David Dodge: The conduct of monetary policy in the presence of economic
shocks
Remarks by Mr David Dodge, Governor of the Bank of Canada, to the National Association for
Business Economics, Washington, D.C., 26 March 2002.
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Globalization - the trend towards greater economic integration around the world - has brought
important benefits to us all. It has boosted world trade, opened up access to sources of global finance,
and facilitated the diffusion of far-reaching technological advances in transportation, communications,
and information processing.
A more integrated world also tends to speed up the transmission of economic and financial
disturbances across national frontiers and increase their spillover effects. Over the past decade,
monetary authorities around the world have had to deal with a number of such disturbances. In
1994-95, we had the Mexican financial crisis. In 1997-98, we had the Asian and Russian crises. And
last year we had the global economic slowdown, which was greatly exacerbated by the tragic events
of 11 September in the United States.
To be sure, the conduct of monetary policy has become more complicated and challenging - but not
impossible or ineffective. In fact, I would argue that in most countries, including Canada, monetary
policy has been very effective in mitigating the impact of global shocks on the domestic economy.
Today, I would like to discuss how Canadian monetary policy has been conducted in the presence of
economic surprises or shocks - both domestic and external. I would also like to add some thoughts on
the issue of the appropriate monetary response, nationally and internationally, to common economic
disturbances.
Economic surprises and Canada's inflation-targeting approach to monetary policy
To put things in context, let me start by providing a bit of background about Canada's
inflationtargeting system.
When it comes to conducting monetary policy, our formal mandate is not dissimilar to that of the U.S.
Federal Reserve or to those of many other central banks. The preamble to the Bank of Canada Act
enjoins the Bank "to mitigate by its influence fluctuations in the general level of production, trade,
prices and employment, so far as may be possible within the scope of monetary action, and generally
to promote the economic and financial welfare of Canada."
We have chosen to achieve the objectives of the Act through a policy focused on inflation control. This
is because we believe that a monetary policy that consistently delivers low, stable, and predictable
inflation is likely to be the greatest contribution that the central bank can make to sustained growth in
output and employment.
Since 1991, the Bank and the Government of Canada have agreed to pursue low inflation within a
framework based on an explicit inflation target. The current agreement, which runs to the end of 2006,
aims at continuing to keep inflation at the 2 per cent target midpoint of a 1 to 3 per cent range over the
medium term.
There are two elements I would like to underscore here - the emphasis we place on the 2 per cent
midpoint as our target and the emphasis on the medium term. The significance of the first will become
apparent in a moment. As for the focus on the medium term, it has to do with the fact that monetary
policy actions take anywhere between one and two years to have their full effects on output and
inflation. So, when setting monetary policy, we have to consider what will be the effect of actions we
take today on the economy and on inflation several months down the road.
In practice, setting monetary policy means raising or lowering interest rates to maintain a balance
between the demand for goods and services and the economy's capacity to supply those goods and
services. As long as there is a balance between demand and supply, inflation will remain stable.
When we look at it this way, the rate of inflation is more than a number that tells us how the
purchasing power of the average consumer is holding up. It is also a measure that the central bank
can use to gauge how close to capacity the economy actually is. The presence or absence of
inflationary pressures can tell us a lot about the balance between demand and supply. Our objective is
to help the economy achieve potential output - that is to say, the maximum level of output and
employment that can be sustained over the medium term without putting upward pressure on inflation.
Over the past decade, a monetary policy based on an inflation target has helped us realize important
economic benefits, particularly solid gains in output, employment, and incomes. It has also helped us
to avoid the boom and bust cycles of the past, even in the presence of important surprises. This is
automatic stabilizer
because the forward-looking framework of inflation targeting works like an for the
economy, with interest rates being raised or lowered in response to expected movements in future
inflation relative to our 2 per cent target midpoint. For the most part, such movements reflect changes
in the pressure of demand on potential output.
Thus, our focus on the 2 per cent target midpoint allows us to operate monetary policy symmetrically
in response to surprises in demand. And this helps to reduce the ups and downs of the business cycle
and to promote sustained economic growth.
The forward-looking framework of inflation targeting also allows us to handle temporary supply shocks,
so long as these shocks do not feed into inflation expectations. The monetary credibility gained
through our inflation-targeting system means that changes in volatile energy or food prices no longer
feed into other prices and into wages the way they did in the past. That is why, unlike some other
central banks, we focus on the underlying trend of inflation, and use as our operating guide a core rate
that excludes the eight most volatile components of the consumer price index (CPI) and the effect of
changes in indirect taxes on the remaining components. Such a measure of core inflation is a better
predictor of future inflation than the total CPI. With this approach, monetary policy responds only to
fundamental trends and does not turn temporary price shocks into something that can destabilize the
economy.
How the Bank of Canada deals with international disturbances
So far, I have described how our monetary policy framework, based on an inflation target, helps us
respond to, and deal with, important surprises that have an impact on our economy.
I would now like to say a few words about how the Bank of Canada incorporates external economic
shocks into its decision-making process.
Canada is a small and very open economy. We export more than 40 per cent of what we produce and,
in general, we are price-takers (that is to say, the prices of what we buy and sell abroad are largely
determined in world markets). Thus, the external environment is extraordinarily important to us.
As part of its decision-making process, the Bank has always followed world economic developments
very closely. The Bank's Governing Council starts its deliberations by looking at changes in the
external environment. In particular, we focus on economic prospects for the United States and the
major overseas countries, as well as on world commodity prices. Then we look at the implications of
all this for aggregate demand in Canada. Next, we focus on domestic demand, taking into account
anecdotal information gathered by our regional offices, as well as trends in credit, money, and financial
markets. All this feeds into our decision on interest rates.
Let me try and relate this to recent experience. Take last year, for example. Through the first half of
2001, we moved to loosen monetary policy at a measured pace. This approach was based on a view
that the economic slowdown in the United States, although sharper than initially expected, would lead
to only a moderate slowing of growth in Canada.
By midsummer, however, evidence had begun to accumulate that the slowdown in the United States
and elsewhere would be deeper and last longer than anticipated. Because of this, and because of
signs that domestic demand in Canada was softening, we came to the conclusion, as we looked
ahead, that our economy would be operating substantially below potential for some time, and that
inflation would fall below target. The extraordinary uncertainty introduced by the 11 September terrorist
acts in the United States pushed the recovery further back, so that, even under a relatively optimistic
scenario, our economy was expected to be operating at levels below capacity well into 2003. That is
why, as of mid-September and through to the end of 2001, we stepped up the pace of interest rate
reductions.
As I said in my last speech in Paris earlier this month, more recently, there have been encouraging
signs of a turnaround in the world economy, and the latest economic indicators for Canada show that
a recovery is indeed underway.
What should be the international policy response to common shocks?
Having discussed how Canadian monetary policy has been conducted in the presence of economic
shocks, I would now like to broaden the scope of my presentation somewhat by providing some
thoughts on the appropriate international policy response to common shocks.
Clearly, it is very important that individual central banks do their best to assess the implications of such
shocks and that they respond promptly, within their respective monetary policy arrangements, to
mitigate the effects on their own economies and on the world economy as a whole.
But given the increasing interconnectedness of national economies, a legitimate question is whether
there should not be greater policy cooperation, or even concerted action, in response to major
common shocks.
Here's how I respond to that question, and I will certainly be very interested to hear the views of
others.
First, let me note that we central bankers greatly value our bi-monthly meetings at the Bank for
International Settlements, and our regular meetings at the International Monetary Fund, where we
systematically discuss the world economic situation. So there is an important process in place for
exchanging information on what is going on in our domestic economies as well as globally.
Now, when it comes to policy action, I would argue that the best way to deal with common shocks,
such as last year's global economic slowdown and the 11 September events, is prompt response by
individual central banks. This response should be based on individual circumstances. But it should
also take into account what is happening elsewhere and what fiscal and monetary authorities around
the world are doing to deal with the situation. Otherwise, there is a risk that individual central banks will
either under- or overreact, with potentially undesired consequences for the world economy.
But the way that I and a number of my central bank colleagues around the world see it, prompt action
does not mean concerted action. Indeed, to be clear, I would say yes to co-operation; yes to exchange
of information; and yes to taking into account what is happening elsewhere. But I do not believe that
formal coordination or concerted action are necessary.
Provided that there is a good collective appreciation of the significance of certain global shocks, there
is no reason why individual monetary authorities should not be the ones to take action tailored to their
own domestic circumstances to deal with the implications.
For example, in the days immediately after 11 September, there was no formal joint decision-making,
although the major central banks did exchange information, leading to a shared appreciation of the
grave risks for the world economy. And policy action was taken quickly-although not simultaneously
and not by equal amounts.
Judging from the signs of economic recovery we are now seeing around the globe, I would say that
this process of international consultation and prompt policy action by individual central banks worked
well to help us weather the very difficult circumstances we all faced last year.
I would also like to highlight the significance of personal contacts among central bankers. Regular
contacts build trust. And trust is very important when we have to act quickly, as we did last September
to deal with the pressures faced by financial institutions, markets, and infrastructures immediately
following the terrorist attacks. For example, in Canada, we were able to move very quickly and secure
a temporary increase of our existing swap facility with the U.S. Federal Reserve. This arrangement
was made to facilitate the functioning of Canadian financial markets and to provide liquidity in U.S.
dollars to Canadian banks to settle their U.S.-dollar transactions, if the need arose.
* * *
Let me conclude. Last year, as in previous episodes over the past decade, Canada's inflation-targeting
approach to monetary policy allowed the Bank to respond quickly and successfully to buffer the effects
of worldwide shocks on our economy.
In a very open and increasingly integrated world, it is important that individual central banks take
prompt action, based on their own circumstances and needs, but taking also into account what is
going on outside their borders. Such action has the best chance of mitigating the effects of global
shocks on their economies and, by extension, on the international economy.
When we all do what is right for our domestic economies, we are also most likely to do what is right for
the world economy.