult, but it is vital to our long-term economic prosperity.
Despite the difficulties involved, the adjustment process of the past few years has gone more
smoothly than in previous periods. Canada's labour force participation rate has risen to a
record high, and the jobless rate has fallen to a 33-year low. While the manufacturing sector
has lost about one in seven jobs since 2002 - a total of about 335,000 jobs - total
employment in Canada has risen by 1.6 million jobs over the same period. Equally
encouraging is the quality of the jobs being created. More than 80 per cent of new jobs are in
sectors where the average hourly wage is higher than in manufacturing.
Canada's ability to capitalize on higher commodity prices (or to mitigate the impact of lower
ones) depends crucially on the continued ability of our economy to adjust. Product and
labour market flexibility is essential. The Trade, Investment, and Labour Mobility Agreement
(TILMA) between Alberta and British Columbia is a good example of the type of response
needed. It is encouraging that other governments are contemplating similar liberalizations.
Lessons from the previous boom
Before turning to monetary policy considerations, I would like to recall some lessons from the
last sustained upturn in commodity prices. During the 1970s, a number of commodity prices
spiked - including oil prices, which rose five-fold during the decade. Like today, common
drivers included low real interest rates globally and supply factors, in particular, the
emergence of OPEC. The decline of the newly floating U.S. dollar also pushed oil prices
higher, along with the persistence of inflation in G-7 countries once inflation expectations
began to rise.
Authorities in many oil-producing countries acted as if higher prices would persist indefinitely.
They increased spending rapidly, which would prove calamitous when prices reversed and
large structural deficits were revealed. In Canada, total program spending by the federal
government rose from 17 per cent of GDP in the early 1970s to 21 per cent only a decade
later. In 1985, the general government structural deficit peaked at 8 per cent of potential
GDP. We should keep fresh in our minds the memory of the Herculean efforts required to
eliminate this drain on future generations.
The management of monetary policy, in hindsight, was not much better. Authorities in many
countries mistakenly assumed that the productivity gains experienced over the previous
quarter century would continue. Rising unemployment was taken, falsely, as a sign of rising
excess capacity. This ignored the fact that much of our industrial activity, indeed much of our
society, was based on an assumption of perpetually cheap energy.
The monetary authorities of the day reacted to the oil-price shock by accommodating the
price increase. Viewing the higher prices as contractionary, they loosened monetary policy to
avoid a slowdown. The absence of an explicit nominal anchor for policy made this decision
easier and its consequences far worse. As we know now, the assumed excess supply was
illusory.
The fallout from these errors in monetary and fiscal policy was severe. The global recession
of 1981-82 was, in large measure, the end result. In Canada, both consumer price inflation
and the unemployment rate reached double digits by the early 1980s. The damage to
inflation expectations meant that inflation would remain a real and present danger for years.
Implications for monetary policy in the current situation
This experience is relevant to the current situation. At a fundamental level, it underscores
that the primary goal of monetary policy should be to keep inflation low, stable, and
predictable. While commodity-price shocks raise complex issues, a relentless focus on
inflation clarifies policy decisions, makes communications easier, and maximizes the
likelihood that expectations will remain well anchored. A credible inflation target helps to
keep the cost of capital down and highlights relative price movements, thus allowing
individuals and firms to make better investment decisions.
In Canada, we have developed a well-functioning monetary policy framework based on
inflation targeting and supported by a flexible exchange rate. Inflation targeting naturally
leads the monetary authorities to take a disciplined and rigorous approach to understanding
the drivers of inflation. However, even with the best framework, execution is everything. In
the face of the largest commodity-price shock in our lifetimes, we cannot be complacent.
Indeed, the current period of exceptional volatility in commodity prices raises several issues
for the conduct of monetary policy.
First, the commodity boom underscores the importance of well-anchored inflation
expectations. People's expectations for future inflation do influence actual future inflation
rates. Thus, there is a risk that the high visibility of energy prices could lead to increased
inflation expectations and to more general inflationary pressures. On the other hand, if
people recognize that a one-time increase in commodity prices has a temporary impact on
total CPI, other prices and wages will be unaffected. The demand and supply fundamentals
that I discussed at the start give reasons to expect firm commodity prices, but not necessarily
persistent - let alone accelerating - commodity-price increases. Quite simply, high
rising
commodity prices do not necessarily mean commodity prices. In fact, high prices
themselves make further commodity-price inflation less likely because of the demand and
supply responses they provoke.
The Bank of Canada's clear commitment to its inflation target and its consistent past success
in achieving it, have kept inflation expectations well anchored. The Bank will continue to
monitor movements in inflation expectations using a wide range of survey and market
indicators.
Second, and relatedly, the Bank needs to be mindful of the possibility that rising commodity
prices may affect the relationship between total and core CPI. The experience in Canada has
been that total CPI persistently moves towards the core measure over time.12 Moreover, our
experience has been that commodity-price inflation has been one of the least persistent
forms of inflation. As a consequence, in the pursuit of our 2 per cent target for total CPI, we
use our core measure as an operational guide. This is because, over the years, core CPI has
been a good gauge of the underlying trend of inflation and has been a better predictor of
future changes in the total index than has total CPI itself. In practice, targeting total CPI
inflation requires a high degree of confidence about the future path of commodity prices.
The relationship between core and total CPI is more marked in Canada than in other
countries, reflecting both the success in anchoring inflation expectations around 2 per cent
and the fact that, as a major commodity exporter, movements in our dollar in response to
commodity-price changes generally provide an offset that reduces the Canadian-dollar prices
of all imports, including commodities. For example, the past appreciation of the Canadian
dollar is one reason why food-price inflation has been markedly lower in Canada than in the
rest of the developed world.13 Overall, the Bank of Canada's commodity-price index (BCPI)
has risen only half as much in Canadian-dollar terms as it has in U.S.-dollar terms, since
2002.
The Bank will continue to monitor the stability of the relationship between core and total CPI.
The Bank will also continue to look at a range of measures to assess the underlying trend of
inflation. Considerable judgment must always be applied, and no one measure should be
relied on exclusively.
Third, we need to consider the possible impact of higher commodity prices on Canada's
potential growth. The Bank spends a great deal of effort trying to understand the factors that
shape potential output and its components. This focus on potential should mean that we are
less likely to misread the outlook for productivity and potential growth in the face of large
relative price shifts, and thus avoid a key policy mistake of the 1970s. In particular, we need
to consider the possibility that the combination of Canada's relatively high energy intensity,14
the exploitation of more marginal resource deposits that high prices encourage, and the
significant shifts in productive resources across our economy could temporarily lead to lower
productivity and potential growth. There are, of course, countervailing forces that could raise
potential growth, including the strong capital investment incentives arising from a stronger
dollar and the tightness of the labour market. We will make such determinations carefully and
will provide our updated views in the October Monetary Policy Report.
Fourth, the pace and nature of recent commodity-price moves has important positive
demand implications. As I mentioned earlier, large improvements in our terms of trade mean
large increases in Canadian real income and wealth. This fuels domestic demand, especially
for non-traded goods and services, and provides a timely offset to weaker external demand
from our largest trading partner, the United States.
Finally, a central lesson from past commodity booms (and busts) is the value of a flexible
exchange rate as shock absorber. A floating exchange rate is a key element of our monetary
policy framework that allows Canada to pursue an independent monetary policy appropriate
to our own economic circumstances. To be absolutely clear, irrespective of the path of
commodity prices specifically, or global price movements more generally, a floating
exchange rate means that we can continue to achieve our inflation target.
Exchange rate movements act as a signal to shift resources into sectors where demand is
strongest. During the Asian crisis in the late 1990s, commodity prices fell sharply. The
resulting depreciation of the Canadian dollar helped with the significant but necessary
reallocation of resources out of the resource sector and into other sectors, such as
manufacturing, whose competitive positions had improved. In recent years, the process has
worked in reverse. It is important to remember that with changes in terms of trade,
adjustment will follow. It is only a question of how. Our floating exchange rate helps to
achieve the appropriate adjustments without forcing very difficult changes in the overall level
of wages, output, and prices.
Conclusion: the current environment
Let me close with a few words about the current stance of monetary policy. In addition to
sharply improved terms of trade driven by commodity prices, the Canadian economy is being
hit by two major and related shocks: a marked and prolonged slowdown in the U.S. economy
and severe dislocations in financial markets. The challenge for the Bank is to assess the
combined implications of these three forces and other factors for the balance of aggregate
supply and demand in the Canadian economy and the prospects for inflation in Canada.
Reflecting the severity and persistence of the downside shocks, the Bank reduced its key
Monetary Policy
policy rate by a cumulative 150 basis points since December. In our April
Report, we reviewed these forces at length and laid out a base-case projection for the
economy that contained upside and downside risks to inflation. Those risks were judged to
be balanced. We said at the time that "some further monetary stimulus will likely be
required," but noted that the timing of "any further monetary stimulus will depend on the
evolution of the global economy and domestic demand, and their impact on inflation in
Canada."
Since then, there have been developments in the global economy relative to our
expectations in April that led the Bank to decide on 10 June to maintain its target for the
overnight rate at 3 per cent. Commodity prices, as measured by the BCPI, rose 10 per cent
over the period between decisions, and the futures curve for oil moved sharply higher. This
will support domestic demand. Other considerations included stronger global growth than
previously expected and higher global inflation, which increases the risk of
higher-thanprojected costs for Canadian imports. In addition, many of the downside risks to inflation
have eased. For instance, the price discounting on cars and books, which followed the move
of the Canadian dollar to parity with the U.S. dollar, does not appear to be spreading
materially to other products. In addition, as I noted a moment ago, the risk remains that
potential growth will be weaker than currently assumed. Although global financial conditions
remain strained, their evolution has been in line with expectations. Credit conditions in
Canada are better than elsewhere, as evidenced by the Bank's decision in May to become
the first G-7 central bank to begin withdrawing its extraordinary provision of liquidity to
markets.
Thus, developments since April shifted the balance of risks to the inflation projection in the
April MPR slightly to the upside. This evolution of the global economy and domestic demand
was sufficient to alter the view that "some further monetary stimulus will likely be required."
As a result, the Bank now judges that the current accommodative stance of monetary policy
is appropriate to bring aggregate demand and supply back into balance and to achieve the
2 per cent inflation target. Going forward, there remain important downside and upside risks
to inflation, but these risks are now judged to be evenly balanced.
The Bank will continue to monitor closely the evolution of developments in the Canadian and
global economies in order to assess their implications for aggregate supply and demand and
the outlook for inflation. One thing is certain: over time, the balance of risks will change
again. Monetary policy will adjust accordingly, while always remaining focused on achieving
our inflation target. In this manner, the Bank of Canada can make its best contribution to
helping Canadians capitalize on the current commodity boom, and that famous bumper
sticker can remain a relic.