John Murray: Stepping outside - analysing the Canadian economy from
an international perspective
Remarks by Mr John Murray, Deputy Governor of the Bank of Canada, presented to the
Victoria chapters of the Certified Management Accountants, Certified General Accountants
and the Financial Management Institute, Victoria, British Columbia, 6 March 2014.
* * *
Accompanying charts can be found at the end of the speech.
Introduction
Good morning. Thank you for the invitation to address your workshop.
One of my responsibilities as a Deputy Governor of the Bank of Canada is overseeing the
Bank's analysis of international economic developments. And before I became a Deputy
Governor, I was Chief of the Bank's International Department. So over the years, I have had
the opportunity to study other economies and the policies of other governments and central
banks in some detail.
Looking at Canadian economic issues from an international perspective allows us to ask:
How are we the same? How are we different? There is often a benefit to looking outward,
examining developments beyond our borders as an aid to diagnosing and addressing
suspected policy puzzles and problems at home. At the same time, we must be careful not to
assume that what has happened elsewhere will necessarily happen here.
Canada's superior economic performance during the financial crisis and through the
subsequent recovery, relative to that of most other advanced economies, was due in no
small part to the Bank of Canada's success in controlling inflation and the credibility that it
has earned since 1991, when we adopted our inflation-targeting monetary policy (Chart 1
and Chart 2).1 Of course, other advantages, such as a resilient financial system and timely
fiscal stimulus, also contributed importantly.
However, I am not here to boast about our past successes. My purpose today is more
immediate, and comes in three parts. I will begin by describing the two major macroeconomic
challenges to sustainable economic growth that we are presently facing in Canada. Next, I
will outline three analytic puzzles underlying those challenges, which we need to understand
in order to formulate an appropriate monetary policy response. Finally, I want to demonstrate
how information gleaned from the experiences of other countries can help answer these
puzzles and guide the conduct of policy here.
Two major macroeconomic challenges
Economic activity in Canada has remained significantly below its potential level for some
time (Chart 3), and the weak rates of inflation that have recently been observed are largely a
reflection of this (Chart 4). The Bank's first challenge, therefore, is to return inflation to the
2 per cent target jointly adopted by the Bank and the Government of Canada, and to return
production in the real economy to its capacity level, since satisfying these two conditions
generally goes hand-in-hand.
Eliminating excess supply in the economy and returning inflation to target are not enough,
however. The second challenge is unbalanced economic growth. The sources of growth
must be well balanced for growth to be sustainable. A rapid return to potential is neither
sufficient nor desirable, if it is only temporary and purchased at the cost of future instability
and lower growth.
What do I mean by unbalanced economic growth, you might ask? Why isn't all growth, by
whatever means, good? In today's economy, a lack of balance implies growth that has relied
too heavily on increases in household spending - in particular, the purchase of houses, with
a resultant rapid increase in household debt. Future growth, if it is to last, needs to draw
more support from business fixed investment and exports.
During the depths of the last recession, demand for our exports collapsed, and
extraordinarily accommodative monetary policy was needed to boost domestic demand in
order to support employment and income (Chart 5). The Bank's timely and aggressive policy
actions - combined with extraordinary fiscal stimulus - worked, with extra internal demand
effectively substituting for weak external demand. However, there are limits to how far this
can be taken. The household sector is now largely played out; pushing it much further could
lead to trouble. So we are left with an economy that in many respects has done well, but one
in which both output and inflation are roughly 1 per cent below where they should be, and
where the sources of demand need to be rotated.2
Macroeconomic puzzles
The Bank's base-case projection, as presented in our January Monetary Policy Report, has
output returning to potential and inflation gradually returning to target in roughly two years.
Setting the Bank's overnight interest rate - the Bank's primary monetary policy instrument -
at the appropriate level over this period to achieve our objective always requires
considerable judgement and must often balance more than one risk to the economy. Some
of this uncertainty derives from not having a clear fix on where the economy is at present and
what forces are acting on it. The output gap, for example, is not observable, and has to be
estimated.
But the challenge is more serious than simply not knowing exactly where the starting point is.
Since monetary policy operates with long and variable lags, policy formulation must be
forward-looking and anticipate the forces that might be acting on the economy one and two
years out.3
The present situation is further complicated by three macroeconomic puzzles - the recent
behaviour of three key variables and their implications for future economic performance.
First, inflation has been unusually weak given the estimated size of the output gap and other
identifiable forces thought to be putting downward pressure on prices.
Second, fixed investment has been unusually weak given healthy corporate balance sheets,
historically high profits, the low cost of capital and the growing momentum of the global
recovery.
Third, non-commodity exports have been unusually weak given strengthening global growth
and somewhat improved competitive conditions.
In other words, the macroeconomy has not been unfolding exactly as we had expected.
The tendency in these situations is to view the puzzles as uniquely Canadian and to look for
domestic explanations. Perhaps inflation is surprisingly weak because the output gap in
Canada has been mismeasured: there might be more excess supply in the economy than the
Bank has estimated. Perhaps exports are weak because Canadian firms are less competitive
than originally thought, so exports are not rebounding as quickly as the growth in U.S.
demand would suggest. Perhaps investment is weak because Canadian firms are inherently
cautious and too conservative or because exports have underperformed.
Looking inward for answers might be too limiting, however, and cause us to ignore helpful
information elsewhere. Economic developments in Canada are often surprisingly similar to
those observed in other countries. This is not simply because Canada is a small, open
economy, and therefore subject to significant shocks originating in the global economy,
although this no doubt accounts for much of the synchronous movement here and abroad.
The similarity is also driven in many cases by more general global forces that are affecting
several economies simultaneously, and that manifest themselves in Canada even when
there are no obvious direct trade or investment links to these other countries. Alternatively,
the similarity could be to events in another country that happened some time ago, which
nevertheless bear a striking resemblance to our own situation, and are therefore instructive.
Whatever the nature or source of these common patterns, they are potentially useful as a
counterpoint to our own experience, an important and valuable lens through which to
examine the Canadian condition.
What I propose to do now, is to take each of the puzzles described above and show how
looking outward has improved our understanding of what is happening within.
The three puzzles from an international perspective
Weak inflation
The first thing to note about inflation is that it is weak across virtually all of the advanced
economies. Canada is not alone. Indeed, inflation is well below the target levels in almost all
advanced economies (Chart 6). It is not just the low level that is noteworthy, however. It is
also the timing of the weakness. Most of the observed down-shift in inflation has occurred
within the past two years. The significance of this will become apparent in a moment.
In Canada, the weakness has been credited largely to continuing excess supply in the
economy, which is putting downward pressure on wages and prices, and to an increase in
competitive pressures in the retail sector. But, according to our best estimates, these factors
are unable to explain the entire shortfall.
Looking at inflation in other countries, one might be tempted to argue that there are global
forces at work, and that inflation in Canada is not determined exclusively by domestic forces.
In fact, statistical evidence gathered from something known as principal component analysis,
which captures a common factor from various data sets, suggests that for total inflation as
measured by the consumer price index (CPI) this is, to a degree, true.
The high correlation one observes among rates of total CPI inflation in all of these countries
is driven to an important degree by common movements in food and energy prices, which
are known to be highly volatile and largely determined in world markets. This finding is not a
surprise, but more a confirmation of something that was already known.
The surprise relates more to the movements in core inflation, which also exert an important
influence on total CPI inflation.4 While it is difficult to identify a common component using
statistical techniques, they have moved in concert and have all shifted down quite recently.
The existence of a sizable output gap in each of the countries could offer an explanation, but
the timing is not right. These gaps have existed for several years, and, in some cases, have
been narrowing (Chart 7). So why would inflation weaken now?
It is possible that idiosyncratic developments, peculiar to each country, could explain the
common pattern, but such an extreme coincidence seems unlikely. The more likely lesson
that one might draw from this shared international experience is that the effect of output gaps
on inflation is subject to a much longer lag than previously thought and that, to have an
effect, the gaps must be not just large, but persistent. Indeed, the sensitivity of prices to
excess supply might increase through time.
This is not to preclude the possibility of other forces at work in Canada, such as an output
gap that might be underestimated, just that the alternative explanation - a delayed response
- must be given serious consideration. Provided this relationship holds, inflation can be
expected to return to target as output returns to potential.
Weak investment
The story for "missing investment" in Canada is much the same. One can easily identify a
number of homegrown factors that might be inhibiting business investment here (Chart 8 and
Chart 9). Are Canadians risk-averse by nature? Are Canadian businesses too comfortable
with what has worked in the past, and reluctant to strike out in new directions? Are there
institutional or financial impediments that we are not aware of? Could weak investment be
the result of the poor performance of our non-commodity exports since the end of 2011?
Before answering yes to one or all of the above, it is important to note that businesses in
other countries have also been accumulating cash balances and delaying fixed investments
- in many instances reporting rates of investment that are much lower than the rates of
depreciation, pushing the capital stock ever lower. "Dead money," as it has been called, is
not a uniquely Canadian phenomenon.
Researchers in the United States have advanced an explanation based on their statistical
work that is both intuitive and convincing.5 They have shown that uncertainty exerts a
significant and distinct dampening effect on investment decisions, separate from other
factors that might be closely related to it. Their results have been replicated by researchers
elsewhere, and one can see a tight correspondence, if not causal relationship, between their
measures of uncertainty and fixed investment activity. It would not be surprising if businesses
were a little gun-shy and reluctant to commit large sums of money following the traumatizing
experience of the crisis. The value of waiting for greater clarity is simply too high.
Fortunately, the uncertainty appears to be receding, and there are signs that investment
activity will accelerate in the near future.
Weak exports
The recent disappointment related to Canadian exports follows much the same pattern as
inflation and investment, but with one or two notable differences. There has been a seeming
disconnect between foreign demand and the performance of Canadian non-commodity
exports over the past two years. The sectors of the U.S. economy that did especially badly in
the recession were those that were especially important to Canadian exporters. As these
sectors recovered, our exports should have accelerated. But they didn't. This disappointing
performance is true even after one adjusts for the persistent strength of the Canadian dollar
and the marked decline in our international competitiveness since the early 2000s. While it is
possible that competitiveness or foreign demand, which the Bank proxies with a foreign
activity measure (FAM), could have been mismeasured, sagging competitiveness seems to
be a less obvious candidate.6 Neither the dollar, nor competitiveness defined more generally
(i.e., in terms of productivity and wage gaps adjusted for the exchange rate), has shown any
evident break in trend. Most of the export disappointment is specific to the past two years
(Chart 10 and Chart 11).
Interestingly, the growth in global trade collapsed at about the same time and even more
dramatically than the fall-off in Canadian trade (Chart 12). Perhaps the weakness in
Canadian exports has a common cause and we should be thankful for what we have.
In this case, however, any race to judgment based on coincident timing could be misleading.
Most of the reasons put forward for the collapse in global trade, such as constraints on the
availability of trade financing and exceptionally weak economic activity in Europe, have little
direct relevance for Canada.7
An alternative explanation has been put forward, however, that also has a foreign origin and
holds a little more promise. It relates to the fiscal cliff in the United States and the significant
budget consolidation that has been underway there in the past two years.
Although one might assume that the demand for Canadian exports from U.S. governments
(federal, state and local) would be minimal, preliminary evidence suggests that approximately
12 per cent of our non-commodity exports over the 1997 to 2012 period went to the U.S.
government sector. Moreover, a modified version of the Bank's foreign activity measure,
which gives greater recognition to U.S government purchases, seems to improve our ability
to capture the weakness in exports over the last two years. However, its explanatory power
over the previous three years is not nearly as good. Work is ongoing, therefore, with a view
to developing alternative measures of foreign activity which might perform better over the
entire period.
This provides a useful example of how the international perspective has the potential to
mislead as well as inform. One possible connection proved to be a dead-end, while the other
points to a possible answer. Correlation does not necessarily imply causation, but it helps us
to flag events that might warrant further investigation.
High household debt and housing sector activity
Household debt and activity in the Canadian housing sector have also attracted considerable
attention in the past few years. Unlike the three earlier examples - inflation, investment and
exports - high household debt and housing sector activity do not necessarily represent a
puzzle. However, they have reached historic highs and have been stronger and more
resilient than many economists had expected. Household debt and housing sector activity
are not only exceedingly elevated relative to past experience in Canada, they have also
approached levels where real estate busts were observed in other countries.
Charts 13 and 14 provide some international comparisons for two series that have attracted
particular attention from international organizations (as well as The Economist magazine).
These are the ratio of household-debt-to-disposable income and the ratio of average housing
prices to disposable income. Needless to say, they have not gone unnoticed by the Bank of
Canada either. The Bank has identified household debt and stretched housing evaluations as
the most important domestic risks to financial stability in the country.
It is important to stress that the figures in these charts represent national averages and vary
across regions and types of accommodation. In some areas, they are much lower and in
others, such as Vancouver and Victoria, they are much higher.
Although countries such as the United States and the United Kingdom have experienced
sharp and painful corrections at comparable debt and price levels, leading to much more
serious economic and financial consequences, it would be a mistake to assume that a similar
outcome is therefore inevitable in Canada.
The Bank's base-case projection sees household debt, housing prices and housing starts
levelling off and then gradually declining (in real terms, in the case of housing prices): in
other words, achieving a soft landing. Recent data, such as decelerating monthly price
increases for existing homes, a declining number of housing starts and historically low rates
of household credit growth, all support this view and indicate that the situation is stabilizing,
although the risks remain elevated.
International evidence also provides some support for this more benign scenario. Countries
such as Australia have managed a soft landing and the preconditions for this, one could
argue, are even more favourable in Canada. Higher mortgage underwriting standards, higher
home equity margins, historically low debt-servicing costs, a more resilient banking sector
and a number of pre-emptive macro-prudential measures that have been undertaken, in the
form of tighter mortgage insurance and mortgage-lending standards, all work in this direction.
Indeed, credit quality in Canada has been increasing even as credit continues to expand.
In this instance, the international perspective illuminates the downside and the upside. It
highlights the risks that might be realized if the situation is not well managed, but it also
provides evidence that a more positive outcome is possible - and indeed more likely. Close
monitoring is nevertheless required to help ensure that this cautionary tale does not become
a reality.
Conclusion
The global economy and the experiences of other countries provide a sort of natural
experiment through which we can better assess economic developments in Canada. In many
cases, the economic cycles of other countries are either moving in step with ours or have
preceded them. Often, this will be because events elsewhere are shaping events in Canada;
at other times it may be mere happenstance or the result of some more general force hitting
us and others in a synchronous manner.
An international perspective can provide both understanding and policy insights. While it is
important to interpret with caution what you see through the international lens, we have seen
how it can help us resolve domestic economic puzzles and guide policy. With regard to
inflation, fixed investment, exports and the household sector, it has also pointed the way to
more positive outcomes and supported the base-case projections of the Bank. The
international perspective deepens our understanding of how the Canadian economy works
and gives us greater confidence in how our policy actions influence the ultimate outcomes.
Economic developments in Canada are not predetermined by events outside our borders.
Domestic factors are important and we are ultimately the masters of our own destiny. The
international perspective simply allows us to conduct our affairs in a more informed way, and
improves the odds of a favourable outcome.
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