Agathe Côté: The promise of potential
Remarks by Ms Agathe Côté, Deputy Governor of the Bank of Canada, to the CFA Society
Winnipeg/Manitoba Chambers of Commerce, Winnipeg, Manitoba, 29 October 2013.
* * *
Accompanying charts can be found at the end of the speech.
Introduction
Thank you. It is a great pleasure to be here.
I want to talk today about potential, a word that speaks optimistically to the future - to what
can be.
It's a word that means different things to different people under different circumstances.
It's an abstraction: a concept that promises a road leading to success. That is the finish line -
the promised destination. Getting there is another story. The way forward is seldom direct
and reaching potential is a trajectory where the journey is as important as the destination,
especially for the "dismal" science of economics.
We can think of Canada's economic potential as where we can be if we do our best and
make all the right decisions. It is what we can hope to achieve over the longer run.
Since potential output growth is key to a country's standard of living, it should be of interest
to all of us. Consider this: if potential output were to grow by an extra percentage point every
year for the next ten years, the cumulative increase in income would be almost $30,000 for
every Canadian.
At the Bank of Canada, we care about potential output for two reasons. First, the growth rate
of potential output sheds light on the prospects for our country's economic growth. Second,
the difference between the level of actual and potential output - or the output gap - is a key
measure of inflation pressures. And keeping inflation at the 2 per cent target rate is the best
contribution that monetary policy can make to the financial well-being of Canadians.
The Bank's assessment of the current output gap and the projected growth of potential
output have a direct bearing on the Bank's inflation outlook and monetary policy decisions.
Other things being equal, a larger degree of slack in the economy implies a greater need for
monetary policy stimulus. As well, the higher the projected growth rate of potential output, the
higher the economy can grow without stoking inflation.1
Each year in October, the Bank reviews its estimates of potential output. I will share with you
some of our findings and what we think they say about the journey Canada's economy is
taking.
Although Canada came out of the recession earlier and recovered faster than other G-7
countries, our economic growth has been disappointing in the past year. I think we can agree
that the finish line is proving elusive; we "are not there yet."
Looking ahead, the Bank sees the economy gaining momentum through next year and 2015,
but there are uncertainty and risks around the outlook.
If my speech today achieves its potential, you will gain a deeper understanding of potential
output in Canada, why it is hard to measure, why it has slowed, where we are today, and
what the future may hold for our economy.
Deconstructing the immeasurable
Measuring potential output and the output gap is difficult because potential is not directly
observable. It is hard to measure what could be.
What we try to do is determine the level of output that can be achieved with available
resources (labour, capital and materials) without creating inflationary pressures.
Potential output as a concept, and its link to inflation, make a lot of sense. Time is the most
precious quantity, and as you know too well, balancing our professional and personal lives is
no easy task. And as the former encroaches on the latter, history tells us that wage
pressures begin to build, eventually leading to higher prices. Similarly, when a firm's
production can't keep pace with demand, prices move up in an attempt to restore balance.
But while conceptually appealing, accurately measuring potential output is a formidable task.
To do so, we must take a view not only on how many hours people are willing to work at a
given wage, but also on how productive these people will be when their labour is combined
with other inputs, such as machinery and equipment or on-the-job training.
At the aggregate level, the future trajectory of potential output will depend on a lot of
variables: on how strong the demand is for our goods and services, on how much existing
firms decide to invest in research and development and technology, on how many new firms
are created, and other unknowns.2 It will also depend on our workforce - who is working and
until what age, and whether workers can move easily to where the best jobs are and where
they are most needed.
In light of all these unknowns, the Bank of Canada has to use various models, indicators, as
well as information gathered from businesses, and a good deal of judgment to come up with
its estimates.3 Our analysis focuses on the two variables that determine actual output and
whose trends determine potential output, that is, labour input (or total hours worked) and
labour productivity (or real output per hour worked).
The results of our most recent analyses tell us that the output gap is sizable and that the
growth rate of potential is likely to remain fairly steady at around 2 per cent in coming years.
But, before I go into further detail on the outlook, let me step back and describe how we got
to where we are now.
A tale of troughs and trends
For that I have a short story and a long story.
I'll begin with the short story: the recession.
As I said, Canada weathered the global financial crisis relatively well, but we were severely
affected nonetheless. In the space of three quarters in 2008 and 2009, the level of output fell
by 4 per cent. The export-oriented sectors (including resources) were hardest hit, with GDP
dropping by 15 per cent (Chart 1). Across Canada, almost 400,000 jobs were lost.
The recession also led to a drop in the growth rate of potential output (Chart 2). Some
businesses shut their doors. Machinery and other capital were left idle or scrapped
altogether. Rather than investing in new capital, other firms made do with old equipment.
These factors combined to make workers less productive. Our best judgment is that trend
labour productivity growth might have fallen to less than half a per cent during that period
and that potential output troughed at about 1.5 per cent.
But as I said, there is also a long story. That story has two parts: trend labour productivity
and trend labour input.
Trend labour productivity
I'll start with trend labour productivity. From the mid-1990s to about 2000, the boom in
technology production was associated with a sharp increase in the growth rate of productivity
and potential output in Canada. Since then, however, productivity growth has slowed to
historically low rates and has languished well below U.S. rates. While U.S. companies
started using information and communication technology (ICT) capital (specifically software)
to boost their processes and business practices, it appears that Canadian companies did not
follow suit.
Many other factors likely contributed to the slowing of productivity growth in Canada and the
widening gap with the United States (Chart 3). The explanations range from measurement
issues, to economic restructuring in response to large commodity price shocks, to deeper
structural determinants, including a poor innovation record, low competition in some sectors
and a less-skilled workforce.4 The Canada-U.S. gap may also reflect greater offshoring and
foreign affiliate sales by U.S. firms.
Since much of the decline in actual productivity growth in the first half of the 2000s coincided
with strong overall economic growth, this suggests that a significant part was structural (and
not only cyclical) and therefore affected trend labour productivity growth. Since 2008,
however, part of the weak growth has been due to cyclical factors associated with the
recession.
It is worth noting that in spite of low productivity, Canadians have enjoyed relatively high
incomes in the past several years. Our standard of living depends not only on the volume of
output but also on the trading value of that output. As commodity prices rose, our terms of
trade - the price we get for our exports relative to the price we pay for our imports -
improved, helping to boost Canadian income growth. But going forward, productivity may
become more crucial to our financial well-being, since real commodity prices, while expected
to remain elevated, may not rise as much as they did in the past decade.
Trend labour input
Let me turn now to the second part of the story: trend labour input.
The total hours worked by the labour force is a function of the working-age population, the
employment rate, and average hours worked. Demographic factors are key to all of these.
Until around 2008, the growth rate of the working-age population remained fairly steady
(Chart 4) and the increased participation rate of women almost completely offset the
declining participation rate of men. But, since then, the effects of an aging population have
become more noticeable. We are getting older, living longer and having fewer children.5
Baby boomers are retiring or reducing the amount of hours they work and lower fertility rates
over the past 20 years means that more people are leaving the workforce than entering it.
While net immigration is important, and currently accounts for half of the population growth in
Canada, it cannot stop the labour force deceleration.
Other factors, besides demographics, are evidently affecting labour input, but their impact on
the trend is harder to discern. For instance, the recession affected both the demand and
supply of labour. On the one hand, firms cut back on hiring and hours worked diminished. On
the other hand, individuals looked to work more to make up for lost wealth and income. It is
unclear to what degree these two factors offset each other in terms of the trend and how
persistent they are. The Bank's estimates assume that, on balance, the recession had little
impact on trend labour input growth.6
Taking stock
To sum up, productivity growth was on a downward trend going into the recession and the
recession exacerbated this trend. Largely as a result, the growth rate of potential output is
estimated to have declined from above 3.5 per cent in the late 1990s to about 1.5 per cent in
2009. With output well below potential during the recession, the amount of excess supply
grew to as much as 3.5 to 4.5 per cent.
Thanks to strong domestic demand, Canada recovered fairly rapidly from the recession and
registered solid growth in 2010 and 2011. As production increased and business investment
accelerated, we estimate that trend labour productivity growth has slowly increased, leading
to a pickup in potential output growth to about 2 per cent in the past year.
While our estimates suggest that the economy was getting close to potential in late 2011,
slower growth since then has led to a significant buildup of excess capacity. Taking into
account a range of indicators and models, the Bank judges that the amount of slack today is
between 1 and 2 per cent.
Given the enormous complexity in estimating potential output, it is no surprise that the
various indicators monitored by the Bank suggest a range, rather than a single point.
Furthermore, distinguishing between movements in indicators that reflect cyclical
demanddriven factors from those that are more structural is very tricky. Let's take the
employment-topopulation ratio as one example. This ratio has been hovering at about 0.62 for more than
two years, much lower than its pre-recession peak of 0.637 (Chart 5). Taken at face value, it
points to a considerable degree of slack in the labour market. But, our discussion of
demographics suggests that there are other forces at play not related to cyclical labour
demand. With each passing year, older workers are making up a larger share of the
workforce, and these workers understandably have a much lower participation rate. If we
focus instead on the employment ratio of prime-age workers, we see that a much larger
proportion of the losses suffered during the recession have been recovered.
Whether we should expect to get back to the pre-recession peak is also open to question,
since this period marks the highest employment ratio going back several decades. The
problem with using historic peaks in employment, or connecting historic peaks in GDP, is that
by definition, the economy can never be in excess demand. But, of course, history suggests
otherwise. Economies can and do produce above their long-run sustainable level.
Reaching our destination
Looking forward, the Bank of Canada expects that excess supply will be absorbed slowly
over time and that the Canadian economy will return to its full potential around the end of
2015.
This outlook depends on the various forces at play that will affect demand growth in Canada,
and also on how potential output growth will evolve.
The Bank expects the underlying momentum in the economy to build over time. Growing
foreign demand will benefit our export sector. Growth in the export sector, combined with
continued moderate growth in household spending, should boost business confidence and
investment - investment that will contribute to higher productivity growth. But this growth is
expected to be offset by a further slowing in trend labour input, such that potential output
growth remains fairly stable at about 2 per cent (with a range of ± 0.3 percentage points).
The projected slowdown in the growth rate of trend labour input (from 0.8 per cent in 2013 to
0.5 per cent in 2016) is the result of the continuing demographic trends I mentioned earlier.
This could change a little if older people stay in the workforce longer or increase the average
number of hours they work. Whether or not they do so will depend importantly on their
financial situation and whether they think they can afford to retire. For example, if
15,000 additional workers over 55 decide to stay in the labour force next year, we could
expect the growth rate of trend labour input to remain stable.
The growth rate of trend labour productivity is expected to continue to increase in the next
few years, reaching an above-average rate of 1.4 per cent in 2015.
Since the recession, we have seen strong investment in the mining, oil and gas sector
(Chart 6). Given the time it takes for these investments to translate into stronger output, the
continued expansion of infrastructure in this sector is expected to contribute to future
productivity growth.
The Bank expects to see greater investment across most sectors of the economy.
Investment in machinery and equipment (M&E) and in research and development (R&D),
which have been slower to recover, are expected to gain strength as foreign activity, in
particular U.S. demand, accelerates.
In addition to contributing directly to productivity through capital deepening (the amount of
capital available per worker), investment in M&E and R&D are associated with the adoption
and creation of new technologies and processes that have a further positive effect on
productivity.
Other factors that are expected to contribute to the recovery in the growth of trend labour
productivity include Canada's highly educated workforce, which will be able to adapt quickly
to new technologies.7 As well, we expect firms to continue to adjust to the strong Canadian
dollar as they adapt to highly competitive international markets.
Stronger investment also means more new jobs. Already we are seeing job creation in
occupations that demand relatively high skill levels in industries with above-average wages.
Recent experience has shown how new technologies and industries can emerge from
recessions and create new classes of jobs and a virtuous circle of improving confidence and
expanding economic capacity.
There are also positive signs pointing to improved labour productivity. But there is still
considerable uncertainty on the road ahead, and relatively weak performance in the recent
past should temper our expectations. This said, productivity could also increase at a faster
pace than we currently anticipate. This could occur if, for instance, net firm creation, which
has been relatively weak since 2008 rebounds at a faster pace. Canadian firms' plans to
expand exports to the fastest-growing emerging market economies and greater integration
into global supply chains could also result in higher productivity growth over time.
Conclusion
As I said at the beginning, potential output growth is key to a country's standard of living.
In arriving at its forecast for Canadian economic growth and inflation, the Bank analyzes
where economic activity could be and where it actually is. We assess how - and when - this
gap is most likely to close. This analysis feeds directly into our monetary policy decisions.
Our analysis suggests that low inflation in recent months mainly reflects a significant amount
of slack in the economy. We expect this slack to be absorbed gradually in the next two years,
such that inflation also returns gradually to 2 per cent around the end of 2015. Weighing the
downside risks to inflation against the risk of exacerbating already-elevated household
imbalances has led the Bank to judge that the substantial monetary policy stimulus currently
in place remains appropriate and therefore to maintain the target for the overnight rate at 1
per cent.
As I've made clear in my remarks, estimating the output gap and the speed at which potential
output will grow in the future is subject to considerable uncertainty. As more data become
available, the Bank will continuously review its assumptions, and the balance of risks.
The analysis also offers some key takeaways about what the future may hold for our
economy. While Canada's potential output took a hit during the recession, longer-term trends
have also been at work affecting both trend labour input and trend labour productivity.
An unrelenting demographic shift is under way. Strength in the growth rate of trend labour
input can no longer be counted on to support potential output growth in the face of poor trend
labour productivity. And, while Canada benefits from abundant natural resources, one cannot
necessarily count on commodity prices to provide the same boost to income growth in the
future as they have in the recent past.
Here in Winnipeg you have reasons for confidence, with a productive and skilled workforce,
diverse industry, healthy investment in research and development, and an unemployment
rate that is consistently among the lowest in Canada. Your province has the necessary tools
to build productivity and prosperity.
As we journey forward, the Bank of Canada will continue its efforts to understand the trends
affecting Canada's economy and sharing what we learn with business leaders like you.
We will also maintain our firm commitment to keeping inflation low, predictable, and stable.
While there are many variables at play, the 2 per cent inflation target is a constant at the
Bank of Canada, and an essential part of our role to promote the financial and economic
welfare of Canada.
Thank you very much.
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