timothy lane : the changing face of risk in the global financial system remarks by mr timothy lane, deputy governor of the bank of canada, at the canadian pension & benefits institute, vancouver, british columbia, 19 may 2011. * * * introduction good afternoon. i would like to talk to you today about risk. i know that risk is ever - present in your work, as you fulfill your commitments to the beneficiaries and sponsors of your pension plans. important risks surround the investment performance of those plans, as well as the value of pension liabilities. all of you are, no doubt, acutely aware of these risks, which have become much more pronounced over the past few years. at the bank of canada, we also focus on risk as part of our commitment to canadians. our mandate demands that we take an economy - wide perspective on risk. in setting monetary policy to achieve our 2 per cent target for inflation, we assess the risks to the real economy and inflation. in our work promoting a stable financial system, we assess the various risks to financial stability, both in canada and globally. it is on these risks to financial stability that i would like to focus my remarks today. the global financial crisis was a watershed. during the crisis, many financial system risks materialized and new risks emerged. i will talk briefly about the pre - crisis setting – the great moderation – when risks were perceived to be diminishing. i will then discuss how this complacency was shattered, the risks that materialized and the actions being taken to address those risks. finally, i will talk about new risks that have emerged in the global financial environment, which stem from the “ two - speed ” recovery of the global economy. i would like to use this discussion today to illustrate two main points. first, the sources of risk are evolving, and continuous effort is needed to identify and track risks as they evolve. second, risk can come from unexpected sources. that means we must strive to ensure that the canadian and the global financial systems are resilient enough to withstand the impact of unexpected events. at the bank of canada, we are working on both of these fronts. the great moderation let me begin by talking about the “ great moderation. ” for much of the past quarter - century, conventional wisdom held that the global economy was becoming increasingly stable. in the advanced countries, inflation had been tamed, recessions were milder than in the past and financial stability seemed assured. ironically

too hot. we needed to raise interest rates to bring demand and supply back into balance and to cool inflation. but there ’ s more to the story. there ’ s reason to believe that, by eliminating excess demand, our actions ended up having more of an effect on inflation than is normal. 10 this idea is complicated, so — bear with me here — i ’ m going to set it up with a potatorelated anecdote. imagine you own a french fry factory. suppose one day, consumers 10 see r. asghar and m. jain, “ perceived monetary policy transmission, ” bank of canada staff working paper ( forthcoming ). - 7decide they want to start eating more french fries, so orders increase. at first, your factory can meet that demand by being more efficient. but orders keep coming in, and you need to hire more workers to keep up. labour markets are tight, which means you have to pay higher wages and charge a bit more for your fries. as time goes on, it gets more and more costly to expand your output to meet even small increases in orders. as a result, you raise your prices at a faster pace. this anecdote demonstrates that prices tend to become very responsive when the economy has a lot of excess demand. if this is happening in sectors across the economy, inflation begins to rise more rapidly. but a key feature of this responsiveness is that inflation acted in the same way on the way down as it did on the way up. the bank raised interest rates, which eliminated excess demand. as that excess demand diminished, inflation declined relatively quickly. 11 now let me show you how this phenomenon played out during the pandemic using a phillips curve. the phillips curve is what economists call the relationship between inflation and economic activity. we can see that the phillips curve was relatively flat until the middle of 2021 ( chart 3, blue dots ). 12 this means inflation never strayed too far from 2 %, regardless of the level of economic activity. 11 in the post - pandemic episode, it took just over two years to bring inflation in canada back to 2 % from its peak of 8. 1 %. this is much shorter than the average duration of disinflation of 4. 4 years in the international experience between 1990 and 2019. see a. blanco, p. ottonello and t. ranosova, “ the dynamics of large inflation surges, ” national bureau of economic research working