David Dodge: Macroeconomic stabilization policy in Canada
Remarks by Mr David Dodge, Governor of the Bank of Canada, to a symposium sponsored by the
Federal Reserve Bank of Kansas City, Jackson Hole, 31 August 2002.
The references for the speech can be found on the Bank of Canada's website.
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What I propose to do on this panel today is to talk about stabilization policy and policy co-operation
from the viewpoint of an industrial country that has a floating exchange rate and both an explicit
inflation target for monetary policy and a clear objective for fiscal policy. While my perspective has
been particularly influenced by my time as Deputy Minister of Finance and now as Governor of
Canada's central bank, the broad outlines of my conclusions are widely shared, not only in those two
institutions, but in Canadian academic and public policy circles as well. Moreover, I believe that our
experience and the lessons that can be drawn from it are applicable to all open economies with
flexible exchange rates.
In the 1990s, the Bank of Canada and the Government of Canada reached a series of joint
agreements on inflation-control targets. As well, the government established a framework that greatly
reduces the probability of running a fiscal deficit and thus puts the debt-to-GDP ratio on a clear
downward track.
Initially, the credibility of these policies was not high; so it was essential to demonstrate clearly our
resolve to achieve greater fiscal prudence and lower inflation until credibility was gained. Thus, it was
sometimes necessary to override the automatic stabilizers of fiscal policy in order to establish
credibility. And for monetary policy it meant that we could not always implement the easing warranted
by our inflation targets. But as the targets were achieved, the public's trust that the authorities were
going to do what they said they would do increased. That trust is tremendously important.
Now that the credibility of both monetary and fiscal policies is firmly established, the stabilizers are
able to do their job.
I would like to begin by considering stabilization policy, then say a few words on policy co-operation.1
Stabilization Policy
Monetary policy and stabilization
In aiming to achieve a 2 per cent inflation target over an 18- to 24-month horizon, Canadian monetary
policy plays an important role in stabilizing the economy in response to demand and supply shocks.
When there are shifts in demand, the direction of changes in our policy interest rate is quite clear.
Suppose that the economy is operating at its production potential and that inflation is at the 2 per cent
target. A downward shift in demand would create excess supply in the economy, putting downward
pressure on inflation. To bring inflation back to 2 per cent over a period of 18 to 24 months, the Bank
of Canada would lower its target for the overnight interest rate. Through its effect on market interest
rates and the exchange rate, this action would increase the level of output in the economy, moving it
back towards production potential. Inflation would, therefore, return to the target shortly after the
excess supply disappeared from the economy. An upward shift in demand would, of course, generate
symmetric responses.
While the theory is clear about the appropriate response to demand shocks, the magnitude and
persistence of shocks-and hence the size and timing of interest rate adjustments-are always
difficult to judge. This is where the art of monetary policy-making comes into play.
It is even more difficult, of course, to gauge the appropriate monetary policy response to supply
shocks-which take the form of higher (or lower) inflation than expected for a given level of demand.
The Bank's framework for inflation targeting allows temporary supply shocks to be largely ignored, as
long as they do not feed into inflation expectations. The credibility that has been established means
that they typically no longer do so. Consider price surprises coming from the most volatile components
of the consumer price index-components such as fruits and vegetables or fuel oil and natural gas. As
our operating guide, we use a measure of core inflation that excludes these components. This gives
us, and economic observers, some confidence that we are looking at something close to the
underlying trend of inflation. Thus, our interest rate response to price shocks that are perceived to be
temporary can be minimal. As a result, there will be little effect on output. In other words, monetary
policy does not turn temporary supply shocks into something that is destabilizing for aggregate output.
A more difficult situation occurs when persistent increases or decreases in prices coming from the
most volatile components of the consumer price index threaten to keep the total index away from the
target for a significant period of time. Credibility helps here too, but the Bank must be particularly
cautious that these movements in inflation do not feed into inflation expectations.
Supply shocks that take the form of a change in the level, or growth rate, of potential output are often
hard to recognize. Here, however, the key is for the central bank to return the trend of inflation to the
target if it has moved away. Since the trend of inflation relative to the target is the best indicator of
where demand is relative to potential output, this will be consistent with moving demand back into line
with the new path of potential output over the medium term.
Fiscal policy and automatic stabilization
In Canada, the main automatic fiscal stabilizers are various types of tax revenues, as well as
employment insurance payouts. Some of these fiscal stabilizers work almost immediately-for
example, personal income tax deducted by the employer. Others, such as employment insurance
payments, work with a fairly short lag.
Comparing and contrasting automatic fiscal and monetary stabilizers
Automatic fiscal stabilizers are very effective in dampening an output cycle. But they offset only part of
the change in output.
In contrast, monetary policy can fully offset a change in output, but it takes time to work, with the full
impact on output normally felt only after 12 to 18 months.
Discretionary stabilization policy
While the automatic or quasi-automatic stabilization provided by monetary and fiscal policies is very
desirable, the question remains as to whether there is a role for something further-a discretionary
stabilization policy.
In the case of monetary policy, the nature of the response is the more or less automatic one described
earlier. As I implied then, judgment is key to the process. That is particularly true in times of great
uncertainty, such as last autumn. But a clear inflation target means that, in principle, the discretionary
choice for monetary policy-makers is limited relative to that of the fiscal authorities.2
The arguments for and against discretionary fiscal policy as an important element in macroeconomic
stabilization in an open economy tend to revolve primarily around lags and around the effectiveness of
short-run fiscal policy relative to monetary policy.
If the timing were close to perfect, fiscal policy measures that lasted for two or three quarters could, in
principle, and under ideal circumstances, shorten the time it takes to move output back to its desired
level. Thus, in principle, discretionary fiscal policy is a useful tool. But, as a practitioner, I can tell you
that the great problem here is that temporary measures are both difficult to initiate quickly when the
need arises and extraordinarily difficult to stop once the need is past.
Thus, as a practical matter, not a philosophical one, there are some severe limitations to the use of
discretionary fiscal policy as a stabilizer.3,4
My views about this have been reinforced by the way the business cycle in Canada has developed
over the last 18 months or so. In early 2001, we were expecting that the slowdown in both the U.S.
and Canadian economies would be modest. In Canada, an earlier announced tax cut was fortuitously
coming into effect. It was not until the middle of last summer that it became evident that the Canadian
economy was undergoing a more pronounced slowdown than we had expected. Between January and
August 2001, we had lowered our policy interest rate by 175 basis points. Even the most ardent
supporters of discretionary fiscal policy would not have thought about doing anything major until
August. With the horrific events of 11 September, economic forecasters marked down their forecasts
for 2001 and 2002 significantly. We, like other major central banks, accelerated the pace at which we
were cutting interest rates-from September through January 2002, we lowered our policy interest rate
by a further 200 basis points.
Fortunately, the Canadian government added only a small amount to spending in its budget
announcements in late 2001-and that consisted mainly of necessary spending for security and
border issues. I say "fortunately" because, based on the national accounts published at the end of May
2002, growth in the Canadian economy actually rebounded in the fourth quarter of 2001 and
accelerated to about 6 per cent in the first quarter of this year.
Thus, with the benefit of hindsight, it is evident that there was more underlying strength in the
economy than we expected. Combined with the large amount of monetary stimulus that was applied,
this meant that the economy could recover rapidly. Therefore, added fiscal stimulus was not necessary
to get the economy going. And the monetary stimulus provided is proving much easier to turn around.
Since mid-April, we have raised our policy rate by 75 basis points. To be sure, other uncertainties
have arisen and will continue to arise in the future. Our best judgment about these uncertain factors
will continue to be taken into account. But, overall, this episode is clearly showing that monetary policy
actions can be used more flexibly than fiscal policy actions.
I would stress that discretionary fiscal policy can also get governments into trouble if it leads them to
neglect their long-run fiscal anchor-particularly since discretionary action is more likely to be
associated with an easing in policy than a tightening. This neglect would risk eroding fiscal credibility-
the trust that the public has that the fiscal targets will be met.
Policy Co-Operation and Stabilization
Now let me turn to the issue of policy co-operation and policy coordination.
Our inflation targets are joint targets. They are not just the Bank's targets-they are the targets of the
Government of Canada as well.
Our view is that, essentially, "coordination" came through the joint agreement on inflation targets. With
clear agreement on the medium-term policy objectives and with a shared understanding of the policy
framework, there is no need for coordination on the setting of interest rates and fiscal policy
instruments.
The economic literature on policy coordination tends to be about situations where the fiscal and
monetary authorities have one or more of the following: very different views of economic welfare,5
inconsistent policy objectives, policy that is totally discretionary, or a tendency to get involved in
gamelike behaviour with one another. None of these applies in Canada-and none should apply anywhere.
Given our policy framework, when the government changes fiscal policy, it needs to think of how these
changes will affect inflation and, consequently, interest rates. Similarly, the Bank of Canada needs to
consider how changes in fiscal policy will affect demand and inflation, and thus its setting of interest
rates. Therefore, it is to the mutual benefit of both parties to co-operate in sharing information and
analysis as they adjust their policy settings.
Co-operation between the Bank and the federal Department of Finance occurs on a number of levels. I
have frequent discussions with the Minister and Deputy Minister. And there are meetings at the staff
level to share, for example, information from economic forecasts, surveys, and contacts with various
groups and organizations. One of the key reasons for our regular discussions has been to ensure that
each institution understands the details of the framework within which the other one is pursuing its
objectives and how this framework is being implemented with respect to current economic surprises.
The Bank also keeps in close touch with provincial fiscal authorities.
Thus far, I have not said anything about the appropriate mix of monetary and fiscal policies when
talking about coordination and co-operation. Quite simply, with explicit frameworks in place for
monetary and fiscal policies, the whole issue of policy mix becomes moot. The fiscal and monetary
authorities are both adjusting their policy instruments to attain their respective objectives. There is no
other mix of interest rates and fiscal thrust that the authorities will perceive as consistent with meeting
the monetary and fiscal objectives.
Concluding Thoughts
Clear monetary and fiscal objectives, combined with clear accountability for meeting those objectives,
provide the background for policy co-operation and stabilization in Canada. The monetary and fiscal
policy frameworks have created an environment where co-operation in the form of sharing information
and analysis is most effective. Fiscal and monetary credibility is high. In other words, economic agents
trust that the monetary authorities and the fiscal authorities will maintain these frameworks.
With trust in place and with expectations well anchored, the automatic fiscal stabilizers can be allowed
to operate fully and monetary policy actions can be directed to achieving the inflation targets. In
addition, when major shocks occur, with trust in place, there can be a temporary overshoot or
undershoot of the fiscal or monetary targets without unhinging confidence in the framework or in
expectations that the targets will be met over time.
I believe that Canada's experience and the lessons we have learned about having clear policy
objectives and supportive, transparent policy frameworks have broad applicability in open economies
with a flexible exchange rate.