Lynn Patterson: Adjusting to the fall in commodity prices - one step at a
time
Remarks by Ms Lynn Patterson, Deputy Governor of the Bank of Canada, to the Edmonton
Chamber of Commerce, Edmonton, Alberta, 30 March 2016.
* * *
Introduction
Good afternoon. Thank you for inviting me here today.
It's a pleasure to be in Edmonton and speaking to the Chamber of Commerce.
When I accepted this invitation, it took me all of about 10 seconds to decide what my topic
would be: the impact of lower commodity prices on Canada's economy, which is important to
all of us.
As business leaders in Alberta, you know this better than most because you are experiencing
it first-hand.
At the Bank we have committed a lot of resources to understanding the impact on the
economy of the drop in prices, and so I thought it would be helpful to share some of our
insights, from a macro perspective, into the adjustment we are facing.
Oil prices alone are down by well over 60 per cent since the highs we experienced in
mid2014. Given the supply dynamics that we are currently faced with, it is highly unlikely that we
will see those levels again in the coming years.
While this price drop is affecting all Canadians, it is being felt most acutely here in Alberta
and other oil-producing regions. We at the Bank are well aware of the toll this is taking on
firms and the hardship it means for many individuals and families. Yet the message that I
want to share with you today is that Canada's economy is diverse and dynamic enough to
achieve, in time, a new balance of economic growth.
While energy and other commodities will continue to play a very important role in the
domestic economy, we don't expect that they will account for as large a share of our exports
as they did in the recent past.1
I want to focus on three key questions that are top of mind for us at the Bank and, most
likely, for many of you.
First, how do we assess the impact of this shock?
Second, how will the economy adapt and how long will it take?
And third, what will the economic landscape look like when it's done?
In answering these questions, I will highlight a simulation of the commodity price shock that
we ran through one of our economic models to help us understand the implications for the
economy. I will also describe in some detail the insights into the adjustment process that the
model gave us.
Let me begin with some context.
Context: Impact of the commodity boom on Canada
A broad-based boom in global commodity markets began in the early 2000s. It was fuelled
by growing demand from emerging-market economies. Canada was a big beneficiary of the
rising prices. Our terms of trade - the price of our exports relative to that of our imports -
improved substantially. So did our real gross domestic income (GDI), which is a measure of
the purchasing power of income generated in Canada. The terms of trade directly boosted
GDI by approximately 7 per cent between 2002 and 2013.2 Rising commodity prices also
boosted economic activity, particularly business investment, which generated job growth in
the natural resource sector. In 2014, business investment in the oil and gas extraction sector
peaked at almost $80 billion.
As commodity prices and Canada's terms of trade improved, the Canadian dollar
strengthened. From a low of about 62 cents U.S. in 2002, the dollar rose to average around
parity between 2010 and 2013. This increase was not merely coincidental. In addition to the
improvement in our terms of trade, other factors, such as international interest rate
differentials and safe haven flows, were at play. All of these elements influenced the level of
the Canadian dollar.3
In this environment, Canada's flexible exchange rate helped to prevent the economy from
overheating. As the Canadian dollar appreciated, it became a headwind for some industries
in the non-commodity export sector. This, in turn, reinforced incentives for capital and labour
to shift to commodity-producing sectors and regions. Indeed, workers migrated in large
numbers to regions of the country that were benefiting from job creation in the natural
resource sector. The oil boom in Alberta provides the strongest example. Between 2002 and
2013, more than a quarter of a million people moved here from other provinces. We also saw
the number of workers commuting to Alberta double during this period, rising to about 8 per
cent of the province's workforce.
Assessing the magnitude of the shock
I'm sure many of you felt the benefits of higher commodity prices. You likely witnessed
changes in your neighbourhoods and city. But, by late 2014, you may have begun to feel a
cold wind blowing.
With the significant decline in commodity prices, the economy was faced with a material
shock.
Let me turn to my first question: how we assess a shock such as this.
The Bank uses a variety of analytical tools and sources of economic intelligence to better
understand and assess the impact of shocks like this one. Some of our tools, such as our
Business Outlook Survey, help us identify near-term impacts, including changes in business
investment. Others help us look at a longer horizon.
The recent oil price drop merited particular attention, not only because of the size and speed
of the decline, but also because of the relative importance of oil production and investment.
As oil prices began to fall, we closely monitored announcements of capital expenditures. We
also analyzed the impact of past oil price shocks on investment and we talked with firms in
the energy sector to understand how they were responding to the price decline. The picture
that emerged was of a sizable contraction of investment in the oil and gas sector in the near
term.4 And so in January 2015, and again in July, concerned about the impact of lower oil
prices and the risks to inflation, and to facilitate the economy's adjustment to its new
circumstances, we lowered our policy rate.
For insights into the longer horizon, we ran a simulation of the shock in our workhorse model,
the Terms-of-Trade Economic Model (ToTEM).5 A paper that we released with our January
Monetary Policy Report has all the details.6 ToTEM is designed to capture the impact of
terms-of-trade shocks, which is a necessity for analyzing an economy such as Canada's that
is so heavily engaged in international trade.7
ToTEM is fed data on everything from consumer spending to household wealth, labour
markets, wages, imports and exports, long- and short-term interest rates, business
investment and government spending. The model helps us understand how these
components interact in response to shocks. It also allows us to explore the linkages between
the commodity and non-commodity sectors, as well as how the exchange rate and monetary
policy facilitate adjustment to shocks.
The ToTEM simulation provided insight into how a fall in commodity prices would affect the
broader economy. The shock is complex because it sets in motion several, seemingly
nonsynchronous forces: on the one hand, it indicated that our resource sector would shrink and
we would earn less income from the rest of the world; on the other hand, the non-resource
sector would gradually begin to expand. At the same time, the Canadian dollar would
depreciate.
A front-loaded restructuring of the resource sector
By convention, we assumed for the simulation that commodity prices would remain roughly
where they were at the time (the third quarter of 2015), when West Texas Intermediate was
trading at about US$46 per barrel, almost 60 per cent below its peak in June 2014.8
Our simulation suggested that, by the end of 2015, the commodity price decline would cause
GDP to be 1 per cent lower than it otherwise would have been.
And that's what happened. As investment fell, firms cut their workforces. You all likely have
friends, neighbours or colleagues who were affected by the cuts. By December of last year,
about 30,000 jobs had been lost in the mining, oil and gas extraction sectors in Alberta,
Saskatchewan, and Newfoundland and Labrador, a decline of almost 20 per cent from the
4
Indeed, around $28 billion in oil and gas sector investments, or over 35 per cent, evaporated in 2015.
5
The simulation looked at the adjustment process over a 5-year period, unlike our forecasts, whose typical
projection horizon is 18 to 24 months.
6
J. Champagne, N. Perevalov, H. Pioro, D. Brouillette and A. Agopsowicz, "The Complex Adjustment of the
Canadian Economy to Lower Commodity Prices," Staff Analytical Note 2016-1, Bank of Canada, 2016.
7
P. Fenton and S. Murchison, "ToTEM: The Bank of Canada's New Projection and Policy-Analysis Model,"
Bank of Canada Review (Autumn 2006): 5-18; and J. Dorich, M. Johnston, R. Mendes, S. Murchison and
Y. Zhang, "ToTEM II: An Updated Version of the Bank of Canada's Quarterly Projection Model," Technical
Report No. 100, Bank of Canada, October 2013.
8
In fact, our research shows that this simple "no change" assumption is generally about as good as those
produced by sophisticated models or futures markets. However, we believe that, over the medium term, there
are upside risks to this assumption.
employment peak in 2014. But supply-chain linkages and spillovers to other sectors meant
that the losses were much broader: almost 70,000 jobs disappeared in these provinces.
Regional divergences also emerged. While employment in these energy-producing provinces
fell, it grew in the rest of Canada. As a result, unemployment rates rose by roughly 2 to
3 percentage points in the three provinces while remaining flat or declining in British
Columbia, Ontario and Quebec.
The employment decline in the resource sector also had an outsized impact on national
aggregate earnings. Not only do these jobs pay well, they also tend to call for longer work
days and, therefore, a greater number of hours worked. For example, in 2014, average
hourly earnings and average hours worked in the resource sector were, respectively, about
40 per cent and 25 per cent higher than the national average. Our simulation suggests that
the commodity price shock will cause aggregate earnings to be almost 2 per cent lower than
they otherwise would have been by the middle of this year.
Broader income and wealth effects
The retrenchment in the commodity sector is the first and most visible step in the adjustment
process. Over time, the losses in income and wealth associated with the price decline will
spread across the country.
As I mentioned earlier, our terms of trade improved substantially in the 10-year period before
commodity prices began to fall. We have now lost about half of those gains. Measured at
annual rates, this represents a loss of more than $60 billion in national income, or about
$1,800 for every Canadian.
This drag on household spending was initially small, because the restructuring in the
commodity sector has been fairly concentrated and the monetary stimulus from the Bank's
interest rate cuts last year helped support the broader economy. But the impact of lower real
incomes is gradually building. We expect it to become the dominant source of drag on the
economy by 2017. As their wealth and incomes decline, households will likely restrain their
spending and we will see lower, but still positive, consumption growth.
How is the economy adapting?
Now that I have given you some numbers around the impact of the oil price shock on the
Canadian economy, let's turn to my second question: how long and what form the
adjustment will take.
It is difficult for us to be precise about the timing of the underlying shifts in the economy. But
our best guess is that the full adjustment will take longer than two years, our normal forecast
horizon. Having said that, we have a few clues that can help us to frame the timeline.
First, in examining labour markets, we see an interesting development that suggests we may
be adjusting to the economic shift more quickly than we have historically.
In the past, regional shocks would have led to a persistent divergence in employment rates
across provinces. Between 1976 and 1997, the average difference between employment
rates in any one province and the national rate was 5.5 percentage points. This was much
higher than the corresponding gap in the United States.
But the gap in Canada has now shrunk to U.S. levels, below 4 percentage points, as we
explain in a staff analytical note posted on our website today.9 While this is just one indicator
of labour mobility, the convergence suggests that Canadians have become more willing to
move to where the jobs are. That may mean that regional labour markets will adjust more
quickly to the decline in commodity prices. Indeed, we are already seeing shifts in migration
patterns. Net interprovincial migration to Alberta reversed in the fourth quarter of 2015. At the
same time, over the past two quarters, Ontario registered the largest inflow of interprovincial
migrants since 2002.
In addition, the flow of workers who were commuting from their homes in other provinces to
Alberta has fallen sharply.10
A second clue is the close but imperfect link between our terms of trade and the value of our
currency. It is no surprise that the value of the Canadian dollar has fallen along with
commodity prices. Since late 2011, when some commodity prices first began slipping, the
Canadian dollar has lost almost one-third of its value. While many factors influence the
exchange rate, its depreciation, which will certainly hurt some businesses, is a necessary
part of the adjustment process.
The weaker dollar acts as a buffer for Canada's exporters. It offsets part of the drop in
U.S.dollar commodity prices, softening the blow to the Canadian-dollar revenues of commodity
exporters. Similarly, the depreciation boosts the Canadian-dollar revenues of non-commodity
exporters that price their goods in U.S. dollars.11
The weaker dollar also makes Canada's exports more competitive. We are already seeing
some evidence of this increased competitiveness. In particular, export categories sensitive to
the exchange rate have performed better than average. These categories include building
materials, furniture, industrial machinery and equipment, and pharmaceuticals. The service
sector also benefits. Tourism is surging: the number of foreigners travelling to Canada
jumped 11 per cent in January compared with the same month last year. Film and television
production is also enjoying a revival across the country - The Revenant was filmed here in
Alberta. And in Vancouver more than 350 productions were shot last year, a record that
surpassed 2014 by 40 per cent.12
Estimates from ToTEM and other models suggest that it typically takes up to two years for
the full effect of exchange rate movements to be felt. Since the loonie fell by roughly 15 per
cent against the U.S. dollar in 2015, more gains are coming to the non-commodity sector,
consistent with the notion of a two-track economy. What we are witnessing is a reallocation
of productive resources to the non-commodity sector.
And, of course, the resource sector is not standing still. We expect to see new efficiencies,
further innovation and shifts in investments. For example, here in Alberta's industrial
heartland, there are ongoing investments in upgrading and processing that will help diversify
the mix of products from your natural resources.
What will the landscape look like after the adjustment?
Now, let me turn to the last question I posed at the outset: what the economic landscape is
likely to look like after these adjustments have worked their way through.
Again, although we can't be precise about the timing, we expect that, several years from
now, the Canadian economy will have found a new balance. Our simulation suggests that the
share of the commodity sector in the economy will decline toward its pre-boom level. By
2020, the sector could account for roughly 40 per cent of exports, compared with about
50 per cent in 2014. Similarly, the sector's share of business investment could fall to 40 per
cent, compared with 56 per cent in 2014.
Lower commodity prices will lower incomes and are likely to lower the economy's potential
output. This is the result of a number of factors, primarily the drop in investment in the
resource sector, but also the rise in the price of imported capital, which negatively affects
investment in all industries. With less investment, the country's stock of capital will be smaller
than it otherwise would have been, lowering the economy's productive capacity.13
The extent to which potential GDP is permanently lower will depend on how much capacity is
rebuilt in the non-commodity sector. As well, low oil prices could spur companies to innovate
and achieve greater efficiencies in their production cycles. We are studying these questions
now and will update our estimate of potential output in our April Monetary Policy Report.
Assumptions and assessments
While our modelling exercise laid out a plausible longer-term scenario for the economy, it is
subject to many assumptions. Three are worth noting: (i) the magnitude - whether we have
accurately assessed the extent of the declines in business investment; (ii) the timing - both
with respect to the pickup of non-commodity exports and the reallocation of labour; and
(iii) our assumption of flat oil prices.
Let me say a few words about our oil price assumption.
In the near term, the risks to oil prices appear to be balanced. While elevated inventories still
represent the main downside risk, we now have an upside risk in the form of a
faster-thanexpected decline in U.S. oil production.
In contrast, over the medium term, the risks remain tilted to the upside. The significant
reductions in oil investment since late 2014 could leave future increases in global demand
unmet, putting upward pressure on prices and drawing investment back into the sector. The
level of prices that would balance the oil market in the medium term is still highly uncertain,
particularly since technical improvements and other efficiency gains by oil-producing firms
have lowered their costs of production.
Moreover, as we highlighted in the January Monetary Policy Report, low oil prices make it
more likely that adverse threshold effects on economic activity may occur. If prices fell to
such a low level that firms struggled to cover their ongoing costs, consolidation could
accelerate, resulting in more-pronounced declines in production and weighing on the broader
economy by hurting demand and confidence.
Conclusion
Let me conclude.
Our simulation of the commodity price shock is just one example of how we assess the
various factors influencing the Canadian economy. Examining the shock in isolation
enhances our understanding of its potential influence on our outlook for inflation. We
consider this type of analysis, together with many other inputs, when we set monetary policy.
As we note in our Monetary Policy Reports, we conduct a rich analysis around our
projections and identify risks to the inflation outlook. This analysis acts as the foundation for
Governing Council to assess and exercise its judgment about the appropriate stance for
monetary policy.
Earlier this month, we left our policy rate unchanged at 0.5 per cent, since the economy was
evolving broadly in line with our expectations and projections set out in January - about
1.5 per cent GDP growth in 2016 and 2.5 per cent in 2017. In our April Monetary Policy
Report, we will update this forecast and take into account the fiscal measures that were
announced last week.
We are mindful that the changes to our economy that are under way are, and have been,
difficult, particularly here in Alberta. Adjustments to large negative shocks take time.
Although painful for many, the shifts are signs of a dynamic economy.
We are fortunate that Canada's wealth is based on a broad set of natural and human
resources and that the growth of our economy is powered by a wide range of industries. To
make the most of our opportunities as a trading nation, we need to let the adjustment
process unfold as effectively as possible. It won't be easy and it will take time.
For the Bank, the best contribution we can make is to set policy that will help keep inflation
low, stable and predictable, so that Canadians can plan and invest with confidence. And as
business and community leaders, you can help by being proactive and innovative in your
respective fields.
I would like to thank Rhys Mendes for his help in preparing this speech.