Mark Carney: Retail price differentials between Canada and the United
States
Opening statement by Mr Mark Carney, Governor of the Bank of Canada, presented to the
Senate Standing Committee on National Finance, Ottawa, Ontario, 2 November 2011.
* * *
Good evening. Tiff and I are pleased to be here with you today to discuss retail price
differentials between Canada and the United States.
The mandate of the Bank of Canada is to enhance the well-being of Canadians by
contributing to sustained economic growth. The single, most direct contribution that monetary
policy can make to sound economic performance is to provide Canadians with confidence
that their money will retain its purchasing power. In Canada, this is achieved through an
inflation-control targeting framework.
Inflation-control targeting has been a cornerstone of monetary policy in Canada since its
introduction in 1991. Since 1995, the target range has been 1 to 3 per cent, with the Bank's
monetary policy aimed at keeping inflation at the 2 per cent target midpoint.
It is important to stress that the target is for total CPI inflation, which is the best measure of
the overall cost of living for Canadians. We do not target or try to control prices of individual
goods and services. With 2 per cent inflation, there will always be some prices rising more
quickly and others more slowly. Central to a market-based economy is the role of relative
price signals in allocating resources.
To understand the evolution of CPI inflation, the Bank looks at the forces shaping various
prices, one of which is consumer price differentials between Canada and the United States.
We also examine the role played by the exchange rate in price gaps, about which I will speak
in a moment. We look at both of these, and the factors that drive them, to understand how
prices are set in Canada which, in turn, contributes to our analysis of the inflation
expectations of Canadian households and businesses and, ultimately, to our ability to fulfill
the Bank's mandate.
At the Bank, we use two sources of information to estimate the size and evolution of retail
price differentials between Canada and the United States. The first is the consumer price
index information from Statistics Canada and the U.S. Bureau of Labor Statistics. In
particular, we examine the ratio of the Canadian CPI to the U.S. CPI for three price
categories: autos, other durables and clothing. These ratios provide information about the
evolution of prices in Canada relative to prices in the United States. On their own, however,
they do not tell us the absolute dollar amount of price gaps between the two countries.
To assess the price-gap level, we use information about the prices of specific goods in both
countries gathered from an informal Internet survey conducted by Bank of Canada staff. We
record the prices of a list of identical goods in Canada and the United States at the same
retail outlet. U.S. dollar prices are converted into Canadian dollars using the bilateral
exchange rate for that day.
Using these two sources of information, the Bank of Canada's best estimate is that the
Canada-U.S. retail consumer-goods price differential was 11 per cent in September, down
from 18 per cent in April. In other words, prices of a set of comparable goods in Canada are
an average of 11 per cent higher than the prices of these same goods in the United States. I
caution that these are estimates and there is some uncertainty around them.
An important question is why has the gap not narrowed more for similar goods, given the
increase in the value of the Canadian dollar. For your consideration, allow me to discuss
some of the possible factors, both macroeconomic and structural, that influence the prices of
goods and services in both countries.
First, cyclical issues may be responsible for some differences between Canadian and U.S.
prices. Unexpected economic weakness in one country could lead to an undesirable buildup
of inventories and result in local discounting of prices. In addition, as long as markets are
partially segmented across international borders, market power may enable firms to respond
to local demand conditions-possibly resulting in lower prices in areas with weaker demand.
Secondly, from a macro perspective, prices take time to adjust. Importantly, this is not only
true in response to the exchange rate, but also to anything that changes the economic
environment (and this is why there are lags in the effect of monetary policy).
In addition to the macro elements, there are structural factors, including profit margins and
underlying costs, that influence the prices of goods and services and that can also contribute
to the gap in prices in Canada and the United States.
Operating profit margins for both the wholesale and retail sectors will have an impact on the
prices of consumer goods in retail outlets. One possible reason that margins have remained
elevated in Canada may be that the retail environment is more concentrated in Canada than
in the United States. In Canada, the top four retailers have a 28 per cent market share,
compared with only 12 per cent in the United States.
On the cost side, there are a number of factors that are important for understanding the
differences in prices in Canada and the United States.
Labour costs tend to be higher in Canada than in the United States. For instance, in the retail
sector, total compensation per hour is higher in Canada. Despite this, retail- and
wholesalesector employment is higher as a share of total employment in Canada, even though retail
and wholesale trade in Canada each represent a smaller share of real GDP. The latter
reflects Canada's productivity performance in the retail sector, which has lagged that of the
United States. This is partly a result of a much lower level of capital intensity and lower total
factor productivity growth.
Total factor productivity refers to how labour and capital are combined to create efficiency
gains. Here, industry structure appears to matter, with larger productivity gains from
investment at chain stores than individual stores. Following 1995, productivity surged in the
United States, with investment in new equipment and organizational change. In Canada,
these effects do not seem to have been experienced to the same degree, perhaps due to the
more localized nature of Canadian markets.
Transportation is another factor on the cost side. While fuel costs are only a portion of total
transportation costs, the difference in gasoline taxes between the two countries makes gas
more expensive in Canada. Lower population density in Canada may also contribute to
higher transportation costs on a per-item basis.
All of these factors and other domestic value-added services, such as marketing, are priced
in local currency. Thus, when the value of the exchange rate moves, these costs to Canadian
retailers, which must be paid in Canadian dollars, do not change.
For imported goods, reflecting the smaller size of the Canadian market, the price paid by a
Canadian importer of a good may be higher than that paid by an American importer. The
Canadian market is roughly one tenth the size of the U.S. market, suggesting a much smaller
potential for economies of scale. While this may not be as much of an issue for large retail
chains with presence in both markets, smaller mostly domestic retail firms could be affected.
Finally, given all of these factors just discussed, allow me to turn to the role played by the
exchange rate in price differentials between Canada and the United States.
As mentioned earlier, consumer prices tend to be sticky-this is true on both sides of the
border. More broadly, the segmentation of international markets, in part due to the higher
costs of shopping abroad, creates limits to competitive pressures.
In addition, paying attention and adjusting to fluctuations in the exchange rate requires time
and energy. It is costly. When fluctuations in the exchange rate are relatively small, not all
firms and consumers tend to pay close attention. It makes sense to focus attention where it
matters most. That is one reason why prices are only adjusted over time and price gaps
persist.
However, when the movements in the exchange rate are particularly large, they attract more
attention and the adjustments are much faster, which we saw in the fall of 2007.
The most useful illustration of these phenomena is the behaviour of online book prices.
These are often completely homogeneous goods on both side of the border. The cost of
changing prices for an online retailer should be minimal. In addition, it is difficult to think of an
easier case for consumers to take advantage of price differentials: comparing prices is just a
matter of visiting different websites, there is no constraint or tariff involved when ordering
from abroad, and transportation costs are known. Despite all this, while online book prices do
change frequently, they typically do not respond quickly to fluctuations in the exchange rate.
However, in the fall of 2007, they did adjust to the strong Canadian-dollar appreciation.
Typically, exchange rate movements tend to be reflected quickly in prices for only a narrow
range of goods that are homogeneous in nature, e.g. fruits, vegetables, gasoline and meat
prices. For other goods and services, there is no apparent short-run pass-through. The
greater the value added in Canada to a good or service, the smaller the role played by the
exchange rate in its price. However, estimates of pass-through at a more aggregated level,
such as core CPI or total CPI, are quite low. Estimated pass-through is about 3 per cent for
core inflation and 4 per cent for total inflation. To elaborate further, this means that a 10 per
cent rise in the dollar would be expected to lower the level of total CPI by 0.4 per cent.
Similar to the experience of many countries, exchange rate pass-through has declined in
Canada in the last 20 years. Some possible explanations include:
 better-anchored inflation expectations associated with the conduct of monetary
policy and increased credibility, and
 the changing composition of trade (e.g. switching to different goods as relative
prices change).
I trust these comments provide some insights to the underlying dynamics of Canadian-U.S.
price differentials.
With that, Tiff and I would be pleased to take your questions.


6 BIS central bankers' speeches