Remarks by Lawrence Schembri
Deputy Governor of the Bank of Canada
Halifax Regional Chamber of Commerce
September 5, 2019
Halifax, Nova Scotia
Economic Progress Report: Inflation in
Canada-Well Behaved and Well Controlled
Introduction
Thank you for inviting me to speak with you today.
The Bank of Canada's mandate is to promote Canada's economic and financial
welfare. We fulfill this mandate in a number of ways, but we are probably best
known for conducting monetary policy. We set our key policy interest rate with a
goal of keeping inflation low, stable and predictable because that is the best way
to promote sustained growth in employment and living standards.
on the Bank's Governing Council
Eight times a year, my colleagues and I
announce the setting for our policy interest rate. As you will likely have heard, we
announced yesterday that we left our policy rate unchanged at 1.75 percent.
Today, I would like to give you a sense of the thinking that led to our decision. I
will also say a few words about the inflation process in the Canadian economy.
To better understand how the Bank made its decision yesterday, you should
know that four of our eight annual decisions are based on a projection for the
Canadian and global economies produced by Bank staff.1 On those four dates,
we use that projection as a basis for the forecast in the Monetary Policy Report
that we publish with the announcement. On the other four dates, we base our
decision largely on how the Canadian and global economies have evolved
relative to the previous forecast.
Yesterday's announcement was one of the latter group.
Before making our
decision, we looked closely at how the economic data have been unfolding since
the announcement in July. So, let us take a look at our last forecast and review
what has happened over the past eight weeks.
1
on the Bank's
You can find a detailed description of the decision-making-process website.
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The July forecast
Our July forecast painted a mixed picture. The outlook for the global economy
Canada's
was clearly weakening. At the same time, economic rebound from a
soft patch around the end of last year was stronger than we had expected.
Globally, the big issue in July was the ongoing trade war between the United
States and China. Rising tariffs and the related uncertainty about global trade
policy were taking more of a toll on both trade and business investment than we
had previously thought, causing commodity prices to fall. Meanwhile, we saw that
growth in the US economy was slowing to a sustainable pace, as we had
expected.
Another global highlight was that many other central banks had either lowered
their own policy rates to stimulate their economies or said they were prepared to
do so, if necessary. These moves, along with the deteriorating global outlook, led
to lower bond yields and borrowing costs in many economies, including here in
Canada. Looking at all of these factors, we forecast in July that the global
economy would be weaker, but there would not be a US or global recession.
In contrast to the weakening global outlook, however, most indicators for the
Canadian economy in July were positive. Growth had rebounded more strongly
than we had earlier forecast, driven by factors that were not likely to last-for
example, a surge in oil production.
Still, a strong job market and rising wages were supporting growth in Canadian
household consumption. This growth, along with the lower interest rates I just
mentioned, led us to anticipate that the housing market would stabilize this year
and would finish working through the dampening effects of various local housing
measures, primarily in the greater Vancouver and Toronto areas, and the B-20
mortgage stress-test rules. All told, we projected that the economy would grow at
a pace of 2.3 percent in the second quarter and that inflation would be close to
our 2 percent target. Global trade tensions continued to cloud the outlook and
represented the biggest risk to our forecast.
July. Now
That is a quick review of how we saw things in let's look at how things
have evolved since then.
Recent developments
Economies outside Canada
The first thing to note is that the main themes from July have not changed. We
still see ongoing weakness in the global economy and resilience in the Canadian
economy.
However, a few key aspects of the storyline have changed. Internationally, the
US-China trade war has gotten worse. Escalating tariffs and uncertainty are
reducing global trade and investment by more than we had forecast. The volume
of global trade has now shrunk for a third straight quarter. Growth in major
economies is slowing as manufacturing output and business investment weaken.
slower
Specifically, recent data point to momentum than anticipated in both
China and the euro area, with the risk of a recession rising in Germany. The US
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economy continues to moderate but remains solid, supported by consumer and
government spending.
Financial markets have continued to react to this weaker outlook, and more
central banks have taken measures to stimulate their economies. Bond yields are
lower, and the yield curve is inverted in many countries. An inverted yield curve
means that short-term interest rates are higher than long-term rates. This is the
opposite of how the yield curve normally looks because longer-term lending is
usually considered riskier. Historically, an inverted yield curve has been viewed
as a sign of a future recession, especially in the United States. Today, with
interest rates so low to begin with, an inverted curve is more likely a sign that
investors foresee weaker long-term growth.
The Canadian economy
In contrast to the global economy, Canadian economic data since July have
surprised on the upside. Last week, we received the national accounts report for
the second quarter. It showed the economy grew at a pace of 3.7 percent, much
stronger than we had forecast.
Among the highlights from the report was labour income, which grew by
7 percent, reflecting continuing growth in employment and hours worked and a
notable pickup in wages. That rise in income, along with the lower interest rates I
mentioned earlier, helped support unexpected strength in housing. In fact, most
people renewing a five-year fixed-rate mortgage today are paying a lower interest
rate than they did five years ago. Housing is once again contributing to growth,
with resales and starts catching up to underlying demand. High levels of
household debt remain the main risk to Canadian financial stability, but with
tighter mortgage rules in place, the quality of the stock of household debt should
continue to improve.
However, consumption was surprisingly soft in the quarter, particularly given the
increase in labour income. And the national accounts data suggest that some of
the economy's
strength will be temporary. Exports were very strong, but much of
that came from a sharp rebound in shipments of crude oil and transportation
equipment. Imports were surprisingly weak, and companies are still carrying high
levels of inventories. Business investment contracted sharply after a strong first
quarter, likely reflecting, in part, the impact of the escalating trade war.
The stronger second-quarter growth means that the economy was operating
close to its productive capacity, or potential-a concept I will explain in a minute.
And inflation has been very close to our 2 percent target.
Inflation and the Phillips curve
Now, let me spend a few minutes on the relationship between inflation and
economic growth.
This issue has been in the news lately because inflation rates in the United
States, the euro area and Japan have stayed low, even though their economies
had been strengthening, at least until recently. In particular, there has been much
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debate about the continued existence of what economists call the Phillips curve.
This is the idea that there is a close link between economic growth and
inflationary pressures.2
Because of the persistently low inflation experienced in several major countries,
some observers have gone so far as to declare the Phillips curve dead. Here at
home, though, our experience has been different. As the title of my speech says,
inflation in Canada has been well behaved.
Before looking at the evidence that supports this claim, I would like to explain
approach to
why this relationship is an important part of the Bank of Canada's
conducting monetary policy.
the primary objective of the Bank's
As I said at the beginning of this speech,
monetary policy is to achieve low, stable and predictable inflation. Like many
other central banks that also practise inflation targeting, we adjust our policy
interest rate to try to bring overall demand and supply into balance so that all of
our productive resources are fully utilized. At this point, our labour force would be
fully employed, and the economy overall would be using all of its productive
capacity.3 This is what we mean when we say the economy is operating at its
potential output.4 The concept of potential output is important because inflation
should be close to our 2 percent target when the economy is operating at that
level.
When there is a difference between the economy's potential output and what is
actually being produced, we say there is an output gap. If we project that strong
growth is likely to push the economy above potential-creating a positive output
causing to increase
gap and inflation above our target-we may raise interest
rates to cool demand growth.5 And the reverse is true if weak growth is set to
thus
pull the economy below its potential, creating a negative output gap. So, by
adjusting our policy interest rate, we influence demand for output and
employment, aiming to close the output gap and achieve our inflation target.
To be sure, other factors beyond the output gap can affect inflation, measured by
the consumer price index (CPI). Exchange-rate movements can affect inflation
because they directly affect the price of imported goods and services consumed
by households. And, because Statistics Canada calculates CPI inflation using
2
There are a few different ways to define the Phillips curve. In this speech, I am talking about the
relationship between inflation and the economy's output gap, not the relationship between
inflation or wage growth and unemployment (which is related to the size of the output gap).
3
In practice, the concept of full employment does not imply that the unemployment rate would be
zero because some workers are always transitioning between jobs for various reasons.
4
For more on this topic, see L. Schembri,
"The (Mostly) Long and Short of Potential Output"
(remarks to the Ottawa Economics Association and CFA Society Ottawa, Ottawa, Ontario,
May 16, 2018).
5
Monetary policy is transmitted both through its effect on interest rates and its effect on the
exchange rate. So, for example, a rise in the policy interest rate tends to appreciate the value of
the Canadian dollar, making our exports more expensive and imports less expensive. This
reduces the demand for Canadian-produced goods and services.
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prices for a basket of goods and services that a typical family buys, swings in
specific prices-such as for gasoline-can have a large impact.6
So, to help us see the underlying trend of inflation, we rely on a number of
measures of core inflation that filter out most of the impact of these shocks. As a
result, these core measures are less volatile than total CPI inflation and do a
better job of capturing persistent, underlying movements in prices. In 2016, Bank
staff evaluated various core measures in detail, which led us to announce that we
would pay particular attention to three of them.7
Chart 1:
Range of core inflation measures and the output gap
%
2.0 %
2.5
1.0
0.0 2.0
-1.0
1.5
-2.0
1.0
-3.0
0.5
-4.0
-5.0 0.0
07 08 09 10 11 12 13 14 15 16 17 18 19
Range of core inflation measures (right scale) Output gap at t-4 (left scale)
Last observation: 2019Q2
The behaviour of these three core measures in recent years offers some
compelling evidence for the relevance of the Phillips curve in Canada.8 Think
back to 2014-15, when the price of oil plunged, growth slowed, and the economy
slipped below its potential output. Over that period, core inflation was well below
2 percent. As the Canadian economy adjusted to the oil price shock, the output
gap began to close rapidly in 2017. By the second half of that year, core inflation
moved back up toward our target, responding to the closing of the gap with a bit
of a lag. Since then, our preferred measures of core inflation have been hovering
around 2 percent. This is consistent with our estimate that the economy has been
operating close to potential output throughout most of that period.
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Today, the Bank is publishing an updated evaluation of our core inflation
measures that shows that they continue to perform well.9 They are less volatile
than CPI inflation and strongly linked to the output gap, with a lag.
This evidence of a close correlation between underlying inflation and the output
gap bolsters our confidence in our inflation projections and in our framework for
conducting monetary policy.
The latest data show that total inflation remained right at the 2 percent target in
July. This is a bit stronger than we expected, mainly because of temporary
factors, including higher prices for air travel, mobile phones and some food items.
Our core inflation measures were also around 2 percent in July, which is
consistent with the idea that the economy's output gap is essentially closed.
Our decision
So, with all that as background, let me conclude by talking about the Bank's
decision yesterday.
My colleagues and I began our discussions by recognizing that the data indicate
the Canadian economy is operating close to full potential, the unemployment rate
is near historic lows and inflation-our primary responsibility-is right on target.
The economy has clearly gotten past its earlier soft patch, the labour market has
been strong and housing markets have begun to rebound. Although household
debt levels remain high, mortgage underwriting rules are helping to contain
financial vulnerabilities. This solid starting point means the economy has a
welcome degree of resilience to possible negative economic developments.
That said, we agreed that the data show some areas of concern. Among these is
the weakness in consumption. It is difficult to square the softness in consumption
with the strength in labour income. And, of course, we are concerned about the
drop in business investment, which is likely linked to ongoing trade war and
related uncertainty. So, we continue to expect that economic activity will slow in
the second half of the year.
Given Canada's reliance on
international trade, we agreed that the trade war
policy
remains our primary concern and the biggest risk to our forecast. Trade
and exports
uncertainty has been weighing on business investment for a couple
of years now. And things could certainly get worse internationally, which would
deliver a complex shock to our economy affecting both supply and demand.
In this uncertain environment, central banks have been conducting monetary
policy appropriate to their own circumstances and outlooks. This has contributed
to lower bond market yields and reduced borrowing costs in Canada. The Bank
of Canada will continue to conduct monetary policy appropriate to our own
circumstances. We will continue to ground our decisions in our policy framework,
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setting interest rates to achieve our inflation target, mindful of the implications for
financial vulnerabilities. Our current policy setting of 1.75 percent, which is 50
basis points below the US policy rate, continues to support the economy.
Canada's economy is
To sum up, as I said earlier, operating close to potential
and inflation is on target. However, escalating trade conflicts and related
uncertainty are taking a toll on the global and Canadian economies. In this
context, the current degree of monetary policy stimulus remains appropriate. As
the Bank works to update its projection in light of incoming data, Governing
Council will pay particular attention to global developments and their impact on
the outlook for Canadian growth and inflation.
I hope I have been able to shed some light on the Bank's rate-setting process. I
thank you for your attention and look forward to answering your questions.