. 5 a separate issue that bears on the relevance of breakeven inflation for policymaking is that tips returns depend on the overall consumer price index ( cpi ), whereas for many purposes policymakers are more interested in the behavior of core inflation, a measure of inflation that strips out volatile food and energy prices. in fact, tips returns appear sensitive to fluctuations in oil prices. as a partial fix of this problem, the breakeven inflation rates shown in figure 1 are calculated by comparing the yields of tips and so - called off - the - run securities. within a given class of securities, say treasury bonds with ten years until maturity, off - the - run securities are securities other than those most recently issued. because off - the - run securities are less liquid than newly issued ( on - the - run ) securities, they provide a more appropriate benchmark against which to compare the yields of relatively illiquid inflation - indexed bonds. as sack ( 2000 ) has pointed out, this difference in duration implies that the breakeven inflation rate may be sensitive to the expected profile of future short real rates or be affected by differences in risk premiums arising from different exposure to interest - rate risk. sack addressed the issue of differing durations of nominal securities and tips by comparing yields on tips to yields on artificial securities constructed to provide the same pattern of real payments as a tips security, thereby eliminating the differences in duration noted in the text. he found, however, that the duration mismatch is less important quantitatively than differences in liquidity between on - the - run nominal securities and tips. a number of technical issues, such as the lags in the inflation adjustment procedure, affect the relationship of breakeven inflation and expected inflation. one such potential complication arises if the tax rates applicable to the marginal tips investor and to the marginal holder of nominal government securities are not the same, in which case the equilibrium breakeven inflation level will be affected. roll ( 2004 ) discusses the effects of taxation on the breakeven inflation rate. as you can see in figure 1, breakeven inflation rates have proven surprisingly volatile over their short history. for example, when nominal treasury yields swung sharply during the spring and summer of 2003, ten - year breakeven inflation moved sharply as well, declining about 40 basis points as the bond market rallied, then rising about 80 basis points when nominal yields came back up ( top panel ). this effect was seen also in inflation compensation at the five

3 per cent. since the beginning of 2003, when our terms of trade have been strengthening, inflation has averaged 2. 6 per cent. thus, during both of these recent episodes, inflation has remained relatively close to target. this is in sharp contrast to the 1972 - 74 period, when canadian terms of trade improved dramatically as a result of steep increases in energy and other commodity prices. inflation rose sharply, spiking to more than 12 per cent in late 1974. inflation remained high and variable for quite some time after that, causing severe economic disruptions, and great difficulty for people living on fixed incomes. clearly, the monetary policy framework at the time was not robust enough to contain the inflationary consequences of rising energy and raw material prices and strong demand for commodities. the comparison of these episodes illustrates how the two key elements of our current monetary policy framework — the inflation - control target and the flexible exchange rate — work together to facilitate the adjustment to terms - of - trade shocks. to summarize : sharp changes in the terms of trade necessitate a reallocation of economic resources. that adjustment process, while always a challenge, and sometimes painful, can be helped a great deal by a coherent monetary policy framework. of course, monetary policy is only one part — albeit an important part — of the adjustment process. also of great help in facilitating economic adjustment to terms - of - trade shocks are the ingenuity of canadian business people, the diversity and resilience of the canadian economy, and the flexibility of labour and product markets. over the past three years, we've seen strong growth in capital spending in commodity - producing industries, as well as substantial gains in both capital spending and employment in sectors with low exposure to international trade. exports have continued to grow, despite the higher canadian dollar. and a surge in investment in machinery and equipment suggests that firms are, in fact, taking advantage of the stronger exchange rate ( which reduces the cost of imported machinery and equipment in canadian dollar terms ) to improve their productivity and enhance their competitiveness. there is also evidence that canadians are more mobile, making the best of work opportunities in strong growth areas such as the athabasca tar sands. indeed, it has recently been reported that air canada is introducing an " oil express " pass to facilitate the movement of labour between eastern canada and fort mcmurray, alberta. and strong economic activity in alberta is not only drawing in migrant labour from other provinces ; it is also generating large