Mr Thiessen converses on the conduct of monetary policy
in Canada under a floating exchange rate system
Speech by Mr Gordon Thiessen, Governor of the Bank of Canada, to the Canadian Society of New
York, New York, on 9 March 2000.
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The conduct of monetary policy when you live next door to a large neighbour
Both in Canada and elsewhere, much ink has been spilled over the past year on the pros and cons of
different exchange rate regimes and the implications for monetary policy.
Interest in the subject was piqued by the difficulties experienced in 1997-98 by a number of
emerging-market economies in Asia - difficulties that had a lot to do with unsustainable exchange rate
arrangements. As well, the formation of a large single currency area in Europe, just over a year ago,
focused attention on monetary unions. Canada's floating exchange rate system has itself been the
subject of debate, particularly while our economy was adjusting to the effects of falling world
commodity prices.
There have been a number of changes in exchange rate regimes recently. Several Asian countries have
abandoned their fixed exchange rate arrangements for more flexible systems. Last year, Brazil also
moved to a floating exchange rate. Conversely, Argentina was seriously debating giving up its
currency board arrangement and adopting the US dollar. And of course this past January, Ecuador
embarked on the road to "dollarization" in an effort to restore political and economic stability there.
In a world of increasingly open markets for goods and services, burgeoning international trade, and
massive global capital flows, what can we say about the appropriate exchange rate arrangements and
the scope for independent monetary policies in individual countries?
I believe that Canada is well placed to offer some useful insights, living next to a much bigger
neighbour, with whom we have forged very close economic and financial links over the years. And so
today, I would like to talk about the conduct of monetary policy in Canada under a floating exchange
rate system. I will end with a brief summary of the state of the Canadian economy.
Economic and financial links between Canada and the United States
No two other countries share as much as the United States and Canada - and I do not just mean
hockey, baseball, or the longest undefended border in the world! Let us look at some basic economic
facts.
The value of goods and services that cross the Canada-US border every year amounts to about
US$370 billion - 40% of our gross domestic product. Canada accounts for nearly one-fifth of US
international trade in goods and services, while the United States accounts for close to four-fifths of
ours.
With the Free Trade Agreement (FTA) of 1989 and the addition of Mexico in 1994 to form the North
American Free Trade Agreement (NAFTA), tariffs between Canada and the United States have been
eliminated on a large number of goods.
Financial flows between our two countries have also generally been free of controls since shortly after
the Second World War. Today, the United States accounts for two-thirds of our net international
liability position and for approximately half of all Canadian gross international assets and liabilities.
With this much economic and financial integration between our two nations, it is not surprising that
there are people who believe that Canada should be in some type of monetary union with the United
States (and perhaps Mexico) or that it should peg its currency to the US dollar.
Instead, the Canadian dollar has been floating against the US dollar for all but eight of the last 50 years
- the longest time that any industrial country has been on a floating exchange rate system. Indeed, this
coming September will be the 50th anniversary of our first move to a floating rate.
Canada's floating exchange rate regime
The main reason for choosing to float is that economic shocks affect our two countries differently.
Even when Canada and the United States are hit by the same shocks, the impact on our economies can
vary. Movements in the world prices of primary commodities are a classic example. Although the
share of primary products in total Canadian exports has fallen by nearly half since the 1970s - to about
30% - primary-producing industries are still important to us. In the United States too, the primary
sector is significant. But, unlike Canada, the United States is not a net exporter of commodities.
Indeed, it is a net importer.
So, when world commodity prices tumbled in 1997-98 in the wake of the Asian crisis, this actually
helped a vigorously expanding US economy, by reducing input costs and dampening upward pressure
on the general level of prices. In Canada, however, lower commodity prices caused a deterioration of
our terms of trade - the prices we receive for our exports relative to the prices we pay for imports.
Between mid-1997 and the end of 1998, the US terms of trade rose by about 3%, while ours fell by
close to 5%. This had a negative effect on both our national income and the profitability of our
primary sector.
When something like this happens, our floating exchange rate helps us to absorb the consequences.
This is not to say that it eliminates the effects of a decline in commodity prices. But it does cushion
them, and it facilitates the necessary adjustments in the economy.
In this instance, the external value of the Canadian dollar fell by about 12% between mid-1997 and
late-1998, reflecting a drop of some 20% over the same period in the average world price (in
US dollars) of the key primary commodities we produce. Because of this movement in our currency,
the price of these products in Canadian dollars fell by less than their world price in US dollars, thus
reducing the negative impact on our exporters of commodities. Even more important was the incentive
that the lower exchange rate provided to Canadian producers and exporters of non-commodity goods
and services to expand their sales abroad.
With the exchange rate moving in response to the commodity-price shock, the negative effects were
spread out more evenly across the economy and were less pronounced overall than they might
otherwise have been. Yes, real GDP growth slowed from 4% in 1997 to 3% in 1998. But it picked up
again to 41⁄4% in 1999. Moreover, employment has been rising, and unemployment has continued to
fall since 1997. And in response to the acceleration in economic activity and rising commodity prices,
the Canadian dollar has strengthened over the past year.
The other important characteristic of a floating exchange rate is that it allows us to have a monetary
policy that is separate from that of the United States. Typically, economists express this independence
as the ability to choose one's own national objective with respect to inflation. I do not find this to be a
particularly useful way of looking at autonomy. And I most certainly would not want to suggest that
there are serious shortcomings with the present objectives and approach of US monetary policy that
would justify pursuing a fundamentally different policy in Canada. In fact, the objectives of monetary
policy in our two countries are very similar.
Monetary policy affects the level of aggregate demand in the economy which, in turn, leads to an
ultimate effect on prices and the inflation rate. The real essence of pursuing a separate monetary policy
is having the option and the ability to respond to fluctuations in demand that are unique to our
economy. Let me give you an example from recent Canadian history. It goes back to the sharp fiscal
tightening that we had to implement in 1995 in order to turn around our large public sector deficits and
mounting indebtedness. Of course, fiscal deficits also had to be reduced in the United States during the
1990s, but the relative tightening has been much less than in Canada.
In any event, the dampening effect on aggregate demand of this dramatic change in Canadian fiscal
policy called for easier monetary conditions. As progress was made in restoring fiscal credibility, the
Bank of Canada was able to lower its policy rate during 1996-97, to levels well below the comparable
US Federal Reserve rate. Both market interest rates and the exchange rate moved down in response,
helping to stimulate foreign and domestic demand and so moderate the effects of fiscal restraint on
economic activity.
For all these reasons, a flexible exchange rate has an important role to play in an open economy like
Canada's.
Let me now turn to the framework for monetary policy that the Bank of Canada has adopted.
Inflation-control targets
The objective of Canadian monetary policy is to keep inflation low and stable. The Bank of Canada
pursues this objective by means of an explicit target for inflation control. This target has been the main
feature of our monetary order since the beginning of 1991. The current goal is to hold inflation inside
a range of 1 to 3%.
However, the Bank of Canada could not have targets for inflation control and be held accountable for
achieving them without the flexibility provided by a floating exchange rate regime.
But it is also true that a floating exchange rate system is more effective and reliable when there is a
firm commitment to targets for inflation control. And our ability to have short-term interest rates for
monetary policy purposes that are different from US rates is greater in those circumstances.
The Bank of Canada's success in meeting the targets over the past nine years has helped to increase
public confidence that inflation will stay inside the target range. And this has been true even during
periods of turbulence and relatively wide fluctuations in the external value of the Canadian dollar.
Moreover, this increased confidence in the Bank's commitment to low inflation has, in turn, helped the
operation of financial markets by providing a strong underpinning to the valuation of the Canadian
dollar.
This is a relatively new phenomenon for Canada. During the years of high inflation - the 1970s and
1980s - a depreciation of the exchange rate would, all too often, raise fears of still higher inflation,
which would then lead to further depreciation and higher interest rates.
Needless to say, it is only when expectations of inflation and of the future value of the Canadian dollar
are well anchored that an independent monetary policy is possible. For only then will movements in
the exchange rate permit adjustments in real (after-inflation) interest rates in Canada that are different
from those in the United States.
Put another way, monetary policy actions cannot bring about Canadian real interest rates that remain
below US rates for any significant length of time, unless markets have a fair amount of confidence in
Canada's commitment to prudent macroeconomic policies, and unless there is a reasonable
expectation of a real appreciation of our currency in the future.
In this context, I strongly believe that, without our inflation-targeting framework, we could not have
had interest rates in Canada generally below those in the United States, as we have in the past four
years. But I should add that neither would this have been possible without the remarkable progress
made by Canadian governments during the second half of the 1990s to reduce budget deficits and to
bring down the amount of public sector debt relative to the size of our economy (debt-to-GDP ratio).
Now, you may ask, how important can inflation-control targets really be if the United States has
consistently turned in a strong economic performance and low inflation without their benefit?
The key element here is monetary policy credibility. And credibility is not necessarily tied to inflation
targets. As US experience shows, a strong commitment to low inflation can do the job. But, where past
price performance has not been particularly favourable, inflation targets can help to strengthen
confidence in the central bank's commitment to low inflation. From the early-1970s to the
early-1990s, on average, Canada had a somewhat higher inflation rate than the United States.
Other factors that matter are the size and importance of the US economy as well as the fact that the
US dollar is the pre-eminent international reserve currency. All this incites considerable investment
interest and greater market confidence in the US dollar compared with any other currency, especially
during turbulent times. The Canadian economy, by contrast, is much smaller and more open.
Because of these considerations, we in Canada have had to affirm our commitment to a more concrete
monetary policy objective in the form of explicit inflation targets.
The importance of credible macroeconomic policies
In summary, I would suggest that our experience with a floating exchange rate system and a
"made-in-Canada" monetary policy, despite high economic and financial integration with our much
larger US neighbour, provides an interesting example for those exploring the gamut of exchange rate
and monetary policy options.
As I look at Canada's exchange rate experience over the past few decades, however, one thing is very
clear to me. And that is the importance of credible domestic macroeconomic policies. Without a sound
fiscal policy and without a strong explicit commitment to inflation control, exchange markets will not
have full confidence in the underlying value of the currency. And the ability of a flexible exchange
rate to respond to shocks and to facilitate the interest rate movements needed for an independent
monetary policy will be seriously compromised.
This in the end says it all. No exchange rate system is going to bail you out of bad economic policies.
And that is equally true of a floating exchange rate system, as it is of the alternatives - a fixed
exchange rate or indeed a monetary union, even if that monetary union is with the world's largest,
strongest economy.
In today's rapidly changing, increasingly open world economy, there is an even greater need for
flexibility than before. I believe that a flexible exchange rate regime continues to serve Canada well in
dealing with the challenges of this new economic reality.
The current economic situation in Canada
Let me finally say a few words about the current economic situation in Canada.
The Canadian economy had a good year in 1999.
Our export industries benefited from the strong US economy. And with global economic conditions
generally improved, primary commodity prices rebounded. The resulting gains in incomes and
employment in Canada led to higher levels of domestic spending. Recently revised statistics now show
stronger economic growth in Canada during 1999 than previously estimated.
And we continue to see strong momentum in our economy so far this year. Indeed, by some
calculations, we could be operating at full capacity.
However, as has been the case in the United States for some time, Canada has also recently
experienced an increased level of investment in machinery, equipment, and technology. This should
lead to improvements in productivity and in our economy's production capacity. But we cannot be
sure by how much.
In light of this uncertainty, the Bank of Canada has been concerned about our economy picking up too
much speed. There is a risk that we could hit the capacity ceiling too hard, causing supply bottlenecks
and shortages that could lead to an ongoing increase in inflation.
To reduce this risk, the Bank of Canada increased its Bank Rate twice, in November and February,
following similar rate hikes by the US Federal Reserve. The latest data indicate that the external
demand for Canadian output, especially from the United States, is stronger than previously expected.
Under these conditions, it is essential for the central bank to be vigilant.
Moreover, in view of the uncertainty about the production potential of our economy at this time of
structural change, the Bank is now monitoring a wide range of indicators for early-warning signs of
pressure on capacity and prices.
Up to now, our inflation performance has been somewhat better than we had expected. While the
increase in the total CPI over the past 12 months to January was 2.3%, our core rate of inflation
(excluding food, energy, and the effect of changes in indirect taxes), at 1.3%, remains in the bottom
half of the 1 to 3% target range.
This good inflation performance bodes well for the continued expansion of the Canadian economy.
But what remains to be seen is whether this expansion will bring with it strong productivity gains for
Canada similar to those witnessed in the United States.
One thing is clear. The job of the Bank of Canada must be to keep inflation in Canada low and stable.
Without that, we will be risking both the economic expansion and the potential productivity gains.