David Dodge: How Canada is adjusting to global economic forces
Remarks by Mr David Dodge, Governor of the Bank of Canada, to the Canadian Association of New
York, New York, 15 April 2005.
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The Bank of Canada has been examining the issue of how the Canadian economy adjusts
movements in the exchange rate for a long time. Canada's economy is very open, so we always need
to understand how exchange rate movements are affecting real economic activity and, in turn, what
the implications are for monetary policy. And with a 25 per cent appreciation of the Canadian dollar
over the past couple of years, this has been a major preoccupation.
Of course, there's much more to the story than just the exchange rate. Powerful forces have been
shaping the global economy. These include the emergence of the economic powerhouses of China
and India, and large and growing financial imbalances in the United States and Asia. As a result, we
have seen large movements in relative prices, and not just the realignment of exchange rates. We
have seen firming prices for non-energy commodities, rising oil prices, flat or falling prices for many
consumer goods, and dramatic reductions in the prices of communications services and computer
equipment. Today, I want to talk about the kinds of adjustments that the Canadian economy is making
to these forces. I will start with a brief review of how our monetary policy operates, and how it helps
with the adjustment process. I'll spend a few minutes talking about how the Bank takes exchange rate
movements into account as we conduct monetary policy. Then, I will discuss the ways in which the
real economy is adjusting to movements in the exchange rate and other global forces. Finally, I will
recap the projections for the Canadian economy contained in the Monetary Policy Report.
How monetary policy helps the economy adjust
Let me begin with a few words about our monetary policy framework. The Bank of Canada Act calls on
us to "mitigate 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 do this by trying to foster an environment of low, stable, and
predictable inflation. In particular, we aim to keep the annual rate of consumer price inflation at the
2 per cent midpoint of a 1 to 3 per cent target range. This is the best contribution that we can make to
achieving high, sustainable growth of output and employment. To be clear, inflation targeting is not an
end in itself. Rather, it is the best means of fulfilling our commitment to promote the economic and
financial welfare of Canadians.
We pursue this objective by trying to keep the economy operating at full capacity; that is, we aim for a
balance between total demand and supply in the economy. When the demand for goods and services
pushes the Canadian economy against the limits of its capacity, and inflation is poised to rise above
the target, the Bank will raise interest rates to cool off the economy. And when the economy is
operating below its production capacity, and inflation is poised to fall below the target, the Bank will
lower interest rates to stimulate growth. So by maintaining low and stable inflation, monetary policy
promotes greater stability in economic output.
A flexible exchange rate is an important part of our monetary policy framework. I hasten to add that we
do not have a target or preferred level for the Canadian dollar. I'll come back to the topic of the
exchange rate in just a moment.
But first, let me talk about how our monetary policy helps the economy to adjust to the powerful
economic forces we see today. To begin with, low and stable inflation allows businesses and
consumers to better read price signals in markets, which helps them to make better long-term
decisions in the face of major economic developments.
A second way that monetary policy helps with the adjustment process comes from our strategy of
keeping total supply and demand in balance. In these circumstances, economic resources that are
released by shrinking sectors where demand is weak can be absorbed by expanding sectors where
demand is strong. Of course, adjustment is never simple or without pain, especially at the personal
level. But from a macroeconomic point of view, adjustment can take place with less social and
economic cost when inflation expectations are well anchored and the economy is operating close to its
potential.
Having a floating exchange rate is a third way in which our monetary policy framework helps with the
adjustment process. Let me explain how. Changes in global demand for a country's goods and
services tend to bring about movements in that country's currency. The resulting exchange rate
movements help to keep balance in the economy by offsetting the impact of the change in demand.
For example, rising global demand for Canadian goods and services tends to lead to a stronger
Canadian dollar. The stronger currency, in turn, tends to restrain exports and to encourage imports. By
restraining the demand for Canadian-produced goods and services, the floating exchange rate helps
to keep total supply and demand in balance. Similarly, when there is falling global demand for
Canadian-produced goods and services, the floating exchange rate will encourage demand for these
goods and services, again helping to keep total supply and demand in balance.
Exchange rate movements and monetary policy
This brings me to my next subject, which is how we at the Bank of Canada view movements in the
exchange rate. As I said earlier, we do not have a target or a preferred level for the Canadian dollar.
But this does not mean that the value of the currency is unimportant, far from it. The exchange rate is
something that we at the Bank are always watching closely; looking for the valuable information that
helps us to better interpret and predict the strength of total demand for Canadian goods and services.
The way that we take the exchange rate into account as we conduct monetary policy is complicated.
This is because the exchange rate can move for different reasons. Sometimes, movements in the
exchange rate reflect changes in the demand for a country's goods and services. But sometimes, they
do not. This distinction is important, because the two types of movements have different implications
for demand in the economy and, hence, for monetary policy. Indeed, the reason behind a movement
in the Canadian dollar can be just as important for monetary policy as the movement itself.
Let me take a couple of minutes to explain. First, consider the type of currency movement that reflects
changes in foreign demand. In 2003 and much of 2004, we saw a strong increase in the value of the
Canadian dollar. This reflected, at least in part, the strong demand for Canadian exports, and a sharp
rise in the global prices of many of these exports, particularly commodities. The stronger Canadian
dollar, in turn, encouraged imports and discouraged exports. This is an example of how the
appreciation of the Canadian dollar can work to dampen an initial increase in aggregate demand.
Were this dampening effect on aggregate demand to exactly offset the initial, direct increase in
demand, all other things being equal, there would be no need for a monetary policy response.
Now, consider the other type of exchange rate movement, which does not reflect changes in demand
for a country's goods and services. Instead, it can reflect changes in foreign demand for that country's
financial assets, or changes in domestic demand for foreign financial assets. For example, during the
past two years, investors have become more concerned about the large and growing U.S. current
account deficit which, according to the Bureau of Economic Analysis, hit a remarkable US$666 billion,
or 5.6% of GDP, in 2004. And so we have seen the U.S. dollar depreciate against many major
currencies, including the Canadian dollar. In this example, the stronger Canadian dollar leads to a
decline in net exports, just as in the previous example. But in the absence of an initial increase in
demand to be offset, the overall effect on Canadian aggregate demand would clearly be negative. And
this decrease in demand - if it were to persist - would generate downward pressure on Canadian
prices and employment that could push inflation below our target. All other things being equal, this
would require monetary policy to be more stimulative than it otherwise would have been.
To be clear, I don't want you 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.
When we look at the movement of the Canadian dollar against the U.S. dollar over the past couple of
years, it is clear that the upward movement during this period has been driven by both stronger
demand for Canadian goods and services, and by widespread weakness in the U.S. dollar. But there
have been times during this period when the first factor appears to have been the strongest influence,
and at other times, it appears that the second factor dominated.
How businesses are adjusting
Now that I have talked about how the Bank of Canada deals with exchange rate movements, let me
turn to how the real economy is adjusting to global economic developments, and to the large relative
price movements associated with them.
It is interesting to compare the experience of the past two years with that in the period from 1997 to
2002. From the beginning of 1997 to the end of 2001, falling commodity prices led to a decline of more
than 6 per cent in Canada's terms of trade - the ratio of the prices Canadians receive for their exports
to the prices Canadians pay for their imports. At the same time, "irrational exuberance" about the
prospects for the U.S. economy led to heavy financial flows into the United States, and this helped to
drive up the value of the U.S. dollar relative to other currencies. The Canadian dollar fell from just
under 75 cents US in early 1997 to a low of 61.8 cents US in January 2002, before ending the year at
about 63.4 cents US.
During this time, the cost of labour relative to capital goods declined in Canada because most capital
goods are imported and priced in U.S. dollars, while labour is paid in Canadian dollars. Businesses
reacted appropriately to these price signals by increasing their production of services and of those
manufactured goods that require relatively more labour and less machinery and equipment.
What we have seen over the past couple of years is, in many ways, a mirror image of the 1997-2002
period. Commodity prices have risen, and our terms of trade improved by more than 16 per cent from
the fourth quarter of 2001 to the fourth quarter of 2004. The cost of labour has increased relative to the
cost of capital goods. Again, Canadian firms are responding to the price signals. We are currently
seeing large increases in investment spending in oil and gas extraction, other mining activity, and
wood-product manufacturing. Firms have been motivated both by high prices for their products and by
the expectation that these high prices will persist.
We are also seeing rising investment spending in sectors with low exposure to international trade,
such as electric power generation, finance and insurance, and information and cultural industries. In
these cases, firms are reacting to recent substantial gains in Canadian domestic demand.
For both of these groups, a crucial point to note is that a large part of the planned investment is
motivated by the desire to increase production capacity.
But the story is somewhat different for those sectors that are highly exposed to international trade, but
where the prices of their products are not rising. Here, I am referring to sectors such as auto parts,
textiles, and clothing manufacturing. Firms in these sectors are feeling the pressure of the higher
Canadian dollar, and are also facing increased competition from places such as China and India.
The good news is that there is evidence that many of these firms are making adjustments in the face
of adversity. Investment spending for these firms is being channelled toward increasing productivity
and reducing costs, not increasing capacity. Because much of the productivity-enhancing machinery
and equipment is produced abroad and priced in U.S. dollars, the appreciation of the Canadian dollar
has lowered the cost of this machinery and equipment relative to that of labour.
Other firms are using different strategies to adjust to the stronger Canadian dollar and to increased
competition from abroad. A growing number of firms are looking to cut costs by importing more inputs.
Others are phasing out production of goods and services with low profit margins and concentrating on
those that yield higher returns.
And of course, all of these adjustments have implications for the Canadian labour market. Overall job
growth has been strong, but there have been important sectoral differences. We have seen job gains
in commodity-producing sectors and in those that have low exposure to foreign competition. However,
employment has fallen in a number of manufacturing sectors. This reflects, at least partly, the fact that
some firms are now substituting capital for labour in order to reduce costs, which is the opposite of the
situation we saw in the late 1990s and at the beginning of this decade.
Canadian economic prospects
Before I conclude, let me quickly review the projections for the Canadian economy that we set out in
Monetary Policy Report
our yesterday.
The global economy has been unfolding largely as expected, and the prospects for continued robust
growth are quite favourable, especially over the near term. The outlook for the Canadian economy
through to the end of 2006 is essentially unchanged from that in our January Monetary Policy Report
Update.
Our base-case projection calls for annualized growth of about 2 1/2 per cent in the first half of 2005
and 3 per cent in the second half. Growth of about 3 1/2 per cent is expected through the four quarters
of 2006, consistent with closing the output gap in the second half of next year. To express it in annual
average terms, growth in 2005 is projected to be about 2 1/2 per cent, down slightly from the January
Update, while the projection for 2006 is little changed at about 3 1/4 per cent.
With the economy expected to return to full production capacity in the second half of 2006, core
inflation should move back to 2 per cent around the end of next year. Based on the scenario implied
by oil-price futures, total CPI inflation is expected to remain above the 2 per cent target for some time,
before moving slightly below 2 per cent in the second half of 2006.
In line with this outlook, a reduction of monetary stimulus will be required over time. However, I want to
stress again that the Bank is not committed to any particular interest rate path or timetable.
Conclusion
Let me conclude. As I noted at the beginning, there are powerful global economic forces at work, and
economies everywhere need to make adjustments. In Canada, businesses are, indeed, making
adjustments to meet these challenges and to take advantage of emerging opportunities. At the Bank
of Canada, we will continue to monitor these global forces closely and to assess their impact. We will
continue to conduct monetary policy with the aim of keeping inflation close to target, and thus keeping
the economy operating at full potential. In this way, we will do our part to facilitate the adjustments that
Canadian businesses are making to changes in the global economy.