become more efficient and productive in what we do. because potential output depends on many factors and their interaction, it is not something we can measure precisely — either in level or growth terms. but we can roughly estimate it, by analyzing the trends in those factors. at the bank, we estimate that potential output in canada is likely to rise by about 3 per cent per year over the medium term ( as shown in chart 1 ). in estimating potential output, we find the emphasis on inflation control to be particularly helpful. it helps us to avoid systematic errors in assessing potential. for example, if inflation was coming in persistently below our expectations, it would be a strong signal that production capacity was higher than our estimate, and vice versa. now, in terms of setting monetary policy, the key question is where the economy is likely to be relative to potential several quarters down the road, and how that will affect future inflation. if the economy is likely to be operating close to, or above, its capacity to produce, it is reasonable to expect that this will put upward pressure on inflation in the future ( chart 1 ). if this seemed likely to take inflation above target, the bank would tighten monetary policy ( that is, raise its key policy interest rate ) to moderate demand and head off those pressures. on the other hand, if the economy is likely to be operating below potential, then there will be downward pressure on future inflation. if it looked that this would take inflation below target, the bank would ease monetary policy to provide more room for the economy to expand. thus, the emphasis on inflation control works symmetrically. it allows the bank to take policy actions to prevent overheating, when the economy is strong and is pushing against its capacity limits, and to support growth when the economy is weak. let me now try to relate this to our recent experience in canada. if we go back to the fall of 1998, when the worldwide reverberations of the asian and russian financial crises were still very much with us, we can see from chart 2 that our economy was operating below potential. since this implied that there was a good chance future inflation would be below target, we eased monetary policy through the latter part of 1998 and the first part of 1999. our economy rebounded strongly during 1999, and expectations were that it would continue to grow robustly — above potential — for some time, bolstered by strong domestic and u. s. demand. with signs of emerging capacity pressures

money supply. but none of these methods provided a suitable medium - term anchor for inflation expectations. this made it difficult for individuals and businesses to form long - range plans with any degree of certainty. on the fiscal side, the picture was pretty grim at the start of the 1990s and getting worse. public sector deficits would eventually peak at around 8 per cent of canada ’ s gdp, and public debt levels were continuing to mount. clearly, the situation was not sustainable. adjustments were urgently needed. the first of these adjustments came in 1991, when the bank and the government of canada agreed to adopt a series of explicit inflation - control targets. the agreement called for an inflation target - defined in terms of the annual rate of increase of the consumer price index - that descended gradually to 2 per cent, the midpoint of a 1 to 3 per cent range. that initial agreement has been extended three times, with the latest agreement covering the period to the end of 2006. in each case, the midpoint of the inflation - control target range has been kept at 2 per cent. this framework has worked well - better than might have been expected. by january 1992, inflation was already close to 2 per cent, and from the end of 1994 to today, inflation has averaged almost exactly 2 per cent. moreover, not only has inflation fallen, it has become more stable. indeed, the trend of inflation - as measured by what we call core inflation - has stayed within the target range almost continuously for the past 10 years. just as importantly, we found that, after a few years of inflation targeting, the inflation expectations of canadians fell into line with the 2 per cent target. and expectations have remained close to the target in recent years. the point of all this is that we have been successful in using monetary policy to create an economic environment of low, stable, and predictable inflation. with a credible monetary policy, the whole nature of the inflation process has changed. inflation itself has become more stable and, in turn, this has led to a more stable and better - functioning economy. the second big adjustment began in earnest around the middle of the 1990s. as i said before, at that time, canada was facing an unsustainable fiscal situation. compounding this immediate fiscal problem were the looming challenges posed by our aging population. spending had to be put on a viable long - term course, and the ratio of public debt to gdp on a steady downward track. by the middle of the decade, governments