Remarks by Paul Beaudry
Deputy Governor
University of Waterloo Faculty of Arts
Distinguished Lecture in Economics
September 20, 2022
Waterloo, ON
Macroeconomics of the 2020s:
What we've learned, and what's to come
Introduction
present this year's
Good afternoon, and thank you for inviting me to
I'm honoured to be the ninth
Distinguished Lecture in Economics. lecturer to take
this stage.
I would especially like to thank Professor Francisco Gonzales for thinking of me
for today's talk. Francisco and I have known each other for almost 20 years and
have discussed many economic issues during that time. I hope that some of the
concepts I will address today-especially spillovers and the value of
coordination-will resonate with him, and with students who have had the
pleasure of taking his classes.
I'm very happy to be here in person after more than two years of
virtual and
hybrid events. COVID-19 has certainly disrupted many aspects of our lives-our
physical and mental well-being, and our ability to study and work. Unfortunately,
some of us even lost loved ones to this deadly virus.
It goes without saying that the pandemic has also had unprecedented effects on
the domestic and global economies. Never before had the entire world effectively
battened down the hatches so quickly and all at once. And never before had we
experienced the roller coaster of re-openings and closures that has taken place
we're also dealing with supply chain disruptions, war in
since March 2020. Now
that's higher than we've seen in
Ukraine and inflation decades.
When COVID-19 first hit, the Bank of Canada-and many other central banks-
took a series of actions. Some were new and innovative in response to the
situation before us. Others stemmed from the playbooks we used during other
crises. This is a key approach to policy-making: we draw from past experiences
to figure out what actions will best support the economy, keep inflation on target
and protect the well-being of households and businesses.
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Looking back now, I believe we got a lot of things right when trying to manage
the economic fallout from the pandemic. But in other areas, we could have done
better.
So today, with the benefit of hindsight, I want to talk about some early lessons we
I'll
can draw from this episode. discuss what worked, and where we could
improve our response to future downturns.1
I'll focus specifically on three issues.
The first is how international spillovers have been shaping the macroeconomic
Here I'm thinking about how countries responded
landscape. to and are
recovering from the pandemic, and how policy-makers' actions in individual
countries affected global outcomes. And I'll emphasize how cross-country
interactions played out differently during the pandemic than they did in other
recessions, such as the one that followed the 2008-09 global financial crisis
(GFC).
Second, I'd like to that we've seen in
compare the strong rebound the labour
market with the jobless recoveries that advanced economies sometimes
I'll
experienced in the past. Here stress how these differences partly reflect the
way policy shaped the evolution of public and private sector balance sheets.
Finally,
I'll look ahead to an issue on so many minds these days: inflation. Just
this morning new numbers were released. In August, inflation stood at 7%. While
we're headed in the right direction, that's still too high. Consumers and
businesses are rightfully wondering when we'll stop feeling the pinch of high
prices. And so I'll talk about the role that expectations play in driving inflation,
how central banks try to influence those expectations and what this means for
the Bank of Canada as we guide inflation back to our 2% target.
International policy spillovers
Let's start by noting that Canada has a small open economy, accounting for less
than 1.5% of global gross domestic product. We are integrated with, and
dependent on, global trade partners. So what happens elsewhere has significant
impacts on the Canadian economy.
isn't
This situation unique to Canada. Most countries are small in this sense.
Accordingly, policy-makers in individual countries often take global conditions as
given. This means they focus on making monetary and fiscal policy choices that
best serve their national interests. They may not necessarily internalize all the
spillovers those choices might impose on other countries.
Now, it's not always possible or appropriate to
act in ways that consider these
spillovers. But it's important to understand
how the policy choices of individual
countries collectively determine the overall level of global stimulus and to
consider whether that level is appropriate. Accordingly, spillovers are a regular
topic on the agendas for international forums like the G7 and G20. The
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conversations we have around those tables can help identify areas where some
degree of coordination could make all countries better off.
Of course, spillovers are complicated, and modelling and measuring them are
challenging. However, during periods when many countries are recovering from
large global shocks-like COVID-19 or the GFC-we can look at spillovers as
operating mainly through two dimensions.
The first is a real activity dimension. Stimulus in one country boosts imports of
goods and services from other countries, raising demand around the globe and
thereby supporting the recovery.
The second is the inflation dimension. It relates to how stimulus measures also
raise prices for many internationally traded goods. And during COVID-19,
unprecedented supply chain disruptions caused an additional layer of problems.
I talked earlier about how policy-makers looked back on previous crises when
navigating the pandemic. A lot of literature on policy-makers' responses to the
GFC and its aftermath focuses on the real activity dimension.
Specifically, some research proposes that slower withdrawals of fiscal stimulus
following the GFC could have made all countries better off through positive
demand spillovers. Put differently, a more gradual global withdrawal process
could have allowed each country to benefit more fully from the demand boost
trading partners' stimulus
triggered by its efforts.2 That lesson has coloured many
thinking
fiscal policy-makers' as we come out of COVID-19, with many
conversations at the international level focused on avoiding premature
withdrawals of stimulus.3
However, no two crises are created equal. A distinctive feature of the GFC was
that many sectors and countries were left facing levels of demand well below
available supply, and for extended periods of time. This excess capacity meant
that price pressures associated with stimulus measures were modest. The
inflation dimension was therefore a relatively small part of the overall story during
this period.
The COVID-19 crisis was clearly very different. Even when countries were
experiencing excess supply overall, key sectors were operating at or near
capacity limits, including many sectors that rely on internationally traded goods.
Bottlenecks occurred in these sectors because of demand surges driven by a
combination of stimulus policies, shutdowns and re-openings as well as by
consumers shifting away from services.
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Normally when demand goes up following a recession, supply responds strongly.
during the pandemic, supply couldn't keep up because of public health
But
protocols and shutdowns. This caused delays in consumers getting their hands
on goods like bicycles and furniture. So prices rose more sharply than usual.
Compared with the GFC, this resulted in a stronger response on the inflation
one country's
dimension and a weaker response on the activity dimension. So
decision to maintain stimulus disproportionately impacted others through the
effects of that stimulus on the prices of globally traded goods.
For instance, as US stimulus spread through the economy and led to a greater
demand for new vehicles, Taiwan-a key manufacturer of microchips needed to
make modern vehicles-was struggling to adapt its production processes and
facing long backlogs of orders. Instead of stimulus-induced demand leading to
more output, this bottleneck meant global automobile production stalled and
prices increased-not only in the United States, but also in Canada and around
the world.
it's
The net result was that, during the recovery phase of the pandemic, likely a
somewhat faster global withdrawal process could have made all countries better
off.
To summarize, lessons from the GFC informed key parts of the policy response
to the pandemic. However, in hindsight, policy-makers everywhere should have
been more alert to the possibility that the nature of global spillovers can change
over time. A better understanding of these dynamics and how policy actions can
ripple around the world should enable more effective global responses to future
shocks.
Labour market recoveries and balance sheets
Next, I'd like to
discuss how the labour market has recovered from the pandemic.
also
I'll talk about the role that balance sheets have played in making that
recovery stronger than recoveries following previous downturns.
The left-hand panel of Chart 1 shows how unusual the recovery phase of the
pandemic has been relative to historical experience. Despite an unprecedented
initial drop, Canadian employment took only about 20 months to return to its
prerecession peak. This is about 6 months faster than we experienced coming out of
the GFC, and at least 18 months ahead of the tepid recoveries that followed
recessions in the 1980s and 1990s. As shown in the right-hand panel, the
difference in the recoveries following COVID-19 and the GFC was even more
pronounced in the United States.
Research and history teach us a lot about the forces that made many previous
recoveries so slow. One lesson is that recessions that take a significant toll on
the financial health of businesses, financial institutions or households are often
followed by weak recoveries.4
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Chart 1: Relative to past downturns, employment in Canada and the United States
recovered quickly from the COVID-19 recession
Index: last pre-recession peak level of employment = 100, seasonally adjusted, monthly data
a. Employment in Canada Index b. Employment in the United States
Index
105 105
100 100
95 95
90 90
85 85
80 80
0 4 8 12 16 20 24 28 32 36 0 4 8 12 16 20 24 28 32 36
Months since last pre-recession peak in employment
Months since last pre-recession peak in employment
COVID-19 recession 1981-82 recession
COVID-19 recession 1981-82 recession
1990-91 recession 2001 recession
1990-92 recession 2008-09 recession 2007-09 recession
Sources: Statistics Canada, US Bureau of Labor Statistics and Bank of Canada calculations Last observation: August 2022
A good example is the United States during the GFC, when a collapse in house
prices left many indebted households and financial institutions over-leveraged or
known as a
even in negative net wealth positions. That set the scene for what's
"balance sheet
recession." During this type of recession, key parts of the private
sector are focused on rebuilding healthier balance sheets.
That rebuilding process takes time. Paying down debt and accumulating savings
may be good in the long term. But, in the short term, having many firms and
households preoccupied with these issues doesn't support strong demand and a
fast recovery. Even for economies not directly impacted by the initial underlying
shocks-like Canada during the GFC-having a trading partner caught in these
balance sheet headwinds can be a major drag.
what economists call the "paradox of
This is an example of thrift," a situation
where savings decisions that seem sensible at the individual level lead to
insufficient spending overall. In other words, too much personal savings can be a
drag on overall economic growth during recessions and recoveries.
Another example of this paradox is when the risk of unemployment rises during a
recession, leading some households to cut back on spending and focus on
building precautionary savings. This may make sense for individuals, but it takes
a toll on total spending and demand. As businesses respond to that weaker
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demand, they can even set off a self-fulfilling spiral of higher unemployment and
stronger precautionary savings incentives, worsening the initial downturn.5
easy to imagine how
It's such mechanisms could have resulted in a much deeper
downturn and slower recovery associated with COVID-19. Luckily, policy-makers
had learned from previous episodes, and their strong responses over the past
two and a half years helped prevent the unusual savings and balance sheet
dynamics that often hobble recoveries.
Fiscal policy measures clearly prevented a worse outcome. These included a
range of wage and income supports that helped preserve private sector balance
sheets and supported consumption.
Monetary policy played an important supporting role. For example, disruptions in
financial markets in early 2020 could have layered a serious financial crisis on
top of a devastating health crisis. But central banks around the world
aggressively lowered their policy rates and deployed a range of facilities that kept
markets functioning and credit flowing. And the next two years saw central banks
use forceful combinations of conventional and unconventional stimulus to support
consumption and guide their economies to strong recoveries.
As you'll see
in Chart 2, these fiscal and monetary policy measures effectively
expanded public sector balance sheets to offset pressures that would have
strained balance sheets in the private sector. Of course, such policy measures
are not without their costs or risks. And taking prudent steps to normalize
government and central bank balance sheets is important to help bring down
inflation today and ensure room to respond to future downturns. At the Bank of
Canada, this normalization is underway with our quantitative tightening program.
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Chart 2: Total government expenditures and central bank assets increased in several
advanced economies
Percentage of gross domestic product, annual data (panel a), quarterly data (panel b)
a. Total general government expenditures b. Total central bank assets
% %
%
150 80
55
50
60
100
45
40
40 50
20
35
0 0
30 2005 2008 2011 2014 2017 2020
2005 2009 2013 2017 2021
Bank of Japan (left scale)
Bank of Canada (right scale)
Canada United States
US Federal Reserve (right scale)
Euro area Japan
European Central Bank (right scale)
United Kingdom
Bank of England (right scale)
Note: For some countries, 2021 values are preliminary.
Source: International Monetary Fund Sources: Bloomberg and
via Haver Analytics Last observation: 2021 Bank of Canada calculations Last observation: 2022Q2
All told, there are encouraging lessons to be learned from the speed and scale
with which policy-makers were able to marshal stimulus measures in response to
COVID-19. This allowed the Canadian and other economies to bypass many of
the pain points that often follow recessions-setting the scene for a historic
bounce back in labour markets.
also
With many students in the audience, I'll stress that young people-
especially those who recently entered the labour market-have been key
beneficiaries of this. In past recessions, scarring effects meant that people
entering the labour market often took years to catch up to other cohorts.6
don't want to
I certainly imply that coming into the labour market over the past
few years has been easy. But the rapid recovery and abundant employment
opportunities have meant that new entrants are better positioned to find jobs that
That's
match their qualifications. helped many young people start their careers
on firm footing, which is good news for them and for our economy.
Managing expectations to tame inflation
While the previous two topics come with the benefit of hindsight, my final topic is
we're still squarely in the
something middle of-the ongoing battle to bring
inflation back to our 2% target.
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Since we introduced inflation targeting in 1991, the Bank has been largely
successful at keeping inflation low, stable and predictable. Because of this,
Canadians had grown to expect that this would remain the case. So they
generally behaved accordingly, making saving and spending decisions and
salary demands based on inflation running around 2%.
Today, that record is being seriously tested as we emerge from the first global
Russia's unprovoked invasion of
pandemic in a century and face the effects of
Ukraine. Both factors are contributing to inflation levels well above our target
while also raising short- and medium-term inflation expectations as seen in
Chart 3. Monetary policy is actively tightening to cool the economy and contain
these pressures.
Chart 3: The inflation and wage growth expectations of households and firms have
increased
Quarterly data
b. Firms (BOS and BLP)
a. Households (CSCE)
%
%
7 6
6
5
5
4
4
3
3
2
2
1
1
0 0
2018 2019 2020 2021 2022 2018 2019 2020 2021 2022
Inflation expectations: 1-year-ahead
Inflation expectations: 2-year estimate (BOS)
Wage growth expectations: 1-year estimate (BOS)
Inflation expectations: 2-year-ahead
Inflation expectations: 1-year (BLP)
Inflation expectations: 5-year-ahead
Inflation expectations: 2-year (BLP)
Wage growth expectations: 1-year-ahead
Inflation expectations: 5-year (BLP)
Note: CSCE is the Canadian Survey of Consumer Expectations, BOS is the Business Outlook Survey, and BLP is the Business Leaders' Pulse
survey.
Source: Bank of Canada Last observation: 2022Q2
Against this backdrop, a lot of discussion involves what monetary policy should
do to minimize the risk that inflation expectations will drift persistently above our
target. This is a process known as "de-anchoring," and it can be associated with
the self-fulfilling wage-price spirals that I warned against in my last speech.7 To
avoid this and bring inflation sustainably back to target, some have suggested
that policy-makers may need to engineer a substantial slowdown-or even a
recession.
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I want to address these concerns.
The best strategy for responding to high inflation-and, most importantly, for
avoiding de-anchoring-depends partly on how people form their inflation
expectations. So let me start with two very different theories of expectation
formation and what they mean for the disinflation process.
The first theory assumes that inflation expectations are backward-looking-or
what economists call
"adaptive." This means that households and businesses
base their inflation expectations on past inflation, without trying to forecast how
the future might differ from the past. Essentially, this theory says that people
don't believe anything the central bank may say about inflation until they've seen
it for themselves.
An adaptive-expectations view implies that when inflation is high, inflation
expectations will drift up, and central banks can't rely on simple communication
about future policy to bring them back down. Instead, policy-makers must
engineer a period of sufficient economic slack so that inflation falls, and these
lower inflation outcomes then feed back into lower expectations over time.
Researchers sometimes liken this to a process of earning credibility. This is
because what eventually brings realized and expected inflation sustainably back
they're
to target is policy-makers showing that willing to tolerate a sizable
downturn to get there.
The second theory is the polar opposite-that expectations are what economists
call
"rational." This theory assumes that firms and households are
forwardlooking and understand the economy and how monetary policy affects it. In
particular, businesses and households are assumed to be capable of the mental
gymnastics needed to process incoming data and assess their likely implications
for future outcomes.
view, people's understanding
Under this rational-expectations that appropriate
policy choices will eventually bring inflation back to target can help keep
expectations close to target during periods of high inflation. To achieve this
outcome, central banks must commit to an inflation target and communicate this
clearly to households and firms.
the private sector's anticipation
If the commitment is credible, then that inflation
will return to target in the long term sets off a series of price- and wage-setting
decisions. And these decisions help keep inflation in line over the short and
medium terms. This greatly reduces the need to engineer a period of significant
economic slack to get back to target on a sustainable basis.
The truth, as you can imagine, lies somewhere between these theories. History is
helpful here. For example, an extensive literature focuses on the disinflation that
Paul Volcker implemented as Chair of the US Federal Reserve in the 1980s.8 It
suggests that the associated downturns were larger than assumed with purely
rational expectations, but they were not as severe as purely adaptive
expectations would assume.
At some level, you don't need an
economist to tell you this. No one naïvely
assumes that just because inflation is high today, it will stay there. Instead,
people try their best to understand the economic environment and form
expectations based on that understanding. However, that environment is
complicated, so the mental gymnastics associated with fully rational expectations
feels understandably foreign.
In a stable environment where the central bank has established a credible track
record, as a rule of thumb the private sector can quite safely assume that
inflation will evolve close to target. Firms can then make price- and wage-setting
decisions accordingly, and that generally leads to inflation outcomes not far from
target.
This has largely been the case in Canada for decades. However, with inflation
now well above our target and its future trajectory uncertain, many firms feel less
confident applying the rule of thumb I just described. Instead, they must directly
confront the complexity of the economic environment, relying more heavily on
their own knowledge and reasoning to predict inflation outcomes.
This is where direct, effective monetary policy communication has an important
role to play-helping to guide and coordinate these difficult reasoning
as Canada's central bank is to
processes.9 An important part of our mandate
provide coherent, clear and relatable messages to those we serve. Equally
important is reaching out to hear how our policies affect everyone. We are a
public institution working on behalf of all citizens. Speaking and listening to
Canadians is at the core of building trust and accountability.
As the Governor recently put it, with so much uncertainty already out there, we
don't want monetary policy to be an additional source of uncertainty.
This is why
the Bank is committed to keeping its communications during this difficult period
clear, simple and focused on our inflation mandate. Our messages are designed
to cut through the noise and simplify the difficult problems facing price- and
wage-setters in this unusual environment.
The more effective the Bank can be in its guiding role, the greater the chance of
a soft landing-and the lower the risk of a hard landing.
Conclusion
It's time for me to conclude.
The COVID-19 pandemic has certainly brought its fair share of challenges to
Canadian households, businesses and policy-makers. While experience from
past crises has played an important role in guiding our decisions, we truly have
much more to learn.
We at the Bank will continue to listen to Canadians, analyze the situation and
grow our knowledge in order to best respond to downturns in the economy.
We will work with our international partners to continuously improve how we
respond as a group to shocks like the pandemic that have implications far
country's borders.
beyond our own
We will continue to pay close attention to how this recovery differs from others
we've experienced. This includes
keeping an eye on the health of the labour
market and on how public and private sector balance sheets evolve over time.
And, most importantly, we will continue to take whatever actions are necessary to
Canadians'
restore price stability for households and businesses and to maintain
confidence that we can deliver on our mandate of bringing inflation back to 2%.
Thank you for your time, and I look forward to our discussion.