Mr Thiessen discusses the change in views on the role of monetary policy since the
Porter Commission
Text of the Tony Hampson Memorial Lecture by Gordon G Thiessen, Governor of the Bank
of Canada, at the C D Howe Institute, Toronto, Ontario, on 11 March 1999.
A. TONY HAMPSON AND THE PORTER COMMISSION
Tony Hampson made a number of outstanding contributions to Canadian public life as well as
having a successful business career. Many in this audience will be familiar with the fact that
for a number of years he was Chairman of the C.D. Howe Institute's Policy Analysis
Committee. Early in his career, he worked on the Royal Commission on Canada's Economic
Prospects (the Gordon Commission) and, most prominently, served as secretary of the Royal
Commission on Banking and Finance (the Porter Commission).
His colleagues, on these Commissions as elsewhere, remember an engaging personality, an
ambitious and demanding manager, a clear-headed analyst, and a thorough and helpful editor.
He was also a superb communicator and writer. Let me quote the acknowledgement in the
Porter Report: "Our greatest debt has been to Mr. H. A. Hampson, the Secretary of the
Commission. His intellect, organizing ability and energy proved invaluable in the planning of
our work, the development of our views and the drafting of our entire report."1
The hearings and analysis undertaken in the early 1960s by the Porter Commission, together
with its Report and the discussions it generated, were events of major importance for the
Canadian financial system and for the Bank of Canada. Indeed, I will suggest in this lecture
that the Porter Report contained the seeds of a major reorientation of thinking about financial
structure and monetary policy. Its emphasis on competition, and on the use of market
mechanisms in the implementation of monetary policy, clearly showed the way ahead. It also
foresaw many of the subsequent changes in financial institutions and markets. Moreover, the
Commission underlined the necessity for inflation control at a time when the view that
inflation could be traded off for lower unemployment was gaining in popularity.
The Commissioners themselves, chaired by Chief Justice of Ontario Dana Porter, were people
of experience and insight. They assembled an extraordinarily talented young research staff,
and Tony Hampson proved to be an admirable team leader.
The Commission believed in markets. This was not such a popular stance at the time.
Extensive government controls, a legacy of the post-World War Two period, were still in
place in many advanced economies, and they were widely thought to be necessary, if not
desirable. In contrast, the Porter Commission felt that the somewhat more liberal financial
regime in Canada was by and large working effectively. The financial system had played a
central role in the post-war expansion, especially in the smooth financing of the tremendous
wave of investment in the 1950s. Moreover, at the time it was undergoing considerable
change, in response to the evolving demands in the financial markets of households, firms and
governments. On the basis of this encouraging experience, the Porter Report came out
strongly in favour of increased competition and deregulation. It was aware that this might
entail some risks, but thought they were worth taking.
This advice was followed in the revisions to federal financial legislation of 1967, notably in
the following measures:2 removal of the 6 per cent ceiling on bank loan rates; permission for
banks to enter conventional (i.e. non-government-insured) mortgage lending; prohibition of
interbank agreements on interest rates and of interlocking directorates; and the reduction of
the burden of cash reserve requirements on chartered bank deposits.
These measures have stood the test of time and have served Canada well. For example, the
liberalization of interest rates allowed financial institutions to adapt appropriately to the
requirements of the more volatile financial environment of the decades that followed. Canada
was spared the systemic weaknesses caused elsewhere by ceilings on administered interest
rates. In the United States, for example, such ceilings were a major factor encouraging the
unbalanced portfolios of the thrift institutions, which in the 1980s would be revealed as a fatal
flaw.
In more philosophical terms, Porter's arguments on financial liberalization and competition
were ahead of their time, and still read very well today.
I cite all this to underline that the Porter Commission made an important difference to our
financial landscape. But financial reform, important and topical though it may be, is not the
central theme of my lecture. Instead, I will focus on the Commission's work on the conduct of
monetary policy. First, I will set out a broad characterization of the view of monetary policy in
the Porter Report. I have not tried to provide a thorough description of the Commission's
analysis of monetary policy. Rather, I have focused on a few general policy issues that strike
me as important. Next, I will present the general approach to policy that is taken today.
Comparison of the two, you will see, reveals some striking differences, but also some
common themes. These themes lead me to the view that the Porter Commission Report and
the surrounding debate were a key step in the evolution towards the current monetary policy
framework in Canada.3
B. THE PORTER COMMISSION VIEW OF MONETARY POLICY
1. The basic framework
The Porter Report in most respects adopted a standard 1960s view of monetary policy. It was
the heyday of Keynesianism, in official circles as well as in the universities. Although Milton
Friedman and his collaborators had begun their restoration of the quantity theory with some
2
The main revisions were to the Bank Act and the Bank of Canada Act. While the Commission had
recommended a comprehensive definition of banking, the legislation did not go so far as to eliminate
distinctions between different kinds of financial institutions. Moreover, the Commission was against
government-backed deposit insurance, which was nevertheless enacted in 1967, following a run on a
trust company.
3
The Commission also dealt with the issue of central bank governance. It recommended formalizing the
agreement on dual government-Bank of Canada responsibility that Louis Rasminsky had drawn up
before accepting his appointment as governor. In consequence, the Bank of Canada Act was amended in
1967 to provide the Minister of Finance with the right to issue a directive to the Bank if the government
disapproved of the Bank's policy. Thus, the government is ultimately responsible for monetary policy,
but if no directive is issued the Bank has full responsibility for designing and implementing monetary
policy.
impressive, if controversial, empirical work,4 theirs was very much a minority view in the
early 1960s.
There were four key tenets in the standard view of monetary policy at the time.5
First, monetary policy was seen as just one element of macroeconomic policy, which in its
entirety has multiple objectives (high employment and output, low inflation, rapid economic
growth, external balance, etc). And it was argued that monetary, fiscal and debt management
policies should be coordinated in pursuit of these objectives. These propositions reflected a
strong focus on the short run. While there is no doubt that monetary policy and fiscal policy
both affect real variables in the short run, it was less clear at the time that the effects of
monetary policy on the demand for goods and services did not extend into the longer run.
Given its short time horizon, it was not surprising that macroeconomic analysis in the 1960s
focused on stabilizing output and employment.
Second, monetary policy on its own was viewed as not very effective. Large movements in
credit conditions or interest rates might in theory have a large economic impact, but they had
to be avoided because of harmful side effects (instrument instability, financial instability,
balance of payments repercussions, etc.). The changes in credit conditions that were feasible
had a comparatively limited effect.
Third, the credit channel was thought to be the main source of impact of monetary policy on
the economy. Conventional monetary policy instruments (open market operations, bank
reserve management, and Bank Rate changes) were said to affect credit flows by changing the
liquidity positions of financial institutions. This credit channel embodied the effects of both
the availability and the cost of borrowing. However, its overall influence was complex and
typically slow; and the impact of an easing of credit was considered to be especially weak -
"you can't push on a string."6
Fourth, a need was seen for moral suasion or formal controls on lending in difficult short-run
situations, such as balance of payments crises. The Commission recognized the defects of
such measures: arbitrary discrimination, economic distortions, and eroding effectiveness over
time. However, the general view at the time was that such controls were helpful when quick
effects were urgently needed.
2. The relationship between inflation and economic activity
In 1958, A.W. Phillips published the analysis of the relationship between wage increases and
unemployment in the United Kingdom that now bears his name, and researchers in the United
States soon found a similar relationship.7 By the early 1960s macroeconomists were regarding
4
See, for example, Friedman (1956).
5
These ideas were also to be found in similar inquiries of that time in the United Kingdom (the Radcliffe
Report) and in the United States (the Commission on Money and Credit). However, there were some
differences in the argumentation of the three reports. For example, Radcliffe was most interventionist
while Porter was the strongest advocate of market mechanisms.
6
Porter Commission Report, p. 434.
7
Phillips (1958), Samuelson and Solow (1960).
the Phillips curve as a description of a policy trade-off between inflation and unemployment.
By accepting more inflation, it seemed possible to reach a higher level of output. A seminal
study of the policy implications of the Phillips curve was in a Royal Commission Working
Paper by Grant Reuber.8 The Porter Commission accepted this line of reasoning and argued
that a balance had to be struck between the goals of price stability and maximizing output, and
that neither should be pursued to the exclusion of the other.
At the same time, however, the Commission was aware that inflation could have very
negative longer-run consequences for the economy. "The objective of stable prices..., while
desirable for its own sake, is also important as a means to a wider end.... rising prices can
weaken real economic growth by undermining the system of fixed value contracts on which
efficient business is founded, by generating a fear of long-term saving and lending
commitments, and by diverting real resources into unproductive and inefficient channels ...."9
In a similar vein, the Report rejected the argument for mild inflation to lubricate real wage
adjustment, after noting that productivity was increasing at 2 per cent a year, so that a
considerable degree of adjustment was possible without real wage declines, and that measures
to increase market flexibility were a better solution. The Report also described inflation as
acting "like a drug whose dose must be continually increased to get the same effect: if the
authorities permitted the economy to become addicted, the inevitable return to reality would
bring about very painful withdrawal adjustments."10
These passages were prescient in the light of what was to happen over the next 20 years.
However, the Report struggled to reconcile its advocacy of multiple targets with its vivid
warnings about inflation. The tension between the two, we can now see, stemmed largely
from a lack of clarity about relevant time horizons. The multiple targets approach to monetary
policy focused on the short-run trade-off between inflation and unemployment. It did not
recognize that this trade-off disappears over time as inflation expectations adjust to changes in
the rate of inflation. The idea of a vertical long-run Phillips curve, which was implied by the
adjustment of inflation expectations, was developed only later in the decade.11 At the same
time, the Report did recognize the likely damage that inflation could cause in the longer run to
the productive capacity of the economy.
In the end, the Report did not recommend the firm guideline for monetary policy that its
spirited advocacy of price stability would, in retrospect, seem to have justified.12 Despite this
ambivalence, the Commission was more far-sighted in its concerns about inflation than the
8
See Reuber (1962, 1964).
9
Porter Commission Report, pp. 399-400.
10
Porter Commission Report, p. 419.
11
The main authors were Milton Friedman (1968) and Edmund Phelps (1967).
12
The Submissions of the Bank of Canada also pointed to the importance of restraining inflation (II,
paragraph 59): "Central banks feel a particular obligation for seeing that in the consideration given to
the proper 'mix' of public policies adequate emphasis is at all times placed on price stability... being in a
position to exercise an influence on the volume of money, they must inevitably be concerned with its
value."
consensus of economists of the day, which was that the Bank of Canada had been investing
too much in fighting inflation.13
3. The scope for monetary policy under a fixed exchange rate
Canada had been on a floating exchange rate regime when the Porter Commission was
appointed in October 1961, but the government adopted a fixed exchange rate in May 1962.
Given the degree of asset substitutability between Canada and the United States, Canadian
interest rates were thereafter tightly constrained by the objective of maintaining the dollar at
the parity of 92.5 U.S. cents.14
With respect to longer-run policy objectives, as we know today, the fixed exchange rate
implied that monetary policy in Canada would be mainly determined in the United States.
However, the prevailing opinion among economists, reflected in the Porter Report, was that
Canadian monetary policy could nevertheless serve a constructive short-run purpose with
respect to the range of macroeconomic policy objectives, as long as the currency was fixed at
a reasonable value and the government had an adequate reserve of foreign exchange.
At the time, most policy-oriented economists did not draw the sharp distinction we now do
between fixed and floating exchange rate regimes. To understand this, we have to recognize
three factors. First, under Canada's floating exchange rate regime of the 1950s - which was
the only post-war experience in the industrialized world to go by - variations in the exchange
rate had been quite modest, as had the movements in Canada-U.S. interest rate differentials.
That is, in practice, the float did not appear to be very different from a fixed rate regime.
Second, with their focus on short-run output and employment, policy-makers tended to
neglect the possible inconsistency between the objective for domestic inflation and the fixed
exchange rate. Third, the theory of monetary policy in an open economy was in a fairly
rudimentary state.15 The severe constraints that a fixed exchange rate imposes even on
shortrun monetary policy choices in a world of high asset substitutability were not fully appreciated
at the time.
In the case where a conflict might materialize between domestic objectives and the fixed
exchange rate for the dollar, the Commission recommended that domestic considerations
should prevail, and that the exchange rate parity be allowed to change. But it did not reopen
the debate over the exchange rate, which had been a topic of heated political controversy
earlier in the decade. By 1964, at the time the Report was published, the view of the Canadian
authorities was very much that the fixed exchange rate system was appropriate, and that the
existing parity was in the right range.
4. Monetary policy instruments and the transmission mechanism
Both the Porter Commission and the Bank in its submissions described the transmission of
monetary policy actions in terms of their effects on credit conditions. By credit conditions
they meant "the whole range of terms and conditions affecting borrowing and lending and the
purchase and sale of financial assets."16 This would include, most importantly, interest rates,
but also standards of creditworthiness, collateral, repayment periods, and other terms and
conditions.
In general, whereas the Bank of Canada17 stressed the importance of availability effects, the
Porter Report was more inclined to give a central place to interest rates. One of the reasons
why the Bank of Canada put so much emphasis on credit availability at that time was because,
even apart from the 6 per cent bank loan rate ceiling, it believed that wide fluctuations in
interest rates were not feasible. Indeed, historical experience was of a quite narrow range of
interest rate movements. For example, the prime lending rate of the chartered banks, a key rate
in the transmission mechanism, had never been lower than 4.5 per cent, while the maximum
legal rate was 6 per cent - a range of 150 basis points. There simply had not been much scope
for borrowing costs to vary.
As outlined by the Commission and the Bank, there were a number of possible reasons for this
belief that wider movements in interest rates were not feasible: the possibility of instrument
instability (with interest rates swinging abruptly), the potential effect of sharp changes in
security prices on the stability of financial institutions, adverse public opinion, and the
external constraint posed by the fixed exchange rate. While the Commission agreed with some
of these concerns, it nonetheless argued that such considerations should not stand in the way
of a vigorous monetary policy.
The Porter Report accepted, however, the description put forward by the Bank of Canada of
the way that monetary policy affected the operation of chartered banks. The provision of cash
reserves by the Bank of Canada would bring about changes in chartered bank holdings of
liquid assets, which over time would affect the banks' willingness to make loans. However,
when quick results were deemed necessary, the Bank felt that resort to direct limits on bank
lending would be justified. On the several occasions that moral suasion had been employed in
the 1950s, it had seemed to work. The Commission showed little enthusiasm for such
intervention. It argued that controls impaired market efficiency, were discriminatory, and were
of diminishing effectiveness over time. There was also a concern about their clumsiness,
especially the delays in making instructions effective in bank branches across the country, and
possible misinterpretation of their eventual withdrawal.
Despite all that was said and done about the credit conditions approach to monetary policy,
empirically any significant effects seem to have been confined to a few brief periods of moral
suasion and the impact on residential construction of the lags in changing the administered
NHA mortgage rate and the interaction between this rate and the 6 per cent bank lending rate
ceiling. The available empirical evidence did not indicate that changes in credit conditions
systematically had much effect on aggregate demand. Econometric tests reported in the
Commission's Working Papers show no significant effects on consumption and investment
16
Bank of Canada Submissions, II, para. 11.
spending from interest rate or credit variables.18 This seems to have been because monetary
policy actions had not been very aggressive.
These results confirmed the conventional belief that ordinary monetary policy actions were
not very effective. And this was a major reason for the insistence on policy packages with the
right mix of fiscal and monetary policy, plus coordinated debt management policy, and on the
possible need for moral suasion and/or some sort of direct controls on bank lending.
5. The role of debt management
I have noted that the package of macroeconomic policies advocated during the 1960s tended
to include debt management policy along with fiscal and monetary policies. Certainly, central
bankers of the day regarded debt management policy as an integral part of macroeconomic
policy. The Porter Report had some sympathy with this notion. There were three discernible
lines of thinking here.
First, monetary policy is itself a kind of debt management with an open market operation
switching one public sector liability (central bank deposits) for another (e.g. treasury bills).
Second, changes in relative supplies of debt could affect the liquidity of the banks and hence
their willingness to lend. Third, debt management might directly alter the term structure of
interest rates.
These notions may have had greater plausibility at the time, when there were some indications
of segmented markets. But over time, market segmentation diminished in importance as both
lenders and borrowers became increasingly willing to adjust the maturity of their
commitments in response to interest rate differences across the term structure. Moreover, in
the years following the publication of the Porter Report, evidence accumulated supporting the
expectations theory of the term structure of interest rates. According to this theory, long-term
rates are the average expected value of future short-term rates, plus a liquidity risk premium.
Although in principle the latter could vary systematically as the composition of debt changes,
in practice such effects, if they exist at all, are of too short duration to have any
macroeconomic impact.
C. THE CANADIAN POLICY FRAMEWORK IN THE 1990s
1. The basic propositions
Between the 1960s and the 1990s, informed opinion about the appropriate role of central
banks shifted radically. The current mainstream view can be briefly summarized in the
following four propositions.
First, the main objective of monetary policy is to preserve the value of money, in other words
to achieve a very low rate of inflation over the long run. Other economic objectives are not
ignored, however, because price stability is the best contribution that monetary policy can
make towards high employment and, more generally, towards a prosperous, growing
economy. Second, an independent monetary policy, or, more precisely, a domestically set
objective for inflation, logically requires a floating exchange rate. Third, markets, and price
mechanisms, work efficiently and thus provide effective channels for the transmission of
monetary policy through short-term interest rates and the exchange rate. Fourth, short-term
interest rates must be adjusted as much as required to meet the monetary policy objective.
Most of the present policy framework is, I hope, reasonably familiar to you. So I will spare
you further detail. Instead, I would like to underline the magnitude of the revision that has
taken place in accepted thinking about monetary policy since the Porter Commission, and to
speculate on the reasons for the shift.
2. Contrasts in views about policy objectives
The sharpest apparent contrasts between the ideas and practices I have sketched for the two
periods concern the objectives of monetary policy. Nowadays we focus the job of the central
bank squarely on the single objective of price stability. In the 1960s, that would have been
looked upon by most observers as an extreme and partial view of the role of monetary
policy.19
What has been learned from the experience over the years is that high and variable inflation
can be very costly for the economy and that aiming at low and stable inflation is the best
contribution that monetary policy can make to achieving, over time, the multiple economic
objectives espoused by Porter. Desirable economic outcomes can never be guaranteed, but
chances of achieving them are best when inflation is low and stable. That is, low inflation is
an indispensable asset for the achievement of the other economic goals.20
Consider, for example, the accepted view during the 1960s that there was an exploitable
tradeoff between inflation and unemployment. Along with the short-term perspective of
policymakers, this view led to excessively easy monetary and fiscal policies in most industrial
countries. In Canada, we found ourselves confronted by an enormous and destructive
inflation, with peaks in the mid-1970s and the beginning of the 1980s, and another bout of
upward pressure in the late 1980s. Moreover, the high rates of inflation were accompanied by
an economic slowdown in the 1970s (reflected in the coining of the term "stagflation") and
were followed by unusually sharp economic recessions in the early 1980s and early 1990s.
The idea of an exploitable long-run trade-off between inflation and unemployment was
effectively demolished by this experience. And the lesson was reinforced by the success of the
firm stance in favour of price stability taken by the German and Japanese central banks in the
late 1970s.
19
The Bank has long had a concern about restraining inflation. What was lacking in the past was the
support from theory and experience to make that focus more precise and explicit. Public milestones in
the evolution of the Bank's views were three lectures by my predecessors: the 1966 Per Jacobsson
Lecture by Louis Rasminsky on the objectives of monetary policy and the mechanisms through which it
operates; the 1982 Per Jacobsson Lecture by Gerald Bouey, which highlighted the need for a "place to
stand" or, in other words, for a "nominal anchor"; and the 1988 Hanson Lecture of John Crow, which
singled out price stability as the objective of monetary policy in Canada. Also, I would draw attention to
Gerald Bouey's final Annual Report, for 1986, which emphasized the costs of inflation and the difficulty
of reducing it once entrenched.
20
For a fuller explanation of the relation between price stability and other economic objectives, see
Thiessen (1998-1999).
The inflation of the 1970s and early 1980s demonstrated just how costly inflation was and
how difficult it was to eradicate once rooted in expectations. These experiences were key
factors underlying the shift in views about monetary policy. They also were central to the
acceptance of the expectations-augmented Phillips curve in place of the simple Phillips curve
as part of the analytic framework underlying monetary policy.
This is not just theory or central bank ideology. As we look around the world and over history,
we see that countries that achieve high standards of living and sustained strong output growth
have also maintained low rates of inflation.
3. Understanding the role of the exchange rate in monetary policy
As I explained earlier in this lecture, when the Commission was preparing its Report, neither
the then current economic theory nor the Canadian experience of the 1950s provided strong
evidence for the crucial role that exchange rate flexibility plays in the operation of monetary
policy in an open economy like Canada's. When we floated our exchange rate in 1950 and
again in 1970, it was because we were pushed off our pegged rate by the pressures of rising
commodity prices and associated strong inflows of capital. The notion of a national monetary
policy with an independent inflation target did not feature in these decisions.
As we now see it, a floating exchange rate plays two key roles. In the first place, in the long
run a floating currency allows the central bank to pursue a national inflation target, regardless
of the behaviour of foreign inflation. In the second place, variations in the currency allow the
real exchange rate, and hence the economy, to adjust more smoothly to international shocks to
relative prices.
It was only after currency and capital controls began to be removed (or were increasingly
bypassed) in the post-war period, and domestic financial markets became more deregulated in
a number of countries, that economists came to appreciate fully the interaction of domestic
interest rates and exchange rates. In open economies with unhindered capital flows, it is only
when the real exchange rate moves to levels where it is widely expected to appreciate or
depreciate that domestic real interest rates can temporarily move away from their international
counterparts.
Furthermore, what we understand much more clearly these days is that movements in the real
exchange rate are a major part of the process whereby an economy returns to a sustainable
growth path after being hit by a shock. For example, it is well known that a drop in world
commodity prices reduces the real equilibrium value of the Canadian dollar. If this is brought
about by currency depreciation, the overall domestic price level need not deviate from its
target path. In contrast, with a fixed exchange rate, domestic prices would have to fall below
that path, and perhaps fall absolutely, to bring about the required decline in the real exchange
rate. It is clear that real exchange rate adjustment works much more smoothly when the
nominal exchange rate can adjust. However, for the benefits of exchange rate flexibility to be
realized, expectations about nominal exchange rates must be anchored by a monetary policy
that is focused on maintaining low and stable inflation over the medium term.
4. Increased confidence in the resilience and efficiency of markets
It would have been unthinkable in the 1960s to have suggested that the central bank's
influence over interest rates was, in and of itself, enough to enable it to keep the rate of
inflation low and stable. The view at the time was that there were narrow bounds on how far
interest rates could be moved, and that these severely limited what the central bank could
accomplish by varying them. As a result, moral suasion to affect bank lending policies or
direct controls were seen as important additional instruments for central banks.
A key reason for the change in attitude today is an increased confidence in markets. Certainly,
at central banks, we are more confident than we were in the 1960s of the ability of financial
markets to absorb changes in interest rates. At the same time, we have accumulated strong
evidence to support the view that market mechanisms transmit monetary policy actions
effectively.
In the 1960s the Porter Commission was ahead of the Bank, and of conventional wisdom, in
this. It envisaged a monetary system that in key respects would function much as it does today
- driven by market forces, flexible, and frequently undergoing rapid change. In its
recommendations for reform, the Commission was looking forward to a world in which
monetary policy would be increasingly reliant for its effectiveness on appropriate movements
in financial market prices.
In line with this view, the Porter Report maintained that institutions and markets were well
able to withstand substantial shocks and warned against letting the conduct of monetary policy
be excessively influenced by an undue concern for the stability of asset values. It saw that the
aversion to significant interest rate movements expressed at the time by the Bank of Canada
put at risk its ability to achieve its macroeconomic objectives. In one of its more colourful
phrases, the Report warned that "the authorities must not be restrained by excessive
tenderness."21
However, the present confidence in markets is not just a question of philosophy. Since the
1960s, a variety of legislative and structural changes have made the financial sector still more
resilient and flexible. This has made the transmission of monetary policy more efficient and
has eliminated residual concerns about the inability of the markets to cope with the effects of
central bank actions.
D. CONCLUDING REMARKS
Even though the Porter Commission had some remarkable insights, there is no doubt that
there has been a major change in views since the 1960s with respect to the objective of
monetary policy and the mechanisms through which policy works. Two factors stand out in
trying to understand the change. The first is the simple accumulation of experience that has
exposed some of the shortcomings in earlier thinking about macroeconomic policy. The
second is the advances in the analytic framework available to policy-makers to help them
analyze the workings of the economy and of monetary policy. These are not independent
factors, of course, since economic analysis does change in response to experience. In this case,
it was the inability of the previous framework to provide a satisfactory explanation of the
developments in the second half of t