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Remarks by Mr Paul Jenkins, Senior Deputy Governor of the Bank of Canada, to the Canadian Association of New York, New York, 6 November 2007.
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Paul Jenkins: North America in today's global economic setting Remarks by Mr Paul Jenkins, Senior Deputy Governor of the Bank of Canada, to the Canadian Association of New York, New York, 6 November 2007. * * * Good afternoon. I'm very happy to be here today and to have the opportunity to address the Canadian Association of New York. The goals of the organization, as set out in your mission statement, are laudable ones. And I hope today to make a contribution towards your efforts "to disseminate information and knowledge relating to Canadian business". In recent months, much has been said, and written, about developments in financial markets. The turbulence in global credit markets, which had its roots in developments in the market for subprime mortgages here in the United States, has been a focal point of attention for market participants and policy-makers around the world. At the Bank of Canada, we have worked hard to understand the causes of this financial market turbulence and assess the implications. But while attention has been focused on financial markets, it's important not to lose sight of other developments and trends with implications for the real economy. So today, I want to switch the focus back on to the real side of the Canadian and U.S. economies. What I plan to do is discuss the implications of global economic trends for the evolution of the ties between our two economies. First, I want to look at how the economic links within North America have been evolving. Second, I'll talk about how trends in the global economy have been affecting those links. Then, I'll look at some of the policy implications of these evolving trends, and close with a few words about the state of the Canadian economy. Economic links within North America Let me begin by going back almost exactly 20 years to the signing of the original U.S.Canada Free Trade Agreement (FTA) in October 1987. Since this watershed event, businesses on both sides of the border have cemented the already-close economic ties that existed between our two countries. This agreement recognized the growing importance of trade for both economies. Of course, Canada does rely more on trade than the United States. But since the implementation of the FTA in January 1989, trade flows measured in constant dollars have more than tripled for both countries, and trade as a share of GDP has risen sharply. Indeed, more broadly, the volume of world trade has risen at an annual rate of 8.4 per cent since 1990, compared with an average annual rate of growth for world GDP of 3.75 per cent over the same period. It is safe to say that this tremendous growth in world trade has been far greater than anyone had expected. Given the close trade ties between our two economies, it is not surprising that there has traditionally been a rather strong correlation between economic growth rates in Canada and the United States. 1 Our economies have tended to move fairly closely together throughout economic cycles. So it's not hard to see how, for example, developments in the auto sector in the United States are felt almost immediately in Canada, or how swings in housing starts in the United States affect Canada's forest products industry. In the Bank's latest Monetary Policy Report, we noted that our base-case economic projection for the United States incorporates a 15 per cent decline in residential investment this year, and a further 11 per cent drop next year. All else being equal, our analysis suggests that this would lead to a The IMF estimates that a 1-percentage-point decline in U.S. GDP growth is associated with a decline of 0.5 percentage points in Canadian GDP. See the IMF's April 2007 World Economic Outlook, page 137. reduction in the growth of Canada's GDP of 0.4 percentage points this year and 0.3 percentage points in 2008. Following the implementation of the Free Trade Agreement, Canada began to send an increasing share of its exports to the United States. From 1990 to 2000, the percentage of Canadian goods exported to the United States rose from just under 75 per cent to just under 87 per cent. Of course, the original FTA turned into the North American Free Trade Agreement (NAFTA) with the addition of Mexico in 1994. And under NAFTA, Mexico has also increased the concentration of its exports that go to the United States, reaching a peak of about 89 per cent in the year 2000. But below the surface, the story is much more interesting and complex. While the share of Canadian and Mexican exports to the United States remains higher today than before free trade, the share of imports received by both countries from the United States is not higher. 2 Further, the year 2000 looks to have been a turning point. With the accession of China to the World Trade Organization in 2001, that country and, to a lesser extent, India started to become increasingly important global players. So the share of both Canadian and Mexican exports to the United States began to decline at about that time, while both countries began to import more from outside North America. I don't want to overstate the situation. The United States remains Canada's most important import source and export destination by far. But despite these close ties, it is clear that developments in the global economy have affected the economic links between Canada and the United States. To understand how these links are changing, it's important to understand the differences in how the structures of the U.S. and Canadian economies have been responding to recent global developments. Global cyclical and structural developments Over the past decade, we have seen a number of economic shocks that have affected the U.S. and Canadian economies differently. Why has this happened? Part of the reason has to do with the rise to prominence of economies such as China and India. Because of their size and their growing share of world output, it is their influence, rather than the U.S. economy, that is increasingly shaping the global business cycle and determining the prices of traded goods, including commodity prices. The other, related, reason why our two economies have been affected differently is, of course, the fact that commodity-price shocks result in opposite movements in the terms of trade for Canada and the United States. This means that when Canada's terms of trade have improved – that is, when Canadians receive higher prices for exports and pay lower prices for imports – the terms of trade for the U.S. economy have tended to deteriorate. And the situation has been the reverse when Canada's terms of trade have deteriorated. What this negative correlation in the terms of trade tells us is that even though the two economies are integrated, they have very different structures that, quite naturally, respond in different ways to certain shocks. Consider both the Asian crisis of 1997-98 and the events of the past five years or so, as China and India have risen to economic prominence. Both of these events have had significant implications for the economies of North America. In the case of the Asian crisis, we saw a marked slowdown in global economic growth, which resulted in a sharp decline in the prices for many of Canada's primary commodities. With Canada's share of exports to the United States rose from 72.8 per cent in 1988 to a peak of 87.1 per cent in 2002, compared with 79 per cent in the first half of 2007. Canada's share of imports from the United States rose from 65.6 per cent in 1988 to a peak of 68.2 per cent in 1998, compared with 54.5 per cent in the first half of 2007. these swings in relative prices, Canada saw its terms of trade deteriorate, while the U.S. terms of trade improved. In these circumstances, we saw a decline in the exchange rate for the Canadian dollar against the U.S. dollar. These movements sent price signals that triggered important shifts across sectors and regions of the Canadian economy. With lower commodity prices, resources flowed out of commodity-producing sectors and into sectors such as manufacturing. But over the past five years, we have seen essentially the reverse take place. There has been very vigorous global growth, accompanied by high prices for the commodities that Canada produces. As a result, Canada's terms of trade have seen a sharp improvement, while the U.S. terms of trade have deteriorated. And the Canadian dollar has appreciated against the U.S. dollar. Not surprisingly, resources have shifted back to the production of commodities where prices have risen, and away from sectors such as manufacturing. Economic data clearly illustrate the structural changes that have been brought about by the integration of China and India into the global economy and by the increasing competition coming from emerging economies more generally. Consider Canada's manufacturing sector. This sector expanded in terms of both its share of employment and its share of GDP, following the implementation of the original Free Trade Agreement. And, as I just noted, the sector expanded strongly in the wake of the Asian crisis. But since 2000, in the face of high commodity prices, a strong dollar, and rising competition from Asia, Canada's manufacturing sector has declined in terms of its shares of employment and output. 3 Policy implications So what are the implications of these developments for policy-makers? In answering that question, I want to make a general observation, and that is the importance of allowing market-based adjustment mechanisms to work in an economy. Markets send price signals that indicate the best way for resources to be allocated to the highest value-added activities. This implies that policy-makers should not try to impede or frustrate these market signals. And it implies that our economies will be best served by policies that promote flexibility – policies that allow economies to respond to price signals and to adapt to changing circumstances. Let me make three points about how policy-makers can encourage flexibility. The first thing to note is the importance of continuing to promote free trade, and resisting the siren song of protectionism. We must never forget that trade – whether in goods or services – is a positive-sum game. That is to say, in the end, all countries can be winners. But if countries yield to protectionist pressures, everyone in the international community will be worse off in the end. Moreover, protectionist actions that focus on bilateral imbalances will not reduce the size of a country's overall current account deficit. If the underlying cause of that deficit is not addressed, protectionism will only result in trade flows being diverted to other countries. But to support an open and robust global trading system, we also need to actively support a market-based international financial system. Policies that thwart market-based economic adjustments can threaten global growth and stability. That is why we at the Bank of Canada have been quite active in saying that surveillance at the International Monetary Fund should be focused on countries that are following policies that do not allow market-based adjustments to take place. The second point I want to make is the importance of sound macroeconomic policies. I'll confine my remarks here to monetary policy. Although there are differences in approach, From 1995 to 2000, the share of manufacturing employment rose from 14.3 per cent to 15.2 per cent, while the share of manufacturing output rose from 17.2 per cent to 18.8 per cent. But by 2006, those shares had declined to 12.9 per cent and 15.8 per cent, respectively. both the Bank of Canada and the U.S. Federal Reserve have inflation control as a fundamental goal, with that goal supported by a floating exchange rate. For an economy as open as Canada's, having a flexible exchange rate is a critical element in allowing it to pursue an independent monetary policy that is appropriate to its specific domestic circumstances. And by focusing on inflation control, both the Bank of Canada and the Federal Reserve are allowing changes in relative prices to send those clear signals that help the economy adjust to different circumstances. Of course, it is not easy for businesses competing in the global economy to adapt to sharp movements in exchange rates. But movements in exchange rates encourage the kinds of adjustments that are necessary in response to economic shocks. In the absence of a floating exchange rate and with limited labour market mobility between Canada and the United States, the adjustment that would otherwise take place would be significantly more costly and more difficult. The third point I want to make is the need to have structural or microeconomic policies in place that encourage flexibility and adaptability. In Canada, we have made good progress in improving the flexibility of our economy. This is evident in the way that the economy has been able to adjust to the various shocks that have come its way in recent years. Indeed, although these shocks have had different effects across sectors and regions of the country, growth in overall output and employment has remained solid, while inflation has remained low and stable, as resources have shifted to those sectors whose products have been in high demand. But this does not imply that we should not be looking to improve Canada's structural policies. There are some priority areas in this regard. Considerably more needs to be done to enhance the flexibility and functioning of our internal markets from coast to coast. Business regulations and standards, including those for the financial sector, need to be harmonized across Canada. And, to make our labour markets more flexible, trades and professional designations should be recognized and fully transferable across the country. The Trade, Investment and Labour Mobility Agreement reached between British Columbia and Alberta is an important step in that direction. But more progress of this sort is needed in Canada. Policies that support flexibility can obviously help economies adjust to economic shocks. But there is also a longer-term payoff that can come from encouraging flexibility. When policies provide the right environment for entrepreneurship to flourish, economies can adapt to longer-term global economic forces and continuously exploit their comparative advantages. Consider some of the iconic firms here in the United States, and how a company such as IBM has evolved. IBM was once primarily a manufacturer of "business machines," as its name implies. But as other countries and economies developed and became better placed to manufacture goods, IBM redefined itself and used its comparative advantage to become a "business solutions" firm, offering software, consulting, and even financing services in addition to computers. Recent economic and financial developments Let me now turn to recent developments. A little more than two weeks ago, the Bank published its Monetary Policy Report. In that document, we noted that growth in the Canadian economy has been stronger than projected, supported by the robust global economic expansion and strong commodity prices. Canada's economy is now operating further above its production potential than had been previously expected. We also noted three major and related developments since the summer that have affected the outlook for the Canadian economy. First, the Canadian dollar has appreciated sharply. In the Report, we noted that while the dollar has been supported by firm commodity prices, and strong domestic demand, the magnitude of the recent appreciation appears to be stronger than historical experience would have suggested. The second major development affecting the Canadian outlook is the weakening of prospects for the U.S. economy, and the third is a tightening of credit conditions. Despite these tighter credit conditions, the momentum of domestic demand in Canada is expected to remain strong. But the combined effect of a weaker U.S. outlook and a higher assumed level for the Canadian dollar implies that net exports will exert a significant drag on the Canadian economy. Given these developments, the Bank revised its projection for growth. We now project Canada's gross domestic product to grow by 2.6 per cent in 2007, 2.3 per cent in 2008, and 2.5 per cent in 2009. With the economy moving back towards balance, and with the direct effect of the stronger Canadian dollar on consumer prices, core inflation is projected to gradually decline to 2 per cent in the second half of 2008. Total CPI inflation is expected to peak at about 3 per cent later this year and then move back down to the 2 per cent target in the second half of 2008. 4 But there are a number of upside and downside risks to the Bank's inflation projection. The main upside risk is that excess demand in the Canadian economy could persist longer than projected. The main downside risk is that output and inflation could be lower if the average level of the Canadian dollar were to be persistently higher than the 98 cents U.S. level that we assumed in the Report, for reasons not associated with demand for Canadian products. Given recent information, both the upside and downside risks appear to be greater than they were when we completed the Report. In the Report, we said that after considering all factors, we judge that the risks to the Bank's inflation projection are roughly balanced, with perhaps a slight tilt to the downside. And we also said that we judge, at this time, that the current level of the target for the overnight rate is consistent with achieving the inflation target over the medium term. Conclusion Let me conclude. The Canadian and U.S. economies remain highly integrated, and there is every indication that our economic ties will remain strong. But developments in the global economy and the growing prominence of emerging economies have important implications for policy-makers on both sides of the border. Indeed, while our economies are highly integrated, they have different structures, and they respond differently to shocks that are increasingly global in either nature or origin. So, it is important that policy-makers heighten their focus on the need to promote and enhance flexibility. Our economies must be able to adjust to changing circumstances. If we are successful in this effort, not only will both the Canadian and U.S. economies be able to deal with economic shocks, but we will also be able to sustain strong economic performance in North America. And that is the best outcome for Canadians and Americans alike. The projection for total CPI excludes the impact of the recently announced one-percentage-point cut in the federal GST, which would be effective 1 January 2008.
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Remarks by Mr Pierre Duguay, Deputy Governor of the Bank of Canada, to CFA Quebec, Quebec City, Quebec, 20 November 2007.
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Pierre Duguay: Managing risks to financial system stability Remarks by Mr Pierre Duguay, Deputy Governor of the Bank of Canada, to CFA Quebec, Quebec City, Quebec, 20 November 2007. * * * Good afternoon. I'm very pleased to be here today. When I was offered the opportunity to speak to you, early this year, I thought this would be the perfect occasion to promote the Bank of Canada's work on financial system stability, to share our assessment of some of the risks and vulnerabilities facing the system, and to underscore the necessity of striving continuously to identify emerging risks, to understand the possible consequences, and to implement measures to contain the impact, should they materialize. The recent dislocations in credit markets have brought these issues into sharp focus. Among other things, the market turbulence has highlighted the critical role that confidence and liquidity play in financial markets. Confidence in the ability of the financial system to withstand shocks is essential if savers are to be encouraged to put their money into investments, and liquidity is a prerequisite to trade and price discovery in financial markets. The recent events also drove home the fact that shocks never materialize in quite the manner that we expect. Certainly, many of the individual sources of the recent turbulence in global financial markets had been apparent for some time, prompting warnings from numerous stakeholders, including the Bank of Canada. Among the concerns expressed was a fear that, in their quest for higher yields, global investors might have underpriced risk and rushed into products whose complexity made it extremely difficult for them to judge the risk exposure they were assuming. But while these key sources of vulnerability had been correctly identified, no one anticipated the extent of the strains that developed in the interbank money markets. With this as background, I'd like to explore a few of these issues from the Bank of Canada's perspective. I've organized my thoughts around five general questions. First: Just what do we mean by financial system stability, and why does it matter? Second: What is the Bank of Canada doing to foster stability? Third: What lessons are we learning from the recent turbulence? Fourth: What is being done at home and at the international level? And fifth: What can you, as chartered financial analysts, do to help? I will then close with a few words about Canada's current economic situation. Promoting financial system stability To begin, let me focus on what I mean by financial system stability and why it matters. The financial system is composed of financial institutions such as banks, caisses populaires, pension funds, and insurance companies; financial markets such as debt and equity markets; and settlement arrangements such as the payments and securities settlements systems. The financial system provides the channels through which savings become investments, money and financial claims are transferred and settled, and, ultimately, risk is allocated. A key role of the financial system is to provide insurance against adverse economic outcomes by allocating risk to those who are most willing and most able to bear it. The result is a more effective allocation of capital which, in turn, can contribute to more productivityenhancing investments and improved living standards. But for the financial system to perform this important role, households and firms must have confidence in its ability to withstand shocks. This is a crucial point, because problems in one area of the system can quickly spread, as recent events have vividly demonstrated. Thus, to help the financial system perform its role efficiently, public authorities and market participants themselves put a great deal of effort into finding ways to strengthen the system. And since shocks can never be fully anticipated in advance, we must strengthen the shock absorbers in the system, while still allowing room for innovation. This involves such elements as a secure system for large-value payments, deposit insurance, bankruptcy laws, central bank provision of liquidity, and sound risk-management practices, including capital cushions and prudential regulation. Let me be very clear, the goal of these shock absorbers is not to prevent losses, but to absorb them without impairing the effective functioning of credit markets and the financial system in general. And because the best levees can break down in a hurricane, we need strong crisis management that will mitigate the fallout from financial shocks without weakening the incentives for prevention of such breakdowns. One method that is increasingly being used to gauge the robustness of the financial system is the conduct of simulations to identify vulnerabilities to extreme shocks. Such stress testing of the Canadian financial system was undertaken recently through the International Monetary Fund's Financial Sector Assessment Program. The Bank of Canada used its models to design a macroeconomic scenario involving a disorderly resolution of global imbalances and to assess the possible impact on corporate default probabilities by sector. Major Canadian banks were then asked to estimate the losses they might incur under such a scenario, and their results were assessed by the central bank, the Office of the Superintendent of Financial Institutions (OSFI), and the IMF against results obtained from their own less complex models. The results generated by sophisticated internal models used by banks were broadly in line with those generated by the Bank of Canada and the Fund. They showed that major Canadian banks have enough capital to withstand a severe macroeconomic shock. This is useful information, but such simulations do not tell the whole story. For instance, they ignore important feedback from market participants. Factoring these effects is no easy task, but it is a prerequisite to a full assessment of risk in the financial system. This is an active area of research at central banks, including the Bank of Canada, as well as at international organizations such as the IMF. The Bank of Canada's contribution Now, let me talk more specifically about the Bank of Canada's role in helping to maintain a robust financial system, the second of my five points. Promoting financial system stability is a common goal for a number of public and private sector bodies, both nationally and internationally. In Canada, the public sector responsibility is shared among a number of agencies including the central bank, the Department of Finance, OSFI, the Canada Deposit Insurance Corporation, Quebec's Autorité des marchés financiers, and provincial securities commissions. As Canada's central bank, our key functions in the area of financial system stability are to provide liquidity to facilitate the settlement of financial transactions and to ensure that the risks of a systemic disruption in the payments and settlements systems are virtually eliminated. The Bank also contributes to financial stability by providing an environment of low, stable, and predictable inflation through monetary policy. We use our key position at the centre of Canada's financial system, our membership in international bodies – such as the International Monetary Fund (IMF), the Bank for International Settlements, and the Financial Stability Forum – and our extensive research capabilities to foster the safety, soundness, and efficiency of the financial system in Canada and internationally. For example, the Bank has been an active promoter of improved transparency in domestic markets and of IMF reform – including strengthened IMF surveillance – internationally. The promotion of financial system stability is complementary to our conduct of monetary policy in two ways: First, because monetary policy works through financial markets; and second, because financial turbulence may affect aggregate demand and require a monetary policy response. For example, a reassessment of default risk that increases risk premiums and results in tighter credit conditions may require a lower policy rate than would have otherwise been the case. We communicate our research and analysis of trends and developments in the financial system, including policy and infrastructure developments, as well as our assessment of systemic risks and vulnerabilities, in our semi-annual Financial System Review (FSR). The next issue of the FSR will be published on 6 December and will examine, among other things, recent developments in the market for asset-backed commercial paper, as well as the current debate around credit-rating agencies. The FSR will be available on our website on that date. Lessons from the events of last summer That's a quick overview of the work that we do to strengthen financial system stability. Now, let me go on to the third question that I raised in my introduction, which relates to the lessons we've learned from this year's turbulence in global financial markets. While the turbulence is not over, it is not too early to begin to probe its causes and effects and start to draw lessons as to how we can strengthen the ability of the financial system to deal with stress. The recent turbulence was triggered by greater-than-expected losses on U.S. subprime mortgages, which unexpectedly spread around the world because these mortgage loans were re-packaged into opaque structured products funded, in many cases, by short-term asset-backed commercial paper. Liquidity evaporated in the market for structured products as investors shunned them. A flight to the safety and liquidity of government securities ensued, and credit spreads increased. Many commercial banks were affected, with the impact coming from such sources as their direct holdings of these structures, their commitments to provide funding to conduits, their difficulty in securitizing loans, and the fact that companies began to fall back on their bank lines of credit. At the same time, many banks became reluctant to make loans to one another because of uncertainties around counterparty risk and about their own future funding needs. The effect was to increase the cost and reduce the availability of credit, both in Canada and globally. In Canada, the ABCP problem took on a unique characteristic since non-bank sponsors had issued paper with restrictions on the back-up lines of credit which prevented their access to these lines. This prompted a call for a standstill (known as the Montreal Proposal) to effect an orderly workout for most of these ABCP conduits. The standstill period has been extended to 14 December and it has been reported that progress is being made in the negotiations to convert short-term paper into medium-term tradable financial instruments. Although some dislocation continues, it appears that the financial system has thus far weathered the turbulence reasonably well. Canadian and global banks have had large enough capital cushions to withstand the shock and support an expansion of their balance sheets. Canadian banks have been able to issue medium-term paper and capital-eligible subordinated debt to meet existing and future funding needs. However, it is clear that there is now a greater awareness of risk – an awareness that was slow in developing, despite numerous warnings of the possibility of a sudden repricing of risk in credit markets. And this repricing is being hampered by a lack of liquidity in markets for some structured products because of the complexity and opacity of these new products. In a sense, we are witnessing the growing pains of an immature segment of the market, a segment that did not exist five to seven years ago. So, there are lessons to be learned and corrections to be made. Most of the corrections will undoubtedly be driven by market participants themselves, who will seek greater disclosure and greater standardization of structured products, and who will adopt stronger risk-management practices, including lesser reliance on credit ratings. The recent market events have made crystal clear just how crucial disclosure is to financial markets. To operate efficiently, markets need information. At the heart of the summer's market turbulence were structured products that were so complex and opaque that even some sophisticated investors couldn't understand exactly what they were buying. This lack of transparency led to a breakdown when investors started to question the value of the assets backing the securities that they owned. So, it is in the interest of market participants to make sure that all parties to a transaction have access to all the necessary information. Investors must demand greater transparency where it is now lacking. Vendors of financial instruments will then need to structure them in such a way that market players can clearly see what they are buying and what leverage is embedded in the instrument. In this way, market discipline will be more effectively exercised. Credit-rating agencies can help with this by being more forthcoming about the assumptions on which they based their ratings, and by adjusting their ratings promptly when circumstances require. The role credit-rating agencies played in the recent market turmoil has generated a great deal of debate. Bank of Canada research to be published in next month's FSR notes that there are some natural self-correcting market forces at work, which should help to ensure that rating agencies improve their rating process in the future. There may still be a useful role for regulators in fostering an industry-led code of conduct and in reconsidering the role that ratings play in various regulations. But they should avoid any knee-jerk response to calls for stricter regulations for rating agencies. Allowing market forces to chart the route to the desired outcome is generally preferable to burdensome regulation, which may have the unintended consequence of absolving the regulated entity from responsibility for its ratings. One important lesson from recent developments is just how vital liquidity is in a marketbased financial system. We saw very clearly this summer how banks may be called upon to fill the gap by providing credit when there is a sudden erosion of market liquidity. This is because only banking institutions, including credit unions and caisses populaires centrals, can provide liquidity throughout the financial system, since only these institutions have direct access to the ultimate source of liquidity: the central bank. But the modern financial system has evolved in such a way that, today, financing is increasingly done through securities markets. And the recent turbulence has shown that sudden re-intermediation when liquidity dries up can have implications that had not been anticipated. The provision of liquidity through regular operations – the Bank of Canada's standing liquidity facility to direct clearers, our supply of settlement balances in the Large Value Transfer System, and our open-market buyback operations with primary dealers – has been effective in keeping the overnight rate close to target. However, liquidity further out the maturity spectrum was more problematic, owing in part to the precautionary build-up of liquidity by financial institutions. This raises the question of whether some market failures might be better dealt with if the central bank had a facility that would provide liquidity at terms longer than overnight, collateralized with a possibly wider range of securities. The types of market failure that such a facility would be designed to deal with would obviously need to be very carefully considered to avoid weakening the incentive for preventative risk and liquidity management by market participants. That being said, it is the case although term money market spreads remain wider than usual, they have narrowed considerably, and the market is functioning. Indeed, liquidity has returned in the market for bankers' acceptances. What is happening abroad? Since the recent market turbulence has been felt around much of the globe, you won't be surprised to hear that the issues that I've highlighted thus far are being actively discussed at a global level. And this brings me to my fourth point, which is the international perspective. The global community – market participants, regulators, and policy-makers alike – are all examining the causes and effects of this summer's events and attempting to distil lessons from them. Important work has already begun through a number of international bodies, including the Financial Stability Forum (FSF). The FSF has been asked by the G-7 finance ministers and central bank governors to establish a working group to identify weaknesses that merit attention from policy-makers, and to recommend actions to enhance market discipline and institutional resilience. The working group, which includes Canada's Superintendent of Financial Institutions, is looking into a number of issues. First is the financial institutions risk management practices including liquidity management, stress testing, and assessment of counterparty risk. Second, the FSF group is also probing valuation and risk disclosures, including the role of credit-rating agencies. Third, it is re-examining the principles and practices of prudential oversight, particularly with respect to off-balance-sheet exposures. And fourth, it is exploring issues related to the authorities' capacity to respond to market turbulence, including the tools available to central banks and supervisors in times of distress. Numerous other bodies – IOSCO, the Basle Committee on Banking Supervision, the OECD, BIS, the G-20, and the IMF – are also addressing many of these issues. Market participants, including financial institutions, hedge funds, and rating agencies are also assessing the need for changes in light of recent events. For example, the Institute of International Finance has established a committee to review a host of issues, including risk management, the use of off-balance-sheet vehicles, the valuation of complex products, and transparency. What can CFAs do? To this point, I've talked about the efforts that are being made at the institutional and international levels to understand the reasons behind the recent market turbulence and draw lessons for the future. Now, for my fifth and final question, I'll turn to you, my audience, and ask: What can chartered financial analysts do to help? As I said earlier, disclosure is a very important principle in financial markets, one that seems to have been lost in the period leading to the latest turbulence in credit markets. But effective disclosure goes beyond making information available. It involves ensuring that the information is understood by investors. This is an area where you can play an important role. Investors must demand greater transparency where it is now lacking, and credit-rating agencies will have to be more forthcoming about the basis on which their ratings are assigned. But all of you, as investment professionals, have a special responsibility for diligent research and for helping your clients understand the nature of their investments. I'm glad to see that this is reflected in the CFA code of conduct, which requires that members: "use reasonable care and exercise independent professional judgment when conducting investment analysis, making investment recommendations, taking investment actions, and engaging in other professional activities." The Canadian economy Let me now say a few words about what we economists call the "real side" of the economy. The recent turbulence in global financial markets has occurred at a time of robust global economic expansion and strong commodity prices. In the context of ongoing global developments, the Bank has identified several important issues and increased associated downside risks that currently face the Canadian economy. The marked volatility and sharp appreciation of the Canadian dollar warrant particular attention. Indeed, the volatility we have seen in foreign exchange markets has been extremely high and the magnitude of the recent appreciation of the Canadian dollar has been stronger than historical experience would have suggested. The weakening of prospects for the U.S. economy is another issue. At the same time, the Canadian economy is operating above its production capacity and the momentum in domestic demand has been strong in spite of the tightening of credit conditions that has occurred in the wake of recent financial market turbulence. As always, we at the Bank of Canada will be considering all the accumulated information on trends and developments in the global and Canadian economies, and their implications for the outlook for inflation in Canada, as we sit down to make our decision for the 4 December fixed announcement date. Conclusion Let me conclude. The financial market dislocation that arose in the summer from the reassessment of credit risk has yet to fully run its course. But it seems that, so far, Canada has come through the recent turbulence reasonably well. There has been some tightening of credit conditions, but it appears that Canadian companies and Canadian banks are in a strong position to withstand the turmoil. Still, there are important lessons to be learned in terms of how we can continue to strengthen the resilience of our financial system. For our part, we at the Bank of Canada will carefully examine how liquidity is supplied to the economy. We will continue to do research to understand financial system mechanisms and developments so as to increase our ability to identify risks. And we will work with our partners to implement preventative measures. I am confident that you will do your part, too.
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Opening statement by Mr David Dodge, Governor of the Bank of Canada, to the Standing Senate Committee on Banking, Trade and Commerce, Ottawa, 6 December 2007.
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David Dodge: Economic outlook and recent developments in Canada Opening statement by Mr David Dodge, Governor of the Bank of Canada, to the Standing Senate Committee on Banking, Trade and Commerce, Ottawa, 6 December 2007. * * * Good morning, Mr. Chairman and committee members. Let me start by saying how much I have appreciated our semi-annual meetings with this committee over the past seven years. The discussions that Paul and I have had with you have been very valuable for the Bank of Canada. I hope that you have found them equally useful and that these regular appearances will continue long after I have left the Bank. Today's meeting comes just a couple of hours after we published the latest edition of our Financial System Review. But it has been quite some time since we issued our October Monetary Policy Report. Nevertheless, I want to begin with the economic outlook as we saw it in October. I will then talk about developments since that time and our current assessment of the risks to the outlook. The Bank's outlook from October is summarized in Tables 1 to 3 of the Monetary Policy Report. In October, we saw strong global economic growth continuing in 2008 and 2009, although we foresaw considerably weaker U.S. growth in 2008 than had previously been the case. The global outlook is summarized in Table 1. In Canada, we were looking for weaker economic growth in the fourth quarter of this year and the first half of 2008, but some strengthening thereafter. As you can see from Table 2, we were expecting continued strong final domestic demand throughout the projection period, but considerably weaker net exports. This outlook reflected weaker U.S. growth and a stronger Canadian dollar, which was assumed to average 98 cents U.S. over the projection period. Inflation was expected to peak in the fourth quarter of this year before returning to the 2 per cent target around the middle of 2008, as you can see from Table 3. Against this background, we left the target for the overnight rate unchanged at 4 1/2 per cent on 16 October, and judged the risks to our outlook to be roughly balanced with perhaps a slight tilt to the downside. Now, let me turn to developments since October. The Canadian economy continues to operate above its production capacity. Given the strength of domestic demand and weak productivity growth, there continue to be upside risks to the Bank's inflation projection. However, other developments since October suggest that the downside risks to the Bank's inflation projection have increased. Difficulties in global financial markets, related to the valuation of structured products and anticipated losses on U.S. subprime mortgages, have worsened since mid-October. These difficulties are expected to persist for a longer period of time than previously thought. In these circumstances, bank funding costs have increased globally and in Canada, and credit conditions have tightened further. There is an increased risk to the prospects for demand for Canadian exports since the outlook for the U.S. economy – particularly, the U.S. housing sector – has weakened. All these factors considered, the Bank judges that there has been a shift to the downside in the balance of risks around its October projection for inflation through 2009. In light of this shift, the Bank decided to lower the target for the overnight rate at our fixed announcement date on Tuesday. At our next interest rate decision in January, we will assess all economic and financial developments and the balance of risks, and have a full updated projection for the economy and inflation in the Monetary Policy Report Update, to be published on 24 January 2008. Mr. Chairman, Paul and I will now be happy to answer your questions.
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Remarks by Mr David Dodge, Governor of the Bank of Canada, to the Canadian Club of Toronto and the Empire Club of Canada, Toronto, Ontario, 10 December 2007.
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David Dodge: Reflections on developments in the Canadian financial system Remarks by Mr David Dodge, Governor of the Bank of Canada, to the Canadian Club of Toronto and the Empire Club of Canada, Toronto, Ontario, 10 December 2007. * * * I'm happy to be here in my home town of Toronto to deliver my final public speech as Governor of the Bank of Canada. Nearly seven years ago, I gave my first public speech in Toronto, so it is fitting that I should be here for my last. It has become a tradition that I deliver a speech late in the year on issues related to the financial system. When I say "financial system," I mean financial institutions and markets, together with the clearing and settlement systems through which financial assets flow. This tradition of speaking about the financial system began in 2004 with a speech I gave to a joint meeting of the Empire and Canadian Clubs about the need to promote economic efficiency in Canada. You may be asking why the Bank of Canada, with its well-known responsibility for monetary policy, would put such emphasis on financial system issues. The answer is that the two are tightly linked. We care a great deal about the financial system because a serious disruption in it would affect our ability to conduct monetary policy, and because increasing the efficiency of the financial system can increase the effectiveness of our monetary policy. At the same time, contributing to a stable economy through sound monetary policy helps reduce the risk of instability in the financial system. I'll talk about monetary policy a bit later. But first, I want to look back over the past seven years – in particular, the past seven months – and discuss some of the developments that we have seen in terms of financial system issues. To begin, I will give a brief overview of the Bank's role in the financial system, and review some of the issues I've raised in the past few years. Then, I will discuss the dislocations in financial markets that began during the summer, and talk about how problems related to information contributed to the market turbulence. Finally, I'll look at the effects that these events continue to have, both on financial markets and on the outlook for the Canadian economy. The Bank and the financial system One reason for giving these financial system speeches near year-end is so that they coincide with the publication of the December edition of the Bank's Financial System Review (FSR). The purpose of my previous speeches was the same as the Bank's purpose in publishing the FSR; that is, to improve public understanding of financial system developments and trends, to point out potential vulnerabilities in the system, to highlight some of the Bank's research, and to promote discussion of financial system issues in general. Ultimately, the goal is to help provide the context that will lead to stronger financial system policies in Canada. The latest issue of the FSR was published last week, and it deals extensively with the market turbulence that began during the summer. The Bank actively works to promote a financial system that is both stable and efficient. I've already mentioned that financial instability can impair the Bank's ability to conduct monetary policy. But most importantly, a stable financial system is crucial for an economy to function well. In Canada, the responsibility for promoting financial stability is shared by a number of agencies. Our partners include the Department of Finance, the Office of the Superintendent of Financial Institutions, the Canada Deposit Insurance Corporation, and provincial regulators and securities commissions. The Bank is also the ultimate provider of liquidity to facilitate the settlement of financial transactions and is the lender of last resort for financial institutions. Despite the importance of financial system efficiency, there is no single body responsible for promoting it. What do I mean when I say "efficiency"? An efficient system is one where scarce economic resources can be allocated to the most productive uses in a cost-effective way. In an efficient financial system, investors can get the highest risk-adjusted returns on their investments, and borrowers can minimize the costs of raising capital. Inefficiencies can stunt investment and cut into economic growth. The Bank of Canada contributes to financial system efficiency through our monetary policy, which keeps inflation low, stable, and predictable. We also have a legislated role to oversee Canada's most important clearing and settlement systems. These systems have been designed to provide certainty that large-value payments or securities transactions will settle in real time, while using relatively small amounts of liquidity. This frees up resources that can be put to better use elsewhere. Over the past four years, I have tried to highlight some important efficiency issues for Canada. In 2004, 1 I spoke of the need to promote efficiency in our financial institutions, arguing that our policy framework should provide greater incentives for innovation by encouraging competition while, at the same time, giving our financial institutions the scope to improve efficiency. There remains much work to do to encourage innovation, competition, and efficiency. I also spoke about the need to improve Canada's securities regulation so as to have uniform laws and regulations, based on principles that apply to everyone, but tailored to take into account the differing size and complexity of firms. There has not been as much progress here as I would have hoped. So, Canada remains at risk of seeing its capital markets eroded as business migrates to other financial centres. I've also talked about the need to improve enforcement in securities markets, because markets work more efficiently when they operate under clear, transparent, and reasonable rules and principles, which are enforced and are seen by all as being enforced. Some progress has been made here, and I welcome the commitment of the RCMP to improve and to implement many of the recommendations set out by Nick Le Pan in his report last week. However, much better co-operation and coordination of efforts among securities commissions, law-enforcement agencies, Crown prosecutors, and ministers of justice and attorneys general is absolutely crucial. Another efficiency issue I've raised is the need to strengthen Canada's regulatory, legal, and accounting frameworks related to private defined-benefit pensions, so that risks are dealt with in an appropriate way. 2 Pension funds can generate important gains in terms of economic efficiency. They help to achieve a more efficient allocation of savings; they are invested by asset managers who have the incentive and the ability to invest across varied asset classes; and, with their very long investment horizons, pension funds can be used to finance long-term investment projects at competitive rates of return. Reviews of pension regulations are under way at both the provincial and federal levels. If we can collectively get these changes right, sponsors would have the appropriate incentives needed to manage risk effectively, thus enhancing the viability of our system of private, voluntary defined-benefit pensions for the good of Canadian workers and firms, and for the benefit of our capital markets. These issues are critical for Canada's future economic prospects. The role of the Bank of Canada has been to do the research and provide the analysis to inform public policy in these areas. I am confident that this work will continue at the Bank in the years ahead. It is up to David Dodge, "Financial System Efficiency: A Canadian Imperative," (Bank of Canada, 2004). David Dodge, "Economic and Financial Efficiency: The Importance of Pension Plans," (Bank of Canada, 2005). the responsible authorities to act on these research findings, and to move these issues forward. At the heart of many of the issues that I've just mentioned are problems related to information. Indeed, one of the key lessons of the past seven months is how information asymmetries can lead to, or exacerbate, disruptions in financial markets. So let me now turn to a discussion of these recent events, and look at how problems with information contributed to the market turbulence. Market dislocations and the role of information To truly understand these events, it's important to have some context. You can find a detailed account of recent events in the December issue of the FSR. The turbulence in financial markets came about against a backdrop of remarkable strength in the global economy. We had seen continuing robust demand for Canadian goods and services that led to a significant improvement in our terms of trade, helping to support the Canadian dollar. Despite this positive backdrop, there were signs of potential trouble in the global economy. As early as 2003, the Bank had flagged concerns about global imbalances. 3 The high level of global desired savings relative to desired investment naturally served to drive down real longer-term interest rates, even as central banks around the world were in the process of raising short-term policy rates. With the decline in longer-term interest rates, investors stepped up their demand for riskier assets that would deliver greater returns. This search for yield led to a narrowing of spreads between the yields on risky assets and government bonds. This narrowing of risky spreads became so pronounced and so persistent that many central banks began to question whether they adequately reflected the credit risks that were involved. In fact, the Bank of Canada highlighted this precise concern as far back as our June 2004 issue of the FSR. 4 A repricing of risk appeared necessary, but the real question was how, and in what manner, it would take place. Besides the need for a repricing of risk, other factors have contributed to the market turbulence that began this summer. Originators of loans – both bank and non-bank institutions – were increasingly opting to securitize the loans they made in the form of highly structured asset-backed securities, some of which embedded very significant leverage. These were often sold in tranches that provided varying degrees of protection from the default risk involved. Such structures allowed higher-risk assets to appear to take on the qualities of lower-risk assets. The increased use of leveraged structured products was pioneered in major financial centres such as New York and London, although eventually, non-bank institutions began to market these products elsewhere, including here in Canada. The ease with which these highly structured products were sold fuelled the demand for the creation of higher-risk assets, including U.S. subprime-mortgage loans. This, in turn, contributed to the global decline in lending standards. At times, the originators of these loans had fewer incentives to carefully assess the creditworthiness of borrowers. This is because the originators were sometimes distributing all of the loans they had made. In these circumstances, once the loans had been securitized and sold, the originator no longer faced the consequence if the borrower defaulted. I'll return to this point a bit later. But for now, suffice it to say that the decline in standards for loan origination, combined with financial engineering, was helping to spur greater lending. David Dodge, "Past Adjustments and Future Trends in the Canadian Economy," (Bank of Canada, 2003). Bank of Canada: "Financial System Review" (June 2004), p.4. The process of securitization is not new. Securities backed by mortgages, credit card receivables, or other types of assets, have been around for years. Indeed, the development of a market for "plain vanilla" asset-backed securities was important since it allowed for the expansion of credit through the market. Initially, this market developed in a reasonably transparent way, in that the nature of, and risks associated with, the underlying assets were clear. Here in Canada, for example, an investor could know with certainty that the mortgages backing securities met the lending standards set by Canada Mortgage and Housing Corporation, or that the loans backing a security were of high enough credit quality that a bank or a retailer was prepared to stake its reputation on the securities. These plain-vanilla asset-backed securities continue to exist and remain an important source of high-quality market-based financing. But more recently, we have seen the emergence of increasingly complex structured products, which were developed in response to the demand for higher returns. And as these securities have become more complex and opaque, in many cases, it has become harder to assemble and understand all the information needed to determine what kinds of assets are backing the security, the quality of those assets, and the counterparty risk involved. A final point here has to do with how these complex securities are valued. Trading of these securities in secondary markets is rare. Thus, prices for these securities are not very transparent. Most of these highly structured securities are valued on a "marked-to-model" basis, meaning that statistical models are used to provide values. But the models typically provide only estimates of values, and these estimates can vary widely if there are changes in the underlying assumptions. Indeed, many of the models assume that the assets backing these securities can be readily traded in a liquid secondary market – an assumption that is clearly not always valid. So it becomes extremely difficult to put a firm value on a particular security at any given time. So, we can now see that many factors made credit markets vulnerable to the recent dislocations. The repricing of risk I mentioned earlier was, in fact, under way before August. By late spring, the spreads on lower-rated corporate bonds had begun to widen to levels closer to historical averages. As we moved into summer, however, we saw rising delinquency rates and higher probabilities of default on U.S. subprime mortgages. And so, there were rising expectations of losses for holders of securities backed by these mortgages. But because of the complexity and opacity of some of these securities, it is extremely difficult for even sophisticated investors to determine, with confidence, both the creditworthiness of the assets backing a particular security and the market value of the security itself. In these circumstances, uncertainty led to contagion and dislocations in money markets more generally, even those markets that have no link to U.S. subprime mortgages. Liquidity, which was recently thought to be too abundant, became scarce. Some investors found that the assets that they assumed were liquid were, in fact, frozen. Investors suddenly became extremely risk averse, leading to a surge in demand for the least-risky assets, such as government bonds and treasury bills. The lack of transparency and problems with information have clearly contributed to the ongoing market turbulence. The global repricing of credit risk is taking longer than many of us initially expected. This is because it is taking more time to unravel some of these complex and opaque instruments to get to the underlying assets, and then to find values for the assets themselves. In addition, uncertainty remains about the extent to which banks are holding these securities, how much they may be required to take onto their balance sheets, and what value to place on them. This uncertainty has exacerbated problems in the global interbank funding market, but because of their strong balance sheets, Canadian banks have been somewhat less affected. Over time, market forces can still be expected to work out these problems. But markets need information to operate efficiently. So, it is in the interest of market participants to make sure that parties have access to all necessary information. Globally, markets for structured asset-backed securities remain under stress. In Canada, the problems have been most acute in the market for structured, non-bank-sponsored, assetbacked commercial paper. The information needed to properly price these products is only now beginning to be made available. With this information, investors and the providers of assets and liquidity are now progressing towards restructuring agreements. As we go forward, we can expect that investors will demand greater transparency where it is now lacking. Vendors of financial instruments will then need to structure them in such a way that market players can clearly see what they are buying. More fundamentally, investors must take on more responsibility for diligent research, so that they can better understand the nature of their investments. Put another way, investors must demand access to appropriate information so that they can do their own homework, and then they must do that homework. It seems to me that many of these desired outcomes will be accomplished through natural market forces responding to these events. For example, when investors demand much higher rates of return for opaque products, there will be a strong incentive for vendors to provide products that are more transparent. Let me touch briefly on the role of credit-rating agencies in all of this. There is an article in the current FSR that expands on the issues related to the possible reform of the credit-rating process. 5 One thing that is clear is that in the future, credit-rating agencies will find it to their advantage to explain more clearly the rationale for, and limitations of, their ratings for highly structured products. There are some natural, self-correcting market forces at work that should lead the rating agencies to improve their processes. Indeed, those credit-rating agencies that do not work harder to improve their processes will likely have fewer clients willing to pay for their services. As I understand it, most agencies are working on such improvements. But credit-rating agencies are not to blame for the lack of information about those highly structured products that were sold to highly-sophisticated investors in the so-called exempt market. In the retail market, securities regulators impose strict requirements about the information that must be provided through a prospectus or term sheet. But there are no such requirements in the exempt market. It seems to me that some very basic disclosure is needed in every market. And since securities designed for the exempt market are usually required to carry a rating from a credit-rating agency, one way to ensure that appropriate information is available could be to require issuers to publicly disclose the same information that they make available to credit-rating agencies. In this way, investors would have access to the information they need in order to make informed decisions. Another issue that we need to think about is how to get the right incentives in place for loan originators, so that credit quality is maintained and credit can be appropriately priced. I mentioned earlier that, in some cases, the creation of loans largely for immediate securitization reduced the incentive for originators to maintain credit standards. Since the originators were immune from default risk once the loan was completely securitized and sold, they lacked the proper incentives to adequately assess the creditworthiness of the borrower. It may be that natural market forces will go a long way towards rebalancing incentives, but the question can be asked: Are there ways to encourage the more appropriate use of securitization? It may be possible, for example, to have asset-backed securities carry some type of "branding" or "certificate of origination" that would provide a clear incentive for the loan originator to exercise due diligence in extending the loan before it is securitized. Or, we can look for ways to encourage originators to keep a substantial portion of the riskiest tranche of the product they are selling on their own books. Mark Zelmer, "Reforming the Credit-Rating Process." Bank of Canada “Financial System Review” (December 2007): p 51-57. Implications for monetary policy and the economy Let me now discuss the impact of these recent market dislocations, both on our work at the Bank of Canada, and on the Canadian economy. The impact on the Bank has been two-fold. First, we have undertaken open-market buyback operations and made sure that Canadian banks have had access to our Standing Liquidity Facility, so that they have been able to deal with any overnight liquidity difficulties. This is a normal role for any central bank, and it will continue. But, in the wake of recent events, we are currently looking at whether some types of liquidity disruptions in Canada might be better addressed if the Bank of Canada had a facility that would provide liquidity at terms longer than overnight. We are also examining changes necessary to allow the Bank to accept a wider range of securities for our buyback operations. The Bank's other role, of course, is to conduct monetary policy with the aim of delivering low, stable, and predictable inflation. We have been working to ensure that the financial system has the proper amount of liquidity so that the overnight interest rate – our key policy rate – remains close to target. But what we have seen since this summer is a widening of the spread between short-term market interest rates, such as the rate for commercial paper, and our target for the overnight rate. This is important, because these short-term market rates are a crucial link in the way monetary policy is transmitted: from our key policy rate, to the cost of credit, to spending, production, employment and, ultimately, to the rate of inflation. These wider spreads have persisted, and they represent a tightening of credit conditions in Canada. These tighter credit conditions have come as financial market difficulties have intensified over the past few weeks and as bank funding costs have increased globally. At the same time, there is an increased risk attached to the prospects for demand for Canadian exports because the outlook for the U.S. economy – particularly the U.S. housing sector – has weakened. Uncertainty related to all of these factors has led to exceptional volatility in financial and currency markets globally. While there remain upside risks to inflation in Canada, all factors considered, the Bank judges that there has been a shift to the downside in the balance of risks around our October projection for inflation. In light of this shift, we lowered the target for the overnight rate last week. Before our next interest rate decision in January, we will assess all economic and financial developments and the balance of risks, and do a full projection for the economy and inflation. Conclusion Ladies and gentlemen, as you know I will be stepping down as Governor of the Bank at the end of January, and concluding more than thirty-five years of involvement in economic policy within the public service. Since this is my last public speech as Governor, I thought it might be apt to conclude my remarks today with three of the most important lessons for economic policy that I – and I believe many Canadians – have learned over the past thirty-five years. The first lesson is that both individuals and firms must always be prepared to adjust quickly to changing global economic circumstances. The world will evolve in ways that we cannot predict, so we must be prepared to deal with change and seize new opportunities as they arise. Perhaps even more importantly, we should not cling to activities that are no longer economically justified, however difficult and painful adjustment may be. Not adjusting is not an option. In the end, rapid adjustment is less painful than prolonging activities where we no longer hold a comparative advantage. This is the lesson that I and many other Canadians learned from our difficulties in the 1970s and the early 1980s. Second, we have all learned the importance of achieving and maintaining sustainable levels of public debt. Canadians paid a very real price in the 1990s to control the growth of public debt, and have wisely used the favourable conditions of the past decade to bring down the ratio of public debt to GDP. Although conditions will not necessarily be as favourable over the next decade as they have been recently, nonetheless, further efforts to reduce the debtservice burden are needed in order to prepare for the inevitable effects of the aging of our population. Third, we have all learned that the most important contribution a central bank can make to economic welfare is to maintain confidence in the future value of money. In the 1970s, we all witnessed the economic and social instability caused by high and volatile inflation. In the 1980s, we paid the price of recession to get inflation under control. Since the early 1990s, our inflation-targeting regime has kept inflation low, stable, and predictable at 2 per cent. This, together with fiscal consolidation, has helped to keep growth more steady, employment to rise to historically high levels, and unemployment to fall to levels not seen for decades. My colleagues at the Bank will continue to search for technical improvements in our inflationtargeting regime, but I am confident that the Bank and my successor, Mark Carney, will continue to keep inflation low, stable, and predictable, for the benefit of all Canadians. Finally, let me close by saying that it has been an enormous privilege for me to be able to serve Canadians for three and a half decades. I am grateful for having had that opportunity, and I am hopeful that, in some way, my efforts over the years may encourage others to follow in the service of Canada and its people.
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Remarks by Ms Sheryl Kennedy, Deputy Governor of the Bank of Canada, to l'Association des femmes en finance du Québec, Montréal, Quebec, 8 January 2008.
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Sheryl Kennedy: Transparency – the more, the better? Remarks by Ms Sheryl Kennedy, Deputy Governor of the Bank of Canada, to l'Association des femmes en finance du Québec, Montréal, Quebec, 8 January 2008. * * * Transparency is the cornerstone of a well-functioning financial system. It's an issue that has been getting a lot of attention, and deservedly so, as we consider what has gone wrong in the market for asset-backed commercial paper. I'll be happy to take any queries you might have on this topic during the question and answer session following my remarks. But first, I want to talk to you about transparency in central banking and in setting monetary policy. Then, I'll close my remarks with a review of the changing monetary policy outlook over the past six months, which serves to illustrate my key points. So, what has been done, and what more can we do to improve transparency in monetary policy? Are there any limits? I'll approach these questions from three perspectives: transparency about the Bank's policy framework; transparency about the inputs, the processes, and the reasoning behind monetary policy decisions; and transparency about our assessment of the outlook for the economy and monetary policy. That last element, disclosing more of the Bank's assessment about the outlook, including forward-looking statements about monetary policy actions, is particularly tricky and really tests the limits of transparency. Nevertheless, it is in this area that there may be the most room to increase transparency. But first, we must figure out if it would be beneficial to provide more information for market participants, firms, and individuals. More fundamentally, would it improve the effectiveness of monetary policy? And if we find that it would be beneficial, how can we convey this information so that it would be readily understood? Or more importantly, how can we convey this information in a way that will not be misunderstood? At the Bank of Canada, we do not believe in constructive ambiguity, nor in saturating the market with a lot of information that has no clear message. Real transparency involves judgment: communicating what is important, what clarifies, and not what obscures. I'll have more to say on this in a few minutes. Why be transparent? But first, let's back up one step to look more closely at just why transparency is so important to the conduct of monetary policy. It has become very clear over time and with experience, that monetary policy is most effective when the policy objective is clearly understood and accepted. When consumers and savers, business owners, and financial market players, all understand the Bank of Canada's policy objective – and believe that it is attainable – then they can make better long-term plans and decisions. And when everyone expects this target to be maintained, and acts accordingly, then the target becomes self-reinforcing. But the benefits of transparency don't stop there. I believe that transparency also helps us to make better decisions. The extra rigour that comes from holding the rationale behind our decisions up to external scrutiny leads to better results. Finally, the Bank of Canada is a public institution – funded by, and accountable to, the taxpayer. Information and analysis gathered in the context of the Bank's business should be considered a public good – except when the release of such information would compromise the implementation of the Bank's mandate. Are there limits to transparency? In general, more transparency is better than less. But this does not mean that there are no limits. First, there is the need to protect the confidentiality of some information and analysis that is given to the Bank by outside parties, be they public- or private-sector institutions. Indeed, public release of third-party, confidential information would jeopardize the central bank's ability to get all the information it needs to make good monetary policy decisions. Second, there is the need to protect the integrity of some internal policy deliberations. For example, the public release of policy advice and recommendations could stifle the free debate and consensus building that is necessary for sound policy-making. We want to hear all aspects of an argument, but it could be hard for staff members to play devil's advocate, knowing that such a position will be made public and could be taken out of context. And certain information should not be released while policy is still being developed, or has not yet had its full effect. In such cases, premature transparency could lead to misinterpretation or be acted on inappropriately, which could derail good policy intentions and could potentially be damaging to Canada's economic interests. Third, there is the need for good quality information. Providing useful, relevant information is far more important than dumping a large quantity of information of questionable quality. Too much information can actually cloud what is important. As a result, actions and decisions can become less transparent, because the really important, effective, and relevant information gets lost in the minutiae. Good quality information must not only be accurate, it must also be communicated clearly and simply, so that it won't be misunderstood. This is especially germane when we try to be transparent about our assessment of the outlook by publishing our economic projections, along with the risks and uncertainties surrounding them, and forward-looking statements about possible future policy actions. Transparency in setting monetary policy Debates about the limits to transparency for effective monetary policy are certainly not unique to the Bank of Canada. Central banks around the world are still learning the best ways to communicate monetary policy. This is an important element of the art, rather than the hard science, of central banking. I believe that we at the Bank of Canada have made great strides in this area. So let's now take a closer look at the issue of transparency in setting monetary policy from the three perspectives that I mentioned at the outset: transparency about our policy framework; transparency about the inputs, the processes, and the reasoning behind monetary policy; and transparency about our assessment of the outlook. The Bank made a major leap forward in increasing transparency about our policy framework when we adopted an explicit inflation target in 1991. This target provides a clear objective for monetary policy, which has helped to anchor financial and economic decisions. It makes it easy to measure the success of monetary policy and to hold the Bank accountable for its actions. Canadian individuals and firms can align their savings, investment, and spending plans with a common inflation-control objective. If inflation persistently deviates from the target, we are committed to explaining the reasons why, what we will do to return it to target, and how long we expect the process to take. Previously, when we targeted monetary aggregates, for example, there was ambiguity about what the bank was trying to achieve, and we were not always clear about the implications of such a target for output, inflation, and interest rates. Now, as well as being clear about our objective, we are also being transparent about our assessment of the factors that influence inflation and about how we implement monetary policy. We conduct monetary policy in a symmetric way, worrying as much about the trend of inflation falling below target as we do about it rising above target. To keep inflation on target, we try to keep the economy operating near its full capacity. When the demand for goods and services pushes the Canadian economy against the limits of its capacity, and inflation is poised to rise above target, the Bank will raise interest rates to cool off the economy. And when the economy is expected to operate below its production capacity, and inflation is poised to fall below target, the Bank will lower interest rates to stimulate growth. We also factor in shocks that directly affect inflation. Because we target domestic inflation, we have a floating currency. A central bank cannot successfully control both the domestic and external values of its currency at the same time. And a flexible exchange rate is an important price signal of changing global and domestic circumstances that can help to prompt and facilitate necessary adjustment. This is our paradigm for the conduct of monetary policy, and we have been so transparent about it that we have devoted entire speeches and published a great deal of staff research on the topic. We do this so that a careful observer can understand just how monetary policy will adjust to changing circumstances. Our inflation target is established under an agreement with the federal government. When this is reviewed periodically, we look for ways to improve the conduct of monetary policy based on recent experience and research in order to clarify aspects of our framework. In the most recent review, for example, we examined how to deal with asset-price bubbles and looked at the appropriate time horizon for returning inflation to target following an economic or financial shock. In preparation for the next review of our inflation targeting agreement in 2011, we are conducting an intensive research program into possible improvements to our policy framework. Specifically, we are looking into the merits of a lower inflation target and price-level targeting. Now, let's look at transparency about the inputs, the processes, and the reasoning behind monetary policy decisions. Just a little over a decade ago, the Bank didn't even issue a press release when it made an interest rate decision. Now, our rate announcements are widely anticipated. There is a very high level of interest, stretching from households to office towers, in what the Bank of Canada has to say on interest rates, inflation, and the economy. This interest is at least partly the result of a series of measures taken by the Bank to increase transparency. After the introduction of the inflation target, we moved in 1994 to become more open about how we implement monetary policy by targeting the overnight interest rate. A further major step towards greater transparency came in 1995 when we began to publish a regular Monetary Policy Report, and later added MPR Updates, to provide a window for financial markets and the general public into the analysis behind our conduct of monetary policy. Soon after that, the Bank began to publicly announce interest rate changes through press releases. These steps helped to increase understanding and acceptance of the Bank's policy objective. Still, there was a lot of ambiguity and uncertainty in financial markets about exactly when the Bank of Canada might change its monetary policy stance. So, in 2000, we decided to set eight fixed dates each year for interest rate announcements, regardless of whether rates were changed or not. This commitment to a timetable provided more certainty for markets, a better focus for external commentators to develop and expand their own views on the economic outlook, and regular opportunities for us at the Bank of Canada to review the accumulation of data and to update our views about the outlook for inflation and the appropriate course for monetary policy. This extra focus and rigor has, in my opinion, improved our decision-making process. Of course, the Bank retains the option of moving between dates in extraordinary circumstances, an option that has been exercised only once since fixed announcement dates were established. Most of the information and analysis that the Bank uses when it makes monetary policy decisions are based on data that are also available to the public. There was a time when one such input – our Business Outlook Survey – was not publicly available. But after we conducted research to determine which of our survey questions provided the most useful information, we began to publish the results of those questions. The motivation was not only to help improve the public's understanding, but also to be as open and transparent as we could, given our responsibilities as a public institution. We continue to examine whether we can make public more of the inputs to monetary policy, without compromising the policymaking process. Indeed, in the upcoming January Business Outlook Survey, we will be including responses to two additional questions on past sales and credit conditions. I'll now turn to the third perspective, which is transparency about our assessment of the outlook for the economy and monetary policy. Because it can take as long as two years for monetary policy actions to have their full effect on inflation, we must always be looking well into the future. So, the questions become: how can we effectively communicate the kind of uncertainty and the many risks that any views about the future must always include? How can we talk openly about possibilities and risks in a way that won't be misunderstood? It would not aid transparency if our assumptions and projections of what might transpire – assessments which are, by their very nature, conditional – were misconstrued as more concrete predictions or commitments. At the Bank of Canada, the Governing Council sets out its base-case projection for inflation and growth in the Canadian economy four times a year in our Monetary Policy Reports and Updates. This base-case projection reflects Governing Council's best judgment about the most likely outcome, based on a number of assumptions. Over the years, we have become increasingly transparent in describing our projections, and the underlying assumptions. This January, we will include in our Update projection tables on global economic growth – tables that previously had only been included in full Monetary Policy Reports. We have provided more detail about how we see the economy unfolding, what forces might affect inflation, and what assumptions we have had to make about more volatile or uncertain variables. This, in turn, helps to explain the reasons behind our most recent decisions and provides some insight into possible future actions. The base-case projection embeds changes in the policy interest rate that would be necessary to achieve our 2 per cent inflation target over the medium term. We describe the direction and magnitude of that interest rate path in a few words, in Chapter 4 of the Monetary Policy Report and when we update the base-case projection in the Update. We may also give an indication of the time horizon for this path. We have also become more forthcoming in recent years about the risks that we see surrounding the base-case projection and whether we think these risks are balanced or not. Our policy rate statements, in press releases and in the Overview section of the Monetary Policy Report and Update, reflect our best judgment in the context of the overall outlook at that time, including the balance of risks. But that, too, is no guarantee that the future will play out the way we expect. There are several ways we might consider providing more transparency about the risks and uncertainties around our base-case projections. Some central banks use fan charts showing confidence intervals that can suggest the extent of uncertainty around a particular factor in the overall forecast. Another approach is to publish complete alternative scenarios in addition to presenting a base-case projection. And some academics have called for more transparency by sharing the monetary authorities' probability estimates of different risks. Examining some of these possibilities is in our work plan for the year ahead. What is not in our work plan is the use of stock words and phrases to signal policy intentions. This isn't our practice at the Bank of Canada. Instead, we try to spell out the situation as we see it. We set out our base-case projection for the economy and the key risks; we make clear the indicators that we're closely following; and by being clear about our paradigm, we try to help a careful observer to better understand how monetary policy could evolve, depending on changing circumstances. But we count on outside observers to do their own analytical heavy lifting as well. In preparing for our interest rate decisions, we look at market prices, external commentary, and other analysis. We rely on observers to provide their own perspective on the outlook. If our views differ substantially from the consensus of external observers, we might consider either redoing our own analysis, seeking out further information, or communicating more explicitly our views and analysis to help those observers to understand the factors that we consider to be important. As I have said on many occasions, if you are considering placing a bet between what you think we said we were going to do and what you think we ought to do, I'd go with the latter. Outlook for the Canadian economy and inflation So, let me conclude by looking at the evolution of monetary policy over the past six months. It certainly has been a fluid situation, and an excellent example of how forward-looking assessments can change quite rapidly. Back in July, we raised our policy rate by a quarter of one percentage point because we judged that the economy was operating, at that time, at a level further above its production potential than had been projected at the time of the April Monetary Policy Report. As we expected both total and core CPI to remain above 2 per cent, we concluded that some modest further increase in the overnight rate might be required to bring inflation back to 2 per cent over the medium term. By the end of the summer, the situation had changed in many respects. The Canadian economy was operating even further above its production potential than estimated in July, which was putting upward pressure on inflation. Developments in financial markets had led to some tightening of credit conditions for Canadian borrowers, however, which would temper the growth in domestic demand. And the U.S. economic outlook had also weakened. This, together with a higher assumed level for the Canadian dollar, suggested that there would be more drag from net exports in 2008 and 2009 than previously expected. Given these developments, we held our policy rate steady through September and October. We identified several risks to the outlook for inflation and judged them to be roughly balanced, with perhaps a slight tilt to the downside. In the event, the downside risks prevailed. When we re-examined our monetary policy stance early in December, the Canadian economy was growing broadly in line with the Bank's expectations, reflecting in large part the underlying strength of domestic demand. But both total CPI and core inflation were now below the Bank's expectations, reflecting increased competitive pressures related to the level of the Canadian dollar. In addition, other developments since October suggested that the downside risks to our inflation projection had increased. Global financial market difficulties had worsened, tightening credit conditions further, and there was an increased risk to the prospects for the demand for Canadian exports, since the outlook for the U.S. economy had weakened further. So, on 4 December, we judged that the balance of risks had shifted to the downside, and we lowered our target for the overnight rate to 4 1/4 per cent. Now, as we prepare for our next interest rate announcement on 22 January, and our Monetary Policy Report Update two days later, we are preparing our regular quarterly economic projection and risk assessments, so that we can fully assess the implications of all economic and financial developments since the October Report, and set the appropriate course for monetary policy. Conclusion At the Bank of Canada, we are very interested in any ideas you might have on this topic of transparency in monetary policy – what the limits are and how transparency can continue to be improved. In my view, generally, more is better. Apart from the need to protect confidential information and not compromise the policy-making process, the true limits to transparency in monetary policy lie in communicating effectively in the face of uncertainty, a skill which we are constantly striving to master.
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Opening statement by Mr David Dodge, Governor of the Bank of Canada, at a press conference following the release of the Monetary Policy Report Update, Ottawa, 24 January 2008.
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David Dodge: Summary of the latest Monetary Policy Report Update Opening statement by Mr David Dodge, Governor of the Bank of Canada, at a press conference following the release of the Monetary Policy Report Update, Ottawa, 24 January 2008. * * * Good morning. I'm pleased to be here with you today, for my final press conference as Governor of the Bank of Canada, to discuss our January Monetary Policy Report Update. The Canadian economy continues to operate above its production capacity, despite some slowing in growth and inflation in the fourth quarter of 2007. Financial conditions have deteriorated since October, leading to tighter credit conditions in industrialized countries. Given this, and a deeper and more prolonged decline in the U.S. housing sector, the outlook for the U.S. economy in 2008 is now significantly weaker than at the time of the October MPR. The weaker U.S. economy will lead to additional downward pressure on Canada's export growth. Despite tighter credit conditions, domestic demand in Canada is expected to remain strong, supported by continued income growth associated with the increase in commodity prices seen since October. Overall, the Bank now projects that the Canadian economy will expand by 1.8 per cent in 2008 and 2.8 per cent in 2009. This growth profile implies that the economy will move into excess supply in the second quarter of this year, and then return to balance in early 2010. Inflation is projected to fall below 1 1/2 per cent by the middle of this year before returning to 2 per cent by the end of 2009. This reflects a price-level adjustment related to increased competitive pressures in the retail sector stemming from the level of the Canadian dollar, as well as the recent reduction in the GST. Excluding the impact of the GST reduction, total CPI inflation is projected to average close to the 2 per cent target throughout 2008 and 2009. Of course, there are a number of upside and downside risks to the Bank's base-case projection for inflation. But overall, we judge these risks to be roughly balanced. On 4 December and on 22 January, the Bank lowered its target for the overnight rate by onequarter of one percentage point, bringing it to 4 per cent. Further monetary stimulus is likely to be required in the near term to keep aggregate supply and demand in balance, and to return inflation to target over the medium term.
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Opening statement by Mr Paul Jenkins, Senior Deputy Governor of the Bank of Canada, to the House of Commons Standing Committee on Industry, Science and Technology, Ottawa, 30 January 2008.
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Paul Jenkins: Impact of exchange rate movements on the Canadian economy Opening statement by Mr Paul Jenkins, Senior Deputy Governor of the Bank of Canada, to the House of Commons Standing Committee on Industry, Science and Technology, Ottawa, 30 January 2008. * * * Thanks very much, Mr. Chairman. I'm pleased to be here with you today and hope to help your committee as it examines the impact of exchange rate movements on the Canadian economy. With me is John Murray, who was recently appointed as a deputy governor and member of the Bank of Canada's Governing Council. To begin, as a little background I would like to quickly review the framework within which we conduct Canada's monetary policy. The Bank of Canada Act calls on us to mitigate "fluctuations in the general level of production, trade, prices and employment, so far as may be possible within the scope of monetary action, and generally to promote the economic and financial welfare of Canada." Over time, we have learned that the best way to fulfill this mandate is to keep inflation low, stable, and predictable. Specifically, that means we aim to keep the annual rate of inflation, as measured by the consumer price index, at 2 per cent. To keep inflation on target, we aim for a balance between total demand and total supply in the economy. By maintaining low and stable inflation, our monetary policy helps to keep the economy operating at full capacity and promotes greater stability in economic output. This is crucial in helping the economy to adjust to changing economic circumstances. Now, what does all of this have to do with the exchange rate? Well, the exchange rate of the Canadian dollar is a key element of our monetary policy framework. Without a floating exchange rate, we would not have the ability to conduct an independent monetary policy appropriate to our domestic situation. This means that we do not have a target for the Canadian dollar. But the exchange rate is an important relative price in our economy and we pay very close attention to its movements. Movements in the exchange rate influence the levels of imports and exports, which can help to keep total demand and supply in balance, and have a direct influence on price levels in our economy. Further, exchange rate movements act as a signal to shift resources into sectors where demand is strongest. Our floating exchange rate helps to facilitate that process. That said, we recognize that these types of adjustment can be, and have been, difficult for some sectors and regions of the country. When the Canadian dollar rises or falls, we try to determine the degree to which those movements are due to changes in world demand for our goods and services, and how much is due to other, unrelated factors. It is important that we understand the causes of exchange rate movements, because the implications for the economy – and the appropriate monetary policy response – depend on the reasons for the change. We must then incorporate this information with our assessments of other data, and set a course for monetary policy that works to keep total demand and supply in balance, and inflation on target. Exchange rate movements can also be, as we have seen recently, quite volatile. That has sometimes led to calls, for example, for Canada to fix its currency to the U.S. dollar. That would be a mistake. The United States is certainly our closest neighbour and by far, our largest trading partner. But the structures of our two economies are very different. This means that each of us often requires different adjustments and different policies in reaction to shocks. Canada's floating exchange rate helps in this process by acting as a shock absorber. We cannot avoid adjustment; the question is how we can best adjust to changing global and domestic economic forces. With a fixed exchange rate, the adjustments would have to come through movements in overall output and in all wages and prices. History has shown that those adjustments are more protracted and more difficult when the nominal exchange rate is not allowed to move. Again, however, I stress that this does not mean that the Bank is indifferent to movements in the exchange rate. Now, let me conclude with a few summary comments on our latest Monetary Policy Report Update released last week. Copies are available for committee members. In this, we said the Canadian economy continues to operate above its production capacity, despite some slowing in growth in the fourth quarter of 2007. The Bank projects that economic growth in 2008 will be weaker than was expected in October, averaging a little over 1 per cent in the first half of this year and a little over 2 per cent in the second half. On an average annual basis, the economy is projected to expand by 1.8 per cent in 2008 and 2.8 per cent in 2009. Both core and total CPI inflation are projected to fall below 1 1/2 per cent by the middle of this year before returning to 2 per cent by the end of 2009. On 4 December and on 22 January, the Bank lowered its target for the overnight rate by one-quarter of one percentage point, bringing it to 4 per cent. In line with the Bank's outlook, further monetary stimulus is likely to be required in the near term to keep aggregate supply and demand in balance, and to return inflation to target over the medium term. With that, Mr. Chairman, John and I would now be happy to take your questions.
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Remarks by Mr Mark Carney, Governor of the Bank of Canada, to the British Columbia Chamber of Commerce and the Business Council of British Columbia, Vancouver, British Columbia, 18 February 2008.
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Mark Carney: The implications of globalization for the economy and public policy Remarks by Mr Mark Carney, Governor of the Bank of Canada, to the British Columbia Chamber of Commerce and the Business Council of British Columbia, Vancouver, British Columbia, 18 February 2008. * * * I am delighted to give my first public address as Governor of the Bank of Canada in Vancouver, not only because my roots are here in the West, but also because Vancouver aptly symbolizes the subject of my remarks today – globalization. I chose to speak about globalization at the outset of my tenure because it will continue to be one of the forces shaping our economy and economic policy for years to come. Steady advances in transportation, communication, and information technologies, underpinned by the more widespread adoption of free-market economic policies, are shrinking the globe and expanding the global economy. It is incontestable that the current wave of globalization has been, on balance, of great benefit. Hundreds of millions of people have already been lifted out of poverty, with the real potential for hundreds of millions more to share their destiny. 1 Globalization has also had numerous economic benefits for Canada. The recent period of international integration has coincided with the second-longest expansion in our nation's history, characterized by rising real incomes, surging employment, and low, stable, and predictable inflation. However, these outcomes are not preordained; to reap fully the benefits of globalization, policy-makers must weigh its implications and respond effectively to its challenges. In my time today, I will discuss these policy challenges, particularly those related to the conduct of monetary policy. First, I will talk about how the current wave of globalization differs from previous periods of economic integration, and then I will address some of the economic impacts of globalization. Before concluding, I will also say a few words about the current outlook for the Canadian economy, which, not surprisingly, is importantly influenced by global economic developments. What is different? In some respects, the current wave of globalization resembles earlier episodes. There have been occasional periods of intense economic integration over the centuries, most notably during the Roman Empire and in the latter half of the 19th century. These have shared several common features: for example, technological innovations that shrank economic distances (e.g., standardized roads, the telegraph and, more recently, the Internet) and, very importantly, governments that pursued supportive economic policies. These governments recognized the long-term benefits of economic integration and were large enough to internalize the costs – both political and fiscal – of promoting public goods such as the rule of law; common standards for trade, products, and services; and the liberalization of trade. Many of their decisions, such as the repeal of the Corn Laws in England, were unpopular at the time, but ultimately proved beneficial. 2 We should all hope that similar courage will begin to guide participants in the current Doha Development Round of trade negotiations. For a further discussion, see X. Sala-i-Martin, "The World Distribution of Income: Falling Poverty and … Convergence, Period," The Quarterly Journal of Economics. CXXI, no. 2 (May 2006): 351–397. See M. King, Speech at a Dinner for Kent Business Contacts, Ashford, Kent, U.K., 16 January 2006, which cites the example of protests against the use of foreign hops in beer. So, is there anything different about this period of integration? I would argue that there are three aspects. First, the sheer scale of the process is unprecedented; second, the relative size of the emerging economies being integrated into the core of the global economy means that their policies matter for advanced economies, as well as for their own; and third, the widespread adoption of supply-chain management by business further enhances the depth of integration. In terms of scale, it is safe to say that never in history has economic integration involved so many people, both in raw numbers and as a percentage of the global population. For example, when North America and the periphery of Europe were integrated during the latter half of the 19th century, their total population was half the size of the then-advanced countries. The comparable ratio for postwar Japan was 10 per cent. Contrast that with China and India today, which alone represent 2.5 times the current population of advanced countries. 3 Of course, the entire populations of China, India, and other emerging markets are not being instantly integrated into the global economy. If you adjust for the percentage of the population in the traded-goods sector, however, the effective global labour supply quadrupled between 1980 and 2005, with most of the increase taking place after 1990. 4 This trend is set to continue: The globally integrated labour force is projected to double again by 2050. 5 Similarly, the scale of cross-border flows of goods, services, and capital is now unprecedented. The global economy has opened dramatically – merchandise exports now make up about 20 per cent of global GDP, compared with about 9 per cent at the height of the last great wave of globalization, roughly a century ago. 6 According to research at the OECD, advances in communications technology mean that up to 1 in 5 services are now tradable, although this potential has only just begun to be tapped. 7 Cross-border capital flows are now roughly 15 per cent of global GDP, compared with 3 per cent at the turn of the last century. 8 The second difference that characterizes this wave of globalization is that, given the relative size of emerging markets, their policies matter. For the most part, the economic policies of emerging-market countries have improved the welfare of both their citizens and our own, through the gains from trade. With some policies, however, most notably in the degree of exchange rate flexibility and, by extension, in the conduct of their domestic monetary policies, some emerging markets have run great risks. In particular, they continue to import, what is, for them, overly loose monetary policy that will ultimately lead to adjustments in the real exchange rate through higher domestic inflation, with the attendant economic distortions, adjustment costs, and risk of a hard landing. Moreover, at the global level, there are important spillovers of these policies onto other economies, such as Canada's. Export-promotion strategies underpinned by undervalued For a more complete discussion, see A. Maddison, "World Development and Outlook 1820–2030: Evidence Submitted to the House of Lords" (20 February 2005). Available at <http://www.ggdc.net/maddison/>. International Monetary Fund, World Economic Outlook (April 2007), 162. Each country's labour force is weighted by its export-to-GDP ratio. Ibid., 180. See A. Maddison, Monitoring the World Economy, 1820–1992 (OECD, 1995) and C. Alexander and K. Warwick, "Governments, Exports and Growth: Responding to the Challenges and Opportunities of Globalisation," The World Economy 30, no.1 (2007), 178. See D. van Welsun and G. Vickery, "Potential Offshoring of ICT-Intensive Using Occupations," (OECD, April 2005). See K. H. O'Rourke and J. G. Williamson (1999), Globalization and History; The Evolution of a NineteenthCentury Atlantic Economy, and R. Battellino (2006), Regional Capital Flows, a speech to the 6th APEC Future Economic Leaders Think Tank, Sydney, 28 June. exchange rates are generating unprecedented reserve accumulation, as central banks intervene to forestall exchange rate adjustment. 9 In contrast to earlier periods where emerging markets imported capital to finance investment, today's largest emerging economies are important capital exporters, to such an extent that they have been significant drivers of lower global long-term interest rates. Since the level of long-term interest rates influences risk appetite and capital allocation, the extent to which they are determined by non-market forces can lead to distortions. Indeed, the low level and relative stability of longterm interest rates encouraged investors to "search for yield," which in turn contributed to the dramatic increase in highly structured credit products, including those backed by U.S. subprime mortgages. The third aspect of today's globalization that is different is the relative novelty of global supply-chain management. Advances in information technologies, specialized production processes, and reduced communication and transportation costs have all led to a whole new range of goods and services becoming tradable. For example, over the past 30 years, the share of imports as a percentage of manufacturing production has tripled to nearly 30 per cent. 10 These developments mean that firms are now able to increase production efficiency in ways previously unimaginable. In addition to the rising trade in components or intermediate products, an entirely new class of tradable services – including financial, engineering, medical, and legal – has emerged. There is reason to believe that these trends will continue. With these advances, it is easy to imagine a product designed and marketed in Canada, will be assembled in China, using parts sourced from elsewhere in emerging Asia and supported by technicians in India. By breaking down production processes along a global supply chain, firms are better able to find the efficiency gains that have led to increased productivity and lower prices. 11 Integration has had a clear dampening effect on the prices of manufactured goods. In effect, technology and globalization are facilitating more widespread application of two of the most powerful forces in economics: the division of labour and comparative advantage. This allows companies to organize the production process in the most cost-effective way possible, which maximizes the likelihood that Canada will retain positions in the high-value-added segments of many industries. A recent analysis by the Conference Board of Canada suggests that, at least with respect to Asian supply chains, Canadian firms could do more to exploit opportunities. 12 Some economic implications of globalization At the same time, the rapid increase of manufacturing in emerging markets has led to strong demand for many commodities, and thus, to steady upward pressure on the prices of many of the commodities that Canada produces and exports. The combination of lower prices of our imports and higher prices for our exports means, by definition, an improvement in Canada's terms of trade. Rising terms of trade alone have bolstered real disposable income Between the end of 2001 and the end of 2004, global foreign exchange reserves increased by over US$1.6 trillion, reflecting reserve accumulation by emerging-market economies in Asia. See Bank for International Settlements, "Foreign exchange market intervention in emerging market economies: motives, techniques and implications," BIS Papers No. 24 (May 2005). OECD Economic Outlook No. 81 (2007), 188. M. Amiti and S.-J. Wei, "Demystifying Outsourcing." (IMF, 2004). Also, see D. Leung and Y. Zheng, "What Affects MFP in the Long-Run? Evidence from Canadian Industries," Bank of Canada Working Paper No. 2008-4. The Conference Board of Canada, Canada's “Missing” Trade with Asia (2008). per capita by 8.5 per cent over the past five years, and have contributed to healthier corporate balance sheets and continued improvement in government fiscal positions. Canada has adjusted well to the sharp movements in our terms of trade. Through conversations that we at the Bank have had with business leaders, through the responses to questions in our Business Outlook Surveys, and through data showing an average annual increase of 8 per cent in the volume of business investment since 2002, there is clear evidence that the Canadian economy is becoming increasingly oriented to high-end services. Within the goods sector, firms are specializing and concentrating on those areas where they hold a comparative advantage. 13 Globalization is commonly charged with being responsible for increasing inequality and falling wages in certain sectors of industrialized economies, as lower-skilled jobs are shifted offshore. Indeed, the OECD's 2007 Employment Outlook noted that the share of labour income relative to GDP has fallen in a majority of member countries, including Canada, over the past two decades, while in 16 of the 19 countries where data are available, the earnings of workers at the top of the wage distribution have risen relative to earnings of those at the bottom of the distribution since the early 1990s. While globalization has played a role in these trends, the story is much more complex. There is considerable evidence that technological change is behind a large part of the declining ratio of labour income to GDP. 14 Further, labour income in Canada has continued to rise in recent years because of strong employment growth. What is clear is that globalization has affected the makeup of the labour force in many countries by promoting a shift of lower-skilled, labour-intensive production processes to emerging markets and encouraging the growth of higher-skilled, knowledge-based production in industrialized countries. While it is true that this adjustment process can be, and has been, difficult for certain individuals and firms, the overall picture is quite positive. In countries where labour markets are flexible, displaced workers have been more able to reskill or retrain and, on balance, find more productive employment. Since December 2002, employment in Canada's manufacturing sector has fallen by roughly 14 per cent, or 320,000 jobs, while employment in other goods-producing sectors has risen by roughly 23 per cent, or 382,000 jobs. Further, over the same period, employment in the services sector has risen by more than 1.4 million jobs. Average hourly earnings have increased over this period at an average annual pace of 3.3 per cent. Moreover, everyone in our economy benefits from the lower cost of imports. While Canada's impressive employment performance cannot be ascribed to globalization per se, clearly globalization has not prevented it. At the same time, just as globalization has a long way to run, the adjustment process is far from finished. That is why it is so important for Canada to continue to improve its economic flexibility – a point that has been made repeatedly in Bank of Canada speeches. Policy challenges posed by globalization It is plain from this discussion of the economic impact of globalization that it also has important implications for the conduct of monetary policy. I will touch briefly on four implications that are relevant for the Bank of Canada. It should be recognized at the outset, however, that these implications can be conflicting, and none is relentless, so they need to be considered carefully. First, the Bank needs to be mindful of the possibility that movements in the terms of trade may affect the relationship between core and total CPI inflation. Recall that globalization has J. Mair, "How the Appreciation of the Canadian Dollar Has Affected Canadian Firms: Evidence from the Bank of Canada Business Outlook Survey," Bank of Canada Review (Autumn 2005): 19–25. International Monetary Fund, World Economic Outlook (April 2007), 161–192. led to lower prices for many manufactured goods and higher prices for many commodities, particularly energy products. While both of these groups are represented in the total consumer price index, many energy prices are excluded from our core measure of inflation because of their volatility. In the pursuit of our 2 per cent target for total CPI, we use our core measure as an operational guide because it has been a good gauge of the underlying trend of inflation and has been a better predictor of future changes in the total index than has total CPI itself. Forthcoming research at the Bank of Canada indicates that this relationship continues to hold in Canada, although it has diminished in many other countries. 15 We will continue to monitor the stability of this relationship, and the Bank will also continue to look at a range of measures to assess the underlying trend of inflation. Considerable judgment must always be applied, and no one measure should be relied on exclusively. Second, globalization may affect the degree and speed of the pass-through of exchange rate movements to domestic prices. It is widely believed that globalization acts as a stabilizer that should dampen exchange rate pass-through because the increased competition faced by businesses will lead them to compress their margins to remain competitive and absorb rising costs. 16 Eventually, however, local prices should adjust to exchange rate movements, if they persist. We may, in fact, be seeing this effect here in Canada, since some retailers in the automotive and book sectors have recently adjusted prices downwards in the face of greater competitive pressures stemming from the rise of the Canadian dollar. Third, globalization may have a conflicting influence on productivity. I have already mentioned how globalization promotes higher productivity by allowing firms to arrange their production processes in the most cost-effective ways. Again, however, the reality in Canada is more complex. The large swings in relative prices fed by globalization have sparked a reallocation of resources between sectors and regions. This reallocation can lead to a temporary slowing in productivity growth as the adjustments take place. This is particularly true in the natural resources sector, where investments typically have long lead times, where a substantial amount of labour has been absorbed, and where high commodity prices have encouraged the production of more marginal resources. These effects may be behind a portion of Canada's disappointing productivity record in recent years. 17 Fourth, the impact of globalization on market interest rates is an area where economic theory and reality do not quite align. The increase in the effective labour supply in the global economy should have raised the return on investment, all other things being equal, and led to an increased demand for capital to employ this extra labour. This, in turn, would be expected to lead to higher interest rates. As I mentioned earlier, however, long-term interest rates around the world have fallen in recent years, partly because of the exchange rate policies of some emerging markets. There are several other possible explanations for this phenomenon, including the balance of private savings and investment in emerging-market economies, itself the product of the economic policies in these countries. 18 See Bank of Canada, Renewal of the Inflation-Control Target – Background Information (2006) and J. Hoddenbagh, M. Johnson, and E. Santor, "Total and Core Inflation: Recent International Evidence" (Bank of Canada Working Paper, forthcoming). There is evidence that import competition dampens markups in Canada. See D. Leung, "Markups in Canada: Have They Changed and Why?" (Bank of Canada Working Paper, forthcoming). R. Dion, "Interpreting Canada's Productivity Performance in the Past Decade: Lessons from Recent Research," Bank of Canada Review (Summer 2007): 19–32. Bank of Canada research has pointed to the relative weakness of investment demand as more important than the relative increase in desired global savings in explaining the low level of interest rates (B. Desroches and M. Francis, "World Real Interest Rates: A Global Savings and Investment Perspective," Bank of Canada Working Paper No. 2007-16). The research also found that the key factors explaining movements in savings and investment were variables that evolve slowly, such as growth of the labour force and age structure of the population. Other factors may also explain the low interest rates, including the policy choices of some emerging markets and imperfect development of global financial markets. Given these four effects, some have argued that the large scale of the current globalization is undermining the effectiveness of monetary policy. 19 I disagree. In short, provided that a country retains a flexible exchange rate, it retains control of its monetary policy. The rate of inflation in Canada is a function of the effectiveness of our monetary policy in the face of both global forces and evolving domestic circumstances. Essentially, the main challenges for monetary policy posed by globalization are: the impact on the growth of our economy's potential output, and changes in relative prices, such as the prices for energy or manufactured products. The growth rate of our economy's potential matters because it affects the balance of supply and demand in the economy. If the effects of these changes are not addressed by monetary policy, they will affect the degree of inflationary pressures in the economy. As for relative price changes, the Bank tries to look through one-off changes, since these only temporarily affect inflation. However, the "temporary" price-level shifts driven by globalization can last a long time, and the pace of the shifts can be variable. It is the job of the Bank of Canada to conduct monetary policy in a manner that takes into account such persistent shocks and ensures that they do not affect inflation expectations. Recent economic and financial developments So how have these different factors been affecting the conduct of monetary policy in Canada? Many of the factors just discussed featured prominently in the recent Tokyo meeting of the G-7 finance ministers and central bank governors. Key topics included the slowdown in the U.S. economy and the related tightening of credit conditions in most advanced economies. In addition to outlining a series of measures to improve the functioning of financial markets, my colleagues and I agreed that each country should continue to take fiscal and monetary policy measures appropriate to their particular economic circumstances. Canada's current economic circumstances were spelled out in the Bank's Monetary Policy Report (MPR) Update last month. In that document, the Bank said that the economy has been operating above its production capacity, thanks to strong domestic demand. This demand has been supported by a rise in real incomes, stemming from the gains in Canada's terms of trade which, as I mentioned earlier, have been driven by globalization. The evolution of our terms of trade will depend importantly on demand from major emerging markets. The impact from our terms of trade is one factor that could lead to stronger domestic demand growth than we had assumed. This is something that we at the Bank will continue to watch closely. Another issue that will continue to be important for us is the evolution of the pass-through to prices of movements in the exchange rate. As I noted earlier, some retailers – notably of motor vehicles and books – have adjusted prices downwards in the face of greater competitive pressures stemming from the rise of the Canadian dollar. In the MPR Update, the Bank said that we expect this to be a one-off movement in prices, but there is a possibility that there could be greater and more persistent downward pressure on prices than we assumed. The Bank also identified the downside risk that the tightening in credit conditions could be greater and more protracted than assumed. As well, there could be a more prolonged slowdown in the U.S. economy, exerting a greater drag on Canadian GDP growth and inflation. These two risks are, of course, related. In line with our base-case projection and the associated risks, the Bank lowered the target for the overnight rate by one-quarter of one percentage point on 22 January. This followed a C. Borio and A. Filardo, "Globalisation and inflation: New cross-country evidence on the global determinants of domestic inflation" (Bank for International Settlements Working Paper, May 2007). similar reduction on 4 December, and brought the Bank's key policy rate to 4 per cent. In making the announcement in January, the Bank said that further monetary stimulus is likely to be required in the near term to keep aggregate supply and demand in balance and to return inflation to target over the medium term. As I said recently, the timing and degree of that stimulus will be determined at future fixed announcement dates, after we have conducted a thorough analysis of, and applied our judgment to, all information available to us at that time. Conclusion Let me conclude with some brief thoughts about how policy-makers in general should approach the issue of globalization. There are tremendous benefits from embracing this integration of markets, but there are adjustment costs as well, in the form of exposing our economies to global competition and swings in relative prices. The challenge for policy-makers is to ensure that the benefits of globalization are maximized and widely shared. In general, this means making sure that policies do not frustrate marketbased adjustments, but rather are aimed at promoting flexibility in markets – particularly labour markets. This means maximizing the ability of workers to relocate if they wish, maintaining appropriate social safety nets that do not discourage employment, and focusing on lifelong learning and training. Beyond labour markets, governments should focus on domestic integration. The Trade, Investment and Labour Mobility (TILMA) pact between British Columbia and Alberta is a good example. Internationally, governments should also concentrate on removing barriers to trade and investment to maximize the benefits of globalization. These imperatives will be tested during the current economic slowdown. From the Bank of Canada's perspective, our challenge is to understand the various ways in which globalization affects both financial stability (a topic for another speech) and inflation. At the Bank, we will continue to share our perspectives on globalization and other broader trends so that individual Canadians, companies, and governments have the necessary context when making their savings and investment decisions. Finally, in light of the growing importance of global forces and the risk of negative spillovers from the policies of some emerging markets, we will continue to use our participation in international fora to shape global institutions and national policies so that globalization can fulfill its promised benefits for all.
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Remarks by Mr Mark Carney, Governor of the Bank of Canada, to the Toronto Board of Trade, Toronto, 13 March 2008.
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Mark Carney: Addressing financial market turbulence Remarks by Mr Mark Carney, Governor of the Bank of Canada, to the Toronto Board of Trade, Toronto, 13 March 2008. * * * Since last summer, many of us here today have been preoccupied with the ongoing dislocations in financial markets. What began in securities linked to U.S. subprime mortgages has spread to a broad range of structured assets, conventional credit markets, and, to a lesser extent, equities. As a consequence, some of the world's largest financial institutions have recorded substantial losses, the cost of borrowing has increased, and the availability of credit has decreased. More than seven months on, the end is not yet in sight, although it is safe to say that we have reached the end of the beginning of this turmoil. This is not because the dislocations in markets have eased; in fact, strains in financial markets have intensified recently, but rather because we are entering a new phase where policy-makers and market participants have a better understanding of both the shortcomings in the current financial system and what needs to be done – by both groups – to address them. This response is important for all economies. Even though most of the practices that contributed to the crisis took place beyond our borders, and our financial institutions are in comparatively robust health, Canada is not isolated from global events. Some of our institutions have suffered losses, and our economy is beginning to feel the effects of the deterioration in global financial conditions. Moreover, going forward, national markets will be judged by new standards of liquidity, transparency, and the greater integrity that comes from properly aligned incentives. Our institutions will have to compete in that environment. In my remarks today, I would like to discuss briefly three of the factors behind the market turbulence and then outline corresponding priorities for the official sector and market participants. This list is far from exhaustive, but I chose these three because they are among the most important, and because efforts are now under way – in both the public and private sectors – to address them. Causes of the turbulence Recent events represent an overdue repricing of risk; the direction of which was predicted by many and desired by some. 1 However, the speed and virulence of the repricing has illustrated the adage "Be careful what you wish for." While the repricing was triggered by significantly higher-than-expected defaults in U.S. subprime mortgages, we should all recognize that the trigger could have come from a wide range of sources. The social and economic costs of the events in the subprime market are concentrated in the United States, while the financial costs are both widely dispersed and – relative to the scale of the system – readily absorbable. In short, as painful as they are to those affected, subprime losses have been important primarily because they have revealed deeper flaws in the financial system. While a number of underlying causes can be identified, I will concentrate on three in particular. The first relates to liquidity. In recent years, market participants were overly confident that liquid markets would continually provide an outlet for new products and represent an ongoing source of funding liquidity for financial institutions. Ample market liquidity had its origins in benign macroeconomic conditions, low and relatively stable long-term interest rates, financial Indeed, central banks had been discussing the possibility of a repricing of risk for some time. See "Developments and Trends," Financial System Review (Ottawa: Bank of Canada, June 2004): 4-5. innovation, and the broadening list of financial market participants. Ultimately sowing the seeds of its own demise, market liquidity fed a supreme confidence in the ability to sell holdings at prices that matched mark-to-model valuations. This overconfidence encouraged the rapid growth of the "originate-to-distribute" credit model. In this model, the borrower often became separated from the end investor by several transactions, as credit risk was repackaged, tiered, securitized, and distributed. Many originators and distributors felt confident that long-term credit risk had been transformed into short-term "warehouse" risk prior to distribution and that distribution itself was irrevocable. Others knew that they had not fully eliminated these risks, but felt they could get out in time. Such confidence was misplaced. Risk had not disappeared, it had merely been redistributed, and that distribution was often not final. The current market disruptions represent, in part, the painful process of finding out where that risk ultimately lies. Liquidity was also the Achilles heel of many asset-backed commercial paper (ABCP) programs and structured investment vehicles. In many such vehicles, medium-term, illiquid, hard-to-value assets were funded by short-term money market securities at yields only marginally higher than those offered by the most liquid, transparent, risk-free securities. As confidence that this paper could be rolled over faltered, there was indiscriminate selling of structured assets. In markets where backstop liquidity was judged not to be automatic, such as the ABCP currently involved in the Montreal Accord, noteholders could no longer redeem their paper. 2 In markets where backstop liquidity was robust, investors could exit and, as a result, ABCP came back on the balance sheets of financial institutions, which in turn raised concerns about the scale of their exposure. From a medium-term perspective, the disappearance of segments of ABCP markets around the world will have important implications for the viability of many securitized products, since ABCP represented an important funding source for the most senior tranches of securitized credit structures. The second cause of current market disruptions has been the lack of transparency and inadequate disclosure that characterizes many highly structured financial products. These shortcomings were ignored when times were good to the extent that many investors did not actually understand the characteristics of the securities that they owned. Market participants were often less surprised by the deterioration in subprime market fundamentals than by the marked-to-market losses of subprime collateralized debt obligation (CDO) securities, given the defaults in the underlying mortgages. This surprise, in turn, has prompted a broad reevaluation of structured products and, in some cases, indiscriminate selling. Even months later, the opacity of these structured products has made them harder to value, thus dramatically reducing secondary market liquidity. Poor disclosure of many securitized products continues to make it difficult for new investors to enter the market confidently and purchase securities despite distressed prices and the presence of still-substantial global liquidity. Indeed, as I will discuss in a moment, the high cost of default protection in many markets – such as that for corporate bonds – implies a pessimism about actual default probabilities that appears excessive. 3 At the same time, widespread uncertainty about the distribution of losses has fed concerns over counterparty risk. With the assumption that risk had been irrevocably transferred found wanting, market participants became uncertain about the true financial situations of their counterparties, and have sometimes been reluctant to lend, even at very short horizons. The The Bank of Canada raised this concern in P. Toovey and J. Kiff, "Developments and Issues in the Canadian Market for Asset-Backed Commercial Paper," Financial System Review (Ottawa: Bank of Canada, June 2003): 43-49. For example, in recent weeks, the default rates implied by the levels of the ITRAAX crossover index have reached almost twice the cumulative default rate experienced by comparably rated companies during the last two recessions. resulting "reckless prudence" has, on occasion, created very unusual conditions in interbank markets and intensified the already sharp reduction in market liquidity. Inadequate transparency was also a factor behind the breakdown of trust in credit-rating agencies, which has amplified the stresses in financial markets. This breakdown occurred for several reasons. First, the default and ratings transition probabilities of structured products have not always been consistent with those of corporate and sovereign ratings. Moreover, recent events have brought into focus some potential conflicts of interest in the ratings business. 4 The fall from grace of the rating agencies has had a significant impact because rating agencies had grown more powerful than anyone intended. Indeed, many investors seem to have performed little or no in-house credit analysis of their investments; in other words, they substituted a subscription to a ratings publication for analysis and due diligence. The third and final cause that I will mention was a series of misaligned incentives. It has been belatedly recognized that the severing of the long-term relationship between the originator and the borrower has contributed to the decline in credit quality. Historically, the original lenders (or originators of a credit) would be meticulous with their documentation and careful with their due diligence, because they knew that they would likely retain the exposure to risk of default until the loan matured. However, as originators became increasingly confident that they could sell off the loan, documentation and credit standards declined to the nowinfamous extreme of "Low doc/NINJA" (no income, job or assets) loans to U.S. subprime borrowers. Performance has deteriorated accordingly: for example, default rates for U.S. subprime mortgage loans made in 2006 have already reached almost 8 per cent less than two years after origination, a rate 2.5 times the comparable figure for similar loans made in 2004. 5 There also appear to have been a number of problems with incentive alignment in several global financial institutions. These include mismatches between the timing of trader compensation and the realization of profits from their trades, an insufficient recognition and compensation of risk-management professionals, and provision of funding at risk-free rates to trading desks that placed risky bets. All of these factors encouraged excessive risk taking. Finally, it appears possible that the incentives provided by a series of regulations may have encouraged crowded trades. The so-called "cliff risk" created by the mandated use of ratings is one example. A paradox of the current turbulence is that a desire to shelter in the perceived safety of AAA-rated assets led to a dangerous explosion in the supply of synthetically created AAA-rated assets. Since many of these assets were financed by excessive leverage and many participants were constrained by mandates to sell on downgrades, the rush to the exits has proven extremely destabilizing. Next steps for policy-makers Before addressing specific responses in detail, I would like to make a couple of general points. The first is that, while the need to restore well-functioning markets is of paramount importance, the official sector can afford to take some time to ensure that the actions they take are appropriate. This is because many of the market practices that contributed to the dislocations have stopped. At present, many financial institutions are, at best, assuming limited access to market-based liquidity and, in the extreme, hoarding liquidity. It is an understatement to say that credit exposure is once again receiving active scrutiny. The For a full discussion, see M. Zelmer, "Reforming the Credit-Rating Process," Financial System Review (Ottawa: Bank of Canada, December 2007): 51-57. Data supplied by Merrill Lynch U.S. See also J. Kiff and P. Mills, "Money for Nothing and Checks for Free: Recent Developments in U.S. Subprime Mortgage Markets" (Working Paper WP/07/188, International Monetary Fund, 2007). demand for complex, opaque securities has dried up. With institutional memory longer than a few months, even in the financial sector, there is no need to rush to judgment or to impose hastily conceived measures. The other point is that market participants have every reason to learn the lessons of these events and to change their behaviour as required. As I will discuss in a moment, there are some encouraging signs in this regard. That said, recent events have revealed serious and widespread shortcomings that, if not addressed promptly, completely, and credibly, will demand a more activist response on the part of regulators. The ultimate response will likely be a combination of improved private sector standards and more effective regulation. With those general points in mind, I would like to describe the current responses to the three factors I just mentioned. First, in terms of liquidity, in many countries the official sector has been working to strengthen and modernize their liquidity arrangements where necessary. Since August, many central banks have provided liquidity to keep the financial system functioning, while not favouring any one market. In the case of the Bank of Canada, our provision of liquidity through standard operations has been effective in keeping the overnight interest rate close to our target. However, as in other countries, liquidity further out the maturity spectrum has been more problematic. While liquidity in term money markets in Canada is currently better than it was in December and better than that now experienced in other jurisdictions, it has not yet returned to historical norms. There are a number of ways in which the Bank of Canada is seeking to improve its ability to provide liquidity to the system. First, the Bank has indicated that we plan to expand the list of collateral that we will accept in our Standing Liquidity Facility. Last week, we issued a consultation paper on our plans to take some types of ABCP as collateral by 31 March. We also plan to accept U.S. Treasuries as collateral by the middle of the year. Second, we are examining the types of term purchase and resale facilities that we should make available in times of financial instability or market failure. These facilities could be similar to the term purchase and resale agreements (or PRAs) that the Bank conducted in December and will be conducting again over the next few weeks. In both of these cases, announcements of these term PRAs were made as part of coordinated actions taken by major central banks to address liquidity pressures in funding markets. The G-10 central banks will continue to work together and will take appropriate steps to address these liquidity pressures. Finally, in its recent budget, the Federal government announced proposals to amend the Bank of Canada Act in order to modernize our authorities to support the stability of the financial system. In parallel with these initiatives, liquidity management at financial institutions must also be improved. Reinvigorated institutional memory has reminded a broad range of institutions of the importance of liquidity management and credit discipline. It is worth noting that, a year ago, the Institute of International Finance published a thoughtful document that outlined potential vulnerabilities in the management of liquidity risk at financial institutions and suggested best practices in the private and official sectors. 6 However, as with so much in life, implementation is everything. Regulators are now developing new guidelines and increasing their focus on liquidity management to redress these shortcomings. The second priority area for action is the need for improvements in both transparency and disclosure practices. Such improvements would help to reduce the information asymmetries that impede the smooth functioning of markets. Globally, there is an urgent need for credible, timely disclosure. Recent reports from Canadian financial institutions have met this requirement. However, information alone is Institute of International Finance, Principles of Liquidity Risk Management (Washington: Institute of International Finance, 2007). insufficient; investors also need to know how to interpret it. The combination of the relative novelty of fair value accounting and extremely volatile markets has made this interpretation more difficult. Some have questioned the utility of requiring mark-to-market valuations of all assets and liabilities on a corporate balance sheet. 7 The point can be made that, in the current circumstances, existing accounting rules provide a degree of precision that is not warranted. By reflecting market moves, fair value accounting certainly increases the volatility of reported earnings. Whether it contributes pro-cyclically to market volatility depends on the behaviour of management. Management's incentive to realize mark-to-market losses depends not only on their expectations of future market moves but also, importantly, on the extent to which investors reward them for capping downside risk or penalize them for higher book leverage caused by unrealized losses. This depends, in part, on investors' interpretation of existing rules. Investors should keep several factors in mind. First, in volatile markets, reported earnings will be volatile. Second, investors should distinguish between realized and unrealized losses. Third, securities may be marked-to-market using imperfect proxies, such as thinly traded derivative indices. As a consequence, investors should be wary of assigning unwarranted precision to such valuations. Fourth, for many complex securities, valuation might be better expressed as a range of outcomes. Since current accounting rules do not permit this, investors must use their judgment to construct valuation distributions. Institutions should provide the information necessary to facilitate such judgments. From a medium-term perspective, the Financial Stability Forum is looking at accounting and valuation procedures for financial derivative instruments, particularly those for complex, narrowly traded products that become difficult to price in times of stress. More generally, authorities around the world are promoting prompt and full disclosure by financial institutions of losses and valuations of structured products, and are seeking to improve the understanding and disclosure of institutions' exposure to off-balance-sheet vehicles. Loss recognition by major financial institutions is proceeding much more rapidly than during previous periods of financial turmoil. This will ultimately speed the recovery process, provided that investors realize that the rules of the game have changed. Losses that would have been hidden in reserves in the past are now quickly, and sometimes imprecisely, in the open. Some of these losses will be revised later; thus, reported earnings may be more volatile than realized final results. What can authorities do themselves to encourage greater transparency in structured products? First, as announced last week, the Bank's high disclosure standards for the ABCP that it will accept as collateral in its Standing Liquidity Facility may encourage market participants to raise their own standards. In the end, it will be their decision. While issuers and arrangers have every incentive to improve the transparency of structured products, ultimately, disclosure guidelines are set – or not – by regulators. One lesson from the ABCP situation may be that blanket disclosure exemptions were too broad. At the same time, however, authorities should resist the temptation to bring forward overly prescriptive regulations. Rather, they should consider greater application of principles-based regulation. There is no point in regulators trying to anticipate every new product or to restrain their development. There is a point in encouraging issuers to ensure the adequacy of their disclosure within a principles-based framework and to bear the consequences if it is subsequently found wanting. As I commented earlier, the evolving role of rating agencies relates closely to issues of disclosure and transparency. Authorities are examining the role of credit-rating agencies in For example, see B. Connolly, "Accounting for Depression." Banque AIG Research, 4 March 2008. evaluating structured products and the impact of the mandated use of ratings due to investment guidelines or regulation. Going forward, securities regulators will want to see agency incentives aligned more closely with those of investors, and will ensure that agencies are quicker and more thorough in reviewing past ratings. Other regulators must also take responsibility for looking at the extent to which the mandated use of ratings has encouraged credit outsourcing, led to pro-cyclical price movements, and encouraged discontinuous crowded trades. Since rating agencies rely on their reputations, they have powerful incentives to sharpen their practices, improve the information content of their ratings for complex financial instruments, ensure that all material facts are disclosed in a concise and timely manner, and address inherent conflicts of interest in the ratings process. Recent announcements by rating agencies in this regard are encouraging. I should again stress that investors must not rely exclusively on changes in the rating methodologies of the agencies to repair deficiencies in their own risk-management practices. In a mark-to-market world, with leveraged, collateralized positions, investors need to make their own judgments about the creditworthiness, liquidity, and price volatility of the securities they own. The third priority area for action concerns the proper alignment of incentives. The market dislocations have revealed some examples of serious principal-agent problems, most notably, within the originate-to-distribute model. For securitization markets to function well, the incentives of originators should be aligned with those of end investors. Indeed, originators and distributors are finding it difficult to sell products where they do not face first loss or otherwise retain exposure through reputational risk. I have little doubt that, over time, originators and distributors will adjust. Incentive alignment is a necessary but not sufficient condition to revive many structured-product markets. It will need to be accompanied by greater standardization, improved transparency, and the development of an appropriate investor base. Another example of misaligned incentives can be seen in the risk-management practices and remuneration structures of financial institutions globally. 8 Many financial institutions have pay structures that reward short-term results and encourage potentially excessive risk taking. Investors should take the lead in demanding compensation structures that are more aligned with their interests. Others have suggested that the regulators themselves should make these determinations. While I think regulation of compensation within private institutions is entirely inappropriate, I do think that regulators need to consider carefully the incentive impact of compensation arrangements as they assess the robustness of risk-management and internal control systems. Regulation also creates incentives. The Financial Stability Forum is reviewing the basic supervisory principles of prudential oversight and the possibility that the incentives created by accounting standards and bank capital regulation are contributing to pro-cyclicality in the financial system. 9 Conclusion Let me conclude with some comments on the role of monetary policy. At a time of great uncertainty, it is more important than ever that monetary policy act as a stabilizing force. This underscores the importance of keeping inflation low, stable, and predictable. This means that M. Wolf, "Why regulators should intervene in bankers' pay," Financial Times, 16 January 2008, 11. Both the Basel Committee on Banking Supervision and the International Organization of Securities Commissions are working in this area. the Bank will continue to watch developments in the real economy for their impact on inflation. Developments in the financial sector will be important from a monetary policy perspective only to the extent that they are expected to influence developments in the real economy and, therefore, inflation. I do not mean to downplay the current financial turbulence – it has clearly begun to affect the U.S. economy and, to a lesser extent, ours as well. At the Bank of Canada, we will continue to monitor these effects, while aiming neither to favour particular market segments nor to insulate market participants from the consequences of their decisions. Those consequences will continue to reveal themselves in the weeks and months ahead. This will remain a difficult process. However, the responses that I have just outlined will help the market translate uncertainty into risk, and encourage the appropriate repricing of risk so that markets can ultimately return to more normal functioning. However, this will not mean a full return to the status quo ante. While risk will still be distributed, securitization will be increasingly transparent and standardized, and perhaps eventually exchange traded. First loss will likely remain, to some degree, with the originator. Liquidity and balance sheet strength will be more highly valued. Volatility will be less restrained by overconfidence. In short, we will see a world in which financial institutions with sound credit judgment, effective risk management, and patient capital can prosper; a world in which capital is allocated more efficiently; a world that rewards the traditional attributes of Canadian financial institutions. I feel very positive about Canada's medium-term prospects in such a world.
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Opening statement by Mr Paul Jenkins, Senior Deputy Governor of the Bank of Canada, to the Standing Senate Committee on Banking, Trade and Commerce, Ottawa, 12 March 2008.
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Paul Jenkins: How trade and impediments to internal trade affect the Canadian economy Opening statement by Mr Paul Jenkins, Senior Deputy Governor of the Bank of Canada, to the Standing Senate Committee on Banking, Trade and Commerce, Ottawa, 12 March 2008. * * * Thank you, Mr. Chairman, for the opportunity to appear before this committee. With me is John Murray, a deputy governor at the Bank of Canada and member of the Bank's Governing Council. Let me start by saying that the issue of internal trade barriers is critically important, and I'm very pleased, Mr. Chairman, that your committee is examining it. We have reviewed previous submissions to this committee, and you will see that our focus will be slightly different. Rather than address the details of any given restrictions to internal trade, I'd like to focus on how trade and impediments to internal trade affect the overall performance of the Canadian economy. In these remarks, I'd like to address two important issues from that perspective: the need for flexibility in adjusting to economic change, and the need for economic policies that promote flexibility in markets for goods, services, capital, and labour. Economic flexibility refers to the ability of an economy to adjust to changing circumstances. Changes in economic conditions often relate to movements in relative prices, which in turn send important signals to markets. A flexible economy is one that adjusts to these signals and returns to its production potential as quickly, and with as little cost, as possible. Over the past decade or so, economic expansion in Canada and around the world has been robust, despite a series of major shocks. These shocks included: - the 1997-98 financial crisis in Asia, which spread to Russia and Latin America - the worldwide collapse of the high-tech bubble - the 9/11 terrorist attacks in the United States - SARS and BSE - intensified competition from China and India - and, since 2003, a sharp increase in commodity prices and an associated sharp increase in the external value of our currency. More recently, of course, we have been faced with the fallout of credit market turbulence associated with problems in the American subprime-mortgage market and the increased use of structured financial products. It's important to note that all of these shocks were international in origin and/or in dimension. Many of these shocks – notably, the Asian crisis and the recent sharp run-up in commodity prices – involved large movements in relative prices, that is, in the prices of energy and nonenergy commodities, as well as large movements in the exchange rate for the Canadian dollar. And these movements have in turn triggered important shifts in economic activity, as well as reallocations of production resources across sectors and regions of the country. All of this underscores the fact that we live in an era of rapid change, and we operate in a global environment that is constantly shifting. Uncertainty, risks, and shocks are constant features of the economic landscape. For Canada, it is particularly important that we recognize this reality, given how open our economy is to international trade and capital flows. The best approach to dealing with risks and sudden developments is to constantly ask ourselves what steps we can take to make our economy and domestic markets more flexible, and thus better able to adapt to changing circumstances. And we need to recognize that this is a shared responsibility among firms, workers, and policy makers. Firms and their workers need to be able to respond quickly to technological advances and to shocks that require changes in the way they conduct business, the kinds of goods and services they produce, and the markets they choose to develop. A well-functioning marketbased economy that sends clear relative price signals is critical in this context. At the same time, policy-makers need to be wary of barriers to adjustment, such as labour regulations that inhibit the movement of workers from one type of job, or from one sector or region, to another. To enhance flexibility, to raise the growth potential of the economy, and to increase its resilience to shocks, we need policies that encourage structural reforms. For Canada, structural reform has a broad context, with priorities across a number of jurisdictions. The financial system, with its vital role in supporting a healthy modern economy, has been and will continue to be one priority. An efficient and sound financial system enhances overall economic flexibility by helping to redirect capital and resources to the most productive uses, in a cost-effective way, following a shock. Removing internal barriers to the free movement of goods, services, and labour is another priority. These barriers are rightly attracting attention in Canada as differences in regional economic performance and shortages of skilled labour are becoming more pronounced, and as demographic challenges intensify. A number of initiatives to remove internal barriers have been undertaken over the years, but with mixed and generally modest results. The Red Seal Program was introduced more than 45 years ago to help standardize and recognize workers' trade qualifications. The Agreement on Internal Trade (AIT), signed by First Ministers in 1994, aimed to reduce barriers to the movement of goods, services, investment, and labour. One very important recent example is the Trade, Investment and Labour Mobility Agreement (TILMA) reached in April 2006 between British Columbia and Alberta to strengthen enforcement and dispute resolution and to harmonize labour credentials and business regulations and standards by early 2009. Considerably more needs to be done to enhance the flexibility and functioning of our internal markets from coast to coast. Business regulations and standards, including those of the financial sector, need to be harmonized across Canada. Dispute resolution and enforcement under the AIT need to be strengthened. And to make our labour markets more flexible, trades and professional designations should be recognized and fully transferable across the country. A significant step forward would be for others to adopt the British Columbia-Alberta accord. The Bank of Canada also has an important role to play in helping the economy to adjust to economic change. The Bank's monetary policy aims at keeping inflation low, stable, and predictable, which in turn helps Canadian businesses to read price signals more clearly, respond to relative price movements more promptly, and allocate production resources more efficiently. I'll conclude by saying that uncertainty, risks, and shocks will be as much a part of tomorrow's economic picture as they have been in the past. We all have a stake in Canada's economic well-being, and we all have a role to play in improving our flexibility and adaptability. From that perspective alone, this committee's study of issues related to internal barriers to trade is timely and important. Thank you, Mr. Chairman. John and I would be happy to respond to your questions and comments.
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Remarks by Mr Paul Jenkins, Senior Deputy Governor of the Bank of Canada, to the London Chamber of Commerce, London, Ontario, 2 April 2008.
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Paul Jenkins: Trends and challenges in the global economy and what they mean for Canada and Ontario Remarks by Mr Paul Jenkins, Senior Deputy Governor of the Bank of Canada, to the London Chamber of Commerce, London, Ontario, 2 April 2008. * * * Good morning. First, I would like to thank the London Chamber of Commerce for inviting us here today. It's a pleasure for me to be back in London, given my close family ties and my years at the University of Western Ontario. As is the case for so many cities and regions in Canada, London's economy and that of southwestern Ontario are directly affected by changes in the global economy. And, as with so many things in life, the better we understand the forces of change, the better equipped we are to deal with them. What I'd like to do this morning is discuss some of the key trends in the global economy, as well as the challenges they present, and then talk about some of the implications for Canada and for Ontario. And because one of the main reasons that we have come to London is to hear your thoughts and concerns, I'll leave plenty of time for your comments and questions. Macroeconomic trends in the global economy The turbulence in global financial markets, which has been with us since last August, continues to be a major focus. But rather than starting there, allow me to first step back and provide a perspective that covers the past five or six years. From 2002 to 2007, the world economy expanded strongly, growing by an average of 4.6 per cent per year, measured in terms of real GDP. The growth of world trade was even more impressive, at about 7 per cent on an annual average basis. This period of robust growth benefited most nations, and was strongest in emerging-market countries such as China, India, and Brazil. In industrialized countries, growth was also steady and solid. What we are now confronting is a marked slowdown in global economic growth, emanating primarily from the sharp correction under way in the U.S. housing market and the associated tightening in credit conditions linked to the collapse of the U.S. subprime-mortgage market. I will come back to discuss these financial developments in a moment. But in keeping with the theme of taking a longer-term perspective, it's important to note that some slowing in global economic growth was necessary. After five to six years of nearly unprecedented growth, levels of economic activity around the globe were straining capacity limits and beginning to put upward pressure on inflation. These pressures can be seen in the sharp run-up in commodity prices. Compared with the beginning of 2002, U.S.-dollar prices are more than 5 times higher for crude oil, and more than triple for metals and grains. In real terms (that is, compared with the increase in overall consumer prices) the price of crude oil has more than quadrupled over this period, and is now above the levels reached in the 1970s and early 1980s. The impact of these elevated commodity prices on consumer prices can be seen in the latest numbers on total consumer price inflation. In the United States, the United Kingdom and the euro zone, total CPI inflation is currently at 4.0 per cent, 2.5 per cent, and 3.5 per cent, respectively. Emerging-market countries are also facing rising price pressures. Core inflation, which excludes the effects of rising food and energy prices is, however, running closer to 2 per cent in industrial countries. With global economic growth slowing, it is unlikely that the higher prices of food and energy will spill over into prices and costs more generally, but this risk is something central banks are watching closely. In other words, central banks are focused on keeping inflation expectations well anchored. Challenges in the global economy With that backdrop, let me now discuss three key challenges facing the global economy and, by extension, Canada and Ontario: first, the slowdown of the U.S. economy and the associated financial turbulence; second, global trade imbalances; and third, competition from emerging-market countries. The most immediate challenge facing the global economy is the marked slowdown in the U.S. economy. This slowdown involves several interconnected elements, and, given our close trade links to the United States, has very direct consequences for Canada. One element is the sharp and protracted correction under way in the U.S. housing sector. This correction stems from the fact that house building had risen to unsustainable levels and from the related implosion of the subprime-mortgage market with its weak underwriting standards. Construction, sales, and prices in the housing market have fallen dramatically, and inventories of unsold houses remain high. Another element is, of course, the financial turbulence and changes in credit markets that we've witnessed over the past eight months. Given the complexity of this situation, let me spend a little more time on it. To understand the cause of this turbulence, it's again useful to look back over the past five or six years. During this period, a decline in inflation, together with an excess of global savings relative to desired investment, resulted in real interest rates that were low by historical standards. It was also a period, as I noted earlier, of strong, steady global economic expansion. In this macroeconomic setting, spreads between higher-risk and lower-risk investments declined. At the same time, a variety of new financial instruments, such as new types of asset-backed securities and collateralized debt obligations, were introduced. Investors who were looking to enhance their returns were attracted to these products. This led to greater leverage (that is, debt financing) and to investors taking on risks that many clearly did not fully understand. The link back to the United States is that many of these new, or structured, products had subprime mortgages embedded in them. Once delinquencies and defaults on these mortgages started to mount, and given the opacity of these investment products, risk premiums started to widen, market liquidity started to dry up, and credit conditions tightened. And these financial market reactions were felt globally. I will quickly add, however, that the pressures in Canadian financial markets have been less intense because of the relatively healthy balance sheets of households, firms, and financial institutions in Canada. The entire episode, which is by no means fully played out, can be seen as an overdue repricing of risk, a recognition of losses, and a recapitalization of balance sheets. Governor Carney spoke recently about this topic, so I won't dwell on it here, but suffice it so say that these events highlight the need for change in both the private and public sectors so that markets can return to more normal functioning. In the private sector, the most pressing needs for change include greater transparency in financial products, improved risk and liquidity management, and more rational, better-aligned incentives. For our part, we at the Bank are taking steps to support the functioning of markets by expanding the list of eligible collateral that we will accept in our Standing Liquidity Facility, by examining types of term operations and term lending, and by modernizing our legislative authority to support the stability of the financial system. The second challenge facing the global economy and Canada has to do with the large current account imbalances that exist today. In a nutshell, the United States has been running a very sizable current account deficit for a number of years, while most of the rest of the world – especially Asia and oil-exporting countries – has been running current account surpluses. Large imbalances such as these are not sustainable over long periods, so the question arises: what needs to be done to effect an orderly resolution? Two main adjustments are needed. First, those countries with large surpluses need to rely more on domestic demand as a source of growth, and those with deficits (mainly the United States) need to increase their national savings rate. Second, there is a need for more exchange rate flexibility. This is particularly the case for China, but also more broadly across Southeast Asia. China continues to resist exchange rate flexibility, and thus adjustment, through the accumulation of foreign exchange reserves, which now total US$1.5 trillion. I want to quickly add that greater exchange rate flexibility is in China's own best interest. It would greatly enhance their ability to manage their own economy, including dealing with their mounting inflationary pressures. The third major challenge is the integration of China and India into the global economy. Not surprisingly, some perceive the growing economic clout of and competition from China and India as a threat, especially as both countries increasingly produce more high-value-added goods and services. But the growth of emerging-market economies represents a tremendous opportunity for Canadian businesses. We need to exploit our comparative advantages and see these rapidly expanding markets as places to do business. So, that's a quick look at some of the trends in and the challenges posed by the global economy. Let me now turn to the home front and discuss some key economic issues facing Canada and Ontario, in light of these global developments. Canada and Ontario in the global economy These global economic trends represent significant and, in a very real way, competing or contrasting, forces shaping developments here at home. Strong commodity prices are generating a substantial boost to incomes in Canada. In economic jargon, we have had an increase in our terms of trade – the prices of the products we sell internationally are rising faster than the prices of the products we import. The resulting rise in real incomes is providing support for domestic demand in Canada, which has been showing up in rising consumption, construction spending, investment in machinery and equipment, and, more broadly, in employment gains. At the same time, the weakness of the U.S. economy, the strength of our dollar (reflecting the increase in our terms of trade and the relative weakness of the U.S. dollar), and competition from Asia have led to flat to declining exports, especially in the manufacturing sector. Thus, overall, what we have had in Canada is strong domestic demand offsetting a weak traded-goods sector. Monetary policy has been calibrated based on judgments about the relative strengths of these competing forces, with an eye firmly fixed on the policy objective of keeping inflation at our 2 per cent target. Currently, total CPI inflation in Canada is 1.8 per cent. Excluding the one-time effect of the January GST cut, total CPI inflation is 2.4 per cent, and core inflation (which excludes the more volatile components) is 1.5 per cent. Staying on top of all the forces at play is an essential preoccupation of the Bank of Canada. As we said in our last policy press release a month ago, the correction in the U.S. housing sector, knock-on effects of this correction to other parts of the U.S. economy, and the tightening of credit conditions in global financial markets have led us to conclude that the risks surrounding the Canadian economy have shifted to the downside, resulting in our decision to lower our policy interest rate by 50 basis points to 3.5 per cent. We also said that further monetary stimulus is likely to be required in the near term to keep aggregate supply and demand in balance and to achieve the 2 per cent inflation target over the medium term. With that global and national perspective, I'll now talk about some of the issues, challenges, and opportunities facing the Ontario economy. Ontario's economy is being confronted by both cyclical and structural economic forces. On the cyclical front, we have the marked slowdown in the U.S. economy. This has had a direct impact on the province's forest products industry – from lumber, to doors, windows, and building materials generally – and on the automotive industry. But these and other industries are feeling the effects of strong structural forces. Clearly, competition from emerging-market countries is one of those forces. Because of these cyclical and structural forces, demand has turned away from a number of products that Ontario has traditionally produced. In other words, relative prices have moved against some key segments of the Ontario economy. To draw a comparison to the national situation, one could say that there has been an adverse movement in Ontario's terms of trade. Of course, the rise in value of the Canadian dollar over the past five or six years has been an important part of these relative price movements. At the same time, some sectors of the province's economy are benefiting from these changes in relative prices, including the mining and agrifood sectors. We must also remember that the manufacturing sector is not homogenous – the high-tech sector standing out as an example. And Ontario has strong financial services and health services sectors. What this adds up to is the need for adjustment within the Ontario economy in response to these global forces. Adjustment is not easy. But London and its surrounding area does seem to me to stand out as an example of the importance of having the flexibility to respond and adjust to changing circumstances. Some 20 years ago, manufacturing accounted for 20 per cent of the jobs in London, compared with 14 per cent today. This decline has been more than offset over the past 20 years by employment gains in financial, business, and professional services, and in transportation and warehousing. In addition, we have seen significant investments, including in the manufacturing base of this community, in technology that supports world-class operations. The result for London over this period has been rising employment and rising real incomes. Good macroeconomic management is certainly part of what is needed to help provinces, cities, and communities adjust to global change. This includes sound fiscal policies, policies that help to reduce public sector debt levels relative to the size of the economy. The Bank of Canada also has an important role to play. The Bank's monetary policy aims at keeping inflation low, stable, and predictable. This, in turn, helps households, businesses, and governments to read price signals more clearly, respond to relative price movements more promptly, and allocate production resources more efficiently. When relative prices move to the extent that they have in recent years, markets are essentially telling us that there has been a fundamental change in the type of products that the rest of the world wants to buy from Canada. In setting monetary policy, our job is to understand what this means for Canada's overall economic picture, which implies a focus that is national in nature and scope. Conclusion To conclude, the first point I wish to make is the importance of allowing market-based adjustment mechanisms to work. Markets send price signals that indicate the best way for resources to be allocated. Second, it is also important for households, businesses, and governments to take a medium- to longer-term perspective in making decisions. The global forces at play are not going to disappear any time soon. We therefore need to encourage flexibility and adaptability in the Canadian and Ontario economies. In other words, more needs to be done to enhance the functioning of our internal markets. Policies that support flexibility can obviously help economies adjust to cyclical economic shocks. But encouraging flexibility can also have a longer-term payoff. When policies provide an environment where initiative and innovation can flourish, the Canadian economy is able to adapt to longer-term global forces in ways that continuously exploit our comparative advantages. Thank you for your attention. I would now be happy to respond to your questions and comments.
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Remarks by Mr David Longworth, Deputy Governor of the Bank of Canada, to the Global Investment Conference, Lake Louise, Alberta, 10 April 2008.
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David Longworth: Credit markets, financial stability and monetary policy Remarks by Mr David Longworth, Deputy Governor of the Bank of Canada, to the Global Investment Conference, Lake Louise, Alberta, 10 April 2008. * * * Good afternoon, ladies and gentlemen. It's good to be here in my home province of Alberta to discuss with you some interesting topics at a very interesting time. I remember back in January thinking that the previous five months had been the busiest of my career at the Bank of Canada. However, I believe I can now say that the past eight months have definitely been the most active – and most interesting – in my Bank of Canada career. Today, I'd like to discuss some of the crucial issues that we have been dealing with during this period. I'll begin with a brief overview of some key events that have led to the turbulence that continues to upset financial markets and that greatly contributed to the remarkably wide credit spreads that we now witness. I'll discuss some of the ongoing analysis of these credit spreads that we are conducting at the Bank of Canada. I will then turn to the policy issues around financial stability that the turbulence has highlighted and describe some of the work that we are doing to promote financial stability throughout this period of uncertainty. Finally, I'll describe how we take financial market developments into account as we conduct monetary policy and the important role that this policy plays in promoting economic and financial stability for Canadians. How did this happen? What were some of the root causes of the current market turbulence? We know that for a number of years, desired world savings exceeded desired world investment. As a result, long-term real interest rates decreased around the world. This led investors to search for yield, and they became willing to take on risk at lower premiums than they had demanded in the past. Part of this search for yield led to rapid growth in the demand for, and development of, more complex structured financial products, such as collateralized debt obligations (CDOs) backed by asset-backed securities or by other CDOs, and asset-backed commercial paper (ABCP) backed by CDOs, some of which (after 2000) were based on U.S. subprime mortgages. 1 These complex instruments were rated by credit-rating agencies using the same scale that they had used in the past for plain-vanilla corporate debt. Some sellers of these complex financial instruments emphasized that these products were highly rated – many were AAA – but placed little emphasis on their other features. A number of investors failed to perform their own research or due diligence and instead relied too much on credit ratings as a measure of the ultimate risk in holding these complex debt instruments. In doing so, they failed to take into account other risks such as liquidity risk. The complexity of these instruments frequently made them opaque, and too often investors put their money and confidence into investments that they did not fully understand. At the same time, U.S. policy interest rates rose, and the basic loan quality of U.S. subprime mortgages worsened through 2005 and 2006, although this worsening did not become broadly apparent until the first half of 2007. The belated realization by the rating agencies of the poor quality of these loans resulted in downgrades of structured products with exposure to subprime mortgages, often by multiple notches. These instruments were held by a variety For a further discussion of these financial market events, please see the most recent issue of the Financial System Review (Ottawa: Bank of Canada, December 2007). of investment funds, including many sponsored by banks. Indeed, some products were directly held by banks themselves. Investors in Canada, as well as those in the United States, soon came to realize that highly rated structured debt instruments could fall substantially in value and were subject to severe downgrades. As a result, they began to shun almost any type of structured product, partly because the complexity of such products made it difficult for many market participants to understand these instruments and, therefore, to accurately price the risk that these products posed to financial institutions. In Canada, this included instruments such as ABCP. Almost immediately, non-bank-sponsored ABCP stopped rolling over in Canada, which led to the standstill under the Montreal Accord. As market players observed the downgrades of structured products based on U.S. subprime mortgages and the drying up of ABCP markets, two additional concerns emerged. First, there was a concern about the financial health of counterparties, particularly banks. Second, there was a concern that securitization would proceed at a much slower pace than in the past, thus requiring re-intermediation that would result in a more rapid expansion of bank balance sheets and an associated need for capital. These two concerns led to a significant increase in the interest rate spreads of bank debt over government benchmarks. Widening of credit spreads As time has passed, it has not been only bank credit spreads that have widened. We know from past experience that variations in credit spreads can be driven by several different factors. One basic component of credit spreads is expected loss from default, while a second relates to risk premiums, of which there are two main types: a credit-risk premium and an illiquidity premium. 2 The credit-risk premium is related to the variability of underlying expected loss, and both this premium and the expected loss from default itself are affected by changes in macroeconomic activity. The illiquidity premium relates to a lack of general market liquidity. The credit and illiquidity premiums, like other risk premiums, can vary with any change in the risk appetite of investors. Now, let me look specifically at the Canadian situation. From early 2004 to mid-2007, spreads on Canadian corporate investment-grade and high-yield bonds were fairly stable and narrow relative to historical norms, as were those in most other industrialized countries. (This can be seen in Chart 1.) But these spreads began to widen last summer as the crisis in the subprime-mortgage market started to take hold. Some of this widening can be explained by rising concerns about Canada's economic outlook due to the impact here of a possible recession in the United States. However, credit spreads – while not all at historic peaks – are now far wider than one would have predicted, based on past experience with economic downturns, and given the fact that Canada's economy is in a healthier position than the U.S. economy. (Chart 2 shows spreads on investment-grade bonds in both Canada and the United States.) T. Gravelle and A. Garcia, "Decomposing Canadian Corporate Spreads: What Are the Drivers of the Current Widening?" Financial System Review (Ottawa: Bank of Canada, forthcoming, June 2008). One partial explanation for the current wide credit spreads – globally, not just in Canada – relates to an unusual rise in factors not related to credit risk, such as the systemic drying up of market liquidity for debt issued by corporations, particularly for debt issued by investmentgrade companies like financial institutions. Another partial explanation is that the current wide credit spreads are being driven by what appears to be excessive pessimism about expected default rates. We can see evidence of this in the very high cost of default protection in many markets, despite some improvement recently. 3 (Chart 3 shows the evolution of credit default spreads in North America and Europe, for both investment-grade and "crossover" companies, that is, those with lower-quality but still investment-grade ratings or slightly below.) For example, in recent weeks, the default rates implied by the levels of the ITRAXX crossover index have reached almost twice the cumulative default rate experienced by comparably rated companies during the last two recessions. As we work to better understand the forces behind these particularly wide credit spreads, we do realize that as difficult as it can be to price risk, the current situation demonstrates how much more difficult it is to price uncertainty. 4 Market participants are facing issues and questions that are unfamiliar and that cannot be easily answered, which is creating this uncertainty. The first source of this uncertainty is the unique nature of the U.S. experience with the kind of housing crisis that the U.S. economy is facing. This is the first time in more than a half-century that we have seen such a fall in nominal U.S. house prices. A second source of uncertainty in markets relates to questions about the solvency of financial institutions. When market participants lose confidence in their ability to assess the solvency of their counterparties, which are often other financial institutions, they become reluctant to lend to one another. In the current example, when firms did agree to loan to each other, they often demanded unusually high short-term interest rates, which contributed to the wide credit spreads that we have been witnessing. Most recently, we've seen a powerful example of this uncertainty playing out in the situation involving Bear Stearns. The positive news is that financial institutions have revealed more of their losses and exposures, and have taken steps to rebuild capital. These actions have tended to settle markets. As I alluded to earlier, market uncertainty has been global in nature. Most industrialized countries have seen sharp and often unprecedented widening in the spreads between rates in short-term credit markets, such as the 3-month London Interbank Offered Rate (LIBOR) or Canadian Dollar Offered Rate (CDOR), and expected overnight interest rates. (Chart 4 shows how short-term spreads have widened significantly since last August. Canadian spreads are now significantly below their peaks, but remain elevated relative to historical norms.) The uncertainty we speak of is the so-called Knightian uncertainty, in which probabilities cannot be attached to individual events and, as such, risk (or the variance) cannot be measured. A third source of market uncertainty relates to the degree of de-leveraging of hedge funds, proprietary desks, and other highly leveraged institutions. With some prime brokers facing capital constraints and with the volatility of asset prices having risen, certain institutions – including hedge funds – are seeing their lines of credit cut and their margin requirements raised. This typically forces them to sell assets, which has exacerbated the illiquidity in markets, making it extremely difficult for market participants to price these assets or, at times, to find a market for them. One might assume that this situation could create an excellent buying opportunity for sizable, unleveraged institutional investors, the so-called "real money funds." Yet most have remained largely on the sidelines. They may be held back by the continued uncertainty, perhaps waiting to see if the market has further to fall, thus creating even better buying opportunities. Again, the increased provision of information by financial institutions on their losses and exposures should be very helpful in easing uncertainties. Financial stability policies Now, let me turn to issues regarding financial stability policies that have arisen out of this period of turbulence. I will touch briefly on three issues: first, polices related to transparency and information; second, policies regarding the regulation of financial institutions; and third, central bank financial stability policies. 5 We know that markets work best when relevant information is available to all. One result of the recent turmoil is that concerns have been raised regarding the transparency of complex financial instruments and the role of the information supplied by credit-rating agencies. In Canada, issues regarding the transparency of instruments have been most pronounced with respect to ABCP – particularly the non-bank-sponsored ABCP covered by the Montreal Accord. There has already been some movement towards greater transparency in the banksponsored segments of this market. 6 But greater transparency of financial instruments isn't A more detailed discussion of these and other issues can be found in M. Carney, "Addressing Financial Turbulence" (speech to the Toronto Board of Trade, Toronto, ON, 13 March 2008). For example, we have seen the adoption of global-style liquidity facilities; institutions seeking more than one credit rating; and the Bank of Canada announcing it will accept ABCP securities that meet certain criteria, including transparency criteria. The latter point is discussed later in this speech. enough – investors also need to know how to interpret the information. Although credit-rating agencies have helped with interpretation in the past, they have recently come under scrutiny for their role in the financial market turbulence. However, because rating agencies rely on their reputations, they have strong incentives to improve the information content of their ratings for complex financial instruments, to ensure that all material facts are disclosed in a concise and timely manner, and to address inherent conflicts of interest in the ratings process. They have shown an ability and willingness to learn from their mistakes, and they are regularly refining their rating processes. 7 This does not mean, though, that investors can rely exclusively on the judgment of others. In the end, investors must accept responsibility for understanding and managing the credit risk in their portfolios. I'll turn now to some issues regarding financial institutions and their regulation. I'll focus on a few issues related to the models of operations in these institutions, the management of risks, and the management and regulation of liquidity. We can now see that one of the key problems with securitized U.S. subprime mortgages rested with the so-called "originate and distribute" model in which mortgage originators, many of whom did not face the same regulations as banks, entered into mortgage contracts with homeowners, and then laid off these assets as they were securitized. In principle, there is nothing wrong with having a model based on "originate and distribute," but in practice, a number of major things went wrong, as we saw in the recent U.S. example. For example, some originators did not have sufficient incentives to conduct appropriate credit checks on clients. This model is now being closely examined by regulators in the United States and around the world, to ensure that the right incentives for originators and distributors are in place and are appropriately aligned. Risk management within banks themselves is also facing scrutiny. In many cases, their riskmanagement practices did not prepare banks for the recent market turbulence, and so these market practices need to be addressed. While the Basel Committee on Banking Supervision has devoted most of its time over the past several years to completing its work on capital adequacy, it is now devoting more time and resources to the analysis of risk-management processes in banks and to the principles of liquidity management for banks. 8 Let me turn now to the financial stability policies of central banks. When there is a clear market failure and a major disruption to financial stability, a central bank – depending on circumstances – may wish to relieve liquidity pressures on the financial system by doing one or more of the following. It may choose to extend the maturity of its market operations; it may coordinate closely with other central banks when there is an international dimension to the problem; it may choose to widen the range of securities in its market operations or loan facilities; or, it may choose to increase the frequency of its market operations. 9 We opted for the first three of these with the term purchase and resale operations announced on 12 December and 11 March. Although we typically carry out purchase and resale operations with an overnight maturity, the two operations announced in March were for a much longer maturity (the two March operations were both for 28 days). Both of these announcements were coordinated with the actions of four other central banks and were supported by two other central banks. In all of these operations, the range of eligible securities was essentially the widest allowed under the Bank of Canada Act. For a full discussion, see M. Zelmer, "Reforming the Credit-Rating Process," Financial System Review (Ottawa: Bank of Canada, December 2007): 51-57. For a full discussion, see Liquidity Risk: Management and Supervisory Challenges, (Basel: Basel Committee on Banking Supervision, February 2008). A central bank may also choose to increase the range of participants in its operations and facilities. Recently announced amendments, which will modernize the Act, would allow for a further widening in eligible instruments for such operations. As required by these proposed amendments, the Bank will publish its policy governing the use of these powers. 10 The Bank will carefully consider the circumstances under which these powers would be used. In terms of its lending operations, the Bank of Canada is not legally constrained by its Act in the type of financial instruments that it can accept as collateral under its Standing Liquidity Facility (SLF), a facility that can be used in both normal and in turbulent times. On 31 March, we announced that, in the future, we will take ABCP securities that meet certain criteria – including transparency criteria – as collateral under our SLF. We had two broad policy objectives in making this announcement: first, that the eligibility criteria should mitigate any risks to the Bank that might be associated with accepting ABCP securities as collateral for the SLF. And second, we stated that the eligibility criteria should facilitate the development of a well-functioning market for ABCP by promoting more transparency for investors and by encouraging an active secondary market for these securities. The Bank has also announced that it will take U.S. Treasuries as collateral under the SLF by mid-year. In addition to the above, the Bank continues to work on examining policies related to the use of term operations and term lending facilities at times of major disruption to financial stability. This work is benefiting from the experiences and analysis of other central banks. Monetary policy in times of financial turbulence Earlier, I mentioned that when there is a major disruption to financial stability, a central bank may have to increase the frequency of its operations. Well, for monetary policy reasons – to keep our key overnight interest rate close to its target – we have often had to carry out special purchase and resale agreements (at times, more than once per day). 11 That leads naturally into the topic of monetary policy in times of financial turbulence. It's very clear that at a time of great uncertainty, it is more important than ever that monetary policy act as a stabilizing force. This underscores the importance of keeping inflation low, stable, and predictable and requires us at the Bank to continue to watch developments in the real economy for their impact on inflation. We are certainly aware of the continuing developments in the financial sector. But from a monetary policy perspective, these are important only to the extent that they are expected to influence developments in the real economy and, therefore, inflation. I do not mean to downplay the current financial turbulence – it has clearly been a factor affecting the real economy in the United States and, to a lesser extent, in Canada as well. At the Bank of Canada, we will continue to monitor these effects, while aiming neither to favour particular market segments nor to insulate market participants from the consequences of their decisions. In terms of the financial turbulence, credit spreads in particular – and the credit conditions faced by businesses and households more generally – have an influence on aggregate demand and thus, potentially, on inflation. This needs to be taken into account in setting policy interest rates. (Chart 5 and 6 give an indication of the cost, in level terms, of short- and longer-term borrowing, respectively.) In our October Monetary Policy Report, we estimated that the tightening of credit conditions was worth about 25 basis points relative to our overnight interest rate target. Then, in the January Update to the Report, we noted that the tightening in credit conditions could be greater and more protracted than previously This policy would allow the Bank to widen the range of eligible instruments for its market operations. Furthermore, this widening could occur without necessarily invoking the pre-existing power to do so in circumstances where the Governor declares a situation of severe and unusual stress on a financial market or financial system. At times, the Bank also carried out sale and repurchase agreements. assumed. As well, we stated that there could be a more prolonged slowdown in the U.S. economy. Given the situation, we lowered our policy rate by 25 basis points. In our 4 March policy rate announcement, we indicated that deterioration in economic and financial conditions in the United States could be expected to have significant spillover effects on the global economy. We also said that those developments suggested that important downside risks to Canada's economic outlook, which were identified in the January Update, were materializing and, in some respects, intensifying. In response, we lowered our policy rate by 50 basis points to 3.50 per cent, and said that further monetary stimulus is likely to be required in the near term to keep aggregate supply and demand in balance and to achieve the 2 per cent inflation target over the medium term. Conclusion I've talked about some of the causes of, and the lessons learned from, the recent financial market turbulence. In particular, as I mentioned at the outset of my remarks, we at the Bank of Canada are continuing our analysis of the unusually wide credit spreads that we've been seeing and what these mean for the stability of the financial system and, potentially, for the economy, inflation, and monetary policy. It's very clear that these unusual spreads, and the financial market upheaval that exacerbated these spreads, will continue to have an impact for some time to come. We do not know just when or how this turmoil will ultimately be resolved. You can be confident, however, that our focus at the Bank of Canada will remain on our core functions of supporting financial stability, and maintaining consumer price inflation at our 2 per cent target. In this way, we will continue to maintain an anchor for the economy through what will continue to be very interesting times. Thank you very much for your attention, and now I'll be happy to take your questions.
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Opening statement by Mr Mark Carney, Governor of the Bank of Canada, at a press conference following the release of the Monetary Policy Report, Ottawa, 24 April 2008.
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Mark Carney: Summary of the latest Monetary Policy Report Opening statement by Mr Mark Carney, Governor of the Bank of Canada, at a press conference following the release of the Monetary Policy Report, Ottawa, 24 April 2008. * * * Today, we released our April Monetary Policy Report, which discusses current economic and financial trends in the context of Canada's inflation-control strategy. Growth in the global economy has weakened since the January Monetary Policy Report Update, reflecting the effects of a sharp slowdown in the U.S. economy and ongoing dislocations in global financial markets. Growth in the Canadian economy has also moderated. Buoyant growth in domestic demand, supported by high employment levels and improved terms of trade, has been substantially offset by a fall in net exports. Both total and core CPI inflation were running at about 1.5 per cent at the end of the first quarter, but the underlying trend of inflation is judged to be about 2 per cent, consistent with an economy that is running just above its production capacity. The U.S. economic slowdown is projected to be deeper and more protracted than in the January Update. The projection reflects a more pronounced impact on consumer spending of the contraction in the U.S. housing market and significantly tighter credit conditions. The deterioration in economic and financial conditions in the United States will have direct consequences for the Canadian economy. First, exports are projected to decline, exerting a significant drag on growth in 2008. Second, turbulence in global financial markets will continue to affect the cost and availability of credit. Third, business and consumer sentiment in Canada is expected to soften somewhat. Nevertheless, domestic demand is projected to remain strong, supported by firm commodity prices, high employment levels, and the effect of cumulative easing in monetary policy. The Bank projects that the Canadian economy will grow by 1.4 per cent this year, 2.4 per cent in 2009, and 3.3 per cent in 2010. The emergence of excess supply in the economy should keep inflation below 2 per cent through 2009. Both core and total inflation are projected to move up to 2 per cent in 2010 as the economy moves back into balance. There are both upside and downside risks to the Bank's new projection for inflation; these risks appear to be balanced. In line with this outlook, some further monetary stimulus will likely be required to achieve the inflation target over the medium term. Given the cumulative reduction in the target for the overnight rate of 150 basis points since December, including the 50-basis-point reduction announced on 22 April, the timing of any further monetary stimulus will depend on the evolution of the global economy and domestic demand, and their impact on inflation in Canada.
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Opening statement by Mr Mark Carney, Governor of the Bank of Canada, to the House of Commons Standing Committee on Finance, Ottawa, 30 April 2008.
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Mark Carney: Bank of Canada’s views on the Canadian economy and its monetary policy objective Opening statement by Mr Mark Carney, Governor of the Bank of Canada, to the House of Commons Standing Committee on Finance, Ottawa, 30 April 2008. * * * Good afternoon, Mr. Chairman and committee members. It is a pleasure for me to appear before your committee for the first time as Governor of the Bank of Canada. We at the Bank appreciate the opportunity to meet with your committee, which we usually do following the release of our Monetary Policy Reports. These meetings are important in terms of our accountability to Canadians, since they allow us to keep members of Parliament and, through you, all Canadians, informed of the Bank's views on the economy, the objective of monetary policy, and the actions that we take to achieve that objective. These meetings have been very valuable for the Bank over the years, and I hope that we will continue them during my tenure as Governor. Before Paul and I take your questions, I would like to give you some of the details from our latest Monetary Policy Report, released last week. Growth in the global economy has weakened since the January Monetary Policy Report Update, reflecting the effects of a sharp slowdown in the U.S. economy and ongoing dislocations in global financial markets. Growth in the Canadian economy has also moderated. Buoyant growth in domestic demand, supported by high employment levels and improved terms of trade, has been substantially offset by a fall in net exports. Both total and core CPI inflation were running at about 1.5 per cent at the end of the first quarter, but the underlying trend of inflation is judged to be about 2 per cent, which is consistent with an economy that is running just above its production capacity. The U.S. economic slowdown is now projected to be deeper and more protracted than was expected at the time of the January Update. Our latest projection reflects a more pronounced impact on consumer spending from the contraction in the U.S. housing market and from significantly tighter credit conditions. The deterioration in economic and financial conditions in the United States will have direct consequences for the Canadian economy. First, exports are projected to decline, exerting a significant drag on growth in 2008. Second, turbulence in global financial markets will continue to affect the cost and availability of credit. Third, business and consumer sentiment in Canada is expected to soften somewhat. Nevertheless, domestic demand is projected to remain strong, supported by firm commodity prices, high employment levels, and the effect of the cumulative easing in monetary policy. We at the Bank project that the Canadian economy will grow by 1.4 per cent this year, 2.4 per cent in 2009, and 3.3 per cent in 2010. The emergence of excess supply in the economy should keep inflation below 2 per cent through 2009. Both core and total inflation are projected to move up to 2 per cent in 2010 as the economy moves back into balance. There are both upside and downside risks to the Bank's new projection for inflation; these risks appear to be balanced. In line with this outlook, some further monetary stimulus will likely be required to achieve the inflation target over the medium term. Given the cumulative reduction in the target for the overnight rate of 150 basis points since December, including the 50-basis-point reduction announced last week, the timing of any further monetary stimulus will depend on the evolution of the global economy and domestic demand, and their impact on inflation in Canada. With that, Paul and I would now be pleased to answer your questions.
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Opening statement by Mr Mark Carney, Governor of the Bank of Canada, to the Standing Senate Committee on Banking, Trade and Commerce, Ottawa, 1 May 2008.
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Mark Carney: Brief overview of the Canadian economy Opening statement by Mr Mark Carney, Governor of the Bank of Canada, to the Standing Senate Committee on Banking, Trade and Commerce, Ottawa, 1 May 2008. * * * Good morning, Mr. Chairman and committee members. Let me begin by saying that it is a pleasure for me to appear before you for the first time as Governor of the Bank of Canada. I know that these regular discussions with your committee have been very valuable to the Bank, and they are also an important part of our accountability to Canadians. I look forward to these meetings during my tenure. I would also like to acknowledge the important work that this committee does in addressing longer-term economic and financial issues facing Canada. Before Paul and I begin to answer your questions, allow me to take a moment to review some of the conclusions from our latest Monetary Policy Report, released last week. In it, we noted that growth in the global economy has weakened since the January Monetary Policy Report Update, reflecting the effects of a sharp slowdown in the U.S. economy and ongoing dislocations in global financial markets. Growth in the Canadian economy has also moderated. Buoyant growth in domestic demand, supported by high employment levels and improved terms of trade, has been substantially offset by a fall in net exports. Both total and core CPI inflation were running at about 1.5 per cent at the end of the first quarter, but the underlying trend of inflation is judged to be about 2 per cent, which is consistent with an economy that is running just above its production capacity. We now expect that the U.S. economic slowdown will be deeper and more protracted than was projected in the January Update. Our latest projection reflects a more pronounced impact on consumer spending from the contraction in the U.S. housing market and from significantly tighter credit conditions. The deterioration in economic and financial conditions in the United States will have direct consequences for the Canadian economy. First, exports are projected to decline, exerting a significant drag on growth in 2008. Second, turbulence in global financial markets will continue to affect the cost and availability of credit. Third, business and consumer sentiment in Canada is expected to soften somewhat. Nevertheless, domestic demand is projected to remain strong, supported by firm commodity prices, high employment levels, and the effect of the cumulative easing in monetary policy. We at the Bank project that the Canadian economy will grow by 1.4 per cent this year, 2.4 per cent in 2009, and 3.3 per cent in 2010. The emergence of excess supply in the economy should keep inflation below 2 per cent through 2009. Both core and total inflation are projected to move up to 2 per cent in 2010 as the economy moves back into balance. There are both upside and downside risks to our new projection for inflation; these risks appear to be balanced. In line with this outlook, some further monetary stimulus will likely be required to achieve the inflation target over the medium term. Given the cumulative reduction in the target for the overnight rate of 150 basis points since December, including the 50-basis-point reduction announced last week, the timing of any further monetary stimulus will depend on the evolution of the global economy and domestic demand, and their impact on inflation in Canada. With that, Paul and I would now be happy to take your questions.
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Remarks by Mr Mark Carney, Governor of the Bank of Canada, to the New York Association for Business Economics, New York, 22 May 2008.
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Mark Carney: Principles for liquid markets Remarks by Mr Mark Carney, Governor of the Bank of Canada, to the New York Association for Business Economics, New York, 22 May 2008. * * * Over the past year, both private sector financial market participants and public sector authorities have been preoccupied with the topic of liquidity as never before. Throughout the financial market turbulence, private liquidity management has become tremendously important. In parallel, policy-makers have re-examined their roles and responsibilities for the provision of liquidity, as well as the methods they employ in doing so. The Bank of Canada is certainly no exception. Recent events in financial markets have prompted us to think about why, how, and to whom we provide liquidity. Historically, discussions involving central banks and liquidity have revolved around the traditional role of the central bank as lender of last resort – providing sufficient liquidity to still-solvent deposittaking financial institutions so they can continue to function. However, as recent events have made abundantly clear, policy-makers also have an interest in seeing that key markets have sufficient liquidity. Over the course of my remarks today, I will share some of the Bank of Canada's thinking on the principles for liquid markets. 1 What is liquidity and why do central banks care? To begin, it would be useful to set out a definition of liquidity for the purposes of this speech. Liquidity takes on different guises within the financial system. Central bankers worry about aggregate system or macro liquidity, because of its connection with interest rates, credit conditions, and future inflationary pressures. Investors are preoccupied with market liquidity, which refers to how readily they can buy or sell a financial asset without causing a significant movement in its price. Financial institutions are concerned with balance sheet liquidity, which refers broadly to the cash-like assets on balance sheets that can be used to settle payment obligations at short notice. Further, they care about funding liquidity, which refers to their ability to raise funds in money markets at reasonable premia. There is a common element to these concepts. In all cases, liquidity refers to the ability to transact in specific assets at a predictable price. 2 For example, a broker-dealer wants to know that it can transact in securities at a price approximating that on the screen. For our purposes today, we can say that when this condition is satisfied, there is an appropriate amount of market liquidity. This is important because liquid markets support economic efficiency. In most economies, financial markets are the channel through which scarce economic capital is allocated to the most productive uses and risk is distributed among those most willing to assume it. An efficient financial system is required for investors to receive the highest risk-adjusted returns on their investments, and for borrowers to minimize the costs of raising capital. Since the efficiency of the system suffers when markets function poorly, policy-makers have an interest in promoting well-functioning markets. For a more detailed discussion of some of the issues raised in this speech, see W. Engert, J. Selody, and C. Wilkins, "Financial Market Turmoil and Central Bank Intervention", Financial System Review (Ottawa: Bank of Canada, forthcoming). In the case of macro liquidity, "predictable price" is analogous with price stability as defined by the inflation target. In the Bank of Canada's case, this means a 2 per cent annual increase for the total consumer price index. A central bank further desires well-functioning, liquid financial markets because they assist in the transmission of monetary policy. Movements in our policy interest rate set off a chain of events, beginning with movements in a series of prices in financial markets. Improperly functioning markets can make it more difficult to predict the effects of our monetary policy actions, thus complicating our task. It is important to keep in mind that central bank activities to support liquidity in specific markets or in specific institutions do not represent a change in the stance of monetary policy, which relates to macro liquidity. Rather, they are undertaken to address concerns about financial instability. I want to pause on this point for emphasis. When the Bank of Canada conducts liquidity operations (such as term repos, or "purchase and resale agreements" (PRAs) as they are called in Canada), we are merely changing the distribution of liquidity in the financial system by changing the composition of our balance sheet. When we do term repos, we aim to hold fewer government treasury bills, 3 which means that the private sector would hold more. 4 We are injecting liquidity where the system had generated it before, essentially by exchanging less-liquid assets for more liquid ones. Moreover, when we roll over previous operations, as the Bank of Canada has done recently, the scale of the liquidity injection is held constant. The overall level of liquidity in financial markets is determined primarily by market participants themselves. Under normal conditions, private agents supply sufficient liquidity such that injections of central bank liquidity are not needed. Financial institutions create liquidity by buying and selling assets to make the markets in which financial institutions fund themselves. The financial system is liquid because institutions regularly borrow from each other, and because they regularly buy and sell each others' short-term paper. There are times, however, when liquidity dries up as confidence erodes in the ability of private agents to remain in markets. When the regular process of lending and transacting slows down or stops, the lack of liquidity means that institutions are unable to transact assets at predictable prices at minimal cost, and financial markets become stressed. At such times, a central bank can help restore liquidity by directly or indirectly providing liquid assets in exchange for illiquid assets, thus helping to restore confidence in the ability of the private sector to generate liquidity. What has happened to market liquidity since August? A review of recent events helps to clarify the principles of liquidity provision. The current situation in securitization markets serves as a good example of how information problems are at the root of market failure and how liquidity, or a liquidity shock, can cascade through markets. The events of last summer represented a severe shock to markets. In particular, the realization of the potential scale of subprime losses and the associated loss of faith in structured products and rating agencies collectively created uncertainty about – and an associated loss of confidence in – counterparty credit quality. This uncertainty persisted because of the extreme asymmetric information among market participants, which impaired market makers' ability to transact with confidence and, therefore, to supply liquidity. At the same time as the supply of liquidity was shrinking, demand for liquidity by financial institutions was rising dramatically – for two reasons. First, the reintermediation of off- This occurs either by not replacing maturing treasury bills, or by selling them outright. The other way in which term PRAs can be financed is by having more government deposits on our balance sheet. This means that there would be fewer government deposits on private sector balance sheets, and thus fewer liquid assets as well. Although the total size of the Bank of Canada's balance sheet increases in this scenario, the liabilities of the Bank to the private sector (currency plus private sector deposits) do not, so there is no monetary stimulus involved in this type of operation. balance-sheet assets and contingent claims expanded, and continues to expand, along with bank balance sheets. Second, the banks' preference for liquidity increased because of uncertainty about these types of securities. In addition, the number of potential market participants for these securities has fallen as key investors have either disappeared – such as asset-backed commercial paper (ABCP) and structured investment vehicle conduits – or fled to safer havens – such as money market funds. The result has been a liquidity shock leaving interbank interest rate spreads over expected overnight levels substantially higher (at times, up to 90 basis points in some currencies) and considerably more volatile than historical norms. This widening in spreads reflects both a rise in the default-risk premium – largely related to a rise in actual and perceived counterparty risks – and a rise in the liquidityrisk premium – largely related to increased demand for liquidity by banks related to the rise in the amount of assets being reintermediated, and a contraction in the supply of bank-funding liquidity. The scale of the reintermediation process may matter. For example, in Canada, where it is less acute, interbank spreads have risen considerably less than in other jurisdictions. Since our current system relies on transactions among an interconnected web of financial institutions, a liquidity shock can cascade quickly through the system. Concerns about the solvency of one institution can lead to liquidity hoarding and dysfunctional markets. This reduces the number of potential participants willing to transact in a market, which undermines price discovery. As a result, it becomes less likely that markets will price assets at their fundamental values, and the efficient allocation of resources and the distribution of risk are thus threatened, at potentially great cost to the economy. In such circumstances, the role of the central bank was accurately described more than a century ago by Walter Bagehot in Lombard Street: "Theory suggests, and experience proves, that in a panic the holders of the ultimate Bank reserve … should lend to all that bring good securities quickly, freely, and readily." 5 Note that Bagehot did not differentiate between deposit-taking institutions and market makers, stipulating only that the lending should be collateralized with "good securities." However, the idea that central banks should support the functioning of a broader range of markets through direct liquidity support is relatively new. Previously, it was believed that central banks could adequately support markets by allocating liquidity through banks, by altering liquidity in payments systems, or by changing the stance of monetary policy, and that this liquidity would flow unimpeded through the financial system. The events of last summer have challenged this consensus. The financial system will be more stable, and the effects of monetary policy actions more predictable, if the central bank directly supports liquidity in a wider range of markets when appropriate. Such support, which would be expected to occur only during extraordinary circumstances, could entail expanding the range of terms, collateral, and counterparties for central bank operations beyond what is required for routine monetary policy operations. 6 Considerations around a central bank decision to intervene Let me elaborate on two of the words I just said: "when appropriate." How can a central bank determine, with any level of confidence, when actions to support market liquidity are appropriate? At the Bank of Canada, we have been thinking about the principles that would govern any facilities that we might offer. W. Bagehot, Lombard Street: a Description of the Money Market (New York: Wiley, 1999) p. 173. In the Bank of Canada's case, some of its legal authorities would need to be modernized in order to be able to carry out interventions to the same degree as other institutions. Amendments to the Bank of Canada Act that would address this issue are currently before Parliament. A central bank may want to make several judgments before deciding to lend to market makers. In particular, it should ask itself four questions: First, is the impairment of the market temporary or permanent? Second, will the instruments at its disposal be effective? Third, what net benefits could come from intervention? Fourth, what are the likely costs? In the heat of financial market turbulence, it is difficult to determine whether a situation of illiquidity (a market impairment) is temporary or permanent. To make this determination, it is useful to recall the Arrow-Debreu theorem of complete markets. 7 In reality, complete markets do not exist because of information costs and because not all agents participate in all markets. A central bank must decide whether its provision of liquidity is a bridge – while information asymmetries are resolved and potential market participants return to the market – or whether it is a pier because there is a permanent impairment. To underscore the distinction, consider again three aspects of recent events. First, before the current market turmoil, many investors relied on rating agencies for credit analysis about structured products, and this information was relatively inexpensive to obtain. The process of financial turbulence demonstrated that rating-agency judgments were not always reliable. Consequently, market participants are now relying more on their own credit analysis, thereby increasing the costs for investing in structured products considerably. It will take some time for rating agencies to re-establish their credibility. Second, investors have discovered that there are considerable costs of accumulating independent information on non-standardized products in order to perform, at a minimum, risk-based analysis to check the opinions of credit-rating agencies. This is a case where markets themselves should be able to establish standards to minimize information costs. In the interim, the central bank or a regulatory body may help to reduce the costs of information. The Bank of Canada has adopted high disclosure standards for ABCP that it will accept as collateral in its Standing Liquidity Facility. This may encourage market participants to raise their own standards. Whether they do in the end will be their decision. Third, recent problems raised concerns over the health of counterparties – initially tied to uncertainty about exposure to U.S. subprime mortgages and later to structured products in general. These concerns, while material, should prove temporary before being resolved by time and disclosure. This is why it is so important to implement immediately the best practices for disclosure endorsed last month by the G-7 finance ministers and central bank governors. This is a priority in Canada. A central bank can supply liquidity to financial institutions and markets. However, it cannot create markets where there is no private desire for them, nor can it change the fundamental value of a security. Thus, when confronted with a market failure, a central bank should identify the basic nature of the failure and act when it judges that a shock has distorted the liquidity-risk premium embedded in the price of a security. The most important potential cost of intervention is moral hazard – the risk that central bank actions might ratify or encourage behaviours that would increase the likelihood or severity of a future crisis. In today's circumstances, one might worry that market participants could alter their behaviour owing to a mistaken belief that central banks would never allow any counterparty to fail. Another concern is that in the future, banks would worry less about market liquidity and assume that central banks would always act to provide liquidity in any or all markets, even in cases of a very minor disruption. There could also be costs related to The Arrow-Debreu theorem of complete markets states that there is a competitive equilibrium of prices so that aggregate supplies will equal aggregate demands for every commodity in the economy, and that there will be a price for every commodity, a market for every time period, and a forward price for every commodity at all time periods. The theorem is based on two important assumptions: participation of every agent in every market and complete information. See G. Debreu, Theory of Value: An Axiomatic Analysis of Economic Equilibrium (New Haven: Yale University Press, 1959). distortions in markets caused by lending, or costs associated with the crowding out of private sector counterparties. The Financial Stability Forum recommendation that central banks have access to financial institutions' liquidity-management contingency plans has the potential to partially limit this aspect of moral hazard. Other mitigants can be found in the principles behind the conduct of these operations, which I will discuss in a moment. First, one final consideration: How does a central bank know when intervention has been sufficiently successful for it to exit? Success should not necessarily be judged on the basis of spreads returning to predetermined levels, since fundamentals are likely to have changed during and because of the shock that caused the turmoil. Rather, judgments about the effectiveness of intervention should be based on evidence of better-functioning markets, such as higher volumes, narrowing bid-ask spreads, and reduced liquidity-risk premia even, potentially, if total risk premia do not fall. The absence of spread volatility at the end of each quarter would be another welcome sign of improving markets. In Canada, spreads indicative of bank funding costs (such as the spread between 3-month CDOR and the expected overnight rate as measured by 3-month overnight indexed swaps) have fallen markedly over the last few weeks, and are substantially below equivalent spreads in some other currencies. The results of the term PRA auctions held by the Bank of Canada have broadly shown a narrowing of the spread between the average yield and the expected overnight rate. In addition, the range of the collateral being pledged shows no sign of intensifying liquidity pressures. Principles to guide intervention Let me now elaborate on the five principles that we believe should guide interventions to support liquidity in markets. First, lending to support market liquidity should mitigate moral hazard. Such measures include limited, selective intervention and the promotion of the sound supervision of liquidityrisk management. Second, interventions should be graduated. The strength of the intervention should be calibrated to the severity of the problem, so as to guard against overreactions that could unnecessarily raise the costs of the intervention and potentially crowd out private agents. Third, interventions should be targeted. A central bank should attempt to mitigate only those market failures that it is best placed to rectify. Specifically, central banks should concentrate on liquidity disruptions which, by their nature, are not permanent. Fourth, intervention tools should be well-designed for the job at hand; that is, lending at a penalty rate to particular institutions is appropriate for institution-specific liquidity problems. Market-specific liquidity problems should be addressed with market transactions at competitive prices. Finally, when there are shortages of collateral, market transactions should be conducted in that collateral. 8 In these regards, along with traditional central bank tools, such as lender-of-last-resort arrangements, a range of facilities is likely necessary. Each of these has distinct characteristics suitable for different circumstances. Term purchase and resale agreements could be offered to any financial market participant with marketable securities as the basis for the transaction. This type of transaction would be most useful when liquidity premia in money markets were distorted and associated with widespread liquidity problems in a particular asset class or maturity. Term securities lending would increase the supply of high-quality securities that could be used for collateral at times when such collateral was in short supply. The Bank of Canada is currently constrained in its ability to ease collateral shortages, however, legislation currently before Parliament would address this issue. It could also allow for a direct exchange of less-liquid securities for those that are more liquid, thus reducing the incentive to hoard precautionary liquidity. Term loan facilities could be most useful when liquidity premia in money markets were distorted because several financial institutions were facing liquidity shortages. Fifth, and finally, interventions should not create further market distortions. Transactions should, to the extent possible, take place at market-determined prices and under conditions that are aligned with those in the market. This limits the possibility that the central bank will crowd out the return of markets. This is an important point, on which I will expand. Under most circumstances, central bank provision of liquidity should be priced at an auction, where prices are set competitively, so that funding markets for the assets involved would not normally be distorted. A well-designed auction process can help institutions avoid any stigma associated with the receipt of central bank liquidity and minimize the possibility of confusion about lending at rates that differ from the key monetary policy interest rate. As well, an auction can provide a central bank with the flexibility needed to tailor the provision of liquidity to the specific need. Auctions can also provide the central bank with valuable information about the health of a particular market or participant. Finally, they can help to restart markets that have stopped by providing a multi-party mechanism to determine asset prices. 9 The search for symmetry Before closing, I would like to raise one final issue. Much of the discussion about central banks and liquidity in markets has been motivated by current circumstances, in which banks and market makers are unable to create a sufficient level of liquidity themselves. This is a one-sided approach to the issue. One of the reasons that the Bank of Canada's monetary policy has been successful in anchoring inflation expectations is that we implement policy symmetrically. Our actions are motivated as much by inflation threatening to fall below our target as by inflation threatening to rise above it. Indeed, our recent decisions to lower our key policy rate were motivated by a concern that future inflation was poised to remain below our 2 per cent target. Is a symmetrical approach to liquidity also appropriate? As I mentioned earlier, a lack of liquidity can hamper the efficient allocation of resources and distribution of risk, and complicate the conduct of monetary policy. It is equally true that an overabundance of liquidity – or, more precisely, easy financing conditions for financial assets themselves – can have similar effects. Logically, if a central bank were concerned enough to lend to market makers in a time of scarce liquidity, would it not also want to borrow from the same institutions in periods of excess liquidity, again assuming that such periods could be determined with confidence? Unfortunately, liquidity instruments such as those I have described today are poorly suited to this task. Central banks are the stores of liquidity in our economy, and can readily supply it by agreeing to take less-liquid assets from counterparties in exchange. Generally speaking, central banks are not set up to operate in reverse; that is, they do not have on their balance sheets a ready supply of illiquid assets that can be used to absorb excess liquidity held by banks or market makers. Moreover, during an asset boom, they may have limited influence over the confidence of financial market participants. The principle, however, remains. Central banks and other authorities should be as concerned about the distortions and inefficiencies created by overly easy financing conditions, rapid credit growth, and excess confidence about future market liquidity as those created by a lack To be clear, in these auctions, the price being determined is the price for borrowing central bank money against a given set of collateral. It is not the price to buy and sell the collateral outright or to lend cash unsecured. of liquidity. So how can we achieve symmetry in our approach? In my opinion, it is worthwhile for policy-makers to consider the promotion of macro-prudential regulations that could serve to restrain pro-cyclical liquidity creation among banks and market makers when appropriate. To be clear, the same tests should apply in terms of "when appropriate." There would also be the added complication of determining where to house this regulatory authority, and how it would be coordinated across jurisdictions. Despite these issues, this is a serious concern that warrants closer attention. Conclusion The market turbulence that began last summer has eased in recent weeks. That progress, and perhaps the coincident start of the baseball season, has prompted some to muse about whether we are in the seventh, eighth, or ninth inning. I will not venture to be that precise, but I would note that baseball games frequently go into extra innings, and in any event, there is always another game and another season. It is important that we not let a sense of complacency distract us from learning the appropriate lessons, and acting accordingly, once the game begins again.
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Remarks by Mr Mark Carney, Governor of the Bank of Canada, to the Haskayne School of Business, Calgary, Alberta, 19 June 2008.
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Mark Carney: Capitalizing on the commodity boom – the role of monetary policy Remarks by Mr Mark Carney, Governor of the Bank of Canada, to the Haskayne School of Business, Calgary, Alberta, 19 June 2008. * * * Everyone here remembers the bumper sticker. For two decades, Albertans promised not to waste the next boom if one were granted. With US$130 oil, US$10 natural gas, US$200 coal, and US$8 wheat, the next one has clearly arrived. The question now is how to make good on that promise. This evening, I will concentrate on one aspect of the answer: how monetary policy can help to create the conditions that will allow all Canadians to benefit from sustained high commodity prices. I am grateful for this opportunity because monetary policy is more effective when it is well understood. Seldom is this understanding more important than when our economy faces the types of supply and demand shocks engendered by a series of sharp increases in commodity prices. Outlook for commodity prices We are experiencing a commodity super cycle. Throughout the current boom, the scale of price increases has been higher, and the range of affected commodities broader, than in previous upturns. Since 2002, grain and oilseed prices have more than doubled, base metals prices have tripled, and oil prices have quadrupled. Beyond the breadth and magnitude of these price increases, the current boom is also unusual in that it began earlier in the global economic cycle and has lasted longer. While booms usually herald a downturn, this one appears to be evidence of unusually robust momentum in global growth. 1 These dynamics suggest that a combination of very favourable and mutually reinforcing factors are at work. These include burgeoning demand, a subdued supply response, important links among commodity markets, and supportive financial conditions. An environment for a secular increase in commodity prices has been building since the middle of the 1990s. That said, we can expect considerable volatility around this longer-term trend and must remember that while supply and demand may be inelastic in the short term, they are decidedly more flexible over longer periods. Current commodity-price dynamics are intimately linked to the globalization process. In particular, rapid growth in emerging-market demand is driving most prices. Positive underlying demand fundamentals in emerging markets include sustained growth in per capita income, rapid industrialization, and a more intensive use of commodities in production. Research at the Bank of Canada and elsewhere suggests that while oil and metals prices have historically moved with the business cycle in the developed world, this relationship has broken down over the past decade. For example, industrial activity in emerging Asia now appears to be the dominant driver of oil-price movements, 2 and China alone is expected to become the world's largest consumer of energy by 2010. 3 Emerging markets and developing economies have accounted for nearly 95 per cent of the increased demand for oil since See International Monetary Fund, World Economic Outlook (Washington: IMF, April 2008) p. 198-99. C. Cheung and S. Morin, "The Impact of Emerging Asia on Commodity Prices" (Working Paper No. 2007-55, Bank of Canada, 2007). International Monetary Fund, "Global Energy: Increasingly Unstable," Finance & Development 45, no. 1 (March 2008). 2003. 4 As recently as the 1990s, marginal demand was roughly split between OECD and non-OECD countries. In the face of this demand, the supply response has been disappointing. Consider oil. OPEC's annual production has declined by 2 per cent since 2005 and, with a few exceptions, non-OPEC supply has failed to meet expectations. Among OECD countries, oil output has fallen by 8 per cent since 2002. As a consequence, inventories remain very tight at 31 days, and spare capacity is limited. With inelastic demand in the short term, actual or perceived supply disruptions can lead to sharp price spikes and continued volatility. There are many reasons why the supply response has been limited thus far. First, access to many of the world's most promising regions is often tightly controlled or wholly restricted to state-owned enterprises. Second, while nominal investment has surged, so too have costs. 5 Many in this room know from direct experience how hard it is to find skilled workers, drilling rigs, and pipeline capacity. Exploration and development costs for conventional crude have doubled, and oil sands costs have tripled. Across the global industry, surging investment costs have meant that real investment has remained flat. The net result is that a 70 per cent nominal increase in non-OPEC capital expenditure since 2003 has barely replaced declining production from existing fields. 6 Over the medium term, high prices will encourage the development of new supplies and energy alternatives. Canada will be one of the most important marginal suppliers of oil. With more than $150 billion of new investment in the oil sands proposed or under way, 7 output from the oil sands is expected to grow by 3 million barrels per day by 2020, representing about 15 per cent of expected marginal global demand. 8 Other supplies can be expected to come on stream, and alternative energy sources should be developed. Although there will be lags, it would be a mistake to assume that the market has ceased to function. Demand will also be more responsive over time. SUV sales in the United States have fallen by nearly one-third so far this year – an important early indicator. Oil demand in OECD countries has been essentially flat since 2003, and the International Energy Agency projects it to remain weak for the next few years. 9 As a result, the extent of continued upward demand pressure will depend almost exclusively on emerging markets. There are several considerations. First, we are about to find out the extent to which slowing domestic demand growth in the G-7 will affect growth in emerging Asia. Second, the stance of monetary policy in emerging markets will be an important determinant of prices in the short term. Monetary policy remains highly accommodative in a number of fast-growing economies that are major marginal consumers of commodities. The combination of accommodative monetary policy and overheating economies will eventually be reversed, either through policy action or generalized inflation. In either case, aggregate demand in emerging markets will likely slow relative to current trends. A third consideration is that the demand response in many economies is currently being muted by the prevalence of administered food and energy prices. These efforts to protect the most vulnerable are usually poorly targeted and, as a consequence, highly distortionary. By keeping domestic commodity prices artificially low, the authorities are simultaneously Data supplied by the Energy Information Administration (EIA). See http://www.eia.doe.gov/ipm/. According to the Canadian Association of Petroleum Producers (CAPP), a 100,000-barrel-per-day integrated oil sands project that cost $3.3 billion to build in 2001 now costs over $10 billion. See http://www.capp.ca/raw.asp?x=1&dt=PDF&dn=134739. Data provided by IMF. Data provided by Alberta Finance and Enterprise. Production estimate from CAPP. Demand estimate from the EIA. Data from the Energy Information Administration. See http://www.eia.doe.gov/emeu/steo/pub/3atab.pdf. encouraging consumption, which leads to higher prices elsewhere, and discouraging the internal supply response that would normally occur. In addition, by interfering with the price signals, these policies delay necessary economic adjustment and increase the risk of a dramatic and difficult reversal in the future. Encouragingly, in recent weeks, several countries have taken important steps to ease such controls. Demand can be expected to follow. As in the wake of previous commodity-price spikes, this demand response will ultimately include the adoption of new technologies. Indeed, commodity-intensive economies will likely replace energy-inefficient capital more rapidly than their peers did three decades ago. With today's major marginal commodity consumers operating at levels well below peak efficiency, the question is how quickly they will adopt more efficient, existing technologies once they have determined that the relative price adjustment will be sustained. There has been much discussion about the contribution of financial factors to the commodity boom. It does appear that low long-term interest rates and past weakness in the U.S. dollar may have played minor supportive roles. The impact of outright speculation and index investment is less clear cut. 10 If speculation were keeping the spot price of a commodity substantially higher than the level where supply and demand naturally intersect, inventories should build as the incentive to increase supply outstrips the desire to increase consumption. However, there is little evidence of this in commodities as diverse as crude oil, wheat, or aluminum. At this point, the bulk of the evidence suggests that the increase in most commodity prices is due to the fundamentals of strong demand and weak supply. This appears to be a durable relative price shift. That does not necessarily imply persistent price increases. Demand and supply will adjust, particularly as prices are passed through. In the short term, low inventories suggest continued price volatility, which may be amplified by trend-following speculation. What the current boom means for Canada Although natural resources as a whole represent only 6 per cent of direct employment and 12 per cent of GDP, the sector has an important influence on Canadian economic activity through a number of channels. Resources account for roughly one-third of all business investment and about 45 per cent of our exports. As such, the benefits of the current commodity boom can be felt across Canada – not just in resource-heavy sectors and regions. Above all, rising commodity prices have made Canada wealthier as a nation. Since 2002, rising commodity prices have fuelled a 25 per cent improvement in our terms of trade, which alone has been responsible for roughly two-thirds of the 15 per cent gain in real per capita disposable income recorded over that period. These income gains have helped reduce corporate leverage to its lowest level in a quarter of a century and have helped our governments to record consistent fiscal surpluses. Higher commodity prices bring increased investment, which entails direct and indirect benefits not only for the sectors in question, but also for the service sectors that support them. As well, many individual Canadians – and their pension funds – have benefited greatly from the gains in the value of their own investments in commodity-producing firms. 11 Finally, the rise in our terms of trade has brought with it an associated appreciation of our currency that has benefited everyone by lowering the cost of imported goods and services. With this downward pressure on import prices, productivity- For example, the prices of many non-indexed commodities have risen more rapidly than those of indexed ones. The TSX energy sector has risen roughly 18 per cent per year since the beginning of 2002, while the metals and mining sector is up 11 per cent annually and the fertilizers and agricultural chemicals sector is up 44 per cent annually. These sectors have a combined weighting of 50.3 per cent of the TSX composite index. enhancing machinery and equipment – much of which is imported – has become less expensive for all firms, not just commodity producers. These benefits are important. However, it is unavoidable that large, sustained changes in terms of trade – whether favourable or unfavourable – will cause stress and dislocation because of significant shifts in production and employment among economic sectors. In macroeconomic terms, terms-of-trade shocks trigger a shift of resources to activities generating higher income. From that perspective, postponing adjustment would mean forgoing the potential income gains that the reallocation of resources can bring. Adjustment is always difficult, but it is vital to our long-term economic prosperity. Despite the difficulties involved, the adjustment process of the past few years has gone more smoothly than in previous periods. Canada's labour force participation rate has risen to a record high, and the jobless rate has fallen to a 33-year low. While the manufacturing sector has lost about one in seven jobs since 2002 – a total of about 335,000 jobs – total employment in Canada has risen by 1.6 million jobs over the same period. Equally encouraging is the quality of the jobs being created. More than 80 per cent of new jobs are in sectors where the average hourly wage is higher than in manufacturing. Canada's ability to capitalize on higher commodity prices (or to mitigate the impact of lower ones) depends crucially on the continued ability of our economy to adjust. Product and labour market flexibility is essential. The Trade, Investment, and Labour Mobility Agreement (TILMA) between Alberta and British Columbia is a good example of the type of response needed. It is encouraging that other governments are contemplating similar liberalizations. Lessons from the previous boom Before turning to monetary policy considerations, I would like to recall some lessons from the last sustained upturn in commodity prices. During the 1970s, a number of commodity prices spiked – including oil prices, which rose five-fold during the decade. Like today, common drivers included low real interest rates globally and supply factors, in particular, the emergence of OPEC. The decline of the newly floating U.S. dollar also pushed oil prices higher, along with the persistence of inflation in G-7 countries once inflation expectations began to rise. Authorities in many oil-producing countries acted as if higher prices would persist indefinitely. They increased spending rapidly, which would prove calamitous when prices reversed and large structural deficits were revealed. In Canada, total program spending by the federal government rose from 17 per cent of GDP in the early 1970s to 21 per cent only a decade later. In 1985, the general government structural deficit peaked at 8 per cent of potential GDP. We should keep fresh in our minds the memory of the Herculean efforts required to eliminate this drain on future generations. The management of monetary policy, in hindsight, was not much better. Authorities in many countries mistakenly assumed that the productivity gains experienced over the previous quarter century would continue. Rising unemployment was taken, falsely, as a sign of rising excess capacity. This ignored the fact that much of our industrial activity, indeed much of our society, was based on an assumption of perpetually cheap energy. The monetary authorities of the day reacted to the oil-price shock by accommodating the price increase. Viewing the higher prices as contractionary, they loosened monetary policy to avoid a slowdown. The absence of an explicit nominal anchor for policy made this decision easier and its consequences far worse. As we know now, the assumed excess supply was illusory. The fallout from these errors in monetary and fiscal policy was severe. The global recession of 1981-82 was, in large measure, the end result. In Canada, both consumer price inflation and the unemployment rate reached double digits by the early 1980s. The damage to inflation expectations meant that inflation would remain a real and present danger for years. Implications for monetary policy in the current situation This experience is relevant to the current situation. At a fundamental level, it underscores that the primary goal of monetary policy should be to keep inflation low, stable, and predictable. While commodity-price shocks raise complex issues, a relentless focus on inflation clarifies policy decisions, makes communications easier, and maximizes the likelihood that expectations will remain well anchored. A credible inflation target helps to keep the cost of capital down and highlights relative price movements, thus allowing individuals and firms to make better investment decisions. In Canada, we have developed a well-functioning monetary policy framework based on inflation targeting and supported by a flexible exchange rate. Inflation targeting naturally leads the monetary authorities to take a disciplined and rigorous approach to understanding the drivers of inflation. However, even with the best framework, execution is everything. In the face of the largest commodity-price shock in our lifetimes, we cannot be complacent. Indeed, the current period of exceptional volatility in commodity prices raises several issues for the conduct of monetary policy. First, the commodity boom underscores the importance of well-anchored inflation expectations. People's expectations for future inflation do influence actual future inflation rates. Thus, there is a risk that the high visibility of energy prices could lead to increased inflation expectations and to more general inflationary pressures. On the other hand, if people recognize that a one-time increase in commodity prices has a temporary impact on total CPI, other prices and wages will be unaffected. The demand and supply fundamentals that I discussed at the start give reasons to expect firm commodity prices, but not necessarily persistent – let alone accelerating – commodity-price increases. Quite simply, high commodity prices do not necessarily mean rising commodity prices. In fact, high prices themselves make further commodity-price inflation less likely because of the demand and supply responses they provoke. The Bank of Canada's clear commitment to its inflation target and its consistent past success in achieving it, have kept inflation expectations well anchored. The Bank will continue to monitor movements in inflation expectations using a wide range of survey and market indicators. Second, and relatedly, the Bank needs to be mindful of the possibility that rising commodity prices may affect the relationship between total and core CPI. The experience in Canada has been that total CPI persistently moves towards the core measure over time. 12 Moreover, our experience has been that commodity-price inflation has been one of the least persistent forms of inflation. As a consequence, in the pursuit of our 2 per cent target for total CPI, we use our core measure as an operational guide. This is because, over the years, core CPI has been a good gauge of the underlying trend of inflation and has been a better predictor of future changes in the total index than has total CPI itself. In practice, targeting total CPI inflation requires a high degree of confidence about the future path of commodity prices. The relationship between core and total CPI is more marked in Canada than in other countries, reflecting both the success in anchoring inflation expectations around 2 per cent and the fact that, as a major commodity exporter, movements in our dollar in response to commodity-price changes generally provide an offset that reduces the Canadian-dollar prices See J. Armour, "An Evaluation of Core Inflation Measures" (Working Paper 2006-10, Bank of Canada, 2006) and J. Hoddenbagh, M. Johnson, and E. Santor, "Total and Core Inflation: Recent International Evidence" (Bank of Canada Working Paper, forthcoming). of all imports, including commodities. For example, the past appreciation of the Canadian dollar is one reason why food-price inflation has been markedly lower in Canada than in the rest of the developed world. 13 Overall, the Bank of Canada's commodity-price index (BCPI) has risen only half as much in Canadian-dollar terms as it has in U.S.-dollar terms, since 2002. The Bank will continue to monitor the stability of the relationship between core and total CPI. The Bank will also continue to look at a range of measures to assess the underlying trend of inflation. Considerable judgment must always be applied, and no one measure should be relied on exclusively. Third, we need to consider the possible impact of higher commodity prices on Canada's potential growth. The Bank spends a great deal of effort trying to understand the factors that shape potential output and its components. This focus on potential should mean that we are less likely to misread the outlook for productivity and potential growth in the face of large relative price shifts, and thus avoid a key policy mistake of the 1970s. In particular, we need to consider the possibility that the combination of Canada's relatively high energy intensity, 14 the exploitation of more marginal resource deposits that high prices encourage, and the significant shifts in productive resources across our economy could temporarily lead to lower productivity and potential growth. There are, of course, countervailing forces that could raise potential growth, including the strong capital investment incentives arising from a stronger dollar and the tightness of the labour market. We will make such determinations carefully and will provide our updated views in the October Monetary Policy Report. Fourth, the pace and nature of recent commodity-price moves has important positive demand implications. As I mentioned earlier, large improvements in our terms of trade mean large increases in Canadian real income and wealth. This fuels domestic demand, especially for non-traded goods and services, and provides a timely offset to weaker external demand from our largest trading partner, the United States. Finally, a central lesson from past commodity booms (and busts) is the value of a flexible exchange rate as shock absorber. A floating exchange rate is a key element of our monetary policy framework that allows Canada to pursue an independent monetary policy appropriate to our own economic circumstances. To be absolutely clear, irrespective of the path of commodity prices specifically, or global price movements more generally, a floating exchange rate means that we can continue to achieve our inflation target. Exchange rate movements act as a signal to shift resources into sectors where demand is strongest. During the Asian crisis in the late 1990s, commodity prices fell sharply. The resulting depreciation of the Canadian dollar helped with the significant but necessary reallocation of resources out of the resource sector and into other sectors, such as manufacturing, whose competitive positions had improved. In recent years, the process has worked in reverse. It is important to remember that with changes in terms of trade, adjustment will follow. It is only a question of how. Our floating exchange rate helps to achieve the appropriate adjustments without forcing very difficult changes in the overall level of wages, output, and prices. Canadian food-price inflation has averaged 1.4 per cent over the past year, versus the OECD average of 4.3 per cent. Reasons include the past appreciation of the Canadian dollar, increased competition among food retailers, and some special factors such as the excess supply of meat. Although these factors can be considered temporary, the same may well apply to the future path of food-price increases. For instance, there is evidence from the United States that the productivity slowdown of the 1970s was concentrated in sectors that were most energy intensive and were therefore the hardest hit by the energy shock. See W. Nordhaus, "Retrospective on the 1970s Productivity Slowdown" (Working Paper No. 10950, National Bureau of Economic Research, 2004). Conclusion: the current environment Let me close with a few words about the current stance of monetary policy. In addition to sharply improved terms of trade driven by commodity prices, the Canadian economy is being hit by two major and related shocks: a marked and prolonged slowdown in the U.S. economy and severe dislocations in financial markets. The challenge for the Bank is to assess the combined implications of these three forces and other factors for the balance of aggregate supply and demand in the Canadian economy and the prospects for inflation in Canada. Reflecting the severity and persistence of the downside shocks, the Bank reduced its key policy rate by a cumulative 150 basis points since December. In our April Monetary Policy Report, we reviewed these forces at length and laid out a base-case projection for the economy that contained upside and downside risks to inflation. Those risks were judged to be balanced. We said at the time that "some further monetary stimulus will likely be required," but noted that the timing of "any further monetary stimulus will depend on the evolution of the global economy and domestic demand, and their impact on inflation in Canada." Since then, there have been developments in the global economy relative to our expectations in April that led the Bank to decide on 10 June to maintain its target for the overnight rate at 3 per cent. Commodity prices, as measured by the BCPI, rose 10 per cent over the period between decisions, and the futures curve for oil moved sharply higher. This will support domestic demand. Other considerations included stronger global growth than previously expected and higher global inflation, which increases the risk of higher-thanprojected costs for Canadian imports. In addition, many of the downside risks to inflation have eased. For instance, the price discounting on cars and books, which followed the move of the Canadian dollar to parity with the U.S. dollar, does not appear to be spreading materially to other products. In addition, as I noted a moment ago, the risk remains that potential growth will be weaker than currently assumed. Although global financial conditions remain strained, their evolution has been in line with expectations. Credit conditions in Canada are better than elsewhere, as evidenced by the Bank's decision in May to become the first G-7 central bank to begin withdrawing its extraordinary provision of liquidity to markets. Thus, developments since April shifted the balance of risks to the inflation projection in the April MPR slightly to the upside. This evolution of the global economy and domestic demand was sufficient to alter the view that "some further monetary stimulus will likely be required." As a result, the Bank now judges that the current accommodative stance of monetary policy is appropriate to bring aggregate demand and supply back into balance and to achieve the 2 per cent inflation target. Going forward, there remain important downside and upside risks to inflation, but these risks are now judged to be evenly balanced. The Bank will continue to monitor closely the evolution of developments in the Canadian and global economies in order to assess their implications for aggregate supply and demand and the outlook for inflation. One thing is certain: over time, the balance of risks will change again. Monetary policy will adjust accordingly, while always remaining focused on achieving our inflation target. In this manner, the Bank of Canada can make its best contribution to helping Canadians capitalize on the current commodity boom, and that famous bumper sticker can remain a relic.
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Remarks by Ms Sheryl Kennedy, Deputy Governor of the Bank of Canada, to the Investment Industry Association of Canada, Banff, Alberta, 23 June 2008.
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Sheryl Kennedy: Real estate, mortgage markets, and monetary policy Remarks by Ms Sheryl Kennedy, Deputy Governor of the Bank of Canada, to the Investment Industry Association of Canada, Banff, Alberta, 23 June 2008. * * * Good afternoon. It's great to be in Banff – today especially. On this day in 1887, Parliament enacted the Rocky Mountains Park Act, which established Banff as Canada's first National Park. Happy birthday, Banff National Park! I am delighted to be at this IIAC conference. Just as parks and conservation are vital for our, and our children's environmental and spiritual well-being, sound investment is vital for our long-term economic and financial well-being. For many Canadians, one of the most important investments they'll make is the purchase of a house. And for you as financial market professionals, the links between the housing market and financial markets have important consequences. Today, I'd like to speak about housing and how it interacts with the economy, financial markets, and monetary policy. Over the past 10 years, the Canadian housing market has exhibited a good deal of strength. Demand, supply, and prices have increased [chart: Housing Activity in Canada: 1998-2008]. But while the Canadian real estate market does not currently exhibit the generalized signs of excess we see in some other countries, 1 we cannot afford to be complacent. After a fairly substantial run-up, real house prices have declined in the United States, the United Kingdom, and Spain, and Canadians would be wise to remember that house prices can fall as well as rise [chart: Changes in Real House Prices in the U.S., the U.K. and Spain]. It wasn't that long ago – in the late 1980s and early 1990s, to be exact – that Canada experienced its own real estate boom and bust. It took a decade after that before we saw activity pick up and real prices increase [chart: Changes in Real House Prices in Canada]. More recently, of course, we have seen in this part of the country a strong housing market cycle. The current state and likely future evolution of the housing market in Canada have implications for the economy, financial markets, and policy-makers. I will describe these implications later, but first I'd like to set the stage by discussing the role of housing in the Canadian economy and some of the factors that drive housing activity and prices. Housing, the economy, and financial markets Housing plays an important role in the economy, with direct and indirect effects on household wealth and consumption. In Canada, residential investment has, for the past decade, averaged about 6 per cent of GDP – somewhat higher than in the United Kingdom and the United States. About a third of residential investment is spent on renovations. Canada's home ownership rate of over 68 per cent is similar to that in the United States, a little lower than it is in the United Kingdom and Australia, but higher than in European countries such as France and Germany. Real estate assets also represent a large stock of wealth – more than $2.2 trillion, or 37 per cent of total household assets in Canada. Changes in the level of housing activity and in the price of houses have many implications for the economy, not only directly, because housing is an important source of economic activity, but also indirectly, because home equity is an important source of household wealth and finance. So, what are the main drivers of these changes? Although they overlap and interact For insight into valuations and risks in international housing markets, see chapter 3 of the International Monetary Fund's April 2008 World Economic Outlook, "The Changing Housing Cycle and the Implications for Monetary Policy," available at http://www.imf.org/external/pubs/ft/weo/2008/01/pdf/c3.pdf. with one another, I like to think of them in three groups: the fundamentals of supply and demand, financial innovation, and policy. Let me say a word about each. First, as in most markets, the price of housing is driven largely by the fundamentals of supply and demand. Over the long term, of course, supply and demand inevitably balance, with neither upward nor downward pressure on prices. But in the shorter term, supply (that is, new houses and resale listings) can be slow to adjust, and therefore significant price changes can occur when there are significant shocks to demand. Such shocks can come about with changes in demographics (which include the working-age population, immigration, and migration) [chart: Household Formation and Housing Starts]; changes in the labour market, disposable income, wealth, and financing costs [chart: Disposable Income, Unemployment, and Mortgage Interest Rates]; and changes in the price and availability of alternatives in the rental market [chart: Rental Vacancy Rate and House Price Growth: Calgary]. Second, financial innovation also plays a role in driving housing demand and prices. Most home buyers require financing, and therefore the mortgage market and its increasingly innovative products can affect when people purchase a house and the type of house they buy. In recent years, several new mortgage and mortgage-insurance products have been introduced in Canada. These include the low (or even zero) down payment mortgage; the longer-amortization mortgage (that is, for an amortization period of longer than 25 years and up to 40 years); and, to a small extent in Canada, mortgages for non-prime borrowers. Of course, innovations can increase a household's financial flexibility by allowing for reduced down payments and mortgage payments. And, because financial innovation often results in new means by which savings can be allocated to desired investments, it can also increase the efficiency of financial markets. But financial innovations can carry risks as well. For example, if financial innovations are introduced when demand is already strong, they can amplify a rising price trend, which, in turn, could result in higher mortgage rates overall. For the home buyer, of course, some innovations can increase the total cost of ownership – significantly in some cases – and can thus reduce lifetime savings or spending and investments in other areas of the economy. For example, a $200,000 mortgage, serviced with monthly payments on a 40-year mortgage at 5 per cent, will cost the homeowner about $110,000 more in total than if the mortgage were for a 25-year period [chart: Impact of Amortization Period on Mortgage Payments]. Although there are no publicly available statistics for amortization periods in Canada, anecdotal evidence suggests that more than half of new, insured mortgages issued in Canada over the past year were for extended amortization periods. While many people with longer amortization mortgages may choose to make accelerated payments, the potential effect of this shift in financing behaviour, when combined with low or zero down payment mortgages, can raise concerns, especially if there were also to be an easing of lending standards. Furthermore, if financial innovations allow people to buy houses with very little "skin in the game," they can, in a rising-price environment, encourage speculation in "quick flip" financial investment. This additional stimulus to demand can, in a market already characterized by tight supply and rising prices, boost house prices further, and increase the risk of a correction. For investors in innovative mortgage products, there can also be risks – as recent events in the United States have so clearly shown. Take securitization, for example. The movement from an originate-and-hold model to an originate-and-distribute model by means of securitization, and the creation of complex, synthetic instruments, together diminished the incentive for sound credit evaluation in the United States and some other countries. Also, because they were believed to be off balance sheet, these securitized products were not always properly considered in the liquidity plans and capital structure of sponsoring financial institutions. Because these products were complex and not fully transparent, the risks associated with them were difficult to understand and consequently mispriced. Fortunately in Canada, we were not as aggressive in breaking the links between originator and distribution, nor, for the most part, did we develop complex, synthetic securitized instruments involving Canadian mortgage assets. Furthermore, mortgages with less than a 20 per cent down payment must be insured in Canada, and most of the securitized mortgage market consists of Canada Mortgage Bonds, which carry a government guarantee. Overall, then, financial innovation can be helpful when all parties – borrowers, lenders, and investors – understand the risks and are properly positioned to bear them. It can be detrimental if it exacerbates cyclical pressures, leads people to buy homes they cannot sustainably afford, encourages speculation, or if the inherent risks are not well understood. Now, in turning to the third influence on housing activity and prices, I should note that fundamentals and financial innovation don't exist in a vacuum. They are affected – for better or worse – by the policy environment. One important element here is monetary policy, but other domains of public policy can also have an impact. Some policies – whatever the intention – can restrict supply and affect cost directly or indirectly. These would include land use and zoning, development charges, and building codes. Other policies can affect demand. They include immigration, housing, and mortgage policies, for example. The housing market and monetary policy Let me turn to the policy area I know best. Monetary policy has an important role in the housing market from several perspectives. It has effects on more than just the cost of a mortgage. I'll elaborate briefly. The aim of monetary policy in Canada is to keep inflation low, stable, and predictable, close to our 2 per cent target for total CPI inflation. This inflation-control policy has at least two key implications for housing activity and prices. First, low, stable, and predictable inflation acts as a macroeconomic stabilizer – it tends to enhance the growth of output and reduce its variability, while keeping interest rates lower and less volatile. These outcomes, in turn, tend to support the housing market in a very general sense, and help to stabilize housing demand. Second, against a backdrop of low and stable inflation, both house builders and house buyers can make better-informed decisions. Overall, then, monetary policy in Canada is an important element in supporting a sound and stable housing market. That being said, for a number of years, there has been debate over whether central banks can or should take asset prices into account in their decision making. Recently, of course, the asset class of primary interest has been housing. As I just mentioned, we believe that the best framework to achieve this end is one that focuses on keeping inflation low, stable, and predictable. In this context, changes in housing activity and prices are important to the conduct of monetary policy for a number of reasons. I will mention three. First is the direct effect on inflation, which is captured in the "owned accommodation" component of the consumer price index. Second is the indirect impact on household spending. And third is the impact that a rapid change in prices – the inflating or deflating of a bubble – can have on the real economy. Let me discuss each of these in turn. In Canada, unlike some countries, the CPI fully captures the direct effect on inflation of changes in house prices in the "owned accommodation" component of the CPI, which includes mortgage interest cost, replacement cost, property taxes, house insurance, maintenance and repairs, and "other owned accommodation expenses." This component represents 16.5 per cent of the CPI basket [chart: Total CPI and Owned Accommodation]. Changes in the price level of this component, therefore, have a significant direct effect on total inflation. Changes in house prices can also have an important effect on household spending. Housing wealth is widely distributed – much more so than stock market wealth, for example – and thus has an important influence on aggregate demand which, in turn, has an effect on inflation. Furthermore, there can be a "financial-accelerator effect" associated with rising house prices. When the value of a house rises, the owner can typically borrow against this increased equity to fund home renovations, a second house, or other goods and services [chart: Home Equity Withdrawal and Home Renovations]. 2 These expenditures can "accelerate" a rise in house prices, reinforcing the rise in collateral values, access to additional borrowing, and thus a rise in household spending. Of course, this accelerator effect can also work in reverse: a decrease in house prices tends to reduce household borrowing capacity, and amplify the decline in spending. Finally, a significant increase or decrease in house prices from historic norms – that is to say, the inflating or deflating of a "bubble" – can have an impact on the real economy. In a nutshell, bubbles are costly (in both directions) because they distort decision making and impede the optimal allocation of resources. As a bubble develops, people tend to build and purchase more housing than would be the case when prices reflect fundamentals, and lenders may divert investment to housing from alternative, more productive opportunities. When the bubble bursts, decision making is again distorted, and both households and lenders suffer the consequences. This boom-and-bust cycle can prove very costly to the economy. The appropriate monetary policy response to these bubbles is the focus of considerable debate. The Bank of Canada considered this issue in the period preceding the renewal of the inflation targeting agreement with the government, 3 and we continue to examine it. These three effects – the direct effect on inflation, the effect on consumption, and the effects of an inflating or deflating bubble – carry important implications for monetary policy, implications we consider when we set policy to achieve our 2 per cent inflation target over the medium term. Let me now turn to some challenges for the Bank, other policy-makers, lenders and investors, with regard to the promotion of a sound housing market in Canada. Challenges for policy-makers and financial markets The first challenge is to continue to ensure that policies encourage the right kind of practices and innovation in mortgages and home equity lending. In this regard, it is extremely important that sound lending standards be consistently applied – even in "good times." We should be wary of innovations that encourage price run-ups beyond what fundamentals would justify; many such innovations will fail the test of time. New products should not be dependent upon an assumption of appreciating house prices, and incentives must be aligned to promote prudence in borrowing and lending. Finally, the financial-accelerator dynamics The Bank of Canada has examined the related issue of appropriate time horizons for monetary policy when there are financial-accelerator effects triggered by a persistent shock, such as an asset-price bubble. See Don Coletti et al., "Another Look at the Inflation-Target Horizon, available at http://www.bankofcanada.ca/en/review/summer06/coletti.pdf. The Bank continues to research various aspects of the financial-accelerator effect. For further details on home equity borrowing, see Technical Box 2, "Total Home Equity Borrowing in Canada," in the April 2007 Monetary Policy Report, available at http://www.bankofcanada.ca/en/mpr/pdf/mpr260407.pdf. See, for example, J. Selody and C. Wilkins, "Asset Prices and Monetary Policy: A Canadian Perspective on the Issues," Bank of Canada Review, Autumn 2004, available at http://www.bankofcanada.ca/en/review/autumn04/selody.pdf. that I mentioned, and how innovation affects them, need to be adequately recognized and better understood. 4 A second, and related, challenge is to ensure that innovations in the funding of mortgage finance do indeed make the financial system more efficient and do not threaten financial stability. It is important that investors and financial market participants understand the risks they take on so that they can manage these risks effectively. It is also important that there be sufficient transparency so that financial markets can price the risks efficiently and allocate risk to those who are best positioned to bear it. Risk is more likely to be priced efficiently when pertinent information is readily available and incentives are aligned. Adequate transparency and disclosure help investors to understand the characteristics of the securities they are holding, and make it easier for market participants to value assets, which, in turn, helps to maintain liquid markets. Finally, incentives must be properly aligned to prevent conflicts of interest that can confound and distort the pricing of risk. A final challenge I'd like to mention is that of enhancing the financial literacy of potential and current mortgage holders, and of investors. One of the best ways to avoid painful outcomes in the housing market is to have individuals making well-informed financing decisions. The need for financial acumen has increased in recent years, and may continue to increase. 5 The good news about innovation in the mortgage, mortgage insurance, and home equity markets is that people have greater choice in financing. But individuals need the financial literacy and all the relevant information from those selling mortgage products to make the choices best suited to their circumstances. The housing market in Canada As I said at the outset, unlike the situation in many countries, conditions in the Canadian housing market remain relatively favourable. Housing activity remains at a high level, and house prices continue to rise overall. The moderation in activity and price increases that we have seen in recent months is both expected and welcome. Still, we cannot afford to be complacent. That is the lesson from previous boom-and-bust cycles – a lesson underscored by the current problems in the U.S. housing market. In the first half of this decade, the U.S. housing market underwent a boom as various financial innovations were introduced, some of which encouraged the buying of houses by those who clearly could not afford them. The emergence of subprime mortgages as a means of financing the purchase of a house played a significant role in this boom. At the end of 2007, about 14 per cent of total residential mortgage loans outstanding in the United States were subprime. From 1998 to the peak of the boom in 2007, real house prices appreciated by, depending on the measure used, about 45 per cent (OFHEO) or even 105 per cent (Case-Shiller). However, since the peak, real house prices have fallen by between 7.4 per cent and 22.3 per cent (OFHEO and Case-Shiller, respectively). This decline has had The Bank of Canada puts a good deal of effort into monitoring and assessing the state of the Canadian housing market, as well as analyzing the impact of changes in activity and pricing on credit markets, the real economy, and the financial system. Some of this analysis is reported in the Bank's Monetary Policy Report and Financial System Review. In the past few years, we have tried to improve our understanding of the links between house prices, credit growth, and spending, and we will publish research in this area as it bears fruit. The Bank of Canada informs the public about financial system issues in reports, in speeches and on its website. For practical information on mortgages and mortgage default insurance, individuals can refer to the Financial Consumer Agency of Canada's website http://www.fcac-acfc.gc.ca/eng/default.asp. The FCAC's goal is to provide consumers with "objective information about financial products and services," and to inform Canadians of their "rights and responsibilities when dealing with financial institutions." Of course lenders not only have a responsibility, but they also have a stake in helping borrowers to make informed decisions. Defaults are not generally in their interest. deleterious effects on the real economy and the financial system, and has caused real hardship for many individuals. Largely because of Canada's more conservative mortgage culture – with fairly prudent lending standards, and with most mortgage lending to be found on commercial banks' balance sheets or financed by sound securitized vehicles – the housing market in this country has not demonstrated the same excesses seen in the United States. The strength of the Canadian housing market over the past decade can be seen in home sales and housing starts, which have increased by about 55 per cent. Real prices for existing houses increased by 52 per cent over this period, while real prices for new houses increased by about 27 per cent. Of course, these averages mask regional variations. In Western Canada, strong labour markets, sustained income growth, and demand resulting from the migration of Canadians from other provinces have resulted in house price increases that are higher than the national average. Much of the growth over this period was the result of pent-up demand following the housing downturn of the late 1980s and early 1990s. 6 In examining the current situation, our most recent Financial System Review notes that income growth, low unemployment rates, and relatively good financing conditions have supported rising house prices, although the pace of increase has slowed somewhat. This deceleration has been most noticeable in markets (such as Alberta) that have posted very steep price increases over the past two years. The slower price growth is the result of increased supply combined with some softening in demand, which can be attributed to the previous run-up in the hottest markets, and some slowing in economic growth. This moderation in housing activity has been expected and is welcome. The Canadian housing market does not appear to be characterized by excess supply at this time. The proportion of unoccupied, newly built dwellings in most cities remains below historical averages, suggesting that a major widespread reversal in house prices is unlikely in the near term. The recent downward trend in building permits suggests that supply is adjusting to softening demand. And importantly, the Canadian mortgage market is in reasonably good shape. The Canadian "subprime" mortgage market accounts for less than 5 per cent of the residential mortgage market, and might be better characterized as a "nearprime" market, with quite different lending standards than appear to have been applied in the United States [chart: Percentage of Subprime Mortgages in Arrears for More Than 90 Days or in Foreclosure]. Conclusion Allow me to conclude. The housing market plays an important role in the national economy. And changes in housing activity and prices can have far-reaching effects. The turbulence of the past 12 months emanating from the U.S. housing market has posed risks and challenges for many people – and for the conduct of monetary policy. Although the Canadian economy has not escaped the effects of financial market dislocations or the weakening U.S. economy, the Canadian financial system and the housing market have shown considerable resilience, in part reflecting prudent practices. Canada's monetary policy framework continues to play an important role in anchoring inflation expectations, and thus in supporting sustainable economic growth and a sound Growth in housing activity and prices over the past decade was underpinned by a number of factors including regional migration; income growth from strong employment, rising wealth from financial assets, and relatively low interest rates; as well as, in recent years, innovations in the mortgage market. housing market. Macroeconomic stability cannot eliminate asset-price run-ups, but it does help a good deal when financial decisions are made, and it helps to mitigate the impact when run-ups and reversals do occur. A foundation of low, stable and predictable inflation will continue to prove valuable in helping Canadians to make informed decisions about housing – and indeed about many forms of spending and investment.
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Remarks by Mr Mark Carney, Governor of the Bank of Canada, at the 7th BIS Annual Conference, Lucerne, Switzerland, 27 June 2008.
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Mark Carney: Flexibility versus credibility in inflation-targeting frameworks Remarks by Mr Mark Carney, Governor of the Bank of Canada, at the 7th BIS Annual Conference, Lucerne, Switzerland, 27 June 2008. * * * It is an honour for me to participate in this panel alongside Martin Feldstein and Stanley Fischer. Just as central bankers are forward looking in the conduct of monetary policy, it is entirely appropriate that the BIS coordinate a session that looks beyond price stability to the challenges ahead. With the challenges that we currently face, it is understandable that some may desire greater flexibility in the conduct of monetary policy. However, the value of this greater flexibility depends on the extent to which it detracts from monetary policy credibility. I will concentrate my brief remarks today on the themes of flexibility and credibility. I would like to state at the outset that what follows is a discussion of ideas worthy of consideration. It should not be seen as having any bearing on the current conduct of monetary policy in Canada. The Bank's current inflation-control agreement with the Government of Canada will remain in effect until the end of 2011. Changes to our agreement with the Government, if any were desired by both parties, would only come into effect thereafter. Arguments for greater flexibility There are two broad classes of arguments for greater flexibility in the design and application of monetary policy frameworks. The BIS has done a great deal of useful work on asset-price targeting in particular and on the complicated interplay between monetary policy and financial stability in general. My fellow Canadian, Bill White, framed the discussion about flexibility for inflation targeters with his paper "Is Price Stability Enough?" In this paper, Bill argues that policy-makers should respond flexibly to shocks that create persistent financial imbalances. In particular, he suggests that policy-makers should extend the inflation horizon and pre-emptively tighten policy when faced with such shocks. This would have the practical consequence of purposely deviating from the inflation target temporarily in order to avoid more costly deflationary busts down the road. Others argue that globalization creates similar imperatives. For instance, throughout this decade, there has been a secular disinflation (relative to target) in goods prices, reflecting the efficiencies from creating global supply chains and outsourcing some production to emerging markets. Some suggest that these same emerging markets are creating persistent commodity-price inflation. 1 Finally, the current international monetary order – wherein a large dollar block coexists with floating currencies – may create additional shocks, including low long-term interest rates and unevenly distributed exchange rate adjustment. Should any of these forces be taken into consideration in either the design of monetary policy frameworks or the choice of monetary policy parameters? Flexibility and adjustment Arguments for flexibility in monetary policy frameworks can be considered in the context of the broader principle that policy flexibility helps lower adjustment costs. In theory, social That view is certainly not unanimous, as I argue in "Capitalizing on the Commodity Boom: the Role of Monetary Policy" (speech to the Commodities, the Economy, and Money conference, Calgary, 19 June 2008). welfare is reduced when there are constraints on the ability of policy-makers to optimize economic adjustment. Policy frameworks should be flexible enough for the natural adjustment processes in the economy to determine the speed of adjustment to shocks. Throughout this decade in Canada, we have seen how policies that promote flexibility in labour and product markets reduce adjustment costs. In contrast, policy constraints on market prices – such as fixed exchange rates or subsidized energy prices – make adjustment to economic shocks more costly. If a shock is major and has widespread consequences, such rigidities impose costs on other countries because those flexible prices must adjust in an unnecessarily large or rapid way. In the face of large and possibly persistent shocks, the design and parameterization of monetary policy frameworks depends in part on the trade-off between flexibility and credibility. This, in turn, is a function of both the extent to which (inflexible) rules enhance credibility and our ability to make the judgments required to deploy any flexibility in a credible manner. The principle of policy flexibility is already embodied in our macroeconomic models. When we calculate the policy response to shocks in these models, it is optimal for policy to allow inflation to return to target at different speeds, depending on the type and characteristics of the shocks hitting the economy. This implies different amplitudes of the inflation cycle and different time horizons for inflation to return to target. In contrast, the parameters in today's inflation-targeting frameworks generally do not vary with the type of shocks hitting the economy. For example, the numeric value of the target itself is held constant in the face of all shocks, even though it might sometimes be beneficial to temporarily adjust it to lean against the wind. This point can also be cast in terms of making the operational target – i.e., core inflation – a function of the shocks hitting the economy. As well, the band or confidence interval around the target is held constant, even though it may sometimes be beneficial to worry less about inflation volatility in a period of highly volatile, but transient, shocks. Finally, the time horizon for returning inflation to target is usually held constant. As a consequence, it can be too short to factor in fully the longer-run disruptions associated with, for example, building asset imbalances. The current parameters are not arbitrary. In Canada, the 2-per-cent target for the total consumer price index reflects the measurement bias inherent in the CPI, the risks associated with the zero lower bound and concerns about downward nominal wage rigidities. The 1-percentage-point range around the target reflects the unconditional variance of the inflation process. 2 The 18- to 24-month time horizon reflects the lagged response to monetary policy action. 3 This inflexibility has significant value. It provides clarity of objectives and holds central bankers accountable. When policy lacks credibility, it can be beneficial to have simple inflexible elements in the framework because they demonstrate the policy-makers' commitment to that policy. If the inflation target is achieved, it enhances the credibility of the central bank and creates a virtuous circle whereby increased policy credibility further anchors inflation expectations, which then contribute to a more stable macroeconomic environment, which, in turn, enhances policy credibility. We should be careful neither to underweight the value of resulting simple heuristics nor to minimize the risks of complicating them. It can also be argued that the range should be conditional on the nature of the shock to inflation. Note that in Canada, unlike some countries, the CPI fully captures the direct effect on inflation of changes in house prices in the "owned accommodation" component of the CPI, which includes mortgage interest cost, replacement cost, property taxes, house insurance, maintenance and repairs, and "other owned accommodation expenses." This component represents 16.5 per cent of the CPI basket. When then to be flexible? Once credibility is achieved and the operation of the framework better understood, could credibility be retained if the parameters were adjusted to reflect the characteristics of the shocks hitting the economy at any particular time? Flexible inflation targeting works well with temporary or one-off shocks. Whether it can adapt to address unique but longer-lived shocks (such as an asset boom or secular changes wrought by globalization) is the pertinent question. What constitutes a "unique" shock? Can we expect authorities, if they are granted flexibility, to be sufficiently disciplined not to decide that all shocks are uniquely virulent? Everyone always thinks they live in interesting times. Financial imbalances certainly are interesting. However, it is not clear that monetary policymakers should be the first line of defence. Recent events in a variety of jurisdictions demonstrate the shortcomings of the current system where the degree of financial stability is a by-product, rather than an objective, of regulatory policy. Central banks, as guardians of macroeconomic stability, naturally ask whether they should play a role. It does not necessarily follow that that role extends to the conduct of monetary policy. Central banks may have the ability to foresee macrofinancial instability. Whether they have the appropriate tools to prevent it is another matter. I am most sympathetic to the idea that policy-makers should consider the development of macroprudential regulations to restrain procyclical liquidity creation among financial institutions. The design and scope of such regulation remains to be determined and in many jurisdictions, including Canada, there are the added complications of determining where to house this regulatory authority and how to coordinate it with other regulators. 4 If the regulatory framework is appropriately designed, could it be reinforced by monetary policy? Professor Issing provides one answer. He argues that the ECB's monetary pillar can act as a signal for flexibility, perhaps in the monetary policy horizon, in the presence of excess credit creation. Michael Woodford agrees that money and credit can have a useful role, but cautions against incorporating them in the monetary policy reaction function. 5 Do those situations that arise from the globalization process create a case for additional policy flexibility? There are some practical difficulties such as the conflicting implications globalization may have for consumer-price inflation. For example, its impact on manufactured goods prices argues for a lower target; its impact on commodity prices for a higher one. 6 Moreover, these conflicting forces are basically price-level effects, though ones that could go on for some time. Similarly, the current international monetary order argues for tighter policy due to artificially low long-term interest rates and for looser policy in countries that have seen excessive exchange rate appreciation. Further complicating matters is the fact that the globalization process is neither monotonic nor relentless. Its impacts will wax and wane over time, raising the question of how frequently policy parameters might be adjusted in the face of these shifting trends. In the pursuit of flexibility, how do we prevent this from looking terribly arbitrary? These difficulties are not trivial, so considerable care needs to be taken. The benefit of greater flexibility may not be worth the risk of forfeited credibility, particularly if it simply adds For a full discussion, see M. Carney, "Principles for Liquid Markets" (speech to the New York Association for Business Economics, New York, New York, 22 May 2008). See the presentations by Issing and Woodford to this conference, published by the BIS. Some of these effects are not that material. Recent Bank of Canada research estimated that, on average, the direct effect of consumer goods imported from China reduced the inflation rate by about 0.1 percentage points per year from 2001 to 2006. See L. Morel, "The Direct Effect of China on Canadian Consumer Prices: An Empirical Assessment" (Discussion Paper No. 2007-10, Bank of Canada, 2007). to confusion about the conduct of policy. This points to the overriding importance of communication, rightly stressed by Alan Blinder. 7 The current environment underscores many of the strengths of flexible inflation targeting. The commodity-price shock has resulted in inflation rising above target in a number of jurisdictions. Provided expectations are well-anchored, policy appropriate, and communication effective, people will look through this spike to the eventual return of inflation to its well-understood target. Of course, this implies the need for short-term flexibility in the target, but a well-designed inflation-targeting regime allows for temporary deviations from target in the face of shocks. Provided the framework retains credibility, that flexibility can and should be used. Price-level targeting There is one final consideration. Inflation-targeting regimes have one element of flexibility that could potentially reduce credibility: their use of an annual inflation measure that allows monetary authorities to overlook price-level adjustments that they believe to be one-off events. Bygones are bygones. This is not a problem when shocks are small and symmetrical because the price level will fluctuate around the level consistent with the inflation target. Indeed, that has been our experience in Canada over 15 years of targeting inflation. Shocks have been random and the price level has ended up almost exactly where one would have expected since we adopted a 2-per-cent target. However, if shocks were large and one-sided and policy did not respond, the price level would drift from the expected path. Such a persistent error would reduce credibility over time. It is worth considering whether targeting the price level would enhance policy credibility in the face of a large, persistent shock. If anticipated, temporary price-level drift could be accommodated by extending the horizon, while credibility would be retained by the fact that the drift would be tracked and eventually reversed. If unanticipated, the promise to correct it that is central to price-level targeting could preserve credibility. The Bank of Canada is currently pursuing a research agenda to determine the gains from adding greater price-level memory to the inflation-targeting framework. Conclusion To conclude, constraints in the policy framework may have helped to gain credibility for the framework when it was new, but now that it is better understood, it is time to ask whether we can do better. In principle, we could do better by making inflexible elements more flexible or by giving the framework more memory about the price level to compensate for any loss of credibility. Doing so should increase social welfare by allowing policy to be better aligned with the natural adjustment processes in the economy, thereby adding to the social welfare benefits that come from delivering low, stable, and predictable inflation. See the presentation by Blinder to this conference, published by the BIS.
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Opening statement by Mr Mark Carney, Governor of the Bank of Canada, at a press conference following the release of the Monetary Policy Report Update, Ottawa, 17 July 2008.
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Mark Carney: Summary of the latest Monetary Policy Report Opening statement by Mr Mark Carney, Governor of the Bank of Canada, at a press conference following the release of the Monetary Policy Report Update, Ottawa, 17 July 2008. * * * Good morning. We are pleased to be here with you today to discuss the July Monetary Policy Report Update, which we published this morning. In the Update, the Bank described three major developments affecting the Canadian economy: protracted weakness in the U.S. economy, ongoing turbulence in global financial markets, and sharp increases in certain commodity prices, particularly energy. While the first two of these developments are evolving roughly in line with expectations, many commodity prices continue to outpace earlier expectations, which has altered the outlook for global and domestic inflation. Although economic growth in Canada in the first quarter of 2008 was weaker than expected, final domestic demand – supported by strong terms of trade – continued to expand at a solid pace. The Canadian economy is judged to have moved into slight excess supply in the second quarter of 2008, and this excess supply is expected to increase through the balance of the year. High terms of trade, accommodative monetary policy, and a gradual recovery in the U.S. economy are expected to generate above-potential economic growth starting early next year. This will bring the economy back to full capacity around mid-2010. Assuming energy prices follow current futures prices, total CPI inflation is projected to rise temporarily above 4 per cent, peaking in the first quarter of 2009. As energy prices stabilize, and with medium-term inflation expectations remaining well anchored, total inflation is projected to converge to the core rate of inflation, at the 2 per cent target, in the second half of 2009. Core inflation is projected to remain well contained. The three major developments affecting the Canadian economy pose significant upside and downside risks to our projection. On the upside, domestic demand could be greater than projected, given the strength of Canada's terms of trade and the momentum of household credit growth. Potential output could be lower than assumed, given ongoing weakness in labour productivity. Global inflationary pressures could also lead to higher-than-projected import costs for Canada. On the downside, commodity prices could be weaker than assumed. Growth in the U.S. economy could also be weaker than expected, particularly in those sectors that are most relevant for Canadian exports. As well, continued strains in global financial markets could have a greater-than-projected impact on global growth and on the cost and availability of credit in Canada. Weighing the implications of these considerations, the Bank views the risks to its projection for inflation as balanced. Against this backdrop, the Bank judges that the current level of the target for the overnight rate – 3 per cent – remains appropriate. We will continue to monitor carefully the evolution of risks, together with economic and financial developments in the Canadian and global economies, and set monetary policy consistent with achieving the 2 per cent inflation target over the medium term.
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Remarks by Mr David Longworth, Deputy Governor of the Bank of Canada, to the Canadian Association for Business Economics, Kingston, Ontario, 26 August 2008.
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David Longworth: Work in progress – the Bank of Canada's response to the financial turbulence Remarks by Mr David Longworth, Deputy Governor of the Bank of Canada, to the Canadian Association for Business Economics, Kingston, Ontario, 26 August 2008. * * * Good afternoon. It's been a little over a year since the first effects of a series of financial dislocations were felt. The financial turbulence over the past year has been costly and difficult for many individuals and financial institutions; it's been challenging for policy-makers; and it's had implications for the overall economy. But the episode has also led many to reexamine their assessment of risks, to question risk-management practices, and to improve policies and operations. This has certainly been the case at the Bank of Canada. In my remarks today, I'd like to describe how the Bank responded to the liquidity aspect of the turbulence as the year unfolded, and the changes that we made in our liquidity-policy framework, both to deal with problems as they arose and to improve our ability to operate in the future. I'll also provide an overview of current conditions in Canadian credit markets and a brief comment on economic developments since we published our Monetary Policy Report Update in mid-July. I'll begin by providing a summary of the origins of the turbulence. Origins of the financial turbulence For a number of years, desired world savings exceeded desired world investment. As a result, long-term real interest rates decreased around the world, which led investors, in their "search for yield," to take on risk at lower premiums than they had demanded in the past, and to accept much higher levels of leverage in financial products and on their balance sheets to obtain their hoped-for returns. The search for yield also led to rapid growth in the demand for, and development of, more complex structured financial products, such as collateralized debt obligations (CDOs) backed by asset-backed securities or by other CDOs and asset-backed commercial paper (ABCP) backed by CDOs, some of which, after 2000, were based on U.S. subprime mortgages. These complex instruments were rated by credit-rating agencies using the same scale that they had used in the past for "plain-vanilla" corporate debt. Some sellers of these complex financial instruments emphasized that these products were highly rated – many were AAA – but placed little emphasis on their other features. A number of investors failed to do their own due diligence and instead relied too much on credit ratings as a measure of the overall risk in holding these complex debt instruments. Among other things, they failed to take into account risks other than credit risks, in particular, market and liquidity risks. The complexity of these instruments frequently made them opaque, and too often investors put their money and confidence into vehicles that they did not fully understand. The basic loan quality of U.S. subprime mortgages worsened through 2005 and 2006, although this worsening did not become broadly apparent to the investors in securitized mortgages until the first half of 2007. 1 Subprime loans were premised on continued increases in house prices. When house prices stopped rising, the belated realization by rating agencies of the poor quality of these loans resulted in the downgrading of structured products with exposure to subprime mortgages, often by several notches. These instruments were held by a variety of investment funds, including many sponsored by banks. Indeed, The problem was exacerbated by the originate-to-distribute model, which led to misaligned incentives for the U.S. originators of subprime mortgages. some products were held directly by banks themselves. Investors soon came to realize that highly rated structured-debt instruments could fall substantially in value and were subject to severe downgrades. As a result, they began to shun almost any type of structured product – either because the complexity of these products made it difficult for many market participants to understand them, and therefore to accurately price the attendant risk, or because they were really looking to hold only true AAA assets. In Canada, these instruments included ABCP. Following the onset of the crisis, non-bank-sponsored ABCP stopped rolling over in Canada, which led to the standstill under the Montreal Accord. As time passed, the markets for securitized products became much less liquid to varying degrees across instruments. As market players observed the downgrades of structured products based on U.S. subprime mortgages and the drying up of ABCP markets, two additional concerns emerged. First was a concern about the financial health of counterparties, particularly banks, as marked-tomarket losses eroded capital. Second was a concern that securitization would proceed at a much slower pace than in the past, thus requiring reintermediation that would result in a more rapid expansion of bank balance sheets and an associated need for capital. These two concerns led to a significant increase in interest rate spreads and to a decline in the liquidity of short-term bank-funding markets in many countries. Now, it is important to note that the decline in the liquidity of bank-funding markets and the decline in the liquidity of asset markets in general are not unrelated. Indeed, there are theoretical reasons to believe that market liquidity and the funding liquidity of banks with trading operations are mutually reinforcing, thus leading to the possibility of a "liquidity spiral" in a downward or upward direction. 2 This possibility arises because first, the ability of traders to provide market liquidity depends on the amount of funding they have and, second, the amount of funding they have, through capital and margin loans, depends on market liquidity. This second linkage arises because, with mark-to-market accounting, asset-price movements affect capital and because, empirically, margins tend to rise when asset prices fall. 3 On a different note, I would add that the leverage of trading operations is strongly procyclical, falling when asset prices fall and rising when they rise. 4 The decline in market liquidity, especially bank-funding liquidity, was of utmost concern to central banks. So how did the Bank of Canada respond? The liquidity policy response Last month, the Bank for International Settlements' Committee on the Global Financial System (CGFS) released an important report 5 that summarized central bank responses to the financial turbulence and put forward seven recommendations aimed at strengthening central bank effectiveness in dealing with liquidity problems, including funding-market pressures. As these recommendations were developed over a number of months, they were, in many cases, already being implemented by individual central banks. I thought it would be useful to use these recommendations as an organizing device to summarize what we at the See M. K. Brunnermeier and L. H. Pedersen, "Market Liquidity and Funding Liquidity," forthcoming in Review of Financial Studies and M. K. Brunnermeier, "Deciphering the 2007-08 Liquidity and Credit Crunch," forthcoming in Journal of Economic Perspectives. Brunnermeier and Pedersen, op. cit., note that, empirically, margins tend to rise when there are large drops in asset prices. They also note that changes in margins can be destabilizing to both asset-market liquidity and funding liquidity. See T. Adrian and H. S. Shin, "Liquidity and Leverage" (Staff Report No. 328, Federal Reserve Bank of New York, May 2008). "Central Bank Operations in Response to the Financial Turmoil," a report submitted by a study group established by the Committee on the Global Financial System, at the Bank for International Settlements. The report is available at: http://www.bis.org/publ/cgfs31.pdf?noframes=1. Bank of Canada have done since last August in terms of actions and the development of new liquidity policies and principles. The first recommendation is that a central bank should make sure that its operational framework is capable of achieving its policy rate target – even in times of turmoil. Both before and during the crisis, the means by which the Bank reinforced its target overnight rate, when necessary, were the intraday use of one-day repo transactions – special purchase and resale agreements (SPRAs) and sale and repurchase agreements (SRAs) – and, at the end of the day, the setting of the target for next-day settlement balances. These policy tools were used aggressively from 9 August of last year to 30 April of this year to reinforce the target for the overnight rate. 6 Because they proved effective, there has been no policy or operational change directly related to this recommendation (Chart 1: Overnight Rate Minus Target Overnight Rate). The second and third recommendations aim at the central bank's ability to conduct liquidity operations effectively, even when key markets are illiquid. In concrete terms, this means that the central bank should be prepared, if necessary, to take steps that go beyond adjusting the aggregate supply of reserves, including providing an increased volume of term funds, conducting operations against a broad range of collateral, and conducting operations with a broad range of counterparties. The frequency and size of overnight liquidity injections (SPRAs) was greater than normal on 9 and 10 August 2007, in early October, from mid-November to early January 2008, as well as ahead of the 30 April quarter end for chartered banks. The level of settlement balances in the payments system was generally (but not always) targeted at higher-than-normal levels over these periods. Since 30 April, the frequency of SPRA operations has been much less, with most occurring around the banks' 31 July quarter end. To this end, the Bank modified three of its policy tools. First, in August of last year, the Bank temporarily expanded the range of securities that are eligible for overnight operations. Second, between December 2007 and January 2008, and again between March and June of this year, the Bank conducted a series of term purchase and resale agreements (PRAs) – typically of 28 days – against a broader-than-normal range of securities. 7 Third, late last year, the Bank announced that the range of acceptable collateral for its Standing Liquidity Facility would be expanded to include a subset of ABCP sponsored by deposit-taking institutions, and U.S. Treasuries. Specified types of ABCP became acceptable on 31 March 2008, and U.S. Treasuries became acceptable on 30 June 2008. Steps have also been taken to modernize the Bank of Canada Act. Amendments to the Act, designed to allow the Bank more flexibility in providing liquidity to the financial system in response to changing circumstances, were passed by Parliament, and have recently been proclaimed. The amendments will allow the Bank to use an even broader range of securities in its buyback operations, importantly, those of a term nature. Under the revised policy, the Bank may choose to engage in buyback operations to address a situation of financial system stress that could have material macroeconomic consequences. In this "exceptional" circumstance, the Bank may buy and sell securities beyond Government of Canada bonds and treasury bills, and for a period longer than one day. The list of securities that may be used in such transactions can be found in the Bank's policy, which was published in the Canada Gazette on 26 July 2008. 8 I should stress that the Bank is not obligated to accept the full range of these securities for any particular transaction. The extent to which the Bank would exercise this power, once the state of affairs was deemed to be "exceptional," would be governed by a set of principles for Bank of Canada market intervention. I will describe these principles when I come to the final recommendation of the CGFS report. We also recently announced that a term securities-lending facility and a term loan facility could be used in certain circumstances. 9 While the Bank currently has a securities-lending facility (whereby it makes available from its balance sheet Government of Canada securities that are temporarily in high demand in the market), the loans under this facility have a term of one business day and are intended to address stresses in the repo market for a single security. The term securities-lending operations would be used to provide longer-term liquidity more broadly to financial market participants by increasing the supply of high-quality securities that could be used for collateral at times when there is a shortage. Term loan facilities would be most useful when liquidity premiums in money markets are distorted and when at least two deposit-taking financial institutions face liquidity shortages. The fourth recommendation addresses the possibility that channels for distributing liquidity across borders can become impaired in times of turmoil, and the need for central banks to consider accepting assets denominated in foreign currency, or establishing foreign exchange swap lines among themselves. To address this issue, as noted earlier, the range of acceptable collateral for the Standing Liquidity Facility was expanded to include U.S. Treasuries, effective 30 June. Swap lines also help to avoid bottlenecks in the international distribution of liquidity, potentially enabling domestic institutions to obtain foreign currency While the Bank had used term PRAs in the past, it had done so to manage its own balance sheet during seasonal, temporary peaks in liabilities; over the past year, however, the primary purpose was to increase liquidity in money markets. The policy for buying and selling securities under subsection 18.1(1) of the Bank of Canada Act is available at: http://www.bankofcanada.ca/en/markets/pdf/policy_gazette-e.pdf. For context, see W. Engert, J. Selody, and C. Wilkins, "Financial Market Turmoil and Central Bank Intervention," Financial System Review (Ottawa: Bank of Canada, June 2008): 71-78, available at: http://www.bankofcanada.ca/en/fsr/2008/fsr_0608.pdf. liquidity. For many years, the Bank of Canada has had a swap line with the Federal Reserve in the United States to give it access to U.S. dollars. This facility was not needed in the recent period of turmoil, however, and may not be used often, if at all, because most Canadian banks have U.S. branches or subsidiaries, and thus have access to U.S.-dollar funding through the Fed's discount window. The fifth recommendation is to enhance communication with market participants and the media during times of financial stress. Over the past year, in addition to its normal communications on regular operations, the Bank actively communicated any unusual steps taken in its operations, as well as the reasons for those steps. Members of the Bank's Governing Council spoke publicly on several occasions about the situation as it evolved, and about our response. 10 Staff at the Bank regularly communicate with market participants about funding needs, and these communications proved important when liquidity was under pressure. In late spring, Governor Carney made clear which market conditions we would consider to end a form of intervention, such as term PRA, and this message was given in advance of the announcement that the Bank would not renew the term PRA maturing 26 June. Throughout this turbulent year, we have been clear about our liquidity operations, both when we expanded them and when we became the first major central bank to end special operations. The sixth recommendation is to reduce the stigma associated with the use of standing lending facilities by, for example, enhancing the understanding of all market participants regarding the role of such facilities and, where applicable, designing new facilities that should have less stigma than was associated with past instances of emergency assistance. Both before and during this period of turbulence, little stigma was associated with the use of the Bank of Canada's Standing Liquidity Facility, which offers one-day loans for temporary, and typically relatively small, liquidity needs. The term-loan facility that we are considering should have little stigma attached to its use, because it will be offered at the Bank's discretion at times of stress that involve more than one deposit-taking financial institution. 11 The final recommendation in the CGFS report is aimed at limiting moral hazard. The report suggests that central banks carefully weigh the expected benefits of actions to re-establish liquidity against their potential costs and, where necessary, introduce safeguards against the distortion of incentives. The events of the past year have prompted us to re-examine the issue of moral hazard in the provision of liquidity. An article in the June Financial System Review 12 outlines a set of principles to guide the central bank on when and how to supply liquidity to financial markets. These principles, which clarify the extremely limited cases in which the Bank of Canada might intervene in financial markets, are useful in limiting moral hazard. Here is a summary of the principles: See, for example, D. Dodge, "Turbulence in Credit Markets: Causes, Effects, and Lessons To Be Learned" (speech to the Vancouver Board of Trade, September 2007), available at: http://www.bankofcanada.ca/en/speeches/2007/sp07-17.html; D. Longworth, "Liquidity, Liquidity, Liquidity" (speech to the Investment Industry Association of Canada, 3 October 2007), available at: http://www.bankofcanada.ca/en/speeches/2007/sp07-18.html; M. Carney, "Addressing Financial Market Turbulence" (speech to the Toronto Board of Trade, 13 March 2008), available at: http://www.bankofcanada.ca/en/speeches/2008/sp08-3.html; D. Longworth, "Credit Markets, Financial Stability, and Monetary Policy" (speech to the Global Investment Conference, 10 April 2008), available at: http://www.bankofcanada.ca/en/speeches/2008/sp08-5.html; and M. Carney, "Principles for Liquid Markets" (speech to the New York Association for Business Economics, 22 May 2008), available at: http://www.bankofcanada.ca/en/speeches/2008/sp08-6.html. The Federal Reserve's Term Auction Facility, similar to the Bank of Canada's proposed term-loan facility, has significantly less stigma than its discount window lending. See W. Engert, J. Selody and C. Wilkins, "Financial Market Turmoil and Central Bank Intervention," op. cit. Also see M. Carney, "Principles for Liquid Markets," op. cit. - first, intervention should be targeted, aimed at mitigating only those market failures of system-wide importance with macroeconomic consequence that can be rectified by a central bank providing liquidity - second, intervention should be commensurate with the severity of the problem - third, intervention should use the right tools for the job: market-based transactions, provided through auction mechanisms, should be used to deal with market-wide liquidity problems, while loans should be used to address liquidity shortages affecting specific institutions - fourth, intervention should be at market-determined prices to minimize distortions - and fifth, the central bank should use measures that include limited, selective intervention; an element of coinsurance; penalty rates as appropriate; and the promotion of sound supervision of liquidity-risk management. So that's a summary of the steps we've taken since last August to address the concerns covered in the CGFS report (see summary table). Summary table Other central banks have also been working towards the same goals. The CGFS report suggests that central bank actions in response to the market turbulence have been effective in that they have "reduced, though not resolved," tensions in short-term money markets, thereby mitigating the damage to the economy. However, it has been much more difficult to address funding-market pressures in the broader sense, particularly in term, unsecured markets. The report notes that "the assessment of central banks about their ability to deal with such market pressures depends crucially on the pressures' origins: how much came from liquidity concerns, which are amenable to central bank actions, and how much from counterparty risk or other concerns, which are beyond the reach of central bank operations. Overall, the judgment was that tensions would have been more acute and more damaging without the forceful interventions of central banks." That does not mean that our work in dealing with the broad policy lessons from this period of financial turbulence is done. One important set of issues being studied is how fluctuations in the financial sector play out in the real economy, and how regulations and practices – including the regulation of financial institutions – can dampen or exacerbate these fluctuations. Under the umbrella of the Financial Stability Forum, various international committees have been looking at these important issues and are considering a variety of proposals. It is important to reduce procyclicality in the financial system – perhaps including the key aspects of leverage and liquidity – in order to reduce the magnitude of the effects of future financial disturbances. I'd like to turn now to the current state of the markets. The current state of the markets Although credit conditions in Canada remain challenging, they are better in many respects than those in other major markets. For example, short-term credit spreads, as measured by the spread between short-term lending rates and the expected overnight rate, have narrowed significantly in recent months (Chart 2: Spreads between 3-Month LIBOR and OIS). In large part, the lower short-term credit spreads in Canada reflect the healthier state of Canadian financial institutions. This relative strength is also shown in the smaller decline in stock market valuations for Canadian financial institutions relative to their foreign peers over the past 14 months (Chart 3: Performance of Financial Sector Equities). Nevertheless, there remains a risk that ongoing strains in global financial markets could have further implications for Canada. While the average effective borrowing spreads faced by banks, non-financial businesses, and households have increased by about 75 basis points vis-à-vis the overnight rate since the onset of turbulence in financial markets last summer, this increase has been more than offset by the cumulative 150-basis-point reduction in the target overnight rate. As a result, the effective borrowing costs faced by banks, businesses, and households are estimated to have fallen by about 75 basis points over the past year. Chart 4 (Bank Funding Costs) indicates one element of increased funding costs for banks. Reflecting the recent contraction in economic activity and generally challenging credit market conditions, growth in business credit has slowed in recent quarters (Chart 5: Yield Spreads on Canadian Corporate Bonds). In contrast, growth in household credit remains robust (Chart 6: Business and Household Credit). This likely reflects high levels of employment and past increases in wealth and real income. Nonetheless, the continued strength in household credit growth is somewhat surprising, given the moderation of activity in the housing market and the reported decline in consumer confidence. The growth of household credit is expected to moderate in coming months. Recent economic developments The ongoing turbulence in global financial markets has been one of three major developments affecting the Canadian economy – the others being the protracted weakness in the U.S. economy and the sharp changes in the prices of certain commodities, energy in particular. In the second quarter of 2008, U.S. economic growth was somewhat stronger than expected at the time of the July Monetary Policy Report Update, while growth in the Japanese and European economies was somewhat weaker than expected. Recent data also suggest that Canadian GDP growth in the second quarter was likely somewhat weaker than expected. Weakness in overall global growth has been a major reason for the downturn in commodity prices, particularly energy prices, since mid-July. In turn, this downturn has been a significant factor in the declining value of the Canadian dollar in U.S. dollar terms. These two developments will have opposing effects on the demand for Canadian goods and services. In July, total CPI inflation was 3.4 per cent, and core inflation was 1.5 per cent. The Bank of Canada continues to expect that both total CPI inflation and core inflation will converge on the 2 per cent inflation target in the second half of 2009. However, the recent decline in the spot and futures prices of energy means that the temporary spike in total CPI inflation between now and the first quarter of 2009 should be lower than projected in the July Update. The Bank will continue to carefully monitor the evolution of risks, together with economic and financial developments in the Canadian and global economies, and to set monetary policy consistent with achieving the inflation target over the medium term. Conclusion In conclusion, I want to stress that the problems of the past year posed challenges, and they offered lessons for individuals, businesses, and policy-makers. Two conclusions can be drawn from how these problems played out in Canada. First, the financial system is sound, and the Canadian financial, non-financial, and household sectors are strong enough to deal with the problems we have seen in financial markets. Second, we can all do better. Over the course of this turbulent year, financial firms and individuals have learned to do better – to better understand and manage the risks that come with investing and the use of credit. This is a welcome outcome. The past year has been a learning experience for all of us, including central banks and other policy-makers. The Bank of Canada's policy tools were tested. Generally speaking, they were up to the job. Where we saw opportunities to improve, develop, and refine our liquidity-policy framework, we took them. Financial stability and liquid markets are important to the health of the economy. With an expanded set of tools, the Bank of Canada will continue to support the stability and efficiency of the financial system and thus contribute to the well-being of Canadians.
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Remarks by Mr John Murray, Deputy Governor of the Bank of Canada, to the Certified General Accountants of Ontario, Toronto, 18 September 2008.
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John Murray: Measuring inflation – methodology and misconceptions Remarks by Mr John Murray, Deputy Governor of the Bank of Canada, to the Certified General Accountants of Ontario, Toronto, 18 September 2008. * * * These past few months have been busy for central bankers, to say the least, and the past few days are certainly no exception. While developments on Wall Street have garnered much attention, the cost of living has also been an issue for us all, whether we're buying gas at the pumps, booking an airline ticket, or just picking up a loaf of bread at the grocery store. Of course, the cost of living is always front and centre for us at the Bank of Canada, where our primary monetary policy objective is to ensure that inflation remains low, stable, and predictable over the medium term. Some periods, however, are clearly more challenging than others in terms of meeting this objective. To set effective policies in both tranquil and turbulent times, we must understand what drives inflation and be able to anticipate its future movements. So tonight I'd like to talk in some depth about inflation: exactly what it is, how we measure it, and how we gauge the underlying economic pressures that cause it to rise or fall. I'd particularly like to discuss the Bank of Canada's "core measure" of inflation, and explain why and how it is used by the Bank as an operational guide for monetary policy. I've chosen this topic because of its timely nature, as we now see rising price pressures in various forms. Along the way, I'd like to use this examination of core inflation to highlight for you just how important the Bank's research is to the conduct of Canada's monetary policy. Innovative research and analysis related to core inflation, like all our research efforts, underpin the Bank's policy formulation and implementation of monetary policy, and contribute significantly to our understanding of how the economy operates. At this point, I should emphasize that the Bank consistently aims for low and stable inflation – not for its own sake, but because it enhances the economy's performance. Aiming for an explicit 2 per cent inflation target not only helps stabilize prices, it also helps stabilize real output and employment, allowing the economy to grow at its maximum sustainable rate. Experience has shown that this is the best contribution that monetary policy can make to the economic welfare of Canadians. Developments in inflation around the globe Before I go into detail about particular Canadian measures and experiences with inflation, let me take a step back to look at the larger, international picture. As I mentioned a moment ago, Canadians have become increasingly aware of price pressures, but this is, in fact, a global phenomenon. Indeed, sharp increases in inflation have been reported in both advanced and emerging-market economies in recent months. It is true that world prices of oil, natural gas, many minerals, and food products have eased in the past few weeks. Nevertheless, earlier dramatic increases in the prices of these same commodities accounted for sharp increases in inflation. In many cases, these have been some of the highest rates of inflation observed in the past 10 to 15 years. It is important to note that inflation performance varies widely across countries. In some cases, excessively loose monetary policies, implemented in an attempt to push economic growth higher than the sustainable limits of a country's production capacity, have also been an important contributing factor. In many countries, the recent surge in inflation has been coupled with a dramatic slowing in real economic growth, rekindling memories of the 1970s and concerns over stagflation – the uncomfortable combination of high inflation and slow or negative growth. Most observers believe it would be too great a stretch to draw parallels between the current experience and that of the 1970s. Still, recent developments do pose a serious policy challenge for central bankers, especially when combined with the dislocation and difficulties evident in global financial markets. Conventional monetary policy reactions might not be appropriate in circumstances where we see a combination of rising inflation, slowing GDP growth, and concerns about financial instability. Rising inflation, for example, often leads to calls for tighter monetary policy. Yet, would that be wise if a slowing economy and other developments were expected to reverse these inflation pressures in the future? Slower economic activity often leads to calls for easier monetary policy. But would that reaction be wise if inflation pressures were believed to be rising rather than receding? Around the world, monetary authorities are determined not to repeat the policy errors of the 1970s, when overly stimulative measures led to double-digit inflation and rising inflation expectations. We all seek reliable indicators with which to gauge how serious and longlasting the current inflation pressures might be. This kind of information can materially affect the stance of monetary policy. This illustrates why monetary policy-makers must gather and weigh as much information as possible in their decision making – and why inflation research is so important. Defining and measuring total and core CPI inflation Before I describe some of our inflation research, let me give you some background on the measures of inflation that we use at the Bank of Canada: measures based on Statistics Canada's consumer price index (CPI). Inflation is, of course, defined as a persistent increase in the average price of goods and services; in other words, a trend increase in the cost of living. In the broadest terms, this is measured by the total, or headline, CPI, which tracks the retail prices of a representative "shopping basket" of goods and services over time. It is also the rate that the Bank of Canada officially targets for its monetary policy. Here I would remind you that the Bank and the federal government have a formal agreement that sets out a target of 2 per cent for the annual rate of increase in the CPI. As I said earlier, we pursue low and stable inflation because it enhances the performance of the economy. Yet, as much as we aim for low, stable, and predictable inflation, there will always be sharp movements in total or headline inflation. These are generally driven by volatile price changes in a small number of goods and services. In Canada, for example, fully 90 per cent of the observed monthly variations in the CPI are linked to price changes in just 8 of the 54 major goods and services categories included in the CPI. Further, these price changes are often volatile and are often quickly reversed. They therefore add considerable "noise" to total CPI, making it difficult to discern genuine movements in trend inflation. For this reason, many central banks calculate core inflation measures, which are designed to minimize the influence of the most volatile components of the CPI. Although opinions differ among central bankers concerning the usefulness of core inflation measures, many monetary authorities – including the Bank of Canada – find these measures helpful for two important reasons. First, by focusing on the more stable components of the CPI, policymakers are able to get a better fix on the underlying trend in inflation. This is important, because monetary policy operates with long and variable lags. It can take as long as two years before the full effect of a policy change is felt on inflation. Monetary policy must therefore be forward-looking, focusing on a one- to two-year horizon. Any attempt to control short-term movements in inflation is likely to prove to be counterproductive and will simply destabilize both inflation and real economic activity. Core inflation can, therefore, serve as a useful operational guide for policy by looking past these short-term price movements. The second reason core inflation measures can be useful is that they can help anchor the inflation expectations of businesses and households. Having an explicit 2 per cent target for inflation, coupled with a strong commitment to achieve it, goes some distance towards realizing this objective. But providing a reliable measure of core inflation that the public can readily use to track trend movements in the CPI can strengthen the anchoring of expectations by providing assurances that the Bank will not allow the rise in volatile components to spread to other prices. The Bank of Canada's core inflation measures Now, let me talk about our core measures in detail. Measures of core inflation are usually calculated in one of two ways. The "exclusion method" is the most straightforward and, as the name suggests, involves excluding the prices of those goods and services that typically display more than a predetermined amount of variability. The "reweighting method," in contrast, doesn't exclude the prices of any goods and services. Instead, it assigns a weight to each component that is inversely related to its volatility. In other words, more volatile price series are given a lower weight. The core inflation measure that the Bank of Canada currently uses is called CPIX and is based on the exclusion method. It removes eight of the most volatile components of the total CPI, as well as the effects of changes in indirect taxes such as the GST. The excluded items in CPIX are fruit, vegetables, gasoline, fuel oil, natural gas, mortgage-interest costs, intercity transportation, and tobacco products. It is important to note, however, that the Bank calculates and monitors several different measures of trend inflation, not just CPIX. It uses these, along with many other sources of information, as checks against its preferred core measure. While all of the measures of trend inflation tend to move in a similar fashion, the differences can be informative. It is also worth noting that the Bank has changed its definition of core inflation over time, to improve its reliability. When the Bank first began targeting inflation in 1991, the core inflation measure it adopted was similar to that used by many other central banks and excluded all food and energy prices. As a result, it was less inclusive than the current measure. After gaining more experience, and through a process of extensive research and analysis, the Bank refined its core inflation measure, as well as the set of additional measures that it currently follows. In 2001, the Bank moved to CPIX because of its demonstrated superiority on both empirical and theoretical grounds. Its advantage was confirmed by additional research when our inflation targets were renewed again in 2006, and it has recently been retested as part of a more comprehensive international study looking at a range of measures of total and core inflation. Clearly, this process of refinement and retesting never ends. This is because it is crucial that we be able to determine the most effective indicators of underlying inflation and how these might be further refined and improved upon over time. So the next question becomes: how can we distinguish between good and bad measures? An effective core measure must have four key properties. First, and most obviously, a core measure should be less volatile than total inflation. Second, it must be unbiased. By this we mean that the core inflation measure must track long-run movements in the total CPI very closely. Third, a good core measure must also be a reliable predictor of future trend movements in the total CPI. Fourth, a good core measure must be easy to understand and to explain to the public. When all four requirements are considered together, CPIX has been shown to be as good as, or better than, all of the alternative measures that the Bank might use. Other measures may outperform CPIX when they are judged on just one or two of these four criteria. CPIW, for example, which is calculated using the reweighting method, can give slightly better predictions of the total CPI and bears a somewhat tighter relationship to the long-run trends in the total CPI. These differences are very minor, however, and are offset by other considerations such as ease of understanding. For this reason, CPIX is still the Bank's preferred core measure. Nevertheless, given the demonstrated strengths of CPIW and one or two other trend measures, the Bank continues to monitor a set of indicators rather than relying on any single one. Popular misconceptions about core inflation Our choice of CPIX as an operational guide for monetary policy has, at times, been a source of controversy and has led to several popular misconceptions. Journalists and other interested observers frequently question the use of CPIX and other measures of trend inflation as operational guides. They argue that such measures give an overly sanguine picture of true inflation, especially during episodes of sharply rising food and energy prices. Critics say that CPIX inflation is frequently lower than total CPI inflation because, they claim, the Bank has stripped out the fastest-rising prices. These critics of CPIX argue that it doesn't relate to the real-life experiences of typical households. "After all," they point out, "what household doesn't buy food, drive a car, or have a mortgage?" I'll respond to these criticisms with three related points. First, and most importantly, the Bank's official target of 2 per cent inflation is based on total CPI inflation, not on CPIX. The latter is only one of several indicators used to judge where the total CPI is likely to go in the future. It is an important indicator that we use to judge what the inflation trends are, but it is not our target. Second, the Bank's decision to use core inflation as a policy guide is based exclusively on empirical considerations. CPIX is used only because it has been shown to track future movements in total CPI better than the past movements of the total CPI itself. If this were to change, and if CPIX no longer outperformed the total CPI in this regard, we would stop using it. Finally, as noted earlier, it is critical that the Bank continue to focus on the future trend of CPI inflation, as opposed to its current level, because monetary policy operates with such long and variable lags. If the Bank were to react to every observed change in total CPI, it would destabilize both inflation and real economic growth. It would be reacting to volatile changes in a small subset of prices that would likely reverse course in the near future. Is core always a better predictor than total CPI inflation? Experience in Canada has shown that core inflation does outperform total inflation as an operational guide for policy. When the two series deviate, total CPI inflation tends to converge on core inflation rather than the reverse. Core inflation is therefore a better guide as to where total inflation is going. This phenomenon might reflect the success that the Bank has enjoyed over the past 17 years in keeping total CPI inflation close to its 2 per cent target. When total inflation temporarily moves higher or lower than the target, households and businesses know that it will probably return to target within a relatively short time. Some countries haven't enjoyed the same positive experience. They've found that core inflation tends to deviate persistently from total CPI inflation and is not a very reliable measure of underlying inflation pressures. These differences have been documented recently by researchers at the Bank, but they are not well understood. 1 They appear to be systematic in nature, as opposed to chance occurrences, and Bank researchers suspect that they reflect differences in the way core inflation is defined, as well as structural differences in Serious research at the Bank of Canada on alternative measures of core inflation began with the work of Laflèche (1997), Crawford et al. (1998), Hogan et al. (2001), and Macklem (2001), who built on the efforts of Canadian academics such as Parkin (1984) and U.S. policy-makers such as Cogley (1998). It continued with contributions by Armour (2006) and has been extended more recently through the innovative analysis of Hoddenbagh et al. (2008) and Martel (2008). the various economies. Such a situation isn't so surprising in less-developed countries and in emerging markets; however, long-standing differences between core and total inflation have also been observed in advanced countries. Core inflation measures tend to perform very well in Australia, Canada, New Zealand, and the United States, for example, but they perform poorly in the euro zone, Japan, and the United Kingdom. More research will be needed to understand these differences. 2 The Bank's successful use of core CPIX has helped anchor Canadian inflation expectations which, in turn, has helped dampen movements in total inflation. If households and businesses are convinced that inflation will soon return to 2 per cent, they are less likely to form extrapolative expectations based on movements in current headline inflation. Consequently, they are less likely to push prices higher or lower. This self-reinforcing cycle makes the Bank of Canada's job much easier and is clearly beneficial for the economy as a whole. Canada's strong performance on the inflation front over the past 17 years is a testament to the usefulness of our inflation targets, our timely monetary policy actions, and the supportive role played by core inflation measures. Implications for Canadian inflation So what is CPIX telling us about current price pressures in Canada? On the face of it, it would seem to suggest that the underlying, or trend rate of inflation has recently been at about 1.5 per cent. Although this measure is likely to rise modestly towards the end of this year, it is still well below the headline or total CPI inflation rate, which has been running at about 3.4 per cent. Because that 1.5 per cent core rate is also below the Bank's 2 per cent target for inflation, can we assume that inflation in Canada is not much of a problem? I wouldn't want to go that far, but the relatively low level of CPIX does provide at least some reassurance that inflationary pressures are reasonably contained. Further, as we said in our 3 September interest rate announcement, we anticipate that certain temporary factors now affecting both the total and CPIX measures of inflation should dissipate over the coming quarters and that both measures will converge on 2 per cent in the second half of 2009. In the interim, total CPI inflation is likely to continue rising, as past energy-price increases push it higher. However, the recent decline in both spot and futures prices for energy commodities means that the spike in total CPI inflation expected between now and the first quarter of 2009 will be lower than projected in July. Seen from another perspective, does the current 1.5 per cent CPIX rate suggest that inflation is too low, implying underlying economic weakness? I wouldn't want to make that assumption either, because other trend measures suggest that underlying inflation is a touch higher than 2 per cent. Further, there is reason to believe that, over the most recent period, CPIX has shown a very slight downward bias in its estimate of trend inflation. This is due to the higher weight that it assigns to automobile purchases than some of the other trend measures do, plus its exclusion of mortgage interest costs. This has been particularly apparent recently, as auto prices have been falling over the past 12 months, while home-finance costs have been rising faster than many other items in the CPI basket. I don't think this means that the CPIX measure is no longer reliable; rather, this is likely a temporary situation. But it serves to demonstrate why it is important to look at a range of indexes and to understand why they may be moving differently. Finally, I want to say a few words about inflation and monetary policy in the context of the recent market turmoil in general, and the events of the past few days in particular. We know from experience that inflation control works much more predictably when there are well- One cause of the poor performance of core inflation measures in the United Kingdom and euro zone is that these jurisdictions use a harmonized index of consumer prices (HICP) that excludes shelter costs – an important piece of the cost of living. functioning financial markets operating within a sound and stable financial system. While markets in Canada have certainly been volatile in recent weeks, it is worth noting that strains in Canadian credit markets have been considerably less intense than those seen in the United States and elsewhere. The Bank is committed to supporting the efficient functioning of financial markets, and earlier today, announced that it will enter into a $2-billion, 28-day term purchase and resale agreement. The case for further operations will continue to be reviewed in light of conditions in financial markets. Canadian banks have healthy balance sheets and absolute leverage that is significantly lower than many of their international peers. They are less exposed than their U.S. counterparts to the subprime-mortgage market that is at the root of the market turmoil, and are less dependent on securitization for their financing and on capital markets for their revenues. Throughout this period of market turmoil, the Bank of Canada has remained in close contact with policy-makers both in Canada and abroad, including colleagues in other major central banks. We are closely monitoring global market developments, and will continue to provide liquidity as required to support the stability of the Canadian financial system and the functioning of financial markets. Conclusion There are four main messages that I would like you take away from this evening's presentation. First, core inflation continues to be a useful operational guide for monetary policy. Second, it is always combined with other information as a check on the current state and future direction of trend inflation. Third, CPIX has not replaced the total CPI as our official inflation target. It is simply a tool that helps us achieve our 2 per cent objective for total CPI inflation. Finally, our continued research on this and other critical policy issues makes a vital contribution to the Bank's ability to successfully carry out its responsibilities. As I said off the top of my remarks, our research at the Bank has been crucial to the effective conduct of Canada's monetary policy. Of course, our researchers continue to make a contribution today as they explore the feasibility of new and innovative ways to calculate core measures, as opposed to the standard exclusion and reweighting methodologies. Of course, our researchers are working on many issues, which I don't have time to discuss now, but I do encourage you to visit the Bank's website for more information. 3 References Armour, J. 2006. "An Evaluation of Core Inflation Measures", Bank of Canada Working Paper No. 2006-10 Armour J. and T. Laflèche. 2006. "Evaluating Measures of Core Inflation", Bank of Canada Review (Summer): 19-29. Bank of Canada. 2006. Renewal of the Inflation-Control Target: Background Information – November 2006. Binette, A. and S. Martel. 2005. "Inflation and Relative Price Dispersion in Canada: An Empirical Assessment", Bank of Canada Working Paper No. 2005-28. Cogley, T. 1998. "A Simple Adaptive Measure of Core Inflation", Federal Reserve Bank of San Francisco Working Paper No. 98-06. www.bankofcanada.ca/en/fellowship/highlights_res08.html. Crawford, A., J.-F. Fillion, and T. Laflèche. 1998. "Is CPI a Suitable Measure for Defining Price Stability". In Price Stability, Inflation Targets, and Monetary Policy, 39-73. Proceedings of a conference held by the Bank of Canada, May 1997. Ottawa: Bank of Canada. Hoddenbagh, J., M. Johnson, and E. Santor. 2008. "Core and Total Inflation: Recent International Evidence." Preliminary draft. Hogan, S., M. Johnson, and T. Laflèche. 2001. Core Inflation, Bank of Canada Technical Report No. 89 (January). Laflèche, T. 1997. "Statistical Measures of the Trend Rate of Inflation", Bank of Canada Review (Autumn): 29-47. Lascelles, E. and Pascal G. 2008. "The Core Argument Against Total CPI," T-D Economics. Macklem, T. 2001. "A New Measure of Core Inflation," Bank of Canada Review (Autumn): 3-12. Martel, S. 2008. "A Structural VAR Approach to Core Inflation in Canada", Bank of Canada Discussion Paper No. 2008-10. Parkin. M. 1984. "On Core Inflation by Otto Eckstein," Journal of Monetary Economics 14: 251-64.
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Remarks by Mr Mark Carney, Governor of the Bank of Canada, to the Canadian Club of Montreal, Montreal, Quebec, 25 September 2008.
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Mark Carney: Reflections on recent international economic developments Remarks by Mr Mark Carney, Governor of the Bank of Canada, to the Canadian Club of Montreal, Montréal, Quebec, 25 September 2008. * * * As always, it is a great pleasure to be here in Montréal, and I would like to thank the Canadian Club for inviting me to address its members this afternoon. I would like to take this opportunity to speak in some depth about international economic developments. The events of the past few weeks in global financial markets have been dramatic. Money and credit markets seized up. There was a massive flight to the safety of the highest quality of government debt. Equity markets convulsed and some of the most storied names in finance succumbed. Fortunately, even this ferocious storm has a silver lining: its cathartic nature and the decisive policy response it is prompting could mark the beginning of the end of a 14month crisis that has gripped the global financial system. A restructuring that for some countries took a decade is now likely to take only a few years in total in the United States. This will greatly reduce the cost in terms of lost output and employment in that country, as well as the negative spillovers to the rest of the world. Nonetheless, the months ahead will bring more financial losses, significant consolidation in the financial industry and further increases in the cost of capital. The eventual reordering of the financial system will be historic. 1 To some extent, we are experiencing the inevitable correction of a period of unbalanced growth. These are the famous global imbalances, which are characterized by excess savings and underconsumption in major emerging markets, and by negative savings, rapid credit expansion and asset-price booms in many western economies. This correction has not been pretty. The world is now grappling with three major shocks, which have had important effects on the Canadian economy. The U.S. economy is undergoing its first consumer-led slowdown in almost two decades. Global financial turbulence is increasing the cost of capital and decreasing its availability. Finally, commodities have been in a supercycle, with the prices of agricultural commodities nearly doubling, base and precious metals nearly tripling and energy products more than quadrupling since 2002. In the face of these developments, global inflationary pressures have risen even as the global economy has begun to slow. I would like to address each of the three in more detail. Commodity-price volatility The increase in a broad range of commodity prices over the past few years suggests a combination of very favourable and mutually reinforcing factors. These include robust global economic growth and the slow increase in supply of many commodities. Importantly, emerging-market demand has been strong, reflecting sustained growth in per capita income, rapid industrialization and a more intensive use of commodities in production. The outlook for commodity prices matters to Canada for a number of reasons. Primarily, higher commodity prices increase national income by improving our terms of trade. The roughly 25 per cent rise in our terms of trade since 2002 is responsible for about two-thirds of the 14 per cent gain in real per capita disposable income over the same period. Higher J. Lipsky, "The Global Economy and Financial Turmoil: Finding Our Footing" (speech to the Center for Strategic and International Studies, Washington, D.C., 18 September 2008). commodity prices have other benefits, such as increased investment, portfolio gains for Canadians and our pension funds and a contribution to the appreciation of our currency, which in turn lowers the cost of imported goods and services. These benefits are felt across Canada – not just in resource-heavy sectors and regions. Some of these effects are now being unwound owing to the recent sharp fall in some commodity prices, particularly those for energy. In our July Monetary Policy Report Update, we highlighted this possibility as a downside risk for the outlook for inflation in Canada. Slower economic growth in emerging markets, as well as in Europe and Japan, appears to be the primary factor behind declines such as the roughly one-third fall in the price of oil from its peak in the summer. Even with this decline, oil prices are back around levels of only six months ago and are still one-quarter higher than a year ago. With both supply of and demand for commodities highly inelastic in the short term, inventories remaining tight and emerging-market growth prospects more uncertain, we can expect continued volatility in commodity prices. Let me turn now to the renewed weakness in the U.S. economy. Weakness in the U.S. economy As the effects of the U.S. government's spring fiscal stimulus package wear off, a fall in U.S. domestic demand seems likely. Household credit growth has slowed sharply and will likely slow further. Indeed, credit conditions faced by U.S. households have tightened despite the cumulative 3.25-percentage-point reduction in policy interest rates. The most recent survey of U.S. senior loan officers showed an expectation of still tighter credit conditions for business and consumers in the months ahead as banks reduce their tolerance for risk and react to the unfavourable economic outlook. Recent financial market events will reinforce these tendencies. The U.S. housing sector is central to that country's economic and financial outlooks. Housing has been contracting since the end of 2005, with steep declines in the construction of new homes, the sales of existing homes and the prices of both. There are reasons to expect that housing will continue to act as a drag on the U.S. economy for a few quarters yet. Inventories of unsold new and existing homes remain well above historical averages, both in terms of actual units and months of supply remaining, with existing-home inventories near all-time highs. At the same time, the availability of mortgages has become increasingly restricted, and mortgage costs have fallen only marginally despite the sharp reductions in policy interest rates. Most importantly, even if residential construction stops shrinking later next year, as we now expect, the usual sharp rebound in housing activity is unlikely. The overhang of inventories and tight financial conditions will restrain the housing recovery for some time. Any slowdown in the U.S. economy would have consequences for Canada, but the current situation poses particular problems. The prolonged housing slump has affected Canadian exports of lumber and building materials. In addition, the fall in U.S. motor vehicle sales – by 35 per cent at annual rates in the second quarter for vehicles assembled in North America – has adversely affected our auto sector. Even the spring fiscal stimulus package does not appear to have boosted consumption in the areas that matter most for Canada. 2 We will continue to monitor closely both the composition as well as the rate of U.S. growth for its overall impact on Canada. The Bank is currently revisiting its projection for the U.S. economy as part of our preparations for our October Monetary Policy Report. In our interest rate announcement earlier this month, we identified the possibility of a negative feedback loop between a weaker U.S. economy Data for the second quarter show declines in areas that have a large impact on Canadian exports, including industrial production, investment in machinery and equipment and automobile sales. and tighter credit markets as the main risk to a modest U.S. recovery next year. Subsequent events have further weakened the U.S. financial sector, making this risk more probable. Global financial turmoil After 14 months of turmoil, global financial markets are at a critical juncture. Risk aversion across the system has risen to unprecedented levels, and an aggressive deleveraging process is under way. Many foreign financial institutions need to raise significantly more capital at a time when their ongoing earning power appears to have been permanently reduced. These dynamics could intensify the current global slowdown and will have an impact on the cost of capital in Canada, despite the relative strength of our financial institutions. In order to illustrate the potential magnitude of these concerns, I would like to emphasize three points. First, the deleveraging process in the global system is far from finished. There are only three ways for a financial institution to reduce leverage: raise capital, sell assets (at a price at or above their carrying values) or restrain the rate of credit growth. Over the past year, financial institutions in many countries have raised over US$350 billion of new equity, which covered only 70 per cent of announced losses. As a result, leverage has actually increased. With virtually all of these shares now trading below issue price, the ability of firms to raise capital appears very constrained. Similarly, private asset sales have been limited by the complexity of the underlying assets, the ongoing impairment of securitization markets, difficulties in supplying financing to leveraged buyers and the desire of investors to "time the market." In sum, banks have an increasing need for capital, but it has become more difficult to raise it. In this environment, the U.S. government's initiative to buy distressed assets is critically important. The plan announced by Treasury Secretary Paulson and being developed through discussions in the U.S. Congress is bold and timely. The size and breadth of support provided by this measure will help firms "rightsize" their balance sheets, re-liquefy closed markets and establish market prices for these distressed assets. This should eventually encourage private buyers to re-enter the market and complete the deleveraging process. A well-executed program will undoubtedly speed the resolution of this crisis and limit its economic cost. Asset sales alone will be insufficient, and additional capital will still be needed. Over time, acquisitions of the weak by the strong will play an important role. At the moment, valuation uncertainties, some accounting standards and investor caution are all restraining mergers and acquisitions in the sector. 3 In the end, reflecting the likely scale of the shortfall, it is possible that, in countries other than Canada, public capital may be necessary to complete the deleveraging process in an orderly and timely manner. The second point regarding the current financial situation is that while the Canadian financial system does not need to reduce leverage, we are not immune from the fallout from this process elsewhere. Canadian institutions are in considerably better shape than their international peers. Their losses on structured products have been relatively modest. 4 More importantly, their absolute leverage is markedly lower. As a simple illustration, major Canadian banks have an average asset-to-capital multiple of 18. The comparable figure for U.S. investment banks is over 25, for European banks is in the 30s, and for some major For example, changes to purchase-accounting rules for goodwill would be welcome in the current unique environment. Losses for Canadian financial institutions are roughly 10 per cent of total capital, compared with 28 per cent so far in the United States. global banks is over 40. 5 While foreign banks are in the process of moving towards Canadian levels, our banks obviously face no such pressures. Indeed, Canadian banks could modestly increase leverage by growing their lending relative to their current capital base. This flexibility gives our economy a rare advantage. Reflecting better domestic credit conditions, there are few signs that Canadian financial institutions are restricting the availability of credit to households. In fact, such growth has remained surprisingly robust to date. While growth in Canadian business credit has slowed in recent quarters to rates around historical norms, there is no evidence at this point that our corporations are facing unusual credit restrictions. That said, especially in light of the intensified global financial strains, we will continue to watch closely the evolution of credit availability in Canada, through analysis of monetary and credit aggregates, industry visits, and surveys. While the globalization of financial markets and services has led to a more efficient allocation of capital on a global scale, it has also made it easier for financial difficulties to spread across national borders. 6 The absolute borrowing costs for U.S. and other financial institutions has risen significantly, and this has put upward pressure on borrowing costs for Canadian financial institutions. All else being equal, this would have increased the financing costs for our businesses and households. However, all else is not equal. The stronger financial position of Canadian banks means that they now borrow at rates considerably lower than those of many of their international peers. In addition, the Bank of Canada has eased its overnight rate substantially since the onset of the crisis. As a result, the effective borrowing costs faced by banks, businesses and households are estimated to have fallen over the past year. This decline contrasts with the experience of most other developed countries. 7 In its upcoming Monetary Policy Report and in light of recent events, the Bank will revisit its current assumption that borrowing spreads will begin to narrow in 2009. My third point regarding the current financial situation is that market liquidity becomes strained during times of acute financial distress. The Bank of Canada has taken several actions over the past months to maximize the effectiveness of the monetary policy transmission mechanism. When necessary (such as on Monday of last week), we have reinforced our target rate through overnight operations. Over the past week, in response to exceptional circumstances, the Bank has also provided term liquidity and expanded our list of eligible collateral. The Bank will continue to provide additional term liquidity as long as conditions in financial markets warrant. We will then withdraw term liquidity as conditions normalize, as we did in the spring of this year. 8 In addition, as part of an unprecedented US$180 billion coordinated action by the world's major central banks, the Bank of Canada entered into a US$10 billion reciprocal currencyswap arrangement with the U.S. Federal Reserve. This is a prudential move during a volatile One of the advantages of the Canadian regulatory system is that the banks' asset-to-capital multiple is generally limited to 20. In the case of Canada and the United States, an IMF study found that "while trade linkages are sizeable, financial conditions – broadly defined as changes in U.S. bond yields, equity prices, and short-term interest rates – are the largest source of U.S. spillovers to Canada." See International Monetary Fund, "Canada: Selected Issues" (Country Report No. 08/70, 2008). Since August 2007, absolute all-in borrowing rates are about 60 basis points higher for AA- and AAA-rated U.S. banks and about 250 basis points higher for BBB- and A-rated U.S. banks, while all-in borrowing costs for non-financial U.S. corporations are about 50 basis points higher. By comparison, effective all-in funding costs for major Canadian banks have declined by about 50 basis points, and all-in borrowing costs for nonfinancial firms are about 60 basis points lower. A list of the types of indicators that the Bank will look at in deciding when to stop the provision of extraordinary liquidity can be found in M. Carney, "Principles for Liquid Markets" (speech to the New York Association for Business Economics, New York, New York, 22 May 2008). period. The facility would be activated in the event of an acute shortage of U.S. dollars in Canada. The agreement provides the Bank with additional flexibility to address rapidly evolving developments in financial markets. Last week's coordinated action was a public demonstration of the extraordinary degree of communication and co-operation among the G-10 central banks that has taken place throughout this crisis. This is a testament to a shared recognition of the interdependence of the global financial system. I am convinced that this dialogue, and concerted action when appropriate, has led to better policy outcomes and helped contain the negative international spillovers from this series of financial shocks. I also believe that rapid implementation of the measures proposed by the Financial Stability Forum 9 to enhance the resilience of the global financial system will help create a more stable international financial order. The message, as expressed in this week's communiqué of G-7 finance ministers and central bank governors, is clear: the G-7 is ready to take whatever actions may be necessary, individually and collectively, to ensure the stability of the international financial system. Conclusion The global economy is undergoing a difficult period. Moreover, in recent days, several articles of faith in the financial system have been shaken. These include: that good collateral can always be used to raise liquidity; that certain institutions are too big or too interconnected to fail; or that this was merely a liquidity crisis. However, there is one constant on which Canadians can rely. The Bank of Canada will not deviate from its relentless focus on its monetary policy mandate to achieve low, stable and predictable inflation. Events beyond our borders have important influences on the outlook for inflation in our country. They must be considered in tandem with domestic factors, including the strength of domestic demand, the evolution of potential growth, and the health of our financial system. As we prepare to publish our Monetary Policy Report in October, we will continue to monitor carefully economic and financial developments in the Canadian and global economies, together with the evolution of risks. Most importantly, we will continue to set monetary policy consistent with achieving the 2 per cent inflation target over the medium term. This remains the best contribution that monetary policy can make to sustained growth. Available at http://www.fsforum.org/publications/r_0804.pdf.
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Opening statement by Mr Mark Carney, Governor of the Bank of Canada, at a press conference following the release of the Monetary Policy Report, Ottawa, 23 October 2008.
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Mark Carney: Summary of the latest Monetary Policy Report Opening statement by Mr Mark Carney, Governor of the Bank of Canada, at a press conference following the release of the Monetary Policy Report, Ottawa, 23 October 2008. * * * Good morning and thank you for joining us. Before I discuss today's Monetary Policy Report, which reflects the Bank of Canada's latest thinking on the economy, I would like to say a few words about the global financial crisis. We realize that this has created a great deal of uncertainty and stress. We understand the severity of the situation, and we are taking action to address it. These problems originated outside of our borders, and the primary solutions to correct them must take place there as well. That is why we are working so closely with our international colleagues and why the G7 Plan of Action is so important. Many international banks need substantial additional capital, and efforts to provide this capital are now under way in earnest. In Canada, our financial system is sound, and our financial institutions are already well capitalized. We are nonetheless affected by global developments. That is why the Bank of Canada has taken extraordinary measures to provide liquidity. This will aid the ongoing functioning of our financial system during this time of stress, and we will continue to provide additional liquidity for our financial institutions as long as conditions warrant. It is important to remember that Canadian monetary policy remains firmly focused on the Bank of Canada's mandate to maintain low, stable, and predictable inflation. We know through long experience that this is the best way to promote the economic and financial wellbeing of Canadians. Let me turn to today's Monetary Policy Report. In it, we note that three major interrelated global developments are having a profound impact on the Canadian economy and making the outlook for growth and inflation more uncertain than it was at the time of the July Monetary Policy Report Update. First, the intensification of the global financial crisis has led to severe strains in financial markets. The associated need for the global banking sector to continue to reduce leverage will restrain growth for some time. Second, the global economy appears to be heading into a mild recession, led by a U.S. economy already in recession. Third, there have been sharp declines in many commodity prices. The Bank expects growth to be sluggish through the first quarter of next year, then to pick up over the rest of 2009 and to accelerate to above-potential growth in 2010 supported by improving credit conditions, the lagged effects of monetary policy actions, and stronger global growth. The recent sizable depreciation of the Canadian dollar will also provide an important offset to the effects of weaker global demand and lower commodity prices. With excess supply projected to build throughout 2009, and with lower assumed energy prices, inflationary pressures will ease significantly relative to the projection in the July Update. Core inflation is now projected to remain below 2 per cent until the end of 2010. Total CPI inflation should peak during the third quarter of 2008, fall below 1 per cent in mid2009, and then return to the 2 per cent target by the end of 2010. In light of diminished inflationary pressures, the Bank of Canada has acted decisively and lowered its policy interest rate by a total of 75 basis points over the past two weeks. These actions provide timely and significant support to the Canadian economy. The Bank's policy rate has been cut in half since the beginning of December 2007. In line with the Bank's new outlook, some further monetary stimulus will likely be required to achieve the 2 per cent inflation target over the medium term. The evolution of the financial crisis, its impact on the global economy, and the timing of the effects of the various extraordinary measures being taken to address it pose significant risks to the inflation projection on both the upside and the downside.
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Remarks by Mr Pierre Duguay, Deputy Governor of the Bank of Canada, to students and faculty of Laval University, Quebec City, Quebec, 10 November 2008.
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Pierre Duguay: The quest for confidence: 400 years of money – from La Nouvelle France to Canada today Remarks by Mr Pierre Duguay, Deputy Governor of the Bank of Canada, to students and faculty of Laval University, Quebec City, Quebec, 10 November 2008. The original speech, which contains various links to the documents mentioned, can be found on the Bank of Canada’s website. * * * Good afternoon. It's a real pleasure to be here. As we celebrate the 400th anniversary of the founding of Quebec, I thought it would be fitting for me, as a central banker, to take a look at how money has evolved over part of the past four centuries. As I relinquish my responsibilities for the issue of Canada's bank notes to concentrate more fully on financial system stability, I welcome this opportunity to underline recent progress in the fight against counterfeiting. But I'm getting ahead of myself. I'd like to thank Laval University and professor Kevin Moran for making this event possible. The history of money is fascinating. It reflects economic, political, and social history. The history of money in Canada is particularly colourful. Here, as elsewhere, it is largely the story of two opposing forces. On the one hand, there has always been a need for a secure and practical medium of exchange and store of value – that is, for sound money. Sound money is money in which we can justifiably place our confidence. On the other hand, there have also always been two main enemies of sound money – inflation and counterfeiting. It's an exciting story, this contest between sound money and the forces that can undermine it. Over the next 45 minutes, I'd like to tell you a bit of this story. I'll start by focusing on the early days in la Nouvelle France, and then I'll mention two important developments in the 19th century. I will then provide a context for understanding modern money by briefly describing the role of the central bank. I'll conclude by covering a few recent developments in money, particularly electronic alternatives. I'm going to illustrate my remarks with slides of material from the National Currency Collection, which is maintained by the Bank of Canada. But before I get started, I should say what I mean by "money." Money is one of those things. Everyone knows what it is – until they study it – and then it gets more complicated! The American writer Gertrude Stein said that it was the ability to understand and count money that differentiated humans from other animals. 1 A conventional definition of money is that it is a "medium of exchange" – we use it as the basic tool to settle commercial transactions. Money solves the many problems that arise with barter, such as the requirement for a "coincidence of wants." Money is also a "store of value." It can be saved for future use, and, unlike a private IOU, it is readily accepted because it is free from the risk of default. Indeed, modern economists would now argue that the main reason for the use of money as a means of settlement is the risk of default. 2 Finally, money acts as a unit of account – it provides a uniform way to express prices, incomes, debts, and assets numerically, which is useful for guiding production, consumption, savings, and investment decisions. One peculiar thing about money is that in most of its modern forms, it doesn't have much intrinsic value – you can't eat it and you can't keep yourself warm with it. In fact, the bulk of G. Stein, "Money," Saturday Evening Post, 22 August 1936. See, for example, J. Chiu and A. Lai, "Modelling Payments Systems: A Review of the Literature," Financial System Review (Ottawa: Bank of Canada, June 2007): 63-66. money nowadays does not even have a physical form. It consists of deposits in financial institutions, which exist merely as data in computers. 3 But money is nonetheless useful and valuable to the extent that it is a reliable store of value (because its value isn't being eroded by inflation), and to the extent that it can be trusted and readily accepted (because the note or coin can be ascertained as genuine). All to say, money is useful to the extent that people place confidence in it. Now, let's go back in time . . . to the 17th century. 4 The early days of money in Canada Long before the Europeans arrived in North America, natives were engaged in commerce, often using various "trade goods." Perhaps the most important trade good in this part of the world was wampum. Wampum is a string of shells, usually from clams and whelks [image: wampum beads]. 5 Its value came from its scarcity – it took a good deal of effort to produce. In addition to its use in commerce, wampum had symbolic properties and was used in ceremonies. In the absence of sufficient coinage, wampum was used as money after European colonization. Indeed, for part of the 17th century, wampum was legal tender in the Dutch and British-American colonies. But over time, the value of wampum "was reduced and finally destroyed by cheap imitations imported from Europe" 6 – an interesting early example of the destructive power of counterfeiting. In July 1608, Samuel de Champlain founded Québec with the goal of permanent settlement. We don't know much about money during the first 50 years of the colony of Québec, but we can surmise that the first settlers probably used credit for some of their trade. Credit makes sense in a small community where everyone knows everyone. Beaver pelts were universally accepted as a medium of exchange, and so it's fitting that the beaver can still be found on our 5-cent piece [image: "beaver pelt and 5-cent piece"]. Wheat and moose hides also served the same function. 7 But for the most part, "internal trade was probably carried on by barter and accounts kept with [trading companies]." 8 The first modern money in the colony was coinage, initially the coins settlers brought with them – French coins, mostly (deniers, doubles, liards, and douzaines), as well as HispanoAmerican piastres and their divisions. When there were enough of them, these coins were used for small, daily transactions. But two problems undermined their usefulness. First, because there was a trade deficit, many of the larger-value coins that were brought to the colony quickly disappeared. They were shipped to France in payment for supplies and manufactured goods, and hoarded by colonists as a hedge against uncertain times. To address the coin-shortage problem, the French authorities in Paris tried, unsuccessfully as it turned out, in 1670 and again in 1721-1722, to issue coins exclusively for use in New World colonies [image: 15 sols, 1670]. These experiments failed mostly because the coins could not be used beyond the borders of the colony. To keep existing coinage in the colony, the authorities in France also gave a higher value to "monnoye du pays" coins than "monnoye de Bank of Canada. Beads to Bytes: Canada's National Currency Collection (Bank of Canada, Ottawa: forthcoming). For perspective, a time line showing the history of money from prehistoric times to the present, with a focus on Canada, can be seen at: http://www.bankofcanada.ca/currencymuseum/eng/learning/history_flash.php. Before European colonization, various items were used as money by native peoples in the northern part of this continent. Along the west coast, for example, tusk-shaped dentalium shells were strung and used as money. The Story of Canada's Currency. Bank of Canada: 1990, p. 4. J. Powell, A History of the Canadian Dollar (Ottawa: Bank of Canada, 2005), p. 3. A. B. McCullough, Money and Exchange in Canada to 1900 (Toronto: Dundurn Press, 1984), p. 29. France" coins. The premium was initially set at one-eighth in 1664, but was later increased to one third. 9 The second problem was that coins were often "clipped" and therefore underweight – which undermined confidence as to their worth. Necessity being the mother of invention, promissory notes became popular. A promissory note is an IOU. The note pledges that it can, at some specified date, be redeemed for goods or services or for conventional money [image: promissory note]. Promissory notes have a special place in the history of money. They are an early example of a great and enduring invention – paper money – "the gift," according to John Kenneth Galbraith, "of Americans and Canadians to the Western world." 10 In the late 17th century, the American colonies faced similar problems and came up with the same response: they issued promissory notes. While both the United States and Canada were pioneers in developing paper money, the style of each country's first paper money was quite different. In The Age of Uncertainty, Galbraith contrasted the "dull puritanical model of Massachusetts" paper money with the "sparkling example" of New France 11 [image: playing card money and Massachusetts Bay note]. The "sparkling example" he was referring to was playing card money, an ingenious solution to a difficult problem, and believed to be the first paper money ever issued by a Western government. 12 In 1685, Intendant Jacques de Meulles issued three denominations of playing card money (15 sols, 40 sols, and 4 livres). Citizens were advised that the notes would be redeemed as soon as funds arrived from France. Partly because refusal to accept them as payment was punished with a fine, but mostly because they met a need, the cards circulated freely and were a great success. So much so that even though they were redeemed with French money later that year, more playing card money was issued the following year, and at various times thereafter. Unlike coins, playing card money did not leave the colony, and in that respect, represented a clear improvement. The authorities in France, however, saw the idea as "extremely dangerous, nothing being easier to counterfeit than this sort of money." 13 In fact, it wasn't long before a conviction for counterfeiting card money occurred. In 1690, Pierre Malidor, a "surgeon," was sentenced to be "flogged on the naked shoulders by the King's executioner at the gate of the Parish Church of Notre Dame in this town [i.e., Quebec City], and in the customary squares and places, in each of which he shall receive six lashes of the whip . . . ." Poor Mr. Malidor was also fined, bonded into "compulsory service," and banished from the city. 14 This shows that counterfeiting was perceived as a serious threat to the well-being of the colony – which it was. But in fact, it was that other enemy of sound money, inflation, that posed the greater threat to card money. By the early 1690s, soon after it had been introduced, excessive issuance of card money led to rising prices (or, from another point of view, to diminishing the value of money). The problem became so acute that, in 1717, card money was redeemed at 50 per The coin shortage "was not confined to Canada – there was a shortage of coin in the British colonies, in Britain, and in France itself. The shortage in France was as acute as in Canada and economic conditions were worse." McCullough, ibid, p. 34. J. K. Galbraith, The Age of Uncertainty (Boston: Houghton Mifflin, 1977), p. 180. J. K. Galbraith, ibid, p. 181. The first paper money was issued in China, circa 650 AD. A. Shortt, Documents Relating to Canadian Currency, Exchange and Finance during the French Period, Volume I, quoted in J. Powell, op. cit., p. 5. Interestingly, playing card money was issued and used in France some hundred years later during the Revolution. A. Shortt, op. cit., p. 87. cent of its face value and withdrawn "permanently" – despite the reality that no one had come up with a better medium of exchange. Adding to the hardships of settlers, the colony itself lacked stable funding. In the 1720s, "France's finances were still not strong and she could not always forward the necessary money: in 1727 the colony received only 5,000 livres . . . to apply to a budget of 308,156 livres, and in 1728 and 1729 no specie at all was received." 15 The (usually overspent) budget had to be funded, so another form of promissory note, les ordonnances de paiement, was issued by the Treasury in Québec in values ranging from 20 sols to 96 livres [image: ordonnance de paiement]. But to meet the needs of daily commerce, a more practical form of money was required. So in 1729, despite the "permanent" ban, and this time with the permission of the king, the colonial government reintroduced card money. This was not playing card money, but money on card stock of a similar size. Initially again, "Confidence in this new card money was . . . high . . . . With issuance tightly controlled, card money traded at a premium for a while as the government increased its issuance of Treasury notes to pay for its operations." 16 In the late 1750s, the mounting costs of the war with the British, declining tax revenues, and rampant corruption, led to rapid inflation. In April 1759, the Marquis de Montcalm noted that necessities cost eight times more than when his troops had arrived four years earlier – that's an annual inflation rate of almost 70 per cent! "People fear," he wrote, "I think without foundation, that the government will . . . authorize a depreciation. This opinion induces them to sell and speculate at an extravagant scale" 17 And indeed, immediately after Montcalm's defeat, paper money became all but worthless. 18 Following the Treaty of Paris, and on into the 19th century, many different forms of money circulated at the same time in Lower and Upper Canada, and in Nova Scotia and elsewhere. A single transaction might involve a Treasury note, paper notes from different merchants, gold, silver, or copper coins, and private tokens. Adding to the confusion, each colony independently decided the value of the various currencies in circulation. Following the political union of Lower and Upper Canada in 1841, two significant developments helped to simplify things: decimalization and the introduction of government notes. Decimalization – the introduction of dollars and cents as a unit of account – occurred in the years just before and after Confederation, largely because the people of Canada wanted it, despite the wishes of British authorities for Canada to stick to pounds, shillings, and pence [image: example of dual currency note]. At that time, twenty shillings (or a pound) was worth four dollars. And, interestingly, I might add, "trente sous," which today commonly refers to 25 cents, was indeed worth one quarter of a dollar (or 15 pence). It was the failure of two small Toronto banks in the late 1850s that led to a demand for "improved government supervision" – does that sound familiar? – and thus paved the way for government-issued notes. 19 While the first commercial bank notes in Canada were issued as early as 1817 by the Montreal Bank (later called the Bank of Montreal), the first government notes were issued in 1866 [image: Province of Canada note]. These provincial notes addressed two forms of uncertainty: uncertainty about the solvency of the issuer, and uncertainty about the ease of redemption. Many notes issued by private banks could be A. B. McCullough, op. cit., pp. 44-45. J. Powell, op. cit., p. 7. A. Shortt, Documents Relating to Canadian Currency, Exchange and Finance during the French Period, Volume II, quoted in J. Powell, op. cit., p. 9. J. Powell, op. cit., p. 9. A. B. McCullough, op. cit., p. 112. redeemed only within a limited area, and were subject to a discount that depended on the distance between where it was redeemed and the bank's head office. Before we move to the 20th century, I'll mention one of the most interesting and colourful counterfeiting episodes in Canadian history. In this case, counterfeiting was a family business: Ed Johnson, the "king of counterfeiting," engraved the printing plates by hand, his five sons printed the notes, his two daughters forged the signatures on them, and his wife sold the counterfeits to a wholesale dealer. The Johnsons were caught and served many years in prison, but not before they had put a million dollars worth of counterfeit Canadian and American currency into circulation – a significant sum in the 1880s. Banks accepted the forged notes, not recognizing them as counterfeits, and even the men whose signatures appeared on the notes couldn't distinguish the forged signatures from their own. The Johnsons were tracked down and brought to justice by Ontario's first full-time detective, the famous John Wilson Murray. Detective Murray travelled extensively in the United States, trying to track down the Johnson clan, before finally catching up with them in Toronto. The counterfeit notes were extremely well executed, but they "could be distinguished from authentic notes because they were "too perfect" and lacked the engraving flaws present in authentic notes." 20 "Crime lost a genius," Murray said, "when old man Johnson died" 21 [image: genuine note and Johnson counterfeit]. For the sake of brevity, I'm going to skip over some interesting history – Prince Edward Island's "holey dollar," the paper 25-cent "shinplaster," the issuance of $6 and $7 bank notes, the rise and fall of "phantom banks," among other developments. But I hope you're beginning to see that money works only to the extent to which people have confidence in it, and why the raison d'être of an effective monetary authority is always a "quest for confidence." Before turning to the modern era, let me underline two lessons from this early period of history: • there's a basic need for money, and sound money makes business and commerce much easier; and • two main threats – counterfeiting and inflation – can undermine the soundness of money. Money and the central bank To understand money in modern times, it's useful to know a bit about the role of the central bank. The Bank of Canada was created in 1934. Interestingly, proposals to establish a central bank, or something akin to it, go back a long way in Canada – almost 200 years. In 1820, an anonymous pamphlet published in Quebec "advocated the establishment of a governmentowned national bank that would be the sole issuer of paper money." 22 And in 1841, Lord Sydenham, Governor General of the United Province of Canada, proposed the establishment of a bank with many of the powers and responsibilities of a modern central bank. Such a bank, he thought, could finance public works, generate seigniorage, and make paper money more effective. Quoted in J. Chant, "The Canadian Experience with Counterfeiting," Bank of Canada Review (Ottawa: Bank of Canada, Summer 2004): 42. V. Speer (compiler). "The Million Dollar Counterfeiting." Memoirs of a Great Detective: Incidents in the Life of John Wilson Murray, Chapter 30. 1904. Available at: http://gaslight.mtroyal.ca/murray30.htm. J. Powell, op. cit., p. 21. The Depression of the 1930s provided impetus for the creation of a central bank. A widespread sense that the banking system was not serving the public very well – at a time when the economy was contracting – led to support for the formation of a central bank. The Bank of Canada's mandate is to promote the economic and financial well-being of the country. The Bank does this in three important ways: first, by keeping inflation low, stable, and predictable; second, by supporting a safe and efficient financial system; and third, by issuing money that is safe from counterfeiting and readily accepted. These activities help to provide a sound foundation for economic security and growth. The Bank of Canada issued its first bank notes in 1935. Each denomination was issued in separate French and English versions [image: 1935-issue bank notes]. This 1935 series was the only Bank of Canada series to have a $25 denomination. If you want to buy one of these notes, be warned: a single note can fetch up to $15,000 at auction! Since 1937, Canadian bank notes have been bilingual. To deter counterfeiting, the Bank has issued a new series of bank notes every 15 years or so [image: $20 bank note over the years]. Anti-counterfeiting features have included intaglio (or raised) printing, multicoloured tints, microprint, optical security devices, and fluorescent fibres. But today's technology has increased the counterfeiting threat, and the Bank expects to issue new bank note series every seven years or so in the future, with the intention of taking advantage of advances in anti-counterfeiting technology. In the summer of 2000, counterfeit $100 bank notes from the Birds of Canada series started to show up in stores in the Windsor-Montréal corridor. They contained facsimiles of the security devices found in genuine notes, and they were printed on high-quality paper. More than $5,000,000 worth of these notes were put into circulation before the culprits were arrested in July 2001, causing many retailers to refuse to accept any $100 bills – a vivid demonstration of how counterfeiting undermines confidence and exacts many different kinds of costs. 23 This episode prompted the Bank to adopt a comprehensive strategy to deter counterfeiting. The strategy involved intensified efforts to develop and issue bank notes with enhanced security features, expanded education of retailers and consumers about bank note security, and active promotion of law-enforcement and prosecution efforts [image: bank note security features]. This strategy has proven very effective in dealing with a surge in counterfeiting from 2001 to 2004 [graph: counterfeit notes detected per million notes in circulation], but we remain very vigilant. In 2006, we reinforced this strategy by setting a quantitative objective to bring the number of counterfeit notes passed in a year to fewer than 100 for each million genuine notes in circulation by 2009. Drawing on advances in science and technology, the Bank of Canada is busily involved in developing its next series of bank notes for issue starting in 2011, with a view to keeping counterfeiting below 50 parts per million. Before I turn to the future of money, I'd like to say a few words about the exchange rate. In New France and other North American colonies, the value of local currency vis-à-vis foreign currencies was typically set by the government and altered in response to economic imperatives. A similar approach characterized the Bretton Woods system of pegged but adjustable exchange rates, which defined the international monetary order in the period following the Second World War. Canada was a pioneer in departing from that approach, by allowing its currency to float and have its value determined by market forces. With the exception of a short eight-year hiatus J. Moxley, H. Meubus, M. Brown, "The Canadian Journey: An Odyssey into the Complex World of Bank Note Production," Bank of Canada Review (Ottawa: Bank of Canada, Autumn 2007): 47-55. from June 1962 to May 1970, the Canadian dollar has floated freely since October 1950. As a trading nation, and a producer of both commodities and manufactured goods, we learned early on that a flexible exchange rate can facilitate economic adjustment. 24 A floating exchange rate sends important price signals to producers and consumers, prompting them to adjust effectively to changing circumstances. It also permits monetary policy to focus on maintaining the balance between overall demand and supply, and thus on controlling domestic inflation. So that's the context for understanding money in modern times. The central bank strives to keep the enemies of sound money at bay by keeping inflation low and stable, and by making it difficult and unrewarding to counterfeit money. It also strives to maintain a sound financial system so that money can be effectively and efficiently saved, borrowed, invested, and transferred. The future of money What will money look like a decade or two from now? Will there even be physical money? Or will electronic alternatives replace money as we know it? For many decades now, I've seen many premature predictions of the imminent "death of cash," so I will remain cautious. We do know that despite the many and rapidly developing alternatives to paper money, the demand for "old-fashioned" bank notes has continued to grow fairly steadily, in line with the overall economy. Having said that, it's useful to remember that bank notes and coins are simply a means of payment, and "alternative" means of payment have been developed, and some of them are gaining in popularity. Each means of payment has advantages and disadvantages in terms of convenience, security, and financial cost. Because changes in means-of-payment preferences can affect both the demand for bank notes and the overall costs of retail payments, the Bank of Canada monitors and analyzes them carefully. 25 At the retail level in Canada, credit cards, cash, and debit cards are all popular, with credit cards representing roughly 48 per cent of transactions by value, debit card about 30 per cent, and cash about 22 per cent. While in absolute terms, the use of cash remains fairly steady, there is clear evidence that it is in relative decline vis-à-vis the use of credit and debit cards. But it is the use of cheques that has seen the largest decline, as a result of the increasing use of debit cards. Not surprisingly, payment method preferences are affected by an individual's age and income. A survey conducted by the Bank of Canada shows that payment methods also depend on the size of the purchase. For purchases under $25, Canadians generally prefer to use cash. For purchases of $26 to $100, debit cards are the most popular means of payment. For purchases over $100, credit cards are the most popular. 26 Credit cards are also a preferred means of payment across distances. Cash has one attribute that many people find attractive – it offers privacy and protection against identity theft. In coming years, we will likely see an increase in "contactless" payments using credit, debit, and stored-value cards, including those made by cell phones. Such technology promises convenience to consumers and retailers, but it also presents security challenges. For a brief, informative overview of the history of Canada's exchange rate regimes, see J. Powell, op. cit., pp. 53-73. See, for example, C. Arango and V. Taylor, "Merchants' Costs of Accepting Means of Payment: Is Cash the Least Costly?" Bank of Canada Review (Ottawa: Bank of Canada, Winter, 2008-2009), forthcoming. V. Taylor. "Trends in Retail Payments and Insights from Public Survey Results." Bank of Canada Review (Ottawa: Bank of Canada, Spring 2006): 25-36. While it's difficult to predict the future of money, it's safe to say it will be determined largely by people's preferences. We naturally gravitate towards a payment method that best suits our needs. Conclusion With the limitations of this kind of presentation, I've really only scratched the surface of Canada's monetary history. It is a fascinating and colourful story, and opens a window on our social, political, and economic history. Sound money is fundamental to our economic well-being. While counterfeiting and inflation are ever-present threats to sound money, Canada has pioneered some important innovations in deterring counterfeiting and in controlling inflation. The Bank of Canada plays a vital role by keeping inflation low, stable, and predictable; by supporting the stability and efficiency of the financial system; and by producing the currency we depend on in our commercial lives. In other words, we try to earn your confidence – and that of all Canadians – every day. The next time you're in Ottawa, I encourage you to visit the Currency Museum [image: Currency Museum]. It houses and displays some of the National Currency Collection, and it tells many interesting stories about money. It's a wonderful showcase . . . and it's free! The museum also has a terrific website, which you can easily find by visiting the Bank of Canada's website, and clicking on "Museum" [image: Currency Museum web page]. Finally, if you'd like to learn more about money in Canada, I warmly recommend three books published by the Bank of Canada [image: three books]: The Art and Design of Canadian Bank Notes, which explains the art and science of bank note design, and celebrates the beauty of Canadian bank notes; The History of the Canadian Dollar, which tells the fascinating story of our dollar and its place in history, economics, and finance; and the next book in our "souvenir" series: Beads to Bytes: Canada's National Currency Collection, which will be available at the end of this month, and illustrates the role money plays in society with some of the extraordinary trove of bank notes, coins, tokens, and related material to be found in the National Currency Collection. All three books can be obtained at the Currency Museum or ordered via the Bank's website. Thank you for your attention. I'd be happy now to respond to any questions.
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Remarks by Mr Mark Carney, Governor of the Bank of Canada, to the Canada-United Kingdom Chamber of Commerce, London, England, 19 November 2008.
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Mark Carney: Building continuous markets Remarks by Mr Mark Carney, Governor of the Bank of Canada, to the Canada-United Kingdom Chamber of Commerce, London, England, 19 November 2008. * * * It is a pleasure to be back in the City. Twenty years ago, I started my first proper job here, as a credit analyst – remember that quaint role? at an investment bank – remember those archaic institutions? I came to London then because it appeared poised to realize the promise of market-based finance and to reassume its role at the centre of global finance. Today, I come to London, when so many are burying markets, to praise them and set out some thoughts on how to make them more robust. Throughout the years, Canada has been a major beneficiary of London's innovation. Companies of adventurers, conceived and funded in London, opened up large swathes of Canada to international trade. Global capital, channelled through London, financed our infrastructure and commodities booms at the turn of the twentieth century. Our governments leaned heavily on the Euromarkets to finance their borrowings in the 1980s and early 1990s. More recently, we have looked to London for an array of new financial products. We have also given back. Canada helped to finance Britain's World War II efforts, and we were pleased to receive the final repayment, on schedule, in 2006. The Bank of Canada's pioneering of inflation targeting was undoubtedly of some assistance to the Bank of England's thinking in its adoption of this successful framework. We now may have something to contribute amidst the current maelstrom: a dispassionate and ultimately optimistic perspective on how to build sustainable markets in the age of global capital. The simple fact is that, while Canadian markets have been under strain, they have remained open. Our banks have not sought public capital. They continue to expand lending to both the business and household sectors without the kind of prodding seen in other jurisdictions. While we are not immune to the impact of a potentially serious global recession, we have a financial system that affords us the means, and gives us the prospect, of investing for the inevitable global recovery. For that recovery to reach its full potential, we all need a financial system with continuously open markets at its core. It is on this theme that I would like to concentrate my remarks today. Markets and banks The current crisis marks the reversal of a decades-long transition of the global financial system from being primarily relationship-oriented and dominated by banks to being primarily transactions-oriented and dominated by financial markets. This model had the potential to price risk and to allocate capital more efficiently. In some cases, however, the development of markets ran well ahead of the supporting infrastructure. Moreover, lulled by early successes, participants became increasingly reliant on opaque securitization, dependent on excessive leverage, and complacent about market liquidity. A system that appeared resilient (and enormously profitable) in times of low volatility proved brittle in the face of shocks. With the breakdown of many markets, the pendulum is swinging away from market-based finance back towards bank-based finance. This shift carries with it a number of costs and associated risks. First, the sudden re-emphasis on bank-based intermediation has led to an urgent need for banks to raise very large amounts of capital. If not managed properly, this threatens to exacerbate the global economic slowdown. Second, the crisis has shaken a number of articles of faith among market participants: that one could always borrow against "good" collateral, that market-based liquidity would always be available, and that ratings were efficient substitutes for due diligence and judgment. With these assumptions now in doubt, certain markets are now frozen and could take a long time to return, if they do at all. Third, in recent weeks, we have seen evidence of a "home bias" re-emerging in global financial markets as banks and investors furiously repatriate capital. This reflects both the desire of banks to concentrate their limited resources on geographically close relationships, and the need for funds to liquidate assets in preparation for large redemptions. This development has the potential to significantly slow growth in some emerging markets. All of these risks are the consequence of relying on markets built on sand. To find the bedrock on which to rebuild open continuous markets, all of us – market participants and policy-makers alike – must learn the lessons of this crisis. Lessons of the crisis The crisis has its roots in macroeconomic imbalances and microeconomic failures. On the macro side, we are experiencing the inevitable correction of a period of global imbalances, characterized by excess savings and under-consumption in major emerging markets, and by negative savings, rapid credit expansion, and asset-price booms in many western economies. These trends were encouraged by policies including, in Asia, inflexible exchange rates and an overreliance on export-led growth, and in the United States, the response to the bursting of the tech bubble. These measures collectively contributed to a low and stable interest rate environment that fed enormous risk taking and leverage across markets and currencies. With the cavalier "search for yield" now replaced by a desperate "rush for shelter," leverage is being viciously unwound across markets. One clear lesson is that price stability alone is not sufficient to prevent the buildup of macroeconomic imbalances. Indeed, asset bubbles frequently emerge during periods of low and stable consumer price inflation. It does not follow, however, that monetary policy should target asset prices. Monetary policy is a blunt instrument, poorly suited to addressing financial imbalances. Instead, it is increasingly recognized that macrofinancial stability should be one of the core objectives of financial regulation. The current crisis has made it crystal clear that, as designed, the form and conduct of financial regulation is not fit for purpose. It will not be enough for prudential regulators to adopt new measures within their current frameworks. There needs to be oversight of the system as a whole – including both systemically important institutions and systemically important markets. This oversight may be best housed in those public institutions with a macroeconomic orientation. At a minimum, there must be close coordination between regulators, the central bank, and the finance ministry. As part of a new macroprudential approach, regulation must address three significant flaws in market structure – a lack of transparency, misaligned incentives, and inadequate liquidity. I will say a few words about each of these. The first priority is to improve transparency. Many highly structured products at the centre of the turmoil were far from transparent, and the disclosure by their originators was often wanting. The substitution of credit ratings for adequate transparency promoted herding upon downgrades and common valuation errors across a range of asset classes. It also eliminated investor pressure for better disclosure, contributing to today's broken markets. Progress has been made, including the Financial Stability Forum's bank disclosure template and the Bank of Canada's disclosure requirements for asset-backed commercial paper pledged as collateral. Ultimately, if investors are truly doing their credit homework, they will demand better disclosure. Otherwise, they will again pay the price. The second priority is to address a series of misaligned incentives. It has been belatedly recognized that the severing of the long-term relationship between originator and borrower contributed to a decline in credit quality. Further, within several global financial institutions, there were also inappropriate incentives created by the funding of trading desks at risk-free rates and poorly designed compensation structures. There are now prominent calls for increased regulation to better align incentives within institutions. These matters require judgment, not slogans. I firmly believe that regulation of compensation is not appropriate, even though it is in vogue. Rather, regulators should consider carefully compensation incentives within a broader assessment of the robustness of risk-management and internalcontrol systems. Regulators also need to address misaligned incentives created by regulation itself, such as the current state of capital requirements. It goes without saying that liquidity management across a broad range of financial institutions must be improved. Confidence that markets would remain liquid had encouraged the rapid growth of the "originate-to-distribute" credit model. The current illiquidity is hastening its demise. Liquidity problems have spread across markets, reflecting both fundamental concerns about the solvency of counterparties and the procyclicality of collateral margins. Core money markets have broken down as a result of these three failures, thereby worsening the crisis. Had these core markets continued functioning, we would likely be experiencing a credit crunch – where the cost of credit would have been sharply higher – instead of a full-blown credit crisis – where credit is unavailable at any price across a range of core markets. While the provision of extraordinary liquidity by central banks is limiting the damage from the crisis, it has long been apparent that official liquidity, irrespective of size, cannot re-open markets on its own. How to build continuous markets The current situation is unacceptable. The financial system should have a number of core markets – including interbank lending, commercial paper, and repo markets for high-quality securities – that are continuously open even under stress. Achieving this will require a combination of the microeconomic measures just described and the pursuit of two strategies. The G-7 Action Plan announced last month provides the conventional roadmap. This strategy centres on shoring up systemically important institutions so that they can be more resilient and resume their market-making role. To this end, the G-7 has made it clear that no systemically important institution will be allowed to fail and that sufficient capital – public and private – will be provided to restore confidence. In recent weeks, G-7 governments have acted with bold plans to honour these principles. In tandem, central banks have fulfilled their commitments under the plan to "ensure that banks and other financial institutions have broad access to liquidity and funding." In providing liquidity to the core of the system, we expect that key markets will resume functioning as this liquidity cascades through the system to other market participants and, ultimately, through private credit creation, to the real economy. While it will take time for capital and confidence to return, this strategy will be successful. The second strategy requires central banks to act as market-maker of last resort. That is, central banks would ensure that market transactions continue in times of crisis by becoming a counterparty to major market participants. This would address directly the current fear of non-bank participants in many global money markets that they will not be able to continuously access liquidity. It should be acknowledged that the exit of money market funds from non-government money markets may be as damaging as counterparty risk concerns and the liquidity hoarding of core financial institutions. In some jurisdictions, central banks are already acting as a de facto central counterparty by taking in deposits from institutions with excess liquidity and providing it to those with deficient liquidity. The issue is how widely to expand the participants. When central banks act as market-makers, markets become more systemic and institutions less so. Irrespective of which strategy is adopted to rebuild continuous markets, there are additional measures that policy-makers should consider to reduce risks and make individual institutions less systemic. For example, current efforts to create a clearing house for credit default swaps would both reduce counterparty risk and help keep this market open in stressful times. Without underestimating the complexity of this initiative and the potential costs of margining, policy-makers can be expected to look for other markets that could be moved onto exchanges or into clearing houses, as well as working to risk-proof custodial banks. 1 Regulations and standards could reinforce these initiatives. For example, consideration should be given to establishing higher capital requirements for securities that trade outside continuously open markets, as well as limiting the application of fair-value accounting to those securities that trade on exchanges or in continuously open markets. Policy-makers should also seek to reduce the procyclicality of value-at-risk margining, perhaps by maintaining margin requirements at fixed rates throughout the economic cycle. If the central bank were the market-maker of last resort, it could reinforce such standards. Having outlined these strategies, I would now like to use the Canadian situation to illustrate a few points about how they may be applied. The Canadian perspective Canada's experience is instructive. While Canada's financial system has been affected by the crisis in global financial markets, the impact has been significantly less than in many other major economies, not least because Canada is further along than others in implementing the G-7 Action Plan. Canada starts with financial institutions that are healthier than their international peers. Not merely have losses on structured products of Canadian banks been modest, but more importantly, their absolute leverage is markedly lower. As a simple illustration, major Canadian banks have an average asset-to-capital multiple of 18 on a consolidated basis, which is slightly below the regulatory maximum of 20. The comparable figure for U.S. investment banks is over 25. For European banks, it is in the 30s, and for some major global banks, it is over 40. While foreign banks are in the process of moving towards Canadian levels, our banks obviously face no such pressures. In addition, the quality of Tier 1 capital of Canadian banks is among the strongest in the world. Canada's conservative banking culture clearly helped our institutions avoid some the most egregious lending practices seen elsewhere. So, too, has the nature of securitization in Canada. Only about 20 per cent of Canadian mortgages are securitized. With more of this lending remaining on balance sheets, underwriting standards have remained high. Further, since Canada requires insurance on high-loan-to-value mortgages and Canada Mortgage Bonds are explicitly guaranteed by the sovereign, there is no negative feedback loop between the housing market and the financial sector as has been all too apparent in other major economies. Our experience demonstrates that the G-7 strategy will work. Given the combination of strong core institutions, the provision of exceptional term liquidity by the Bank of Canada, and the now material term funding from the Government of Canada, we expect that our major financial institutions will cascade that liquidity through the system by supporting continuous markets and extending credit. Unfortunately, in other jurisdictions, this is not yet the case. The weaker the starting point of regulated institutions and the greater the importance of the shadow banking sector, the longer the healing process could take. Indeed, in a range of countries, this process must be carefully managed to avoid worsening their recessions. In particular, the overhang of large capital requirements could be compounded by concerns that overall capital levels themselves will rise. This could lead banks to hoard any new capital rather than deploy it. Doing so would worsen the economic outlook, which would then increase loan losses and further strain capital levels. For example, in Canada, policy-makers have been encouraging greater use of the CLS Bank, which facilitates the settlement of foreign exchange in an environment without counterparty risk. The explicit G-7 commitment to systemic institutions and the various guarantee programs should be used to help spread over time the necessary capital increases. Moreover, policymakers should have the courage of their (new-found) macroprudential convictions. With G-20 leaders calling for regulators to develop measures to mitigate procyclicality in capital, regulators should be careful about pushing capital standards up too high, too soon in the teeth of an economic slowdown. Through-the-cycle capital means that ratios should fall in a downturn. Finally, some policy-makers should give greater consideration to the central bank acting as market-maker of last resort to maximize the likelihood that core money markets remain open. Notwithstanding the advantages of its financial sector, as one of the most open economies in the world, Canada has been importantly affected by global events. The intensification of the global financial crisis has led in Canada to an increase in credit spreads and a tightening in credit conditions generally. The global recession is deepening, with demand slowing sharply across all major regions in recent weeks. As a consequence, there have been further declines in the prices of many commodities and a deterioration in Canada's terms of trade, which reduces Canadian incomes. The nature of the U.S. slowdown, with its acute weakness in the housing and auto sectors, is also particularly problematic for our exporters. Thus, while domestic demand in Canada remains relatively healthy and the depreciation of the Canadian dollar will offset some of the declines in external demand, the risks to growth and inflation in Canada identified in the October Monetary Policy Report appear to have shifted to the downside. Despite having already cut official interest rates in half over the past year and having a financial sector that is still functioning effectively, some further monetary stimulus will likely be required to achieve the inflation target over the medium term. Act locally, think globally This leads to the final lesson from Canada's experience. As G-20 leaders agreed this past weekend, effective regulation begins at home. To meet this responsibility, Canada has a formal coordination mechanism that brings together institutions with a macroeconomic focus – the central bank and Department of Finance – with the prudential regulator and the deposit insurer. Given the pace of change in financial markets, we subject our regulatory regime to regular scrutiny. We have a legislated requirement to review the legislative and regulatory framework for the financial system every five years. We have also twice subjected our system to rigorous examination under the Financial Sector Assessment Program conducted by the International Monetary Fund. While it is undeniable that good financial regulation begins at home, it is equally clear that it cannot end there. Even if the domestic system is sound, there is no guarantee that core financial markets will always be available. Given the high degree of integration in the world financial system, and since individual countries may still underinvest in the global social good of domestic financial stability, there is a pressing need for international institutions that effectively monitor systemic risk and coordinate macroprudential and financial policy reform. There was no effective international surveillance that identified either the nature or the scale of the financial crisis, because no international organization had yet integrated effectively macroeconomic and macrofinancial analysis. Progress on these imperatives was also made this past weekend in Washington, and they will remain a focus over the coming weeks. Conclusion Allow me to conclude. The turmoil of the past year and a half and the crisis of the past two months have been momentous. This episode will take its place as one of the most important in economic history. Ultimately, however, our response to these events will be more important than the events themselves. We can never eliminate financial crises, but we can reduce their likelihood and severity. In my opinion, the key to success in this regard is to seek to build continuously open markets. The pendulum is currently swinging back from market-dominated financing towards bank-dominated financing. We should not want the pendulum to swing too far. The capital requirements at the extreme are enormous. More fundamentally, market forces should be left to determine the relative size and boundaries of the banking and markets sectors. They will only do so if markets are built on solid foundations. We can construct a global financial system that will lead to the type of sustained and mutually beneficial prosperity that Canada and the United Kingdom have enjoyed over the centuries.
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Remarks by Mr Pierre Duguay, Deputy Governor of the Bank of Canada, to the Pictou County Chamber of Commerce, Pictou, Nova Scotia, 27 November 2008.
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Pierre Duguay: Fostering financial system stability Remarks by Mr Pierre Duguay, Deputy Governor of the Bank of Canada, to the Pictou County Chamber of Commerce, Pictou, Nova Scotia, 27 November 2008. * * * Good evening. It's a great pleasure to be here. When I last spoke in Nova Scotia three years ago – almost to the day – I discussed the Bank of Canada's role in strengthening the country's financial system to make it resilient to shocks so as to limit damage from inevitable economic and financial storms. It was a timely metaphor, given that I spoke shortly after Hurricane Katrina had breached the levees of New Orleans. We were concerned at that time about the buildup of global economic imbalances, and about the narrowing of risk spreads which suggested that risk was perhaps being underestimated and vulnerable to a sudden reversal. These factors have since proven to be key contributors to the current, worldwide turmoil in financial markets. A third contributing factor, which we didn't foresee, has been the extent to which financial markets had expanded without proper support structures, like a house built on sand. I'll have more to say on this point a bit later in my remarks. So, I thought it would be worthwhile to review the risks we were aware of leading up to the current crisis, what took us by surprise, and what we have learned must be done to strengthen financial system resiliency for the future, both here and abroad. The Canadian financial system has fared relatively well through this crisis, thanks to effective regulation and prudent practices that have worked like sandbags to protect our financial system from the storms in today's global economy. In this respect, we may be a model for much of the world. But, because our prudential regulation is focused on protecting institutions, rather than supporting core financial markets, we have learned that there is still much work to do in this area. So I will also discuss some reforms that may be necessary to mitigate the effects of future global financial crises. I will close with a few words on the current economic situation in Canada. The global financial crisis We have all heard a great deal about the tumultuous global events that began in the summer of 2007 as a result of rapidly rising delinquencies on subprime mortgages in the United States. The sudden realization that exposure to these defaults was both widespread and difficult to locate (because of a lack of transparency) led to a drying up of liquidity and an increase in bank funding costs. That turmoil accelerated dramatically this September, moving far beyond liquidity problems to a more acute and broad-based crisis of confidence, sparked by a series of failures and near-failures of financial institutions in the United States and Europe, and increased prospects of a world recession. As a result, wholesale funding markets came to a standstill in many countries, and commercial banks essentially stopped making unsecured loans to one another at terms longer than overnight. The crisis rippled through various markets as investors became very risk averse. Corporate bond spreads surged to new all-time highs, equity prices plunged, and foreign exchange rates became very volatile. Investors' concerns about the impact of the turmoil on the global economy turned into a vicious circle. Financial institutions became increasingly reluctant to extend credit, given their own funding difficulties and their concerns about what an economic slowdown would imply for the credit quality of their loan portfolios. Tighter credit conditions and the increased difficulties that businesses faced in trying to raise funds have, in turn, contributed to the slowdown in the world economy. Another contributing factor was the drop in consumer confidence triggered by the wealth destruction that resulted from sharp falls in equity markets and housing prices. The combination of these factors has produced extremely volatile and difficult financial conditions, and what has become the deepest, broadest, and longest financial crisis since the 1930s. In response, governments and central banks around the world – including the Bank of Canada – have undertaken a series of unprecedented actions aimed at stabilizing the financial system. These include making available significant overnight and term liquidity to a broad range of market participants; guarantees of bank deposits and borrowing; purchases of bad assets; and capital injections for financial institutions. The G-7 Plan of Action announced in early October has provided the foundation for urgent and unprecedented measures to stabilize financial markets and restore the flow of credit, essential to continued economic expansion. Importantly, it included a commitment from G-7 leaders to use all available tools to support systemically important financial institutions and prevent their failure. Governments in industrialized countries and in some systemically important emerging-market economies have also pledged to take steps to encourage economic growth and to reduce the severity of the global recession. Canada’s response Consistent with the G-7 Plan of Action, the Bank of Canada has acted swiftly to ensure that adequate liquidity is available to institutions within our borders. Our actions have been significant. We have moved aggressively by expanding the Bank of Canada's provision of term purchase and resale agreements (PRAs) to a total of $34 billion. Term PRAs provide liquidity to key market participants for terms up to three months against a wide range of securities. Further, we have widened the range of assets we accept, and extended the range of counterparties with whom we will transact. We also introduced a new term-loan facility for those financial institutions that participate directly in the Large Value Transfer System, taking their non-mortgage loan portfolios as collateral. 1 I should point out that none of these liquidity measures are inflationary because they involve sales of government debt either from the Bank's portfolio or from new issuance rather than an increase in the money supply. 2 The substitution of risk-free government securities for less liquid assets on the balance sheets of core financial institutions acts as a kind of lubricant to the machinery of banking. In return, these core institutions are expected to pass on the extra liquidity through other market participants and, ultimately, into the real economy. The federal government has also been actively working to address the impact of the financial crisis. In recent weeks, it announced the Canadian Lenders Assurance Facility, a voluntary program of insurance for interbank lending to ensure that Canadian institutions are not put at a competitive disadvantage to their international peers when raising funds in wholesale markets. The government has also increased to $75 billion the amount of insured mortgage pools that it will buy from financial institutions, thus supporting the availability of credit to Canadian households and businesses. How does the Bank of Canada deal with risks? The Bank of Canada's role in fostering financial system stability is not always well understood. So let me explain our work in this area a bit more. As well, as part of an unprecedented coordinated action by the world's major central banks, the Bank of Canada entered into a US$30 billion reciprocal currency-swap arrangement with the U.S. Federal Reserve. This facility would only be activated in the event of an acute shortage of U.S. dollars in Canada, but it does provide the Bank with additional flexibility to address rapidly evolving developments in financial markets. Proceeds from new issuance of government debt related to Bank operations are held on deposit at the Bank of Canada. As part of its commitment to Canadians, the Bank fosters the safety and efficiency of the financial system, both in Canada and around the world. Our goal is to encourage a resilient system that can withstand shocks – even large shocks. The Bank's power to achieve this goal comes from our central position as Canada's monetary authority. This makes us the ultimate provider of liquidity to Canadian financial institutions and to the country's financial system more generally. It also gives us a prominent voice in international organizations as well as in such domestic bodies as the Financial Institutions Supervisory Committee (FISC) and the Senior Advisory Committee (SAC). FISC and SAC provide forums for the Federal Deputy Minister of Finance, the Superintendent of Financial Institutions (OSFI), the Governor of the Bank of Canada, the Chair of Canada Deposit Insurance Corporation (CDIC), and the Commissioner of the Financial Consumer Agency of Canada (FCAC) to share information, coordinate actions, and advise the federal government on financial sector policy. At the international level, the Bank, the federal Department of Finance, and the Superintendent of Financial Institutions are represented on the Financial Stability Forum (FSF). The impetus for this global forum came from a summit of G-7 leaders in Halifax more than a dozen years ago, and the FSF truly came to life in the wake of the Asian crisis of the late 1990s. This entity brings together senior representatives of national financial authorities from selected countries to promote international financial stability, reduce the spread of shocks, and increase market resiliency. The importance of the FSF as a source of global coordination was recently underscored by the G-20 leaders, with their call for its expansion to include top emerging-market economies such as China and India. As you can tell from that description, the Bank has essentially two key tools at its disposal. One is our power to supply liquidity; the other is our capacity to produce the solid research and analysis that underpins our advice and enables us to influence public sector decisions and private sector behaviour. We do not supervise financial institutions for depositor protection – that falls within the realm of OSFI and CDIC. Nor do we regulate financial markets for investor protection – a responsibility carried out by the provincial securities commissions. 3 To carry out our responsibilities, we monitor trends in financial developments in Canada and abroad, assess their implications for financial system stability, and identify risks to the Canadian financial system so that we can act and convince others to act, to limit damage from economic and financial storms. We publish our assessments, based on this monitoring, in our semi-annual Financial System Review. The next issue will be published and posted on the Bank's website on 11 December. Strengthening resiliency At the beginning of my remarks, I spoke briefly about the need to strengthen the resilience of our financial system. As I have already noted, in Canada we have taken many of the correct steps, some beginning 20 years ago, as we worked to strengthen the supervisory system for individual financial institutions. The coordination among domestic agencies with an interest in the financial services sector is based on a long history of effective collaboration and on a common understanding of where mandates interact. Yet there is still work to do so that we can be even better prepared the next time a crisis crashes onto our shores. History shows this is inevitable, given the difficulty investors have in going against the crowd and resisting the extremes of heady optimism in good times, and fear and even panic in bad times. We also have statutory responsibility for the oversight of risk containment measures in systemically important clearing and settlement systems. This infrastructure has continued to function very well throughout the global turmoil. Given that inevitability, it is imperative that we address the weaknesses in the global financial system and in the regulatory and supervisory architecture that were exposed by the current crisis, if we are to increase the resiliency of the financial system to shocks and better support economic stability. The Financial Stability Forum has examined lessons from the current crisis and made a number of recommendations earlier this year aimed at enhancing market and institutional resiliency. Work continues under the guiding principles of the FSF, to encourage a financial system that: • operates with less leverage; • is immune to the misaligned incentives that contributed to the current crisis; and • has stronger oversight and greater transparency so that risks can be more readily identified and dealt with. Collectively, we must find ways to improve the transparency of complex products traded in financial markets, so that investors are better able to assess the risks they take on. We must also examine how best to strengthen macroprudential regulation (as opposed to institutioncentered microprudential regulation) by: • bolstering controls on leverage; • encouraging the buildup of adequate capital buffers in good times that can be drawn upon in bad times, thus dampening the credit cycle; • developing mechanisms to provide liquidity to core financial markets so that they remain open; and • expanding the amount of financial infrastructure that is properly risk-proofed, for example, custodial banks and clearing houses for credit default swaps (CDS). Economic outlook Let me close with a few words about the economic outlook. The intensification of the global financial crisis has led in Canada to an increase in credit spreads and a tightening in credit conditions generally. The global recession is deepening, and with it there have been further declines in the prices of many commodities and a deterioration in Canada's terms of trade, which reduces Canadian incomes. The nature of the slowdown in the United States, with the acute weakness in the housing and auto sectors, is particularly problematic for our exporters. These factors present serious challenges to Canadian industries, including key Nova Scotia industries in the primary resources, manufacturing, and tourism sectors. Thus, while domestic demand in Canada remains relatively healthy and the depreciation of the Canadian dollar will offset some of the declines in external demand, the risks to growth and inflation in Canada identified in the October Monetary Policy Report appear to have shifted to the downside. In the face of the crisis, we have already cut official interest rates by half, to 2 1/4 per cent over the past year and have stated that some further monetary stimulus will likely be required to achieve the inflation target over the medium term. Conclusion Let me conclude. We have avoided the worst effects of the global financial crisis, thanks to a resilient financial sector built on the conservative lending practices of Canadian banks, and to our effective regulation and prudent practices in the sector. Still, the crisis is being felt in our economy. But we have taken bold steps to re-open financial markets and I can assure you that the Bank of Canada will continue to provide as much liquidity as is needed to encourage the re-establishment of the normal functioning of Canadian financial markets. You can also count on the Bank to add its voice to calls for initiatives to strengthen the resiliency of both the domestic and international financial systems.
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Remarks by Mr Mark Carney, Governor of the Bank of Canada, to Women in Capital Markets, Toronto, Ontario, 17 December 2008.
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Mark Carney: From hindsight to foresight Remarks by Mr Mark Carney, Governor of the Bank of Canada, to Women in Capital Markets, Toronto, Ontario, 17 December 2008. * * * It has been a difficult year for capital markets professionals. The turmoil has deteriorated into a full-blown financial crisis. Most financial markets have experienced historic falls in prices, and some are strained to the point of closing. Issues of financial stability that were once the obsession of a pessimistic few are now the daily concern of many. Policy-makers have had to respond with bold measures. These will work, although it will take time for confidence to return and for capital to flow once again. In the interim, the dramatic repricing of risk across financial assets will be increasingly mirrored in the real economy. Businesses are already beginning to postpone large investments, and households now hesitate over major purchases. Partly as a consequence of financial instability, next year will be a trying one for many Canadians. Few forecast these events; although, in an outbreak of retrospective foresight, an increasing number now claim they saw it coming. The reality is that among all the banks, investors, academics and policy-makers, only a handful were able to identify ahead of time the causes and potential scale of the crisis. 1 Central banks, ministries of finance and international financial institutions all believed either that risks were being adequately managed or that vulnerabilities lay elsewhere. Around the world, private banks exceeded their regulatory capital requirements. Clearly, though, risks were not being managed properly and capital was inadequate. Now, in the rush to respond, we must avoid building the financial equivalent of the Maginot line – overpreparing for a repeat of current events while remaining vulnerable to the root causes of the next crisis. Rather, we must develop early-warning systems with precision and with teeth. This will require progress internationally and domestically. Internationally, both the Financial Stability Forum (FSF) and the International Monetary Fund (IMF) must become more effective. There are several ways of accomplishing this. The first is to divide more clearly responsibilities between these bodies, with the IMF having primary responsibility for surveillance (i.e., the early-warning system) and the FSF for coordinating the development of a resilient financial system. Second, policy-makers themselves must become more engaged. The value of international organizations is not that their bureaucracies possess unique powers of insight, but rather that they can convene senior policy-makers, challenge them, and then forge a consensus on how to foster sustainable global economic growth. Third, countries must recognize that membership in these organizations brings responsibilities. This is why Canada successfully pushed at the recent G-20 summit for mandatory regular reviews of each country's financial system by the IMF (a process carried out under the Financial Sector Assessment Program or FSAP). Finally, it matters who is around the table. In Washington last month, G-20 leaders agreed to expand the FSF to include key emerging markets. These countries not only have first-hand experience of financial crises but also are the major surplus countries who, as major capital providers, need to be part of a global solution. 2 Examples include Bill White, formerly of both the Bank of Canada and the Bank for International Settlements; Harvard University's Ken Rogoff; Nouriel Roubini of New York University; Wynne Godley of Cambridge; and Bernard Connolly of AIG Financial Products. M. Carney, "Reflections on Recent International Economic Developments" (Speech to the Canadian Club of Montreal, Montréal, Quebec, 25 September 2008). Domestic responsibility for financial stability is currently shared among a large number of federal and provincial bodies. This includes the Bank of Canada, which is mandated by legislation to "promote the economic and financial welfare of Canada." Today I would like to focus on how the Bank can fulfill this broad mandate by contributing to financial stability in Canada. A macroprudential approach A clear lesson of the current crisis is the need to take a macroprudential approach to financial stability. Macroprudential surveillance assesses current risks by looking at the broad economic and financial conditions that can contribute to the buildup of risks to the financial system and the economy as a whole. Macroprudential regulation seeks to improve the resiliency of the financial system by designing standards and codes to limit the buildup of financial and economic imbalances. Put simply, a macroprudential approach focuses on the forest, not the trees. Two topical fallacies of composition illustrate the point. The first is what Keynes termed the "paradox of thrift." It may be individually rational for people to want to save more and businesses to invest less during uncertain economic times. If this behaviour is widespread, however, it becomes collectively irrational. Fear of recession feeds a recession. Similarly, a bank may decide to hoard capital in anticipation of increased loan losses during a slowdown. If all banks do the same, their actions will exacerbate the downturn and increase their eventual losses. It is well-known that timely and properly calibrated monetary and fiscal policy can address the first issue. It is less widely recognized that macroprudential regulation can address the second. In many ways, the central bank is ideally suited to bring a macroprudential approach to financial stability. Our mandate demands that we take an economy-wide perspective. Further, we have a strong motivation to maintain a stable, efficient financial system because we rely on it to transmit our monetary policy actions. However, we do not have many of the tools necessary to secure financial stability. Monetary policy is a blunt instrument, poorly suited to addressing financial imbalances. Instead, macrofinancial stability should be one of the core objectives of financial regulation. Until it is, under the current framework, the Bank can promote financial stability through two tools: liquidity and advocacy. The Bank is the ultimate source of liquidity within the economy. We have used our recently enhanced powers under the Bank of Canada Act extensively throughout the crisis, with measures that now total more than $36 billion of term liquidity. There are four important points of context. First, we are not supplying net liquidity to the system – there is no new central bank money. Rather, we are redistributing liquidity by exchanging liquid assets for high-quality, though less-liquid ones. Second, we are substantially over-collateralized to protect our balance sheet. 3 Third, consistent with Canada's relatively strong banking system, our liquidity provision has not been as large as elsewhere. For example, the Bank of Canada is currently providing liquidity equivalent to around 1 per cent of total domestic banking assets. The comparable figures are 4 per cent in Europe, 5 per cent in the United Kingdom and 6 per cent in the United States. Finally, while the provision of extraordinary liquidity by central banks is limiting the damage from the crisis, it has long been apparent that official liquidity, irrespective of size, cannot re-open markets on its own. The Bank's second tool – advocacy – has not received the same profile as the first – a fact I hope to begin to change today. The Bank can promote financial stability by influencing public sector policies and private sector behaviour. We do this in two ways; by leveraging our For example, at the end of November, the Bank had collateral for its term purchase and resale agreements worth 105 per cent of the amount outstanding in term PRAs. position in key domestic and international organizations, and by producing solid analysis and research to ground our advice. Domestically, we work closely with representatives from the Federal Department of Finance, the Office of the Superintendent of Financial Institutions (OSFI), the Canada Deposit Insurance Corporation, and the Financial Consumer Agency of Canada. We meet regularly to share information, coordinate actions, and advise the federal government on financial sector policy. Within this group, the Bank of Canada is the only organization that brings a solely macroprudential perspective to the table – a perspective we intend increasingly to assert. Improving our analysis and sharpening our accountability In recent years, the Bank has made financial stability a strategic priority. Strengthening this priority was one of the primary motivations behind our internal reorganization last month. We now have a department dedicated to financial stability, and we are investing heavily in our research and analysis. We are hiring senior capital markets professionals and drawing on leading academics as special advisers. In addition, the mandate of the Bank's Governing Council has been sharpened to add financial stability assessment to its responsibilities. The deputy governors and I should be held accountable for our analysis; others for whether or not they follow our advice. To be clear, we are not seeking to identify every worthy reform in the financial sector (they are legion). Rather, we will seek to identify stresses in the economy as well as the regulations and practices that have the potential for serious macroeconomic consequences. In doing so, we will want occasionally to change behaviours, conventions and even regulations to mitigate threats. The latest edition of the Bank's Financial System Review (FSR), which was published last week, is a first step. It contains, for the first time, the judgment of the Governing Council as to the main risks to Canadian financial stability. I will return to this shortly. First, I will say a few words regarding an article in the current FSR, which details efforts by Bank staff to construct an early-warning indicator for financial stress in Canada. 4 An early-warning system The Bank of Canada has developed a financial stress indicator, the FSI, which uses a number of domestic variables to measure the degree of financial stress in the economy. 5 As you would expect, the FSI is now showing record levels of stress. It is correlated with how you all probably feel. While this indicator does an excellent job of measuring stress in real time, our objective is to develop empirical measures that could forewarn of potential financial crises. In other words, given that the FSI accurately measures financial stress, what accurately predicts changes in the FSI? It has been clear for some time that rapid growth in credit and sustained growth in asset prices often precede financial crises. Bank researchers have found a promising tool for assessing Canada's vulnerability to crisis: a combination of growth in domestic business credit and real estate prices that tends to be a good predictor of changes to the Bank's financial stress indicator one to two years in the future. However, this combination was unable to predict the current crisis because the root causes came from outside Canada. There is ongoing work at the Bank to refine these tools, which could prove important, not M. Misina, P. St-Amant, and G. Tkacz, "Credit, Asset Prices, and Financial Stress in Canada", Financial System Review (Ottawa: Bank of Canada, December 2008): 29-33. M. Illing and Y. Liu, "An Index of Financial Stress for Canada" (Working Paper No. 2003-14, Bank of Canada, 2003). only for predicting future periods of financial instability and thereby prompting timely corrective actions, but also for the development of countercyclical capital rules that I will discuss in a few minutes. Current risks to stability In the FSR, five major risks to financial stability were identified: first, the liquidity and funding of financial institutions; second, their capital adequacy; third, the state of household balance sheets; fourth, the possibility of a more prolonged downturn in the global economy; and fifth, the threat of a destabilizing unwinding of global financial imbalances. Let me now spend a few minutes discussing the first three of these risks in some detail, although I should stress that these are risks, and not the most likely outcomes. Funding and liquidity The current crisis began in the summer of 2007 as liquidity dried up, leading to major disruptions in money and bond markets. In response, the Bank of Canada provided exceptional liquidity to core financial institutions, with the expectation that this liquidity would cascade through the financial system. This was indeed the case this past spring. With the intensification of the crisis since September, our liquidity efforts have been significantly expanded. While these actions have sharply lowered money market spreads and encouraged some lending at longer maturities, conditions remain far from normal. Bond issuance has been slow to return, which is putting greater pressure on banks as the sole source of lending growth. In tandem, financial institutions have curtailed their central roles as intermediaries and market-makers. This feeds illiquidity and volatility in financial markets and delays the return of confidence in the financial system. This could aggravate the adverse feedback loop between the financial system and the real economy. In essence, we have gone from one extreme – with overabundant liquidity leading to the misallocation of capital – to another – where, in some systemically important markets, capital is barely being allocated at all. The challenge for policy-makers is to provide transition support that effectively restarts rather than replaces markets. As I have argued elsewhere, this may require structural changes to some markets, including the greater use of clearing houses, and a re-thinking of the scale and frequency of central bank liquidity operations. 6 Procyclical capital adequacy The second risk identified in the FSR is the procyclicality of bank capital. Put simply, banks characteristically increase leverage in a boom, further feeding the expansion, before reducing leverage in a downturn, exacerbating the slowdown. Regulation often reinforces these tendencies when it should lean against them. This is now a serious global problem. Banks outside of Canada are under enormous pressure to reduce leverage. Given the scope of likely ultimate losses from structured products alone, it would take an enormous amount of capital to reduce average leverage ratios to Canadian levels. Bank of Canada research estimates that U.S., U.K. and European banks would need to raise a combined US$1.2 trillion to bring their leverage ratios down to Canadian levels. These capital needs will rise linearly with any recession-induced writedowns. In this environment, banks are inclined to hoard capital, rather than deploy it. In a world with guarantees, liquidity and funding support, regulators should not reinforce this tendency. M. Carney, "Building Continuous Markets" (Speech to the Canada-United Kingdom Chamber of Commerce, London, England, 19 November 2008). In Canada, our banks are not facing the same pressures to de-lever as their counterparts abroad. Still, their loan portfolios would experience higher credit losses in a deep or prolonged downturn. The risk identified in the FSR is that market forces could compel banks to maintain higher capital ratios than necessary to guard against the possibility of worse economic outcome. This could lead banks to slow balance sheet growth, which would tighten lending conditions for both households and businesses and weaken the economy. Ultimately, the financial institutions themselves would suffer from this self-fulfilling prophecy. Given these concerns, the Superintendent of Financial Institutions last month took the welcome step of giving Canadian banks more flexibility by allowing them to raise the proportion of preferred shares that comprise their Tier 1 capital from 30 per cent to 40 per cent. The lower absolute leverage of Canadian institutions and the higher quality of their Tier 1 capital should mean that they can expand lending faster than their international peers. The value of this virtually unique advantage of our economy should not be underestimated. The Bank is working with its international counterparts to examine how the current regulatory capital framework may amplify fluctuations in economic and financial conditions. 7 Under current rules, capital requirements are linked to the credit risk in an institution's portfolio. In an upturn, risk goes down, banks are required to hold less capital, and the growth of credit increases. The problem is that this can amplify swings in financial conditions and lead to the emergence of financial imbalances. Recall the link between credit growth and future financial stress that I just mentioned. Then, during the downturn when credit risk increases, banks are required to increase capital holdings, thus exacerbating the economic weakness and financial stress. This is the motivation for proposals to have capital requirements move procyclically. Banks could be required to build up capital buffers during times of rapid credit expansion. This would strengthen their balance sheets and reduce the risk that financial imbalances will develop from overly easy financial conditions. During a downturn, banks could then draw down these buffers, which would reduce the need to liquidate assets or restrict loan growth at a time when credit conditions and asset prices are already under stress. In this way, capital requirements would moderate the ups and downs of the credit cycle – the reverse of what currently happens – reducing the risk of a future crisis. This macroprudential approach to capital requirements is tremendously important, but it is also complex, with a number of practical and logistical concerns. Such a system could be accomplished by linking capital requirements to movements in credit-cycle indicators, such as loan growth and asset prices. For example, our research on the determinants of financial stress that I mentioned a moment ago can help inform the development of such regulatory guidelines. It is probably unrealistic to think that ex ante a perfect formula can be derived. Ultimately, there are important questions regarding the balance of rules and discretion and, regarding the latter, who should exercise that discretion. Household balance sheets The third risk relates to the health of Canadian household balance sheets. Household credit makes up about 60 per cent of the Canadian banking sector's total loan exposure, so losses on household lending would likely have an immediate impact on capital adequacy and forward profitability. The household sector could be an important channel through which global economic weakness affects the Canadian financial sector more widely. While the Canadian household sector remains relatively healthy, its resilience will be tested during the recession. Various indicators of financial stress, such as bankruptcies and loans in See "Recent Proposals for Procyclical Capital Requirements", Financial System Review (Ottawa: Bank of Canada, December 2008): 15. arrears, have increased recently from historically low levels. Falling equity markets and softening house prices have put pressure on household balance sheets at a time when the ratio of debt to income is already at a record high of 140 per cent. The household debt-toasset ratio has risen as the credit crisis intensified, reaching 19 per cent at the end of the third quarter – the highest level since 1990. At the same time, the debt-service ratio of households actually declined modestly to 7.5 per cent, well below the historical average of 9.2 per cent seen since 1992, owing to lower effective borrowing costs. This gives a measure of assurance that most households can comfortably manage their debts. The health of Canadian households is obviously important to our banking sector. If the global economic downturn were significantly more severe than projected, then household defaults in Canada could rise sharply. This risk would be magnified if banks begin to tighten credit conditions to households more significantly than they have so far. In the FSR, we examined these risks using a simulated stress test. Specifically, we examined an extreme scenario where nominal household income drops at an average annual rate of 2 per cent for six straight quarters as a result of global economic weakness. Such an event could double – from 3 per cent to 6 per cent – the proportion of Canadian households considered to be vulnerable; that is, with debt-service ratios above 40 per cent of income. Further, those vulnerable households would own 13 per cent of total household debt, a figure double the average of the past 10 years. If this scenario were to materialize, it would prompt significant losses among Canada's banks. However, it is important not to overplay this scenario, since it actually illustrates the strength of our system. First, the scenario is extreme – the annual growth of household income has not been negative during any quarter over the 37 years for which data are available. Second, while the average Tier 1 capital ratio of our banks would fall from 9.7 per cent to about 8.8 per cent, this figure is still more than two times the minimum ratio allowed under the Basel II Accord, and well above OSFI's 7 per cent threshold. There are a number of reasons why the risk posed by household balance sheets is significantly lower in Canada than elsewhere, not the least of which is Canada's more conservative lending culture. For example, subprime mortgages account for less than 5 per cent of Canadian mortgage lending, roughly one-third the level in the United States. Further, since Canada requires insurance on high-loan-to-value mortgages and Canada Mortgage Bonds carry an explicit sovereign guarantee, there has been no negative feedback loop between the housing market and the financial sector as has been all too apparent in other major economies. While Canada's debt-service ratio remains below its historical average, as I mentioned, the debt-service ratio in the United States remains above its historical average. Further, the absolute cost of household debt in Canada – both mortgage and other loans – has fallen by about 100 basis points since the onset of the crisis last year. Nonetheless, the Bank of Canada will continue to closely monitor the risk posed to financial stability from household balance sheets. In addition, the Bank will closely consider the possibility that households may be more sensitive to shocks to their income or wealth as it develops its outlook for Canadian growth and inflation. Conclusion In times of crisis, it is easy to understand the links between financial stability and the real economy. While these are all too apparent, it is sometimes hard to see the end of the crisis. But end it will. The actions that policy-makers are taking will be effective. The global economy will emerge from this period of weakness. In the years ahead, when times are better, the need to promote financial stability may not be as clear-cut, even though it will be no less important. The Bank of Canada will continue to take a macroprudential approach. We will use all the tools at our disposal to promote financial stability at home and abroad and, in so doing, continue to contribute to the economic and financial welfare of Canada.
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Remarks by Mr Pierre Duguay, Deputy Governor at the Bank of Canada, to the Risk Management Association, Toronto Chapter, Toronto, Ontario, 8 January 2009.
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Pierre Duguay: Financial stability through sound risk management Remarks by Mr Pierre Duguay, Deputy Governor at the Bank of Canada, to the Risk Management Association, Toronto Chapter, Toronto, Ontario, 8 January 2009. * * * It's a pleasure to be here at the beginning of a new year, one that we hope will end on a stronger note than the last year. The extraordinary turmoil of 2007 and 2008 has brought to the fore many issues and challenges, most of which will be with us for some time as we deal with what has become the deepest financial crisis since the 1930s. Policy-makers around the world have taken bold and timely steps to deal with the financial instability and economic crisis, but it will take time for confidence to be restored and for markets to become fully functional again. There are important lessons to be learned from this crisis, lessons that should help us to be better prepared the next time a shock occurs – and even reduce the probability of a large shock by limiting the buildup of financial imbalances in the first place. In that spirit, I'd like to talk about the importance of sound risk management for financial system stability. I will begin by briefly discussing what I mean by financial system stability and why it is important. I will then consider some of the weaknesses that the crisis has exposed in risk-management practices, and suggest possible measures to enhance the management of risk in the future. Finally, I'll look at some of the steps that policy-makers are considering to make the financial system more resilient to shocks, before concluding with a brief discussion of the Canadian economy. The importance of financial system stability Financial system stability is the capacity of the financial system to do its job under a wide range of circumstances. This is critical to the economic well-being of the country, because the financial system provides the channels through which savings become investments, money and financial claims are transferred and settled, and risk is allocated to those most willing and able to bear it. For the financial system to function properly, households and firms must have confidence in it, and investors must know what they are investing in and what risk they are assuming. The current crisis demonstrates what happens when the financial system breaks down. We have seen that investors of all types – even the most sophisticated – did not always know or understand what they were investing in. Their frantic search for yield led many to presume that others knew what they were doing and that risk had been priced appropriately. These investors substituted the judgments of credit-rating agencies and others for their own due diligence. This opened the door to abuses in the creation of increasingly complex and opaque structured products with embedded leverage, and in the origination of loans intended for redistribution. These problems were compounded by a distinct disregard for economic fundamentals, which led many borrowers and lenders to discount the risk of a correction in house prices long after activity in the U.S. housing market had peaked. When the problems finally surfaced, the sudden realization that exposure to defaults was both widespread and difficult to locate led to extreme risk aversion and to a broad loss of confidence that impeded credit expansion and weighed heavily on economic activity. Canada's financial system has fared relatively well throughout this global crisis, thanks to prudent practices and the important steps that we have already taken in Canada to make our system more resilient to shocks. To be sure, our markets have been strained as a result of the global financial crisis but, for the most part, they have remained open. Importantly, banks have continued to extend credit, albeit on tightened terms. Still, the system has not performed as well as it should have. Bank funding costs have come under pressure, and bond issuance has virtually ceased. Further, our economy is now in recession as a result of the weakness in global economic activity engendered by the financial crisis. Risk management: lessons from the current crisis The current global situation has clearly demonstrated the importance of sound risk management. So, let me turn to lessons that we can draw from the crisis to develop more robust risk-management processes in the future. As I noted earlier, a key contributing factor to the global financial crisis was the very high leverage embedded in structured products and actively pursued by some financial institutions – primarily those outside Canada. In their search for higher returns, institutions took on more and more risk, while paying less and less attention to the consequences. Risk-management models (such as estimates of value at risk) that were based on a short history of data and a presumption of continuous liquidity did not prepare them for crisis conditions. Reliance on these models led to a myopic focus within institutions that ignored the risk of a significant disruption to the financial system if everyone reacted to a large shock in the same way. Consequently, when significant problems emerged, and correlations between asset-price movements moved towards unity, institutions were often ill-prepared to cope, because they had not developed effective contingency plans. They did not anticipate the broad consequences of widespread deleveraging, forced asset sales that exacerbated the illiquidity in markets, or the broad loss of confidence that followed. It's now obvious that this inability to anticipate and prepare for extremely bad outcomes posed a significant risk to financial system stability. More robust risk-management practices, grounded in a longer-term, through-the-cycle perspective and appropriately designed stress tests, could have helped to prevent the buildup of leverage that became unsustainable. It has also become clear that riskmanagement models must take into account the collective impact of individual choices. For, without an understanding of this impact, there is a risk that core markets can close, liquidity can dry up, and the type of crisis we are currently enduring could be repeated. The regulator and the central bank can possibly help in this area. By running coordinated macroeconomic stress-test scenarios, they can observe the details of risk-management systems at individual institutions and may identify possible feedbacks that are missing in these systems. They could then disseminate the results of these exercises in a suitably aggregated form among risk managers at individual institutions, to help them internalize these externalities. The crisis has exposed some weaknesses and inconsistencies in the application of fair value accounting methods. First, the reliance on market valuations has the potential to amplify the boom and bust cycle in credit and asset prices, by creating a feedback loop between asset values and lending. Second, the application of fair value methods in illiquid or inactive markets may distort information if the models or observable prices used for valuation are inadequate or inappropriate – a problem that is heightened during periods of market stress, when correlations break down. For example, as the liquidity of many markets became impaired in this crisis, there was considerable uncertainty about how to value certain assets and how to compare financial statements. The Financial Stability Forum (FSF) – which includes senior representatives of national financial authorities from selected countries including Canada, along with international financial institutions and standard setters – has called for improved guidance from standard setters in the use of fair value accounting at times when measurement is challenging, and for improved disclosure by financial institutions. Accounting standard setters have since clarified their position and have proposed increased disclosure standards for the valuation of financial instruments. This is a good first step, considering how essential disclosure of such information is to the efficient functioning of markets and, ultimately, to financial system stability. As the Bank points out in its December Financial System Review, good disclosure can foster a better appreciation of the uncertainty surrounding valuations. This may help avoid the mechanistic use of these valuations. The crisis has also exposed a potential weakness in the new Basel II capital requirements for banks, since these requirements rely on some of the same inadequate risk-management models just described. This topic is also explored in the December Financial System Review. The concern is that the new requirements would encourage higher leverage when times are good, further feeding a booming economy and raising the risk of asset-price bubbles and excessive credit expansion. These requirements would also hasten deleveraging in a downturn, thus exacerbating the slowdown and raising the risk of negative feedback between the real economy and the financial system. Regulation should be designed to counter, not reinforce, the natural tendency to procyclicality. It should encourage institutions to build healthy levels of capital reserves during good times, for use in bad times. This would help institutions to withstand economic crises, in addition to dampening the credit cycle. I'm glad to note that the Basel Committee on Banking Supervision is working on ways to address this issue. Other perspectives on improving financial system resilience I have briefly discussed some of the problems in risk management exposed by the current crisis, as well as the negative implications for financial stability. Let me now turn to some steps that regulators and policy-makers can take to foster greater resilience in the financial system. 1. A macroprudential approach It has become clear that it's time to take a macroprudential approach to financial stability, in terms of both surveillance and regulation. Macroprudential surveillance assesses current risks by looking at the broad economic and financial conditions that can contribute to the buildup of risks to the financial system and to the economy as a whole. Macroprudential regulation aims to strengthen resilience in the financial system by designing standards and codes to limit the buildup of financial and economic imbalances. The Bank of Canada is well-placed to bring a macro perspective to the oversight of the financial system, since our responsibilities for the conduct of monetary policy require a deep knowledge of the economy and the financial system. We intend to leverage our position in key domestic and international organizations to bring that perspective. 1 In terms of surveillance, we are placing increased emphasis on identifying risks and vulnerabilities to the Canadian financial system and on developing a better early warning system. The Bank's Financial System Review was recently revamped with that objective in mind. In terms of regulation, the Bank is drawing attention to the need to mitigate procyclical tendencies within the financial system, to improve transparency, and to keep core financial markets open. In this regard, the central bank has the power to see to it that core markets have continuous access to liquidity by acting as a counterparty to major market participants, if needed, in times of crisis. The principles guiding the Bank's use of that power were discussed in the June 2008 issue of the Financial System Review. 2. Continuously open markets and risk-proofed infrastructure Other measures can contribute to continuously open and resilient markets. For example, efforts outside Canada to create a clearing house for credit default swaps (CDS) have the M. Carney, "From Hindsight to Foresight" (Speech to Women in Capital Markets, Toronto, Ontario, 17 December 2008). potential to reduce counterparty risk and to help keep this market open in stressful times. A clearing house offers the advantages of robust operational arrangements and clear workout procedures in the event of a default. Without underestimating the complexities that this would involve, policy-makers could look for other markets that could benefit from being moved onto exchanges or into clearing houses. They could encourage such moves by establishing higher capital requirements for securities that trade outside of continuously open markets and by working to further risk-proof custodial banks. Recent events have demonstrated the value of well risk-proofed clearing and settlement systems. For example, the use of CLS Bank to settle foreign exchange transactions was a stabilizing factor, especially during the working out of the Lehman Brothers bankruptcy. By providing simultaneous settlement of both transaction legs (payment-versus-payment), CLS Bank virtually eliminates the credit-risk component of foreign exchange transactions. Yet Canadian institutions use CLS Bank relatively less than their international counterparts. This is partly because CLS Bank doesn't currently allow for settlement of same-day, bilateral Canadian-U.S. dollar transactions. Nonetheless, there would be benefits from a greater use of CLS Bank by Canadian institutions. The Bank of Canada encourages them to consider using CLS Bank for managing their foreign exchange settlement risk, while bearing in mind that other risks associated with foreign exchange transactions not addressed by CLS Bank must also be managed. 3. Improved transparency We must also do much more to encourage improved transparency and disclosure, particularly for complex financial instruments. The opacity of many highly structured products contributed importantly to the turmoil. Progress has been made in encouraging greater transparency. The FSF has provided a template for the disclosure of banks' exposures to these products. Closer to home, the Bank of Canada has set out disclosure requirements, available to all investors, for asset-backed commercial paper that it would be prepared to accept as collateral. But those steps must be taken further. Investors require relevant and digestible information tailored to their particular level of sophistication. Here, credit-rating agencies have a very important role. So do institutions that distribute financial products – they have a responsibility to know their clients and to supply them with products and advice consistent with their clients' investment goals, risk appetite, and investment knowledge. The International Organization of Securities Commissions (IOSCO) has launched a task force to address gaps highlighted during the crisis, by developing new standards designed to strengthen financial markets and protect investors. Domestically, the Investment Industry Regulatory Organization of Canada (IIROC) has made several recommendations related to product due diligence, focusing on product transparency, management of conflicts of interest, and dealer use and disclosure of credit ratings. 4. Work with global partners At the international level, the Bank of Canada is working with its global partners to strengthen financial stability. It is contributing to FSF work on procyclicality issues related to bank capital, loan-loss provisioning, and margin requirements. Canada is also actively engaged with its G-20 counterparts and is directly involved in several working groups considering potential regulatory improvements in a broad range of areas. These include: strengthening transparency and disclosure; reinforcing international co-operation in the management and resolution of cross-border crises; promoting integrity in financial markets; assessing measures to mitigate procyclicality; and improving risk-management practices. The activities of the working groups will culminate in action plans for the next summit of G-20 leaders in April. At the outset of these remarks, I discussed the importance of sound risk management for financial system stability. Many lessons have been learned from the current crisis, and we can foster a more robust and more stable financial system through improvements in the critical areas that I have just outlined. The benefits of such stability would be felt throughout the Canadian economy. The Canadian economy Let me close with some remarks about the Canadian economy. As we noted in our December policy announcement, the outlook for the world economy has deteriorated significantly since October. The global recession will be broader and deeper than previously anticipated. Global financial markets remain severely strained. Measures taken by major governments are beginning to encourage credit flows, although it will take more time before conditions in those markets normalize. In addition, monetary and fiscal policy actions announced late in 2008 are expected to support global economic growth. Nonetheless, the Canadian economy is entering a recession as a result of the weakness in global economic activity, the associated decline in our terms of trade, and the drop in household and business confidence. The depreciation of the Canadian dollar is providing an important offset to the effects of weaker global demand and lower commodity prices, and the monetary policy actions taken in October and December (a 150-basis-point reduction in the policy interest rate) will provide timely and significant support to the Canadian economy. As we prepare for the next interest rate announcement on 20 January, and the Update to the Bank's Monetary Policy Report two days later, we will continue to monitor carefully economic and financial developments in judging to what extent further monetary stimulus will be required to achieve the 2 per cent inflation target over the medium term. Conclusion In conclusion, let me stress again the importance of sound risk management for financial system stability. Risk cannot be avoided; it must be anticipated and managed. The current crisis has exposed serious flaws in prevailing risk-management models and showed ways to enhance our ability to manage risk. Policy-makers are also considering steps to make the financial system more resilient so that we may be better prepared for the next storm. Thank you for your attention. I'd now be pleased to take your questions.
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Opening statement by Mr Mark Carney, Governor of the Bank of Canada, at a press conference following the release of the Monetary Policy Report Update, Ottawa, 22 January 2009.
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Mark Carney: Summary of the latest Monetary Policy Report Update Opening statement by Mr Mark Carney, Governor of the Bank of Canada, at a press conference following the release of the Monetary Policy Report Update, Ottawa, 22 January 2009. * * * Good morning. We are pleased to be here with you today to discuss the January Monetary Policy Report Update, which we published this morning. The outlook for the global economy has deteriorated since the October Monetary Policy Report, with the intensifying financial crisis spilling over into real economic activity. Heightened uncertainty is undermining business and household confidence worldwide and further eroding domestic demand. Major advanced economies, including Canada's, are now in recession, and emerging-market economies are increasingly affected. Commodity prices – especially energy prices – have fallen as a result of substantially weaker global demand. Stabilization of the global financial system is a precondition for economic recovery. To that end, governments and central banks are taking bold and concerted policy actions. There are signs that these extraordinary measures are starting to gain traction, although it will take some time for financial conditions to normalize. In addition, considerable monetary and fiscal policy stimulus is being provided worldwide. Canadian exports are down sharply, and domestic demand is shrinking as a result of declines in real income, household wealth, and confidence. Canada's economy is projected to contract through mid-2009, with real GDP dropping by 1.2 per cent this year on an annual average basis. As policy actions begin to take hold in Canada and globally, and with support from the past depreciation of the Canadian dollar, real GDP is expected to rebound, growing by 3.8 per cent in 2010. A wider output gap through 2009 and modest decreases in housing prices should cause core CPI inflation to ease, bottoming at 1.1 per cent in the fourth quarter. Total CPI inflation is expected to dip below zero for two quarters in 2009, reflecting year-on-year drops in energy prices. With inflation expectations well-anchored, total and core inflation should return to the 2 per cent target in the first half of 2011 as the economy returns to potential. Global developments pose significant upside and downside risks to the inflation projection. On the upside, the global economy could be stronger, if global fiscal stimulus turns out to be more expansionary than expected, or if aggressive policy actions taken across major economies restore confidence more quickly than projected. On the downside, the global recession could be deeper and more protracted because financial conditions take longer to normalize. The Bank judges that these risks are roughly balanced. Against this background, the Bank lowered its policy rate by 50 basis points on Tuesday to 1 per cent, bringing the cumulative monetary policy easing to 350 basis points since December 2007. Guided by Canada's inflation-targeting framework, we will continue to monitor carefully economic and financial developments in judging to what extent further monetary stimulus will be required to achieve the 2 per cent target over the medium term. Low, stable, and predictable inflation is the best contribution monetary policy can make to long-term economic growth and financial stability.
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Remarks by Mr Mark Carney, Governor of the Bank of Canada, to the Halifax Chamber of Commerce, Halifax, Nova Scotia, 27 January 2009.
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Mark Carney: Inflation targeting in a global recession Remarks by Mr Mark Carney, Governor of the Bank of Canada, to the Halifax Chamber of Commerce, Halifax, Nova Scotia, 27 January 2009. * * * It's always a pleasure to be in Halifax, a city steeped in history and rich in spirit – a spirit that this Chamber has embodied for centuries, with roots dating back to 1750. Indeed, I am always struck when I come here by how successfully this city celebrates its past, even as it prepares for the future. This dynamism is recognized in the nominees for this year's Halifax Business Awards in the current issue of "Business Voice." I am honoured to be part of your "Distinguished Speakers Series," although my colleagues tell me that "distinguished" is just something people call you when you reach a certain age. I have certainly aged since I became Governor, but I will gratefully accept anything that could be interpreted as a compliment. In these challenging times, you take what you can get. These are challenging times, indeed. We are facing a financial crisis without comparison for generations. Most financial markets have experienced historic declines in prices and unprecedented spikes in volatility. Storied financial institutions have fallen. The global capital market is under great strain. Issues of financial stability that were once the obsession of a pessimistic few are now the daily concern of many. In response, governments and central bankers have taken bold measures. More initiatives are likely in the coming weeks. These measures will work, although it will take time for confidence to return and for capital to flow once again. In the interim, the sudden, synchronized slowdown across the globe will mean lost jobs and foregone output. This global recession has lessened concerns about rising inflation – concerns that seemed all too real just a few months ago, with soaring prices of fuel, food, and other commodities. In some countries, though, these have given way to concerns that the opposite problem – deflation – might materialize. In challenging times such as these, people, rightly, look to a few constants: to institutions they can rely upon and to certain expectations that will be met. My message today is that Canadians can rely on the Bank of Canada to fulfill its mandate; they can expect inflation to be low, stable and predictable. The relentless focus of monetary policy on inflation control is essential in this time of financial crisis and global recession and remains the best contribution that monetary policy can make to the economic and financial welfare of Canada. Inflation, disinflation, and deflation Inflation is, of course, defined as a persistent increase in the average price of goods and services; in other words, a rising trend in the cost of living. In the broadest terms, this is measured by the total, or headline, consumer price index (CPI), which tracks the retail prices of a representative "shopping basket" of goods and services over time. It is also the rate that the Bank of Canada targets for its monetary policy. Disinflation occurs when there is a decline in the rate of increase in prices, while deflation refers to a sustained fall in prices; where the annual change in the CPI actually turns negative year after year. Those of you "distinguished" enough to remember the inflation of the 1970s and 1980s may wonder why anyone – particularly a central banker – might be concerned with too low a level of inflation or even a fall in the general price level. The answer is that we are not concerned if these periods are transitory. In fact, as I will discuss in a moment, the Bank expects total CPI inflation to be below zero in the second and third quarters of this year before returning to the two per cent target by 2011. While such transitory movements in prices are generally harmless over the long term, greater risks arise from a sustained fall in prices. Such deflation, if left unchecked, can weigh on economic activity in two main ways. First, it increases the real burden of debt, making it more difficult for indebted households to consume and leveraged firms to invest. Second, if deflationary expectations take hold, purchases and investments may be postponed in the expectation that they can be executed at a lower price at a later date. After all, if prices are falling, why buy that new car or refrigerator – or invest in technology or equipment – when they could be cheaper in six or nine month's time? A mild deflation took hold in Japan in the 1990s and was associated with a lost decade of missed economic opportunity. Today in the United States, the economy is in the midst of a serious recession and, with the recent dip in U.S. total CPI inflation to below zero, concerns about the possibility of deflation there have increased. Recognizing the risks, the Federal Reserve is responding proactively and presciently – cutting interest rates effectively to zero and committing to using "all available tools" to maintain price stability. With this backdrop, the question is being asked whether sustained deflation could happen here in Canada. The possibility is actually remote for three reasons. First is the resilience of our economy. The Canadian economy has a number of advantages: labour, product, and capital markets that are flexible and open; one of the soundest banking systems in the world; and households, corporations, and a public sector that have considerable financial flexibility. So while our economy will be tested by the current global crisis, it is well positioned to respond. Second, a floating currency means that we have an independent monetary policy. Quite simply, we are in control of our own monetary destiny. Third, we have used that monetary independence to great advantage. As one of the pioneers of inflation targeting, Canada has deep experience with the clearest, most powerful monetary policy framework. The advantages of that framework have been demonstrated, with inflation brought down and kept low and stable since the early 1990s, and they are equally relevant in times of disinflationary pressures. To underscore this point, and before turning to the outlook for growth and inflation, let me review the Bank's monetary policy framework. Inflation targeting In its simplest terms, monetary policy is concerned with how much money circulates in the economy, and what that money is worth. The single, most direct contribution that monetary policy can make to sound economic performance is to provide Canadians with confidence that their money will retain its purchasing power. That means keeping inflation low, stable and predictable. Monetary policy makers have learned over decades that it pays to be precise about this objective. The cornerstone of the Bank's monetary policy framework, therefore, is its inflation target which since 1991 has been set jointly with the Government of Canada. The target aims to keep the annual rate of inflation, as measured by the CPI, close to 2 per cent – the midpoint in a range of between 1 and 3 per cent. The agreement sets out one clear objective – the inflation target – and the Bank is accountable to Canadians through its open and transparent communication of success in achieving that objective. If inflation deviates from the target, the Bank will explain the reasons why, what it will do to return it to target, and how long the process is expected to take. Our Monetary Policy Report Update, released last Thursday, is an example of that communication. Canada has been served extremely well by its inflation-targeting policy framework, which has been widely emulated. Since the targets were initiated, the rate of inflation, as measured by the CPI, has averaged very close to 2 per cent. The Bank's exemplary record of inflation control has meant that we have avoided the destructive effects of high inflation prevalent in earlier decades – effects that were disproportionately felt by poorer Canadians, and that reduced our living standards and increased our unemployment. As in other countries where inflation targeting has been adopted, inflation and interest rates have generally been lower and less volatile. It is important to underline that the Bank approaches inflation control in a symmetric way. This means that we care as much about inflation below the target as about inflation above the target. Just as inflation targeting has proven its ability to prevent the entrenchment of high and volatile inflation, it also has the power to prevent the onset of persistent deflation. Expectations and the 2 per cent target When a shock threatens to push inflation either above or below the target range, the Bank of Canada will act to bring inflation back to the 2 per cent target. This certainty – that the Bank will act – helps to keep expectations of future inflation close to the inflation target. Economists call this "anchoring inflation expectations," and it brings a number of benefits: it helps to reduce swings in interest rates, lowers the cost of borrowing for Canadians, contributes to a more stable, competitive cost of capital for our companies and, ultimately, supports more sustainable growth in output and employment. What matters most for economic decisions is the real interest rate, which is the nominal rate less the expected inflation rate over the relevant time horizon. Importantly, provided medium term inflation expectations remain well-anchored around the 2 per cent target, the Bank can keep real interest rates low even in the face of temporarily falling prices. One of the realities of monetary policy is that it takes time to take effect. For this reason, it must be forward looking. To do that, we use a number of indicators to determine how serious and long-lasting inflation (and disinflationary) pressures might be. Much as we aim for low, stable, and predictable inflation, there will always be sharp movements in total or headline inflation. These are generally driven by volatile price changes in a small number of goods and services. In Canada, for example, fully 90 per cent of the monthly variations in the CPI are linked to price changes in just 8 of the 54 major goods and services categories included in the index. Further, these price changes are often quickly reversed and can add considerable "noise" to total CPI, making it difficult to discern genuine movements in trend inflation. For this reason, the Bank uses core inflation as an operational guide. By focusing on the more stable components, the Bank can get a better fix on the underlying trend in inflation. This is important because monetary policy operates with long and variable lags, and any attempt to control short-term movements in inflation is likely to prove counterproductive, destabilizing both inflation and real economic activity. Our experience in Canada has shown that core inflation is a better tool for discerning inflation trends than is total CPI. Indeed, when the two deviate, total CPI inflation tends to converge on core inflation rather than the reverse. When total inflation temporarily moves higher or lower than the target, households and businesses know that it will probably return to target within a relatively short time. The present situation offers a compelling example. When there is a sudden and persistent shock, as we have seen in the past few months from outside our borders, the immediate effects may be felt before the full effect of the monetary policy response kicks in. However, these monetary actions will have an impact on economic output and will bring inflation back to the target. Current outlook With this background, let me turn now to the current economic climate and its implications for inflation. The outlook for the world economy has deteriorated significantly in recent months. The financial crisis intensified last autumn and spilled over into an already weak global economy. This, in turn, put further strains on the global financial system, increased uncertainty and sharply reduced the confidence of businesses. The major advanced economies, including Canada, are now in recession, and emerging-market countries are increasingly affected. In response to the sudden downturn in global demand, energy prices have fallen further, and global inflationary pressures have abated rapidly. Stabilization of the global financial system is a precondition for economic recovery. To that end, governments and central banks are taking bold and concerted actions. There are signs that these extraordinary measures are starting to gain traction, although more will be required and it will take some time for financial conditions to return to normal. In addition, considerable monetary and fiscal policy stimulus is being provided worldwide. As a result of these global developments, Canada's economic growth is expected to decline through mid-2009. Canadian exports are already falling sharply because of the downturn in external demand, especially from the United States. Here at home, demand is also declining as Canadians households experience a reduction in their net worth. This reflects lower commodity prices, as well as steep declines in consumer and business confidence. That said, the Canadian economy is expected to begin recovering later this year and to accelerate to above-potential growth in 2010 as policy actions begin to take hold and with support from the past depreciation of the Canadian dollar. On an annual average basis, then, real GDP is projected to decline by 1.2 per cent in 2009 and to rebound by 3.8 per cent in 2010. What does this mean for inflation? It means that we should expect a temporary divergence between headline and core inflation in the coming quarters. Reflecting the sharp year-onyear falls in energy prices (and assuming that energy prices follow recent prices in the oil futures markets), total CPI inflation should fall relatively abruptly, dipping below zero in the second and third quarters of 2009. I want to emphasize that this projected brief period of falling prices does not signal the onset of deflation for four reasons. First, most prices will not, in fact, be falling. At present, the prices of more than half the goods in the CPI basket are actually rising at more than the 2 per cent target. Second, while core CPI inflation in Canada should ease through 2009, its anticipated low should be 1.1 per cent in the fourth quarter of this year – still within the target range for total CPI. Third, consistent with the past experience that I referred to earlier, and reflecting the accommodative stance of monetary policy, we expect total CPI inflation to begin to converge towards core, starting at the end of this year, reaching 2 per cent by mid 2011. Fourth, we should again see the benefit of well-anchored inflation expectations in helping to return actual inflation to the target. While measures of near-term inflation expectations have been volatile recently, reflecting the sharp swings in energy prices, over the longer term, they remain well anchored at 2 per cent. Indeed, the Consensus Economics' forecast for total CPI inflation in 2009 fell to 0.7 per cent in January, but moves back up to 1.9 per cent for 2010. Consensus expectations farther out remain at 2 per cent. This pattern in near- and medium-term inflation expectations is very similar to what we saw during the sharp commodity-price spike last spring. At that time, short-term expectations moved up sharply while medium term expectations remained anchored at 2 per cent. These expectations proved to be well justified as total inflation fell back into line with core inflation. The ongoing effectiveness of monetary policy The Bank's projection of an economic recovery reflects, in part, the monetary easing that we have already put in place – cutting the policy rate by 350 basis points since December 2007. Guided by its forward-looking framework, the Bank began cutting interest rates sooner – and has cut deeper – than most other central banks. With the usual lag, these moves will have a powerful impact on economic activity and inflation. Nonetheless, some are questioning, with rates already so low and global credit markets strained, whether the Bank's moves can still have an effect. We know from experience that inflation control works much more predictably when there are well-functioning financial markets operating within a sound and stable financial system. The Canadian system has been under some strain since the onset of global difficulties, but it is important to keep those strains in perspective. It bears repeating that the Canadian banking system does not face the same challenges as those in other major economies. Canadian banks had modest exposures to the U.S. subprime market and other complex structured products. More importantly, our banks are better capitalized and substantially less leveraged than their international peers. In contrast to many international banks, which face enormous pressures to scale back their assets and liabilities to bring them into line with their capital, Canadian banks have actually been raising private capital to grow their businesses. Indeed, over the past year, they have raised over $15 billion in Tier 1 capital from the private capital markets. Consequently, Canadian banks continue to lend. This is significant, because banks are a more important part of our financial system than in many other countries, and their relative strength means that total credit is continuing to grow in Canada. That said, we expect this credit growth to slow in the coming months as result of declining demand during the recession. It is worth noting that our lower overnight rates have largely been passed through at shorter maturities. Since the easing cycle began in December 2007, we have lowered the overnight rate by 350 basis points. The prime rate has fallen by 325 basis points, Bankers Acceptance rates (key short-term financing instruments for corporations) have fallen by about 380 basis points, and variable rate mortgages by about 185 basis points. At longer maturities, the declines have been more modest. In part, this reflects the typical pattern, as long-term rates tend to be less volatile than short-term rates over the business cycle. For example, five-year fixed-rate mortgages have fallen by just over one and a half percentage points. Corporate bond yields have been virtually flat, as a substantial increase in the risk premium charged by investors has offset the decline in government bond yields. While the widening of spreads at longer maturities is larger than usual, this partly reflects the fact that these spreads were unusually narrow to begin with. The Bank has taken into consideration the higher risk premiums demanded in today's markets in setting its overnight rate. As well, it has taken into account the effect on future Canadian inflation of the lower level of foreign demand that has resulted, in part, from financial difficulties in other countries. The policy rate is lower than it otherwise would be in the absence of these difficulties. Finally, the role of the exchange rate in monetary policy should not be overlooked. The substantial past depreciation of the Canadian dollar provides an important offset to weaker global demand and lower commodity prices. Conclusion To conclude, let me say that the inflation target that has served Canada so well when inflation was above the 1 to 3 per cent control range, will also serve it well when inflation falls temporarily below that range. So let me leave no doubt, no uncertainty about the Bank's commitment. Our focus is clear, our actions consistent, and our objective explicit: 2 per cent CPI inflation. Guided by Canada's inflation-targeting framework, the Bank will continue to monitor carefully economic and financial developments in judging to what extent further monetary stimulus will be required to achieve the 2 per cent target over the medium term. The Bank retains considerable policy flexibility, which we will use as required. While the current financial crisis presents challenges for policy-makers and citizens alike, Canada faces those challenges from a position of strength. In time, the global financial crisis will end, and the global economy will recover, although the speed with which this will happen is subject to a high degree of uncertainty. As we work through this difficult period, you can be assured that the Bank of Canada remains relentless in its focus on keeping inflation low, stable, and predictable – the most important contribution we can make to the economic and financial welfare of Canada.
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Opening statement by Mr Mark Carney, Governor of the Bank of Canada, to the House of Commons Standing Committee on Finance, Ottawa, 10 February 2009.
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Mark Carney: Bank of Canada’s perspective on the current state of the domestic and global economies Opening statement by Mr Mark Carney, Governor of the Bank of Canada, to the House of Commons Standing Committee on Finance, Ottawa, 10 February 2009. * * * Good morning. Paul and I are pleased to appear before this committee to discuss the Bank of Canada's perspective on the current state of the domestic and global economies. Let me state at the outset that the speed and synchronized nature of the recent global downturn has resulted in a heightened degree of uncertainty, which is evident in the diverse views on the outlook. Indeed, it is safe to say that the degree of uncertainty – the range of possible outcomes – is greater than the range of point forecasts. It is in this environment that considerable policy actions are being taken globally: the provision of liquidity to stabilize global financial markets, the write-down of assets and the re-capitalization of institutions, and macroeconomic policy measures to boost aggregate demand. A considered and coherent perspective on the likely success of these policies importantly shapes our view of the outlook for the global and Canadian economies. Global outlook – sudden, synchronized, and deep recession The outlook for the global economy has deteriorated significantly in recent months. What began last autumn as a relatively controlled slowdown has become a sudden, synchronized, and deep global recession. The proximate cause was the intensification of the global financial crisis owing to both the failures of several prominent global financial institutions and the growing realization that this was a solvency crisis rather than a liquidity crisis. The recession that originated in the United States is now spreading globally through confidence, financial, and trade channels. In the process, the inevitable correction of unsustainably large current account imbalances in several major economies is now under way. For example, we project that the U.S. current account deficit will narrow to 3 per cent of GDP in 2009, about half its size in 2006. The sustainable rebalancing of global domestic demand from deficit countries such as the United States and the United Kingdom towards surplus countries such as China and Germany will take some time and is likely to dampen the pace of global growth during that period. In the Bank's January Monetary Policy Report Update, we projected that global economic growth will be tepid this year – just 1.1 per cent – before rebounding mildly to a below-trend rate of 3.7 per cent in 2010. As part of that projection, we expect that the eventual U.S. recovery will be much slower than usual. For example, we project that it will take two and half years from the onset of the recession for U.S. GDP to return to its pre-recession level. This sluggishness reflects the lingering effects of the crisis on the U.S. financial system and the slow recovery of domestic consumption owing to the magnitude of wealth effects and the deterioration in the labour market. Reflecting the seriousness of the shock, the global macroeconomic policy response has been unprecedented. In the wake of the intensification of the crisis, monetary policy rates have been substantially and rapidly reduced in most major economies. Fiscal policy initiatives have also been robust, with the world well on its way to spending an average of more than 2 per cent of global GDP in discretionary fiscal measures. These measures will replace some of the lost private demand and – equally importantly – create a window for the necessary rebalancing of global growth. Simultaneous fiscal action is not only more powerful than measures taken in isolation, but also has the potential to provide some support for commodity prices. Given typical lags, the effects of these monetary and fiscal policies will be felt increasingly over the course of this year and 2010. Canadian outlook – sharp recession and milder-than-usual recovery The global downturn and declining demand for our exports will make this a very difficult year for Canada's economy. We are now in recession with GDP projected to fall by 1.2 per cent this year. The first half of the year will be particularly challenging with sharp falls in activity and increases in unemployment. Unfortunately, last Friday's employment report is broadly consistent with our outlook. The 14 per cent drop in our terms of trade since July will translate into a significant reduction in Canadian incomes and thus in our ability to sustain real domestic spending in the economy. Losses by Canadians on their financial holdings, either directly or via their pension funds, and concerns about the employment outlook will also restrain domestic consumption this year. Uncertainty about the economic outlook and strained financial conditions should lead to declines in investment spending this year. In our base-case projection, real GDP is expected to rebound in 2010, growing by 3.8 per cent. Though seemingly impressive when viewed from the depths of a recession, such a recovery is actually more muted than usual. The recovery should be supported by: • the timeliness and scale of our monetary policy response; • our relatively well-functioning financial system and the gradual improvements in financial conditions in Canada next year; • the past depreciation of the Canadian dollar; • stimulative fiscal policy measures; • the rebound in external demand in 2010, particularly in emerging markets, and the associated firming of commodity prices; • the strengths of Canadian household, business, and bank balance sheets; and • the end of the stock adjustments in Canadian and U.S. residential housing. A wider output gap and modest decreases in housing prices should cause core CPI inflation to ease through 2009, bottoming out at 1.1 per cent in the fourth quarter. Total CPI inflation is expected to dip below zero for two quarters in 2009, reflecting year-on-year drops in energy prices. The Bank views the possibility of deflation in Canada as remote. Indeed, with inflation expectations well anchored, total and core inflation should return to the 2 per cent target in the first half of 2011 as the economy moves back to its production potential. Of course, global developments pose significant upside and downside risks to the inflation projection. The Bank judges that these risks are roughly balanced. Uncertainty and the need for policy action As I noted at the outset, in the current environment the Bank's projections – and those of all forecasters – are subject to an unusually high degree of uncertainty. As we have consistently emphasized, stabilization of the global financial system is a precondition for economic recovery globally and in Canada. To that end, throughout the world, policy-makers have acted aggressively and creatively. Central banks have provided unprecedented liquidity to keep the financial system functioning. Last October, extraordinary steps were taken by all G-7 countries to prevent systemic collapse and to promote the effective functioning of money and credit markets. The task is far from complete. Decisions taken in the coming weeks in the United States and in other major economies to isolate toxic assets in order to create a core of "good" banks will be critical. In addition, G-20 countries need to act in concert to improve domestic and international regulatory frameworks. In this regard, measures to improve transparency and integrity, to implement a macro-prudential approach to regulation, and to adequately resource the IMF are vital. If these national and multilateral measures are not timely, bold, and well-executed, Canada's economic recovery will be both attenuated and delayed. The reality is that the financial crisis and subsequent recession originated beyond our borders and the necessary triggers for a sustainable recovery must be found there as well. Canada has much to offer to these efforts, which is why the Bank is working closely and tirelessly with our international colleagues. At home, the Bank has acted decisively. We have eased monetary policy by 350 basis points since December 2007, including 250 basis points since the start of October. In doing so, we cut rates deeper and sooner than most other major central banks. With the strains in our financial system considerably less than elsewhere, monetary conditions have eased significantly in Canada since the start of the crisis. In fact, we are entering this recession with negative real interest rates – an unprecedented situation. In time, this will have a powerful impact on economic activity and inflation. Guided by Canada's inflation-targeting framework, we will continue to monitor carefully economic and financial developments in judging to what extent further monetary stimulus will be required to achieve the 2 per cent target over the medium term. The Bank retains considerable policy flexibility, which we will use if required. In challenging times such as these, people, rightly, look to a few constants: to institutions that they can rely upon and to certain expectations that will be met. Canadians can rely on the Bank of Canada to fulfill its mandate; they can expect inflation to be low, stable, and predictable. The relentless focus of monetary policy on inflation control is essential in this time of financial crisis and global recession and remains the best contribution that monetary policy can make to the economic and financial welfare of Canada.
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Opening statement by Mr Pierre Duguay, Deputy Governor of the Bank of Canada, to the House of Commons Standing Committee on Finance, Ottawa, 5 March 2009.
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Pierre Duguay: Bank of Canada’s perspective on the stability of the Canadian financial system Opening statement by Mr Pierre Duguay, Deputy Governor of the Bank of Canada, to the House of Commons Standing Committee on Finance, Ottawa, 5 March 2009. * * * Good morning. Thank you for inviting me here to discuss the Bank of Canada’s perspective on the stability of the Canadian financial system. As we have consistently emphasized, stabilization of the global financial system is a precondition for economic recovery, both globally and in Canada. To that end, policymakers around the globe have acted aggressively and creatively by initiating a series of unprecedented actions aimed at stabilizing the global financial system. Central banks throughout the world, including the Bank of Canada, have provided unprecedented liquidity to keep the financial system functioning. Because the crisis we are facing is global in nature and began outside our borders, most solutions must be found at the international level. We are taking part in discussions with our international colleagues on ways to strengthen financial stability globally. I would note that there has been a great deal of interest worldwide in the resilience of Canada’s financial institutions in the face of the global economic crisis. Unlike their counterparts in other major economies, Canadian banks have not been materially affected by the financial crisis. They have managed to raise capital during this troubled period to support continued lending and to make up for some of the decline in the demand for securitized products as well as the exit of non-bank lenders which had relied on securitization for financing their activities. In contrast, banks in most other major economies have suffered significant losses and have required significant capital injections from their governments. Thus, Canada has maintained much healthier credit conditions since the onset of this global recession than have been seen in other major countries. Still, the Canadian financial sector has felt the effects of the global turmoil which has increased funding needs while at the same time raising the costs and the uncertainty of term funding. In response, the Bank of Canada has made significant efforts to support liquidity in financial markets. Our actions aimed at stabilizing the Canadian financial system since the global crisis began 18 months ago have been unprecedented and significant. The Bank of Canada has moved aggressively by expanding the provision of term purchase and resale agreements (PRAs) to a total of $41 billion at its peak in December, and $35 billion currently. Term PRAs provide liquidity to key market participants for terms of up to three months against a wide range of securities. The Bank has widened the range of assets that it will accept in these operations and has extended the range of counterparties with whom it will transact. We also introduced a new Term-Loan Facility for those financial institutions that participate directly in the Large Value Transfer System, taking their non-mortgage loan portfolios as collateral. Last week, the Bank announced a new term PRA facility for private sector instruments that expands on the private sector term PRA facility that we set up last autumn for money market instruments. The facility is opened to a broader range of participants, against a broader range of eligible securities, and it is available for a longer term and at a lower minimum bid rate. The liquidity from this new facility should provide indirect support to credit growth in Canada by improving secondary-market liquidity and increasing demand for corporate securities. I would like to point out that these facilities have been financed, not by expanding the supply of central bank money to the financial system, but rather through the sale of treasury bills, either from the Bank’s own portfolio or from new issues whose proceeds are in turn held on deposit at the Bank of Canada. I would also note that, on a consolidated basis, the Government of Canada earns net income from these operations, represented by the spread between the yield on our own term PRAs and by the yield on treasury bills. Furthermore, there is little risk to the taxpayer in these operations, as we require participants to pledge a greater amount of collateral than the amount of money borrowed. These liquidity operations have resulted in a significant reduction in spreads at the short end of the market. CDOR-OIS spreads have narrowed substantially since last fall, when conditions were extremely negative. Improvements are especially notable at shorter maturities (such as 1-month) and are largely attributable to the liquidity facilities that have been put in place. Spreads at 3 months which peaked at about 125 basis points in Canada, are now close to more normal levels; that is, about 25 basis points. While the Bank of Canada’s liquidity operations are focused on short-term financing, the Government of Canada has introduced measures aimed at supporting long-term financing for businesses and consumers. Let me highlight two. One is the Insured Mortgage Purchase Program, which allows financial institutions to fund new financing by selling pools of insured residential mortgages to CMHC; another is the Canadian Secured Credit Facility under which the Business Development Bank of Canada will buy term asset-backed securities backed by loans and leases on vehicles and equipment. All of these measures are helping to meet a rising demand from business and individuals who have been finding it difficult in this environment to raise adequate funds. We have all heard reports about ongoing tightening in both the availability and the pricing of credit. Nonetheless, our latest figures show continued strong growth in total household credit – 9.6 per cent in January compared with the same period one year earlier – and limited deceleration in growth of total business credit. The latter stood at 4.2 per cent in January compared with the same period one year earlier as accelerating growth in bank lending has helped to offset a contraction in market financing. We will continue to closely monitor credit growth and credit conditions in Canada. In conclusion, as we are all very well aware, the Canadian economy is feeling the effects of the global turmoil and recession. Authorities have put a lot of fiscal and monetary stimulus in place – in Canada and globally – to support the recovery. However, as I noted at the outset, stabilization of the global financial system remains a precondition for the global and Canadian economic recoveries. Investor and public confidence has been badly shaken, but will recover with the timely implementation of ambitious plans in some major countries to address toxic assets and to recapitalize financial institutions. However, if these national and multilateral measures are not timely, bold, and well-executed, Canada’s economic recovery will be both attenuated and delayed. I would now be pleased to answer your questions.
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Remarks by Mr David Longworth, Deputy Governor of the Bank of Canada, to the Financial Markets Association of Canada, Toronto, Ontario, 12 March 2009.
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David Longworth: Financial system policy responses to the crisis Remarks by Mr David Longworth, Deputy Governor of the Bank of Canada, to the Financial Markets Association of Canada, Toronto, Ontario, 12 March 2009. The original speech, which contains various links to the documents mentioned, can be found on the Bank of Canada’s website. * * * Good afternoon. It's a pleasure to be here. With your professional interests in foreign exchange, money markets, capital markets, and derivatives, I'm sure the past year and a half has been exciting and interesting – if those are the right words. We've been living through a period of astonishing financial turbulence, historic marketplace losses, and serious threats to financial stability. The real economy is being affected by this financial turmoil, and Canada is now in the second quarter of a painful recession. As a result of the crisis, financial decisions are more difficult. Investment plans have been scaled back. And confidence has fallen. I think it fair to say that confidence will return when people have the sense that policy-makers have not only put into place appropriate policies to mitigate the effects of the recession, but have also implemented sound policies to stabilize the global financial system and to promote long-term stability and growth. In Canada and other major economies, central banks have lowered policy interest rates aggressively, and governments have announced sizable fiscal stimulus packages. The effects of these actions will begin to be felt in the second half of this year and will build through 2010. But to ensure our long-term economic well-being, financial and credit markets need to return to good health and stay in good health. To that end, we need policies that promote a stable, efficient, and sustainable financial system. That is what I would like to discuss today. Specifically, I'd like to talk about two different kinds of financial system policy: one that has changed in response to the extraordinary events of the past year and a half, and one that needs to change to enhance the stability of the financial system. First I'll describe how the Bank of Canada has changed its liquidity policies and practices, especially since September 2008. Then I'll describe developments in the thinking on the procyclicality of the financial system – particularly that of financial markets and financial market prices. The Bank of Canada's liquidity policy response to the crisis Last August, about one year into the crisis, I provided an overview of the changes that the Bank had made to its liquidity policies. 1 Since the onset of the crisis in August of 2007, there has been a general global decline – and in some cases, a complete disappearance – of liquidity in key funding markets. Liquidity is essential for both the efficiency and the stability of the financial system, and this decline, especially in bank-funding liquidity, has been of great concern to central banks. The liquidity of bank-funding markets is related to the liquidity of asset markets in general, and problems in one market can spill over into the other. It was in this context that the Bank for International Settlements' Committee on the Global Financial System (CGFS) made recommendations aimed at strengthening the effectiveness See D. Longworth, "Work in Progress: The Bank of Canada's Response to the Financial Turbulence" (speech to the Canadian Association for Business Economics, Kingston, Ontario, 26 August 2008). Available at: http://www.bankofcanada.ca/en/speeches/2008/sp08-10.html. of central banks in dealing with liquidity problems, including pressures in funding-markets. 2 Two recommendations focused on the central bank's ability to conduct liquidity operations effectively, even when liquidity in key markets is severely constrained. In concrete terms, this means that central banks should be prepared, if necessary, to take steps that go beyond adjusting the aggregate supply of bank reserves to meet changes in demand. These steps include providing an increased volume of term funds, conducting operations against a broad range of collateral, and conducting operations with a broad range of counterparties. This is precisely what the Bank of Canada and other central banks have been doing over the past year and a half. From August 2007 to August 2008, the Bank of Canada made two significant changes to support liquidity, and thereby the stability of the Canadian financial system and the efficient functioning of financial markets. First, we introduced a term purchase and resale agreement (PRA) facility to purchase securities from primary dealers and resell them to the original owners at term. Second, we broadened the range of securities acceptable as collateral for the Standing Liquidity Facility (SLF) – the overdraft facility accessible to participants in the Large Value Transfer System (LVTS) – to include certain types of asset-backed commercial paper (ABCP) and U.S. Treasuries. Since August 2008, the Bank has both expanded its liquidity facilities and introduced new ones. With regard to expansion: the regular term PRA facility has been the "workhorse" of the Bank's liquidity program since the onset of the crisis. It was reintroduced in September 2008, following a pause, starting in June, that followed improvements in funding conditions. The term of PRAs was increased from one month to both one and three months, and the frequency of term PRA operations was increased to weekly (from biweekly in the spring). In addition, we substantially increased the size of this term financing from $4 billion in the spring of 2008 to about $35 billion currently. The value outstanding peaked at $37 billion in December 2008. And we expanded the list of eligible counterparties to include not only primary dealers, but also all participants in the LVTS. Finally, we expanded the list of eligible securities for the term PRAs to include bank-sponsored ABCP and certain U.S. Treasury securities, consistent with the expansion of SLF collateral mentioned earlier. The Bank of Canada has also introduced three new liquidity facilities since last summer, one of which is an expansion and replacement of another [Table: Bank of Canada Liquidity Facilities Introduced since 2007Q4]. Bank for International Settlements (BIS), "Central Bank Operations in Response to the Financial Turmoil" (CGFS Papers No. 31, BIS, 2008). Available at: http://www.bis.org/publ/cgfs31.pdf?noframes=1. The Term Loan Facility was introduced in November. The aim of this facility is to give LVTS participants increased flexibility in efficiently managing their balance sheets. It allows direct LVTS participants to use their non-mortgage loan portfolios, which consist of high-quality but illiquid assets, as collateral for term loans. Two billion dollars is auctioned weekly for a 28day term. The maximum amount outstanding at any one time was about $4.2 billion. Although the Term Loan Facility has had the highest take-up of the new facilities, its use has been relatively modest, largely because the minimum bid rate is the Bank Rate 3 [Chart: Weekly Par Value Outstanding for BoC Liquidity Facilities]. The Bank Rate is 25 points above the target for the overnight rate. When the expected target for the overnight rate is significantly lower than the current target, the "penalty" is effectively larger when the term goes past the next fixed announcement date. At the same time, we introduced a term PRA facility for private sector money market instruments, the aim of which was to support liquidity in the markets for these instruments. Bankers' acceptances and promissory notes, as well as commercial paper, including banksponsored asset-backed commercial paper, were eligible securities for this facility. Primary dealers could participate, as well as federally or provincially regulated market participants who demonstrated significant activity in private money markets. This facility was designed as a backstop facility, with a high minimum bid rate of 75 basis points above the overnight indexed swap rate. Given its backstop nature, this facility was rarely used. Of the $1 billion offered in the weekly auction for 14 days, a maximum of only $25 million was taken up in any one week. With these new and expanded facilities in place in Canada, and with improvements in liquidity facilities at other central banks and actions taken by governments to stabilize the financial system, there has been a noticeable general improvement over the past four months in money markets in Canada and elsewhere [Charts: Spreads between Interbank Offered Rates and Overnight Index Swap Rates]. Since the beginning of the year, there has also been some improvement in corporate bond issuance. Nevertheless, there continue to be problems in financial markets. In particular, liquidity in secondary markets for fixed-income instruments remains poor; repo-rate spreads for private sector instruments – if a quote can even be obtained – are, in many cases, much higher than before the market turmoil began; 4 commercial paper issuance has declined; and there have been no public offerings of term asset-backed securities in months. Even before the financial turmoil, the repo market in Canada for private sector instruments was very thin. It was against this background that, as part of its provision of liquidity to support the efficient functioning of the market for private sector securities, the Bank announced, on 23 February, a new term PRA facility for private sector instruments. The new facility expands upon and replaces the previous term PRA facility for private sector money market instruments. The terms and conditions for the facility were announced on 6 March. 5 The first auction will be held on 17 March. This liquidity facility should indirectly support credit in Canada by helping to improve secondary-market liquidity and to reduce credit spreads. This, in turn, should help stimulate the issuance of new corporate instruments [Chart: Canadian Corporate Bond Index Option-Adjusted Spreads]. The new term PRA facility for private sector instruments is aimed at a broader set of market participants who do not have access to the regular term PRA facility. They can access the facility on an indirect basis via primary dealers. Relative to the previous term PRA facility for private sector money market instrument, there are four major changes: i. the set of eligible securities has been expanded to include eligible corporate bonds (those with at least a BBB rating, and including certain callable bonds) in addition to private sector money market instruments; ii. the set of potential eligible counterparties now also includes federally or provincially regulated market participants who can demonstrate significant activity in the corporate bond market, in addition to the main participants in the money markets; iii. the minimum bid rate has been significantly reduced, as befits a facility that is not designed to be just a backstop; and See http://www.bankofcanada.ca/en/notices_fmd/2009/not060309_final_pra.html. iv. the term of the transactions has been extended to 1 and 3 months from two weeks. I should note that the Bank is currently in a consultation process with regard to the possible inclusion of term asset-backed securities as eligible securities for this facility. An additional liquidity facility that we have in place is a US$30 billion swap line with the U.S. Federal Reserve. Swap lines help to avoid bottlenecks in the international distribution of liquidity and potentially enable domestic institutions to obtain liquidity in foreign currency, in this case, in U.S. dollars. This facility has not been needed at any time throughout the crisis, however, and it may not need to be used, because most Canadian banks have U.S. branches or subsidiaries and thus have access to U.S.-dollar funding through the Fed's discount window. The Bank of Canada continues to closely monitor the state of liquidity in financial markets, and we will continue to provide exceptional liquidity to the Canadian financial system as long as conditions warrant. In addition, as the Governor outlined in his speech on 19 November 2008, the Bank is looking carefully at what it should be doing for the longer term to provide for continuously open markets. 6 I will turn now to the second set of policies: those that affect the stability of the overall financial system. Here I will focus on policies that can affect the degree of procyclicality of financial market prices. Financial system stability – a macroprudential approach to the procyclicality of financial market prices Until recently, most financial system policy has focused on individual institutions, with the aim of limiting the damage that could be caused by distress at a given institution – the so-called "microprudential" approach. Over the past few years, interest has been growing in a "macroprudential" approach to regulating the financial system. 7 This approach aims to prevent or limit damage to the financial system as a whole, thereby avoiding or reducing the economic costs that attend financial instability. Such an approach is needed because systemic risks arise from the collective actions of institutions and markets. But developing an effective macroprudential approach is easier said than done. It depends crucially on understanding complex relationships across institutions and markets, and how various factors can amplify the procyclicality of the financial system – that is, the tendency of the system's behaviour to amplify financial and economic cycles. A sound macroprudential approach to analysis and regulation needs to focus on all aspects of the financial system, including amplification mechanisms within the system, and the possibility of contagion. To date, much of the discussion on how to move forward on the macroprudential agenda has focused on financial institutions: how they relate to one another and how their behaviour is influenced by overall capital requirements and loan-loss M. Carney, "Building Continuous Markets" (speech to the Canada-United Kingdom Chamber of Commerce, London, England, 19 November 2008). Available at: http://www.bankofcanada.ca/en/speeches/2008/sp0814.html. An early description of macroprudential policy concerns can be found in: Bank for International Settlements, Recent Innovations in International Banking (prepared by a Study Group established by the Central Banks of the Group of Ten Countries, Basel, Switzerland, 1986). A fuller description of the macroprudential approach is given by Claudio Borio in "Towards a Macroprudential Framework for Financial Supervision and Regulation?" (BIS Working Paper No. 128, February 2003). Available at: http://www.bis.org/publ/work128.pdf?noframes=1. provisioning practices. 8 Much less has been said about the implications of the behaviour of institutions for the behaviour of financial markets and financial market prices. This is what I will focus on today. In particular, regulations and market practices regarding capital for trading book activities, for risk-management systems within institutions, 9 and for margin requirements can – especially if they are too focused on short-run volatility – lead to procyclicality in asset prices and a general amplification of the procyclicality of the financial system as a whole. Let me explain. The value-at-risk (VaR) methodology has come to dominate not only riskmanagement systems within institutions, but also the setting of capital requirements on their trading books by the Basel Committee on Banking Supervision, 10 and the way that institutions think about setting margin requirements in their securities-financing operations or the initial margin for over-the-counter derivatives. The VaR methodology essentially uses recent historical data to estimate the losses on the trading book (typically over a one- to sixty-day period) that would come from a negative shock whose size would be exceeded only (say) an estimated one per cent of the time. Problems can arise if most participants in a given market use the same short historical period to calculate a simple VaR, which is then used to carry out risk management within institutions for a given allocation of economic capital, to calculate regulatory capital requirements, and to set margin requirements for counterparties. When that happens, the dynamics of asset prices could be most unfortunate in response to a significant shock. Consider first the case of an improvement in the fundamentals of a given asset. This would lead to an increase in the market price of that asset and, typically, to a reduction in the volatility of its price as well. This, in turn, would lead to a lower VaR for the existing portfolio. As a result, the capital requirements would fall, a bigger trading book could be held for a given allocation of economic capital, and margin requirements could be lowered for counterparties. Those counterparties, in turn, would participate more actively in markets. 11 Market liquidity would increase as more trading occurred in a growing range of assets. Perceived risk would fall as asset prices rose and volatility continued to fall. A "virtuous circle" for prices and volatility would result, not unlike what was seen in the 2003-06 period. As a result, however, assets may become overvalued as risks become underpriced. Next, consider what would happen if there was a downward shock to asset prices, resulting from a change in fundamentals, or an increase in volatility, resulting from the withdrawal of a major institution from trading. In this case, everything would work in reverse. The rise in VaR would mean a reduction in the size of trading books for a given allocation of economic capital. Margin requirements for counterparties would be raised. 12 Institutions would therefore sell assets, driving prices down further and increasing volatility. A vicious circle would result (as it did in the lead-up to the rescue of Bear Sterns and particularly following Bank of Canada Governor Mark Carney addressed procyclical capital adequacy in "From Hindsight to Foresight" (speech to Women in Capital Markets, Toronto, Ontario, 17 December 2008). Available at: http://www.bankofcanada.ca/en/speeches/2008/sp08-16.html. Some of the lessons that the current crisis holds for risk management can be found in P. Duguay, "Financial Stability through Sound Risk Management" (speech to the Risk Management Association, Toronto Chapter, Toronto, Ontario, 8 January 2009). Available at: http://www.bankofcanada.ca/en/speeches/2009/sp09-1.html. The 1996 "market risk amendment" to the Basel I Framework included a VaR-based methodology to set capital requirements for the trading books of banks. For useful information on "liquidity spirals," see M.K. Brunnermeier and L.H. Pedersen, "Market Liquidity and Funding Liquidity," Review of Financial Studies (forthcoming). Margin requirements have risen enormously since the beginning of the financial turbulence in August 2007. This was documented, for instance, in the IMF's October 2008 Global Financial Stability Report (Chapter 1, Box 1.5, 41-43). Available at: http://www.imf.org/external/pubs/ft/gfsr/2008/02/pdf/text.pdf the failure of Lehman Brothers). For those of you active in foreign exchange markets, I would note that following the Asian crisis of 1997-98, some of these same factors were thought to have contributed to that crisis. 13 Now, the assumption that most market participants use the same risk-management systems based on short historical samples is very much an exaggeration. Some researchers, however, have argued that enough institutions follow very similar risk-management systems that the dynamics described above can happen, and indeed have happened, in the real world in response to sizable shocks. 14 Moreover, in its Global Financial Stability Report issued in the second half of 2007, the International Monetary Fund concluded – based on simulations it carried out, which seemed realistic based on observed risk-management practices – that "seemingly prudent behavior by individual firms, reacting to similar marketrisk systems, could serve to amplify market volatility in periods of stress beyond what would otherwise have occurred." 15 Observations and anecdotal information following the failure of Lehman Brothers suggest that this behaviour of firms was very important in amplifying price volatility in the autumn of 2008. Analysis of such behaviour strongly suggests the need for a macroprudential approach. Policy proposals to deal with procyclicality in financial markets stemming from VaR I would now like to turn to what can be done to reduce the procyclicality in financial markets that comes from the use of VaR-based methodologies that are too dependent on short historical samples. Two main principles have been proposed. The first is that, in parallel with the probability of default on credit exposures on the banking book being calculated on a "through-the-cycle" basis, VaR for the trading book also be calculated on a through-the-cycle basis. One implication of this principle is that all historical data should be exploited to calculate the distribution of possible losses for a given asset or asset class. The second principle is that a "stress VaR" – a VaR calculated on the basis of assumed stress conditions – should be used, especially to consider the heightened correlation of losses across various assets or asset classes. It is well known that correlations among losses in categories of risky assets increase dramatically (sometimes approaching one), when the financial system is under great stress. Unfortunately, there are many firms that either do not perform such calculations or do not act upon them. Were all firms to undertake and act upon such calculations when short-run volatility decreased, VaR calculations would not decrease, because through-the-cycle stress VaRs would not be affected. As a result, the amplification mechanisms affecting prices and volatility described above would not be at play in boom times. In times of decreasing asset prices, some amplification could occur if the decreases were large enough. But to the extent that firms were allowed to undertake their own through-the-cycle stress VaR calculations, there would probably be much less similarity in their calculations than there is now, when there is a much greater effect coming from those institutions that are effectively acting on the basis of short-sample VaRs. Thus, there would likely be less amplification. See, for example, A. Persaud, "Sending the Herd Off the Cliff Edge: The Disturbing Interaction Between Herding and Market-Sensitive Risk Management Practices" (BIS Papers, No. 2, Proceedings of a Workshop held at the Bank for International Settlements, April 2001). Available at: http://www.bis.org/publ/bppdf/bispap02l.pdf. See A. Persaud (previous footnote) and the Committee on the Global Financial System, "A Review of Financial Market Events in Autumn 1998" (CGFS Publications No.12, Bank for International Settlements, 1999). This latter text has a section (see page 14) on the over-reliance on quantitative tools. International Monetary Fund, "Do Market Risk Management Techniques Amplify Systemic Risks?" in Global Financial Stability Report October 2007, 52-76. Now to specific policy proposals. First, such through-the-cycle stress VaRs could also form the basis for capital requirements set by the Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commissions (IOSCO) for the trading books of banks and securities dealers. Recently, the BCBS has proposed a small step in this direction by adding a stress VaR to the calculation of its trading-book capital. Second, regulators could encourage an improvement in internal risk-management procedures in the institutions they regulate to emphasize through-the-cycle VaR. Third, minimum margin requirements for securities-financing operations and initial margin for overthe-counter derivatives transactions could be set on the basis of through-the-cycle calculations and expected to remain constant. 16 Regulation might be required to accomplish this. Finally, the IMF has noted that having some institutions that are not subject to regulatory capital requirements for their trading books is helpful because these institutions will have more independence in the way that they carry out their risk management. 17 This independence of action would tend to increase market liquidity, reduce volatility, and therefore reduce procyclicality. However, sharp procyclical increases in margin requirements tend to preclude these typically leveraged institutions from participating and providing needed market liquidity at the times it's most needed. If all these specific proposals were put in place, there would likely be a significant reduction in the procyclicality of asset prices – particularly the procyclicality that stems from the drying up of liquidity in a period of falling prices and spiking volatility. Conclusion A strong economy requires a sound financial system. It's important to make sure that the policies that shape that system are designed not only to help financial markets operate effectively, but also to support stability over the long term. Liquidity is essential to a well-functioning economy, and central banks have an important and evolving role in helping to maintain the liquidity of key markets. Over the past year and a half, the Bank of Canada has introduced new liquidity facilities and expanded existing ones. Although some markets remain impaired, these facilities have helped to restore liquidity in a number of key markets. We continue to monitor the situation carefully, and we will continue to provide exceptional liquidity to the Canadian financial system as long as conditions warrant. Macrofinancial stability is equally essential to a well-functioning economy, and central banks are in a unique position to promote it through the development of macroprudential policy, especially in the area of reducing the procyclicality of financial markets. While much work remains to be done, there is a growing appreciation of the importance of this issue. The progress that we have made and are making to develop effective financial system policy will help to return markets to better health. It will also help to restore confidence, and to build a stronger, more sustainable economy in the years to come. The Counterparty Risk Management Policy Group has urged market participants to establish margin requirements and initial margins that are stable over the cycle. CRMPG, "Containing Systemic Risk: The Road to Reform" (Report of the CRMPG-III 6 August 2008). "Because they are not required to calculate and hold a minimum of economic capital, such pools of private capital can have the freedom to take advantage of the possible herd behaviour of others that could result from those that apply more rigid risk management procedures required of regulated institutions." IMF, Global Financial Stability Report October 2007, 72.
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Remarks by Mr Mark Carney, Governor of the Bank of Canada, to the University of Alberta School of Business, Edmonton, Alberta, 30 March 2009.
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Mark Carney: What are banks really for? Remarks by Mr Mark Carney, Governor of the Bank of Canada, to the University of Alberta School of Business, Edmonton, Alberta, 30 March 2009. The original speech, which contains various links to the documents mentioned, can be found on the US Federal Reserve System’s website. * * * Across the world's major economies, addressing the failures of banking ranks among the highest policy priorities. In the harsh glare of the current financial turmoil, it is clear that many banks outside of Canada were either not doing their jobs or were doing them in ways that created enormous risks. It is vital that we learn from these mistakes to build a more robust financial order. The financial system should be the servant of the real economy. As one of my international colleagues recently remarked, "it is time the banks stopped swanning around like the Queen of England and resumed their traditional role as handmaidens to industry." It is apparent that an era of self-absorbed finance that viewed itself as the apex of economic activity led to widespread misallocation of capital. Now, in some major economies, the challenge is that banks are not allocating capital at all. Around the world, banks are accused of not lending enough, charging too aggressively when they do lend and, most fundamentally, of deepening the recession rather than dampening it. These concerns are much less valid in Canada than abroad, but we too should reflect upon them and respond accordingly. My remarks today will address the role of banks and markets in our economy. In recent years, these core elements of our financial system became increasingly intertwined, with each expanding into the traditional role of the other, and each reliant on the health of the other. This blurring between banks and markets led to the emergence of the so-called "shadow banking" sector, whose presence helped trigger the crisis and whose absence will complicate the recovery. We now face important policy questions about which activities banks should perform, which should be located in sustainable, continuously-open markets, and which should be prohibited. The final answers to these questions require reflection and implementation will take time, but broad direction is needed now. Markets are overshooting. On the current trajectory, virtually all financial activities will be put back onto bank balance sheets at potentially tremendous cost in terms of lost output and employment. Restoring stability to financial markets requires broad direction on the type of global financial system that should emerge from the current financial mess. Important steps will be taken at this week's meeting of the leaders of the G-20 in London. Canada has much to offer these discussions, and is participating actively and constructively. Let me stress at the outset that many of my comments today apply more acutely internationally than domestically. While some commentators have been too quick to ascribe global failings to our local institutions, we should not engage in a bout of perverse envy. Our system is better. Regulation has been more consistent. Our banks have been more conservative. Credit conditions in Canada remain superior to those in virtually every other industrialized country. That is not to suggest that access to credit is not a challenge, that risks do not lie ahead, or that our system cannot be improved. However, many of the current constraints in our system reflect the impact on Canada of failures in the international financial system and of international institutions. The core of our system has many – although not all – of the elements of a more sustainable global financial system. The traditional roles of banks Commercial banks perform several key functions in our economy. To begin with, banks are a critical part of the payments system – the pipes through which financial transactions occur. By facilitating decentralized exchange, the payments system is critical to the functioning of a market economy. Like oxygen, the payments system passes unnoticed unless disrupted. It is one of the Bank of Canada's jobs to oversee systemic elements of the payments system, as well as its reliability. Reflecting years of investment and planning, our payments system has functioned smoothly and reliably, despite the enormous shocks to our financial system over the past two years. The second important role of banks is to transform the maturities of assets and liabilities. Banks take short-term liabilities, usually in the form of deposits, and transform them into long-term assets, such as mortgages or corporate loans. Households and businesses can therefore do the reverse, holding short-term assets and longer-term liabilities. This helps them to plan for the future and to manage risks arising from uncertainties over their cash flows. Banks also provide liquidity to their customers by allowing rapid access to those same short-term assets. Indeed, by transacting at a wide range of maturities, banks provide arbitrage which increases the efficiency of financial markets. This allows borrowers to obtain the lowest rate of interest appropriate to their risk characteristics. The social value of maturity transformation is without question. However, by definition, it also leads to a maturity mismatch that creates a fundamental risk for banks. Banks hold liquid reserves that are only a fraction of their outstanding obligations. What if a depositor wants his money back, but that money is committed to long-term investment projects? Generally, this is not a problem, because banks maintain sufficient liquidity to meet typical demands and can borrow from other banks if the shock is larger than anticipated. But what if many depositors want their money back at the same time? There is a tipping point when the liquidity problem becomes self-fulfilling. To manage this risk, banks rely on two crucial supports. First, deposit insurance gives depositors the comfort that their funds will be there when they need them. 1 Second, the Bank of Canada acts as a lender of last resort to solvent but illiquid institutions. 2 These support mechanisms are carefully crafted to discourage banks from taking inappropriate risks while still providing the necessary support. They are also accompanied by a robust regulatory framework. Bankers implicitly accept a social contract that gives them access to liquidity support in times of a stress in return for regulation of their behaviour at all times. Banks perform a third essential role of credit intermediation, channelling funds from savers to investors. This allows savers to diversify their risk and all of us to smooth our consumption over time. Young families can borrow to buy a house, students can pay for university. Canadians can invest in low-risk, interest-bearing accounts for their retirements, and businesses can finance working capital and investment. The Canada Deposit Insurance Corporation insures eligible deposits up to a maximum of $100,000 (principal and interest combined) per depositor against the failure of a bank or other financial institution if it is a CDIC member. Canadian chartered banks are CDIC members, as are federally regulated trust and loan companies that take deposits and deposit-taking associations governed by the Cooperative Credit Associations Act. A more detailed description of the Bank's role as lender of last resort can be found in the Winter 2004-05 issue of the Bank of Canada Review, available at http://www.bankofcanada.ca/en/review/winter04-05/daniel.pdf. Banks, markets, and the crisis Banks are not the only game in town. In recent years, markets have grown to the point that they are now an important alternative for corporate and household finance. From a financial system perspective, the deepening of markets is generally very welcome because it makes the system more robust and increases competition, which disciplines banking activity. While markets expand the choices and lower the prices available to financial consumers, they function differently from banks. Unlike banks, markets rely more completely on confidence for liquidity. We have seen during this crisis that confidence is not always present. Liquidity waxes and wanes, and with it, so do the prices of securities. In recent months, as we have seen a fundamental repricing of virtually every financial asset across the world, liquidity in many securities has fallen dramatically. Banks have relationships with their customers. They follow borrowers over time and monitor their payment history and reliability. When performing their role properly, banks tailor their products to the borrower, imposing higher or lower standards as appropriate. In contrast, markets are transaction oriented. They act as an intermediary between savers and borrowers but maintain relationships with neither. Consequently, market instruments are more robust when the underlying product is more standardized. Determining whether an activity is best financed through a bank or a market depends on the relative benefits to that activity of specialization versus standardization. In response to increased competitive pressure from markets, banks have become direct participants in markets. This move helped to sow the seeds of the crisis through three channels in particular: wholesale funding, securitization, and proprietary trading. First, banks have become increasingly heavy users of markets to fund their activities. In recent years, many international banks borrowed in short-term markets to finance asset growth and, in the process, to substantially increase their leverage. This made them increasingly dependent on continuous access to liquidity in money and capital markets. In the process, banks conflated a reliance on market liquidity with their access to central bank liquidity. This exacerbated the potential liquidity problems of banks to a magnitude that we now better appreciate. Second, banks increasingly used securitization to straddle relationship banking and transactional market-based finance. Under the originate-to-distribute business model, banks originated a set of loans, repackaged them as securities, and sold them to investors. In essence, banks took specialized loans and sold them in standardized packages. While securitization promised to diversify risks for banks, the transfer of risk was frequently incomplete. Banks often sold securities to "arms-length" conduits that they were later forced to reintermediate or held onto AAA tranches of structures that proved far from risk-free. At the extreme, the business models of some institutions were wholly reliant on the continuous availability of markets for securitized assets (e.g., Northern Rock). The global financial crisis exposed the fundamental incentive problems that can occur with securitization. In the originate-to-distribute model, the incentives of the originating institution were no longer aligned with those of the risk-holders. Once that relationship was severed, the standards for new loans and their ongoing monitoring were adversely affected. However, pricing and risk management did not reflect these changes until they were abruptly adjusted, helping to trigger the onset of the crisis. Third, many retail and commercial banks expanded into investment banking. This allowed banks to package traditional lending with higher value-added agency business, marketmaking activities and, increasingly proprietary trading. Banks' push into markets helped spur the proliferation of over-the-counter derivative products, which created counterparty and investment risks that were difficult to identify and control. Incentive problems also plagued this transition. In many banks, a culture that rewarded innovation and opacity over risk management and transparency eventually undermined its creators. Senior managers and shareholders of banks discovered that actual risks were much greater than originally thought. By that time, the more junior traders who had assumed the risks had already been paid, largely in cash. Many large, complex institutions learned too late that there can be principal-agent problems within firms, as well as between firms and their shareholders. Just as banks began doing what markets traditionally did best, there was an explosion in highly specialized products that required monitoring and continuous access to funding liquidity. More and more of the traditional functions of banks – including maturity transformation and credit intermediation – were conducted through a broader range of intermediaries and investment vehicles, which have been collectively referred to as the "shadow banking" system. Shadow banks included investment banks (in other countries), mortgage brokers, finance companies, structured investment vehicles (SIVs), hedge funds, and other private asset pools. The scale of these developments was remarkable. During this decade, banking assets grew enormously, to anywhere from one and a half times to six times national GDP in Canada, the United States, the United Kingdom, and Europe. In all countries besides Canada, much of this growth was financed by increased leverage. 3 In the final years of the boom, when complacency about access to liquidity reached its zenith, the scale of the shadow banking system exploded. The value of SIVs, for example, tripled in the three years to 2007. The growth in financial activity and the increasingly complex array of financial players have prompted a dramatic increase in claims within the financial system, as opposed to between the financial system and the real economy, which created risks that were difficult to identify and evaluate. Financial institutions, including many banks, came to rely on high levels of liquidity in markets. In the United States, the total value of commercial paper rose by more than 60 per cent and the ABCP market by more than 80 per cent in the three years before the crisis. In essence, the shadow banking system practiced maturity transformation without a safety net – that is, it was wholly reliant on the continuous availability of funding markets. The collapse in market liquidity that began in August 2007 crystallized these risks. The regulatory system neither appreciated the scale of this activity nor adequately adapted to the new risks created by it. The shadow banking system was not supported, regulated, or monitored in the same fashion as the banking system. With hindsight, the shift towards the shadow banking system that emerged in other countries was allowed to go too far for too long. Financial deleveraging The financial crisis is now reversing the decades-long transition from bank-based, relationship-oriented finance towards market-based, transaction-oriented finance. Banks are playing a larger role in the ongoing extension of credit. However, this transition carries enormous risks. Banks alone cannot support the same level of economic activity as the entire system did before, particularly since many need to delever. Moreover, the financial system as a whole is more robust when both banks and markets are strong, healthy, and liquid. Financial deleveraging is now one of the dominant forces in the global economy. After a decade during which household debt, leverage in the financial sector, and cross-border Average asset-to-capital ratios for U.S. investment banks rose to 25 prior to the onset of the crisis, to 30 in the euro area, and to over 40 for some major global banks. These are all much higher than the Canadian equivalent of about 20. capital flows all rose rapidly, all have slowed or are now falling. The duration and orderliness of these shifts will help to determine the severity of the global recession. Financial institutions around the world must bring their leverage down to more sustainable levels by shrinking assets and raising more capital. Considerable, albeit disruptive, progress has been made in the shadow banking system, where SIVs and other conduits have been largely wound up. Hedge fund assets under management have been cut in half to about US$1 trillion, and the leverage applied to these assets has been substantially reduced. As liquidity in many funding markets has dried up, so has embedded leverage in many pension funds. However, there has been less progress in the regulated banking sector. This is a large task. We estimate that to bring leverage ratios down to Canadian levels by raising capital alone, global banks would need more than US$1 trillion in new capital, before any additional writedowns on assets. The deleveraging process has contributed to a dramatic reversal in cross-border capital flows. Many of the largest global banks have dramatically curtailed their international activities. Hedge funds have similarly retreated to their home countries in anticipation of redemptions and over concerns for cross-border liquidity. The Institute of International Finance (IIF) estimates that net flows from private creditors to emerging markets, which topped US$630 billion in 2007, will be negative this year. Once the crisis passes, the scale of cross-border financial transactions is unlikely to return to pre-crisis levels. This reflects both the re-emergence of home bias amongst investors and the impact of measures to support domestic institutions. This financial protectionism, if not checked, could permanently impair cross-border capital flows and could be a serious setback for the global economy. Reform of the global financial system It is clear that the global financial system needs to be restructured, but doing so requires a clear view of the objectives. The fundamental objective is a system that efficiently supports economic growth while providing financial consumers with choices. The system must be robust to shocks, dampening rather than amplifying their effect on the real economy. It should also support sensible innovation. The system needs both stable banks and robust markets, since both play a central role in financing and, if properly structured, each can support the other. Achieving these objectives will require a range of measures starting with short-term initiatives to keep the system functioning and then bridging to more fundamental long-term reforms, which help define the roles of banks and markets. Keeping the system functioning Extraordinary measures have been taken to underpin the financial system. All G-20 countries have explicitly and repeatedly confirmed that no systemically important institution will be allowed to fail. In some countries, there has been direct support for banks through capital injections using public money. Support has also taken less direct forms, such as liquidity support to help keep open the markets on which banks and market participants depend. Some of these measures are expediencies taken in the midst of a crisis and elements may need to be adjusted later to support a more permanent solution. 4 For example banks have been provided with considerable liquidity support to reflect the scale of the funding pressures. The broader intent has been to grease the wheels of the financial system. In providing liquidity to banks at the core of the system, central banks expected that The Bank of Canada has outlined some principles for the provision of liquidity in the following article http://www.bank-banque-canada.ca/en/fsr/2008/pol0608.pdf. key markets would resume functioning as liquidity cascaded down to other market participants and, ultimately, through private credit creation to the real economy. However, the weaker the starting point of regulated institutions and the greater the importance of the shadow banking sector, the longer the healing process has taken. While the provision of extraordinary liquidity is limiting the damage from the crisis, it has long been apparent that official liquidity, irrespective of size, cannot re-open markets on its own. Reopening markets will ultimately require a series of measures to improve the infrastructure of core funding markets, securitization, and credit default swaps (CDS). Building systemic markets A robust and efficient financial system needs core markets for interbank lending, commercial paper, and repos of high-quality securities that are continuously open, even under periods of stress. To that end, the Bank of Canada is currently engaged in wide-ranging discussions with market participants, regulators, and other central banks on the steps that may be needed to create continuously open markets. Potential measures include improving the transparency of securities (as with ABCP), standardizing terms such as through-the-cycle haircuts for repos, and exploring the potential use of clearing houses to limit counterparty risks. Regulations and standards could reinforce these initiatives. Central bank operations could also be adapted to create a market-maker of last resort. Authorities are also taking important steps to improve the functioning of key markets such as securitization and CDS by creating more robust infrastructure and standardizing the products. For example, to reduce opacity, the models and data underlying securities could be published to move securitization from black box to open source. An extreme would be to standardize securities by introducing a government "wrap" or guarantee, as is the case with Canada Mortgage Bonds. 5 6 Similarly, a host of measures are being pursued to make the CDS market more sustainable. The U.S. Federal Reserve has improved clearing and settlement arrangements, and has encouraged the move of CDS onto clearing houses. This will encourage the standardization of these products, while making CDS counterparties – often banks – less systemically important at the margin. The limits between banks and markets These initiatives will change the margin between banks and markets and will make markets much more robust. This will reduce risks to those institutions that rely on these markets and reduce the extent to which certain banks are "too interconnected to fail." Nonetheless, even with these changes, banks can be expected to continue to be active market participants. For some, such progress is insufficient. A simple lesson that they draw from the crisis is that banks should be divorced from markets. To those who think this way, banks are most naturally heavily regulated utilities that collect deposits and make loans. Once banks become involved in the market "casino," they are overwhelmed by the resulting risk-management challenges and all too often have to draw on their public safety nets. Indeed, the very existence of those safety nets may encourage excess risk taking and promote financial crises. That is why some advocate restricting banks' activities to their "core" functions of deposit taking and lending. The range of activities related to the markets would be kept For example, the former Deputy Chairman of the United Kingdom Financial Services Authority, Sir James Crosby, proposed the introduction of government guarantees of newly-issued mortgage-backed bonds. In March, the Bank of England introduced an Asset Purchase Program to support corporate credit markets. In addition, to align incentives, originators could brand their products to retain part of the security or to absorb first loss. outside the heavily regulated banking sector. To this way of thinking, banks could not then get themselves into trouble or, if they did, their demise could be safely managed. In the midst of the crisis, this is a seductive viewpoint, but its practical value may be limited for three reasons. First, banks perform a broad range of market-related activities that are vital to the existence of markets. Canadian banks are the major agents, market makers, underwriters, and traders of most government debt and corporate debt. Even with substantial improvements to market infrastructure, it is difficult to see markets functioning effectively in the absence of bank participation. These activities can be distinguished from principal positions or proprietary investments and are essential to well-functioning markets. Efforts to improve market infrastructure described above will make markets less risky and the system as a whole more robust. Second, banks are the major providers of cross-border financing products ranging from trade finance, to foreign exchange hedging, to foreign financing. In a world of global supply chains and corporations, it would be very costly to prohibit bank provision of these services that have become integral to global commerce. Moreover, with global cross-border flows already under such pressure, further impediments would be extremely risky. Third, the crisis has demonstrated that there are many firms that have been deemed systemic and worthy of rescue even though they were not deposit-taking banks. Efforts to build more robust markets and to define clearer and more comprehensive resolution schemes may limit these cases in the future, but they are unlikely to eliminate them entirely. In my opinion, a better approach is the plan by the G-20 to expand the perimeter of regulation. As a general principle, all financial activities that can pose a systemic risk to financial stability should be supervised and regulated. This will include pools of capital of material size, leverage, and maturity mismatches. In addition, to avoid regulatory arbitrage, markets should be regulated according to economic substance, placing similar activities into the same regulatory bucket, even if undertaken in different institutions. Regulating by economic substance should limit the destabilizing impact of shadow banks on the banks themselves. In many respects, the relative success of Canadian banks and their consolidated supervision by the Office of the Superintendent of Financial Institutions demonstrates that, with the proper regulatory regime and professional management, banks can be much more than utilities. In this spirit, Canada is contributing to the international debate on financial sector reform. We are stressing the need for a macroprudential (i.e., comprehensive and systemwide) approach that takes into account the importance of banks, markets, and the interactions between them. Conclusion Our principal preoccupation is weathering the financial and economic storm, but as we respond to the current tempest, policy-makers must also focus on where we want to end up when calmer conditions arrive. Our destination should be one where banks and financial markets play critical, and complementary, roles in a financial system to support long-term economic prosperity. The system as a whole will be more stable if market infrastructure is substantially improved, market products are more standardized and transparent, and banks can fulfill their market-making roles with appropriate liquidity backstops. As the G-20 pursues its critical agenda of financial reform, Canada will contribute an important perspective on these issues, drawing on the fine example we continue to set.
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Remarks by Mr Mark Carney, Governor of the Bank of Canada, to the Northwest Territories Chamber of Commerce and Yellowknife Chamber of Commerce, Yellowknife, Northwest Territories, 1 April 2009.
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Mark Carney: Rebuilding confidence in the global economy Remarks by Mr Mark Carney, Governor of the Bank of Canada, to the Northwest Territories Chamber of Commerce and Yellowknife Chamber of Commerce, Yellowknife, Northwest Territories, 1 April 2009. * * * Good afternoon. These are very challenging times. The Canadian economy is in recession. The global economy is facing a crisis of confidence, triggered by the most severe financial meltdown since the Great Depression; fanned by sharp falls in trade, manufacturing output, and financial wealth; and intensified by steep increases in unemployment. In the throes of this crisis, fundamental certainties – about the structure of the financial system, the effectiveness of macro policy, and even the principles of capitalism – are being questioned. In this environment, Canadians from coast to coast to coast are more concerned about their economic future than they have been in decades. These concerns are understandable given the economic realities we face: unemployment has risen sharply, and the job market can be expected to deteriorate further before it recovers. The prices for our exports have fallen, our personal finances are under increasing strain, and our economy is currently shrinking. However, these concerns ought not be boundless. The Canadian economy has fundamental strengths, and has not been prone to the excesses that others have experienced. Moreover, globally and in Canada, policy-makers have mounted an aggressive three-pronged response to the current crisis. Monetary and fiscal policies have been eased substantially to support demand. Unprecedented measures have been taken to support the financial sector in order to keep credit flowing. And bold, longer-term reforms are being developed to create a more stable and efficient financial sector. If well executed, these measures will collectively begin to restore confidence and, with it, promote sustainable economic growth. My message today is simple: there is a plan to restore confidence and growth, we are implementing it, and it will work. The impact of these policies will build over time and will be significant. For maximum effect, it is critical that measures be grounded in robust and principled frameworks: the objectives should be transparent; indicators of success clear; and entry and exit criteria well articulated. Citizens must be able to hold their policy-makers accountable. Policymakers must rise to the occasion. Canadians can have confidence that the right policies are being put in place. They can manage their affairs in expectation – rather than hope – of a recovery. They can also expect that, once the global recovery begins, the Canadian economy will recover faster than many other industrialized economies. Unfortunately, the exact timing of the recovery is uncertain, and the global recovery itself may be more muted than usual. Since these factors depend to a great degree on measures taken outside our borders, the Bank is working intensively with our international colleagues to re-establish confidence in the global financial system. At home, our priorities are to cushion the blow of the global recession on the Canadian economy and to preserve our advantages so that we remain well positioned for the recovery when it occurs. Current global outlook: synchronized and deep global recession Global economic activity is currently falling at the sharpest rate since World War II. What began as a relatively controlled slowdown has become a synchronized and deep global recession. The proximate cause was the intensification of the global financial crisis that resulted from the failures of several prominent global financial institutions and from the growing realization that this was a solvency rather than a liquidity crisis. The recession that originated in the United States has spread around the world through confidence, financial, and trade channels. The consequent drop in global demand can be seen in sharp relief in recent industrial production figures, which have – to use a too-familiar phrase – “fallen off a cliff.” U.S. industrial production is down 11 per cent from its peak – with a majority of the losses in motor vehicle production. This is the worst performance since the oil shock of 1973-75, when large swathes of U.S. manufacturing capacity were rendered uncompetitive. The picture is even worse in Japan, where industrial production has fallen by 30 per cent over the last year. Indeed, across the G-7 countries excluding Canada, industrial production has fallen an average of roughly 16 percent since its peak about a year ago. To put this into perspective, if Canadian industrial production had fallen by the same proportion, our GDP would have been 3 percentage points lower at year-end. These declines have highlighted the fundamental interconnectedness of the global economy. For example, the reverberations of contracting U.S. consumer demand are spreading rapidly via global supply chains. World trade fell 5 per cent in the fourth quarter and will have fallen further still in the first quarter. The drop-off has been particularly severe across countries that supply goods to China. These economies are now suffering from China’s leverage to U.S. consumers. 1 The sharp fall in industrial demand has had a direct impact on the prices of most major commodities. The Bank of Canada's commodity price index declined by roughly 50 per cent in the second half of last year, helping to fuel a 16 per cent decline in Canada's terms of trade over the same period. The nature of the U.S. recession, with very weak auto and housing sectors, is particularly challenging for Canada. The U.S. household sector is very depressed, with sentiment at its lowest point in 30 years. Housing construction continues to be a major drag on U.S. growth, with housing starts now well below replacement rates. U.S. motor vehicle sales have fallen almost 40 per cent from their average monthly sales value reported between 2000 and 2007. With similar declines in Europe and Asia, there is a global auto crisis, with significant multiplier effects on global growth. We expect that the eventual U.S. recovery will be much slower than usual. In our January Monetary Policy Report Update, we projected that it will take at least two and half years from the onset of the recession for U.S. GDP to return to its pre-recession level. This sluggishness reflects the lingering effects of the crisis on the U.S. financial system, the traditional lags in the impact of policy, and the expected slow recovery of domestic consumption owing to the magnitude of wealth effects and the deterioration in the labour market. Major secular shifts It is increasingly apparent that the current downturn represents more than a cyclical shock. It also marks the advent of three major secular shifts, which any credible policy response must take into account. First, the correction of unsustainably large current account imbalances in several major economies is now under way. The rapid spillover of declining consumer demand in the United States on Asian trade and output demonstrates the tight relationship between these two economic areas. That which was symbiotic is now virulent. In the very short term, these Chinese exports fell by 26 per cent in February of this year, compared with the same time last year. Over the same period, Taiwanese exports were off 25 per cent year-on-year in February, Japan's fell 46 per cent, and Korea's 18 per cent (versus an average growth of 18 per cent over the past five years in these four economies). imbalances will narrow dramatically. For example, the Bank currently expects that the U.S. current account deficit will fall to around 3 per cent of GDP toward the end of 2009, or about one-half of its size in 2006. However, adjustment through a collapse in demand is hardly desirable. The sustainable rebalancing of domestic demand from deficit countries, such as the United States and the United Kingdom, toward surplus countries, such as China and Germany, will take some time and is likely to dampen the pace of growth in the global economy during that period. Second, the crisis marks a watershed for the design and use of financial services. For three decades, major economies have undergone a process of financial deepening, whereby people and firms were able to borrow more readily and efficiently to finance investments and to smooth consumption over time. People also took increasing control of their retirement planning and became steadily more active in financial markets. With these changes, the importance of financial markets relative to banks – and of the financial sector relative to other sectors of the economy – increased. During this process, the level of household debt relative to GDP rose sharply. These trends were at their most extreme in the United Kingdom and the United States. The reversal of these trends began with the current financial crisis and will be encouraged by changes both to the structure of the financial services industry and in the portfolio preferences of individuals. As a result, we can now expect a period of financial shallowing – characterized by reintermediation of transactions onto bank balance sheets, a relative decline in market-based finance, and a decrease in cross-border financial flows. In the process, financial leverage will fall. There has already been considerable deleveraging of the non-regulated financial sector (hedge funds, structured investment vehicles (SIVs) and captive finance companies of major industrial companies). However, there is still much to be done on the regulated side. The Bank of Canada estimates that for foreign banks to delever to Canadian levels, they will need to raise about US$1 trillion in capital prior to any additional write-downs incurred. Third and most fundamentally, it would appear likely that the global economy is entering a period of lower potential growth. It is now readily apparent that there was substantial capital misallocation in the boom years, including heavy investment in non-tradable real estate and a global auto industry geared to outmoded demand patterns. It will take time to reorient, since household savings are likely to rise substantially in many industrialized countries. One of the lessons of Japan’s “lost decade” is that an economy cannot really have sustainable growth until past excesses have been worked off. In the meantime, frictions are rising that could reduce the efficiency of the global economy. Financial nationalism is emerging, not only because of a rise in home bias, but also because of the recognition that financial institutions are global in life but national in death. 2 Regrettably, the designs of some rescue packages and reforms are creating barriers to cross-border capital flows. This could gather momentum, which would be most ominous if it were to accompany a return to trade protectionism. Canadian outlook The global downturn and declining demand for our exports will make this a very difficult year for Canada’s economy. The first half of the year will be particularly challenging, with deep drops in activity and considerable increases in unemployment. The contraction in the first quarter now looks likely to be the worst on record since 1961. This reflects an exceptionally unfavourable combination of factors: further negative growth in the world economy that T. Huertas, “The Rationale For and Limits Of Bank Supervision.” (Speech to the London Financial Regulation Seminar, London, England, 19 January 2009). greatly depressed our exports and terms of trade; the beginning of a substantial inventory correction; worsening labour market conditions combined with falling income and declining household net worth, causing a further decline in household spending; and increasing spare capacity and reduced cash flows that further discouraged business investment. The global recession has meant a significant decline in external demand for Canadian products. The U.S. auto crisis is forcing a wrenching adjustment to our industry. The U.S. housing crisis and the stresses faced by print media are conspiring to create intense challenges for our forestry sector. The drop in our terms of trade since July will translate into a significant reduction in Canadian incomes and thus in our ability to sustain real domestic spending in the economy. 3 Domestic demand in Canada is softening for other reasons as well. Rising unemployment means less income and lower consumer spending. Losses experienced by Canadians on their financial holdings, either directly or via their pension funds, and concerns about the employment outlook will also restrain domestic consumption this year. In addition, uncertainty about the economic outlook and strained financial conditions will likely lead to declines in investment spending this year. Given these factors, the Canadian economy could continue to contract into the second half of this year. As noted in our March interest rate decision, the Bank now expects the output gap will be considerably wider than before, and we do not expect it to begin to close until the first quarter of next year, at the earliest. The Bank will provide a full update of its outlook for the Canadian economy on 23 April when it publishes its Monetary Policy Report. Prospects for recovery: restoring global confidence The timing of the global and Canadian recoveries depends crucially on two related factors: the stabilization of the global financial system and the restoration of confidence among households and businesses. Across the world, the paradox of thrift is now in full force. Firms are postponing investment projects and building cash reserves. Households are delaying purchases and increasing their savings. Banks are curtailing lending and hoarding capital. These decisions, even if individually rational, are collectively damaging to our economic prospects – and are ultimately self-defeating. Once this dynamic has been set in motion, it will only be broken by decisive measures to restore confidence. This will not happen overnight. To quote Montek Singh Ahluwalia, deputy chairman of India’s Planning Commission, “Confidence grows at the rate that a coconut tree grows, but confidence falls at the rate that the coconut falls.” To restore confidence, policy initiatives must be sizable, forward looking, and credible. That is, they should be scaled to the severity of the shocks, take into account the secular shifts just outlined, and incorporate an exit strategy. Most fundamentally, policies must be fully consistent with well-articulated frameworks that support sustainable economic growth. As the Bank has consistently emphasized, stabilization of the global financial system is a precondition for economic recovery, globally and in Canada. In this regard, there are three requirements: 1) keep the system functioning; 2) address legacy or toxic assets; and 3) develop more fundamental reforms. This terms-of-trade shock can be expected to materially lower profits for our producers, reduce wages and employment for workers in our resource sectors, impair orders from related industries and services, and lower revenues for governments. In order to keep the system functioning, central banks have responded aggressively and creatively to supply liquidity. These efforts have been largely successful with interbank lending rates narrowing substantially since the worst periods last fall. Reflecting both the strength of our financial system and the timeliness of the Bank of Canada’s response, Canadian spreads have been the best performing of the major economies. Conditions have been slower to improve in other markets. The issuance of commercial paper (CP) and asset-backed commercial paper (ABCP) has stabilized, but spreads remain wide and maturities relatively short. Corporate bond issuance has improved, though activity remains below trend, and spreads appear to incorporate unusually high liquidity premia. There are also concerns over possible crowding out of private finance by large-scale public debt issuance. Sovereign debt issuance – excluding guarantees – will rise threefold this year. In this context, some central banks have taken direct measures to improve the flow of credit; and governments will need to be prudent when considering additional borrowing. Keeping the system functioning also requires action to mitigate the dramatic reversal in cross-border capital flows. The Institute of International Finance estimates that net flows from private creditors to emerging markets, which topped US$630 billion in 2007, will be negative this year. The scale of these declines means that there is an urgent need for additional IMF resources. In addition, a sharp decline in the availability of trade finance has exacerbated the fall in international trade. G-20 countries could address this by providing additional export credits and trade insurance, as Canada has done. The G-20 summit beginning today could make substantial progress on these issues. Second, the timely implementation of ambitious plans in the United States and other major economies to address toxic assets and re-capitalize financial institutions will be critical to stabilizing the global financial sector. Two weeks ago in Horsham, England, the G-20 agreed on principles for addressing such assets; the issue now is implementation. Throughout this process of restructuring the financial system, policy-makers have made it clear that systemically important institutions will not be allowed to fail. G-20 finance ministers and governors reiterated that commitment earlier this month in Horsham. Moreover, no one should be in any doubt that G-20 countries can afford their banking sectors. The Bank calculates that even in the worst-case scenario, recapitalizing the banking system in an individual G-20 country would cost less than 20 per cent of GDP – a considerable, but still manageable, sum. Third, G-20 nations need to move decisively to define the priorities for the new international financial architecture. In this regard, measures to improve transparency and integrity, to implement a macroprudential approach to regulation, and to widen the perimeter of regulation are vital. If these national and multilateral measures are not timely, bold, and well executed, Canada’s economic recovery will be both attenuated and delayed. The reality is that the financial crisis and subsequent recession originated beyond our borders, and the necessary triggers for a sustained recovery must be found there as well. Canada has much to offer, which is why we are working closely and tirelessly with our international colleagues. Managing demand Stabilizing the global financial system is the top priority. However, success in this regard alone will not necessarily mark an immediate return to global economic growth. Exuberance – of any type – has been in short supply for some time. Confidence will be slow to return, and the rebalancing of global demand will take some time. In short, the global economy faces a period of deficient demand. Both monetary and fiscal policy can help address this shortfall. The scale and appropriate mix of the response will vary by country and will depend importantly on the credibility of the policy frameworks. Reflecting the seriousness of the shock, the global macroeconomic policy response has been unprecedented. Fiscal policy initiatives have been robust, with the world well on its way to spending an average of 2 per cent of global GDP in discretionary fiscal measures. Simultaneous fiscal action is not only more powerful than measures taken in isolation, but also has the potential to provide some support for commodity prices. This is because government infrastructure spending is relatively commodity-intensive. With respect to monetary policy, target interest rates have been substantially and rapidly reduced in major economies. 4 The Bank of Canada has lowered our policy rate by a cumulative 400 basis points since December 2007. Consistent with returning total CPI inflation to 2 per cent, the target for our overnight rate can be expected to remain at this level or lower at least until there are clear signs that excess supply in the economy is being taken up. It is important to recognize that central banks do not necessarily need to keep cutting interest rates to provide additional monetary easing. Duration matters. By keeping rates low for longer, additional stimulus can be provided. The effects of the recent aggressive monetary and fiscal policy actions in Canada and other major economies will begin to be felt in the second half of this year and will build through 2010. Once the global financial system stabilizes and global economic growth recovers, the underlying strength of the Canadian economy and financial sector should ensure a more rapid recovery in Canada than in most other industrialized economies. However, as we highlighted in our last Monetary Policy Report Update, the global recovery will likely be more muted than usual, owing not least to the weight of past excesses in the United States economy. In the coming months, there may be pressure for policy to do more. Such decisions must be taken carefully with an eye to the scale of what has already been done, the traditional lags to policy, and the paramount need to retain the credibility of fiscal and monetary frameworks. Canada is well served in this regard, since inflation targeting gives us an important advantage in focus and communications. Our monetary policy mandate is clear: conduct policy in order to achieve our target of 2 per cent CPI inflation over the medium term. Low, stable and predictable inflation is the best contribution monetary policy can make to the economic and financial welfare of Canadians. It is in this context that we will outline later this month a framework for the possible use of unconventional monetary policy measures, including credit easing and quantitative easing. As the overnight rate approaches zero, it is important that Canadians understand that the Bank retains a considerable number of policy options to achieve its mandate. Moreover, it is essential that these alternatives are outlined in a comprehensive fashion: with clear indicators of success identified, and transparent principles for both entry and exit. To be absolutely clear, outlining a framework does not necessarily imply that these policy options will be deployed. Their use will be a function of the outlook for output and inflation and of the relative effectiveness of the instruments in achieving the inflation target. The G-20 policy rate has fallen to 2.14 per cent from 4.27 per cent in August 2008. Conclusion A deep and synchronized global recession is currently under way. It is being fed by a crisis of confidence. Reversing this will take concerted short-term macro measures, long-term micro reforms, and time. Stabilization of the global financial system is a pre-condition for economic recovery. In this regard, implementation of recently announced plans to address toxic assets in banking systems outside Canada will be critical. In addition, this week’s G-20 summit should provide the road map for a more stable and effective international financial system. In the meantime, the freefall in domestic demand and an atmosphere of exceptional uncertainty has created an intense need for massive, credible policy action. This need is being met – there has been an unprecedented monetary and fiscal response. The effects of these policies will build over time and will be felt with full force next year. Decisions to provide additional stimulus must be carefully considered. It is paramount to retain the credibility of fiscal and monetary policy frameworks. While considerable options for further monetary stimulus remain, their use is not preordained and will solely be determined by their appropriateness in achieving the inflation target.
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Opening statement by Mr Mark Carney, Governor of the Bank of Canada, at a press conference following the release of the Monetary Policy Report, Ottawa, 23 April 2009.
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Mark Carney: Summary of the latest Monetary Policy Report Opening statement by Mr Mark Carney, Governor of the Bank of Canada, at a press conference following the release of the Monetary Policy Report, Ottawa, 23 April 2009. * * * Good morning. Paul and I are pleased to be here with you today to discuss the April Monetary Policy Report, which we published this morning. • These are difficult economic times with the Canadian economy being buffeted by an intense and synchronized global recession. In recent months, that global recession has been exacerbated by delays in implementing measures to restore financial stability around the world. • G-20 policy-makers are now responding to the global crisis with renewed commitment to concrete initiatives and comprehensive plans. Our base-case projection is that these policies will be implemented in an effective and timely manner, and their impact will reach full force next year. • As a result of the current global economic and financial situation, the Bank now projects that the Canadian recession will be deeper, that our return to growth will be delayed by one quarter to the end of 2009, and that our recovery will be somewhat more gradual. • The broad outlines of the Canadian outlook are the same, but its profile has shifted. • Canada's real GDP is projected to decline by 3.0 per cent this year, and growth is expected to resume in the autumn and accelerate to 2.5 per cent in 2010, and 4.7 per cent in 2011. • Our outlook for inflation is broadly consistent with that in January. Total inflation will temporarily fall below zero in 2009, but core and total CPI inflation are expected to return to the Bank's 2 per cent inflation target in the third quarter of 2011. • In that context, on Tuesday, the Bank lowered the policy interest rate by 1/4 of a percentage point to 1/4 per cent, which is judged to be the effective lower bound of the policy rate. Conditional on the outlook for inflation, the Bank has committed to holding this rate at 1/4 per cent until the end of June 2010. • Since December 2007, we have cut interest rates by a total of 425 basis points to their historic lows and lowest possible levels. It is the Bank's judgment that this cumulative easing, together with the conditional commitment to keep rates low for a considerable period, is the appropriate policy stance to move the economy back to full production capacity and to achieve the 2 percent inflation target. • However, these are uncertain times and if additional stimulus were to become necessary, the Bank retains considerable flexibility in the conduct of monetary policy at low interest rates. • Because it is important to outline those alternatives in a principled and transparent fashion, we published today a framework that describes the Bank's approach to the conduct of monetary policy when the overnight interest rate is at its effective lower bound. • Additional stimulus could be provided through quantitative easing, which involves the creation of central bank reserves to purchase financial assets and/or credit easing, which includes outright purchases of private sector assets. • If the Bank were to deploy either quantitative easing or credit easing, it would act in a deliberate and principled fashion. - The focus of these operations would be to improve overall financial conditions in order to support aggregate demand and achieve the inflation target. - Asset purchases would be concentrated in maturity ranges in order to have the maximum impact on the economy. - Actions would be taken in as broad and neutral manner as possible. - The Bank would act prudently, mitigating the risks to its balance sheet and managing its ultimate exit from such strategies at an appropriately measured pace. • Allow me to conclude with a few words on the outlook for the Canadian economy. • While there remains a high degree of uncertainty – particularly with the Canadian economy dependent on forces beyond our borders – we remain confident in the prospects of economic recovery in Canada. • This recovery should be supported by the following factors: • - the gradual rebound in external demand; - the end of the stock adjustments in Canadian and U.S. residential housing; - the strength of Canadian household, business, and bank balance sheets; - our relatively well-functioning financial system and the gradual improvement in financial conditions in Canada; - the past depreciation of the Canadian dollar; - stimulative fiscal policy measures; - the timeliness and scale of the Bank's monetary policy response. In short, we have a plan to restore confidence and growth, we are implementing this plan, and it will work. With that, Paul and I would be pleased to take your questions.
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Opening statement by Mr Mark Carney, Governor of the Bank of Canada, to the Standing Senate Committee on Banking, Trade and Commerce, Ottawa, 6 May 2009.
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Mark Carney: Canada’s economic outlook and framework for unconventional monetary policy Opening statement by Mr Mark Carney, Governor of the Bank of Canada, to the Standing Senate Committee on Banking, Trade and Commerce, Ottawa, 6 May 2009. * * * Good afternoon, Mr. Chairman and committee members. Before Paul and I begin to answer your questions, allow me to take a moment to review some of the highlights and the conclusions from our latest Monetary Policy Report, released on 23 April. In particular, I would like to outline for you some of the details from the Bank's framework for unconventional monetary policy, which was published as an annex to the latest MPR. The economic outlook • These are difficult economic times, with the Canadian economy being buffeted by an intense and synchronized global recession. In recent months, that global recession has been exacerbated by delays in implementing measures to restore financial stability around the world. • G-20 policy-makers are now responding to the global crisis with a renewed commitment to concrete initiatives and comprehensive plans. Our base-case projection is that these policies will be implemented in an effective and timely manner, and their impact will reach full force next year. Discussions in Washington at the end of April were consistent with that outlook. • As a result of the current global economic and financial situation, the Bank now projects that the Canadian recession will be deeper than we projected in the January MPR Update. Our return to growth will be delayed by one quarter, to the end of 2009, and our recovery will be somewhat more gradual. • The broad outlines of the Canadian outlook are the same as those in January, but its profile has shifted. • Canada's real GDP is projected to decline by 3.0 per cent this year, and growth is expected to resume in the autumn and accelerate to 2.5 per cent in 2010, and 4.7 per cent in 2011. • Our outlook for inflation is broadly consistent with that in January. Total inflation will temporarily fall below zero in 2009, but core and total CPI inflation are expected to return to the Bank's 2 per cent inflation target in the third quarter of 2011. • In that context, on 21 April the Bank lowered the policy interest rate by 1/4 of a percentage point to 1/4 per cent, or 25 basis points, which is judged to be the effective lower bound of the policy rate. Conditional on the outlook for inflation, the Bank has committed to holding this rate at 1/4 per cent until the end of June 2010. I will elaborate on this conditional commitment in a moment. • In total, since December 2007, we have cut interest rates by 425 basis points to their historic lows and lowest possible levels. It is the Bank's judgment that this cumulative easing, together with the conditional commitment to keep rates low for a considerable period, is the appropriate policy stance to move the economy back to full production capacity and to achieve the 2 per cent inflation target. A framework for conducting monetary policy at low interest rates • However, these are uncertain times and if additional stimulus were to become necessary, the Bank retains considerable flexibility in the conduct of monetary policy at low interest rates. • We have outlined in detail how we would use that flexibility in conducting monetary policy at the effective lower bound, in the framework published in our recent MPR. In this document, we describe the unconventional instruments that are available, the principles that would govern our use of these tools – should we decide to apply them – and the exit strategies that we would employ when these instruments were no longer necessary. • The three key instruments we have identified for conducting monetary policy at the effective lower bound include: conditional statements about the future path of policy interest rates; quantitative easing, which involves the creation of central bank reserves to purchase financial assets; and credit easing, which includes outright purchases of private sector assets. • If required, these instruments could be used separately or in tandem to improve financial conditions in order to support aggregate demand and ultimately achieve the inflation target. • As you are aware, the Bank deployed the first instrument on 21 April. As a result of our conditional commitment to keep rates at 25 basis points through the end of June 2010, interest rates across the maturity horizon of the commitment fell. They also dropped relative to those in the U.S. • Let me reiterate that the Bank's conditional commitment is not a guarantee. It is conditional on the outlook for inflation. We will always set our policy rate at a level consistent with achieving our 2 per cent inflation target over the policy horizon. • Similarly, if the Bank were to deploy either quantitative easing or credit easing, it would act in a deliberate fashion based on the following principles: (i) The focus of these operations would be to improve overall financial conditions in order to support aggregate demand and achieve the inflation target. (ii) Asset purchases would be concentrated in maturity ranges in order to have the maximum impact on the economy. (iii) Actions would be taken in as broad and neutral a manner as possible. (iv) The Bank would act prudently, mitigating the risks to its balance sheet and managing its ultimate exit from such strategies at an appropriately measured pace. • If we were to use these unconventional policy measures, the Bank would closely monitor a number of indicators to assess their effectiveness. • The most important would be the effect on overall financing conditions faced by households and businesses. • Other indicators would be used to judge the direct impact of a particular instrument. For example: o The effectiveness of conditional statements about the future policy rate can be judged by their impact on longer-term interest rates. As I mentioned a moment ago, we saw almost immediately the impact of our 21 April policy interest rate announcement. o The effectiveness of quantitative easing would be judged in the first instance by a change in the yield curve and more generally by movements in broader financial conditions. o That of credit easing would be judged by reductions in risky spreads and increased issuance activity. o Changes in credit terms and in the conditions faced by firms can also be assessed using the Bank's Business Outlook Survey and its Senior Loan Officer Survey. o In addition, the Bank has constructed measures of borrowing costs and an overall financial conditions index for the economy. • To enhance transparency, the Bank now offers a comprehensive website that details credit conditions in Canada. The link can be found on the left side of our home page. • The unwinding of the Bank's various facilities and its acquisition of assets – or the exit strategy – would be guided by the Bank's assessment of conditions in credit markets and the inflation outlook. • A number of exit alternatives are available, including a natural runoff through the maturing of assets, the refinancing of acquired assets, and asset sales. • Finally, the framework also describes how the Bank would communicate its use of unconventional policy measures. Press releases on each fixed announcement date would remain focused on the target overnight rate and on conditional statements about the future direction of policy rates. • The press release would also indicate any intention to carry out purchase programs and the approximate size of purchases. The Bank would explain the broad objectives of any purchases and how they are to be financed. Detailed operational decisions would be communicated in separate announcements. • Press releases on fixed announcement dates and Monetary Policy Reports would continue to provide an ongoing assessment of the economy and the outlook for inflation. Speeches and parliamentary appearances, such as this one, would provide additional venues for reporting on the details of the Bank's conduct of monetary policy. • As always, the Bank reserves the right to announce policy measures in periods between fixed announcement dates to address exceptional circumstances. • We welcome the opportunity, following my remarks, to discuss with your committee this framework and its potential role in achieving the Bank's inflation target. Conclusion • Allow me to conclude with a few words on the outlook for the Canadian economy. • While there remains a high degree of uncertainty – particularly with the Canadian economy dependent on forces beyond our borders – we remain confident in the prospects of eventual economic recovery in Canada. • This recovery should be supported by the following factors: - the gradual rebound in external demand; - the end of the stock adjustments in Canadian and U.S. residential housing; - the strength of Canadian household, business, and bank balance sheets; - our relatively well-functioning financial system and the gradual improvement in financial conditions in Canada; - the past depreciation of the Canadian dollar; - stimulative fiscal policy measures; - the timeliness and scale of the Bank's monetary policy response. With that, Mr. Chairman and committee members, Paul and I would be pleased to answer your questions.
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Remarks by Mr John Murray, Deputy Governor of the Bank of Canada, to the Global Interdependence Center, Philadelphia, Pennsylvania, 19 May 2009.
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John Murray: When the unconventional becomes conventional – monetary policy in extraordinary times Remarks by Mr John Murray, Deputy Governor of the Bank of Canada, to the Global Interdependence Center, Philadelphia, Pennsylvania, 19 May 2009. The original speech, which contains various links to the documents mentioned, can be found on the Bank of Canada’s website. * * * Good afternoon. The financial turbulence that began in the U.S. subprime-mortgage market in August 2007 reached maximum intensity towards the end of 2008, and enveloped the entire global economy. Strains that had previously been concentrated in a few major financial centers turned into a full-blown crisis, affecting both industrial and emerging-market economies through trade, financial, and confidence channels. Policy-makers reacted quickly, applying unprecedented monetary and fiscal stimulus as the gravity of the situation became clear. For central banks, this involved pushing target interest rates to historic lows and providing emergency liquidity on an extraordinary scale. Although a number of "green shoots" have recently appeared and the global economy is no longer deteriorating at an accelerating rate, we remain in the midst of the deepest and most synchronous contraction of the postwar period. Many central banks have tested the limits of their traditional monetary policy instruments and have turned to so-called "unconventional" measures. Others are giving unconventional measures serious consideration. These instruments are unfamiliar and there is a great deal of confusion over exactly what they are and how they work. Some observers believe that they will be largely ineffective, making a deflationary spiral inevitable. Others worry that they will be too effective, or will be left in place too long, leading to an inflationary spiral. Either way, unconventional monetary policy instruments are regarded by many as a decidedly risky option. The main purpose of my presentation today is to address these misconceptions and to alleviate some of the unnecessary concerns that have arisen about the use of unconventional monetary policies. First, I will explain what central banks mean when they refer to unconventional measures, and how these measures differ from conventional monetary policy measures. Second, I will review the principles that have been developed to help guide the use of such instruments, if it is deemed necessary. Finally, I will examine their potential effectiveness in the light of recent experience. While it's too early to draw strong conclusions, the experience to date with unconventional measures has been largely positive. I'll give some examples to support my upbeat assessment later in these remarks. But I'll begin with a few comments about recent economic developments, and the remedial policy actions that have been undertaken. Recent economic developments A G-7 colleague has cleverly summarized the experience many of us are living these days as "redesigning an airplane while flying it." Sometimes it may feel this way; however, this does not do justice to the coherent policy frameworks and careful planning that help guide many of the policy measures that we are implementing. The unprecedented economic times in which we live and work have forced us to be increasingly creative. Every major industrial country is now in recession, as are many emerging-market economies. Those EMEs that are still growing have witnessed a marked deceleration in real economic activity, and any hopes of "decoupling" have long since disappeared. Concerns about stagflation, which dominated policy debates as recently as eight months ago, have largely dissipated, replaced by concerns of deflation. Headline inflation in advanced economies has fallen dramatically, reflecting the collapse in commodity prices and widening output gaps, and is expected to dip briefly below zero in many countries. It is important to note that despite the dire news, a recovery is still in prospect, aided by aggressive policy actions. The Bank of Canada recently published its spring Monetary Policy Report, where we outlined our views on current economic conditions and the near-term outlook. In a special annex to the Report, we also presented a framework for unconventional monetary policy and how this could be applied, if necessary. These are exceptional and unsettling times; anything that can be done to reduce uncertainty and instill confidence is particularly welcome. It was with this in mind that the Bank of Canada decided to add the special annex to its last Report. Our framework for conventional monetary policy, based on a flexible exchange rate, an explicit inflation target, and clear accountability has served us well, and will continue to guide our future actions. The annex builds on this foundation, providing a clear contingency plan for unconventional measures and for dealing with some extraordinary challenges. Monetary and fiscal policy responses Policy-makers in Canada, the United States, and elsewhere have moved with exceptional speed and determination to support financial markets, restore growth, and re-equilibrate the real economy. Authorities have provided extraordinary assistance to the financial sector in the form of emergency liquidity, balance sheet guarantees, asset purchases, and recapitalization as appropriate. Ambitious and concerted discretionary fiscal measures have also been initiated and, together with automatic fiscal stabilizers, will help lift aggregate demand. Equally impressive and timely action has been undertaken by monetary authorities through aggressive cuts to policy interest rates (see Chart 1) These short-term rates are now close to zero – the lowest level that nominal interest rates can go. Attempts to push nominal rates persistently below zero are bound to be ineffective, since investors always have the alternative of converting their securities into cash. Indeed, the effective lower bound (ELB) for policy interest rates, as I shall explain in a minute, is likely to lie somewhat above zero. This suggests that most major central banks have already reached the maximum dosage of their conventional monetary policy medicine. This doesn't mean, however, that central banks are out of ammunition. Conventional monetary policy and the effective lower bound In more conventional times – that is, when banks and financial markets are fully operational – the process of monetary policy transmission follows a reasonably direct and well-understood path. The first step involves a careful monitoring and forecasting of economic activity and inflation. Second, the central bank must decide whether more or less macroeconomic stimulus is needed. For many central banks, this is guided by an explicit (or implicit) inflation target, since keeping inflation low, stable, and predictable is generally accepted as the best contribution that a central bank can make to the economic well-being of its nation's citizens.1 The value of having such a clear and credible target will be explored in more detail a little later in these remarks. The Bank of Canada was one of the first to adopt explicit targets and aims to keep inflation at 2 per cent. Third, if action is necessary, the central bank will either lower or raise its target interest rate, depending on the circumstances. From there, the monetary impulse is transmitted to other financial instruments with longer maturities, including the interest rates charged by banks on loans. While few transactions are actually conducted at the target rate, the interest rates that they influence further out the yield curve do have a material effect on the borrowing and lending decisions of households and businesses. Once the target interest rate approaches zero, conventional monetary policy has gone just about as far as it can go. Nominal interest rates, as noted earlier, cannot fall below zero, and most central banks would aim to stop slightly above this level, leaving a small positive margin or buffer. Pushing policy rates too low can lead to problems in financial markets and restrict the flow of credit at the very time central banks are trying to restore it. For these and other reasons, policy-makers are often reluctant to drop their target rate much below 25 or 50 basis points, the effective lower bound or ELB for many central banks. Unconventional monetary policy instruments Once the ELB has been reached, monetary policy can continue to ease, but other means must be found to increase the flow of credit and to lower interest rates out the maturity spectrum. Three basic mechanisms have been identified for this purpose. 1. Conditional statements about the future path of policy rates The first mechanism is a conditional commitment regarding the future path of the policy interest rate. In normal times, this type of interest rate guidance is usually kept to a minimum or expressed in very general terms. In extraordinary times – such as we now face – it may be necessary to be more explicit and make a clear conditional commitment to keep the target overnight rate low for an extended period. Using this approach, central banks can influence interest rates well out the yield curve, because long-term rates are largely a reflection of expected future short rates. While it may not be possible to lower the overnight rate any further, expectations at longer maturities can still be shaped by conditionally committing to keep the overnight rate low. For this mechanism to work, the conditional commitment must be credible, and inflation expectations must remain well anchored. Canada's positive experience over the past 18 years with an inflation targeting framework is especially helpful in this regard. Inflation targeting has reduced the risk of deflationary expectations, permitted aggressive policy action in response to the current crisis, and will no doubt make it easier to exit from any unconventional policies that are introduced. 2. Quantitative easing The second unconventional mechanism is quantitative easing. It is sometimes referred to pejoratively, and mistakenly, as "printing money." Quantitative easing occurs whenever a central bank purchases private or public sector securities by expanding its reserve base. These purchases directly affect the yields of the securities that are bought, putting downward pressure on their interest rates and upward pressure on their prices. They also inject additional central bank reserves into the financial system, which deposit-taking institutions can use to generate additional loans. All quantitative easing is, by definition, "unsterilized." Although this is correctly viewed as unconventional, it closely resembles the way monetary policy is described in most undergraduate textbooks, and is broadly similar to how it was conducted in the heyday of monetarism. 3. Credit easing Credit easing is the third mechanism, and is a term reserved exclusively for central bank purchases of private sector assets in segments of the market where dislocations and credit constraints appear to be most severe. It is designed to ease credit conditions by stimulating more active trade in certain assets and through a process of portfolio substitution. Sterilized purchases of private sector assets can be effected either by selling existing assets on the central bank's balance sheet – essentially swapping "good" assets for "bad" – or by creating additional central bank reserves and then sterilizing, or mopping up, the extra reserves by selling new government securities.2 Credit easing can also be combined with quantitative easing, in which case the purchase of private assets will remain unsterilized and the reserve base will expand. Four guiding principles Although the three unconventional monetary policy instruments I have just described have been studied extensively, real-world experience with them in recent times is limited. Any decision to use them necessarily involves some risk and uncertainty. To deal with these challenges, the Bank of Canada has identified four key principles that would guide its actions whenever these unconventional measures are employed. These principles can be summarized in four words: focus, impact, neutrality, and prudence. 1. Focus Any unconventional action initiated by the Bank must have as its primary objective the achievement and maintenance of the Bank's 2 per cent inflation target. Restoring the normal functioning of financial markets and the flow of credit would be important considerations, but only to the extent that they help to achieve the ultimate objective. 2. Impact Decisions regarding which unconventional instruments to use, and when, would depend on current and prospective economic conditions, as opposed to a mechanical game plan. In the case of credit easing, consideration would be given to the severity of the market failure, the ability of the Bank to correct it, and its importance for the functioning of the real economy. Financial markets that were under the most extreme pressure would not necessarily be given priority. The impact on output and inflation would be the determining factor. 3. Neutrality Unconventional monetary policy measures would also be implemented in a manner that minimized the chances of distorting other markets or producing unintended consequences elsewhere. This would imply operating in as broad a market segment as possible and avoiding targeted assistance to specific industries or firms.3 It is important to note that the latter would involve a net expansion of the central bank's balance sheet, but without any increase in reserves. In contrast, quantitative easing involves expanding the reserve base available to the private sector. Unfortunately, many observers mistakenly assume that any increase in a central bank's balance sheet represents quantitative easing. Targeted assistance might be appropriate for achieving other social and economic objectives but is properly viewed as the purview of elected governments as opposed to central banks. 4. Prudence The fourth principle – prudence – can be exercised in several ways. One is to minimize the risks that unconventional policies might pose for the central bank's balance sheet and hence, taxpayers' pockets. Credit and quantitative easing can subject a central bank to market risk, especially if it is holding long-term instruments and interest rates begin to rise more than expected. Ironically, this rise could be a sign that the unconventional policies were working.4 Credit easing could also subject a central bank to credit risk, since it involves the purchase of less-creditworthy instruments. Some of these risks can be mitigated through careful screening, the imposition of a minimum credit rating, and dealing in shorter-term instruments. But this will not always be possible if the central bank wants to achieve a particular effect. Prudence of a slightly different sort is also needed to ensure the unconventional measures that have been put in place can be reversed or undone without undue market disruption or threat to the central bank's macro objectives. Some short-term and short-dated assets can easily roll off the central bank's balance sheet as they mature. Longer-term assets, in contrast, might have to be sold off slowly or held to maturity.5 Some useful indicators Central banks monitor a number of economic and financial indicators in the normal course of events; but in uncertain times, the need for a diversified and vigilant approach is even greater. Changes in interest rate levels and spreads before and after any unconventional measure has been introduced can serve as a rough barometer of its impact – a sort of crude event analysis. Anecdotal information drawn from surveys of businesses, households, and financial institutions can also help central banks monitor changes in the pricing, terms and conditions of debt financing and borrowing. The surveys of senior loan officers conducted in most advanced economies are examples of this. The growth of various credit and money aggregates can also be used as a rough guide. Of course, since movements in credit and money can be driven by either demand or supply factors, it won't always be clear which way the real financial linkages are running. Moreover, relationships between money, credit, and the real economy are seldom stable, even in tranquil times. In periods of high volatility and very low interest rates, the instability becomes even more extreme. As a result, price and interest rate measures are likely to prove more reliable. Many central banks have constructed summary measures to judge the ease or tightness of financial conditions in their markets. These financial conditions indices (FCIs) are empirically based and include a number of different indicators, each weighted by its estimated impact on GDP growth. Some representative indices for Canada and other countries are shown in Charts 2 and 3. Although one shouldn't assign too much importance to a particular FCI level, large changes in an FCI probably indicate a significant easing or tightening. At the Bank of Canada, we have brought all of our credit measures together on a single web page. This collection, which we have dubbed our Credit Dashboard, can be viewed at: http://credit.bank-banque-canada.ca/index.php/about. As financial markets stabilize, interest rates out the yield curve (particularly on government instruments) would be expected to return to more normal levels. Although it isn't a guiding principle, close coordination between the central bank and the treasury is also necessary. This will avoid confusion and help maximize the effectiveness of any measures that are taken to ease credit conditions and stimulate the economy. Just as the boundary between monetary stability and financial stability becomes increasingly blurred in the midst of a financial crisis, so too does the boundary between monetary and fiscal policy actions. It isn't uncommon for both central banks and governments to initiate credit-easing measures, and it is important that the two work together. Are unconventional monetary policies working? The basic question remains: Does unconventional monetary policy actually work? There is good reason to believe that if these measures are implemented vigorously and with the clear support of authorities, they will be successful. Initial results for the unconventional policies recently employed by Canada, Japan, the euro zone, the United Kingdom, and the United States are certainly promising. However, any assessment of the effectiveness of these measures must necessarily be treated with considerable caution. • First, these are early days, and we don't have a great deal of evidence to draw on. • Second, several policies are often initiated simultaneously, so it is difficult to gauge the impact of any particular one. • Third, spillover effects from one market to another could be significant but difficult to detect. • Fourth, short-run and long-run effects could differ enormously and will depend importantly on the initial conditions in the economy and how the policy is applied. • Fifth, lower spreads and interest rates may reflect weaker demand as opposed to an easing in credit conditions. Attempting to draw definite conclusions is therefore risky. It is also important to remember that each country's economic and institutional circumstances are different and may require a different approach to unconventional monetary policy easing. No single formula will suit all cases. This is reflected in the different strategies recently adopted by a number of countries. Switzerland, for example, lacks deep markets in government and private-sector securities, and has decided to conduct quantitative easing via unsterilized intervention in the foreign exchange market. Japan's financial markets have not been as seriously affected as those in many other advanced countries, but its banks have needed significant support, so most of Japan's unconventional efforts in the past year have been focused on banks.6 The United Kingdom has concentrated most of its quantitative easing in the market for government bonds or gilts, since commercial paper and corporate bond issuance are not as significant. The focus in the United States is quite different again. Greater emphasis has been put on quantitative easing using private sector assets. Canada has not been subject to many of the imbalances and vulnerabilities that have affected other countries, and has had less need for unconventional measures. The Bank of Canada has not engaged in credit or quantitative easing, but has made a conditional commitment regarding the future path of the target interest rate. At the Bank of Canada's last fixed announcement date we lowered the target overnight rate to 25 basis points – consistent with our estimate of the effective lower bound – and committed to keep the rate there until the end of the second quarter of 2010, conditional on the inflation outlook. This conditional commitment was buttressed by a decision to offer term purchase and resale agreements out to a one-year maturity, with set maximum and minimum bid rates.7 So, how have all of these diverse actions fared? Here is a brief and tentative summary of how the unconventional measures adopted by Canada and other industrial countries have performed so far. Although Japan's financial system was relatively unaffected by the global turmoil, last fall conditions in its commercial paper and corporate bond markets tightened sharply. In that context, the Bank of Japan began to buy commercial paper and corporate bonds to support corporate financing. We also announced that, in our best judgment, these actions and the easing that they implied would be sufficient to return the real economy to equilibrium and inflation to its 2 per cent target by mid-2011. No quantitative easing would, therefore, be necessary unless conditions deteriorated relative to the Bank's projection. • Conditional commitments – Several countries have made conditional commitments indicating that they are prepared leave their target interest rates at or near the ELB for an extended period. All of them appear to have had some effect on market yields, at least at the time of the announcement. Canada has made the most explicit commitment of the major industrial countries and has backed its words with actions. The result has been significant and lasting, in the form of a 10- to-20-basis-point decline in implied yields on government bonds out to one year (see Chart 4). • Quantitative easing – Experience here is more limited, but targeted unsterilized purchases of corporate debt and commercial paper in Japan and the United Kingdom appear to have reduced spreads and increased issuance. Unsterilized purchases of government securities in the United Kingdom and in the United States led to sharp declines for a short time when these programs were first announced, but yields have since reversed. Authorities believe that this does not reflect the waning influence of the programs, but rather the arrival of more positive economic news and other developments that would have triggered even larger upward movements had the programs not been in place. • Credit easing – Borrowing costs and interest rate spreads in almost all markets have improved for a variety of reasons, but significant changes in specific markets can be linked directly to the introduction of certain central bank (and government) crediteasing programs. These include, among others, the Government of Canada's Insured Mortgage Purchase Plan (IMPP); the U.S. Federal Reserve's purchases of GSE direct obligations and mortgage-backed securities (MBS); and the U.S. Commercial Paper Funding Facility (CPFF) (See Chart 5). The early results, along all three unconventional policy channels, are generally encouraging. Conclusion I would like to leave you with four main messages: First, central banks are not out of ammunition; unconventional monetary policy measures can be effective. Second, while their use is subject to somewhat greater uncertainty than traditional tools, unconventional measures are more fresh than frightening. In many cases, they are direct extensions of what we do in the normal course of business. Third, prudent strategies are available to minimize the credit and interest rate risks borne by the public sector and hence, the taxpayer. Fourth, extra care will be taken to achieve an orderly exit, guided by the clear monetary policy frameworks that most central banks now have in place. This will help to minimize the chances of a premature and destabilizing "exit," and also guard against a sharp rise in inflation. Stated more simply, the risks of either a deflationary collapse or an inflationary spiral have been greatly exaggerated. Central banks will not forget to shut off the liquidity taps when additional stimulus is no longer required. But we shouldn't get ahead of ourselves. We must first reach a point where growth is self-sustaining and we are confident that our inflation objective can be reached.
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Remarks by Mr Mark Carney, Governor of the Bank of Canada, to the International Economic Forum of the Americas Conference of Montreal, Montreal, 11 June 2009.
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Mark Carney: Rebalancing the global economy Remarks by Mr Mark Carney, Governor of the Bank of Canada, to the International Economic Forum of the Americas Conference of Montreal, Montreal, 11 June 2009. * * * The theme of this conference – "Adapting to a New World Order" – suggests that it is clear how global commerce and finance will be reorganized in the wake of the current crisis. However, the outcome is far from preordained. How we manage the rebalancing of the global economy could profoundly influence how open, equitable, and prosperous the New World Order will be. Globalized product, capital, and labour markets 1 lie at the heart of the New World Order to which we should aspire. However, the next wave of globalization needs to be more firmly grounded and its participants more responsible. In recent years, a belief in the power of markets has not always been accompanied by a commitment to build resilient markets. Moreover, at times, policy-makers and the private sector did not live up to their responsibilities. In my talk today, I will outline an agenda to redress these failings in order to build a more responsible, more resilient globalization. But first I want to highlight the current challenges that stem from several key imbalances. Across economies, demand must rotate from deficit to surplus countries. Within our economies, major stock adjustments in inventories, labour, and capital will be required. Excessive levels of private debt must also be reduced. To offset the resulting shortfall in private demand, public demand must increase. The role of public demand is to bridge a gap. To do so successfully, it must be temporary, credible, and accompanied by measures to relaunch an open, resilient, and responsible global economy. The (newly) old world order It was not that long ago that we basked in the seemingly effortless prosperity of globalization. During the past quarter century, steady advances in transportation, communication, and information technologies, underpinned by the widespread adoption of liberal economic policies, shrank the globe and expanded its economy. Never in history has economic integration involved so many people, such a variety of goods, and so much capital. 2 The pace and breadth of globalization were made possible in part by the onset of global supply-chain management. 3 In effect, technology and globalization facilitated a more widespread application of two of the most powerful forces in economics: division of labour and comparative advantage. National economies became tightly linked, with demand in one country driving production and inventory cycles across several countries. From a price The globalization of labour markets is due mainly to information technology, which facilitates the global outsourcing of services, including medical and financial services. The effective global labour supply quadrupled between 1980 and 2005. Merchandise exports grew to 20 per cent of global GDP, more than twice the level reached at the height of the last great wave of globalization a century ago. Advances in information technologies, specialized production processes, and reduced communication and transportation costs all led to a whole new range of goods and services becoming tradable. For example, over the past 30 years, the share of imports as a percentage of manufacturing production has tripled. perspective, the net result was steady downward pressure on the prices of manufactured goods and steady upward pressure on commodity prices. 4 , 5 The global capital market was similarly transformed during this period. Cross-border capital flows reached 15 per cent of global GDP, five times the rate at the beginning of the 20th century. By and large, these flows facilitated the diversification of risk, the transfer of technology, and the acceleration of global growth. At the same time, global markets became more interdependent. The actions of others mattered more, particularly during times of stress. Globalization lifted hundreds of millions of people out of poverty and created the potential for hundreds of millions more to share their destiny. For Canada, it contributed to the secondlongest expansion in our nation's history – a period characterized by rising real incomes, surging employment, and low, stable, and predictable inflation. In recent years, however, the global economy has become increasingly unbalanced. The process of rebalancing will profoundly affect the medium-term outlook for the global economy. Rotation of domestic demand from deficit to surplus countries We are now experiencing the inevitable correction of global imbalances. These were characterized by misaligned relative prices, underdeveloped financial sectors, and excess savings in emerging markets. These were matched by rapid credit expansion, asset-price booms, and negative savings in many Western economies. These trends were encouraged by policies such as inflexible exchange rates and an overreliance on export-led growth in Asia and, in the United States, the promotion of unsustainable household spending in response to the bursting of the tech bubble. These measures collectively contributed to a low and stable interest rate environment, which fed enormous risk taking and leverage across markets and currencies. These imbalances were most evident in current accounts. In a reversal of usual trends, emerging markets ran surpluses, and developed countries ran deficits. Poor countries in effect lent to rich ones. In 2006, the American deficit reached almost 7 per cent of GDP and the Chinese surplus more than 10 per cent. The net foreign liabilities of the world's most developed economy and the net foreign assets of its largest emerging market were both on explosive paths. That which could not go on forever eventually and brutally stopped. When the cavalier "search for yield" was replaced by a desperate "rush for shelter," leverage was viciously unwound across markets, sharply increasing risk premia around the world. In the real economy, the Bank expects that the U.S. current account deficit this year will fall by almost two-thirds from its peak. China's surplus will also narrow, although less dramatically (partly reflecting the offset from a sharp fall in commodity prices). The unwinding of global imbalances has highlighted the fundamental interconnectedness of the global economy. Virtually every financial asset on the planet was significantly re-priced as the crisis intensified. The reverberations of contracting U.S. consumer demand spread rapidly via global supply chains, and a global inventory glut developed virtually overnight. A 3 per cent decline in U.S. consumption of goods over the past six months fed a 20 per For Canada, the combination of lower prices for imports of manufactured goods and higher prices for our commodity exports drove an improvement in our terms of trade, which bolstered real disposable income per capita by about 8.5 per cent in the five years leading to 2008. The rise in commodity prices was due to the rapid increase of manufacturing in emerging markets, where production is relatively more commodity intensive. cent fall in Asian industrial production. A relationship that had been symbiotic became virulent. The recent narrowing of global current account imbalances reflects a collapse in demand, which is hardly desirable. A sustainable rebalancing of domestic demand from deficit countries, such as the United States and the United Kingdom, toward surplus countries, such as China and Germany, will take some time – and this will likely dampen the pace of global growth. Reduction of debt, and the reallocation of labour and capital The second important correction in this period of transition to the "New World Order" will be characterized by significant stock adjustments in the financial and real sectors of major industrialized economies. A key lesson of Japan's lost decade is that an economy will not grow until the excesses that built up during the bubble have been removed. 6 In Japan, these included commercial real estate, physical capital, and a highly leveraged corporate sector. Financial imbalances and losses from a deteriorating economy quickly overwhelmed the capital buffers of the Japanese banking sector. The resulting negative feedback loop between the real and financial economies took nearly a decade to break. There are some striking parallels in the United States. Earlier this decade, there was substantial misallocation of investment (much of which was financed from abroad) into private real estate. In addition, key industries such as autos invested in capital stock that became increasingly misaligned with prospective demand. There are also important differences. Unlike Japan, excess debt in the United States is concentrated in the household and financial sectors, and the deleveraging of the financial sector was a trigger rather than the result of the recession. With U.S. banks now raising significant capital to cushion their losses, the negative feedback loop between the financial and real economies has been slowed, though not yet reversed. More capital will be required globally; the toxic assets in core banks still need to be addressed; and a host of vital financial markets, such as private-label securitization, must be relaunched. As a result, stabilization of the global financial system remains a precondition for a sustainable recovery, both globally and in Canada. This process of financial stock adjustment is mirrored by an adjustment process on the real supply side of the economy. In the last quarter of 2008, it became clear that levels of inventories, employment, and capital were not commensurate with the level of global demand. Each, in turn, fell roughly in the sequence one would expect, given relative adjustment costs: first, inventories; next, employment, which is quasi-fixed; and last, capital, as investment fell below the rate of replacement. Although global demand and trade levels appear to be approaching bottom, and inventory and labour adjustments have already been substantial, there is still more to come. Unemployment will likely rise further across the G-7, with the sharpest increases still to come in those economies with the least-flexible labour markets. Uncertainty over the employment outlook will weigh on consumption in most major economies for some time. The capital stock adjustment process will take longer, and global investment growth is likely to remain negative well into 2010. This will serve as a significant drag on global growth and can be expected to reduce potential growth in most major economies. See "Way Out of Economic and Financial Crisis: Lessons and Policy Actions," Masaaki Shirakawa, Governor of the Bank of Japan, Speech at Japan Society, New York. 23 April 2009. Declining investment and stagnant consumption will mean that private demand, excluding that generated by tax stimulus, will remain weak until the middle of 2010. In the United States, China, and Japan, growth will likely be positive in the third quarter of 2009, but largely owing to massive fiscal expenditures and tax cuts. Self-sustaining private demand in most major economic areas is not yet imminent. The G-20 strategy is to enact extraordinary fiscal stimulus to offset financial headwinds and to bridge the gap until the end of the stock adjustment process and the restoration of private demand. Its success depends on three interrelated factors: the scale of the private savings response; the magnitude, duration, and credibility of the fiscal response itself; and the eventual rebalancing of risk between the public and private sectors. Let me address each of these factors in turn. The evolution of private and public savings One of the biggest imponderables is the outlook for household savings rates. In the run-up to the crisis, households increasingly "saved" through capital appreciation rather than from current income. A decline of roughly 30 per cent in U.S. wealth has caused household savings rates to rise sharply from nearly zero between 2005 and 2008 to 4 per cent in the first quarter of 2009. The new equilibrium of household savings will depend on multiple factors, including wealth effects, risk aversion, the evolution of the financial system, and crucially, the credibility of fiscal policy itself. The surge in private savings is being offset by a rise in public dissaving. The world is well on its way to spending an average of 2 per cent of GDP in discretionary fiscal measures. Simultaneous fiscal action means that spillovers across countries offset each other to some degree, thereby limiting net leakage and maximizing the overall impact. In addition, the current global concentration on infrastructure spending provides some support for commodity prices. But there are limits to everything, including fiscal policy. Across the G-7 this year, the average deficit will be 12 per cent of GDP. Global public borrowing requirements will be two times greater than last year. Compounding effects and the need to avoid an abrupt withdrawal of fiscal stimulus will mean that average public debt levels in many major economies could increase to 110 per cent of GDP before stabilizing. The composition of global savings will need to change radically. These dynamics could become self-defeating if the credibility of fiscal paths is called into question. A combination of substantial upward pressure on interest rates on investment or Ricardian effects 7 on consumption would retard the recovery. It is therefore paramount that fiscal policy frameworks retain credibility. This requires both effective current initiatives and realistic exit strategies. In this regard, Canada's experience of the 1990s with the steady overachievement of near-term targets on the road to fiscal balance is relevant. Ultimately, a return to sustained growth in private sector demand that can accommodate desired private savings is essential. An open, global economy centred on private risk taking is the best prospect for this. But before that can be assured, much needs to be done, starting with an orderly retreat of the public sector. Ricardian equivalence refers to the theory that increases in government spending are largely offset by reductions in private consumption, reflecting future anticipated tax increases. Redistribution of risk between public and private sectors The financial panic required a bold response from the public sector. The loss of faith in the solvency of core banking institutions at times threatened the very functioning of the global financial system. While absolutely necessary, the response to the crisis has profoundly shifted risk from the private sector to the public sector. Since October, the G-7 has committed that no systemically important financial institutions will be allowed to fail. Across the world, bank financings have been guaranteed. With securitization markets still moribund, assets have been purchased and tail risks assumed by the public sector. Governments have even guaranteed warranties on certain car models. With these precedents, there will be further pressure for a host of new risk-sharing arrangements. 8 We need to think carefully about where risks are best held as we emerge from this crisis. There are two considerations. First, risks that can be priced are best borne by the private sector, whereas uncertainties that have a wide and significant potential impact are best borne by the public sector. Second, risks are endogenous: Public policy and private decisions influence aggregate risk in the system. For example, the widespread private use of collateral to mitigate counterparty risk reduced credit risk but sharply increased liquidity risk. Similarly, the public sector's recent assumption of some risks creates moral hazard. If left unchecked, this will eventually promote private behaviours that will add overall risk to the system. The expedient should not become permanent. Governments have assumed extraordinary tail risks and quite ordinary financial risks. They should decide whether to keep the former or to effectively shut down the activities associated with them (for example, some aspects of securitization). They should return the latter to the private sector. A central bank agenda for renewed globalization But how to do so, when animal spirits are so clearly moribund? Perceptions have changed. There is a better appreciation of the amorphous and endogenous nature of risk. There is also a welcome acknowledgement of uncertainty. Knowing that a black swan might be out there disciplines activity. Humility seldom goes before a fall. Unfortunately, a newly humbled private sector may only re-engage if it believes that the system is more resilient. To accomplish this, central banks, along with other public agencies, must promote both the necessary market infrastructure and responsible policy. There are four priorities for renewed globalization. First, transparency should be increased so that risk can be identified more effectively and priced more efficiently. The crisis laid bare important deficiencies such as the woefully inadequate disclosure on securitized products. The Bank of Canada used its collateral policy to improve the disclosure of asset-backed commercial paper (ABCP), creating a standard that should become commonplace. The current global initiative to transfer many over-thecounter derivatives onto clearing houses is motivated partially by the desire to promote standardization. Second, core funding markets should be made more efficient and less susceptible to extreme price movements. The crisis was clearly exacerbated by the seizure of interbank and repo markets: Good collateral became unfinanceable overnight, firms failed, risk aversion skyrocketed, and the global economy plummeted. Promising avenues to break such (il)liquidity spirals include introducing clearing houses, standardizing products, implementing through-the-cycle margining, and ensuring more effective netting. As the ultimate provider of See "(Nearly) nothing to fear but fear itself," Olivier Blanchard, Chief Economist, International Monetary Fund. Published in The Economist, 29 January 2009. liquidity to the system, the Bank is thinking through whether to adapt its facilities to support continuous private liquidity creation. Third, macroprudential regulations must be enacted to help smooth the credit cycle. A prominent example could be a new bank capital regime. It should be dynamic (with buffers and provisions moving through the cycle), simple (including Canadian-style leverage caps), and coherent (consistent with broader initiatives such as moving over-the-counter derivatives onto exchanges). Given where we are in the current crisis, it should also be Augustinian, that is, new requirements should be phased in over time to avoid deepening the recession because of procyclical deleveraging. Fourth, all countries must accept their responsibilities for promoting an open, flexible, and resilient international monetary system. Responsibility means recognizing spillovers between economies and financial systems and working to mitigate those that could amplify adverse dynamics. It means submitting to peer review within the Financial Stability Board and external review by the International Monetary Fund. Fundamentally, it means adopting coherent macro policies and allowing real exchange rates to adjust to achieve external balance over time. This crisis was caused in part by failures to meet the same challenges that bedevilled the architects of the original Bretton Woods system. Given the current, deeply synchronous global recession, the costs of free riding should be obvious to all. Conclusion I would like to conclude with a few words on the impact of this rebalancing for Canada. It appears likely that the global economy is entering a period of lower potential growth. The substantial capital misallocation and financial excesses of the boom years will take years to work off. Rebuilding globalization will also take time. Recognizing the scale of the industrial restructuring and the lower investment over that period, the Bank has lowered its estimate for Canadian productivity and potential growth. The shifting composition of global growth will also have important implications for Canada. The current pattern of U.S. activity, with its weakness in the housing and auto sectors, is proving particularly challenging for our businesses. We expect the U.S. recovery to be relatively subdued compared with historical experience, given the domestic rebalancing requirements in that economy. More positively, the greater proportion of emerging-market growth in the overall growth of the global economy should create new opportunities, particularly by supporting commodity prices. Our research indicates that, even in the throes of the crisis, those emerging markets whose demand is most relevant to our exports are also generally the most resilient. These countries can be expected to make up an increasing proportion of global demand going forward. Unfortunately, a smooth rotation of demand across economies is not assured. Overall, the orderly resolution of global imbalances remains an important risk to the outlook for growth and inflation in Canada. As we noted in our policy decision last week, the recent sharp increase in the value of the Canadian dollar, if it proves persistent, could fully offset recent positive developments in financial conditions, commodity prices, and confidence. In the wake of a major shock to external demand and the financial crisis, the Bank has acted proactively and aggressively. We eased our policy rate to the lowest possible level – 1/4 per cent – to support private demand and to achieve our 2 per cent inflation target. Conditional on the outlook for inflation, the Bank expects the policy rate to remain at its current level until the end of the second quarter of 2010 in order to achieve the inflation target. The Bank retains considerable additional flexibility, including unconventional measures, as outlined in the principles-based framework in our April Monetary Policy Report. With our domestic and international partners, the Bank is working actively to build more resilient markets and to create an open, global financial system. Success is not assured. Setbacks in managing through the recession could undermine support for open economies. More broadly, without credible policy frameworks and robust market infrastructure, private risk taking may not return to the extent required. However, there is every reason that Canada should be among the first to implement the agenda that I have described today. Through such leadership, we can do our part to create a more responsible, resilient globalization.
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Remarks by Mr Mark Carney, Governor of the Bank of Canada, to the Regina & District Chamber of Commerce, Regina, Saskatchewan, 18 June 2009.
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Mark Carney: From green shoots to the harvest – comments on financial stability Remarks by Mr Mark Carney, Governor of the Bank of Canada, to the Regina & District Chamber of Commerce, Regina, Saskatchewan, 18 June 2009. * * * It is a pleasure to be back in Saskatchewan. This great province has been one of the fastestgrowing parts of the country in recent years, benefiting from increasing diversification into biotechnology, alternative energy sources, and carbon-management solutions, among other industries. Today, I will refer to the traditional backbone of this economy: agriculture. I do so because lately there has been much talk of "green shoots" in the global economy. From the initially careful references to data that suggested a slowing of the rate of decline in global activity, the use of the term "green shoots" has quickly evolved. Some now refer to green shoots as if the global recovery is a foregone conclusion or even as if sustainable growth had already begun. Would that it were so easy. Saskatchewanians know that it is a long, anxious time between the appearance of seedlings and the harvest. Much hard work remains, and external forces can profoundly influence the outcome: too little or too much rain, hail, pests, and disease can all frustrate even the most promising beginnings. And, in the end, global forces of supply and demand determine the prices received. Old adages usually contain great wisdom: Just as you don't count your chickens before they are hatched, we shouldn't presume that green shoots today guarantee a bumper crop tomorrow. Financial stability and the Bank of Canada I want to extend this analogy to provide some perspective on recent developments in Canadian financial stability. Financial stability is the resilience of the financial system to unanticipated adverse shocks. This resilience determines the extent to which Canadian households and businesses have access to the credit they need at appropriate terms and conditions. While our financial system is one of the soundest in the world, the ferocity of the once-in-alifetime global financial tempest has affected all Canadians, regardless of their location or occupation. So, does our financial system still leave us well positioned for our green shoots to mature into a viable crop of summer wheat? 1 The Bank of Canada is well placed to make this judgment. As part of our commitment to promote the economic and financial welfare of Canada, the Bank actively fosters a stable and efficient financial system. The Bank constantly assesses the major risks to the soundness of our system, and helps to develop policies to mitigate them. In essence, we worry not only about prospects of external shocks (the equivalent of weather or crop prices), but also about the buffers that our banks, businesses, and households have (the equivalent of the financial reserves farmers need to carry in case the harvest disappoints). Twice a year, the Bank publishes its Financial System Review, or FSR – the most recent edition appeared earlier this week. My talk today will draw on that analysis and assessment. I will concentrate on three risks, in particular: 1) the liquidity and funding positions of our Our financial system is only one of the factors that influence the outlook for growth and inflation in Canada. banks, 2) the adequacy of their capital, and 3) the financial health of Canadian households. I will conclude with a few observations on the economic outlook. Assessment of overall financial stability Since the autumn, the global economy has been in a deep and synchronized recession that was triggered by the worst financial crisis since the Great Depression. In recent months, financial market conditions have improved noticeably and further, gradual progress is likely as numerous international policy initiatives gain traction. Equity markets have seen strong gains in recent months (see Appendix, Chart 1), and credit markets have also rallied (Chart 2). While there is still a long way to go before economic and financial conditions return to normal, markets seem to be turning their backs on worst-case scenarios. The panic that engulfed global financial markets last fall is over. Developments in Canadian financial stability over the past six months reflect the competing influences of improved financial market conditions on the one hand and a deterioration in the economic outlook on the other. Overall, the level of risk to the Canadian financial system is judged to be broadly unchanged since last December. I would sound a note of caution familiar to those who work the land. We are well prepared but will still be tested. While the strong position of our banks has improved further in recent months and the balance sheets of Canadian households remain relatively sound, the global recession will mean that these reserves will be drawn upon in the months ahead. Let me now turn to the three risks that I cited a moment ago, starting with liquidity and funding for banks. Liquidity and funding At the heart of the financial crisis was the collapse of wholesale funding markets for banks. Since August 2007, the very short-term interbank and repo markets have been under great strain. During the most intense periods of the crisis around the collapse of Bear Stearns in March 2008 and Lehman Brothers and others in the fall of last year, these markets seized up entirely: Good collateral became unfinanceable overnight, firms failed, and risk aversion across all financial markets skyrocketed. This crisis of confidence was less acute in Canada, but still produced severe strains in our wholesale funding markets. Heightened uncertainty made counterparties reluctant to extend financing beyond the shortest maturities, resulting in intense funding pressures for Canadian financial institutions. Banks cut back their market-making activities in order to conserve balance sheet capacity, which further aggravated market volatility. These dynamics raised the risk of an adverse feedback loop between the financial system and the real economy. The Bank of Canada responded to these pressures by dramatically expanding our liquidity facilities, and the Government of Canada implemented a program to purchase insured mortgages with the help of the Canada Mortgage and Housing Corporation, thereby increasing the access of Canadian institutions to longer-term financing. Reflecting both the strength of our banks and the scale of our actions, conditions in Canada have been consistently better than elsewhere (Chart 3). Since December, these policies have gained considerable traction, helping to reinforce the improvement in domestic funding conditions as the global financial crisis subsided (Chart 4). This improvement has been reflected in a decline in the spreads on bank financing in money markets, a moderate extension of maturities, and a substantial reduction in the cost of term funding for Canadian banks. In addition, policy initiatives have allowed banks to increase substantially their holdings of government securities, which has helped boost their liquidity situation in a capital-efficient way. These improvements have been further supported by strong growth in retail deposits and slowing credit growth (Chart 5). Market-making activity in Canadian financial markets has also been recovering, although it remains less than satisfactory. Policy response There are important lessons to be drawn from this experience. The performance of core funding markets during the crisis intensified the financial panic and helped trigger the recession. This is totally unacceptable. As a consequence, one of the Bank of Canada's top priorities is to promote institutional changes to create more robust core funding markets. Promising avenues to break such (il)liquidity spirals include introducing clearing houses, standardizing products, implementing through-the-cycle margining, and ensuring more effective netting. As the ultimate provider of liquidity to the system, the Bank is thinking through whether to adapt its facilities to support continuous private liquidity creation. Bank capitalization Since the crisis began, the capital adequacy of banks around the world has been the subject of intense scrutiny. Concerns moved quickly from bank exposures to U.S. subprime debt on to structured products of all types as the crisis spread and, finally, to more traditional credits to businesses and households as the recession took hold. Concerns about capital adequacy for banks outside Canada were made worse by uncertainties caused by accounting standards, valuation methodologies, and a loss of credibility of the Basel II regulatory capital standard. It was not lost on investors that every single financial institution that failed had a capital ratio well above its Basel II regulatory minimum the day before it went down. As a consequence, investors have demanded ever-higher capital ratios from all banks, creating a dynamic that has exacerbated the recession. In this context, Canadian institutions have benefited from several factors: high initial capitalization (minimums set by the Office of the Superintendent of Financial Institutions are well above the Basel threshold), high-quality capital (with one of the highest proportions of common equity), the clarity provided by a simple leverage cap, low exposure to structured products, and clear valuation and disclosure standards (including rapid implementation of the Financial Stability Forum's enhanced disclosure guidance of April 2008) (Chart 6). Writedowns by Canadian banks have been relatively moderate to date, reflecting their conservative lending practices and low exposure to highly impaired asset-backed products. But Canadian banks, as the principal source of finance in our economy, are still exposed to the risk of a marked deterioration in economic conditions, which would depress earnings and generate losses in their household and corporate loan portfolios. In general, this risk is why banks carry high capital buffers. The macroprudential risk is that these capital buffers may not be allowed to play their intended role in absorbing these losses because of market pressures to maintain inordinately high capital ratios. This could force banks to curb balance sheet growth, causing a tightening of credit conditions that would reinforce the negative impact of the economic downturn on the financial system. Reflecting the generalized nature of the financial panic, as the crisis unfolded, Canadian banks came under pressure from markets to increase their capital ratios. In response, Canadian banks raised significant additional, high-quality capital from private sources. The recent improvement in market sentiment has been reinforced by the release in May of the stress-test results for the 19 largest U.S. banks. These tests showed that the amounts of additional capital that need to be raised are manageable – indeed, more than half of the estimated shortfall has already been filled. The results have contributed to a general improvement of confidence in the global banking sector. To the extent that global levels of uncertainty and risk aversion have been lowered, this should also relieve some of the market pressure on Canadian banks to maintain inordinately high capital ratios. It would be welcome if buffers could serve their intended purpose, particularly in light of the extraordinary liquidity and funding support that public authorities have provided to our financial institutions. Policy response The crisis has undermined the credibility and demonstrated the procyclicality of the current bank capital regulatory regime. This, too, is unacceptable. An improved regime should be dynamic (with buffers and provisions moving through the cycle), simple (including Canadianstyle leverage caps), and coherent (consistent with broader initiatives such as moving overthe-counter derivatives onto exchanges). 2 The Bank is working with its domestic partners and is using its positions on the Basel Committee of Banking Supervision, at the Financial Stability Board, and in the G-20 to advance this goal. In April, G-20 leaders made it a priority to find ways to reduce procyclicality in the financial system (procyclicality in the financial sector resembles the hog cycle, except that the boombust nature is further encouraged by regulations, accounting standards, and market practices). 3 To that end, our latest FSR provides detailed analysis of key issues, ranging from reducing the procyclicality of bank capital regimes, compensation packages, and valueat-risk-based risk-management practices. 4 The Bank will continue to devote considerable analytic resources to ensure Canada leads the G-20 effort to reduce procyclicality. Household and corporate balance sheets The resilience of our financial institutions is obviously directly affected by the financial resilience of Canadian households and corporations. Canadian firms entered this recession in very strong shape. Corporate leverage is close to an historic low and is substantially below that in other major countries (Chart 7). The picture for Canadian households is more mixed. The starting point is relatively strong: The debt-service ratio has been stable over the past year and remains just below its longterm average. In addition, equity in Canadian homes is significantly higher than in the United States (Chart 8). However, a deeper-than-expected recession has meant that stresses are rising. Income growth has slowed, and personal wealth levels have been eroded by lower house prices in some regions; credit growth has continued to outpace income growth, contributing to higher debt levels (Chart 9). At the same time, sharp increases in unemployment are raising the incidence of financial stress among households (Chart 10). Non-performing household loans and associated provisioning at Canadian financial institutions are thus increasing, although the deterioration in credit quality is being mitigated to some extent by the decline in effective borrowing rates (Chart 11). The Bank has conducted a partial simulation exercise to estimate the impact on household balance sheets of a more severe economic downturn than currently envisaged, which would Given where we are in the current crisis, it should also be Augustinian; that is, new requirements should be phased in over time to avoid deepening the recession because of procyclical deleveraging. When hog prices are high, more producers opt in to the market. As the product reaches maturity, there is an excess of supply, and prices fall. Given low prices, producers then cut back their production, leading to a shortage and a price increase once again. This issue of the FSR includes the following reports: "Procyclicality and Bank Capital," by N. Arjani; "Procyclicality and Provisioning: Conceptual Issues, Approaches, and Empirical Evidence," by M. Misina; "Regulatory Constraints on Leverage: The Canadian Experience," by A. Crawford, C. Graham, and É. Bordeleau; "Procyclicality and Value at Risk," by P. Youngman; "Procyclicality and Margin Requirements," by N. Kamhi; and "Procyclicality and Compensation," by É. Bordeleau and W. Engert. increase the unemployment rate to 10 per cent of the workforce. The results indicate that the associated rise in financial stress among households would lead to a significant increase in losses (which would reduce the Tier 1 capital ratios by about 1 percentage point) for financial institutions, which is well within their capacity to absorb (Table 1). The economic outlook The global economy is in the midst of a major synchronized recession. The Bank expects that growth will resume later this year but that the recovery internationally and in Canada will be more muted than normal. In part, this reflects the need to correct a series of imbalances across and within major economies. The recovery will initially owe much to monetary policy, which has been very aggressive, and to fiscal policy, which is beginning to have an impact. The effects of monetary and fiscal policy will reach full force in 2010. Self-sustaining demand in most economic areas is not yet imminent. It appears likely that the global economy is entering a period of lower potential growth. The substantial capital misallocation and financial excesses of the boom years will take years to work off. Recognizing the scale of the industrial restructuring and the decline in investment over that period, the Bank has sharply lowered its estimate for Canadian productivity growth and potential growth. The shifting composition of global growth will have important implications for Canada. The current pattern of U.S. activity, with its weakness in the housing and auto sectors, is proving particularly challenging for our businesses. We expect the U.S. recovery to be relatively subdued compared with historical experience, given its need to reduce excesses, particularly of private debt. More positively, the greater proportion of emerging-market growth in overall global growth should create new opportunities. Our research indicates that, even in the throes of the crisis, those emerging markets whose demand is most relevant to our exports are also generally the most resilient. These countries can be expected to make up an increasing proportion of global demand. This should provide an important support for commodity prices over the medium term. The Bank has acted proactively and aggressively to counter the major shocks to the Canadian economy. We eased our policy rate to the lowest possible level – 1/4 per cent – to support private demand and to achieve our 2 per cent inflation target. Conditional on the outlook for inflation, the Bank expects the policy rate to remain at its current level until the end of June 2010 in order to achieve the inflation target. The Bank retains considerable additional flexibility, including unconventional measures, as outlined in the principles-based framework in our April Monetary Policy Report. Conclusion Despite the global crisis, the Canadian financial system remains resilient. Prior to the crisis, Canadian households, businesses, and financial institutions had not built up the high levels of debt that have made other countries vulnerable. Canadian banks have bolstered their already strong capital ratios with new private funds. Wholesale funding conditions have improved significantly and are among the most competitive in the world. The liquidity of bank balance sheets has improved. In short, our system is well positioned to face the strains of both the current recession and a more muted recovery. In farming, you are not in full control of your destiny, and your work is never done. Shocks frequently come from above. You may hope for the best, but you must plan for the worst. Even on the eve of summer, you know that it will soon be a long, cold winter, followed by another spring. The cycle begins anew, and the process is renewed as you constantly innovate by investing in new equipment and crop varieties. Ultimately, you are keepers of the land to pass on to the next generation. And so it is with financial stability. In a highly integrated global economy, shocks frequently come from abroad. We plan for the worst by trying to build a system that can absorb blows rather than amplify them. Canada has a strong system, but this crisis has proven that even the best is not good enough. Just like farmers, policy-makers need to innovate to make our financial system more resilient and efficient. This means more robust core funding markets, a better bank capital regime, and, more broadly, a series of measures to reduce procyclicality. The Bank will continue to work with our domestic and international partners to build such a financial system, so that the economic harvest in Saskatchewan and across Canada can be more consistently bountiful.
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Opening statement by Mr Mark Carney, Governor of the Bank of Canada, at a press conference following the release of the Monetary Policy Report, Ottawa, 23 July 2009.
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Mark Carney: Statement on the July Monetary Policy Report Opening statement by Mr Mark Carney, Governor of the Bank of Canada, at a press conference following the release of the Monetary Policy Report, Ottawa, 23 July 2009. * * * Good morning. Senior Deputy Governor Paul Jenkins and I are pleased to be here with you today to discuss the July Monetary Policy Report, which we published this morning. • Global economic activity appears to be nearing its trough, and there are increasing signs that activity has begun to expand in many countries in response to monetary and fiscal policy stimulus and measures to stabilize the global financial system. • However, this recovery is nascent. To sustain global growth, effective and resolute policy implementation remains critical. • The Bank has long expected that economic growth in Canada would resume in the second half of this year and pick up in 2010. Indeed, growth in Canada should resume this quarter. The dynamics of the recovery projected in today's MPR are broadly consistent with the Bank's medium-term outlook in April. • Stimulative monetary and fiscal policies, improved financial conditions, firmer commodity prices, and a rebound in business and consumer confidence are spurring domestic demand growth. • However, the higher Canadian dollar, as well as ongoing restructuring in key industrial sectors, is significantly moderating the pace of overall growth. • Some of the early strength in domestic demand represents a bringing forward of household expenditures, which modestly alters the profile of growth over the projection period relative to the April MPR. We now expect the Canadian economy will contract by 2.3 per cent this year and then grow by 3.0 per cent in 2010 and 3.5 per cent in 2011. • Total CPI inflation declined to -0.3 per cent in June and should trough in the third quarter of this year. While core inflation held up at 1.9 per cent in the second quarter of this year, the Bank still expects core inflation to diminish in the second half of this year. • The Bank expects both total and core inflation to return to the 2 per cent target in the second quarter of 2011 as aggregate supply and demand return to balance. • A stronger and more volatile Canadian dollar represents an important downside risk to output and inflation. • On Tuesday, the Bank reaffirmed its conditional commitment to maintain its target for the overnight rate at the effective lower bound of 1/4 per cent until the end of June 2010 in order to achieve the inflation target. • The Bank retains considerable flexibility in the conduct of monetary policy at low interest rates, consistent with the framework outlined in the April MPR. With that, Paul and I would be pleased to take your questions.
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Remarks by Mr Mark Carney, Governor of the Bank of Canada, to a symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming, 22 August 2009.
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Mark Carney: Some considerations on using monetary policy to stabilize economic activity Remarks by Mr Mark Carney, Governor of the Bank of Canada, to a symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming, 22 August 2009. * * * It is an honour to provide a few comments on Carl Walsh’s excellent paper, which revisits some fundamental monetary policy issues. Walsh’s paper highlights many useful lessons that can be learned from the conventional framework and its various extensions. However, the financial crisis provides a stark and costly reminder of just how incomplete the standard model is. I will concentrate on the future of monetary policy in light of both the lessons of the crisis and the prospect of some central banks having more formal responsibility to promote financial stability. I will take as my starting point Walsh’s observation that: “distortions in financial markets that generate real effects of monetary policy also imply that financial stability may require making trade-offs with the goals of inflation stability and stability of real economic activity.” 1 There is an emerging consensus that price stability does not guarantee financial stability and is, in fact, often associated with excess credit growth and emerging asset bubbles. 2 There is also general agreement that the first line of defence should be better regulation, including new macroprudential tools. However, it is less widely recognized that this will mean it is not “business as usual” for monetary policy. At a minimum, the regulatory response will change the transmission mechanism and, consequently, the implementation of monetary policy. A more fundamental policy question – one that has not yet been fully thought through – is whether the policy rate itself should lean into the wind for financial stability purposes. If so, how will central banks retain accountability and credibility, and their associated benefits for inflation expectations? Could it be advantageous to amend the price stability mandate? I would like to undertake an initial exploration of these issues today. What follows is a discussion of ideas worthy of consideration. It should not be seen as having any bearing on the current conduct of monetary policy or the prospective management of financial stability in Canada. The Bank of Canada's current inflation-control agreement with the Government of Canada will remain in effect until the end of 2011. Any changes to our agreement with the Government, if desired by both parties, would only come into effect thereafter. Changes to financial stability regulation are generally the purview of the Government of Canada. Is price stability enough? While most central banks have added a financial stability objective in recent years, the monetary policy and financial stability wings of many of our institutions have operated as two solitudes. 3 For example, the standard New Keynesian transmission channels featured in workhorse monetary policy models and described in Walsh’s paper ignore not only the financial accelerator but also broader procyclical dynamics in modern money and credit markets. Importantly, these dynamics could be triggered by the attainment of price stability Carl Walsh, “Using Monetary Policy to Stabilize Economic Activity.” Prepared for the Jackson Hole Symposium on Financial Stability and Macroeconomic Policy, 20-22 August, 2009, pp. 33-34. See, for example, King (2009) and Shirakawa (2009). This was one of the primary motivations for the Bank of Canada’s organizational realignment last year. itself. Such downplaying of real-financial linkages obscured the scale of emerging vulnerabilities and challenged the initial crisis response. The experience of the past two years is quickly changing these attitudes. Central banks are recognizing that they need a deeper understanding of financial system dynamics in order to better understand the relationship between price and financial stability and, ultimately, the contribution of both to the stabilization of economic activity. The variable transmission mechanism Central banks have effectively treated the transmission mechanism as uncertain but fixed (or at best only mildly variable) when it is in fact highly variable and procyclical. The transmission mechanism is a function of, among other factors, (i) regulation, which changes over time; (ii) financial innovation, which often evolves to circumvent regulation; and (iii) confidence, which is influenced by monetary policy in ways not commonly acknowledged. 4 Consider three states of the world. In the normal state, financial agents balance macroeconomic and idiosyncratic risks in their investing, lending, and financing decisions. In the exuberant state, agents become complacent about macroeconomic risks and seek to exploit more idiosyncratic or obscure opportunities. 5 In the panicked state, macroeconomic risks dominate and all idiosyncratic risks are shunned. The normal state is just that, normal. The other two extremes are the tails that we have just lived through. A prolonged, benign macroeconomic environment can encourage the transition from normal to exuberant states. As we have all just been reminded at great cost, low, stable, and predictable inflation and low variability in activity – especially when associated with exceptionally low and stable interest rates – can breed complacency among financial market participants as risk taking adapts to the perceived new equilibrium. 6 Indeed, risk appears to be at its greatest when measures of it are at their lowest. Low variability of inflation and output (reduces current financial VaR and) encourages greater risk taking (on a forward VaR basis). Investors stretch from liquid to less-liquid markets. In parallel, low and stable interest rates promote larger asset-liability mismatches across credit and currency markets. These tendencies are particularly marked if there is a perceived certainty about the stability of low interest rates. 7 Many of these positions are funded on a collateralized basis. Such asset-based financing creates intensely procyclical liquidity cycles. In these cycles, rising asset prices increase funding liquidity, which finances further purchases and prompts additional price increases. Over time, haircuts are relaxed, further intensifying the cycle. 8,9 It is important to recognize that expectations about monetary policy can feed these dynamics. It would appear that the so-called “Clean” doctrine reinforces the risk-taking behaviour of agents. This is a strategy that advocates using monetary policy to “clean up,” or respond to, the consequences of a burst asset bubble rather than “leaning into the wind,” Other factors include where the economy is in the cycle and the state of household and corporate balance sheets. They do so within a perceived risk budget. The actual risk budget has, of course, grown. Either perceptions of risk or risk preferences could change. In the former case, complacency about actual risks can mean taking greater risks within the same risk budget. See Diamond and Rajan (2005). See Gorton and Metrick (2009), Fisher (2008), and Adrian and Shin (2008) for comprehensive descriptions of these dynamics. Ways to limit such procyclicality include enforcing through-the-cycle margins in repo markets and limiting rehypothecation margins in securities lending to 100 per cent. which would limit the progression of excess credit creation. 10 The combination of the central bank’s silence over the existence of a possible bubble, the certainty that it would not respond to emerging financial pressures unless they affect price dynamics over the monetary policy horizon, and the expectation that it would mop up if the bubble bursts all conspire to sow the seeds of the next crisis. 11 Though they are far from the whole story, such dynamics are central to the understanding of the current financial crisis. 12 The first line of defence is better regulation While misery loves company, we must be careful not to generalize recent failings. The foregoing description of liquidity cycles assumes that agents can extend mismatches, increase leverage, and boost collateral-based finance if conditions appear favourable. In other words, regulatory quiescence or arbitrage is also required. Neither has been universal. The oft-derided existing regulatory tool kit has been deployed more effectively in some jurisdictions than in others. Indeed, many Inflation Targeters achieved their price stability objectives and retained well-functioning, appropriately exuberant financial systems (including Canada, Australia, and New Zealand). This advantage is easily replicated and could be further enhanced if an effective macroprudential approach were developed. 13 The implementation of monetary policy will have to change New macroprudential tools will change the transmission mechanism, potentially in real time if discretion is used in their application. As a result, central banks will need to coordinate across conventional monetary policy tools and those emerging financial stability tools that have monetary policy implications. This could prove challenging. Fortunately, we are already on the learning curve. Strains in the interbank, repo, and credit markets dramatically tightened the effective stance of monetary policy. In response, extraordinary liquidity facilities were deployed. The effectiveness of these facilities varied across jurisdictions with the health of core financial institutions and the scale of shadow banking systems. A common lesson is that current market infrastructure does not ensure continuously available core funding markets. A wholesale restructuring of funding markets is thus required. Promising avenues to break such liquidity spirals include introducing clearing houses, standardizing products, implementing through-the-cycle margining, and ensuring more effective netting. As the ultimate provider of liquidity to the system, central banks should consider whether to adapt our facilities to support continuous private liquidity creation. Through such measures, we can reduce the procyclicality of the transmission mechanism. How other emerging macroprudential tools are implemented also matters. If these new tools, such as time-varying capital buffers, are purely rules based, perhaps linked to aggregate credit growth, their impact on the transmission mechanism may be determined with See White (2009) for the definition and broader discussion. An alternative extreme is the “dark side” of credibility, whereby agents make bigger mistakes as a consequence of believing central banks will always get policy right. This is consistent with the exuberant state. For a more complete exposition, see Bernanke (2009). According to Walsh, “targeted and time varying financial regulations are better instruments than monetary policy for mitigating many of the effects of these [financial] frictions. But if regulation fails to do so, central banks cannot ignore financial frictions and financial stability” (2009, p. 28). experience. Unfortunately, it is unlikely that we can get the rules right ex ante and, in any event, private innovation may change their impact over time. If there is an element of discretion in their application, it may be less certain that such dynamic management of the transmission mechanism for financial stability purposes will be both timely and effective. This could place greater pressure on monetary policy to act. For this reason, there is likely value in either coordinating such decisions in the same authority or determining some other mechanism for joint optimization. The basic point is that in order to maximize the probability of achieving both price and financial stability objectives, one objective of macroprudential tools should be to dampen the procyclicality of the transmission mechanism. This will take the weight off monetary policy to act for financial stability purposes and allow its use to be concentrated on the pursuit of price stability. Can central banks achieve dual price and financial stability mandates? With the advent of inflation targeting, price stability mandates for most central banks have become increasingly well defined. Until recently, the vagueness of most financial stability mandates and the assumption that price stability was consistent with financial stability meant that there were few perceived conflicts. In the wake of the crisis, financial stability mandates can be expected to harden and conflicts may become more apparent. Can central banks jointly optimize these objectives? What are the implications for monetary policy of trying to do so? Price stability should be retained as the central objective of monetary policy, although its definition may have to change. Price stability may not be enough to stabilize economic activity in all states of the world, but neither is it undesirable. Indeed, the single most direct contribution that monetary policy can make to sound economic performance is to provide our citizens with confidence that their money will retain its purchasing power. That means keeping inflation low, stable, and predictable. Price stability lowers uncertainty, minimizes the costs of inflation, reduces the cost of capital, and creates an environment in which households and firms can invest and plan for the future. It has generally been coincident with sustainable growth in output and employment. Having a credible price stability objective has also proven enormously helpful during the crisis and should continue to be so during the eventual exit. The coherence of policy and the message derived from one fixed objective provide greater certainty for financial markets in a time of considerable turmoil. The ability to maintain inflation expectations has helped keep real interest rates low and provide the necessary monetary stimulus. The inflation anchor remains essential even when providing extraordinary guidance. This is why the Bank of Canada’s current commitment – that our target rate is projected to remain at its effective lower bound through the end of the second quarter of 2010 – is explicitly conditional on the outlook for inflation. Different time horizons for price and financial stability require flexibility The main challenge for joint optimization is that financial and price stability share common determinants but have different time horizons. Price stability dynamics continuously reflect real shocks and/or policy responses, while financial vulnerabilities are much less predictable. They build over time and can persist for longer than expected. Because of this mismatch, policy actions consistent with targeting one may undermine the other. 14 This may partially explain why asset prices are not accurate predictors of goods prices. See Walsh (2009, p. 29). This timing difference can be partially bridged in a couple of ways. First, housing prices can be incorporated in the consumer price index, as they are in Canada. Second, monetary policy communications could adapt to reflect the behavioural dynamics of financial systems. An effective communications strategy for normal states may prove counterproductive in exuberant states. How central banks communicate can influence the degree to which low, stable, and predictable inflation fosters excess credit growth. It is important that markets understand how a central bank formulates policy, but that does not equate to perfect foresight. Differences in judgment and the fundamental uncertainties surrounding the economic outlook should mean occasional differences in view. These should be particularly marked during turning points in the economic cycle. As the review of liquidity cycles suggests, wider “markets” in expected economic outcomes (which would mean greater short-term volatility) could promote longterm financial stability. 15 The alternative would be to generate price instability to prevent financial instability. That is, the price objective might have to become less stable in order to disrupt the endogenous liquidity creation that comes from relatively stable, predictable rate paths. 16 This, rather than a higher inflation rate (if reliably achieved), would appear necessary to disrupt the dynamics described earlier. The trade-off between flexibility and credibility challenges joint optimization Flexible inflation targeting is the standard approach to bridge the different time horizons for financial and price stability. However, there are limits. The time frame for inflation targeting can be stretched, but the credibility essential for its success may be undermined if such flexibility is taken too far or deployed too frequently. 17 Flexible inflation targeting works well with temporary or one-off shocks. Whether it can adapt to address unique but longer-lived shocks or different states of the financial economy, such as an asset boom, is the relevant question. The design of monetary policy frameworks depend in part on the trade-off between flexibility and credibility. This, in turn, is a function of both the extent to which (inflexible) rules enhance credibility and the ability of central banks to exercise the discretion required to deploy any flexibility in a credible manner. There is an important governance and accountability aspect to this, which the current debate often ignores. Inflation-targeting regimes generally have fixed targets, with bands and tight timelines for their achievement. This inflexibility sets clear objectives and helps hold central bankers accountable. It also can create a virtuous circle. As the inflation target is achieved, it enhances the central bank’s credibility, which further anchors inflation expectations, which then contribute to a more stable macroeconomic environment, and that, in turn, further builds policy credibility. We should be careful neither to underweight the value of resulting simple heuristics of economic agents nor to minimize the risks of complicating them. If the central bank were to lean for financial stability reasons and miss its inflation target as a consequence, its In this regard, the Bank of Canada views its use of a conditional commitment as an unconventional policy instrument, justified by the effective lower bound and by extreme market volatility. As argued below, it is not that the price objective itself should become less stable but that its attainment could become more volatile. This could be the natural consequence of adding a financial stability objective if macroprudential tools and surveillance do not prove sufficient for the task. Since 1998, the Bank of Canada’s horizon has varied from five to ten quarters over our projection period. accountability could be diminished, its credibility reduced, and potentially, inflation expectations themselves could become unanchored. 18 The key question is whether the financial stability benefit of greater flexibility is worth the price stability risk of forfeited credibility. Amending the price stability objective to promote financial stability This all suggests that if monetary policy must lean into the wind for financial stability purposes, then the price stability objective should change in a manner consistent with the desired variability in the price path. This could be accomplished by combining flexible inflation targeting and price-level targeting. In general, policy-makers would rely on enhanced macroprudential regulatory frameworks to curb the enthusiasm in the financial system. 19 While the policy interest rate would not be the primary tool for promoting financial stability, it occasionally might be used to support macroprudential tools. Leaning into the wind for financial stability purposes could thus result in temporary deviations from the inflation target. To avoid threatening the monetary policy objective, these deviations could be recovered over time in order to keep the economy on a predetermined path for the price level. The prospect that the target rate could be deployed in this manner would help maintain a balance between macro and idiosyncratic risk. The discipline of a transparent and accountable price stability objective via the price-level target could maintain central bank credibility. However, authorities, if they are granted flexibility, must be sufficiently disciplined not to decide that all shocks are uniquely virulent. This suggests that exercising any flexibility to lean into the wind for financial stability purposes should be episodic, the product of statedependent rules. That is, the central bank would need to make the judgment not only that an exuberant state is developing, but also that macroprudential tools alone are insufficient to counteract it. The possibility that the central bank would make this judgment would rise with the degree of excess credit creation, providing a partial check on emerging complacent financial expectations. A crucial motivation for this idea is that the balance of long-term price stability (i.e., achieving a predetermined price path) with higher short-term variability (due to the occasional leaning) is ultimately more consistent with achieving financial stability than conventional inflation targeting. 20 This reflects the relationship between price stability; low, relatively stable interest rates; and the emergence of exuberant financial states of the world described earlier. However, it also presumes that regulation is not up to the task. It is important to stress again that the first line of defence against these dynamics must lie in improved regulation and market structure. It is also important to remember that there are concerns about macro stabilization under price-level targeting. In particular, the performance of a price-level target may suffer if inflation expectations are highly backward looking and/or if the economy is vulnerable to shocks generating negative correlation between output and inflation. 21 Highly persistent A current example may concentrate the mind. What if it were thought that central banks might keep rates too low for too long from a price stability perspective in order to repair the banking system (from a financial stability perspective). Rising inflation expectations and bond yields could undermine the recovery. Walsh distinguishes between asset prices in normal and in bubble situations (2009, p. 32). A financial bubble and the policy response to it create the danger of yielding the reverse, i.e., short-term price stability but longer-term persistent deviations from the desired price path. See Steinsson (2003). relative price shocks may also pose a problem for macro stabilization under price-level targeting. 22 Any decision on the overall merits of price-level targeting must take all of these considerations into account. Conclusion Experience has shown that monetary and financial stability are more tightly bound than had been appreciated. Price stability is a necessary, but not sufficient, condition for the stabilization of economic activity, and it must be supplemented by a robust macroprudential regulatory framework. This, in turn, will have consequences for the implementation of monetary policy. If these macroprudential tools prove insufficient to achieve financial stability, monetary policy faces a difficult trade-off between flexibility and credibility. As a consequence, authorities may wish to adjust the monetary policy objective to have the credible flexibility required to achieve both targets. Price-level targeting offers one potential avenue for consideration. A formal assessment of the merits of price-level targeting will require the development of a framework that has a more realistic depiction of real-financial linkages than is embodied in the standard financial accelerator model. These models are still in their infancy, and their use to study the relative merits of inflation targeting and price-level targeting is the subject of ongoing research at the Bank of Canada. The financial stability aspect of the price-level versus inflation targeting debate is only one of many relevant dimensions. The Bank has launched a multi-year research initiative that includes a comprehensive examination of the possible advantages of moving to a price-level target. 23 Our efforts in this area are ongoing and we look forward to continuing to work with monetary policy experts, academics, and central bankers from across the world. Carl Walsh has made a valuable contribution to that debate today. References Adrian, T. and H.S. Shin. 2008. “Financial Intermediaries, Financial Stability and Monetary Policy.” Paper prepared for the economic policy symposium “Maintaining Stability in a Changing Financial System.” Jackson Hole, Wyoming. August. Amano, R., O. Kryvtsov, and J. Murray. 2009. “Price-Level Targeting in a Multi-Sector Economy.” Bank of Canada. Manuscript. Bank of Canada. Inflation http://www.inflationtargeting.ca Targeting Research (website). Available at Bank of Canada Review. 2009. Special Issue: Research on Inflation Targeting. Spring. Bernanke, B. S. 2009. “Four Questions about the Financial Crisis.” Speech at Morehouse College, Atlanta, Georgia. 14 April. Carney, M. 2008. “Building Continuous Markets.” Speech to the Canada – United Kingdom Chamber of Commerce. London, England. 19 November. Cateau, G. 2008. “Price Level versus Inflation Targeting under Model Uncertainty.” Bank of Canada Working Paper No. 2008-15. See Amano, Kryvtsov, and Murray (2009); Coletti et al. (2009); and de Resende, Dib, and Kichian See the Bank of Canada’s website on inflation-targeting research at www.inflationtargeting.ca; Cateau (2008); Kryvtsov, Shukayev, and Ueberfeldt (2008); Cateau, Kryvtsov, Shukayev, and Ueberfeldt (2009); Dib, Mendicino, and Zhang (2008); Covas and Zhang (2008); and Coletti, Lalonde, and Muir (2008). Cateau, G., O. Kryvtsov, M. Shukayev, and A. Ueberfeldt. 2009. “Adopting Price-Level Targeting under Imperfect Credibility in ToTEM.” Bank of Canada Working Paper No. 200917. Coletti, D., R. Lalonde, and D. Muir. 2008. “Inflation Targeting and Price-Level-Path Targeting in the Global Economic Model: Some Open Economy Considerations.” IMF Staff Papers, Vol. 55, No. 2. Coletti, D., R. Lalonde, P. Masson, and D. Muir. 2009. “Commodities and Monetary Policy: Implications for Inflation and Price Level Targeting.” Bank of Canada. Manuscript. Covas, F. and Y. Zhang. 2008. “Price-Level versus Inflation Targeting with Financial Market Imperfections.” Bank of Canada Working Paper No. 2008-26. de Resende, C., A. Dib, and M. Kichian. 2009. “Optimal Monetary Policy in Multi-Sector Small Open Economy Models: Conventional Wisdom?” Bank of Canada. Manuscript. Diamond, D. W. and R. Rajan. 2005. “Liquidity Shortages and Banking Crises.” Journal of Finance 60 (2): 615–47. Dib, A., C. Mendicino, and Y. Zhang. 2008. “Price Level Targeting in a Small Open Economy with Financial Frictions: Welfare Analysis.” Bank of Canada Working Paper No. 2008-40. Fisher, P. R. 2008. “Commentary: The Role of Liquidity in Financial Crises.” Comments on a paper presented by E. Carletti and F. Allen at the symposium “Maintaining Stability in a Changing Financial system.” Jackson Hole, Wyoming. August. Gorton, G.B. and A. Metrick. 2009. “Securitized Banking and the Run on Repo.” Yale ICF Working Paper No. 14. Available at SSRN: http://ssrn.com/abstract=1440752. King, M. 2009. Speech at the Lord Mayor’s Banquet for Bankers and Merchants of the City of London at the Mansion House. London, England. 17 June. Kryvtsov, O., M. Shukayev, and A. Ueberfeldt. 2008. “Adopting Price-Level Targeting under Imperfect Credibility: An Update.” Bank of Canada Working Paper 2008-37. Shirakawa, M. 2009. “Some Thoughts on Incentives at Micro- and Macro-level for Crisis Prevention.” Remarks at the Eighth Bank for International Settlements Annual Conference. Basel, Switzerland. 26 June. Steinsson, J. 2003. “Optimal Monetary Policy in an Economy with Inflation Persistence.” Journal of Monetary Economics 50(7): 1425–65. Walsh, C. 2009. “Using Monetary Policy to Stabilize Economic Activity.” Paper prepared for the symposium “Financial Stability and Macroeconomic Policy.” Jackson Hole, Wyoming. August. White, W. R. 2009. “Should Monetary Policy ‛Lean or Clean’?” Center for Financial Studies. Goethe University. Frankfurt. May.
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Remarks by Mr Timothy Lane, Deputy Governor of the Bank of Canada, to the Canadian Association for Business Economics, Kingston, Ontario, 25 August 2009.
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Timothy Lane: The Canadian economy beyond the recession Remarks by Mr Timothy Lane, Deputy Governor of the Bank of Canada, to the Canadian Association for Business Economics, Kingston, Ontario, 25 August 2009. * * * Good afternoon. It's a great pleasure to join you at this year's CABE meeting. The theme of the conference, "managing the recovery," is particularly timely: As we move past the gravest dangers of the financial crisis toward better days, attention has turned to the policy challenges posed by the recovery. "Managing the recovery" may turn out to be almost as interesting as managing during the crisis! While the outlook is clouded by uncertainty, there are encouraging signs that we will return to positive growth this quarter. Stimulative monetary and fiscal policies, improved financial conditions, firmer commodity prices, and a rebound in business and consumer confidence are spurring the growth of domestic demand. Globally, the vigorous policy actions taken by monetary and fiscal authorities appear to have reduced the probability of an extreme negative outcome for the global economy. But there remain significant upside and downside risks to the outlook for the Canadian economy. As we return to positive growth, policy-makers are facing difficult decisions – when and how to remove stimulus, how to secure the stability of the global financial system, and, importantly, and over the long term, how to set the stage for a return to rising living standards. It is this last challenge that I'd like to focus on later in my remarks. I will start with a few comments on how the recovery is likely to unfold and the forces that will be driving it, and what this outlook means in terms of the output gap. Then I'd like to look at Canada's growth trajectory beyond the recovery by focusing on two key variables that affect both potential and actual output – labour input and productivity. Given the significant changes foreseen in the labour market and their implications for output, it's clear that Canada, like many other nations, needs to improve its productivity if we are to reap the benefits of sustained growth. I'll also touch on the important role of monetary policy and financial system policy in setting the stage for sustainable growth. After I conclude, I'd be happy to respond to comments and questions. The outlook for the economy The Canadian economy is expected to start growing again this quarter. Our July Monetary Policy Report discusses the factors underpinning this earlier-than-expected resumption of growth. Globally, there are signs of a nascent recovery. More specifically, the U.S. economy is likely to start recovering this quarter, and growth is also picking up again in China, a major source of demand for raw materials. In Canada, domestic demand is strengthening, supported by improved financial conditions, a rebound in consumer and business confidence, and firmer commodity prices. We are projecting Canada's GDP growth at -2.3 per cent for 2009, 3.0 per cent for 2010, and 3.5 per cent for 2011. Canada's economic recovery will be supported by a combination of factors, which is likely to make it somewhat more robust than elsewhere. First, the composition of economic activity in the United States as it recovers will prove favourable to Canadian exporters – as the sectors hit hardest by the recession, such as housing and automobiles, rebound. Second, Canada's relatively well-functioning financial system will enable credit to meet the needs of an expanding economy. A third supportive factor is the underlying strength of household, business, and government balance sheets. These favourable circumstances are expected to support the return to economic growth, with the output gap closing by mid-2011. Of course, many uncertainties remain – and economic forecasters are notoriously more prone to error around turning points in the cycle. The July MPR identifies the upside risk of economic momentum in Canada being stronger and more sustained than expected. On the downside, the risks relate mainly to the external sector. There is a possibility that financial conditions may normalize more slowly than expected, and further setbacks cannot be precluded. Two downside risks require elaboration. First, it's important to bear in mind that a good deal of the impetus for the recovery, in Canada and worldwide, is coming from the public sector – from policy actions by governments and central banks. The scale of fiscal expansion has been quite substantial. Monetary policy has also been eased aggressively, bringing policy interest rates close to their effective lower bound in most advanced economies. In Canada, the target overnight rate of 1/4 per cent is reinforced by our conditional commitment to keep the rate at its current level until the middle of next year. This monetary easing counters other factors – such as tighter lending conditions and wider-than-usual yield spreads on corporate bonds – that would otherwise have resulted in tighter overall financial conditions. Other central banks, given the situations they have been facing, have gone even further by providing additional stimulus through quantitative and/or credit easing. In many countries, the authorities have also had to provide substantial direct support to financial institutions facing difficulties. Although we have been spared that in Canada, this support has been an important bolster for the global recovery. While these policy actions have been timely and effective, they imply that the incipient recovery depends to a considerable degree on official action. At what stage will private demand be robust enough to make the recovery self-sustaining? Clearly, we haven't reached that point yet. A second important risk is the possibility of persistent strength in the Canadian dollar, which would work against the positive factors that I mentioned earlier. The recent rise in the dollar is, in part, a reflection of the same factors that are leading to a recovery in Canada, notably the rebound in commodity prices. It is also a result of a more generalized weakening of the U.S. dollar, as global financial conditions normalize. Other things being equal, a persistently strong Canadian dollar would reduce real growth and delay the return of inflation to target. If a stronger dollar were to alter the path of projected inflation relative to that presented in our July Monetary Policy Report, we would need to take that into account. As we have said before, even though we are at the effective lower bound for our policy rate, we retain considerable flexibility through the use of unconventional monetary policy instruments, including quantitative easing. The output gap and the evolution of potential output I'll now turn to the output gap and potential output. The output gap is the difference between actual and potential output – with the latter defined as the level of output that can be achieved with existing labour, capital, and technology without putting sustained upward pressure on inflation. The concept has been much maligned, partly because it is not an observed variable, and it is subject to considerable measurement problems. However, it remains a convenient "shorthand" for characterizing underlying inflation pressures, and for bridging between the current conjuncture and the factors that will condition economic growth over the medium term, as the output gap is closed. Our current situation of excess supply (a negative output gap) implies, all else being equal, that core CPI inflation can be expected to decline and then recover as actual output growth exceeds potential, while the level of output returns to potential. The output gap is best used to complement more detailed and micro-founded analysis, particularly that captured in more formal models. For example, our main projection model for the Canadian economy, ToTEM, has a structure that is based on explicit assumptions about firms' profit objectives and the constraints that they face when setting prices. As a result, the output gap is not a direct determinant of inflation in ToTEM, in the sense that when firms set prices, they do not explicitly take account of the aggregate output gap. More generally, we pay attention to a variety of indicators of inflationary pressures, such as core inflation, yield curves, and credit indicators. 1 I should emphasize that we don't use any of these indicators in isolation nor in a mechanical fashion. We use a good deal of judgment in interpreting changes in the economy, as well as in making monetary policy decisions. Now, three quarters after the onset of a severe recession, the output gap has widened substantially. This is indicated by the fact that output is now below its trend level, as represented by the Bank of Canada's conventional measure of the output gap, and corroborated by other indicators of excess supply. 2 For example, the Bank's summer Business Outlook Survey showed that the percentage of firms that would have difficulty meeting an unanticipated increase in demand remained at an exceptionally low level. Most labour market indicators also mirror the weakness in product markets, and jobs continue to be lost. After reviewing all the indicators of capacity pressures and the ongoing restructuring in the Canadian economy, the Bank judged that the economy was recently operating about 3.5 per cent below its production capacity. While the usual premise is that the output gap will close over time, the interesting question is how this will occur. In the current circumstances, we believe that it will come about both through lower potential and increased output. There are several reasons to expect potential output to be altered by a major recession. In particular: • Some of the decline in employment may turn out to be persistent – for instance, because high unemployment may discourage workers from seeking employment or because workers' job skills may deteriorate during long spells of unemployment. Labour displacement associated with firm closures and mass layoffs tends to increase during recessions, adding to structural unemployment, particularly for older displaced workers. • The lower level of investment during the recession translates into lower productive capacity. In addition, plant closures mean that some capital is effectively scrapped (although this is not fully reflected in the measured capital stock). • Total factor productivity may either increase or decrease, at least temporarily. It could decrease as spending on research and development declines, and as workers' jobspecific human capital is lost as they find employment in different sectors. It could also increase if, for example, the recession weeds out the less-productive activities associated with a pre-crisis "bubble economy," or stimulates efficiency gains through changes in work practices. • There is also evidence that recessions associated with financial crises are more severe and more protracted than other recessions, and that a financial crisis negatively and permanently affects potential output – as highlighted in a recent paper by Carmen Reinhart and Ken Rogoff. 3 The Bank's main indicators of capacity and inflation pressures can be found on our website at <http://bankofcanada.ca/en/rates/indinf.html>. The conventional measure of the output gap reached -4.3 per cent in the second quarter of 2009. However, this measure tends to have a higher margin of error around turning points in the economy. For a discussion of potential problems in estimating the output gap at the end of a sample, see J.-P. Cayen and S. van Norden, "The Reliability of Canadian Output-Gap Estimates," North American Journal of Economics and Finance 16, no. 3 (2005): 373-393. C. Reinhart and K. Rogoff, "The Aftermath of Financial Crises," American Economic Review-Papers and Proceedings (May 2009): 466-72. These forces are at work worldwide, as economies absorb the impact of the global recession. A recent OECD study analyzed the factors influencing potential output across the advanced economies, and traced the implications for growth through 2017. 4 This study concluded that growth will be slower, to varying degrees, in most countries. Similar forces are at work in Canada. In our April Monetary Policy Report, we lowered our estimate of potential output for the 2009-2011 period. Here, one key consideration is the structural changes under way in key sectors of the Canadian economy – notably, automobiles, energy, and forest products. We were also taking account of the sharp drop in investment that has taken place, particularly for machinery and equipment. As a result, we expected potential output growth to slow to 1.1 per cent in 2009, and then pick up gradually to 1.5 per cent in 2010 and to 1.9 per cent in 2011. 5 We will be reviewing this estimate in the October Monetary Policy Report. So, that's the outlook for the medium term. Let me turn now to examine the evolution of potential growth over the long term. I'll discuss each of the two components, trend labour input and trend labour productivity, emphasizing longer-term trends and reflecting on how these trends may have been affected by the current recession. Labour input: A drag on potential output growth For the past 30 years, Canada, like some other nations, has been sailing with a favourable wind at its back. Potential output has increased fairly steadily at about 2.7 per cent per annum, largely because of long-term increases in labour input – that is, the total hours supplied by the labour force. Since 1977, trend labour input – a function of population, the labour force employment rate, and the change in average weekly hours worked – has grown about 1.6 per cent annually. Some key factors here have been the growth of the working-age population as baby boomers reached working age and, to a lesser extent, the increased participation of women in the labour force. Over the next few years, these trends will begin to lose steam. Those on the leading edge of the baby boom are now in their 60s. Growth in the working-age population is slowing, and participation rates are declining. As these changes work their way through the population, they will have a dampening effect on trend labour input. 6 As well, the dependency ratio is likely to double over the next 20 years. 7 The demographic challenges that we have been worrying about for years have started to arrive. D. Furceri and A. Mourougane, "The effect of financial crises on potential output: New empirical evidence from OECD countries" (Working Paper No. 699, OECD Economics Department, 22 May 2009). Available at: <http://www.olis.oecd.org/olis/2009doc.nsf/LinkTo/NT00002D9A/$FILE/JT03265117.PDF>. The Bank's previous estimates, as presented in the October 2008 Monetary Policy Report, were for growth of potential output of 2.4 per cent in 2009 and 2.5 per cent in 2010 and 2011. R. Barnett, "Trend Labour Supply in Canada: Implications of Demographic Shifts and the Increasing Labour Force Attachment of Women," Bank of Canada Review (Ottawa: Bank of Canada, Summer 2007): 5-18. Available at: <http://www.bankofcanada.ca/en/review/summer07/barnett.pdf>. The dependency ratio is the ratio of the population typically not of working age (the dependent part) to those typically of working age (the productive part). In published international statistics, the dependent part usually includes those under the age of 15 and over the age of 64. This estimate comes from Banerjee and Robson (2009) (see next footnote). Immigration is not likely to diminish this challenge significantly. Even a large increase in immigration would be unlikely to provide a major offset to the projected downward trend of labour input. 8 How will these trends be affected by the financial crisis and recession? One potential mitigating factor is the negative wealth effect that households have experienced over the past year. This loss of wealth could lead some older workers to defer retirement or even to re-enter the workforce – and there is anecdotal evidence suggesting that this may be happening. But our estimates suggest that such an effect is likely to be small – perhaps 0.1 or 0.2 percentage points for one to three years into the future. In the larger scheme of things, it is thus unlikely to provide any significant offset to the projected long-term decline in labour input. Working in the other direction, the recession has resulted in sharply higher unemployment, and some of that unemployment may persist. During recessions, long-term spells of unemployment become more prevalent, and such spells can impair workers' ability to find other jobs. Some workers become discouraged and drop out of the workforce. Scenarios from the OECD suggest that such longer-term unemployment will dampen potential output growth in Canada as well as in other countries over the next few years. In sum, the recession has not altered the basic situation: The favourable conditions we've had over the past decades are no longer with us – and indeed, we are about to face some headwinds. This sobering outlook for the likely evolution of labour input leaves one other possibility for boosting potential output: improved labour productivity. Labour productivity: The key to increased living standards Compared with other countries, the growth of labour productivity in Canada over the past decade has been disappointing. After some promising signs of improvement in the late 1990s, average labour productivity growth from 2000 to 2008 has been only about 1 per cent, well below the 2.6 per cent level achieved in the United States over the same period. Canada's productivity ranking has gone from third out of 20 countries in the OECD in 1960 to 17th out of the current 30 members. What accounts for this disappointing performance, and is it likely to continue beyond the recession? Three factors help to explain the situation. First, relative to other countries, especially the United States, workers in Canada have lower amounts of capital with which to do their jobs. But particularly striking is the fact in Canada, Information and Communications Technology (ICT) capital is half the amount per worker in the United States. A study by Andrew Sharpe reveals that Canada's ICT investment gap relative to the United States is not primarily related to industrial structure and firm size; in fact, the gap exists in most industries. 9 This is important because ICT capital investment has been linked to stronger multifactor productivity growth in many countries, as firms reorganize their workplaces to take advantage of new technology. Bank of Canada research suggests that the contribution of ICT capital to productivity growth over the first half of this decade has been considerable. 10 See, for example, R. Banerjee and W.B.P. Robson, "Faster, Younger, Richer? The Fond Hope and Sobering Reality of Immigration's Impact on Canada's Demographic and Economic Future" (C.D. Howe Institute Commentary, Issue 291, July 2009). Available at: <http://www.cdhowe.org/pdf/commentary_291.pdf>. A. Sharpe, "What Explains the Canada-US ICT Investment Gap?" (Research Report 2005-2006, Centre for the Study of Living Standards (CSLS), December 2005). D. Leung and Y. Zheng, "What Affects MFP in the Long Run?: Evidence from Canadian Industries" (Working Paper No. 2008-4, Bank of Canada, 2008). Available at: <http://www.bankofcanada.ca/en/res/wp/2008/wp084.html>. A second, and related, factor is Canada's poor record on innovation. In a recent report, Peter Nicholson concluded that "too many businesses in Canada are technology followers, not leaders" and stressed the need for "innovation-based business strategies." 11 Canada stands only 16th within the OECD in the intensity of business research and development. Moreover, this situation exists despite the fact that Canada would appear to have all the ingredients needed for innovation: a highly educated work force, flexible labour markets, and high rates of firm entry and exit. 12 A third influence on aggregate productivity growth is the reallocation of capital and labour across firms. Recent Bank of Canada research suggests that job reallocation across firms is a significant positive factor explaining Canadian labour productivity growth over the 19922006 period. 13 This in turn suggests that such reallocation may be associated with more efficient economic specialization and the adoption of new work practices. Of course, the short-run effects are likely to be negative, since it takes time and training for workers who have been reallocated to become fully productive. Thus, when the economy undergoes major structural changes – such as at the present time – productivity growth may suffer in the short term and then recover – perhaps even to a higher rate – but only with a lag. 14 Interestingly, a recent study by John Baldwin and Wulong Gu, using a growth-accounting framework, shows results consistent with the three influences just discussed – that is, multifactor productivity (MFP), rather than capital intensity, is the main culprit in Canada's lagging productivity performance. They note that two industries in particular – mining and oil and gas extraction and manufacturing – account for much of the slowdown in MFP growth in this decade. 15 Against this background, we can consider the implications of the global financial crisis and recession for Canada's future productivity growth. Productivity growth tends to vary over the cycle, declining in the downturn and then rising during the recovery as labour is more fully utilized. But the recession may also have more persistent implications for productivity growth. First, investment has fallen off sharply, which in turn reduces the growth of capital per worker – even as labour is shed. And, because capital investment often embodies new technology, reduced investment will dampen MFP growth. Second, investment in research and development is likely to suffer even more in the downturn. Third, as I noted earlier, the ongoing process of sectoral adjustment and reallocation of resources dampens productivity growth during the adjustment process. The adjustments now occurring in several sectors of the Canadian economy, including automobiles and forest products, are a particularly important example. Both physical capital and human capital – in the form of industry-specific and firm-specific skills – are also inevitably lost in such an adjustment. P. Nicholson, "Innovation and Business Strategy: Why Canada Falls Short," International Productivity Monitor, No. 18 (Spring 2009): 51-71. Available at: <http://www.csls.ca/ipm/18/IPM-18-Nicholson.pdf>. R. Dion, "Interpreting Canada's Productivity Performance in the Past Decade: Lessons from Recent Research," Bank of Canada Review (Ottawa: Bank of Canada, Summer 2007): 19-32. Available at: <http://www.bankofcanada.ca/en/review/summer07/dion.pdf>. D. Leung and S. Cao, "The Changing Pace of Labour Reallocation in Canada: Causes and Consequences," Bank of Canada Review (Ottawa: Bank of Canada, Summer 2009): 31-44. Available at: <http://www.bankofcanada.ca/en/review/summer09/leung.pdf>. Statistics Canada research (J. Baldwin and W. Gu, "Competition, Firm Turnover and Productivity Growth" (Economic Analysis Research Paper Series No. 042, Statistics Canada, September 2006)) suggests that the longer-run gains can be large. For example, roughly 35 per cent of labour productivity gains in manufacturing over the 1989-1999 period were attributed to labour reallocation across firms. J. Baldwin and W. Gu, "Productivity Performance in Canada 1961 to 2008: An Update on Long-Term Trends" (The Canadian Productivity Review, Research Paper No. 025, Statistics Canada, August 2009). Available at: <http://www.statcan.gc.ca/bsolc/olc-cel/olc-cel?catno=15-206-X2009025&lang=eng>. Although the recession is likely to exert some drag on productivity growth over the near term, two factors may provide a boost over the longer term. First, in the wake of a recession, resources may be reallocated to more productive uses, which would tend to stimulate productivity growth, once adjustment costs have been borne. Second, the shock we have experienced over the past two years may serve as a "wake-up call" to the financial system, resulting in better scrutiny of investment projects. This latter point leads me to a specific topic on which I would like to touch briefly: the role of the financial sector in aggregate productivity growth. The financial sector and productivity As services take on an increasingly important role in the Canadian economy, improving the productivity of services will grow in importance. The financial sector is key to productivity for two reasons. First, financial services are an important and growing sector of the Canadian economy in their own right – accounting for close to one-fifth of real output. 16 Second, the financial sector plays a pivotal role in the allocation of resources, and hence to productivity growth throughout the economy. How productive is the Canadian financial services sector? Data from Statistics Canada point to a possibly worrisome trend. Productivity growth in this sector has declined from an average of 2.8 per cent per year in the 1990s to just over one-half per cent in this decade. But there is an important caveat here. As you know, financial services, particularly banking and insurance, pose unique measurement difficulties, both in gauging the value of output and in finding an appropriate price series to deflate it. Given that different countries measure these things differently, international comparisons can sometimes be misleading. That said, if we compare Canada with the United States, our own research suggests that generally, the productivity of Canadian banks compares favourably with the productivity of U.S. banks. 17 I said that the productivity of the financial sector also has implications for the wider economy. Since the financial sector helps to allocate resources efficiently, productivity gains in this sector are apt to fuel productivity gains more generally. More efficient allocation of credit means better-targeted loans and a lower cost of capital for firms. These gains, in turn, spread into the wider economy, supporting better-targeted investment by firms. A Bank of Canada working paper concluded that the overall level and quality of financial services is an important influence on long-run economic growth. 18 In other words, the most important issue is not markets versus intermediaries – but how to ensure the proper functioning of both markets and intermediaries. Both the stability and the efficiency of the financial system are important for long-run economic growth. A system that is prone to crises is unlikely to support sustained growth. Credit booms are also a problem: Rapid increases in credit can ultimately hamper productivity growth when insufficient attention is paid to allocation decisions, when the link between the borrower and lender is broken or not adequately monitored, and when risks are ignored or mispriced. A well-functioning financial system creates the incentives to manage The "FIRE" sector of the economy – finance, insurance, and real estate – accounted for about 18.5 per cent of real output in 2000 and just over 20 per cent in 2008, based on 2002 constant prices. J. Allen, W. Engert, and Y. Liu, "Are Canadian Banks Efficient? A Canada-U.S. Comparison," Financial System Review (Ottawa: Bank of Canada, December 2006): 61-65. Available at: <http://www.bankofcanada.ca/en/fsr/2006/research_1206.pdf>. V. Dolar and C. Meh, "Financial Structure and Economic Growth: A Non-Technical Survey" (Working Paper No. 2002-24, Bank of Canada, 2002). Available at: <http://www.bankofcanada.ca/en/res/wp/2002/wp0224.pdf>. the risks associated with financial innovation, in the context of an appropriate regulatory framework. I'd now like to draw some of these threads together by discussing what policy can do to help. The role of policy The combination of factors that are thought to explain Canada's productivity problem suggests that efforts to tackle the productivity challenge must be broad based. Appropriate labour market policies, tax structure, competition policy, and an open trading system can all help to boost productivity. Let me say a few words about the Bank of Canada's roles in monetary policy and financial system policy. Since 1991, Canada's monetary policy has been guided by an explicit inflation target. While we have been successful in meeting the target – for the past 15 years, inflation has averaged almost exactly 2 per cent – it's important to remember why inflation control is so crucial. Low, stable, and predictable inflation contributes to better economic performance. It enables clear price signals to be sent, which in turn helps people to make wise borrowing and investment decisions and thus makes the economy more resilient to economic shocks. The Bank of Canada also has important responsibilities in supporting a stable and efficient financial system, which is critical to long-run growth. The Bank's work on financial stability is carried out in collaboration with federal and provincial regulators and other public sector partners, and as a member of international bodies. One important responsibility is financial system surveillance – identifying, monitoring, and reporting on risks to the financial system. The Bank also oversees Canada's clearing and settlement systems, providing liquidity, both on a regular basis and in times of stress, and acts as the lender of last resort. Stemming from this responsibility, the Bank has been undertaking initiatives to maintain continuously open core financial markets. The Bank is also an active participant in discussions of financial system policy, both in Canada and internationally. The recent crisis has prompted initiatives, both at the global and national levels, toward making the financial system stronger and better able to support longterm economic growth. A central aspect of this work is the establishment of a macroprudential framework for financial supervision and regulation. Here, the emphasis is on systemic stability, for example, through appropriate capital requirements. Finally, the Bank is engaged in research to better understand the sources of long-run economic growth, given its importance in anchoring current policy. While progress has been made in our understanding of productivity growth, there is still a good deal that we simply do not know. Over the next few years, the Bank will continue to explore how relative-price shocks affect the Canadian economy, including the reallocation of resources and its impact on productivity growth. The Bank will also be further investigating the linkages between the financial sector and the real economy – for example, how firm and household balance sheets adjust to various shocks, and the implications for investment and spending. Members of the Canadian Association for Business Economics also have an important role here. With your skills and responsibilities, you are in an ideal position to contribute to this research effort. Conclusion Two years after the onset of a global financial crisis and after three quarters of severe recession in Canada, the economic outlook for this country, and much of the world, has improved. The policies that were put in place to bring about the recovery, are starting to bear fruit. Although the recovery is likely to be muted, and effective and resolute policy implementation will be required, we are likely to experience positive growth this quarter, and a gradual closing of the output gap by the middle of 2011. A serious challenge lies ahead, however – that of continuing to improve our living standards against a less-favourable demographic backdrop. Improved labour productivity is the key to meeting that challenge, and how we set about it will shape our economic well-being for years to come. Meeting the challenge will involve all Canadians: employees, business owners, researchers, policy-makers, inventors, and entrepreneurs. It will require creativity, adaptive learning, and innovation. The Bank has an important role to play. By achieving the inflation target, and by working to make the financial system more stable and efficient, it is contributing to the recovery that will take hold over the medium term. This work also helps to ensure that a sound foundation is in place for the work that must be done to meet the longer-term challenges that lie ahead.
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Remarks by Mr David Longworth, Deputy Governor of the Bank of Canada, to the Greater Summerside Chamber of Commerce, Summerside, Prince Edward Island, 23 September 2009.
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David Longworth: Promoting Canada's economic and financial wellbeing Remarks by Mr David Longworth, Deputy Governor of the Bank of Canada, to the Greater Summerside Chamber of Commerce, Summerside, Prince Edward Island, 23 September 2009. * * * Good morning. It's a pleasure to be here. I'd like to thank the Greater Summerside Chamber of Commerce for hosting this event. In addition to Michael O'Brien, the Bank of Canada's Director for Prince Edward Island, I'm here with Allan Paquet and David Amirault, who are the Bank's representatives in the Atlantic provinces for, respectively, currency and economics. Allan and David are the Bank's eyes and ears for this region, and they help us to keep on top of various currency and economic developments. For example, David has been monitoring how the global recession and price movements have been affecting PEI industries such as the fishery and tourism. I'd like to take this opportunity today to describe the Bank of Canada's work in very general terms. Until recently, some people were given to thinking that central banking is – what shall I say? – a staid business. But the past two years have proven to be extremely interesting, not only for us at the Bank of Canada, but for all our central bank colleagues around the world. The Bank's mandate is to promote Canada's economic and financial well-being. Clearly, this is an important mandate, and we are determined to demonstrate excellence as we work to fulfill it. We conduct leading-edge research and analysis, and, in doing so, we aim to be "second to none" among the world's central banks. To fulfill our mandate, we work in four main areas of responsibility: currency, funds management, financial system, and monetary policy. For each of these areas, the Bank's approach is much the same. First, we have a clear objective. Second, we tend to take a longer-term view of things. Third, we make ourselves accountable by being transparent about the tools we use, the actions we take, and the outcomes of our actions. And, finally, we keep the big picture in mind. In my remarks today, I'll talk about each area of responsibility, with particular emphasis on the last two – financial system and monetary policy. Currency Bank notes are the Bank's most tangible product, and, despite the prevalence of credit and debit cards and other means of payment, the demand for cash continues to grow. The objective of our currency function is to provide Canadians with bank notes that are readily accepted and secure against counterfeiting. In fact, we quantified this goal as fewer than 100 counterfeit notes detected annually per million notes in circulation, and we are now meeting this standard. But we intend to make further progress, and our new goal is fewer than 50 counterfeits detected annually per million notes in circulation. For some time, the Bank has been developing Canada's next bank note series, which we expect to start issuing in late 2011. Planning for a new series of bank notes is a complex job, and so necessitates taking a long view. Our anti-counterfeiting strategy is also a long-term proposition. It contains four elements. The first is to develop bank notes that are ever-more difficult to counterfeit. The second is to increase the routine verification of bank notes by retailers – our regional staff play an important role here by helping in the training of retailers and cash handlers. The third element of the strategy is to maintain the high quality of bank notes in circulation. And the fourth is to promote the deterrence of counterfeiting by lawenforcement officers and prosecutors. Regional staff also play key roles in supporting these last two elements of the strategy by liaising with financial institutions and with lawenforcement agencies. As part of its deterrence work, the Bank has established an annual "Law Enforcement Award of Excellence for Counterfeit Deterrence." This year, the award was presented in Charlottetown to the RCMP's National Anti-Counterfeiting Bureau during the conference of the Canadian Association of Chiefs of Police. Transparency is also important in our currency work. In addition to reporting on the incidence of counterfeiting vis-à-vis our targets, we communicate regularly with the public and retailers about the security features in our bank notes, and we publish the costs of the currency program in our annual report. As to keeping the big picture in mind – well, currency is only one of several means of payment. The Bank conducts research on the factors that influence choices in means of payment, and we monitor trends. This helps us to understand the role of bank notes in transactions, and to forecast demand. I'll now say a few words about the Bank's second area of responsibility: funds management. Funds management The Bank of Canada is the federal government's banker, fiscal agent, and adviser on funds management. The objective of this work is to provide these services effectively and efficiently. The responsibility includes managing Canada's foreign exchange reserves, the government's cash, and, in collaboration with the Department of Finance, the public debt, including Canada Savings Bonds, which go on sale this year on October 5. As part of this responsibility, the Bank also gives advice to the Department of Finance on these issues, as well as on issues that have arisen in the context of the financial crisis. For example, our advice fed into the design of the Insured Mortgage Purchase Program, which allowed the federal government to buy pools of insured mortgages through the Canada Mortgage and Housing Corporation, as well as the design of the Canadian Secured Credit Facility, which was set up to purchase asset-backed securities. Managing and providing advice on debt and reserves also require taking a long view. Generally speaking, the management of financial assets and liabilities requires a forwardlooking risk-management framework, as well as long-term strategies. And of course it's essential to be completely transparent when it comes to managing government funds and public money. The Bank discusses the various tools it uses and reports on the operations and actions it carries out to manage financial assets and the outstanding stock of federal debt. It does this via its own website, the Department of Finance's website, and in the Bank's annual report. Finally, in our funds-management work, we always look at the big picture. The range and complexity of operations and the need to carefully manage risk require us to consider a very broad picture when we develop our framework for the governance of funds management and formulate our policies. Now I'll turn to the Bank of Canada's third area of responsibility – the financial system. Financial system As recent events have made clear, a sound financial system is essential to a well-functioning economy. The objective of the Bank's work here is to promote the stability and efficiency of the financial system, both domestically and globally. To achieve this objective, we again take the long view. Together with other policy-makers in Canada and abroad, the Bank strives to develop, and contribute to, policy that will help to sustain a stable and efficient financial system over time. This long-term focus aids in creating and maintaining an environment in which risks can be properly assessed and sound investment decisions effectively made. That said, we also have to be nimble, and react quickly to market developments. For example, since the onset of the financial crisis, we have provided considerable liquidity to the Canadian financial system, in a variety of forms. We currently auction liquidity three times a week. It is extremely important for a central bank to be transparent in its financial system work. In our Financial System Review we communicate, on a regular basis, our assessment of the key risks and vulnerabilities, as well as our analysis of certain policy issues. We also provide clear information about our operations. For example, as the Bank provided liquidity, we communicated clearly and in a timely fashion, the relevant policies and principles, the facilities we were using, and the scale of our operations, as well as the status of key markets. Financial markets have improved to such an extent that the demand for our term liquidity facilities has been waning. Of the three facilities that we offer, there is currently no demand for the Term Loan Facility, demand for the facility for Private Sector Instruments has recently been half of what we have been auctioning, and even demand for Term Purchase and Resale Agreements, our "workhorse" facility, has declined as conditions in funding markets have improved. Against this background, the Bank announced yesterday that the first two facilities will expire at the end of October, and that the auctions for the third facility will now be held bi-weekly instead of weekly. Of course, the financial system has many interdependent elements, and we again must keep the big picture in mind. This is especially true in our monitoring of the financial system, in our assessment of risks, and in our policy analysis. In the current context, two aspects of our policy work are worth noting. First, there were times during the financial crisis when liquidity dried up in almost all financial markets. However, not all markets are critical to the proper functioning of the financial system, so the Bank has been working to identify "core" markets, markets that, through appropriate policies, we would strive to keep operating without interruption, even during a shock. Second, because the regulatory system has tended to focus more on individual financial institutions than on interdependencies or systemic risk, the Bank of Canada, like many other central banks, has been looking at ways to strengthen financial regulation by adding a "macroprudential" orientation – that is, more focus on the system as a whole. I'll turn now to the Bank's fourth and final area of responsibility: monetary policy. Monetary policy Monetary policy can get complicated, but the objective is straightforward: it's to foster confidence in the value of money by keeping inflation low, stable, and predictable. In an agreement with the government of Canada, the Bank has an inflation target of 2 per cent, which makes this objective very explicit. By its very nature, monetary policy work necessitates having a long view. The Bank achieves the inflation target by raising or lowering the target for the overnight interest rate which, in turn, influences other interest rates, and, ultimately, the overall demand for goods and services. This sequence of events takes time, and monetary policy typically tries to influence inflation 6 to 8 quarters into the future. Put differently, monetary policy works with a significant lag, so, when we make our interest rate decisions, we rely on various indicators of future inflation, and take a medium-term view of the economy. Low, stable, and predictable inflation brings about real benefits. It allows consumers, businesses, and investors to read price signals clearly, and thus to make financial decisions with confidence. It allows businesses to make long-term investments which, in turn, contributes to sustained job creation. And, importantly, it helps to make the economy more resilient to shocks. Many of you will remember the days of high and variable inflation, and can therefore appreciate the progress we've made. Since 1995, total CPI inflation has averaged 2 per cent per year. That's a good record, but the Bank is always looking at ways to strengthen its tools and the outcomes of monetary policy. In response to the global financial crisis and recession, the Bank's monetary policy has been very aggressive, and since April of this year, the target for the overnight rate has been one quarter of one per cent – that's effectively as low as it can go. In other words, we cannot lower our policy rate any further to provide economic stimulus. Recognizing the possibility that additional stimulus might be required, we researched and identified three additional monetary policy tools that we could use. The Bank has not used the first two tools – quantitative and credit easing, which involve the purchase of assets – but they remain available to us. We have, however, employed the third tool identified, and that is the use of "conditional statements" about the future path of monetary policy. In our April monetary policy decision, we said that, conditional on the outlook for inflation, the target overnight rate could be expected to remain at its current, very low level until the end of the second quarter of 2010. This longer-term guidance helps to influence interest rates at longer maturities. The Bank has also been examining whether the inflation-control framework might be improved. Specifically, in advance of the next agreement that we'll sign with the federal government in 2011, we've been studying whether 2 per cent is the best target, and whether the target should be (as it currently is) the rate of inflation or the path of the price level. All to say, our monetary policy work really does take a long view of things. Now a word about transparency in monetary policy. I've spoken about the tools we use to achieve the inflation target. With regard to our actions, we make our policy rate decisions eight times a year on a fixed schedule, issue a press release each time, and, four times a year, explain our analysis and projections in detail in our Monetary Policy Reports. The outcome of monetary policy – total CPI inflation – is measurable, and our performance is transparent. I should add a word about "core" inflation. The more volatile price components of the CPI – such as fruit, vegetables, and gasoline, as well as the effect of changes in indirect taxes – can cause a good deal of temporary movement in total CPI inflation, so the Bank of Canada uses a core measure of inflation, which excludes these volatile components, as a useful guide to policy. The core measure of inflation helps us to "see through" short-term volatility when we make our policy decisions. As to keeping the big picture in mind: monetary policy focuses on the Canadian economy as a whole, and aims to achieve a national inflation rate. Of course, to get a sense of the national economy, we need to closely monitor regional developments. We have five regional offices across the country, including the Atlantic region office in Halifax, from which our staff go out to visit businesses and gather information on issues related to the economy. We communicate the highlights of this information in our quarterly Business Outlook Survey, which is available on our website. So those are the four areas of responsibility in which the Bank of Canada works to carry out its mandate. Before I conclude, I'll say a few words about the economic outlook and the monetary policy decision announced on 10 September. The press release that accompanied the announcement noted that, following a deep, synchronous, global recession, recent indicators point to the start of a recovery in the major economies, supported by aggressive policy stimulus and the stabilization of global financial markets. In Canada, stimulative monetary and fiscal policies, improved financial conditions, firmer commodity prices, and a rebound in business and consumer confidence are supporting the growth of domestic demand. Combined with recent information on inventory adjustments and automotive production, this suggests that GDP growth in the second half of 2009 could be stronger than we projected back in July. Total CPI inflation is expected to trough in the current quarter before returning to the 2 per cent target in the second quarter of 2011 as aggregate supply and demand return to balance. The Bank said that, conditional on the outlook for inflation, the target overnight rate could be expected to remain at its current level until the end of the second quarter of 2010 in order to achieve the inflation target. The underlying macroeconomic risks to the projection were judged to be roughly balanced. We also noted that persistent strength in the Canadian dollar remains a risk to growth and to the return of inflation to target, and that the Bank retained considerable flexibility in the conduct of monetary policy at low interest rates. Finally, it would be timely to mention that, earlier this week, the Bank launched its new medium-term plan. The plan sets out the key priorities for the Bank over the next three years, discusses relevant trends and challenges, and lists the measures by which we will gauge our performance and make ourselves accountable. This plan, which will soon be posted on our website, guides our work over the medium term. It shows that having clear objectives, taking the long view, being transparent, and keeping the big picture in mind, will continue to be our approach in the years ahead. Conclusion The past two years have been difficult for many Canadians. The financial crisis and the recession have taken an economic toll, and they have tested our confidence. However, Canadians can have confidence in their central bank. Specifically, you can be sure that the Bank of Canada will continue to promote the country's economic and financial welfare, communicate its objectives clearly, and stand accountable for its actions. And we will continue to demonstrate a commitment to excellence in all our work. These commitments will help to strengthen the economy in both good times and bad, and they will help to sustain a stable and efficient financial system.
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Remarks by Mr Mark Carney, Governor of the Bank of Canada, to the Greater Victoria Chamber of Commerce, Victoria, British Columbia, 28 September 2009.
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Mark Carney: The three Rs – review, reflect, and reaffirm Remarks by Mr Mark Carney, Governor of the Bank of Canada, to the Greater Victoria Chamber of Commerce, Victoria, British Columbia, 28 September 2009. * * * September is a time to review the past, reflect on the present, and reaffirm goals for the future. Like students who returned to school this month, I will follow this annual discipline today by (i) reviewing the extraordinary events of the past year; (ii) reflecting on the policy response and the current economic outlook; and (iii) reaffirming the Bank of Canada's commitment to price stability. While this September brings signs of renewed growth around the globe, the recovery is in its earliest stages and almost entirely driven by public policy. Over the medium term, a difficult hand-off from public- to private-led growth must occur. Over the longer term, the economic environment will be challenging as the global economy undergoes a fundamental restructuring. Review A year ago, we were in the midst of the most severe economic crisis since the Great Depression. Major institutions had collapsed, and the very functioning of the global financial system was threatened. Virtually every financial asset in the world was being repriced: equity markets plunged, credit spreads soared, and currency volatility spiked. The financial crisis in the United States, the United Kingdom, and continental Europe spread rapidly through financial, trade, and confidence channels, triggering a synchronous and deep global recession. Major central banks reacted immediately by providing hundreds of billions of dollars in extraordinary liquidity to keep the system functioning. On 8 October, G-10 central banks, including the Bank of Canada, conducted an exceptional, coordinated interest rate cut of 50 basis points, the first since the 11 September terrorist attacks. A few days later, the G-7 took decisive action. In a historic meeting on 10 October 2008, G-7 countries, including Canada, committed to: • Use all available tools to support systemically important financial institutions and prevent their failure. • Take all necessary steps to ensure that banks and other financial institutions have broad access to liquidity and funding. • Ensure that our banks can raise capital from public as well as private sources, in sufficient amounts to re-establish confidence and permit them to continue lending to households and businesses. The ambition and clarity of these commitments were unprecedented. In those countries at the heart of the crisis, governments re-capitalized banks and guaranteed their borrowings, while central banks further expanded liquidity provision. In some cases, total government commitments to the financial sector reached a remarkable 25 per cent of GDP. In effect, there was wartime spending on a peacetime calamity. At the beginning of this year, even though the financial system had retreated from the edge of the abyss, the economic outlook appeared exceptionally uncertain. The paradox of thrift – where individually rational actions are collectively damaging – was in full force. The shock and severity of the crisis had deeply shaken business and household confidence. Businesses were delaying investments and building cash reserves. Similarly, households were postponing major purchases and building up precautionary savings. And banks around the world were curtailing lending and conserving capital. As a result, industrial production and world trade were plummeting. Nonetheless, in a decidedly minority view at the time, the Bank judged that the necessary policy responses to secure recovery were being put in place and that economic growth would resume later in the year. The scale and timeliness of monetary policy support were already significant. By April, most major central banks had reduced interest rates to their lowest levels in history, and some went even further by instituting unconventional credit and quantitative easing strategies. Over the same period, fiscal policies around the world were eased substantially to support demand. Finally, through the G-20 process, bold reforms were launched to establish a more stable, more efficient global financial system. The Bank's message over the past year has been relatively straightforward: "There is a plan to restore confidence and growth, we are implementing it, and it will work." The Bank has long expected that the combined impact of policy measures would build over time and reach full force in 2010. And we have consistently expected that the impact would be particularly pronounced in Canada, owing to the combination of the timeliness and scale of monetary policy stimulus, fiscal stimulus, the strength of our financial system, and the relative health of Canadian corporate and household balance sheets. It now appears that those expectations are beginning to be fulfilled. Reflect Indeed, there are increasing signs that activity has begun to expand in many countries. Growth is probable in all major economies this quarter, and the pace of global growth next year is likely to be even higher than the Bank had projected in our last Monetary Policy Report. While this recovery is still nascent and sluggish, its appearance nonetheless makes some ask, what was all the fuss about? Was that truly the Great Recession? Initial success should not give way to complacency. Only the unprecedented and decisive actions across G-20 nations arrested the economic free fall and have begun to boost global demand. Reflecting the scale of fundamental adjustments still going on, the global recovery is likely to be protracted. In other words, we may be on the right track, but there is a long road ahead. As we go forward, it will be important to distinguish between policy-induced growth in the near term, private-demand momentum in the medium term, and the global economy's ability to respond to the longer-term challenges that this crisis has exposed. The near-term outlook: policy-induced growth The nascent global recovery is largely the product of extraordinary policy measures taken over the past year. In the United States, social security payments, tax credits, and temporary incentive programs, such as the "cash for clunkers," are having major impacts on demand. Similarly, in Japan, government transfers to individuals have provided an important, temporary boost to consumption. Chinese domestic demand has also been stronger than originally expected, but here too, the impact of policy should not be underestimated. Crucial measures include a fiscal stimulus package estimated at 5.5 per cent of GDP and a 34 per cent increase in bank lending, underwritten by banks that are predominantly state owned. Global financial conditions have improved markedly, albeit from distressed levels. Spreads have fallen, corporate bond issuance has been very strong, and equity markets have rebounded to levels near those prior to the failure of Lehman Brothers. Nonetheless, in most major economies, bank lending is subdued and non-price terms are tight. Overall, the global financial system remains strained and many markets, including interbank lending and securitization markets in the United States, still benefit from public support. On the business side, the sharp fall in activity around the globe earlier this year has meant that firms were stuck with much higher inventories than desired. A brutal de-stocking followed as firms slashed production. Now, with prospective sales recovering, the inventory cycle has begun to turn. This will provide a significant, but temporary, boost to growth. Against this backdrop, growth has resumed in Canada. Our recovery will be supported by the relative health of Canadian balance sheets, our well-functioning financial system, the timeliness of monetary policy action, and the recent firming of commodity prices. As we signalled in our interest rate decision earlier this month, GDP growth in Canada in the second half of this year will likely be stronger than projected in our July MPR. It is important to recognize, however, the importance of temporary factors. For example, the strength in existing home sales partially reflects pent-up demand from the consumer paralysis at the height of the crisis. In addition, affordability has improved, largely as a result of very low interest rates. Another example is Canadian auto production, which looks on track to more than double (on a seasonally adjusted annualized basis) in the third quarter. That bounce primarily reflects the restarting of capacity that had been shuttered when major auto companies restructured earlier this year, as well as the need to rebuild inventories that have been drawn down as a result of the U.S. cash-for-clunkers program. These dynamics may begin to reduce the amount of slack in our economy. It should be recalled, however, that currently there is a very large gap between the potential of our economy, or aggregate supply, and aggregate demand for our output. The evidence for this is widespread. Manufacturing capacity utilization rates are at their lowest level in at least a quarter century, the unemployment rate has increased by 2.9 percentage points to its highest level in 11 and a half years, and, according to our July Business Outlook Survey, only 28 per cent of firms would have difficulty meeting an unexpected increase in demand, which is the lowest level since the aftermath of 11 September 2001. In our July MPR, the Bank estimated that our conventional measure of the output gap, which is a broad measure of the gap between aggregate supply and demand in the economy, reached -4.3 per cent. This is the widest gap, positive or negative, seen since the recession of the early 1980s. This large output gap will moderate inflationary pressures during the initial phase of the recovery. And it will take sustained private demand growth to return our economy to its productive potential. The medium-term outlook: the hand-off to the private sector G-20 policy-makers have committed to maintain stimulus "until the recovery is assured." So what are the drivers of this recovery? What will be required to not only remain on track but also on schedule? Externally, it is important that private demand consistently grow in the countries that were at the epicentre of the crisis, particularly the United States. Unfortunately, this recovery may be both difficult and uneven. The sharp rise in unemployment will weigh on consumer confidence and the growth of disposable income. In addition, the repair of household balance sheets will take some time. Similarly, the repair of major foreign financial systems remains a work in progress. The disappearance of the shadow banking sector and the ongoing strains of the recession will mean that it will take further restructuring and considerably more capital for financial conditions to return fully to normal. In the meantime, the financial sector will continue to restrain growth in many industrialized economies. There are some offsets to these external headwinds. First, the composition of U.S. activity will likely become more favourable to Canadian growth. The recent pattern of U.S. activity, with its severe weakness in the housing and auto sectors, meant that the U.S. recession proved particularly challenging for our businesses. As these sectors stabilize and begin to grow modestly, this effect will be reversed and will be important for Canada. In addition, while the overall pace of global growth will likely be subdued, the Canadian economy will rely more on emerging-market growth for external demand. This would provide an important support for commodity prices and, therefore, the Canadian economy over the medium term. However, the ability of emerging markets to sustain more vigorous growth in domestic demand remains an open question. For example, rapid expansion of domestic lending is challenging in any environment, particularly in those countries, such as China, with developing banking systems. On balance, the external sector may not be reliable as the sole engine of the Canadian recovery. In this context, domestic factors could prove decisive. As noted earlier, contributions from inventories will be temporary. Housing should provide some near-term strength, but the degree of pent-up demand appears limited. With the fiscal stimulus largely finished by next year, consumer and business spending will need to drive economic growth. Sustained growth in consumer spending will require household decisions that are based on confidence rather than relief, and that are funded by income rather than debt. A rebound in disposable income growth will require improved labour market conditions, starting with hours worked, followed by stabilization, and then by increases in employment. Given the slack in the economy, this could take some time. Firms will need to act with confidence as well. Replenishing inventories and restarting idled capacity will not be sufficient. Hiring and investment intentions, and eventually capital spending and employment decisions, must recover as well. Given the openness of our economy, these prospects will turn importantly on perceptions of external conditions. In assessing the progress of the recovery, the Bank will not rely on a single data point. Survey indicators will likely be the first to show the turn, but we will need to see followthrough in the harder statistics. Ultimately, we will be looking for an accumulation of evidence across a range of indicators. Considerable risks to the outlook for inflation remain. Upside risks include a faster-thanexpected recovery in consumer and business confidence and further improvements in our terms of trade. Downside risks are largely external and include setbacks in the ongoing repair of the global financial system and more persistent weakness in foreign private demand. In addition, the possibility of persistent strength in the Canadian dollar would work against the positive factors just mentioned. The recent rise in the dollar is, in part, a reflection of the same factors that are leading to a recovery in Canada, notably the rebound in commodity prices. It is also a result of a more generalized weakening of the U.S. dollar, as global financial conditions normalize. Other things being equal, a persistently strong Canadian dollar would reduce real growth and delay the return of inflation to target. The Bank will assess the balance of risks to inflation in its upcoming MPR. Even though we are at the effective lower bound for our policy rate, the Bank retains considerable flexibility in the conduct of monetary policy. The longer-term outlook: a more challenging global environment Over the longer term, the pattern and pace of global growth will be significantly altered. This was the Great Recession, and it will have far-reaching repercussions. The rate of potential growth in the global economy has likely fallen in the aftermath of the crisis and will take some time to rebuild. The fiscal cost of arresting the downfall will need to be first contained and then repaid over many years. Most fundamentally, the sources of demand will need to rebalance, both within and across economies. Addressing these challenges will require difficult and extensive measures in all economies. Once the recovery is assured, concerted efforts will be necessary in most economies to restore fiscal sustainability. This need is particularly sharp in those countries with looming demographic pressures and unsustainable entitlement programs. Fiscal pressures could also become more acute if the rebalancing of global growth is not successful. As the recent G-20 meetings attest, major reforms are necessary to create a more resilient and efficient global financial system. In addition, given the sharp rise in unemployment and the likely important changes to global growth, structural reforms to improve labour market flexibility and to retrain workers will be important. Finally, surplus countries that need to boost domestic demand, such as China, will require a comprehensive program of structural reforms. The necessary reforms to social safety nets and to liberalize the domestic financial sector are complex and will take years to bear fruit. They must also be complemented by material adjustments to the real exchange rates of deficit and surplus countries. Reaffirm In the face of these challenges and uncertainties, the credibility of macroeconomic policy is essential. One constant is the Bank's unwavering commitment to price stability. The single, most direct contribution that monetary policy can make to sound economic performance is to provide Canadians with confidence that their money will retain its purchasing power. That means keeping inflation low, stable, and predictable. Price stability lowers uncertainty, minimizes the costs of inflation, reduces the cost of capital, and creates an environment in which households and firms can invest and plan for the future. The Bank's sole monetary policy objective is to achieve its 2 per cent inflation target. Having a simple, credible price stability objective proved enormously helpful during the crisis and should continue to be so during the eventual exit. The Bank approaches inflation control in a symmetric way, meaning that we care as much about inflation dropping below the target as about inflation rising above the target. Inflation targeting is equally able to prevent the entrenchment of high and volatile inflation or the onset of persistent deflation. As a consequence, inflation expectations have remained well anchored at the Bank's 2 per cent target. The ability to maintain inflation expectations has helped to keep real interest rates low and to provide the necessary monetary stimulus. The inflation anchor remains essential, even when providing extraordinary guidance. This is why the Bank's current commitment – that our target rate is projected to remain at its effective lower bound through the end of the second quarter of 2010 – is explicitly conditional on the outlook for inflation. It is important to recognize this statement for what it is – the Bank's judgment that our policy rate should remain at 1/4 per cent at least through the end of June of next year in order to achieve our 2 per cent inflation target. This conditional commitment does not indicate what will happen following the end of the second quarter of 2010. Nor is it a guarantee that rates will absolutely remain at the current level. In short, it is an expectation, not a promise. If circumstances affecting the outlook for inflation change materially, the conditional commitment would change. The only constant is that the Bank will consistently set monetary policy appropriately in order to achieve the inflation target. Conclusion To conclude, one lesson should be clear: policy matters. Aggressive policies arrested the economic free fall triggered by the financial crisis. Policy action is driving the initial recovery. Policy-makers will have to act deftly to maintain stimulus long enough for private demand to take up the burden of growth, but not too long to undermine confidence in and the sustainability of that growth. Even once that feat is accomplished, the aftermath of the crisis will make considerable demands on structural policies in all countries, including Canada. Recent events were a watershed. A powerful and sustained restructuring of the global economy has begun. Canada is entering this period with many strengths, but the efforts required of us will be historic. Our businesses will need to develop new markets as the traditional advantage of relatively open access to U.S. markets becomes less valuable. The Bank of Canada will continue to review, reflect, and report on the broader global forces I have outlined today. As I have reaffirmed, our principal contribution will be to consistently achieve our inflation target, so Canadians can plan and invest with confidence.
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Remarks by Mr Paul Jenkins, Senior Deputy Governor of the Bank of Canada, to the Vancouver Board of Trade, Vancouver, British Columbia, 8 October 2009.
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Paul Jenkins: Central banking in Canada – meeting today's and tomorrow's challenges Remarks by Mr Paul Jenkins, Senior Deputy Governor of the Bank of Canada, to the Vancouver Board of Trade, Vancouver, British Columbia, 8 October 2009. * * * Good afternoon, it's a pleasure to be with you again. When I last spoke to the Board of Trade three years ago, my topic, "Weathering Economic Shocks," was not dissimilar to today's – although our perspective in 2006 was certainly different. Indeed, the global financial crisis of the past two years has presented unique, stressful challenges that have forced us all to assess what has worked well and what needs to change. Today, I would like to review some of the critical thinking around these issues, primarily from the perspective of our work at the Bank of Canada. I will also offer some thoughts on Canadian public policy more broadly, as well as on the economies of Canada and British Columbia. A look back All of us, collectively and as individuals, have been immersed in the fallout from the global financial crisis that began to unfold in August 2007. Its impact has been profound and widespread, across national economies and financial markets. Heightened uncertainty in global financial markets associated with the collapse of the subprime-mortgage market in the United States, the opaqueness of structured securitized financial products, an overreliance by banks on wholesale funding, and generally lax regulation resulted in key markets seizing up. Credit spreads widened dramatically, and a forced deleveraging process made credit expensive and unavailable to many households and businesses. As the process unfolded, it was evident that many financial institutions were insolvent. Firms such as Bear Stearns, AIG, and Lehman Brothers suddenly became household names. The intensity of the stress in financial markets quickly led to a deep, synchronous global economic recession, which some have dubbed the "Great Recession." Policy-makers reacted swiftly to the onset of the recession. Last autumn, on our Thanksgiving weekend, G-7 finance ministers and central bank governors put in place a plan of action acknowledging the need for a global solution. This was followed by a series of G-20 summits – starting last November in Washington, D.C., and most recently, in Pittsburgh two weeks ago – which quickly broadened the reach of countries involved in turning the situation around and preventing a recurrence. While the resulting coordinated set of plans to stabilize global financial markets and provide macroeconomic stimulus is beginning to bear fruit, the recovery is going to be protracted, given the extent of repair required in financial markets and system infrastructures around the world. The gravity and global reach of what we endured during the past two years have been unprecedented in the past half-century. While acknowledging this, we should not forget the valuable lessons learned from other serious economic and financial challenges of previous decades. Let me mention a few. A major challenge was the struggle to reduce the high, variable inflation rates of the 1970s and 1980s and to establish a low, stable, and predictable inflation environment. Another was the effort made in the mid-1990s to put Canada's fiscal house in order, with a medium-term focus on reducing public debt levels relative to the size of our economy. We have had to respond to major external shocks: the Asian, Russian, and Latin American financial crises of the late 1990s and start of this decade; the worldwide collapse of the hightech bubble in 2000-01; and the 9/11 terrorist attacks. And, familiar to this audience, we have witnessed the emergence of China and India, along with technological advances and the increasing globalization of trade and finances. As diverse as these challenges were, two themes are common to them all. The first is the importance of sound policy frameworks to guide our thinking and our actions. The second is the importance of economic flexibility, by which I mean our ability to adjust to changing circumstances and return to full production potential as quickly as possible. Most of my remarks today relate to the first of these two themes; I will pick up on the second towards the end. Canada's response to the global financial crisis As you know, the Bank's monetary policy objective is to achieve its 2 per cent inflation target for the consumer price index (CPI). It is through inflation control, by providing Canadians with confidence in the future value of their money, that we contribute to good economic performance in Canada& – a means to an end. Throughout the global financial crisis and recession, our monetary policy decisions have been anchored by our inflation-targeting framework, and we have calibrated our actions to achieve the 2 per cent target. In a series of rate cuts between December 2007 and April 2009, we reduced our target overnight rate of interest by a total of 425 basis points. This includes an exceptional, coordinated cut of 50 basis points, taken by the G-10 countries one year ago today. Since April, the target rate in Canada has remained at 0.25 per cent, which we regard as the effective lower bound. Also in April, we stated that, conditional on the projection for inflation, we will keep the policy rate at that level until the end of the second quarter of 2010. These actions have resulted in interest rates dropping, for many borrowers, to record post-World War II lows. In addition, inflation expectations – given the credibility of policy – have remained firmly anchored to the 2 per cent target. Clearly, these have been unusual times – so much so that they have demanded consideration of unconventional instruments in our conduct of monetary policy. In an Annex to our April Monetary Policy Report (MPR), we set out a framework for conducting monetary policy at low interest rates. This framework includes three instruments. The first is a conditional statement about our target policy rate, which is the one unconventional instrument we have employed thus far. The second is quantitative easing, which refers to outright purchases of financial assets through the creation of excess settlement balances on the books of the Bank; and the third, credit easing, refers to purchases of private sector assets in key, temporarily impaired credit markets. The use of any of these instruments would clearly be cast in terms of what is needed to achieve our inflation target. Canadians have also benefited through the crisis from other policies. A sound fiscal framework, aimed at reducing the national debt-to-GDP ratio over the medium term, has provided an important degree of flexibility in this time of need. A system-wide focus on financial stability, including the provision of liquidity to key markets by the Bank of Canada and risk assessments in our Financial System Review, has provided further support. Canadians have also benefited from a risk-based approach to financial system regulation. The combined effect of the decisions and actions taken in each of these policy areas is a primary reason why Canada has avoided the worst of the global financial crisis. Although our economy has suffered a deep recession, due to the impact of the U.S. recession and the collapse of commodity prices, Canada has avoided a boom-bust cycle in housing, and our financial system, especially our banking system, has continued to function relatively well. 1 Indeed, some attributes of Canada's regulatory system for financial institutions are being advanced globally through the G-20 process. 2 Overall, the Canadian experience shows that sound policy frameworks, working in tandem, help address difficult circumstances – even situations as extreme as those we have recently faced. Looking ahead Still, our experience of the past two years makes it clear that the status quo is no longer sufficient. At the Bank of Canada, we must strengthen our frameworks, in terms of both monetary policy and financial stability, to increase the country's capacity to avoid crises to the extent possible and to address shocks when they do occur. In terms of monetary policy, there are two critical streams to our work plan. The first relates to our inflation-targeting regime. In November 2006, when we renewed the current five-year inflation-target agreement with the federal government, we also launched a research program to examine ways to strengthen our monetary policy framework. 3 Two questions were posed: What are the costs and benefits of a lower inflation target? What are the costs and benefits of a price-level target? 4 Considerable study on these two questions has already been undertaken, involving not only researchers at the Bank, but also academics and colleagues at other central banks. I won't review this work today. However, more information can be found on our research website, http://www.inflationtargeting.ca/, and in summary articles in the Bank of Canada Review. 5 We will take a hard, objective look at what the research finds, and you can expect to hear more from us on this subject in the coming year. The second stream relates to the transmission mechanism – that is, how our monetary policy actions work their way through financial markets and the economy. The crisis has made it abundantly clear that central banks must have a better understanding of the links between the real economy (that is, output, inflation, and employment) and the financial sector. For example, time-varying term, liquidity, and risk spreads have been shown to be empirically relevant for explaining real activity, as have non-price terms for credit. Another important insight from the financial crisis is that broader procyclical dynamics – that is, forces that amplify cyclical fluctuations – in money, asset, and credit markets also have implications for the real economy and hence, monetary policy. A critical part of the Bank's research agenda is on these real-financial linkages, to better understand them and incorporate them into our models and policy analysis. One exception was in a very specific segment of the Canadian market for non-bank-sponsored, asset-backed commercial paper (ABCP), which had transparency problems and which led to the standstill under the Montreal Accord. For a more detailed review of these attributes, see P. Jenkins, "Canada's Financial Sector: Responses to the Global Crisis" (presentation to the Colombian Banking Association, Cartagena, Colombia, 10 July 2009). See "Renewal of the Inflation Control Target, Background Information" (Ottawa: Bank of Canada, November 2006). In the price-level-target approach to inflation control, bygones are not bygones, unlike the current policy. Under price-level targeting, if inflation has been below trend, causing the price level to fall below target, monetary policy would need to generate above-trend inflation for a while to return the price level to target. Or, if inflation has been above trend, lifting the price level above its target, the central bank would need to temporarily induce below-trend inflation to return the price level to its target path over time. See various articles, Bank of Canada Review (Ottawa: Bank of Canada, Spring 2009). In terms of financial stability, what we have witnessed over the past two years has been an increasingly complex set of interrelationships among credit, market, and funding risks. These interrelationships, involving key segments of the global financial system, have had significant consequences for economies worldwide – consequences that have brought to the fore the critical importance of effectively managing liquidity, credit, and market risks, as well as the importance of ensuring adequate levels of capital. In several of these areas, Canada – as I noted earlier – has stood out for the sound management, regulation, and supervision of its financial institutions. However, the focus at this micro level is not enough. Indeed, another key lesson of the global financial crisis has been a recognition of the need for oversight of the system as a whole, including both systemically important institutions and markets. Such an approach is critical, because systemic risks can arise from the collective actions of institutions and market participants that, at the individual level, may appear to mitigate risk, but that collectively – because of interconnectness and common exposure – contribute to the instability of the system overall. The off-loading of assets in illiquid markets is just one example. A system-wide, or macroprudential, approach is the shared responsibility of the Department of Finance and all of the federal financial regulatory authorities, including of course the Bank of Canada, the Office of the Superintendent of Financial Institutions, and the Canada Deposit Insurance Corporation. Ultimately, it is the Minister of Finance who is responsible for the sound stewardship of the financial system. A macroprudential approach involves two main elements. The first is macroprudential surveillance to identify the buildup of risks to the financial system. The Bank is well placed to contribute to macroprudential surveillance, given our mandate to take an economy-wide perspective, our research on, and knowledge of, the economy and financial system (including the clearing and payments system), and our connections with key international organizations. The second element is macroprudential regulation, or regulation designed to strengthen the resilience of the financial system as a whole, which is the responsibility of the Minister, with advice from the Bank, OSFI, CDIC, and others. Progress here will need to take into account those interdependencies among institutions and markets that have implications for the overall stability of the financial system. Issues to be addressed include sound market infrastructure, product standardization and transparency, counterparty relationships, and countercyclical macroprudential tools such as countercyclical capital buffers. Work on these issues represents a multi-year investment at home and abroad. The Bank is undertaking research and analysis in a number of areas, including how to mitigate procyclical behaviour in the financial system, what is required to keep core funding markets continuously open, and models to stress test the Canadian financial system and gain insights into its functioning. Advancement of this work will be aided by research and analysis in international committees and working groups, as well as in academia and at central banks. A particularly challenging aspect of this work will be the development of macroprudential tools and their use in promoting financial stability. 6 But what do the lessons of the past two years tell us about the interactions and overlap between monetary policy and financial stability? It's clear that monetary authorities need to be concerned about financial instability which, as the past two years have taught us, can threaten price stability due to the recessionary consequences for the real economy. It was in response to such disinflationary forces – even a concern about deflation on the part of some These tools could include minimum risk-weighted capital ratios; minimum capital held against a bank's trading book; maximum leverage ratios; maximum loan-to-value ratios for mortgages; and minimum margin requirements and haircuts. – that we aggressively cut interest rates to support the economy and thus, achieve our 2 per cent inflation target. Financial instability can also affect the monetary policy transmission mechanism. As I noted earlier, heightened uncertainty and instability in financial markets raise spreads and nonprice terms in credit markets in ways that are unpredictable, and with consequences that are uncertain. This puts weight on monetary policy to take aggressive actions – including the potential use of unconventional instruments – to offset these consequences. Financial instability is primarily about market failures and distortions that need to be addressed directly. The experiences of the past two years demonstrate that the best way to do this is through effective financial regulation, which includes macroprudential regulation to address systemic risks. 7 Interest rates are a blunt policy tool. Their use to address financial instability could create uncertainty for pricing financial assets and result in a misallocation of capital, with consequences for the whole economy. There could also be a risk of a loss of credibility for the monetary authorities, as they pursue their mandate of price stability. This all adds up to the fact that there are important issues to be addressed and considerable work to be done in updating and designing new tools to meet the challenges of central banking going forward. In using our conventional monetary policy tool, the target overnight rate, we need to better understand real-financial linkages, and how changes in the target rate are transmitted to the economy. We need to further develop our thinking about, and assess the effectiveness of, unconventional monetary policy tools when the target policy rate is at the effective lower bound. And, in order to promote financial stability, we need to contribute to the development and use of macroprudential tools, especially countercyclical tools, to address periods of both financial exuberance and pessimism. There remains, however, the issue of how central banks should react to developments in asset prices because of their consequences for both inflation and financial stability. Experience shows that increases and collapses in house prices affect aggregate demand, and have played a particularly important role as a driving force behind bouts of financial instability. In Canada, house prices enter directly into the calculation of the CPI. The Bank of Canada follows developments in house prices closely and factors them into our decisionmaking process regarding the level for the target overnight rate, consistent with achieving our inflation target. In our 2006 background document, we indicated that the central bank should focus on the inflation and output consequences of any economic disturbance, including asset-price shocks, and should continue to respond in a manner consistent with meeting our inflation objective. We also said, "some flexibility might be required, however, with regard to the time horizon over which this is realized." 8 That might involve extending the usual horizon for achieving the inflation target in response to an asset-price shock, in return for greater financial, economic, and inflation stability over a somewhat longer horizon. The challenge would lie in making such judgment calls, calls that become even more difficult for an open economy such as ours when the asset-price shock comes from abroad. Here, our flexible exchange rate would be helpful, by performing its usual role as an important shock absorber. M. Carney, "Some Considerations on Using Monetary Policy to Stabilize Economic Activity" (presentation to a symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming, 22 August 2009): p. 3. See "Renewal of the Inflation Control Target, Background Information," op. cit., p. 9. How central banks should respond to asset prices is receiving considerable attention in light of the experience of the past two years. 9 More discussion and debate are called for, drawing on those experiences and on what research can tell us. 10 Issues of broader public policy and the economy Let me now turn to public policy more broadly, and to the economy. There are two elements relating to public policy that I wish to touch on briefly, since both have taken on heightened importance as a result of the global financial crisis. The first is the importance of policies that promote flexibility and an innovative business environment. As we have often seen, most recently during the global financial crisis, many adverse shocks to the Canadian economy come from abroad. We must be able to adapt and adjust in response to these developments. Sound macroeconomic and financial policies are very important, but we also need policies that enable the efficient shifting of resources from one sector to another and that provide incentives for businesses to be nimble in developing new products and markets as trends change in global demand. The second element relates to the importance of a rotation of global demand to address global current account imbalances. Fundamentally, this means that, over the coming years, more U.S. economic growth must come from net exports, and more Chinese growth must come from domestic demand within China. The United States will remain Canada's major trading partner, but we increasingly need to consider other markets outside North America as destinations for Canadian products. Here, I'm referring not only to China, and not only to commodities. Canada has a comparative advantage in many other areas – for example, communications, transportation (ground and air), education, and financial services, to name only a few – and we must exploit these. In terms of the economy, there are increasing signs that activity has begun to expand in many countries in response to the substantial stimulus that has been provided. However, as I noted earlier in my remarks, we should expect a protracted recovery, given the financial repair that needs to take place. In Canada, growth has resumed, supported by stimulative monetary and fiscal policies, a well-functioning financial system, the relative health of Canadian balance sheets, firmer commodity prices, and a rebound in business and consumer confidence. As we signalled in our September interest rate decision, GDP growth in the second half of 2009 will likely be stronger than projected in our July Monetary Policy Report. It would appear, however, that some of this stronger growth reflects the effects of temporary factors, such as the impact of the U.S. "cash-for-clunkers" program on Canadian automotive production. In our September press release, we also reiterated that, conditional on the outlook for inflation, the target overnight rate can be expected to remain at its current level until the end of the second quarter of 2010 in order to achieve the inflation target. Broadly, the factors at play nationally are also evident in the recent developments of the B.C. economy. As elsewhere, activity in British Columbia appears to be picking up after a very difficult year for virtually all areas of the B.C. economy. Residential construction and demand for existing housing are improving, with a dramatic upswing in the resale market that is attributed to the stimulative effects of lower mortgage rates, lower selling prices, and improving consumer confidence. Despite the completion of projects related to the 2010 W. R. White, "Should Monetary Policy 'Lean or Clean'?" (Working Paper No. 34, Federal Reserve Bank of Dallas Globalization and Monetary Policy Institute, August 2009). For example, under certain conditions, price-level targeting could possibly provide a better framework for addressing financial stability issues without jeopardizing the price stability credibility of the monetary authorities. See Carney, op. cit., pp. 5-6. Winter Olympics, it's expected that major public sector spending on transportation and other infrastructure projects will contribute to growth this year and in 2010. Firmer commodity prices are also a positive. However, export markets remain weak, especially the U.S. market, and are only expected to strengthen gradually. Overall, in line with our July projection, we see positive economic growth in British Columbia next year. There will be the boost from the Olympic and Paralympic Winter Games; the results of the Bank's Business Outlook Survey are also consistent with this view. More generally, in looking ahead, further progress in raising business and consumer confidence levels, and growth that is private-sector driven will be increasingly important in spurring full recovery here in British Columbia. Turning to the outlook for inflation, we see inflation returning to our 2 per cent target in the second quarter of 2011, with both upside and downside risks around this projection. Upside risks include a faster-than-expected recovery in consumer and business confidence, and further improvements in Canada's terms of trade. Downside risks are largely external, such as a risk of setbacks in the ongoing repair of the global financial system, and more persistent weakness in foreign private demand. All else being equal, a persistently strong Canadian dollar would also reduce real growth and delay the return of inflation to target. The Bank will assess the balance of risks to inflation in its upcoming MPR, which we will release two weeks from today. Even though we are at the effective lower bound for our policy rate, the Bank retains considerable flexibility in the conduct of monetary policy. Conclusion The Great Recession has taught us many lessons, and has re-affirmed the importance of international co-operation, where Canada has much to contribute. We have also seen, through the turmoil of the past two years, that our policy frameworks have served us well. However, we must improve our capacity to address future challenges. This includes strengthening the Bank's policy frameworks for promoting both price stability and financial stability. This work is well under way at the Bank and internationally. The Great Recession has also drawn attention to the importance of policies that promote economic flexibility and an innovative business environment. It has shown us, once again, how adverse shocks to the Canadian economy often come from outside and thus, why it is essential to continue to develop policies that encourage ready adaptation and adjustment to external developments. As a nation, we have taken major steps in this direction. This is particularly true for the economy of British Columbia, which has seen considerable restructuring in recent years. We cannot now lag in these efforts. Finally, the experiences of the past two years have brought into sharp focus the reshaping of the global landscape that began more than a decade ago. Given our comparative advantages, this phenomenon offers us many opportunities, ones we cannot afford to waste. Thank you for your attention and I would be pleased to answer any questions.
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Opening statement by Mr Mark Carney, Governor of the Bank of Canada, at the press conference following the release of the Monetary Policy Report, Ottawa, 22 October 2009.
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Mark Carney: Summary Canada’s latest Monetary Policy Report Opening statement by Mr Mark Carney, Governor of the Bank of Canada, at the press conference following the release of the Monetary Policy Report, Ottawa, 22 October 2009. * * * Good morning. Paul and I are pleased to be here with you today to discuss the October Monetary Policy Report, which we published this morning. • Recent indicators point to the start of a global recovery. Economic and financial developments have been somewhat more favourable than we expected in July, although significant fragilities remain. • In Canada, as expected, a recovery in economic activity is also under way, following three consecutive quarters of sharp contraction. • This resumption of growth is supported by monetary and fiscal stimulus, increased household wealth, improving financial conditions, higher commodity prices, and stronger business and consumer confidence. • However, heightened volatility and persistent strength in the Canadian dollar are working to slow growth and subdue inflation pressures. The current strength in the dollar is expected, over time, to more than fully offset the favourable developments since July. • Given all these factors, the Bank now projects that, relative to our July Report, the composition of aggregate demand will shift further towards final domestic demand and away from net exports. We now expect growth to average slightly lower over the balance of the projection period. • The Bank projects that the Canadian economy will contract by 2.4 per cent this year and then grow by 3.0 per cent in 2010 and 3.3 per cent in 2011. This projected recovery will be somewhat more modest than the average of previous cycles. • Total CPI inflation declined to a trough of -0.9 per cent in the third quarter, reflecting large year-on-year drops in energy prices. Total CPI inflation should rise to 1.0 per cent this quarter, while the core rate of inflation is projected to reach its trough of 1.4 per cent during the same period. • Owing to the substantial excess supply that has emerged in the economy, the Bank expects both core and total inflation to return to the 2 per cent target in the third quarter of 2011, one quarter later than we projected in July. • The main upside risks to inflation relate to the possibility of a stronger-thananticipated recovery in the global economy and more robust Canadian domestic demand. • On the downside, a stronger-than-assumed Canadian dollar, driven by global portfolio movements out of U.S.-dollar assets, could act as a significant further drag on growth and put additional downward pressure on inflation. Another important downside risk is that the global recovery could be even more protracted than projected. • On Tuesday, the Bank reaffirmed its conditional commitment to maintain its target for the overnight rate at the effective lower bound of 1/4 per cent until the end of June 2010 in order to achieve the inflation target. • The Bank retains considerable flexibility in the conduct of monetary policy at low interest rates, consistent with the framework that we outlined in the April MPR.
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Remarks by Mr Mark Carney, Governor of the Bank of Canada, at a Rendez-vous avec l'Autorité des marchés financiers, Montréal, Québec, 26 October 2009.
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Mark Carney: Reforming the global financial system Remarks by Mr Mark Carney, Governor of the Bank of Canada, at a Rendez-vous avec l’Autorité des marchés financiers, Montréal, Québec, 26 October 2009. * * * It is a pleasure to be here at this year’s Rendez-vous avec l’Autorité des marchés financiers (AMF). After briefly reviewing the current macrofinancial environment, I intend to concentrate on the G-20 reform agenda. The financial crisis has cost tens of millions of jobs and trillions of dollars in foregone output. Its aftershocks will persist for years. To prevent an even more severe outcome, monetary and fiscal policies have been stretched to their very limits. In this context, it would be a mistake to underestimate the determination of G-20 leaders to reshape the financial services industry. Last month in Pittsburgh, the leaders of the G-20 endorsed a comprehensive agenda, whose implementation is just beginning. As I will highlight during my remarks, Canada intends to use its presidency of the G-7 next year to advance some of the most important priorities. Current outlook Recent indicators point to the start of a global recovery. Economic and financial developments have been somewhat more favourable than the Bank had expected in July, although significant fragilities remain. In Canada, as expected, a recovery in economic activity is also under way, following three consecutive quarters of sharp contraction. This resumption of growth is supported by monetary and fiscal stimulus, increased household wealth, improving financial conditions, higher commodity prices, and stronger business and consumer confidence. However, heightened volatility and persistent strength in the Canadian dollar are working to slow growth and subdue inflation pressures. The current strength in the dollar is expected, over time, to more than fully offset the favourable developments since July. Given all these factors, the Bank now projects that, relative to our July Monetary Policy Report, the composition of aggregate demand will shift further towards final domestic demand and away from net exports. We now expect growth to average slightly lower over the balance of the projection period. The Bank projects that the Canadian economy will contract by 2.4 per cent this year and then grow by 3.0 per cent in 2010 and 3.3 per cent in 2011. This projected recovery will be somewhat more modest than the average of previous cycles. Total CPI inflation declined to a trough of -0.9 per cent in the third quarter, reflecting large year-on-year drops in energy prices. Total CPI inflation should rise to 1.0 per cent this quarter, while the core rate of inflation is projected to reach its trough of 1.4 per cent during the same period. Owing to the substantial excess supply that has emerged in the economy, the Bank expects both core and total inflation to return to the 2 per cent target in the third quarter of 2011, one quarter later than we projected in July. The main upside risks to inflation relate to the possibility of a stronger-than-anticipated recovery in the global economy and more robust Canadian domestic demand. On the downside, the global recovery could be even more protracted than projected. In addition, a stronger-than-assumed Canadian dollar, driven by global portfolio movements out of U.S.-dollar assets, could act as a significant further drag on growth and put additional downward pressure on inflation. On Tuesday, the Bank reaffirmed its conditional commitment to maintain its target for the overnight rate at the effective lower bound of 1/4 per cent until the end of June 2010 in order to achieve the inflation target. The Bank retains considerable flexibility in the conduct of monetary policy at low interest rates, consistent with the framework that we outlined in the April MPR. As I said last week, our focus in the conduct of monetary policy is on achieving the 2 percent inflation target. The exchange rate should be seen in this context. It is an important relative price, which the Bank monitors closely. What ultimately matters is the exchange rate’s impact in conjunction with all other domestic and foreign factors on aggregate demand and inflation in Canada. To put it simply, the Bank looks at everything through the prism of achieving our inflation target. Current macrofinancial environment As many of you have no doubt noticed, it is currently a very constructive environment for financial institutions. Flow trading and market making have become more attractive and intermediation spreads have increased. Underwriting fees have recovered along with the capital markets; and there are very early signs that an appetite for mergers and acquisitions has returned. Banks are once again being compensated for their basic businesses of providing liquidity and credit. Interestingly, despite the fall in measured volatility, industry VaR, while down from the peak earlier this year, is still above pre-Lehman levels. What is perhaps less evident is that these returns are largely the product of public policy. While medium-term challenges clearly remain, tail risk has been removed from the economic outlook. The very low policy interest rates and greater-than-usual clarity on policy paths are encouraging investors to return to the markets and to take on greater risk. Direct support to the industry has been breathtaking, with some industrialized countries committing a remarkable 25 per cent of GDP to support their financial sectors. In effect, there was wartime spending on peacetime calamity. The G-7 commitments of last October temporarily eliminated counterparty risk for major institutions. When this support was combined with an intense flight to quality, large financial institutions benefited disproportionately. Even in Canada, public funding has been considerable. The $65 billion in Insured Mortgage Purchase Program (IMPP) funding for banks represents 4.3 per cent of GDP. Bank of Canada extraordinary liquidity facilities have been smaller than elsewhere but they still peaked at 3 per cent of GDP. While government guarantees have not been used, it is noteworthy that Canadian bank term funding is running at less than 30 per cent of normal levels, largely as a result of the use of IMPP and the Bank’s facilities. Initially, the crisis has also had a major impact on the competitive environment for financial institutions. Competition globally has been substantially reduced through the combination of the failure of institutions, a decline in cross-border banking and, most importantly, the collapse of most of the shadow banking system. The reduced competitive dynamics could persist for some time, allowing the core of the financial sector to build sufficient capital for the future. Banks around the world would be well advised to take this opportunity to do so. The G-20 reform agenda The fundamental objective of the G-20 reforms is to create a resilient, global financial system that efficiently supports worldwide economic growth. The system must be robust to shocks, dampening rather than amplifying their impact on the real economy. The Bank of Canada strongly believes that our destination should be one where financial institutions and markets play critical – and complementary – roles to support long-term economic prosperity. The financial system will be more stable if market infrastructure is substantially improved, products are more standardized and transparent, and banks are adequately capitalized to fulfill their market-making and credit intermediation roles. Market forces should be left to determine the relative sizes and boundaries of the banking and market sectors. In doing so, markets can discipline banks by furnishing necessary competition. There are two main approaches to reform: • First, protect the banks from the economic cycle; in other words, make each bank, individually, more resilient. • Second, protect the cycle from the banks; that is, make the system as a whole more resilient. Both are necessary. Protecting the banks from the cycle In effect, the objective of the first approach is to create more resilient institutions. This will require more capital, higher liquidity, and better risk management. In early September, my colleagues and I on the oversight body of the Basel Committee on Banking Supervision (BCBS) met to review a comprehensive set of measures to strengthen the regulation, supervision, and risk management of the banking sector. We agreed on new standards for banking regulation and supervision, which should help reduce the probability and severity of economic and financial stress. These standards were endorsed by G-20 leaders in Pittsburgh. Specifically, to protect banks from the cycle, we agreed to: i. Raise the quality, consistency, and transparency of the Tier 1 capital base. Going forward, the predominant form of Tier 1 capital must consist of common shares and retained earnings. Moreover, deductions and prudential filters (such as goodwill and other intangibles, investments in own shares, deferred tax assets, etc.) will be harmonized internationally and generally applied at the level of common equity. Finally, all components of the capital base will be fully disclosed. ii. Introduce a leverage ratio as a supplementary measure of capital adequacy to the Basel II risk-based framework. To ensure comparability, the details of the leverage ratio will be harmonised internationally, fully adjusting for differences in accounting (such as netting). These two measures will make international bank capital regulation look more like the existing capital regulations overseen by Canada’s Office of the Superintendent of Financial Institutions (OSFI). Other initiatives will be new, even to Canada: 1 iii. Introduce a framework for countercyclical capital buffers above the minimum requirement. The Bank of Canada is working closely with OSFI and our international counterparts on proposed elements of this framework. iv. Create a minimum global standard for funding liquidity that includes requirement for a stressed liquidity-coverage ratio, underpinned by a longer-term structuralliquidity A system-wide, or macroprudential, approach is the shared responsibility of the Department of Finance and all of the federal financial regulatory authorities, including, of course, the Bank of Canada, the Office of the Superintendent of Financial Institutions, and the Canada Deposit Insurance Corporation. Ultimately, it is the Minister of Finance who is responsible for the sound stewardship of the financial system. ratio. As in other areas, standard setters will need to take a comprehensive approach. Central banks have real concerns about ratchet effects (large buffers are built beyond the standard), particularly in light of the inherent procyclicality of liquidity (i.e., institutions want more liquidity in bad times so "buffers" cannot be drawn upon). One potential mitigant would be to ensure that there is a broad range of securities that are liquid in all states of the world. That is tougher than it sounds as anyone who tried to repo quasi-sovereigns throughout the last year knows. I will address some potential solutions to this problem momentarily. The Bank strongly believes that the standard should not bind in times of systemic crises. The Basel Committee will issue specific, concrete proposals on these measures by the end of this year. It will carry out an impact assessment in the first half of next year, and calibrate the new requirements by the end of 2010. Implementation will be timed to ensure that the phase-in of these new measures does not impede the recovery of the real economy. Protecting the cycle from the banks Protecting the cycle from the banks requires building a system that can withstand the failure of any single financial institution and is buttressed by resilient markets. Today, after a series of extraordinary but necessary measures to keep the system functioning, we are awash in moral hazard. If left unchecked, this will distort private behaviour and inflate public costs. As a consequence, there is a firm conviction among policy-makers that losses endured in future crises must be borne by the institutions themselves. This means management, shareholders and creditors, rather than taxpayers. This cannot be accomplished overnight. On the contrary, it is a long-term objective that should consistently guide policy choices now and in the future. The following four measures are designed to create a system in which individual financial institutions are less important and markets more important: i. As is the case in Canada, all regulators should institute staged intervention regimes 2 to detect problems early. ii. Banks themselves should develop "living wills," or plans to unwind in an orderly fashion if they were to fail. If this process results in simpler organizations, so be it. At a minimum, the exercise will underscore the shared responsibility for financial stability and improve regulators’ understanding of firms’ business models. iii. The Basel oversight committee agreed to "reduce the systemic risk associated with the resolution of cross-border banks." Closing down a multinational institution is a horrifically difficult challenge, but without progress in this area, the efficiency of the global system will likely decline, perhaps significantly. For example, viable crossborder resolution is the key to ensure that a financial institution’s liquidity continues to be optimally distributed across its international operations. iv. Finally, the Bank of Canada believes that continuously open markets are essential for a system to be robust to failure. The crisis was clearly exacerbated by the seizure of interbank and repo markets. Good collateral became unfinanceable OSFI has developed Guide to Intervention for federally-regulated financial institutions that provide a framework for responding effectively to circumstances that could undermine the financial viability of an institution. It is based on a graduated and progressive set of responses or stages, depending on the institution’s situation and degree of weakness perceived. Further information on the staging process can be found at www.osfi-bsif.gc.ca/app/DocRepository/1/eng/practices/supervisory/Guide_Int_e.pdf. overnight, firms failed, risk aversion skyrocketed, and the global economy plummeted. Promising avenues to break such (il)liquidity spirals in funding markets include: • Clearing houses for repo • Through-the-cycle margining requirements • Standardizing products • Ensuring that accounting rules permit effective netting • Adapting central bank liquidity facilities as necessary In a similar vein, current efforts to transfer settlement of many over-the-counter derivatives onto clearing houses and potentially the trading of some of them onto exchanges, such as the Montreal Exchange, have the potential to reduce bilateral counterparty risk, increase liquidity, and enhance transparency. As a testament to the seriousness of this initiative, the G-7 – where the vast majority of such transactions occur – has made this a top priority for implementation next year. The Bank of Canada is working with our partners, including the AMF and the federal Department of Finance, to develop a Canadian approach. Globally, substantial progress has been made in recent months – more than two-thirds of credit default swaps (CDS) and three-quarters of interest rate swaps (IRS) are now eligible for clearing houses. Of course, there is much more work to be done as actual volumes are still a fraction of these levels. For such initiatives to be fully successful, regulatory capital requirements should reinforce incentives to process standardized products centrally. That is, trading in standardized products should be capital advantaged and limited basis risk should not result in punitive capital charges. Bespoke transactions will continue to have their place, but should be subject to higher capital requirements so that incentives are appropriately aligned. Securitization needs to be made more sustainable A more resilient financial system will require a return of private-label securitization. When properly structured, securitization can diversify risk, provide competitive discipline on banks and lower borrowing costs for individuals and businesses. Much more must be done to ensure that these objectives can be achieved. Securitization has been slow to come back for two reasons. First, some core buyers of senior tranches (structured investment vehicles, Canadian non-bank asset-backed commercial paper (ABCP), balance sheets of large banks) will not return. This alone will shrink the market substantially. Some of this shortfall in financing capacity will be replaced over time with on-balance sheet credit risk, though the prospect of leverage ratios will limit future buying by banks of senior tranches. Second, the crisis laid bare important structural deficiencies, such as the woefully inadequate disclosure on securitized products. Transparency should be improved so that risk can be identified more effectively and priced more efficiently. For example, the Bank of Canada used its collateral policy to improve the disclosure of bank-sponsored ABCP, creating a standard that should become commonplace. More generally, we advocate publication of models and data underlying securities to move securitization from "black box" to "open source." There are also a host of initiatives for underwriters to have skin in the game (keep similar products or first loss). The Bank is working with government and industry players to explore the effectiveness of these and other alternatives. An integrated approach to return risk to the private sector The financial panic required a bold response. While absolutely necessary, the response has profoundly shifted risk from the private to the public sector. The expedient should not become permanent. Risks must be returned to and, borne by, the private sector. However, this can only happen if banks are resilient and if markets are built on solid foundations. This will require a set of reforms that are internally consistent and mutually reinforcing. Examples just mentioned include clearing houses for CDS and Basel II treatment of basis risk or new liquidity requirements and the development of continuously open funding markets to aid in liquidity options. Reforms cannot be developed and introduced in a piecemeal fashion; the entire package must be integrated. Similarly, banks should take an integrated approach to how they deploy their current earnings. In this regard, it may be wise to consider that both the Basel Committee and the G-20 are stressing capital conservation during the transition to a new capital regime. The compensation debate should be seen in this context. Current bumper profits can compensate employees, be returned to shareholders, or increase capital. The clear priority of the public sector is the recapitalization of the financial system to expand credit formation. The transition timetable for a new capital regime referenced at the start of my remarks is in part designed to take advantage of current higher retained earnings. The industry should be in no doubt that capital requirements are going up. Those who pre-fund will be in the best possible position over the medium term. Moreover, we all agree that bonuses should be tied to long-term performance. In their communiqué, the G-20 leaders urged firms to implement sound compensation practices immediately. The current windfall, dependent as it is on the strongest of safety nets and the policy-driven snap back from the brink, sits uneasily with that principle. Do firms really have a good handle on their medium-term profitability, given the profound regulatory and economic changes on the horizon? Conclusion: working together for common solutions To conclude, the financial system must transition from its self-appointed role as the apex of economic activity to once again be the servant of the real economy. Stronger institutions and a system that can withstand failure are necessary conditions. But full realization of this objective also requires a change in attitude. The Bank of Canada has a strong preference for principles-based regulation and reliance on the judgment of people, rather than blind faith in the security blanket of excess capital. But this approach requires a sensitivity from the industry, which has been absent in recent months. Relief is in danger of giving way to hubris. Financial institutions need to demonstrate an awareness of their broader responsibilities. Financiers should ask themselves every day how their activities affect systemic risk? And what are they doing to promote economic growth? As a colleague said during the crisis, there are no atheists in foxholes, and there are no ideologues in financial crises. Policy-makers had to do many unpalatable things to save the economy from the financial system – a financial system that begged for mercy. We will not remind market participants of the many oaths they swore a year ago; nor do we expect scores of financiers to join religious orders. However, we do expect those fevered battlefield vows to be respected through daily peacetime concern for and contributions to building a better, more resilient financial system – a system that serves the real economy, by replacing those lost jobs and making up for that lost output.
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Opening statement by Mr Mark Carney, Governor of the Bank of Canada, at the House of Commons Standing Committee on Finance, Ottawa, 27 October 2009.
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Mark Carney: Bank of Canada’s economic overview and monetary policy stance Opening statement by Mr Mark Carney, Governor of the Bank of Canada, at the House of Commons Standing Committee on Finance, Ottawa, 27 October 2009. * * * Good morning, Mr. Chairman and committee members. Paul and I are pleased to appear before this committee today to discuss the Bank of Canada's views on the economy and our monetary policy stance. While conditions in the Canadian economy have improved since we met with you in February and April, many of the basic challenges remain. Before Paul and I take your questions, I would like to give you some of the highlights from our latest Monetary Policy Report, released last week. • Recent indicators point to the start of a global recovery. Economic and financial developments have been somewhat more favourable than the Bank had expected in July, although significant fragilities remain. • In Canada, as expected, a recovery in economic activity is also under way, following three consecutive quarters of sharp contraction. This resumption of growth is supported by monetary and fiscal stimulus, increased household wealth, improving financial conditions, higher commodity prices, and stronger business and consumer confidence. • However, heightened volatility and persistent strength in the Canadian dollar are working to slow growth and subdue inflation pressures. The current strength in the dollar is expected, over time, to more than fully offset the favourable developments since July. • Given all these factors, the Bank now projects that, relative to our July Monetary Policy Report, the composition of aggregate demand will shift further towards final domestic demand and away from net exports. • We now expect growth to average slightly lower over the balance of the projection period. The Bank projects that the Canadian economy will contract by 2.4 per cent this year and then grow by 3.0 per cent in 2010 and 3.3 per cent in 2011. This projected recovery will be somewhat more modest than the average of previous cycles. • Total CPI inflation declined to a trough of -0.9 per cent in the third quarter, reflecting large year-on-year drops in energy prices. • Total CPI inflation should rise to 1.0 per cent this quarter, while the core rate of inflation is projected to reach its trough of 1.4 per cent during the same period. • Owing to the substantial excess supply that has emerged in the economy, the Bank expects both core and total inflation to return to the 2 per cent target in the third quarter of 2011, one quarter later than we projected in July. • The main upside risks to inflation relate to the possibility of a stronger-thananticipated recovery in the global economy and more robust Canadian domestic demand. • On the downside, the global recovery could be even more protracted than projected. In addition, a stronger-than-assumed Canadian dollar, driven by global portfolio movements out of U.S.-dollar assets, could act as a significant further drag on growth and put additional downward pressure on inflation. • On Tuesday, 20 October, the Bank reaffirmed its conditional commitment to maintain its target for the overnight rate at the effective lower bound of 1/4 per cent until the end of June 2010 in order to achieve the inflation target. • The Bank retains considerable flexibility in the conduct of monetary policy at low interest rates, consistent with the framework that we outlined in the April MPR. • Our focus in the conduct of monetary policy is on achieving the 2 per cent inflation target. The exchange rate should be seen in this context. It is an important relative price, which the Bank monitors closely. • What ultimately matters is the exchange rate's impact in conjunction with all other domestic and foreign factors on aggregate demand and inflation in Canada. To put it simply, the Bank looks at everything through the prism of achieving our inflation target. With that, Mr. Chairman and committee members, Paul and I would now be pleased to answer your questions.
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Remarks by Mr Mark Carney, Governor of the Bank of Canada, to the Foreign Policy Association, New York, 19 November 2009.
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Mark Carney: The evolution of the international monetary system Remarks by Mr Mark Carney, Governor of the Bank of Canada, to the Foreign Policy Association, New York, 19 November 2009. * * * In response to the worst financial crisis since the 1930s, policy-makers around the globe are providing unprecedented stimulus to support economic recovery and are pursuing a radical set of reforms to build a more resilient financial system. However, even this heavy agenda may not ensure strong, sustainable, and balanced growth over the medium term. We must also consider whether to reform the basic framework that underpins global commerce: the international monetary system. My purpose this evening is to help focus the current debate. While there were many causes of the crisis, its intensity and scope reflected unprecedented disequilibria. Large and unsustainable current account imbalances across major economic areas were integral to the buildup of vulnerabilities in many asset markets. In recent years, the international monetary system failed to promote timely and orderly economic adjustment. This failure has ample precedents. Over the past century, different international monetary regimes have struggled to adjust to structural changes, including the integration of emerging economies into the global economy. In all cases, systemic countries failed to adapt domestic policies in a manner consistent with the monetary system of the day. As a result, adjustment was delayed, vulnerabilities grew, and the reckoning, when it came, was disruptive for all. Policy-makers must learn these lessons from history. The G-20 commitment to promote strong, sustainable, and balanced growth in global demand – launched two weeks ago in St. Andrews, Scotland – is an important step in the right direction. What is the international monetary system and how should it function? The international monetary system consists of (i) exchange rate arrangements; (ii) capital flows; and (iii) a collection of institutions, rules, and conventions that govern its operation. Domestic monetary policy frameworks dovetail, and are essential to, the global system. A well-functioning system promotes economic growth and prosperity through the efficient allocation of resources, increased specialization in production based on comparative advantage, and the diversification of risk. It also encourages macroeconomic and financial stability by adjusting real exchange rates to shifts in trade and capital flows. To be effective, the international monetary system must deliver both sufficient nominal stability in exchange rates and domestic prices, and timely adjustment to shocks and structural changes. Attaining this balance can be very difficult. Changes in the geographic distribution of economic and political power, the global integration of goods and asset markets, wars, and inconsistent monetary and fiscal policies all have the potential to undermine a monetary system. Past systems could not incent systemic countries to adjust policies in a timely manner. The question is whether the current shock of integrating one-third of humanity into the global economy – positive as it is – will overwhelm the adjustment mechanisms of the current system. There are reasons for concern. China's integration into the global economy alone represents a much bigger shock to the system than the emergence of the United States at the turn of the last century. China's share of global GDP has increased faster and its economy is much more open.1 As well, unlike the situation when the United States was on the gold standard See Chart 1. In addition, the U.S. economy was fairly closed from 1870 to 1913, as imports/GNP averaged roughly 4-7 per cent, and the U.S. share of total world trade remained relatively stable (Lipsey 1994; Rostow with all the other major countries, China's managed exchange rate regime today is distinct from the market-based floating rates of other major economies. History shows that systems dominated by fixed or pegged exchange rates seldom cope well with major structural shocks. This failure is the result of two pervasive problems: an asymmetric adjustment process and the downward rigidity of nominal prices and wages. In the short run, it is generally much less costly, economically as well as politically, for countries with a balance of payments surplus to run persistent surpluses and accumulate reserves than it is for deficit countries to sustain deficits. This is because the only limit on reserve accumulation is its ultimate impact on domestic prices. Depending on the openness of the financial system and the degree of sterilization, this can be delayed for a very long time.2 In contrast, deficit countries must either deflate or run down reserves. Flexible exchange rates prevent many of these problems by providing less costly and more symmetric adjustment. Relative wages and prices can adjust quickly to shocks through nominal exchange rate movements in order to restore external balance. When the exchange rate floats and there is a liquid foreign exchange market, reserve holdings are seldom required.3 Most fundamentally, floating exchange rates overcome the seemingly innate tendency of countries to delay adjustment. A brief review of how the different international monetary regimes failed to manage this trade-off between nominal stability and timely adjustment provides important insights for current challenges. The evolution of the international monetary system The gold standard Under the classical gold standard, from 1870 to 1914, the international monetary system was largely decentralized and market-based. There was minimal institutional support, apart from the joint commitment of the major economies to maintain the gold price of their currencies. Although the adjustment to external imbalances should, in theory, have been relatively smooth, in practice it was not problem-free.4 Surplus countries did not always abide by the conventions of the system and tried to frustrate the adjustment process by sterilizing gold inflows. Deficit countries found the adjustment even more difficult because of downward wage and price stickiness. Once the shocks were large and persistent enough, the consequences of forfeiting monetary independence and asymmetric adjustment ultimately undermined the system.5 1978). China, on the other hand, is very open, with imports/GDP around 30 per cent, and it accounts for an ever-increasing share of world trade. There is, however, an important welfare loss in pursuing unbalanced growth. Domestic consumers are made worse off by reduced purchasing power, and thwarting adjustment via sterilization leads to mounting quasifiscal costs and distorts the domestic financial system. The important point is that balanced global growth is sustainable global growth. Except in exceptional circumstances, such as a near-term market breakdown, which creates a severe lack of liquidity and warrants intervention. For example, under the price-specie flow mechanism, if a country ran a trade surplus, gold inflows would occur, raising the price level and thus causing imports to increase and exports to decrease until the balance of trade was equilibrated. More generally, the gold standard suffered from the fact that the money supply was dependent on the supply of gold. Inadequate gold supply led to deflation in the 1880s, which was only alleviated by major gold discoveries in South Africa, Western Australia, and Canada in the following decade. Even then, concerns with respect to the supply of gold remained. The gold standard did not survive World War I intact. Widespread inflation caused by moneyfinanced war expenditures and major shifts in the composition of global economic power undermined the pre-war gold parities. Crucially, there was no mechanism to coordinate an orderly return to inflation-adjusted exchange rates. When countries, such as the United Kingdom in 1925, tried to return to the gold standard at overvalued parities, they were forced to endure painful deflation of wages and prices in order to restore competitiveness. Though this was always going to be difficult, it proved impossible when surplus countries thwarted reflation. During the Great Depression, with an open capital account and a commitment to the goldexchange standard, the United States could not use monetary policy to offset the economic contraction.6 Fidelity to gold meant that the deflationary pressures from the United States spread quickly, further weakening the global economy. Unable to adjust to these pressures, countries were forced to abandon the system. Though deficit countries experienced the first crisis, all countries suffered from the eventual collapse – a lesson that was repeated in subsequent systems.¨ Bretton Woods The Bretton Woods system of pegged, but adjustable, exchange rates was a direct response to the instability of the interwar period. Bretton Woods was very different from the gold standard: it was more administered than market-based; adjustment was coordinated through the International Monetary Fund (IMF); there were rules rather than conventions;7 and capital controls were widespread. Despite these institutional changes, surplus countries still resisted adjustment. Foreshadowing present problems, countries often sterilized the impact of surpluses on domestic money supply and prices. Like today, these interventions were justified by arguing that imbalances were temporary and that, in any event, surpluses were evidence more of virtue than "disequilibria." In contrast, the zero bound on reserves remained a binding constraint for deficit countries, which eventually ran out of time. The Bretton Woods system finally collapsed in the early 1970s after U.S. policy became very expansionary, its trade deficit unsustainable, and the loosening of capital controls began to put pressure on fixed exchange rates. Once again, all countries suffered from the aftershocks. The current hybrid system After the breakdown of the Bretton Woods system, the international monetary system reverted to a more decentralized, market-based model. Major countries floated their exchange rates, made their currencies convertible, and gradually liberalized capital flows. In recent years, several major emerging markets adopted similar policies after experiencing the difficulties of managing pegged exchange rate regimes with increasingly open capital accounts. The move to more market-determined exchange rates has increased control of domestic monetary policy and inflation, accelerated the development of financial sectors, and, ultimately, boosted economic growth. As the Federal Reserve pursued tight monetary policy in the aftermath of the crash of 1929, it simultaneously sterilized the resulting large gold inflows. In 1931, to counteract the outflow of gold (due to the U.K.'s decision to leave gold), the Fed sharply raised its rediscount rate. This effort to maintain confidence in convertibility resulted in considerable monetary tightening and, consequently, a further wave of bank failures in the ensuing six months. Article IV (iii) states that members should "avoid manipulating exchange rates or the international monetary system in order to prevent effective balance of payments adjustment or to gain an unfair competitive advantage over other members….". Unfortunately, this trend has been far from universal. In many respects, the recent crisis represents a classic example of asymmetric adjustment. Some major economies have frustrated real exchange rate adjustments by accumulating enormous foreign reserves and sterilizing the inflows. While their initial objective was to self-insure against future crises, reserve accumulation soon outstripped these requirements (Table 1). In some cases, persistent exchange rate intervention has served primarily to maintain undervalued exchange rates and promote export-led growth. Indeed, given the scale of its economic miracle, it is remarkable that China's real effective exchange rate has not appreciated since 1990 (Chart 2). This flip side of these imbalances was a large current account deficit in the United States, which was reinforced by expansionary U.S. monetary and fiscal policies in the wake of the 2001 recession. In combination with high savings rates in East Asia, these policies generated large global imbalances and massive capital flows, creating the "conundrum" of very low long-term interest rates, which, in turn, fed the search for yield and excessive leverage. While concerns over global imbalances were frequently expressed in the run-up to the crisis, the international monetary system once again failed to promote the actions needed to address the problem. Vulnerabilities simply grew until the breaking point. Some pressures remain. The financial crisis could have long-lasting effects on the composition and rate of global economic growth.8 Since divergent growth and inflation prospects require different policy mixes, it is unlikely that monetary policy suitable for United States will be appropriate for most other countries. However, those countries with relatively fixed exchange rates and relatively open capital accounts are acting as if it is. If this divergence in optimal monetary policy stance increases, the strains on the system will grow. Postponed adjustment will only serve to increase vulnerabilities. In the past, the frustration of adjustment by surplus countries generated deflationary pressures on the rest of the world. Similarly, today, the adjustment burden is being shifted to others. Advanced countries – including Canada, Japan, and the Euro area – have recently seen sizable appreciations of their currencies. The net result could be a suboptimal global recovery, in which the adjustment burden in those countries with large imbalances falls largely on domestic prices and wages rather than on nominal exchange rates. History suggests that this process could take years, repressing global output and welfare in the interim. Reinhart and Rogoff (2009). The way forward To avoid these outcomes, there are several options. The first is to reduce overall demand for reserves. Alternatives include regional reserve pooling mechanisms and enhanced lending and insurance facilities at the IMF. While there is merit in exploring IMF reforms, their effect on those systemic countries that already appear substantially overinsured would likely be marginal. As I will touch on in a moment, the G-20 process may have a greater impact. On the supply side, several alternative reserve assets have been suggested. The motivation of these proposals is primarily to redistribute the so-called "exorbitant privilege" that accrues to the United States as the principal supplier of reserve currency. As such, the United States receives an advantage in the form of lower financing costs in its own currency. This advantage would be shared (and possibly reduced in aggregate) if there were competing reserve currencies. In turn, this could marginally reduce the collective imbalances of reserve currency countries.9,10 Over the longer term, it is possible to envision a system with other reserve currencies in addition to the U.S. dollar. However, with few alternatives ready to assume a reserve role, the U.S. dollar can be expected to remain the principal reserve currency for the foreseeable future. Despite the exuberant pessimism reflected in the gold price, total gold stocks represent only $1 trillion or about 10 per cent of global reserves and a much smaller proportion of global money supply.11 The renminbi's prospects are moot absent convertibility and open capital markets, which would themselves likely do much to reduce any pressure for a change. Increased use of Special Drawing Rights At first glance, Special Drawing Rights (SDRs) would be an intriguing alternative reserve asset.12 Using SDRs appeals to a sense of fairness in that no one country would enjoy the exorbitant privilege of reserve currency status. Like a multiple reserve currency system, it may reduce the aggregate incentives of countries that supply the consistent currencies of the SDR to run deficits. In addition, there appears to be no technical reason why the use of SDRs could not be expanded. However, the question must be asked: to what end? Merely enhancing the role of the SDR would do little either to increase the flexibility of the system or change the incentives of surplus countries. By providing a ready swap of existing reserve currencies into a broader basket, SDR reserves could also further displace adjustment onto other freely trading currencies, thus exacerbating the imbalances in the current system. Indeed, by providing instant diversification, SDR reserves could entrench some of the existing strategies of surplus countries. This would change if the proposal were taken to its logical extreme: the SDR as the single global currency. Setting aside the fact that the world is not an optimum currency area (not However, network externalities and transactions costs would work against multiple reserve currencies, as they did during bi-metallism and the pound/dollar period under the gold standard. The well-known Triffin (1960) dilemma, which argued that, in order for the global economy to have sufficient liquidity, the United States had to run balance-of-payments deficits; but such deficits could undermine confidence in convertibility. Bordo (1993) rightly notes that under flexible exchange rates, the Triffin dilemma disappears, as any adjustment could occur through capital flows (for example, India has accumulated desired foreign reserves, through capital inflows, despite a current account deficit). Recall that under the gold exchange standard, 40 per cent of money supply was backed by gold. Zhou (2009); United Nations (2009). least due to the absence of free mobility of labour, goods, and capital), this appears utopian. While the level of international co-operation has certainly increased since the crisis, it would be a stretch to assert that there is any appetite for the creation of the independent global central bank that would be required.13 As a result, any future SDR issuance is likely to be ad hoc.14 A substitution account Greater use of SDRs might be best suited to encouraging a transition to a more stable international monetary system by facilitating any desired reserve diversification. Establishing, on a temporary basis, an enhanced substitution account at the IMF would allow large reserve holders to exchange U.S.-dollar reserves for SDR-denominated securities, thereby diversifying their portfolios. With the IMF bearing the risk of changes in the U.S.-dollar exchange rate, an appropriate burden-sharing arrangement among its members would have to be agreed upon. A substitution account would create considerable moral hazard, since reserve holders would be tempted to engage in further accumulation. In addition, a substitution account would not address the fundamental asymmetry of the adjustment process. Thus, it would appear essential that a substitution account mark the transition from the current hybrid system to an international system characterized by more flexible exchange rates for all systemic countries. In general, alternatives to the dollar as the reserve currency would not materially improve the functioning of the system. While reserve alternatives would increase pressures on the United States to adjust, since "artificial" demand for their assets would be shared with others, incentives for the surplus countries that have thwarted adjustment would not change. The common lesson of the gold standard, the Bretton Woods system and the current hybrid system is that it is the adjustment mechanism, not the choice of reserve asset, that ultimately matters. With the adjustments that would arise automatically from floating exchange rates or unsterilized intervention muted, the burden is squarely on policy dialogue and co-operation. A practical solution: the G-20 and shared responsibility The G-20 framework moves in the right direction. It stresses countries' shared responsibility to ensure that their policies support "strong, sustainable and balanced growth." Under the framework, members have agreed to a mutual assessment of their monetary, exchange rate, fiscal, and financial policies, with the assistance of the IMF and other international financial institutions. The implications of these policies for the level and pattern of global growth and the risks to financial stability will be reviewed by finance ministers and governors in preparation for agreement on any common actions by G-20 leaders in Canada and South Korea next year. There are several reasons why this mutual assessment process has the potential to develop shared understanding and encourage action across a range of countries. There is a clear timetable. A comprehensive set of policies will be considered. Policy-makers at the highest levels are directly involved, with international financial institutions in a supportive, rather than leading, role. Finally, discussions will take place at the G-20, where all major economies are present and where China has assumed a very constructive, leadership role. That is not to argue that the role of SDRs cannot be enhanced, particularly among central banks (see Williamson 2009). Under current rules, new SDRs can be issued only with the agreement of members, representing 85 per cent of voting share. Framework discussions would be complemented by successful implementation of the G-20 financial reform agenda. These reforms, when combined with the peer review process of the Financial Stability Board (FSB) and external reviews by the IMF, could increase actual and perceived systemic stability and thereby reduce reserve accumulation. Canada's macroeconomic strategy and the G-20 framework Canada will bring to these discussions one of the soundest financial systems in the world and a macroeconomic strategy that contributes to sustainable and balanced global growth. Our economy is one of the most open and our policy response to the crisis has been one of the most aggressive. Starting from the strongest fiscal position in the G-7, Canada's fiscal stimulus this year and next will total 4 per cent of GDP. Monetary stimulus has been both unprecedented and timely. As a result of these policy actions, the IMF projects that Canadian domestic demand will be the strongest in the G-7 next year. With a current account that has shifted from a surplus of 2 per cent of GDP in the first quarter of 2006 to a deficit of 3 per cent today, Canada is doing its part to rebalance global growth. Consistent with the objectives of the G-20 framework, Canadian policy is guided by transparent and coherent frameworks. The Government of Canada has announced a fiscal plan to return its budget to broad balance by 2015. The cornerstone of the Bank's monetary policy framework is its inflation target, which aims to keep the annual rate of CPI inflation close to 2 per cent. It is in this context that we view the exchange rate. A floating exchange rate is a central element of our monetary policy framework. It allows Canada to pursue an independent monetary policy appropriate to our own economic circumstances. Although there is no target for the Canadian dollar, the Bank does care why the exchange rate moves and what the potential impact will be on output and inflation. The challenge for the Bank is to understand the reasons behind currency movements, incorporate those into our assessments of other data, and set a course for monetary policy that works to keep total demand and supply in balance and inflation on target. In the current environment, such determinations are more important than usual. Recent indicators point to the start of a recovery in Canadian economic activity following three consecutive quarters of sharp contraction. This resumption of growth is supported by monetary and fiscal stimulus, increased household wealth, improving financial conditions, higher commodity prices, and stronger business and consumer confidence. However, heightened volatility and persistent strength in the Canadian dollar are working to slow growth and subdue inflation pressures. The current strength in our dollar is expected, over time, to more than fully offset the favourable developments since July. On 20 October, the Bank reaffirmed its conditional commitment to maintain its target for the overnight rate at the effective lower bound of 1/4 per cent until the end of June 2010 in order to achieve the inflation target. To put it simply, the Bank looks at everything, including the exchange rate, through the prism of achieving our inflation target. For example, we do see a risk that a stronger-than-assumed Canadian dollar, driven by global portfolio movements out of U.S.-dollar assets, could act as a significant further drag on growth and put additional downward pressure on inflation. As I mentioned previously, movements in currencies could reflect current challenges in the operation of the international monetary system, which may result in the displacement of adjustment pressures onto a handful of currencies. Whatever happens, the Bank retains considerable flexibility in the conduct of monetary policy at low interest rates, consistent with the framework that we outlined in our April Monetary Policy Report. If downside risks materialize, the Bank will use that flexibility to the extent required in order to achieve our price stability mandate. If upside risks materialize, the Bank will also act to achieve our price stability mandate. While the underlying risks to our October economic projection are roughly balanced, the Bank judges that, as a consequence of operating at the effective lower bound, the overall risks to our inflation projection are tilted slightly to the downside. Conclusion To conclude, this crisis was caused in part by failures to meet the same challenges that bedevilled previous international monetary systems. The common lesson of the gold standard, the Bretton Woods system, and the current hybrid system is that it is the adjustment mechanism, not the choice of reserve asset, that ultimately matters. In this regard, any greater use of SDRs might be best suited to encouraging a transition from the current hybrid system to an international monetary system characterized by more flexible exchange rates for all systemic countries. While surplus countries can delay adjustment, in the end, all nations suffer when the system breaks down. In the current environment, growing strains could spur protectionism, both in trade and finance, or alternatively, raise sanctions.15 The negative consequences for the global economy would be considerable. All countries should accept their responsibilities for promoting an open, flexible, and resilient international monetary system. Responsibility means recognizing spillover effects between economies and financial systems and working to mitigate those that could amplify adverse dynamics. It means submitting their financial policies to peer review within the FSB and external review by the IMF. Fundamentally, it means adopting coherent macro policies and allowing real exchange rates to adjust to achieve external balance over time. Indeed, in a world of global capital, all systemically important countries and common economic areas should move towards market-based exchange rates. References Bergsten, F. 2009. "The Dollar and Deficits: How Washington can Prevent the Next Crisis." Foreign Affairs 88 (6) November/December 2009. Bordo, M. 1992. "The Bretton Woods International Monetary System: A Historical Overview," in A Retrospective of the Bretton Woods System. M. Bordo and B. Eichengreen, eds. 1993. Chicago: University of Chicago Press. Eichengreen, B. 1992. Golden Fetters: The Gold Standard and the Great Depression, 19191939. New York: Oxford University Press. International Monetary Fund. 2009. Articles of Agreement. Washington, D.C.: IMF. Lipsey, R. 1994. "U.S. Foreign Trade and the Balance of Payments, 1800-1913." NBER Working Paper No. 4710. Reinhart, C. and K. Rogoff. 2009. This Time is Different: Eight Centuries of Financial Folly. Princeton: Princeton University Press. Rostow, W. W. 1978. The World Economy: History and Prospect. Austin, Texas: University of Texas Press. Triffin, R. 1960. Gold and the Dollar Crisis. New Haven: Yale University Press. See Bergsten (2009). United Nations. 2009. Report of the Commission of Experts of the President of the United Nations General Assembly on Reforms of the International Monetary and Financial System. 21 September 2009. Available at <http://www.un.org/ga/econcrisissummit/docs/FinalReport_CoE.pdf>. Williamson, J. 2009. "Why SDRs Could Rival the Dollar." Peterson Institute of International Economics: Policy Brief 09-20. Zhou, X. 2009. "Reform the International Monetary System." People's Bank of China, Beijing, 24 May. Available at <http://www.pbc.gov.cn/english/detail.asp?col=6500&id=178>.
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Remarks by Mr Mark Carney, Governor of the Bank of Canada, at The National Forum (Canadian Club of Toronto and Empire Club of Canada), Toronto, 16 December 2009.
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Mark Carney: Current issues in household finances Remarks by Mr Mark Carney, Governor of the Bank of Canada, at The National Forum (Canadian Club of Toronto and Empire Club of Canada), Toronto, 16 December 2009. * * * Introduction As the holiday season approaches, our attention turns naturally to the home front. Accordingly, my comments this afternoon will focus on households. I would like to concentrate in particular on the implications of Canadian household finances for financial stability in our country. I spoke here in Toronto a year ago, almost to the day. Then, the global financial sector crisis was buffeting the real economy. Businesses were postponing large investments, and households were hesitating over major purchases. It was clear then that 2009 would be a difficult year, and so it has proved. With more than 400,000 jobs lost and a $30 billion fall in output, the Canadian economy has suffered a deep, albeit brief, recession. Today, the outlook has improved. While significant fragilities remain, the global economic recovery is now supported by several factors. First, feedback between financial markets and the real economy has reversed direction. In most major economies, the inventory cycle has turned and housing sectors are stabilizing. In addition, considerable fiscal expansion and monetary stimulus are supporting domestic demand. Nonetheless, the Bank expects underlying private demand in many economies to recover only slowly, as significant balance sheet and structural adjustments have yet to run their course. In particular, the rebound in U.S. consumption is projected to be more moderate than in previous cycles. This will have direct implications for Canada. While the Canadian economy will likely grow faster than the other G-7 countries next year, the Bank expects our recovery to be more protracted and more reliant on domestic demand than usual (Chart 1). In the near term, Canada will grow despite – not because of – the pace of external activity. The behaviour of Canadian households will thus be particularly important. Before turning to that in more detail, I would like to briefly review the challenges facing U.S. households, both for their direct impact on Canada and for the insights they offer for financial stability. U.S. household sector For a generation, U.S. households increasingly “saved” through capital appreciation rather than from current income. Over the last three decades, U.S. consumer spending grew substantially faster than national income, driving the ratio of consumption to GDP from 62 per cent to a record 70 per cent (Chart 2). In the same period, the personal savings rate fell from 11 per cent of disposable income to 1 per cent, while household debt doubled from 84 per cent of disposable income to 165 per cent. 1 Financial innovations, including home equity loans and securitization, drove these trends. Initially, they increased financial system efficiency, diversified risk, and smoothed consumption. Over time, however, these financial technologies were applied increasingly indiscriminately. Prudence gave way to exuberance to the extent that the subprime-mortgage Household debt includes the liabilities of households, non-profit organizations, and unincorporated businesses, as the debt of the latter is ultimately a claim on the household sector. market became a mainstay of the expansion. 2 When the U.S. housing bubble collapsed under its own weight, households with the least resilience were the hardest hit. An important lesson of the American experience was that the costs were not confined to the most vulnerable households. In a now-familiar chain, problems in subprime quickly spread to prime mortgages, structured products in general, core funding markets, and, ultimately, the capital bases of most major financial institutions. Eventually, virtually every financial asset in the world was repriced. Financial stability is as much about linkages as it is about specific risks. Shocks can have large, unanticipated consequences. A lengthy period of adjustment for the U.S. consumer has just begun (Chart 3). A decline of roughly 30 per cent in wealth has promoted a quadrupling of the U.S. personal savings rate to 4.5 per cent. Nonetheless, household debt levels have not fallen substantially, and consumer spending as a share of GDP actually rose to a new high of 71 per cent in the third quarter. 3 Given the historic declines in net worth and the need to save for retirement, it appears clear that U.S. household savings need to remain elevated for an extended period of time. The new equilibrium for household savings will depend on multiple factors, including wealth effects, risk aversion, the evolution of the financial system, the employment outlook, and the credibility of fiscal policy. 4 The Bank currently projects that the U.S. personal savings rate will average around 5.5 per cent over the next two years. This judgment is consistent with ultimately stabilizing the U.S. net foreign liability position and rebuilding U.S. household wealth. 5 This sustained, higher savings rate will produce a historically weak recovery in U.S. consumer spending and accounts for the Bank’s relatively subdued forecast for overall U.S. economic growth (Chart 4). Canada’s household sector Canadian household finances were in better shape going into the crisis than those of Americans. The Canadian personal savings rate was higher and household debt was lower (Chart 5). The ratio of consumer spending to GDP, at 55 per cent, was below the longer-term average in Canada. As a consequence, when the crisis struck, Canadian households were less vulnerable. Moreover, throughout the downturn, Canadian labour and housing markets held up better (Charts 6 and 7), meaning that the incomes and net worth of Canadians were not as hard hit as those of Americans (Chart 3). So, while there is no doubt the financial crisis and accompanying recession have been painful here, Canadians have had less need to increase savings to restore their balance sheets. Still, Canadians have saved more. The personal savings rate in this country rose to an eightyear high of 5.5 per cent in the second quarter. The Bank projects that this rate will moderate only slightly over the medium term. We view the sharp increases in household savings as Residential investment accounted for roughly 14 per cent of GDP growth from 2003 to 2005, inclusive. Subprime mortgages accounted for 20 per cent of new mortgage originations in 2005 and more than 22 per cent in 2006. It is worth noting that in an environment of rising unemployment, the savings rate of U.S. households that are working has risen even more sharply than the aggregate numbers suggest. For example, Ricardian equivalence predicts that households would save more in response to higher government deficits, anticipating the future tax liabilities required to address the rising public debt. To the 2002–04 average over the next five years. largely precautionary, that is, reflecting uncertainty about the economic outlook and financial conditions. As the economy begins to grow again and confidence is gradually restored, we expect that some of these precautionary savings will be unwound, and that some consumers will take further advantage of unusually low borrowing rates. Indeed, our current stimulative monetary policy is meant, in part, to encourage such behaviour. Stronger growth in domestic consumption will be necessary to offset weak external demand in order to restore the Canadian economy to balance and inflation to target. Recent data have been consistent with these expectations. Going forward, there are risks, on both the upside and the downside, to this outlook for the Canadian personal savings rate. Canadian households could remain more cautious, chastened by the recent financial and economic trauma, leading to more durably elevated savings. Some of the issues brought to the fore by the crisis, such as retirement funding, could also alter household savings behaviour over the nearer term. Over the next few days, the federal, provincial, and territorial finance ministers will meet to discuss these issues, in recognition of their importance to Canadians. Finally, more protracted U.S. and global recoveries could restrain Canadian households, by affecting both the confidence and economic prospects of Canadians. On the other hand, there is a risk that, as growth returns, the resilience of Canadian households through the crisis could lead to declines in the savings rate that are sharper, and increases in household borrowing that are larger, than the Bank has projected. Whatever happens, the Bank’s monetary policy reaction to consumer behaviour will always be driven by its implications – taken in conjunction with all other relevant factors – for inflation over the medium-term horizon. Households and financial stability in Canada Household finances are also important for financial system stability. As was painfully learned from the U.S. experience, a stable financial system is fundamental for the effective functioning of the economy and the financial welfare of citizens. In this regard, there are two important considerations. First, financial and price stability share common determinants but have different time horizons. Inflation continuously reflects real shocks and/or policy responses, while financial vulnerabilities are much less predictable. They develop over time and can persist for longer than expected. Simply put, behaviour consistent with price stability over the medium term could simultaneously build financial stresses over a longer horizon. Second, when evaluating the financial condition of Canadians, we need to look beyond the aggregate for possible changes in distribution of debt among households. The Financial System Review (FSR) is a semi-annual Bank publication that examines developments in the financial system and provides an analysis of policy directions in the sector. In our most recent FSR, we judge that most of the risks to the stability of the Canadian financial system have ebbed in recent months. At the same time, our assessment of the risks related to household balance sheets is that they have increased further. As noted in the FSR, the vulnerability of Canadian households to adverse wealth and income shocks has grown in recent years. Aggregate debt levels have risen sharply relative to income. Those debt levels have continued to grow fairly rapidly this year, unusually so for a recession. 6 For some households, this additional indebtedness has translated into increased Real consumer credit, including home equity lines of credit, has grown at a 7 per cent pace over the past year, in contrast with the outright declines during the recessions of the early 1980s and 1990s. financial stress. Personal bankruptcies in Canada rose 41 per cent in the third quarter from the same period a year ago, leaving the number of bankruptcies as a proportion of the population at its highest level since 1991. Delinquency rates on loans have risen as well, with the proportion of mortgages with payments in arrears three months or more having increased by half over the past year. Stress testing the Canadian household sector To understand better the vulnerability of Canadian households, and the consequences for financial stability, the Bank undertakes regular stress tests. The June FSR reported on the potential impact of a more severe economic downturn on households. The results illustrated that a hypothetical increase in unemployment could produce loan losses for financial institutions representing about 10 per cent of their Tier 1 capital. 7 While the near-term risks from a further sharp deterioration in labour markets have diminished, the Bank believes that overall risks to financial stability arising from the household sector have continued to increase. In particular, the combination of sustained growth of household debt relative to income and a rising interest rate environment could increase the vulnerability of households to an adverse shock. In the current FSR, the Bank conducts stress-test scenarios to examine the potential impact of growing debt and rising interest rates on the debt-service ratio of Canadian households (Table 1). We look at scenarios such as these, not because we think they are the most likely outcome, but rather to provide an assessment of downside risks that could potentially generate stress in the Canadian financial system. The simulation generates a scenario indicating that, by the middle of 2012, almost one in ten (9.6 per cent) Canadian households would have a debt-service ratio greater than 40 per cent, the threshold above which households are considered financially vulnerable (Table 2). Moreover, the percentage of debt owed by these vulnerable households would almost double. Both of these metrics are well above their recent peaks. 8 While these simulation results are purely illustrative, they give pause for reflection. It would not be healthy to have almost 20 per cent of household debt extended to vulnerable households. Nor is it necessary to secure our recovery. The risks are not isolated to the most vulnerable. A shock to economic conditions could be transmitted to the broader financial system through deterioration in the credit quality of loans to households. In such an event, increased loan-loss provisions and reduced quality of the remaining loans could lead to tighter credit conditions more broadly and, in turn, to mutually reinforcing declines in real activity and in the health of the financial sector. While the broader effects are difficult to anticipate with precision, some sectors, such as retail and housing, would likely be affected more than others. Such a shock would also affect certain segments of the capital markets, such as credit card securitization. More fundamentally, strains on the household sector could also cause a more generalized rise in risk premia, with attendant negative implications for a variety of asset prices. This is the direct impact and excludes indirect effects from induced stress on businesses and financial markets. Both these metrics peaked in 2000 when 7.4 per cent of Canadian households had a debt-service ratio greater than 40 per cent, and the percentage of debt held by these households reached almost 14 per cent. Data available goes back to 1999. Conclusion At present, the risks arising from the Canadian household sector are relatively low. Indeed, by some measures, Canadian household finances appear quite healthy. The current rate of mortgage arrears, for example, remains more than one-third below its peak in the early 1990s. Going into the crisis, Canadian households carried considerably less debt than their American counterparts. That remains true today. Data released Monday show that rebounding housing and financial markets increased Canadian household net worth to 589 per cent of disposable income by the end of the third quarter, above its 10-year average. While asset prices can rise and fall, debt endures. Moreover, the linkages between the real economy and the financial sector are complex, non-linear, and often opaque. That is why we cannot afford to be complacent. Indeed, one objective of using the FSR to profile risks to the Canadian financial system is to help prevent these risks from materializing. When risks are still manageable is precisely the best time to act. We must be vigilant, and all parties must fulfill their responsibilities. Responsibility starts with the individual. Our advice to Canadians has been consistent: We have weathered a severe crisis – one that required extraordinary fiscal and monetary measures. Extraordinary measures are the means to an end: the return to the ordinary. Although we expect the recovery to be gradual and protracted, these measures are working. Ordinary times will eventually return and, with them, more normal interest rates and costs of borrowing. It is the responsibility of households now to ensure that in the future, when the recovery takes hold and extraordinary measures are unwound, they can still service their debts. Similarly, lenders have responsibilities. Financial institutions should actively monitor risk stemming from households and not take false comfort derived from mortgage insurance and past performance of household credit. As our simulations suggest, the overall credit profile of Canadian households could well shift if debt continues to grow at current rates. The Bank expects that Canada’s financial institutions will continue to apply their high standards of risk management, for which they are being justly lauded the world over. Policy-makers and regulators, including the Bank of Canada, have responsibilities, as well. The Bank is working intensively with the Office of the Superintendent of Financial Institutions (OSFI) at the Basel Committee on the design of new international capital and liquidity standards. The Bank collaborates closely with the Department of Finance and discusses with federal agencies, as required, to monitor evolving risks and take appropriate actions. The Bank’s ongoing research and analysis of the financial system, including the work I have discussed today, is an important element of our commitment to helping ensure Canada has a resilient, secure financial system that enhances the economic and financial welfare of all Canadians.
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Remarks by Mr David Wolf, Adviser at the Bank of Canada, on behalf of Mr Timothy Lane, Deputy Governor of the Bank of Canada, at the Edmonton Chartered Financial Analyst CFA) Society, Edmonton, 11 January 2010.
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Timothy Lane: Canada's housing sector in recession and recovery – beyond bricks and mortar Remarks by Mr David Wolf, Adviser at the Bank of Canada, on behalf of Mr Timothy Lane, Deputy Governor of the Bank of Canada, at the Edmonton Chartered Financial Analyst (CFA) Society, Edmonton, 11 January 2010. * * * Good afternoon, thank you for inviting me to speak with you today. The beginning of a new year is a good time for reflection – a chance to look back over the past 12 months and consider what may lie ahead. Certainly, 2009 saw remarkable economic and financial upheaval around the world, which plunged Canada into a severe recession. A global recovery has begun, however, and as we look ahead, we can be confident that this recovery will become more deeply entrenched as the year progresses. Today, I will discuss some trends in the Canadian economy, focusing on a particularly important sector: housing. The strengthening of the housing market – especially in the resale market – over the past few months has been striking. Housing is of considerable interest to the Bank of Canada, from two perspectives. First, it is important to consider the housing market when formulating monetary policy. The housing sector is a crucial part of the Canadian economy, and it typically plays a disproportionate role in economic cycles. Housing wealth provides collateral for household borrowing and spending. Increases in the cost of housing are an important element in consumer price inflation, and demand for housing is a gauge of household confidence. The housing market is also very sensitive to changes in interest rates, so it can provide an important channel through which monetary policy may influence the economy. Second, experience shows that increases and collapses in house prices have been driving forces behind bouts of financial instability in many countries. Because the purchase of a home is the most significant reason for household borrowing, housing looms large on the balance sheets of both homeowners and financial institutions. This nexus between financial system stability and the housing sector has been vividly illustrated by the developments in the U.S. housing market over the past two years. The painful correction in the U.S. housing sector was at the root of that country's financial system turmoil that started in August 2007 and then spread around the world, triggering the global recession. Canada has been spared such drama, both in this recession and in recent history, and this has drawn much international interest. Therefore, it's important to understand the policies affecting the housing market, and then to work to strengthen and preserve the stabilizing aspects of our system. In my remarks today, I intend to review the implications of housing for both monetary policy and financial stability. I will begin by providing some context through a brief overview of the economic outlook for the world and for Canada. Then, I will review in more detail how Canada's housing market has managed so well through the global crisis and some of the challenges it faces in the recovery. I will also explain how we at the Bank of Canada factor developments in the housing market into our policy decisions. The Canadian economy – looking back and looking forward The world economy was on a roller-coaster ride in 2009. It began the year in near free fall, plunging into a deep and synchronous global recession triggered by the worldwide financial crisis. While Canada fared better than many countries through the crisis, we did feel the effects through trade, confidence, and financial channels. Aggressive, coordinated policy actions were taken in many countries to combat the crisis. These included significant measures to support financial systems, substantial fiscal stimulus, and monetary policy easing that took interest rates in all of the major advanced economies to historically low levels. Canada played an active role in this global policy response. While we did not need to bail out our financial institutions, fiscal and monetary policies were applied vigorously. Guided by the 2 per cent target for inflation, the Bank of Canada pushed its overnight interest rate essentially to the floor – that is, to the effective lower bound of 25 basis points. We also set out a framework for unconventional policies that could be used to provide further stimulus if needed. We implemented one element of this framework – our commitment to hold rates at the effective lower bound until the end of the second quarter of 2010, conditional on the outlook for inflation – while stressing that other unconventional policies were available if needed. The worldwide effort provided the impetus for the global recovery that began to take hold in the middle of 2009. The Bank of Canada's October Monetary Policy Report pointed to the start of the recovery, and the global outlook has improved modestly since then. However, significant fragilities remain, since the recovery is still heavily dependent on government support, and sustained growth driven by the private sector has yet to materialize. Canada's economic recovery started in the third quarter of 2009, although it was weaker than had been anticipated in the October Monetary Policy Report. This recovery has been supported by monetary and fiscal stimulus, increased household wealth, improving financial conditions, stronger business and consumer confidence, the beginning of the recovery in the global economy, and a strengthening in the terms of trade. At the same time, the weakness of the recovery in the U.S. economy and the persistent strength of the Canadian dollar have exerted a drag on Canada's growth. The balance of these factors has tended to shift the composition of aggregate demand towards growth in Canada's domestic demand and away from net exports. Overall, we continue to believe that Canada's recovery is likely to be more gradual than in previous cycles. While inflation is now below the 2 per cent target, the Bank expects that it will return to that target as the economy returns to potential. Canada's housing market – recent developments From the outlook for the overall Canadian economy, let me now narrow my focus to the housing sector. First, a bit of recent history. As you know, Canadian housing activity dropped off sharply during 2008 and early 2009 as a result of the global recession. Turnover in resale markets dropped by about 40 per cent from their peaks, while housing starts declined to 118,500, well below the estimated sustainable long-run average of about 175,000. However, the housing correction here was not nearly as destructive as the collapse of the U.S. housing market. This reflects, in part, the fact that the rise in housing prices prior to the crisis was not as sharp in Canada as it was in the United States. Between 2000 and 2006, U.S. house prices appreciated by nearly twice as much as Canadian house prices. That said, Canadian house prices continued to appreciate for a longer period 1. Moreover, Canada has not had the over-investment in housing that has created the need for painful adjustments in the United States and some other countries. The steady growth in housing investment (that is, the construction of new housing units) in Canada over much of the past decade was due largely to strong employment and sustained income growth Data from December 2009 Federal Reserve Bank of Cleveland economic commentary: “Why Didn't Canada's Housing Market Go Bust?” J. MacGee. Sources cited: United States, S&P/Case-Shiller (20-city composite index); Canada, Teranet 6-city composite index). supported by rising commodity prices. There was also a degree of catch-up from underinvestment during the 1990s. The favourable financing environment, marked by relatively low interest rates plus accommodative mortgage terms and conditions in that period played a further, important role. Reflecting all these factors, Canada entered the global financial crisis with a smaller housing inventory than other countries. Behind this national picture, different regions of Canada have experienced different conditions. Housing markets in Western Canada were particularly robust during most of the past decade, as an inflow of new residents, rising income levels associated with the strength of energy prices, and a tight supply of housing combined to put upward pressure on house prices. In Alberta, this led to a strong supply response, with house-building activity rising sharply. But with the recession and tumbling commodity prices, a housing market correction was inevitable. For Canada as a whole, prices for resale housing dropped by about 9 per cent 2 and for new homes, by about 3.5 per cent 3 compared with their 2008 peaks. The correction was much steeper, though, for regions that had previously experienced the largest increases. Here in Alberta, as you know, the drop in prices has been larger. There was also a fall-off in activity – both resale and construction. Despite that correction, many are asking why Canada's housing market in general has tended to be less turbulent than housing markets in other countries. An important factor is Canada's housing finance and regulatory system. Canada's mortgage market is national, with similar lending conditions and mortgage products across most regions. It is dominated by domestic players, especially the six major banks, although a number of new competitors have entered the Canadian market in recent years. Canada's mortgage credit culture has tended to be quite conservative. Mortgage insurance is compulsory for federally regulated financial institutions when the loan-to-value ratio is over 80 per cent. Further, mortgage insurance providers tend to set the lending standards for the industry as a whole. Only about 30 per cent of mortgages in Canada are securitized, so most lenders have ongoing exposures to the mortgages they originate, and that gives them an incentive to be more prudent in their lending practices. Borrowers in Canada also have reasons for prudence: mortgage interest on primary residences is not tax deductible in Canada and (in most provinces) lenders have full recourse to borrowers in the event of default. Thus, a combination of factors contributes to a more stable mortgage market. With Canada's economic recovery, the housing sector has been experiencing a strong rebound. Sales of existing homes have reached a new high, and prices are now almost back to 2008 peak levels. Housing starts have also revived, although they remain below their long-run levels. The rebound has been strong in most regions: in Alberta, resales were up more than 50 per cent in November compared with a year earlier, and housing starts have been increasing at rates of over 20 per cent for the past two quarters. The revival of housing activity is a reflection of the historically high level of affordability that is associated with the current record-low interest rates. Another important factor has been the rebound in consumer confidence, as many Canadians see their economic prospects brightening. But the housing rebound is also partly a matter of timing, rather than a permanent increase in housing demand. Some pent-up demand has been unleashed as many families that a year ago, were too concerned about the future to commit to so large a purchase as a new home, are now willing to take that plunge. There is also an element of pull-forward of demand, as buyers see this as a particularly attractive time to purchase a home. Resale housing prices for 2009 measured by Teranet from August 2008 to March 2009. New Housing Price Index from September 2008 to June 2009. At the Bank of Canada, we follow these developments closely, both at a national level and through the work of our regional offices. We know that what happens in the housing market can have important effects through the macroeconomy, and these implications need to be taken into account as we set monetary policy to achieve our inflation target. At the same time, as I have said, the housing market and related financing have important implications for financial stability. Let me elaborate on both of these aspects of policy. Policy implications As Canada's economic growth moves towards its potential, it is expected that a robust housing market, supported by exceptionally low interest rates, will continue to work as an important engine pulling the Canadian economy out of recession. This has implications for monetary policy, which, as I've said, aims to achieve the Bank's inflation target of 2 per cent over the medium term. It's important to remember that this target is symmetrical; that is, we are equally concerned about whether inflation is above target or below target – as we expect it to be until 2011. The revival of the housing market is one factor that is helping us to achieve our inflation target, and it is a powerful means through which monetary stimulus affects the economy. Of course, we need to keep a close eye on the housing market, along with all other sectors of the Canadian economy, to ensure that we are providing the right amount of monetary stimulus. In setting monetary policy, we view housing – or the exchange rate, the energy sector, the auto industry, or any other factor – through the prism of our inflation target. Developments in the housing market are also an important element in the Bank's assessment of financial stability. The current rebound in the housing sector is taking place in tandem with a very rapid rise in household indebtedness: the household debt-to-income ratio reached a new high of 142 per cent in the second quarter of 2009. Household debt-service ratios remain moderate, but that is because interest rates are currently extraordinarily low. These high debt levels make households vulnerable to increases in borrowing costs, which will inevitably occur. To illustrate the vulnerability of households, both to increases in borrowing costs and to further growth in indebtedness, the Bank conducted a series of stress tests, which we published in the December issue of our semi-annual Financial System Review. Using the current path of household indebtedness, and alternative assumptions about how quickly interest rates may increase, the simulation generates a scenario indicating that, by the middle of 2012, almost one in ten Canadian households would have a debt-service ratio that makes them vulnerable to economic shocks. These projections are not forecasts of what will happen, of course, but they provide an early warning of what could happen, to help us all better understand the downside risks that could generate stress in the Canadian financial system. Consumer difficulties with rising mortgage payments can also lead to wider problems with other consumer loans, such as credit card debt. Consumers may also have to curtail other spending to cope with their debt burdens, creating adverse spillovers to the real economy. This is an illustration of how problems in one area, such as housing, can quickly spread throughout the economy and through the financial system. In addition, some observers have pointed to the risk of a housing bubble – a situation where the level of house prices is based primarily on extrapolative expectations that house prices can only rise further. Housing bubbles are usually fuelled by credit expansion, as borrowers and lenders take false comfort from exaggerated house prices. Generally, when there is a rapid rise in asset prices, including house prices, one should always ask whether they have increased too far, too fast. In the Bank of Canada's view, it is premature to talk about a bubble in Canadian housing markets. Recent house price increases do not appear to be out of line with the underlying supply/demand fundamentals. Moreover, with housing starts below long-term demographic requirements, inventories are still declining. It is likely, though, that a significant part of the surge in housing sector activity is associated with temporary factors – notably the historically low borrowing costs, as well as pent-up and pulled-forward demand – which cannot continue to drive increases in house prices and activity. Thus, we see the housing market as requiring vigilance, but not alarm. This discussion leads to the following question: if the Bank did see the housing market posing a possible threat to financial stability, what should we or other authorities do about it? Some observers – those who see a housing bubble forming – have said that since low interest rates have stimulated housing market activity, the Bank should now raise interest rates to dampen that activity. But that poses a problem. As I've stressed, we have a mandate to use our key interest rate to achieve our inflation target – and the housing market is only one of several factors that influence inflation. If the Bank were to raise interest rates to cool the housing market now – when inflation is expected to remain below target for the next year and a half – we would, in essence, be dousing the entire Canadian economy with cold water, just as it emerges from recession. As a result, it would take longer for economic growth to return to potential and for inflation to get back to target. This is why we say monetary policy is a blunt instrument for achieving financial stability. So what other instruments are available? An array of supervisory and regulatory instruments can be used by the government to restrain a build-up of systemic risks. These include capital requirements for institutions, leverage ratios, loan-to-value ratios, terms and conditions for mortgage insurance, and a variety of other measures. These instruments can be targeted to risks to the entire financial system that stem from particular markets or institutions. Using these instruments to safeguard the whole financial system – not just individual institutions – is the essence of the macroprudential approach. Macroprudential supervision is one of several concepts in a current global initiative to strengthen supervision and regulation in the wake of the global financial crisis. In Canada, a system-wide, or macroprudential, approach is the shared responsibility of the Department of Finance and all of the federal financial regulatory authorities, including of course the Bank of Canada, the Office of the Superintendent of Financial Institutions, and the Canada Deposit Insurance Corporation. Ultimately, it is the Minister of Finance who is responsible for the sound stewardship of the financial system. Conclusion Prudent, conservative policies have provided significant support to Canada's housing market, through both good times and bad. This point has been amply demonstrated, during the recent recession – where many countries saw imbalances roil their housing markets – and in the ongoing recovery here in Canada. The current revival in our housing sector was a desirable, and intended, part of Canada's economic recovery, but like all good things, it must be carefully monitored to ensure that it doesn't go to an extreme. You can be sure that the Bank of Canada will be closely watching developments in the housing sector and taking them into account in our decisions on monetary policy and in assessing financial stability. In setting interest rates to achieve the inflation target, housing developments need to be weighed along with all the other factors influencing economic activity and inflation. In assessing financial stability, we focus on the potential risks to the whole financial system. In carrying out these responsibilities, we are committed to promoting the economic and financial welfare of Canada, by fostering confidence in the value of money, and in the safety and efficiency of our financial system. With that, I wish you a happy and prosperous 2010.
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Opening statement by Mr Mark Carney, Governor of the Bank of Canada, at a press conference following the release of the Monetary Policy Report, Ottawa, 21 January 2010.
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Mark Carney: Summary of the latest Monetary Policy Report update Opening statement by Mr Mark Carney, Governor of the Bank of Canada, at a press conference following the release of the Monetary Policy Report, Ottawa, 21 January 2010. * * * Good Morning. Paul and I are pleased to be here with you today to discuss the January Monetary Policy Report, which we published this morning. • The global economic recovery is underway. Economic and financial developments have been slightly more favourable than we projected in October, and the outlook for global economic growth through 2010 and 2011 is somewhat stronger. • Although the recession in Canada was severe, with real GDP contracting for three consecutive quarters, the magnitude of the downturn was more modest than in other major advanced economies. In particular, domestic demand held up much better in Canada than elsewhere, reflecting the soundness of Canada’s banking system, relatively healthy household and corporate balance sheets, and the speed and scale of monetary policy actions. • Economic growth in Canada resumed in the third quarter of 2009 and is expected to have picked up further in the fourth quarter. Nevertheless, considerable excess supply remains, and the Bank judges that the economy was operating about 3 ¼ per cent below its production capacity in the fourth quarter of 2009. • In Canada, the recovery is expected to evolve largely as anticipated in October, with the economy returning to full capacity in the third quarter of 2011. This recovery is still expected to be more subdued than usual. The main factors supporting the Canadian recovery are: monetary and fiscal policy support, increased confidence, a firming global economy, and higher terms of trade. • At the same time, the persistent strength of the Canadian dollar and the low absolute level of U.S. demand continue to act as significant drags on economic activity. • For the year as a whole, the Canadian economy contracted by an estimated 2.5 per cent in 2009. It is projected to grow by 2.9 per cent in 2010 and 3.5 per cent in 2011. • As a result of year-over-year increases in energy prices, total CPI inflation turned positive in the fourth quarter of 2009, as had been anticipated. • In spite of the large amount of excess supply in the economy, the core rate of inflation has been slightly stronger than expected in recent months. This stickiness of core inflation is likely related to the fact that wage growth had remained high relative to the underlying trend in productivity. • The core rate of inflation is projected to increase gradually, returning to 2 per cent in the third quarter of 2011. Total CPI inflation is projected to follow a very similar path and return to the 2 per cent target also in Q3 of next year. • The main upside risks to inflation are associated with the possibility of a stronger than- anticipated global recovery and of Canadian domestic demand that is more robust and has more momentum than projected. • On the downside, there is the risk that persistent strength of the Canadian dollar could act as a significant further drag on growth and put additional downward pressure on inflation. Another important downside risk is that the global recovery could be even more protracted than projected. • On Tuesday, the Bank reaffirmed its conditional commitment to maintain its target for the overnight rate at the effective lower bound of 1/4 per cent until the end of June 2010 in order to achieve the inflation target. • The Bank retains considerable flexibility in its conduct of monetary policy at low interest rates, consistent with the framework outlined in the April 2009 MPR. With that, Paul and I would be pleased to take your questions.
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Remarks by Mr Mark Carney, Governor of the Bank of Canada, to the Winnipeg Chamber of Commerce, Winnipeg, Manitoba, 4 February 2010.
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Mark Carney: The coming thaw Remarks by Mr Mark Carney, Governor of the Bank of Canada, to the Winnipeg Chamber of Commerce, Winnipeg, Manitoba, 4 February 2010. * * * It is a pleasure to be here in Winnipeg. Today, I intend to elaborate on elements of the Bank of Canada’s economic outlook. After putting the recession in context and offering the Bank’s perspective on the shape of the recovery, my remarks will focus on Canada’s corporate sector. A focus on business is appropriate in Manitoba. This province is not only the geographic centre of our country, but also mirrors Canada’s economic diversity. Manitoba’s distinctive blend of primary, manufacturing, and service businesses represents a true cross-section of the Canadian economy. A focus on business is also appropriate at this stage of the economic cycle. A key determinant of the pace and sustainability of Canada’s recovery will be how investment and hiring intentions of businesses in all sectors evolve as policy stimulus begins to fade. My message is relatively straightforward: the thaw is coming. That may sound a little premature to someone standing at the corner of Portage and Main in early February, but it broadly captures the state of our economy. While its pace will likely be somewhat muted (given the depth of the recession) and while there may be setbacks, the recovery has begun. After a brutal economic winter, spring is within sight. There is, however, a catch. The economic climate that Canadian business will face will be considerably different. Canada is entering this period of adjustment with many strengths, but the efforts required of us will be historic. The global recession In the fall of 2008, the intensifying financial crisis triggered a deep, synchronous global recession. The economic shock in the United States was spread – and in many cases amplified – through trade, finance, and confidence channels. We are just emerging from the worst economic downturn since World War II. The speed and virulence of the slowdown took business by surprise. Over the turn of last year, there was the equivalent of a corporate heart attack: inventories surged, production was slashed, capital spending budgets eliminated, and employment cut. The cascade of collapsing demand through global supply chains shook widely held perceptions. Given the shock of the downturn, many firms understandably have been waiting for confirmation of the recovery before acting. The Canadian recession in context Canada experienced a short, sharp recession. In its depths last year, with the exception of government spending, all major components of aggregate demand declined. At its worst, industrial production fell 15 per cent. Canadian exporters suffered particularly, owing to the sharp fall in the components of U.S. economic activity that matter most for Canada. For example, U.S. demand for motor vehicles fell by more than half and housing starts by twothirds. 1 In response to this new profile of U.S. demand, major Canadian industries (particularly the automotive and forestry sectors) began deep restructurings, which continue to this day. Overall, the Bank’s trade-weighted measure of U.S. activity fell by 22 per cent. In this light, the 20 per cent drop in Canadian exports is less surprising. The recession has had a considerable impact on employment. At its depth, 400,000 Canadians lost their jobs and the unemployment rate spiked by almost 3 percentage points to its highest level in more than a decade. Although the deterioration of the labour market appears to have stopped, too many Canadians who want to work are still out of a job, and many of those still employed are working fewer hours than they would like. As painful as our recession was, Canada has suffered less than most other advanced economies. Domestic demand, fixed capital investment, and employment in Canada all held up substantially better than in the United States. Real GDP fell cumulatively by 3.3 per cent in Canada. That compares with declines of just less than 4 per cent for the United States, about 5 per cent for the Euro area, 6 per cent for the United Kingdom, and more than 8 per cent for Japan. Canada’s better performance can be explained by two factors. First, with a highly credible monetary policy and the strongest fiscal position in the G-7, Canadian policy-makers were able to respond swiftly and effectively with extraordinarily accommodative measures. The Bank of Canada began cutting interest rates in December 2007 and proceeded with a series of aggressive reductions until our key policy rate reached one-quarter of one per cent in April of last year, the lowest it can effectively go. Further, the Bank then provided extraordinary guidance on the likely path of interest rates necessary to achieve the inflation target in order to maximize the monetary stimulus from its policy rate. Fiscal stimulus has already been substantial and will continue to have an important impact on growth this year. Second, Canada entered the recession with notable advantages, including a well-functioning financial system, strong corporate balance sheets, and relatively healthy household finances. In addition, our economy has a demonstrated ability to adjust quickly to changing circumstances. We will have to draw on these advantages as the world emerges from recession. While the downturn was synchronous, economic performance across markets and sectors is likely to be increasingly diverse. For some Canadian businesses, the recovery may prove as challenging as the downturn. Global economic recovery The global recovery, which began in the second half of last year, can be characterized as multi-speed and policy-led. 2 In the industrialized countries, growth is relatively sluggish and heavily dependent on the exceptional monetary and fiscal policy stimulus, as well as the extraordinary measures taken to support financial systems. In emerging markets, where internal demand is already more robust, policy support is beginning to be withdrawn. Ultimately, the sustainability of the recovery depends on the private sector. As yet, there are few indications of autonomous private demand in most advanced economies. In these countries, high unemployment rates, still-challenged financial sectors, and weak household balance sheets will slow the return to pre-crisis growth rates. In this regard, the strength of Canadian domestic demand (currently the strongest in the G-7) is noteworthy. In many economies, it will take time for real output to return to pre-crisis levels. For example, although the Bank expects that the Canadian economy will attain its pre-crisis peak by the third quarter of this year, it will be yet another year and a half before the European and Japanese economies do the same. In contrast, many major emerging economies are already operating well above pre-crisis levels. This is just one illustration of how the nature of the world economy has changed. Indeed, despite its brevity, this was the Great Recession. Recent events will likely have far-reaching repercussions. Over the medium term, the pattern and pace of global growth could be See World Economic Outlook Update, International Monetary Fund, January 2010. significantly altered. The rate of potential growth in the global economy has likely fallen and will take time to rebuild. The rotation of global demand and the restructuring of corporate and household balance sheets are generating important headwinds to economic activity in advanced economies. Conversely, emerging markets are becoming more dominant in the global economy. 3 Global growth may not only be lower in the future, but could also be more volatile as a result of some fundamental vulnerabilities. First, fiscal pressures will be immense. Once the recovery is assured, most economies will need to make concerted efforts to restore fiscal sustainability. But with the debt-to-GDP ratio in industrialized countries expected to rise from 80 per cent, pre-crisis, to 120 per cent by 2014, this challenge should not be underestimated. Even abstracting from the difficult political decisions that will be required in many countries, policy-makers will have to balance the fiscal drag from reducing deficits against the dangers of crowding the private sector if they are not. Second and more immediately, capital inflows to emerging-market economies are creating new pressures. By both resisting exchange rate appreciation and forestalling monetary tightening, these countries are increasing the risk that their economies will overheat. As a stopgap, some of these economies are resorting to regulatory measures 4 of unproven effectiveness. The net result could be higher growth in the short term followed by a sharp contraction later on. Third, policy-makers must ensure that business can operate, as much as possible, in an open and stable trade and regulatory environment. We must live up to the G-20 commitment to resist trade and financial protectionism. It is also essential to maximize the degree of regulatory certainty and coordination across countries as we move forward on vital financial sector reforms. Further progress on this will be one of Canada’s priorities for this weekend’s G-7 meeting in Iqaluit. Securing strong, sustainable, and balanced global growth will require changes in behaviour and policy adjustments on several fronts. 5 These include: a sustained fiscal consolidation in the United States and several other advanced countries; an upward adjustment of U.S. household savings; increased, policy-induced domestic demand in China and other major emerging-market economies; and a real exchange rate appreciation in countries with large current account surpluses. Should these conditions fail to materialize over the medium term, two, equally troubling, paths for the global economy are possible. First, a return to the large, and unsustainable, current account imbalances of the past cannot be discounted. This would only serve to build financial imbalances anew. Alternatively, the combination of fiscal contraction over a number of years and the real prospect of ongoing sluggishness in private consumption in some major economies creates the possibility of deficient demand, with sharp disinflationary pressures at a global level. This scenario can be avoided by the development of new sources of domestic demand in major emerging markets and some surplus industrial countries. Business outlook Against this backdrop of relatively subdued global and U.S. growth, domestic factors in Canada will prove decisive for the recovery in the near term. Current strength in housing About three-quarters of global economic growth is represented by emerging-market economies this year and next, compared with two-thirds in the pre-crisis decade (1998–2007). Examples include changes to loan-to-value ratios, use of reserve requirements, and administrative guidance to lending standards. Among the changes we can anticipate is greater global collaboration and coordination in the oversight of financial markets. The G-20 reform agenda could reshape the financial services industry. The fundamental objective is to create a resilient, global financial system that efficiently supports worldwide economic growth. The system must be robust to shocks, dampening rather than amplifying their impact on the real economy. demand and consumer spending will provide important impetus this year. 6 Owing to the improved financial and economic conditions, 2010 should mark the hand-off from growth that is heavily influenced by public policy to growth that is largely determined by the private sector. By next year, the private sector should be the sole contributor to domestic demand growth in Canada. Canada’s corporate sector begins with a number of advantages. Domestic demand is expected to be relatively strong, providing a base of support for some sectors. Corporate balance sheets are in outstanding shape, and margins have held up very well for this stage in the economic cycle. In addition, Canada’s overall financial conditions are now contributing to, rather than retarding, the recovery. While net financing needs would be expected to be limited, given the stage in the economic cycle, business credit has started to grow again. In part due to monetary stimulus, overall borrowing costs for Canadian businesses remain very low. 7 Taken together, results from the Bank’s latest Senior Loan Officer Survey and the Business Outlook Survey suggest that, following a period of substantial tightening, credit conditions for businesses eased slightly in the fourth quarter of 2009, for the first time since the financial crisis began. The improvement in credit conditions mainly affected large firms, as some small and medium-sized entities continued to experience tightened conditions. It is in this environment that the first signs of a thaw in corporate attitudes have begun to emerge. In our latest Business Outlook Survey, more firms said they are now planning to increase investment spending and employment than did either last summer or fall. 8 With the improvement in financial conditions, economic activity, commodity prices, and growing confidence, business fixed investment should pick up in 2010. This recovery will be relatively modest; it is not until 2011 that we anticipate an acceleration of investment spending, as the excess supply in the economy is taken up. However, given the external environment, the question is whether this pickup will be sufficient. The significant drop in investment that occurred during the recession included spending on new technology, which could have helped firms address coming economic challenges. The relatively slow recovery expected in our most important trading partner, along with ongoing sectoral adjustments, means that firms have to find new markets. In doing so, they will face increased competition. For example, due to exchange rate moves and stellar productivity performance, the competitiveness of the U.S. corporate sector has improved significantly. The need for capital investment by Canadian businesses to meet these challenges is clear. In short, Canadian companies are emerging from the recession to an altered world – one that may require deeper restructuring and bolder strategic initiatives than currently contemplated. New suppliers need to be sourced; new markets opened; a new approach to managing for a more volatile environment developed. To recognize this reality is also to recognize the opportunities available to corporate Canada. For more detailed discussions of these components of domestic demand, see Mark Carney, “Current Issues in Household Finances,” remarks delivered to the National Forum (Canadian Club of Toronto and Empire Club of Canada) in Toronto, 2009, and Timothy Lane, “Canada’s Housing Sector in Recession and Recovery: Beyond Bricks and Mortar,” remarks prepared for delivery to the Edmonton CFA Society, 2010. Available at http://www.bankofcanada.ca/en/speeches/. Borrowing spreads paid by households and businesses spiked in 2008, but fairly quickly dropped back and now are within the normal range. The Bank expects these spreads to return to their longer-term historical averages by early 2011 (although not as tight as they were pre-crisis), which is another factor that will help boost business investment. Nonetheless, while firms expect sales to grow at a faster pace over the next 12 months than over the past 12 months, they still anticipate that the recovery will be gradual. The labour market One of the most important questions for many Canadians is what the coming thaw in business attitudes will mean for employment. Through the recession, Canada experienced significant job losses. Some of these jobs are unlikely to come back. Moreover, substantial slack remains in the labour market in the form of underemployment – for example, people working part-time who prefer to work full-time. The duration of unemployment has also risen, which raises understandable concerns. When an individual is out of work, his or her skills tend to deteriorate, making reintegration into the labour market more difficult. The longer the period of unemployment, the more difficult it can be for the individual. For the economy as a whole, this can translate into higher structural unemployment. As I mentioned earlier, the deterioration in the labour market now appears to have ended, consistent with the resumption of GDP growth. Both employment levels and average hours worked bottomed out in the summer, and the unemployment rate has since been hovering around 8.5 per cent. Against this backdrop, how quickly can the labour market be expected to improve? Or, could Canada experience a jobless recovery? Conflicting forces are at play. On the one hand, history suggests that employment growth is relatively coincident with economic growth in Canada, while improvements in the unemployment rate lag the cycle, because the more positive economic climate tends to pull more people back into the labour market. On the other hand, labour market behaviour has been somewhat unusual during this recession. Employment held up relatively well, while hours worked fell particularly sharply. There is some evidence of what economists inelegantly call “labour hoarding” – the retention of skilled workers even if they may not be immediately needed. This suggests that employment may grow relatively slowly. Indeed, the Bank’s winter Business Outlook Survey reports that the percentage of firms reporting labour shortages declined further, reaching its lowest level since the series began in 1998. With the scale of restructuring required, there may be reluctance to add personnel. Canada is not the only country with large-scale restructuring. In the United States, the unemployment rate has jumped sharply, higher than the decline in GDP would have traditionally suggested, or by about 1 to 1.5 percentage points. 9 At 10 per cent, it exceeds that of Canada – the first time this has occurred since August 1981. 10 As in Canada, there is substantial underemployment and rising long-term unemployment. 11 In addition, American job losses are unusually high in small and medium enterprises (SMEs) while they have been proportionally lower in Canada, where SMEs have been supported by relatively strong domestic demand. Unlike Canada, however, U.S. productivity growth has surged, and wage growth has slowed. The net result is lower unit labour costs, which have boosted competitiveness and should, ultimately, encourage job creation. Canada’s productivity record is puzzling. The flipside of the apparent labour hoarding is that Canada’s productivity growth fell in the latest recession – something that has not happened in any recession in the past three decades. 12 Moreover, in sharp contrast to the United States, Canada’s productivity performance was abysmal over the decade prior to the recession. Kimberly Beaton, “Time Variation in Okun’s Law: a Canada and U.S. Comparison,” Bank of Canada Working Paper, forthcoming. Moreover, when the Canadian unemployment rate is adjusted to match U.S. concepts, this would typically lower the Canadian unemployment rate by about a percentage point. For example, the U.S. measure, published by the Bureau of Labor Statistics, which includes discouraged workers plus marginally attached workers, stood at 11.4 per cent in December 2009. See Philip Cross, “The changing cyclical behaviour of labour productivity,” Canadian Economic Observer, January 2010, Statistics Canada. Some of this undoubtedly reflects the restructuring of industries and the reallocation of capital and labour to new industries. Some may reflect longer-tailed resources investments. There remains the possibility that firms have not yet anticipated intensifying global competitive pressures. While the Bank does not entirely understand why productivity growth has been as slow as it has been, we do understand the consequences. Slower productivity growth means that the rate of potential growth – the speed limit, if you will – of the Canadian economy has fallen. This has implications for both the growth of Canadian living standards and the conduct of monetary policy. To be more specific, the Bank’s working hypothesis is that trend labour productivity declined by 0.2 per cent last year, will rise by only 0.2 per cent this year, and by a still-modest 0.9 per cent in 2011. The combination of slower productivity growth and demographics could mean that the rate of potential growth for the Canadian economy will be closer to 2 per cent going forward than the more than 3 per cent average rate we enjoyed in the first half of the past decade and the latter half of the 1990s. If this differential were to persist over a decade, the cumulative loss of income would be almost $30,000 for every Canadian. 13 Inflation outlook The performance of the labour market and productivity growth will be important influences on monetary policy going forward. In spite of the large amount of excess supply in the economy, core inflation has remained quite close to 2 per cent since the beginning of 2009. This stickiness of core inflation is likely related to the resilience in wage growth relative to the underlying trend in productivity. Although wage growth in Canada remained high through the recession, it has decelerated in recent months, causing the gap between wage growth and measured productivity to begin to narrow. This slower growth in the cost of labour is a factor that should continue to moderate overall pressures on core consumer price inflation. With wage growth expected to stay at the more moderate levels seen recently, and with excess supply being gradually absorbed, both core and total CPI inflation are expected to return to 2 per cent in the third quarter of 2011. The Bank judges that medium- and longerterm inflation expectations remain well anchored to the 2 per cent inflation target. Conclusion To conclude, recent events were a watershed. The global economy that emerges from the recession will be different than the one that led into the crisis. A powerful and sustained restructuring of the global economy has begun. Canadian business will need to develop new markets as the traditional advantage of relatively open access to U.S. markets becomes less valuable. To seize new opportunities, our productivity levels must improve. In the face of these challenges and the ongoing uncertainties about the global outlook, the credibility of macroeconomic policy is essential. One constant is the Bank’s unwavering commitment to price stability. The single, most direct contribution that monetary policy can make to sound economic performance is to provide Canadians with confidence that their money will retain its purchasing power. That means keeping inflation low, stable, and predictable. Price stability lowers uncertainty, minimizes the costs of inflation, reduces the cost of capital, and creates an environment in which households and firms can invest and plan for the future. As expressed in 2009 dollars.
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Remarks by Mr David Longworth, Deputy Governor of the Bank of Canada, at the C D Howe Institute, Toronto, 17 February 2010.
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David Longworth: Bank of Canada liquidity facilities – past, present, and future Remarks by Mr David Longworth, Deputy Governor of the Bank of Canada, at the C D Howe Institute, Toronto, 17 February 2010. * * * Introduction Thank you for inviting me here today. It is a pleasure to be with you. This afternoon, I would like to talk about liquidity and the role of the Bank of Canada. As was unmistakably brought home by the global financial crisis, it is critically important that financial institutions recognize and manage liquidity risk and, at the end of the day, it is essential that central banks respond to systemic liquidity shortages. Central banks are in a unique position to do this. They can create liquidity at virtually no cost. When they undertake liquidity support and are careful to guard against credit risk – as the Bank of Canada is – they do not impose any cost on the taxpayer. Furthermore, liquidity support does not imply inflationary monetary policy. This is because central bank balance sheets can be adjusted in ways that can lead to policy interest rates being maintained at appropriate levels and that do not lead to other sources of inflationary pressure. In my remarks today, I will review how the Bank of Canada’s liquidity measures, 1 including new measures introduced during the crisis, were guided by principles. I will discuss how these principles will continue to help us as we wind down our extraordinary liquidity facilities. Elaborating on one of those principles, I will endeavour to address how the provision of liquidity by the central bank can be done to minimize moral hazard, that is, the potential that actions of policy-makers provide an incentive to market players to take greater risks than they otherwise would. Finally, I will discuss what this may mean for the design and use of our facilities going forward. I am sure no one has forgotten that day in September 2008, when Lehman Brothers went bankrupt, nor the messy aftermath that ensued in the days following. What was striking was the unprecedented spike in the cost of interbank borrowing, which then spread to other markets. Financial institutions around the world became unwilling to lend to each other, worsening an already difficult situation. Key intermediaries began to hoard liquid assets; some went so far as to put a stop, temporarily, to their market-making activities. At several points, interbank lending and other short-term funding markets, including for banks, ceased to exist for terms greater than overnight, thus making it clear that this was a shock of systemic importance. In response, central banks and governments around the world took unprecedented action to stabilize the financial system and reduce the severity of the ensuing global recession. The Bank of Canada intervened repeatedly to provide liquidity to financial market participants to mitigate the risks of serious financial disturbances. See Appendix 1: Bank of Canada Liquidity Facilities, p. 11. Going into the crisis, banks, globally, were highly leveraged 2 and had overestimated the ability of markets to provide liquidity in times of stress. They relied heavily on sources of funding, such as securitization, that disappeared as the crisis gained momentum. At the same time, their funding requirements were growing, because they were forced to take more assets back onto their balance sheets and because they had to meet a surge in demand for credit from those with bank credit lines who had previously relied on market sources of funding. It is important to note that the decline in the liquidity of bank funding markets and the decline in the liquidity of asset markets in general are not unrelated. As was vividly demonstrated during the crisis, liquidity in asset markets is tightly intertwined with the ability of financial institutions to raise funds in money markets. Impairment in one market increased the likelihood of impairment in others. Indeed, market liquidity and funding liquidity of banks with trading operations are mutually reinforcing, creating the possibility of a “liquidity spiral” in a downward or upward direction. 3 Central bank liquidity measures: pre-crisis Prior to the crisis, the tools used by the Bank to provide liquidity to the financial system as a whole were measures designed primarily to reinforce our target for the overnight interest rate. 4 These tools were – and still are – part of the Bank of Canada’s standard operating framework for the implementation of monetary policy. The main facility we use is the provision of settlement balances in the wholesale payments system – the Large Value Transfer System (LVTS) – which is supplemented, when required, by open market special purchase and resale agreements (SPRAs) and sale and repurchase agreements (SRAs). 5 There are two facilities that can provide liquidity to individual financial institutions. 6 First – and also intimately linked to the implementation of monetary policy, the achievement of the overnight rate target, and the settlement of the payments system – is our Standing Liquidity Facility at the Bank Rate. It provides liquidity, as required, to individual LVTS participants facing shortfalls in their end-of-day settlement balances. 7 Second, our Emergency Lending Assistance, which has rarely been put to use, provides extraordinary liquidity support to solvent institutions that are facing serious and persistent liquidity problems. The leverage of the Canadian banks was capped by the existence of the asset-to-capital multiple set by the Office of the Superintendent of Financial Institutions. See A. Crawford, C. Graham, and É. Bordeleau, “Regulatory Constraints on Leverage: The Canadian Experience,” Bank of Canada Financial System Review (June 2009): 45–50. See M. K. Brunnermeier and L. H. Pedersen, “Market Liquidity and Funding Liquidity,” Review of Financial Studies, 22, No. 6 (June 2009): 2201–38; and Markus K. Brunnermeier, “Deciphering the Liquidity and Credit Crunch 2007–2008,” Journal of Economic Perspectives, 23, No. 1 (Winter 2009): 77–100. The overnight rate is the key means for achieving the Bank’s monetary policy objectives and the anchor of the yield curve. Often referred to as a “repo,” or repurchase agreement, a PRA is a transaction in which the Bank of Canada offers to purchase Government of Canada securities from designated counterparties with an agreement to resell them at a predetermined price the next business day. Special PRAs (SPRAs) are transactions initiated by the Bank and are used to reinforce the target rate if overnight funds are generally trading above the target; these instruments add liquidity to the system. Alternatively, sale and repurchase agreements (SRAs) are used when overnight funds are generally trading below the target rate; these remove liquidity from the system. See Bank of Canada, 2004, “Bank of Canada Lender-of-Last-Resort Policies,” Bank of Canada Financial System Review (December): 49–55, and F. Daniel, W. Engert, and D. Maclean, 2004–2005, “The Bank of Canada as Lender of Last Resort.” Bank of Canada Review (Winter): 3–16. When LVTS participants are in deficit at the end of the day, and therefore need to access the Standing Liquidity Facility, aggregate participant deposits at the Bank of Canada will exceed the target for net settlement balances. This simple set of facilities has long served the Bank and the financial system well and continues to do so. Liquidity and monetary policy In normal times, including just prior to the crisis, the focus of the Bank’s liquidity measures was on supporting our monetary policy stance. Liquidity actions were designed and intended to affect aggregate levels of liquidity (often just intraday) to achieve our overnight rate target, rather than the distribution of liquidity within the system. This is because a well-functioning financial system normally allocates liquidity efficiently, which is critical to a central bank since it supports the effective transmission of monetary policy. The crisis did not divert the Bank’s focus from monetary policy. Just as before the crisis began, the Bank reinforced its target overnight rate during the crisis through the intraday use of SPRAs and SRAs, and, at the end of the day, the setting of the target for next-day settlement balances. Early in the crisis, 8 these policy tools were used aggressively. Five principles to guide extraordinary liquidity intervention As global financial markets became more turbulent in the summer of 2007, central banks around the world realized that unusual measures might be necessary to provide liquidity to support financial stability. The Bank of Canada developed and then published in the spring of 2008 a set of five principles to guide its liquidity interventions. These principles were used to shape the design and application of our extraordinary liquidity facilities. 9 Allow me to elaborate on these five principles. i. First, intervention should be targeted, aimed at mitigating only those market failures of system-wide importance with macroeconomic consequence that can be rectified by a central bank providing liquidity. ii. Second, intervention should be graduated, or commensurate with the severity of the problem. iii. Third, intervention should be well designed, using the right tools for the job: marketbased transactions, provided through auction mechanisms, should be used to deal with market-wide liquidity problems, while loans should be used to address liquidity shortages affecting specific institutions. iv. Fourth, intervention should be at market-determined prices to minimize distortions and under conditions aligned with those in the market, to limit the possibility that the central bank will crowd out the return of markets. v. Fifth, and finally, the Bank should mitigate the moral hazard of its intervention. Such measures include limited, selective intervention; the promotion of the sound supervision of liquidity-risk management; and the use of penalty rates as appropriate. From 9 August 2007 to 30 April 2008. The development of these principles was influenced by work by the Bank for International Settlements’ Committee on the Global Financial System; this work was published as CGFS Paper No. 31, “Central bank operations in response to the financial turmoil,” in July 2008. For a more detailed discussion of the principles, see W. Engert, J. Selody, and C. Wilkins, “Financial Market Turmoil and Central Bank Intervention,” Bank of Canada Financial System Review (June 2008): 71–78. Liquidity measures to address the financial market turmoil Guided by these then newly developed principles, the Bank gradually expanded its liquidity framework in four dimensions: terms to maturity, amounts, counterparties, and eligible securities. 10, 11 The first trigger came in the latter part of 2007 when liquidity in credit markets shrank around the world, including in Canada, with credit spreads rising dramatically on a broad range of assets. As the normal generation of liquidity among system participants broke down, there were implications for the broader financial system. To address these heightened pressures, the Bank of Canada conducted term purchase and resale agreements (PRAs) in December 2007 with primary dealers against an expanded set of eligible securities, with maturities extending past the end of the year. This marked the first time that liquidity operations extending beyond one business day were offered in support of funding liquidity. 12 Consistent with what would become our first principle, the Bank did not intervene until it became clear that liquidity distortions were taking on system-wide importance. With this measure, the Bank of Canada expanded its role to provide funding liquidity directly to major market participants to stabilize the financial system and to limit spillover effects to the broader economy. In March 2008, in response to the pressures surrounding Bear Stearns, term PRAs were reintroduced, this time on a biweekly basis. In addition, the Bank expanded the set of assets acceptable as collateral to secure intraday exposures in the LVTS and, correspondingly, for loans provided under the Standing Liquidity Facility. We allowed certain types of assetbacked commercial paper (ABCP) 13 to substitute for other, more-liquid collateral pledged in the LVTS, which, in turn, could be used more easily by financial institutions to obtain marketbased funding. Later, in June of that year, to provide flexibility, we also allowed U.S. Treasury securities. These steps illustrated the second and third principles – that intervention should be commensurate with the severity of the problem and that it should use the appropriate tools for the job. As the spring progressed in 2008, funding conditions in Canadian money markets had improved relative to those in other countries. So, guided by the principle that intervention should be commensurate with the problem, the Bank announced on July 10th that it would not renew maturing term PRAs. In the autumn of 2008, as you all know well, severe financial market pressures suddenly reemerged, sparked by a series of failures and near-failures of financial institutions in the United States and Europe. Lehman Brothers was not the only one, although it was the most significant failure. As I described a moment ago, the ability of both financial and non-financial borrowers to obtain market-based financing was seriously impaired. The deterioration in Canadian financial markets was much less severe than elsewhere, although liquidity was limited at all maturities, and trading volumes were thin. For a more detailed discussion, see L. Zorn, C. Wilkins, and W. Engert, “Bank of Canada Liquidity Actions in Response to the Financial Market Turmoil,” Bank of Canada Bank of Canada Review (Autumn 2009). The complementary liquidity facilities provided by the Government of Canada, such as the Insured Mortgage Purchase Program, were also important in addressing the financial market turmoil in Canada. Prior to December 2007, term PRAs had been conducted only on an occasional basis to manage the Bank’s balance sheet and address seasonal fluctuations in the demand for bank notes. In addition, the December 1999 operations provided stable funding for the primary dealers over the “Y2K” period, given the uncertainty surrounding the ability of software to properly take into account the change to the year 2000. There are strict eligibility requirements for ABCP securities, such that only those securities with minimal credit and liquidity risk are accepted. See: http://www.bankofcanada.ca/en/notices_fmd/2009/securities_collateral060309.pdf. The Bank’s term PRA facilities were resumed, under the existing terms and conditions. 14 Within a few weeks, the Bank aggressively expanded its provision of liquidity, commensurate with the increasing severity of the crisis. The frequency of term PRAs was increased to weekly from biweekly; eligible counterparties were expanded to include LVTS participants in addition to primary dealers; and a 3-month term PRA maturity was added. The Bank also temporarily broadened the list of securities eligible as assets in term PRA transactions to include own-issued ABCP. As the crisis deepened through the rest of the autumn of 2008, new measures were introduced. In October, the Bank temporarily broadened the list of assets accepted as collateral to include the Canadian-dollar non-mortgage loan portfolios of LVTS direct participants. 15 These assets were eligible to secure intraday exposures in the LVTS and, correspondingly, to secure loans under the Standing Liquidity Facility. Also in October, because the traditional liquidity transmission mechanism was not operating, and thus to address liquidity shortages beyond our traditional counterparties, we introduced a new term PRA facility aimed directly at large participants in the money markets. In designing and implementing these tools, the Bank was guided in particular by the third principle, which recommends using the right tool for the job. In November, we introduced a term loan facility at a penalty rate for direct participants in the LVTS, secured by their Canadian-dollar non-mortgage loan portfolios. Because this auction facility accepted these largely non-marketable, illiquid assets as collateral, participants in the LVTS were able to use their marketable, liquid collateral elsewhere. This loan facility was used to make liquidity available to individual financial institutions that may have had difficulties managing their balance sheets but whose problems were not serious enough to warrant Emergency Lending Assistance. Later, in February 2009, the term PRA for money market instruments was broadened to provide liquidity to participants in Canadian private sector bond markets as well. Correspondingly, the list of securities accepted as collateral was broadened to include investment-grade corporate bonds. In designing the term loan facility and the term PRA for private sector instruments, the Bank was guided by the fourth principle, which recommends minimizing market distortions. The facilities use an auction mechanism to allocate liquidity so that the price of liquidity is determined competitively by participants, rather than by the Bank. Both the term PRA facility for private sector instruments and the term loan facility were designed as backstop facilities with appropriate minimum bid rates, which provided the Bank with a natural means to exit from them when market sources of liquidity became a more cost-effective alternative for potential participants. In addition, the facilities were designed to preserve the existing market structures. Finally, intervention was aimed at mitigating liquidity risk that, in the Bank’s judgment, was not in line with fundamentals; it did not attempt to alter credit risk. The fifth principle, that we mitigate the moral hazard of our interventions, served and continues to serve as a guide at all levels of our liquidity program. The Bank of Canada took several precautions to mitigate the creation of perverse incentives that could adversely influence market behaviour. As I noted earlier, the Bank intervened only in response to specific, extraordinary episodes of heightened liquidity pressures. Moreover, the liquidity The Bank also expanded its reciprocal currency swap arrangement with the U.S. Federal Reserve, in order to be able to provide up to $30 billion of U.S.-dollar funding to domestic financial institutions, if necessary. (Such a need never arose in Canada, nor was it expected to.) The swap arrangement was part of coordinated central bank actions designed to address elevated pressures in U.S.-dollar short-term funding markets. Last month, it was announced that the swap arrangement has expired since it is no longer needed, given the improvements in financial market functioning in the past year. This decision respected the principle that measures be commensurate with the severity – or decline in severity – of the problem. These were accepted at a collateral-to-portfolio value of 60 per cent. facilities were introduced as temporary measures in order to reduce the incentives for participants to change their behaviour. The Bank has been working closely with the federal Department of Finance, the Office of the Superintendent of Financial Institutions (OSFI), and other domestic bodies to monitor the liquidity conditions of markets and financial institutions, as well as the liquidity risk management of major financial institutions. In addition, the Bank monitors the results of each liquidity operation. Finally, where applicable, the pricing of new facilities was constructed to preserve incentives to transact in private sector markets. Liquidity facilities: the present By the spring of last year, as financial market conditions continued to improve, participation in our liquidity operations diminished, indicating that the need for the Bank’s support would likely be declining. Indeed, the amount of liquidity support had peaked at $41 billion in December 2008. (It is currently some $23 billion.) It is important to note that at its April 2009 fixed announcement date, the Bank announced that it would introduce 6-month and 12-month PRAs with a minimum bid rate of 25 basis points and a maximum bid rate of 50 basis points to reinforce its conditional commitment to maintain its target for the overnight rate at the effective lower bound of 1/4 per cent until the end of June 2010. This was a new use for its term PRA facility. At the end of June, prospective sunset dates for all of the Bank’s extraordinary liquidity operations were announced. It is important to note that just as they served to guide the creation of our extraordinary liquidity facilities, the set of five principles was used to guide the winding down of these facilities, particularly principles (ii) and (iii), that interventions be commensurate with the severity of the problem and that the right tool be provided for the job. At the end of July, the Bank lowered its pre-announced minimum amounts for the regular term PRA auctions as well as for the term PRA for private sector instruments and the term loan facility. At the end of October, the term loan facility and the term PRA facility for private sector instruments were terminated. The frequency of regular term PRA auctions was reduced from weekly to biweekly and, subsequently, to monthly. At the beginning of this month, we began to reduce the eligibility of non-mortgage loans as collateral for the Standing Liquidity Facility from 100 per cent to 20 per cent. 16 The financial crisis has subsided, and financial conditions have improved significantly over the past ten months, both globally and in Canada. Through the crisis, the Bank’s regular term PRA facility was used heavily and appears to have contributed to reduced market stress and a return to well-functioning money markets. In contrast, there was relatively little demand or need for funding from the term PRA facility for money market instruments, the term PRA facility for private sector instruments, and the term loan facility, which were all designed as backstops. That said, the presence of these facilities – including the latter two until the end of October 2009 – helped to mitigate uncertainty among market participants about the availability of liquidity. Future: dealing with moral hazard and the provision of liquidity I would now like to return to the issue of moral hazard. Recall that our fifth principle is the mitigation of the moral hazard associated with our interventions. Having gone through a financial crisis, we can be even more clear on how to do this. How can we minimize the potential that our actions provide incentives to market players to take increased risks? This process will be complete by 1 April 2010. There are three basic things a central bank can do to mitigate the moral hazard associated with its crisis interventions: (i) limit crisis intervention to significant systemic events, as we have done; (ii) encourage infrastructure development and regulatory reform that make the financial system more resilient to systemic shocks, thereby reducing the frequency and repetition of patterns leading to systemic events; and (iii) maintain a flexible intervention strategy that can deal with specific types of systemic problems as they evolve. This flexibility, which acknowledges the inherent uncertainty surrounding the timing and magnitude of systemic crises, means that individual system participants will not know in advance how to transfer risk to the central bank at artificially low prices. 17 The use of auctions to price and distribute liquidity can be helpful in this regard. I’d like to expand on the second element, making the financial system more resilient to shocks. To reduce the probability of a crisis, there are actions that can be taken by the central bank and by the prudential supervisor. The actions that the Bank of Canada has taken or is taking include: Encouraging and overseeing the implementation of liquidity-generating infrastructure, such as a central counterparty for repo trades, that help market participants self-insure against idiosyncratic shocks; 18. Maintaining standing facilities – our Standing Liquidity Facility and Emergency Lending Assistance – with either penalty rates or with stigma even in non-crisis times, which allow key institutions to determine when to approach the Bank as the lender of last resort for funds. 19 This could stop large idiosyncratic shocks from cascading into systemic events; 20, 21, and, Monitoring financial institution liquidity against tighter criteria (together with OSFI). On the part of prudential supervisors, the following are actions that are under way or have been proposed and that can also help make the financial system more resilient and thus mitigate moral hazard: Establishing standards that encourage financial institutions to maintain sufficient liquidity to deal with the idiosyncratic or small systemic shocks they can expect to face and to have policies for sound liquidity management practices in place; 22 This is consistent with the advice developed in 2008, except for the element of co-insurance, which was considered to be a possible measure in the first iteration of the principles guiding the Bank’s extraordinary liquidity interventions. The concept of co-insurance has been replaced by the idea that financial institutions self-insure against idiosyncratic shocks and that the central bank provides insurance only for systemic liquidity shocks. This change should be more effective in limiting moral hazard because it focuses more on containing the cause of moral hazard. Other examples include standardized transparent securitization and through-the-cycle margining. The Standing Liquidity Facility has a penalty rate (Bank Rate) and the Emergency Lending Assistance has stigma. Allowing key institutions to determine when to borrow from the central bank would reduce information collection and monitoring costs for the central bank, while the penalty rate and stigma would control the moral hazard associated with inappropriate use of the facility. The terms and conditions of the Bank’s collateral policy, including the size of haircuts, can also help to contain moral hazard. The Basel Committee on Banking Supervision’s press release of 17 December 2009 entitled, “Consultative proposals to strengthen the resilience of the banking sector announced by the Basel Committee” covers the introduction of “a global minimum liquidity standard for internationally active banks.” See also C. A. Northcott and M. Zelmer, “Liquidity Standards in a Macroprudential Context,” Bank of Canada Financial System Review (December 2009): 35–40; and “International framework for liquidity risk measurement, standards and monitoring,” a consultative document issued by the Bank for International Settlements, December 2009. Strengthening capital regulations to ensure that risk is appropriately mitigated without imposing an excess regulatory burden on financial institutions or generating additional moral hazard from “not allowed to fail” policies; 23 Ensuring that there are meaningful consequences to financial institution stakeholders who have responsibility for mitigating risk when mitigation strategies fail by, among other things, having a clear and transparent resolution mechanism and “living wills,” which can allow institutions to fail or to be quickly restructured; 24, 25 and, Requiring the use of contingent capital or convertible capital instruments, perhaps in the form of a specific type of subordinated debt, to help ensure loss absorbency and thus reduce the likelihood of failure of a systemically important institution. 26 These are also the building blocks that can be used to reduce the probability of a crisis. The goal is to reach a destination where financial institutions, markets, and infrastructure play critical – and complementary – roles to support long-term economic prosperity. As we move forward, it is important that financial system participants do not believe that our intervention in times of crisis implies a willingness to intervene in normal times. It is also important that we retain considerable flexibility about when and how to intervene in the next crisis to fulfill our mandate to be liquidity lender of last resort to the financial system in the event of a systemic shock. For the Bank, the primary facilities used during the crisis, the term PRA and the term loan facility, should continue to be a part of the Bank’s toolkit, as is our Emergency Lending Assistance. In a crisis with a shortage of good quality collateral, the Bank would also consider a term securities lending facility to exchange good collateral for lower quality collateral – at the appropriate price – in order to support the functioning of core funding markets. Given potential changes to core market infrastructure (the implementation of central counterparties, for example), further study will also be important to determine the appropriate tools to address future liquidity issues. The Basel Committee on Banking Supervision press release of 17 December 2009 covers “raising the quality, consistency and transparency of the capital base” and “strengthening the risk coverage of the capital framework.” The Financial Stability Board (FSB) is working on “a package of measures to address the “too big to fail” problems associated with systemically important financial institutions,” which includes "improving the capacity to undertake an orderly resolution of a failing firm," including one that operates cross-border. See the FSB press release of 9 January 2010 entitled, “Financial Stability Board meets on the financial reform agenda.” Canada has clear and transparent resolution mechanisms for federally regulated, deposit-taking financial institutions, which are periodically reviewed and enhanced as needed. For example, the Canada Deposit Insurance Corporation (CDIC) has long had powers to restructure and resolve troubled deposit-taking institutions, and in 1996 federal legislation was amended to give the Superintendent of Financial Institutions the authority to temporarily take control of an institution, and if necessary, request a winding-up order, subject to certain prescribed conditions and approval of the Minister of Finance. More recently, CDIC was granted the authority in 2008 to establish bridge banks to facilitate the restructuring of federally-regulated deposit-taking institutions. The BCBS press release of 11 January 2010 entitled, “Group of Central Bank Governors and Heads of Supervision reinforces Basel Committee reform package,” announces that the “Basel Committee is reviewing the role that contingent capital and convertible capital instruments could play in the regulatory capital framework.” See also “Considerations along the Path to Financial Regulatory Reform,” remarks by Superintendent Julie Dickson, Office of the Superintendent of Financial Institutions, 28 October 2009. Conclusion To conclude, the principles developed as the crisis began have served the Bank and, more importantly, the financial system well. Throughout the crisis, the Bank has been innovative and nimble. 27 In this period of winding down our temporary facilities, we are acting deliberately and thoughtfully, for example, by providing advance notice and by only gradually reducing both the amounts and frequencies of the auctions. We will continue to act in this manner as we move to reinforce the stability and resilience of the financial system – and, both in the near and longer term, we will continue to employ these principles to guide our actions. An example is allowing LVTS participants to assign their non-mortgage loan portfolios as eligible collateral for LVTS and SLF purposes, a practice that we have indicated will be partially kept in place going forward.
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Remarks by Mr Mark Carney, Governor of the Bank of Canada, at Carleton University, Ottawa, Ontario, 11 March 2010.
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Mark Carney: Principles for interesting times Remarks by Mr Mark Carney, Governor of the Bank of Canada, at Carleton University, Ottawa, Ontario, 11 March 2010. * * * I would like to thank students from universities across Canada for joining me on this special day, the 75th anniversary of the Bank of Canada. This afternoon, I will speak about the past and the present in the hope of enticing some of you to participate in the Bank’s future. Let me caution market participants that nothing that follows relates to the “near future,” that is, the horizon relevant for monetary policy decisions, so if you are not interested in the Bank’s history, the Bank’s gift to you on our birthday is an hour of found time. Introduction The Bank of Canada’s mandate is to preserve the value of the nation’s currency and to promote the economic and financial welfare of Canadians. As a consequence, we focus on the major macroeconomic issues of the day. Over the past two years, these have been considerable. With current debates ranging from the relationship between price and financial stability to the future of the international monetary system, it is an exciting time in central banking. However, I would argue that for students such as yourselves, the issues facing central banks are always intriguing since they go to the heart of how modern economies function and, indeed, how human beings behave. The Bank in turn needs you. The Bank is a learning organization, with immense responsibilities. Our work is grounded in academia, honed by analysis, and disciplined by an unrelenting focus on our mandate. Our response to the recent economic crisis has risen to the highest standard set over our history. Guided by well-researched, policy-based frameworks, the Bank has acted decisively. As a result, the clarity and credibility of these frameworks has made action more powerful. The importance of this combination has been repeatedly demonstrated. The formidable economic and financial challenges facing Canada today are not necessarily more intractable than those in the past. Economic forces do not change. However, the speed and scale of information, capital flows, and trade are radically different. The global economy is more fundamentally interconnected than ever before – and that means the response times for policy-makers have shortened dramatically. In this environment, the value of principlesbased policy frameworks is supreme. I am reminded of a story told to me by Jean-Claude Trichet, President of the European Central Bank. A mutual colleague, at the start of the crisis, was visiting a small village in the Scottish highlands. He was bereft of his BlackBerry and was anxious for the latest financial news. He entered a newsagent and asked for the Financial Times. – The shopkeeper said, “Would you like yesterday’s paper or today’s?” – Given the weight of events, he answered without hesitation, “I would prefer today’s.” – To which the shopkeeper replied, “Then come back tomorrow.” In today’s world, policy-makers cannot wait until tomorrow. They must act immediately. To do so effectively, they need guiding principles. Permit me to elaborate by recounting three challenges that have resonated over the years. Monetary policy response to global economic crisis First, consider a severe, synchronous global recession, triggered by a financial crisis at the heart of capitalism. Commodity prices crash, protectionism is on the rise. There are bank failures around the world, although not in Canada. Nonetheless, our country is not left unscathed. Unemployment rockets and economic activity plummets. Does that sound familiar? Triggered by the stock market crash of October 1929, the Great Depression had a devastating impact on the global and Canadian economies. By 1933, Canadian equity prices had fallen more than 70 per cent from their peak, and national output had dropped by 40 per cent, with the drought-stricken prairies especially hard hit. Nationwide, deflation was punishing, with consumer prices falling by more than 9 per cent in both 1931 and 1932. The human cost was staggering, with the unemployment rate hitting a high of 20 per cent in 1933. By 1933, with bank lending still contracting, pressure on the federal government to “do something” had become intense. Reflecting the high cost and low availability of credit, there was widespread public distrust of the chartered banks. 1 Western farmers, suffering from sharp declines in both crop yields and prices, were vocal critics of the Eastern-controlled banks and strongly favoured the creation of a central bank. The Government responded with the passage of the Bank of Canada Act, and we opened our doors for business and issued our first bank notes exactly 75 year ago. So what did the Bank do? Initially, with respect to monetary policy, the answer was, not much. The economy was already starting to recover, and the Bank maintained its Bank Rate unchanged at 2 1/2 per cent. 2 As well, the notion that central banks could stabilize macroeconomic activity within their borders is relatively new. 3, 4 Moreover, the Bank retained a “gold mentality,” even though Canada had officially broken the formal link between the Canadian dollar and gold in 1931. Consequently, there was a reluctance to do anything that might induce capital outflows. It was also widely believed that U.S. rates provided an effective floor for comparable Canadian rates. 5 Contrast that to the recent experience. The so-called “Great Recession” from which we are just emerging had the potential to replicate the dire experience of the 1930s. However, while the reverberations of the recent experience are far from finished, the aggressive and timely actions of global central banks, including the Bank of Canada, have not only averted the worst, but also created the prospect of a sustained recovery. Recognizing the strong headwinds caused by the seizing up of financial markets, the Bank has dramatically eased monetary conditions and provided significant liquidity to the financial system. The Bank’s actions were guided by its forward-looking inflation-targeting framework, The traditional rate for prime commercial loans was 6 per cent in the early 1930s, implying real interest rates (after inflation) of as much as 15 per cent or more. Indeed, the first cut in the Bank Rate did not occur until 1944. See D. Dodge, “70 Years of Central Banking in Canada,” Bank of Canada Review (Winter, 2005–2006): 3–5. The Bank believed that since chartered banks rarely, if ever, borrowed from the central bank, its Bank Rate had little impact on commercial rates. It did not apparently consider whether banks would change their policy if the Bank Rate were dropped. The Bank Rate was seen as a lender-of-last-resort rate as opposed to a monetary policy tool. The Bank was active on other fronts. In April 1936, Alberta defaulted on its provincial debts and unilaterally reduced the rate paid on bonds. Other Western provinces threatened to follow suit. As monetary policy is national in scope, it could not address such regional problems. Fearing a second provincial default, Towers instead advanced $3 million to Saskatchewan. This was an extraordinary move, unique in the history of the Bank. which prompted easing before the recession began and accelerated stimulus once the crisis intensified. Between December 2007 and April of last year, the Bank lowered the overnight target by a total of 425 basis points, cutting it to a historic low of 1/4 per cent, its lowest possible level. Once we reached that effective lower bound, we developed and published a framework for unconventional monetary policy. Our conditional commitment is the only element of that framework that we have activated. While the Bank’s unconventional policy framework demonstrated to Canadians that we were not out of bullets, the use of the conditional commitment reassured them that we were not trigger happy but, rather, disciplined by the pursuit of our inflation target. Action alone is not sufficient. It must take place within the proper context. Once again, I stress that the Bank places supreme importance on policy measures within a well-developed framework. The Bank’s monetary policy response to the current crisis has been consistent with Ben Bernanke’s mea culpa to Milton Friedman and Anna Schwartz, regarding the lack of action by the Federal Reserve during the Depression: “You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.” Bernanke’s admission underscores the importance of research and learning – something the Bank has long understood. In-depth, comprehensive, and impartial research has always been critical to our success. One of the first steps taken by our first governor, Graham Towers, was to create a research and statistical department. 6 Through aggressive recruitment of promising young academics and co-operation with university-based researchers and international colleagues, innovations have included leading macro models (such as RDX and ToTEM), work on price-level targeting, and cutting-edge research on payments systems. 7 The Bank has also learned from the conduct of policy, including from our mistakes. Gerald Bouey famously recognized that “we did not abandon M1, M1 abandoned us,” before initiating a search for a new monetary anchor. More recently, the Bank has been determined not to repeat the errors of the 1970s, when we overestimated the rate of potential growth in the wake of a major global shock. 8 Most significantly, the Bank is now guided by the discipline of an inflation target. Canada helped pioneer inflation targeting, having adopted it in 1991 under the Governorship of John Crow. 9 During the Great Recession, its value was clear. By disciplining our objectives and promoting transparency and accountability, the target has anchored inflation expectations, thereby ensuring that reductions in our overnight rate drive down real interest rates and stimulate the economy. Financial system stability and the provision of liquidity Consider now a second challenge that has echoed across the decades. In the midst of an economic crisis, a mid-sized financial institution fails, potentially triggering a host of See D. McQueen, “Economic Research at the Bank of Canada, 1935–65,” Canadian Business Economics 5, No. 2–3 (Winter/Spring 1997): 89–95. See J. F. Helliwell, “From Flapper to Bluestocking: What Happened to the Young Woman of Wellington Street?” Bank of Canada Review (Winter, 2005–2006): 31–39. See Bank of Canada, “Revisions to Potential Output,” Monetary Policy Report (April 2009): 12. New Zealand was the first country to adopt an inflation target, doing so in 1990. Canada followed, 11 months later. counterparty defaults across financial systems. The shock spreads globally, threatening market functioning and financial stability. This is the story of Bankhaus Herstatt, a mid-sized German bank, active in foreign exchange markets, that failed in 1974 during the first oil shock. It was shut down at the end of the business day, when many banks still had foreign exchange contracts for settlement. The international impact was substantial, even in the “less-connected” world of the 1970s. As the repercussions from failed transactions mounted, gross funds transferred in New York fell by 60 per cent over the next several days. The Herstatt failure exposed how inadequate market infrastructure and more open capital accounts transmit shocks globally. It led to a deliberate, global process to address these shortcomings. That same year, governors of the central banks of G-10 countries, including Bouey, established the Basel Committee on Banking Supervision, which continues to serve today as an important forum for co-operation on banking supervisory matters. In 1980, a second group on payments systems was established; later upgraded to the Committee on Payment and Settlement Systems (CPSS). Following smaller episodes of settlement and other financial failures, the work of these committees eventually led to the establishment of CLS Bank. 10 CLS links national payments systems and simultaneously settles on its books the foreign exchange transactions submitted by its member banks. Although the response to the failure of Herstatt was slow, it did eventually develop market infrastructure to remove daylight payment risk. It also promoted the deepening of institutional structures such as the G-10. Crucially, this work paid off during the recent crisis. The G-10 has coordinated some of the most important central bank initiatives. The foreign exchange payments system itself was rock solid, despite the enormous financial turmoil. However, new channels of contagion were revealed in new markets. Following the collapse of Lehman Brothers, a mid-sized U.S. investment bank, in September 2008, the cost of interbank borrowing spiked up to unprecedented levels. The functioning of repo, stock, loan, and derivatives markets seized as collateral values plunged and a panic over counterparty risk swept the financial system. Within days, other storied institutions either collapsed or were pushed to the brink. The seizure of the entire global financial system was a very real possibility. The virulence of open global capital flows meant that the response, this time, had to be crafted in days, not decades. G-10 central banks, including the Bank of Canada, acted swiftly, by conducting a coordinated 50-basis-point interest rate cut. Then, in a historic meeting, G-7 countries, including Canada, committed to: use all available tools to support systemically important financial institutions and prevent their failure; and take all necessary steps to ensure that banks and other financial institutions have broad access to liquidity and funding. The G-7 actions – while absolutely necessary – left the system awash in moral hazard. The need for principles-based policy frameworks once again became clear. The Bank’s extraordinary liquidity operations met this standard. As the crisis intensified, we introduced facilities anchored to a principles-based framework developed in the spring prior For instance, Drexel Burnham Lambert, Bank of Credit and Commerce International, Barings Bank, Long Term Capital Management. to the Lehman failure. Total outstandings peaked at $41 billion. These are now being unwound consistent with market conditions and our principles. 11 The crisis also revealed grave shortcomings in market structure and regulation. On the former, rather than wait three decades, the Bank has already assisted an industry-led process to develop a central counterparty for Canadian repo markets. This initiative, which will go live later this year, will help keep core funding markets functioning continuously, including in times of stress. The Bank is also very active through the BIS in advancing reforms of global margining practices in order to dampen liquidity spirals, consistent with both the findings of academic literature and practical experience. 12 Finally, through the G-20 and the Financial Stability Board, the Bank is helping to create a more resilient global financial system. In this regard, imperatives include a new bank capital regime, the development of a more systemic approach to regulation; and a series of initiatives to create a system that can withstand failure. 13 In all of these initiatives, the Bank is relying on a combination of academic research, in-house analysis, and pragmatic judgment. International monetary system Finally, consider a third challenge. The international monetary system frustrates adjustment and builds stresses. Current account surplus countries accumulate massive reserves, forcing a deflationary response on others. As a consequence, global economic growth is both more volatile and suboptimal. There is a need for a new international architecture, one that promotes timely and symmetric adjustment. This challenge bedevilled the global economy during the 1930s. It could only be addressed after World War II, during the career of Louis Rasminsky, our third governor. Allow me to provide a little history. In the 1930s, the combination of fidelity to gold and tight Federal Reserve monetary policy meant that the deflationary pressures from the United States spread quickly, further weakening the global economy. Unable to adjust, countries were forced to abandon the gold standard, which had been adhered to for more than a hundred years. Though deficit countries experienced the crisis first, all countries suffered from the eventual collapse of the rules of the game. In 1944, to avoid revisiting the problems of the 1930s, 730 delegates from 44 nations gathered in the village of Bretton Woods, New Hampshire. Rasminsky was prominent in these efforts. 14 During three weeks in July, he and his peers hammered out a new See D. Longworth, “Bank of Canada Liquidity Facilities: Past, Present, and Future,” remarks delivered to the C.D. Howe Institute in Toronto, 2010. Available at http://www.bankofcanada.ca/en/speeches/. See also W. Engert, J. Selody, and C. Wilkins, “Financial Market Turmoil and Central Bank Intervention,” Bank of Canada Financial System Review (June 2008): 71–78; L. Zorn, C. Wilkins, and W. Engert, “Bank of Canada Liquidity Actions in Response to the Financial Market Turmoil,” Bank of Canada Review (Autumn 2009): 3–22; C.A. Northcott and M. Zelmer, “Liquidity Standards in a Macroprudential Context,” Bank of Canada Financial System Review (December 2009): 35–40. See “The Role of Margin Requirements and Haircuts in Procyclicality,” a report of the Bank for International Settlements’ Committee on the Global Financial System, forthcoming, March 2010; M. K. Brunnermeier and L. H. Pedersen, “Market Liquidity and Funding Liquidity,” Review of Financial Studies 22, 6 (June 2009): 2201–38; and M. K. Brunnermeier, “Deciphering the Liquidity and Credit Crunch, 2007–2008,” Journal of Economic Perspectives 23, 1 (Winter 2009): 77–100. For a more detailed discussion, see M. Carney, “Reforming the Global Financial System,” remarks delivered to the Rendez-vous avec l’Autorité des marchés financiers, Montréal, 2009. Available at http://www.bankofcanada.ca/en/speeches/. As chair of the drafting committee, Rasminsky helped to reconcile views, mediating between the British and the Americans. After the formation of the IMF, Rasminsky became Canada’s first Executive Director, on a international monetary order aimed at establishing a system that allowed for a symmetric adjustment of balance of payments problems and a liberalized trading regime. The Bretton Woods system of pegged, but adjustable, exchange rates was a direct response to the instability of the interwar period. Bretton Woods was very different from the gold standard: it was more administered than market-based; adjustment was coordinated through the International Monetary Fund; there were rules rather than conventions; and capital controls were widespread. Despite these institutional changes, surplus countries still resisted adjustment. Foreshadowing present problems, countries often sterilized the impact of surpluses on domestic money supply and prices. Like today, these interventions were justified by arguing that imbalances were temporary and that, in any event, surpluses were evidence of virtue rather than “disequilibria.” In contrast, the zero bound on reserves remained a binding constraint for deficit countries, which eventually ran out of time. In 1950, Canada faced adjustment problems of its own, and the Bank, as a learning institution responded. Large capital inflows threatened to drive up inflation in Canada in the context of our then-fixed exchange rate. In an effort to maintain price stability, the decision, unpopular internationally, was taken to float the Canadian dollar, which duly appreciated. While this was inconsistent with the rules of Bretton Woods, it was consistent with their spirit, as a floating dollar allowed both for domestic stability and for the market to determine the rate, rather than being set by government for national advantage. Canada’s move to a flexible exchange rate was a precursor to the breakdown of the Bretton Woods system 20 years later. Fast forward to today. The intensity and scope of the recent crisis reflected unprecedented economic disequilibria among national economies. Integral to the buildup of vulnerabilities in many asset markets were large, unsustainable current account imbalances across major economic areas. Once again, the international monetary system failed to promote timely and orderly economic adjustment. Some emerging markets today face challenges similar to those of Canada in the 1950s. Last November, the G-20 launched an important process to address the challenges. Countries committed to promote strong, sustainable, and balanced growth in global demand and agreed on a framework that stresses the shared responsibility of member countries to ensure that their policies support the commitment. In short, the success of these discussions is critical for sustainable medium-term, global growth. Canada brings to the table one of the soundest financial systems in the world and a macroeconomic strategy that contributes to sustainable and balanced global growth. Our economy is among the most open, and our policy response to the crisis has been one of the most aggressive. We also have a long experience with floating exchange rates and a deep understanding of how to best manage domestic policies in that environment. 15 part-time, unpaid basis, while remaining a senior official of the Bank of Canada. J. Powell, A History of the Canadian Dollar (Ottawa: Bank of Canada, 2005): 65. See, among others, J. Murray, S. Van Norden, and R. Vigfusson, “Excess Volatility and Speculative Bubbles in the Canadian Dollar: Real or Imagined? Bank of Canada Technical Report No. 76, 1996; J. Murray, L. Schembri, and P. St-Amant, “Revisiting the Case for a Flexible Exchange Rate in North America,” North American Journal of Economics and Finance 14 (2003): 207–240; J. Murray, “Why Canada Needs a Flexible Exchange Rate,” in The Dollarization Debate, eds. D. Salvatore, J. Dean and T. Willett (New York: Oxford University Press, 2003); R. Issa, R. Lafrance, and J. Murray, “Turning Black Tide: Energy Prices and the Canadian Dollar,” Canadian Journal of Economics, 41, 3(2008): 737–769. Conclusion In conclusion, the Bank of Canada has faced formidable challenges over the past 75 years. These experiences have led us to innovate and to become a more effective institution. As the global crisis revealed, the stakes are high. Canada is a small open economy subject to immense global economic forces. Shocks can be large and response times short. This reality places a premium on the disciplined application of principles-based policy frameworks. The Bank must combine the best of academic research, empirical analysis, and practical experience to manage in such a world. This means that we will need people such as you: to take the torch and join our effort to maintain an environment in which Canadian households and firms can invest and plan for the future with confidence.
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Remarks by Mr Mark Carney, Governor of the Bank of Canada, to the Ottawa Economics Association, Ottawa, Ontario, 24 March 2010.
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Mark Carney: The virtue of productivity in a wicked world Remarks by Mr Mark Carney, Governor of the Bank of Canada, to the Ottawa Economics Association, Ottawa, Ontario, 24 March 2010. * * * It is either brave or foolhardy of the Ottawa Economics Association to organize another conference around Canada’s perennial challenges of demographics, productivity, and potential growth. The cognoscenti wearily deride these shortcomings even while they acknowledge their importance. 1 After all, who really wants to talk about getting old? Similarly, the subject of productivity is described as too dull, or worse, too threatening for Canadians. It is said to imply working harder, not smarter, or to promote job losses rather than income gains. These debates are thus thought best confined to the policy wonks, in order that our diagnoses and prescriptions can occur in a parallel, forgotten universe. However, one wonders, who would not want to be productive in their work? Is there a child whom we do not want to reach his or her full potential? Could what Canadians expect of their economy be so very different from what they expect of themselves? Our ambitions for the Canadian economy should be bold. We are a country of immense strengths and, as demonstrated during the recent crisis, considerable resilience. Yet Canada does underperform. We are not as productive as we could be. Our potential growth is slowing. Moreover, this is occurring as the very nature of the global economy, in which we previously thrived, is under threat. This debate can no longer be avoided. What, then, must be done? There are two imperatives – one domestic, one international – to secure strong, sustainable, and balanced economic growth for Canada. Both recall Aesop’s fable of the ant and the grasshopper, the moral of which can be best summed up as “idleness brings want.” In short, in a wicked world, Canada needs productive virtue. Canada’s slowing potential This conference has already benefited from comprehensive reviews of productivity and potential growth, so I would like to briefly summarize the Bank’s views (which are largely in accord with the emerging consensus). We have a problem: demographic drag will increase in coming years. As the boomer generation ages, labour force participation rates will decline and hours worked will fall. The question is merely one of degree. For some age groups, there is a possibility that participation rates will be higher than currently anticipated, particularly since participation rates of older workers have risen since 1996. Moreover, there is a role for policy to reduce further disincentives for participation in the labour market. Nevertheless, it will not be able to reverse longer-run demographic pressures. We have a second, much bigger problem: our abysmal productivity record. Over the past decade, it has averaged a paltry 0.7 per cent, about half the rate recorded over the 1980–2000 period. See, for example, J. Simpson, “Needed urgently: more creativity from the business class.” Globe and Mail, 25 May 2009. The combination of slower productivity growth and demographic shifts could well mean that the average rate of potential growth for the Canadian economy will be closer to 2 per cent going forward than the more than 3 per cent we enjoyed in the first half of the past decade and the latter half of the 1990s. 2 If this differential were to persist over a decade, the cumulative loss of income would be almost $30,000 for every Canadian. 3 Given Canada’s demographic trends, the principal way to avoid this loss is by improving our productivity. First imperative: improving Canada’s productivity There appears to be ample opportunity to do so, since Canada is not as productive as it could be. Canada’s productivity ranking has dropped from third of the 20 countries in the Organisation for Economic Co-operation and Development (OECD) in 1960 to 15th of the current 30 members (see Appendix, Chart 1). 4 After some promising signs in the late 1990s, average labour productivity growth has since slowed dramatically (Chart 2). In growth-accounting terms, the main culprit has been multifactor productivity growth, which has slumped markedly, while capital intensity failed to pick up pace. 5 I will sketch out three types of explanations based on the research done at the Bank of Canada and by many of you in this room. 6 First, measurement challenges for both output and prices in the resources and service sectors could explain some of the shortfall. Second, lags associated with the economy’s adjustment process could be obscuring otherwise strong performance. These include: longer-tailed resource investments that require substantial upfront expenditures before natural resources can be turned into output, all the while drawing on more marginal reserves; and the large-scale restructuring of industries and the reallocation of capital and labour to new industries, which naturally dampen productivity as they take place. 7 Third, there appear to be deeper structural determinants that will require more concerted efforts on the part of business and government to address: In April 2009, the Bank of Canada lowered its forecast for the growth of potential output to 1.2 per cent in 2009, 1.5 per cent in 2010, and 1.9 per cent in 2011 from 2.4 per cent in 2009 and 2.5 per cent in 2010 and 2011, reflecting significant structural changes and subdued corporate investment. As expressed in 2009 dollars. Compendium of Productivity Indicators, Organisation for Economic Co-operation and Development (OECD), 2006 and 2008. Multifactor productivity measures joint influences on economic growth, such as technological change, efficiency improvements, and returns to scale. Its growth rate is calculated as the difference between the growth in the amount of output produced and the growth of the quantity of all inputs used, such as labour and machinery and equipment. For a recent summary of Bank of Canada research, see R. Dion, “Interpreting Canada’s Productivity Performance in the Past Decade: Lessons from Recent Research,” Bank of Canada Review (Summer 2007): 19–32, available at: http://www.bankofcanada.ca/en/review/summer07/dion.pdf; and R. Dion and R. Fay, “Understanding Productivity: A Review of Recent Technical Research,” Bank of Canada Occasional Paper 2008–3, available at: http://www.bankofcanada.ca/en/res/dp/dp(y)_2008.html. Bank of Canada research suggests that job reallocation across firms is a significant positive factor explaining Canadian labour productivity growth over the 1992–2006 period. D. Leung and S. Cao, “The Changing Pace of Labour Reallocation in Canada: Causes and Consequences,” Bank of Canada Review (Ottawa: Bank of Canada, Summer 2009): 31–44. Available at: http://www.bankofcanada.ca/en/review/summer09/leung.pdf. Canada under-invests in machinery and equipment (M&E), training, and innovation – in fact, all of the underlying drivers of productivity. Canadian workers have about half the amount of information and communications technology (ICT) of their American counterparts. ICT capital has been linked to stronger multifactor productivity growth in many countries. 8 With its highly educated workforce, flexible labour markets, and high rates of firm entry and exit, Canada appears to have all the ingredients needed to be an innovation leader. However, it is only 16th among the OECD countries in the intensity of business research and development. 9 Our dismal multifactor productivity growth indicates that Canadian firms do not effectively use the capital that they purchase. 10 Some possible explanations for why we both under-invest and appear to use capital so poorly include: the wrong skills mix: Canada has a well-educated labour force but, perhaps as the structure of the economy shifts, not in the areas required; small firms: Compared with the United States, Canada has proportionately more small firms that are significantly less productive than large firms; 11 and in particular, inadequate competition in some sectors, especially network industries that have spillovers throughout the economy, including telecommunications, electricity, and retail. 12 Whatever the combination of reasons behind Canada’s poor productivity record, there are several avenues available to policy-makers to encourage sustainable longer-run growth. It is important to acknowledge that successive governments have taken many steps in the right direction. Canadian businesses benefit from a sound macro-policy environment, including sustainable fiscal policy and credible monetary policy, which delivers low, stable, and predictable inflation. Corporate tax competitiveness – particularly for new investment – has improved markedly over the past decade and is now among the most attractive in the industrialised world. Canada has also actively pursued trade openness through new agreements and unilateral tariff reductions. 13 Staying the course in these regards is likely the single most important contribution of the public sector. This is not related to industrial structure–it is found in most industries. See A. Sharpe, “What Explains the Canada-US ICT Investment Gap?” Research Report 2005–2006, Centre for the Study of Living Standards (CSLS), December 2005. A recent report concluded that “too many businesses in Canada are technology followers, not leaders” and stressed the need for “innovation-based business strategies.” See P. Nicholson, “Innovation and Business Strategy: Why Canada Falls Short,” International Productivity Monitor, No. 18 (Spring 2009): 51–71. Available at: http://www.csls.ca/ipm/18/IPM-18-Nicholson.pdf. Using a growth-accounting framework, Baldwin and Gu show that multi-factor productivity (MFP) is the main culprit in Canada’s lagging productivity performance. They note that two sectors in particular – mining and oil and gas extraction and manufacturing – account for much of the slowdown in MFP growth in this decade. See J. Baldwin and W. Gu, “Productivity Performance in Canada 1961–2008: An Update of Long-term Trends,” Statistics Canada, 2009. D. Leung, C. Meh, and Y. Terajima, “Productivity in Canada: Does Firm Size Matter?” Bank of Canada Review, Autumn 2008. Available at: http://www.bankofcanada.ca/en/review/rev_autumn2008.html. OECD, Economic Policy Reforms: Going for Growth, 2010. See The Budget Plan, Department of Finance, Canada 2010. These core framework policies can be supplemented by measures to foster innovation and commercialization, investments in strategic infrastructure, and incentives for scale. Finally, it is vitally important that current global financial sector reform efforts yield a stable and efficient financial system that channels the capital necessary for long-run growth. In general, while there is always more to do, governments have put in place conditions for a productivity revival. Business, thus far, has disappointed. In fact, productivity growth fell in the latest recession, the first time this has happened in three decades. Looking forward, despite the availability of capital, relatively strong balance sheets and improving economic conditions, corporate Canada does not appear ready to invest. Investment intentions for 2010 remain modest and largely driven by the public sector. This appears unwise. The coming global winter? There could be tough times ahead. Canadian grasshoppers, perhaps basking in the historically easy access to the U.S. market and the relative abundance of resource opportunities, could be in danger of wasting their days in the sun and finding themselves unprepared for the winter to come. Canada’s productivity challenge is made more pressing by an international economic landscape that is changing dramatically. A powerful and sustained restructuring of the global economy has begun. The pace and volatility of global growth are likely to be quite different than during the so-called “Great Moderation” earlier this decade. The considerable uncertainty about medium-term global prospects will require concerted, co-operative measures to moderate. The second imperative: the G-20 framework Policy-makers must work to ensure that business can operate, as much as possible, in an open and stable global economy. At a minimum, this means living up to the G-20 commitment to resist trade and financial protectionism. More proactively, it means substantial reforms to build a more resilient, open, global financial system. Ultimately, as I will discuss in a moment, securing strong, sustainable, and balanced global growth will also require changes in behaviour and policy adjustments on several fronts. While the recent financial crisis had many causes, its intensity and scope reflected unprecedented disequilibria. Large and unsustainable current account imbalances across major economic areas were integral to the buildup of vulnerabilities in many asset markets. In recent years, the international monetary system failed to promote timely and orderly economic adjustment. 14 Further postponing adjustment will only serve to increase vulnerabilities. In the past, the frustration of adjustment by current account surplus countries generated deflationary pressures in the rest of the world. Similarly, today, the adjustment burden is being shifted to others. Some advanced countries – including Canada – have recently seen sizable appreciations of their currencies. Their ability to increase domestic demand in response is limited. This failure has ample precedents. Over the past century, different international monetary regimes have struggled to adjust to structural changes, including the integration of emerging economies into the global economy. In all cases, systemic countries failed to adapt domestic policies in a manner consistent with the monetary system of the day. As a result, adjustment was delayed, vulnerabilities grew, and the reckoning, when it came, was disruptive for all. The net result could be a suboptimal global recovery, in which the adjustment burden in those countries with large imbalances falls largely on domestic prices and wages, rather than on nominal exchange rates. History suggests that this process either could take years, repressing global output and welfare in the interim or lead to another crisis, which would accelerate adjustment, but at a terrible cost. The G-20 framework could address this issue The G-20 framework to promote strong, sustainable, and balanced growth in global demand, launched last November in St. Andrews, Scotland, is an attempt to learn these lessons from history. The G-20 framework stresses the shared responsibility of countries for global economic performance. Under the framework, members have agreed to a mutual assessment of their monetary, exchange rate, fiscal, and financial policies, with the assistance of the International Monetary Fund (IMF). The implications of these policies for the level and pattern of global growth and the risks to financial stability will be reviewed by finance ministers and central bank governors in preparation for agreement on any common actions by G-20 leaders in Canada and South Korea this year. To illustrate what is at stake, the Bank of Canada has generated three scenarios for the evolution of global growth and current account positions. 15 The first is a business-as-usual scenario (Chart 3). No significant changes are made to the current mix of policies, which creates a situation similar to the one that led to the recent crisis. In particular, advanced countries do not make the fiscal adjustments necessary to stabilize their debt dynamics, and their household savings rates do not increase. 16 As well, emerging Asia continues to finance the U.S. deficit through reserve accumulation, effectively impeding real exchange rate adjustment. In the short run, this combination of policies provides a fiscal boost, but it does not last. In response to the rising public debt burden, global interest rates begin to rise, crowding out private investment and ultimately lowering potential growth. This, in turn, further worsens the fiscal situation. Global economic growth falls steadily and, by 2013, it is only 2.7 per cent (compared with the 4 per cent average rate during the Great Moderation of 2002–07). More alarmingly, global imbalances reassert at an explosive rate. Paths for public and external debt are unsustainable and could lead to another crisis. An obvious lesson to draw from this scenario is that advanced countries need to engage in fiscal consolidation over the medium term. Indeed, that is the express policy of all industrialised countries. But would that alone be sufficient to rebalance the global economy? Consider a second scenario in which there is fiscal consolidation in advanced countries such that debt-to-GDP stabilizes by 2015 (Chart 4). 17 Other countries maintain current policies. In particular, there is neither a real effective exchange rate adjustment nor an increase in the trend of domestic demand growth in Asia’s emerging economies. Note that these scenarios are purely illustrative and do not represent the Bank’s base-case projection. They were generated using BoC-GEM-FIN, the Bank’s global general-equilibrium macro model. See K. Beaton, C. de Resende, R. Lalonde, and S. Snudden, “Prospects for Global Current Account Rebalancing,” Bank of Canada Discussion Paper, forthcoming in 2010. Countries do not make the necessary fiscal adjustments to stabilize their debt dynamics. There is no stabilization in debt-to-GDP ratios by 2015. In the “framework” scenario, debt/GDP in the United States stabilizes around 75 per cent of GDP. In this “do nothing” scenario, U.S. debt/GDP would reach about 95 per cent of GDP by 2015. At 120 per cent for the United States, 130 per cent for Euro area. In this scenario, there is deficient demand globally. With monetary policy constrained by the zero lower bound, deflation emerges. As a consequence, real interest rates increase sharply, growth stalls, and fiscal consolidation becomes more difficult. It is cold comfort that global imbalances are effectively eliminated. The cost is a prolonged global recession, with massive foregone output. If this scenario were to occur, the risk of protectionism would undoubtedly rise, potentially exacerbating the damage. Finally, consider a “framework scenario,” one that highlights the large gains that the G-20 process could – and should – produce (Chart 5). In this case, the fiscal consolidation of the second scenario is complemented by policies to increase domestic demand in emerging Asia and a modest real effective depreciation of the U.S. dollar (across all major currencies). In this case, current account imbalances stabilize at low levels and, more importantly, global growth rises to 3.7 per cent in 2010 and 4.5 per cent in 2011. Growth is strong, sustainable, and balanced. There is no doubt we would all be much better off with the last scenario (Table 1). By 2015, the difference in the level of global GDP between the deflation and framework scenarios is about 12 per cent (Chart 6). 18 For Canada, the difference would be 10 per cent of Canadian GDP. 19 The morality of global imbalances If the gains to rebalancing are so considerable, why isn’t it assured that countries will take the necessary steps? There are two issues: misdiagnosis and coordination. Regarding the former, some view global imbalances, not as a missed opportunity but, rather, a modern morality tale. To them, deficit countries are the profligate grasshoppers whiling away their hours in the sun, while the surplus countries are ants prudently husbanding resources in anticipation of winter. The problem with this diagnosis is that it ignores the symbiotic nature of the global economy. Excess savings in some countries go hand-in-hand with excess dissavings in others. Taken to the extreme, the husbanding of resources makes the economic winter more likely. The thrift of the Swabian housewife or the obsessive self-insurance of the emerging giants is globally debilitating and self-defeating. Hegel’s observation that all societies die from the morbid intensification of their own first principles comes to mind. The drivers of domestic demand cannot be concentrated in the same countries forever. As the Managing Director of the IMF has suggested, not all countries can simultaneously export their way to growth. 20 The framework process does not appeal to a country’s altruism. As shown in Table 1, the framework scenario is pareto improving – every region is better off under it. The second issue is coordination. To stimulate private domestic demand, surplus countries could enhance their social safety nets, reform financial systems to liberate trapped savings from small and medium-sized enterprises, and sharpen relative price signals (in part through greater exchange rate flexibility). While it is in their own interests to implement these policies, Or a total of $7 trillion. According to the Bank’s rough calculations, the cumulative U.S.-dollar purchasing-power-parity income per citizen would increase by about US$3,000 by 2015. Five years later, in 2020, it would be about US$11,700. Dominique Strauss-Kahn, as cited in C. Giles, “IMF warning over reliance on exports,” Financial Times, 30 January 2010. surplus countries could be further encouraged by industrialised countries implementing the necessary complementary measures. In particular, industrialised countries must develop credible medium-term plans for fiscal consolidation and implement them once the recovery is firmly entrenched. Moreover, it is essential that industrialised countries, particularly those at the epicentre of the financial crisis, implement a series of financial reforms to increase the resilience of the global financial system. This means more and better bank capital, improved market infrastructure for derivatives and funding markets, and a series of initiatives to end “too-big-to-fail.” 21 It will not be enough to propose. Measures must also be credibly implemented. That is why the peer review process of the Financial Stability Board (FSB) and external reviews by the IMF are so important. Through these processes, financial reforms could increase actual and perceived systemic stability and thereby encourage mutually supportive policies in surplus countries. Finally, all countries will need to maintain their commitment to price stability. I will now turn to this issue in Canada before concluding. Update on the inflation outlook The global economy has evolved largely as expected. Strong growth in many emergingmarket economies has been accompanied by positive though uneven growth in most advanced countries. Although the level of economic activity is now somewhat higher than projected, the outlook for inflation and economic growth in the global economy over the near term remains essentially unchanged, with exceptional monetary and fiscal stimulus continuing to provide important support in many countries. Economic activity in Canada has surprised slightly on the upside in recent weeks relative to the projection in our January Monetary Policy Report. Growth has been driven mainly by domestic demand, but exports have also recovered further in response to improving external demand. Significant policy stimulus, combined with increased confidence, improved financial conditions, and higher terms of trade, are the main factors supporting growth in Canada’s domestic demand. At the same time, the persistent strength of the Canadian dollar and the low absolute level of U.S. demand in certain key sectors, such as autos and housing, will continue to act as significant drags on economic activity in Canada. Core inflation has been slightly firmer than projected, the result of both transitory factors and the higher level of economic activity. The outlook for inflation should continue to reflect the combined influences of stronger domestic demand, slowing wage growth, and overall excess supply. At its 2 March 2010 decision, the Bank reconfirmed that the target overnight rate can be expected to remain at its current level until the end of the second quarter of 2010 in order to achieve the inflation target. This commitment is expressly conditional on the outlook for inflation, which will be updated in the Bank’s next Monetary Policy Report, to be published on 22 April. For a more detailed discussion, see M. Carney, “Reforming the Global Financial System.” Speech to the Autorité des marchés financiers, Montréal, Québec, 26 October 2009. Conclusion In conclusion, the twin challenges of boosting Canadian productivity and of implementing the G-20 framework globally are daunting. But the gains are considerable. Now is not the time to rest on our laurels or to take an open global economy for granted. The Bank is committed to tackling these important issues. We have a broad research agenda on productivity. We are working with our domestic and international partners to reform the global financial system. We are active participants in G-20 framework discussions, not merely because they offer the best outcome for the global economy but also because they are in Canada’s interests. Finally, and most fundamentally, the Bank has an unwavering commitment to price stability. The single, most direct contribution that monetary policy can make to sound economic performance is to provide Canadians with confidence that their money will retain its purchasing power. That means keeping inflation low, stable, and predictable. Price stability lowers uncertainty, minimizes the costs of inflation, reduces the cost of capital, and creates an environment in which households and firms can invest and plan for the future.
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Remarks by Mr Paul Jenkins, Senior Deputy Governor of the Bank of Canada, to the Economic Club of Canada, Toronto, 29 March 2010.
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Paul Jenkins: Beyond recovery – sustaining economic growth Remarks by Mr Paul Jenkins, Senior Deputy Governor of the Bank of Canada, to the Economic Club of Canada, Toronto, 29 March 2010. * * * Good afternoon. It is a pleasure to be here. John Maynard Keynes said the objective of “analysis is … to provide ourselves with an organized and orderly method of thinking out particular problems .… This is the nature of economic thinking.” 1 This is very much the tradition of the Economic Club of Canada, which offers an important forum for analysis and discussion of economic issues, certainly those we have had to address since the onset of the global financial crisis. The Bank of Canada has offered its analysis and perspective on these issues, especially global and domestic developments, the policy actions needed to address the situation, and how best to position the Canadian economy to the benefit of all Canadians over the medium-to-longer term. In the wake of the global financial crisis and the “Great Recession”, economic recovery is under way, supported by exceptional monetary and fiscal stimulus. In many countries, however, large output gaps remain and, given the need to repair the balance sheets of households and financial institutions in these countries, the return to full resource utilization will be protracted. What I’d like to discuss today is the economic environment beyond recovery. I’ll set the stage by discussing, in general terms, the kind of global economic landscape we’re likely to see five to ten years ahead. Then I’ll look at several important areas of public policy that will help to shape that outcome and promote sustained economic growth. Finally, I’ll focus on some of the challenges and opportunities that a significantly different global economic landscape will pose for Canadian business. A changing global economic landscape The global economic landscape will change considerably over the coming decade. To get a sense of what it may look like, it’s useful to consider both the developments that are required for global economic growth to be sustained, and the likely impact of the powerful trends that have been shaping, and will continue to shape, the world economy. It is clear that, as a nation, Americans need to save more and rebuild household sector wealth. For too long, the U.S. economy has been consuming more than it has been producing. This means that, in the future, more U.S. economic growth must come from net exports – a combination of higher exports and lower imports. Consumer demand will be a relatively less important source of growth. China, on the other hand, will need to rely more on domestic demand as the engine of growth. This rotation of global demand is needed as part of the solution to the global (current account) imbalances that were a significant part of the genesis of the financial crisis. Without this rotation of demand, resources will not be fully utilized, and global economic growth will be neither as strong, nor as sustained, as it could be. In addition to these requirements, powerful forces are changing the economic landscape. One is the difference in the growth rates of potential output (the rate of growth that can be J. M. Keynes, The General Theory of Unemployment, Interest, and Money (London: Macmillan / St Martin’s Press, 1936; reprinted 1970), p. 297. sustained over time without inflationary or deflationary consequences) that we are likely to see over the next five to ten years. For the major industrial economies, that rate of growth of potential output is estimated to be between 2 and 2 1/2 per cent. For the major emergingmarket economies, the rate is estimated at between 5 and 8 per cent. 2 Much of this difference can be attributed to the fact that emerging-market economies have “catching up” to do – by combining labour and more intensive use of capital in production – and to the fact that they have a large and growing pool of labour to draw upon. This rotation of demand and the differing rates of growth of potential output will have significant implications for trading patterns and investment flows. While it’s not possible to be precise, and it depends on whether one uses market or purchasing-power-parity exchange rates, major emerging-market economies will likely account for over 55 per cent of global output by 2020, compared with about 45 per cent today. 3 To be sure, there are many variables and uncertainties at play that will affect how the global economic landscape will look ten years out. Some refer to these uncertainties as the “known unknowns”. But, one thing seems clear – the economic landscape ten years from now will be significantly different from that of today. An important task for public policy will be to shape that outcome – remove some of the unknowns – for the benefit of everyone. On the heels of the global financial crisis and the Great Recession, one element of that task is to restore trust in markets, particularly financial markets. Trust is needed if financial markets are to price assets correctly and allocate capital efficiently. More broadly, a price-based system remains the most efficient way to allocate resources and generate growth that is led by the private sector. The reality is that for sustained growth to take hold, private sector demand must become the primary source of that growth. Public policy has an important role to play in supporting such an outcome by establishing coherent medium-term policy frameworks that will guide expectations and reduce uncertainty. The role of public policy I’d like to discuss three areas of public policy that will contribute to this goal. Let me start with financial sector reform. A stable, efficient financial system is a cornerstone of a healthy and dynamic economy. Policy-makers are currently at an important stage in multilateral discussions about fundamental reform of the financial sector. The core of the G-20 reform proposals is aimed at: increasing the amount and quality of bank capital; introducing complementary leverage caps; increasing levels of liquidity; mitigating procyclicality; improving over-the-counter derivatives markets; and developing internationally consistent contingency and resolution plans for systemically important institutions. Within the G-20, these economies include Brazil, China, India, Indonesia, Mexico, and Russia. Taking a longer perspective, in two decades the emerging-market economies will account for about two thirds of global output, compared with about one third in the mid-1980s. This is important work. The objective is to make the financial sector more resilient through better and more effective regulation – not more burdensome regulation. The second area of public policy receiving attention is fiscal consolidation. While the recession made it necessary for governments to step in and provide considerable economic stimulus to offset a decline in private spending, sustained growth requires that this stimulus be removed as private spending gains strength. Another way to think about this is that the savings being generated in economies need to be funnelled back for use by the private sector. The IMF estimates that “government debt for advanced G-20 countries [will] reach 118 per cent of GDP on average by 2014”, compared with a pre-crisis level of about 78 per cent. 4 For 2010, the combined fiscal deficits of these countries is estimated at nearly 9 per cent of GDP. One important factor will be clear guidance from governments about the means and the timing of fiscal consolidation. Given the size of the deficits, tough choices will need to be made. Clear communication in this regard can help to manage market expectations and reduce uncertainty. The third area of public policy concerns the openness of markets. One lesson not to be drawn from the global financial crisis is to impose controls on the movement of goods, services, capital, and labour. Protectionism and controls are detrimental to everyone. As a trading nation, we understand that. The focus must be on opening markets and removing barriers to trade and capital flows so that all can participate in the changing global landscape. This focus is equally important for our internal markets. A renewed push is needed to remove barriers to internal trade in Canada. The goal is to have the most efficient allocation of resources possible to enable us to capitalize on the opportunities of a new global economic order. Let me conclude this section with a few additional thoughts on what this changing global landscape means for the major emerging-market countries. These countries have achieved considerable successes in recent years. They responded in a forceful and timely manner to the financial crisis, and they have been the strongest-growing regions in the global economy. Building on these successes, these countries should have the confidence to allow market parameters to play a more active role in their economies. Doing so would include greater exchange rate flexibility to allow relative price signals to contribute to rebalancing and sustaining global economic growth, thus strengthening the global trading and international monetary systems. Indeed, another thrust of the G-20 process is mutual recognition of the need for a collaborative effort with regard to policy actions on those fronts I have just been discussing – financial, fiscal, openness of markets, and exchange rate – to the benefit of all. Let me turn now to the private sector in Canada, and discuss some of the implications of the changing economic landscape for business here at home. Implications for Canadian business What will the new global landscape mean for Canadian business? I said earlier that, going forward, private sector demand must replace public support as the engine that drives sustained economic growth. This transition implies change for business, but, most importantly, beyond the transition, the new international economic order will bring many opportunities. To take full advantage of them, business will need an appetite for change. Significant restructuring is already occurring in many sectors. The forest products sector continues to go through a difficult adjustment. In Ontario, we are all well aware of the See “The State of Public Finances Cross-Country Fiscal Monitor: November 2009”. IMF Staff Position Note, 3 November 2009, SPN/09/25, pp 13–15. challenges facing the automotive sector. More generally, Canada’s export sector has had to adapt to a strong Canadian dollar, intense competition from emerging-market economies, and the shift in the relative weight in global demand from advanced economies to emergingmarket economies. Herein lies one of the most important issues facing Canadian business – how best to deal with the opportunities and challenges posed by the dynamic emergingmarket economies. The strong demand in these countries for materials, finished products, and services – ranging from legal to financial to educational services – presents tremendous opportunities for Canadian business. And these possibilities offer additional opportunities – including those of developing innovative products and services, working with new partners, and optimizing the mix of global and domestic activities. In other words, the opportunities will be substantial, and they come on a two-way street, with benefits for everyone. But taking advantage of them will require a willingness to actively engage with these new markets. Make no mistake. To recognize the potential growth of these markets is to recognize the rising purchasing power of these countries and their citizens. Encouragingly, many Canadian companies are acting now and are entering markets in emerging economies with strategic, long-term initiatives. A common thread of these initiatives is that they are taking advantage of Canada’s comparative advantages, which include a stable financial system, reliable infrastructure, plentiful natural resources, and an educated, multilingual workforce. Of course, with this opportunity comes a broad set of challenges – challenges that apply to all facets of Canadian business. These include acquiring, developing, and retaining the right people, applying technology to enhance research, operational work, and the management of value chains, addressing environmental issues, and recognizing and dealing with increased global interdependencies. At the risk of oversimplifying, a critical element in dealing with both these opportunities and challenges is investment in modern, productivity-enhancing equipment and structures. Our track record in this regard has not been impressive, even adjusting for the cyclical factors and uncertainties of the past two and a half years. Compared with previous decades, productivity growth has weakened substantially in the past ten years. This poor performance appears to be at least partly attributable to insufficient “capital deepening” – that is, the amount of capital with which workers are equipped. Another part of the problem appears to be that capital investment is not always well integrated into the workplace. 5 Let me expand on this last point. I’m referring here to what we call multifactor productivity. You have a computer on your desk, and the question is: Are you making full use of what that technology can do for you? Are you integrating that investment to full benefit in terms of organizational practices and producing end products? We ask ourselves these questions at the Bank of Canada, whether they relate to investments in our analytic computing capability or the handling of bank notes. They are the right questions to ask. With our trading partners, including the United States, continuing to invest and make strong gains in productivity growth, it is all the more imperative that firms in Canada make concerted efforts to boost productivity. And from one perspective, they are well equipped to do so. One possible explanation for this poor productivity performance lies in the shifts in capital and labour that have occurred in Canada in recent years as a result of changes in relative prices, notably, during periods of commodity-price shocks and periods of structural adjustment. For further details on Canada’s productivity challenge, see M. Carney, “The Virtue of Productivity in a Wicked World”, remarks delivered to the Ottawa Economics Association, Ottawa, 24 March 2010; and T. Lane, “The Canadian Economy Beyond the Recession”, remarks delivered to the Canadian Association for Business Economics, Kingston, Ontario, 25 August 2009. Corporate balance sheets in Canada are healthy. Profitability is good, with the ratio of profits to GDP back to its long-term average of 10 per cent. Leverage – i.e., debt-to-equity – ratios are low and liquidity levels are high. Corporate tax rates have declined. Absolute borrowing costs are low. And while the non-price terms for borrowing have been a restraining factor, our Senior Loan Officer Survey indicates that these terms are beginning to ease as the recovery takes hold. From this perspective, then, there should be little holding corporations back from modernizing their capital stock. But there’s an additional perspective, and that is the extent to which firms can access funds for making productivity-enhancing investments. The role of the financial sector is to channel savings to the real economy. Given the importance of small and medium-sized enterprises in Canada, it is critical that this sector invest in productivity-enhancing improvements. Compared with similar-sized firms in the United States, these Canadian firms rely more on individuals for financing and less on financial institutions. 6 This, to me, suggests a market opportunity for our financial institutions. As well, additional sources of higher-risk capital are needed for Canada to be successful in modernizing the economy’s productive capacity through innovation and new technology. For our part, the Bank of Canada, together with financial market participants, is helping by working to make our financial system more robust through continuously open commercial paper, interbank, and repo markets, and through stronger infrastructure arrangements. 7 These initiatives provide greater efficiency in the allocation of financial capital, which benefits all sectors of the economy. Allow me to conclude. Conclusion The world is emerging from the most serious economic dislocation since the Great Depression. While the global economy is on a steadier footing, the pace of change will not slow down. Indeed, five to ten years from now, the global economic landscape will be greatly altered. Public policy has recently played an important role in helping the economy to heal. It must also play an important role in ensuring that the conditions are in place for sustained and balanced growth over the coming decade. That includes public policies that focus on creating an attractive and certain economic environment, an environment that promotes investment and innovation. Progress is being made internationally to meet the major policy challenges of our time – but work must continue until the job is done. Domestically, our frameworks for macroeconomic and regulatory policy served Canadians very well through the financial crisis, and have positioned us to move forward. But we have more work to do here at home – to further open internal markets and to strengthen our ability to address systemic risks to the financial sector that can arise from the collective actions of institutions and market participants. For Canadian business, a rapidly changing economic landscape presents new possibilities and hurdles – chief among them, seizing the opportunities presented by emerging-market economies, and stepping up to the challenge of improving our productivity record. This should be one of the next waves of economic progress in Canada. The Bank of Canada will do its part by contributing to sustained, solid economic performance by providing Canadians with confidence in the future value of money. An environment of See D. Leung, C. Meh, and Y. Terajima, “Are There Canada-U.S. Differences in SME Financing?” Bank of Canada Working Paper No. 2008–41. For related comments, see, for example, M. Carney, “Principles for Interesting Times”, remarks delivered to Carleton University, Ottawa, 11 March 2010; and M. Carney, “What Are Banks Really For”, remarks delivered to the University of Alberta School of Business, Edmonton, 30 March 2009. stable prices lowers uncertainty, reduces the cost of capital, and enables Canadians to plan for the future with greater confidence. I’d be happy now to respond to comments or questions.
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Opening statement by Mr Mark Carney, Governor of the Bank of Canada, at the press conference following the release of the Monetary Policy Report, Ottawa, 22 April 2010.
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Mark Carney: Summary of the latest Monetary Policy Report Opening statement by Mr Mark Carney, Governor of the Bank of Canada, at the press conference following the release of the Monetary Policy Report, Ottawa, 22 April 2010. * * * Good Morning. I am pleased to be here with you today to discuss the April Monetary Policy Report, which the Bank published this morning. Global economic growth has been somewhat stronger than projected, with momentum in emerging-market economies increasing noticeably and moderate recovery underway in most advanced economies. Global growth is now projected to average slightly above 4 per cent a year through 2012. In Canada, the economic recovery is proceeding somewhat more rapidly than expected in January. It is supported by continued fiscal and monetary stimulus, improved financial conditions, the rebound in global economic growth, more favourable terms of trade, and increased business and household confidence. This year should mark the turning point when the private sector takes over from the public sector as the primary source of growth. GDP is now projected to grow by 3.7 per cent in 2010 before slowing gradually to 3.1 per cent in 2011 and 1.9 per cent in 2012. This profile reflects stronger near-term global growth, very strong housing activity in Canada, and the Bank’s assessment that policy stimulus resulted in more expenditures being brought forward in late 2009 and early 2010 than expected. At the same time, the persistent strength of the Canadian dollar, Canada’s poor relative productivity performance, and the low absolute level of U.S. demand will continue to act as significant drags on economic activity in Canada. The Bank estimates that GDP in the first quarter of 2010 was about 1 per cent below its peak in the third quarter of 2008 and some 2 per cent below its potential. The economy is expected to return to full capacity in the second quarter of 2011, one quarter earlier than projected in January. The outlook for inflation reflects the combined influences of stronger domestic demand, slowing wage growth, and overall excess supply. Core inflation, which has been somewhat firmer than projected in January, is expected to ease slightly in the second quarter of 2010 as the effect of temporary factors dissipates, and to remain near 2 per cent throughout the rest of the projection period. Total CPI inflation is expected to be slightly higher than 2 per cent over the coming year, before returning to the target in the second half of 2011. Despite the firming of the global and Canadian recoveries, there are considerable risks around the Bank’s outlook. There are two main upside risks to inflation. It is possible that the momentum in household expenditures and residential investment could be greater than currently expected. Internationally, a faster-than-expected global recovery could stimulate external demand for Canadian exports and improve the terms of trade. On the downside, the global economic recovery could be more protracted than currently projected. A second downside risk is that the combination of the persistent strength of the Canadian dollar and Canada’s poor relative productivity performance could exert a larger-than-expected drag on growth and put additional downward pressure on inflation. In response to the sharp, synchronous global recession, the Bank lowered its target rate rapidly over the course of 2008 and early 2009 to its lowest possible level. In addition, in April 2009, the Bank committed to hold it at that level, conditional on the outlook for inflation. This unconventional policy provided considerable additional stimulus during a period of very weak economic conditions and major downside risks to the global and Canadian economies. With recent improvements in the economic outlook, the need for such extraordinary policy is now passing, and it is appropriate to begin to lessen the degree of monetary stimulus. That is why on Tuesday, 20 April 2010, the Bank removed its conditional commitment. The extent and timing of any additional withdrawal of monetary stimulus will depend on the outlook for economic activity and inflation, and will be consistent with achieving the 2 per cent inflation target. With that, I would be pleased to take your questions.
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Remarks by Mr John Murray, Deputy Governor of the Bank of Canada, at the University of Alberta Institute for Public Economics and C.D. Howe Institute, Edmonton, Alberta, 6 May 2010.
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John Murray: Is there a commodity curse? Lessons from the past Remarks by Mr John Murray, Deputy Governor of the Bank of Canada, at the University of Alberta Institute for Public Economics and C.D. Howe Institute, Edmonton, Alberta, 6 May 2010. * * * Good evening. Thank you for inviting me to this significant and topical event. It’s fitting that this conference is dedicated to Bradford Reid. He will be missed by so many former students and colleagues: as a friend, a dedicated teacher, and an insightful researcher. His particular research interests included fiscal policy and public-debt management, and their implications for the macroeconomy. These would certainly fit well with our discussions here today and tomorrow. As the title of the conference suggests, we have seen many boom-and-bust cycles in the commodity sector. This raises one obvious and central question: How can we avoid them in the future? More specifically, how can Canada and Alberta get out of this seemingly endless cycle of feast or famine? The answer, regrettably, is that it isn’t possible to eliminate the cycle entirely. The best that we can hope to do is to dampen its effects by learning from past experience. History, it has been said, is a good teacher, but policy-makers are not always good students. Tonight, I’ll present a few thoughts on how we might make better use of these sometimes painful lessons. Alberta and Canada are different from the rest Canada’s economy is different from most other advanced economies. Primary commodities – resources – account for a much larger share of our national GDP. The estimated size of the sector varies according to how it is defined, but using a reasonably conservative approach, one finds that resource production represents about 10 per cent of Canada’s GDP, 5 per cent of total employment, and 45 per cent of export sales. 1 The share of resource production in U.S. GDP, by comparison, is only 5 per cent. Canada is a large net exporter of raw materials, unlike the United States, which is a large net importer. In this respect, the United States is similar to most other advanced economies. Countries such as Canada, Australia, and Norway, on the other hand, are the exceptions. Statistics Canada. Alberta is also different when compared with most – but not all – of the nine other provinces in Canada. In 2006, the last year for which Statistics Canada has comparable figures, resources accounted for roughly 32 per cent of Alberta’s GDP. This was lower than the figure for Newfoundland and Labrador (at 40 per cent) and only slightly higher than that for Saskatchewan (at 29 per cent.) But it was far above that of the other provinces. In British Columbia, for example, natural resources accounted for less than 10 per cent of GDP, while in Ontario – not surprisingly – it was barely 2 per cent. The bottom line, simply stated, is that Canada is different, and Alberta is more different still, from many of its counterparts. Special challenges of a commodity-based economy Canada’s natural resources are a tremendous gift. They have brought us enormous material benefits – higher incomes and greater economic security than in many other countries. Most other countries would gladly trade places with us, should we ever grow tired of our rich resource endowment. Indeed, there are probably several provinces that would gladly trade places with Alberta. This isn’t to say that being a commodity-based economy is problem free. In fact, this conference is largely about the problems or, more positively, the challenges that our dependence on commodities sometimes creates. Some economists have gone so far as to say that there is a “commodity curse.” 2 They suggest that rich resource endowments are actually inimical to economic development. Comparing the experiences of a large set of countries, they observe that commodity-based economies tend, on average, to have slightly lower growth rates, as well as lower income levels, than their resource-poor counterparts. Before you become overly concerned or take strong objection to this claim, I should add that the statistical relationship that I have just shown you is rather weak, and is dominated by the results for a large number of developing countries for which the conservatorship of their resources has proven to be more of a challenge. The evidence for advanced resourceproducing countries, such as Canada, is typically much more positive. Once again, we are the exception. The reasons that have been put forward by way of explaining the so-called commodity curse have both a political and an economic dimension. Researchers have found that many countries with rich resource endowments suffer from weak governance and a democratic deficit. The governments are often despotic, and the countries prone to armed conflict and civil unrest. Property rights aren’t respected, and institutional arrangements are weak. For a detailed survey, please see Jeffrey A. Frankel, “The Natural Resource Curse: A Survey.” Faculty Research Working Paper Series, Harvard Kennedy School, February 2010. This, obviously, is not an accurate characterization of countries like Canada, Australia, New Zealand, and Norway. Nevertheless, Canada and all other commodity-based countries are subject to serious economic challenges, linked primarily to the extreme volatility of commodity prices. The long and short of price volatility Some countries are large enough commodity producers (or consumers) that their actions can materially influence global commodity prices. Saudi Arabia might be an example. But these are certainly the exception. For the most part, commodity producers are price-takers. They sell a fairly homogeneous product in a highly competitive market, and their actions have little effect on the price that they receive. Unfortunately, for countries like Canada and provinces like Alberta, these prices are typically volatile, and highly uncertain. This volatility is caused, in large part, by the unusual nature of the short-run demand and supply curves associated with most commodity markets. The products that commodity-based economies sell typically have extremely low short-run demand elasticities (i.e., demand is not very responsive to price changes.) Supply is similarly inelastic, since it often takes time to bring new production online if prices suddenly rise, or to reduce production if prices suddenly drop. 3 Any move in either of these curves, therefore, is likely to lead to outsized changes in global prices. This erratic behaviour is evident in the movement of most commodity prices through time. Commodity prices are typically much more volatile than those of other goods or services – and one of the most volatile commodity prices of all is that of oil. This is bad news for energy producers, and clearly complicates the task of planning and investment. Oil and natural gas now account for the majority of Canada’s commodity production. Some commodities are also subject to frequent supply disruptions that accentuate price volatility. Another important feature worth noting is that the long-run demand and supply elasticities for most commodities are typically much higher. If commodity prices remain high, consumers find ways to economize on their use, or find substitute products. New supplies also gradually come online. All of these factors work to push prices lower. In this sense, there is a selfcorrecting mechanism at play. Indeed, over the very long run – and here, I am referring to decades – the average real price of most commodities has been surprisingly stable. 4 Economists refer to this as “mean reversion.” If we knew that this sawtooth pattern would Don Coletti, “The long-run behaviour of key Canadian non-energy commodity prices: 1900 to 1991.”Bank of Canada Review (Winter 1992–1993): 47–56. always be repeated – short-run spikes followed by an overshoot on the down side and an eventual return to the long-run mean – it would save a lot of unnecessary cost and disappointment. But hope springs eternal, and many of the price movements last just long enough to convince investors and governments that “this time it is different.” And there is always a chance that some day it will be different. In the intervening period, long-range investments may have been set in train, new facilities built, and workers relocated – all initiatives that have to be reversed once prices correct. This is not always a problem, however. If prices stay high (or low) for a sufficiently long time, these reallocations of capital and labour could well be warranted and yield valuable returns, even if prices eventually revert to trend. The trouble is that businesses, households, and policy-makers often get caught out. They overreact and have difficulty engineering a smooth course correction once conditions change. The inherent difficulty associated with predicting how long a boom (or bust) might last, and how high (or low) prices might go, makes the process extremely risky. Critics worry that a commodity-based economy will constantly find itself in motion, never quite settling down. When this constant churning is combined with volatile price changes, the ongoing costs and probability of a significant miscalculation can be high. The policy-maker’s Hippocratic Oath: first, do no harm One of the most important things that policy-makers can do is to avoid making the situation worse. Helpful lessons can be learned in this regard, by looking at Canada’s experience during the 1970s. Although every boom and bust is in some way unique, there is sufficient commonality across commodity cycles that this period is still instructive. Fiscal authorities in the 1970s assumed that the commodity boom would last forever, or at least for a very long time. They believed that the elevated revenues that they were suddenly receiving in the form of higher royalties and tax receipts would continue to grow. New, ambitious government programs were launched, which exacerbated the dramatic economic upturn that was already in progress, and nothing was saved for a rainy day. Monetary authorities at the time didn’t have the benefit of a policy framework anchored on an explicit inflation target. They also underestimated the effect that the run-up in commodity prices would have on demand conditions, and compounded the errors by overestimating the supply potential of the economy. More specifically, they failed to appreciate the serious negative effects that higher commodity prices – principally, energy prices – would have on the economy’s production capacity. The generalized price increases that were subsequently observed across the economy were at first dismissed as one-off effects that would soon pass out of the inflation numbers. The exchange rate appreciation that was triggered by the improvement in Canada’s terms of trade over this period, and that would have helped contain inflationary pressures, was actively resisted for fear of what it might do to other sectors of the economy and employment. The result, when commodity prices subsequently collapsed, was a continuing spiral of rising government deficits and double-digit inflation, both of which took many years to resolve. The ultimate cost in terms of lost output and employment was enormous. What can policy-makers do to improve the situation? Now, let me turn from Canada’s experiences in the 1970s to some of the broader policy lessons that can be drawn. Policy-makers can learn from past mistakes and help to ensure better outcomes in three important ways. First, fiscal authorities should avoid behaving in a procyclical manner, exaggerating the boom with aggressive increases in spending and stimulative tax reductions. Additional infrastructure may be needed to support private investment in certain areas, but by strengthening their fiscal positions in good times, governments can help to relieve inflationary pressures and smooth consumption. This is the motivation for Alberta’s Sustainability Fund and the Heritage Savings Trust Fund. Fiscal strengthening can also help to relieve upward pressure on the exchange rate. The second way in which authorities can help is by maintaining a disciplined monetary policy. Monetary authorities must stay focused on their primary mission of preserving price stability, helping businesses and households to see through the cycle and promoting better decision making by keeping inflation low, stable, and predictable. This is what Canada’s monetary policy framework now provides: greater focus, greater accountability, and greater discipline. The two key elements of our current framework are (i) an explicit monetary policy goal – the 2 per cent target for inflation – and (ii) a flexible exchange rate. Canada’s flexible exchange rate gives the Bank of Canada the monetary policy independence that is required to successfully pursue and attain its inflation objective. The flexible exchange rate also serves as an automatic buffer, helping to cushion the economy and dissipate the effects of the commodity shock. Trying to resist these exchange rate movements typically imposes even greater costs on the economy, since the underlying pressures don’t disappear, they simply manifest themselves in other ways. These take the form of much higher wages and domestic prices in the case of a commodity price boom and, ultimately, lower employment and output. Necessary adjustment is delayed, and leads to a more exaggerated cycle in the overall economy. Another important lesson that has been learned relates to the production capacity of the economy. The Bank of Canada is now more sensitive to the negative supply effects that are associated with large relative price movements and the economic restructuring that follows, adjusting its estimates of potential output appropriately to avoid inadvertently overstimulating the economy. The third and final way that governments can help the economy to cope with commodity cycles is through structural reform. In normal times, the Canadian economy generally performs quite well, but it is still subject to unhelpful frictions and barriers. These affect the resilience of the economy and its ability to weather shocks, making it difficult to reallocate resources in a flexible, efficient manner. Canada has made good progress over the past three decades in allowing goods and services to move more easily. Further efforts to reduce interprovincial trade barriers would be welcome, for instance, extending the excellent Trade, Investment and Labour Mobility Agreement (TILMA) and the New West Partnership initiatives. Governments, of course, are not the only ones responsible for ensuring a well-functioning economy. They are not even the most important players. That role rests with the private sector, which must take responsibility for its actions, looking through the boom-bust cycles and curbing any excessive exuberance or pessimism. How have we been doing lately? The past few years have been extraordinary in many ways and, if nothing else, have provided a useful check on whether the prescriptions that I have just described are being applied. A super-cycle in commodity prices, followed by the biggest financial crisis of the postwar period, represents a significant stress test. Fortunately, the preliminary results are encouraging. The 1970s and the 2000s differ in significant ways. The boom-bust experience in the 1970s was triggered by an unprecedented supply shock and exacerbated by overly stimulative fiscal and monetary policies. Interest rates had to be boosted to over 20 per cent in the early 1980s and combined with aggressive budget tightening in the early 1990s to bring the macroeconomy under control. In contrast, the boom portion of the commodity cycle from roughly 2006–2008 was the result of increased demand for commodities – much of it coming from Asia. It was also fuelled by excessive leverage and elevated asset prices in financial markets. Commodity prices collapsed when the asset bubble burst, and policy-makers had to move with unprecedented speed and co-operation to deal with the fallout. Unlike the situation in the 1970s, CPI inflation through the past five years has remained relatively stable, despite the size of the shocks that hit the economy during the recent global economic crisis. Inflation expectations also remained well anchored during the crisis and, as a result, the Bank of Canada was able to ease monetary policy aggressively without losing the confidence of private agents. The ultimate costs of the crisis in terms of unemployment and lost output, although serious and painful, were nevertheless smaller than many had feared. The Bank’s measure of core inflation, CPIX, proved to be an invaluable tool in this regard. CPIX strips away eight of the most volatile components – including several commodity prices – in the total consumer price index (CPI), giving the Bank, as well as businesses and households, a more reliable measure of how strong or weak underlying inflation pressures might be. The flexible exchange rate has also been allowed to do its job over this period. Although some of the short-term movements in the exchange rate may have been excessive, such as the run-up to US$1.10 in November 2007, on balance Canada’s flexible exchange rate has helped to cushion the economy on the way up and on the way down – an appreciation followed by a depreciation. Fiscal authorities at the federal and provincial levels also acted responsibly in the years preceding the “bust” of late 2008 and early 2009, taking some of the edge off the boom and leaving adequate fiscal headroom when extra stimulus was required. Encouraging steps, as noted earlier, have also been made with regard to structural reforms, although much more still needs to be done in this area. Where are commodity prices headed now? So, where might things be going now, as we look ahead? I’d like to end my presentation by saying a few words about the near-term behaviour of commodity prices and the projection that the Bank released two weeks ago as part of its April Monetary Policy Report. Before discussing our commodity price projections, I must admit that we regularly make use of some simplifying assumptions. Absent a more reliable guide, we typically base our projections for many commodities on the prices embedded in futures curves. 5 This is particularly true for oil and natural gas. We realize that these curves are not a very reliable forecasting tool. But we, and other forecasters, have yet to find a better alternative. The curves do provide a measure of what knowledgeable agents are expecting and are willing to R. Alquist, and I. Kilian. “What Do We Learn from the Price of Crude Oil Futures?” Journal of Applied Econometrics 25 (4). Forthcoming, June 2010. put their money on. Every institution and investor that tries to anticipate commodity price developments experiences similar challenges. Commodity prices, as noted earlier, are inherently volatile and difficult to predict. You might ask, then, what are the futures curves and the Bank projecting now? The Bank left its base-case projections for commodity prices in the April Report largely unchanged from what it had projected in the January Report. Oil and natural gas prices, as judged by the profiles of the futures curves for these commodities, are projected to rise quite modestly over the next three years, while non-energy prices are projected to increase by a cumulative 30 per cent. These increases are driven by the strengthening global recovery, most notably in China and other Asian emerging-market economies (EMEs.) Indeed, most of the upward pressure on commodity prices over the past 10 years has come from the EMEs. These economies are expected to keep growing, barring any unforeseen shock. Does this mean another commodity super-cycle? It is tempting to look at recent developments and extrapolate into the future. China and India alone account for more than 40 per cent of the world’s population. If these two economies continue to grow at annual rates of 8 to 10 per cent, as we have seen recently, they will soon overtake even the largest advanced economies, and their prospective demand for commodities could be enormous. Couple this with the fact that many of the world’s resources are non-renewable or are in limited supply, and you have a recipe for something that’s surely breathtaking. It’s enough to make us all Malthusians. Before we race to this conclusion, however, we need to remember the problems that have arisen in the past when we assumed that commodity prices would rise continuously, or at least would stabilize at a much higher level. It’s always tempting to think that the next commodity cycle will be different. Where have we heard that before? The scenario that I have just outlined is not implausible. That is what makes it so seductive. I can’t say definitely that commodity prices won’t rise to unprecedented levels, but if history is any guide, continuous rapid upward movement in real (inflation-adjusted) prices – oil or otherwise – is unlikely, as is a large permanent increase in the real price level. History suggests, therefore, that we should proceed with caution and, to use a rather corny commodity cliché, not count our chickens before they hatch. In closing, let me mention that tomorrow, we will be releasing a new Bank of Canada commodity price index (BCPI.) This is noteworthy because, as we’ve just discussed, the price of commodities in Canada has important implications for the economy, and the interpretation of developments in commodity markets is important to the conduct of monetary policy. Clearly, we need the most accurate measure of movements in overall commodity prices possible. This new BCPI, which incorporates a new methodology, will be more accurate, representative and flexible.
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Remarks by Mr Pierre Duguay, Deputy Governor of the Bank of Canada, to the Senate Committee on National Finance, Ottawa, Ontario, 26 May 2010.
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Pierre Duguay: The Bank of Canada’s perspective on the penny Remarks by Mr Pierre Duguay, Deputy Governor of the Bank of Canada, to the Senate Committee on National Finance, Ottawa, Ontario, 26 May 2010. * * * Good evening Mr. Chairman, honourable Senators. I’m pleased to have the opportunity to appear before you tonight to provide the Bank of Canada’s perspective on the penny. First, let me take a moment to explain the Bank’s role regarding Canada’s currency. We are responsible for supplying Canadians with bank notes that they can use with confidence. At year-end 2009, there were 1.8 billion bank notes in circulation, with a total value of $55.5 billion – approximately $1,630 per Canadian. The Bank of Canada is not responsible for coins. Decisions on coinage rest with the federal government, in particular, the Department of Finance, and with the Royal Canadian Mint. However, coins are an essential adjunct of bank notes to complete cash transactions. So, the Bank does have an interest in coins, and we welcome your review of the case for keeping or eliminating the penny. I would like to remind you that cash remains very important to Canadians, despite the popularity of alternative payment options. Surveys by the Bank of Canada have found that almost three-quarters of Canadians pay with cash at least once a week, compared with 64 per cent for debit cards and 36 per cent for credit cards. 1 These surveys show that cash is the preferred method of payment for purchases under $25. (Debit cards are preferred for purchases in the $25 to $100 range, and credit cards are preferred for purchases greater than $100.) The Bank’s interest in coins can also be viewed in the context of our responsibility for monetary policy, which is anchored in our commitment to achieve our 2 per cent target for inflation. Experience has shown that the best way for monetary policy to contribute to economic performance is by keeping inflation low, stable, and predictable. Therefore, the Bank views the possible elimination of the penny in terms of the potential impact on inflation, and has conducted some preliminary research on this issue. The findings, which have been made available to other researchers, show that any impact on inflation would be insignificant and more likely non-existent. A common concern is that retailers, who often post prices ending in 9 cents, may round prices up to an even number, absent the penny, and that this would be inflationary. This concern is unwarranted for a number of reasons. First, even if the elimination of the penny did result in a rounding up of prices to the nearest multiple of 5 cents, which is unlikely, that would be a one-time price increase and not a change in trend inflation. Second, this one-time price increase of one or two cents would be so small, relative to the prices of the items that make up the basket of goods and services priced by the total consumer price index (CPI) that it would not register on that index since the CPI is rounded to the nearest 0.1 per cent. Third, it is very unlikely that prices would be rounded up, since such rounding would not carry through to the cash register after sales taxes are applied, and retailers would lose the perceived marketing benefit of posting a price that ends in 9 cents. In the absence of a penny, rounding would only need come into play in cash transactions and would apply to the total bill after tax, and not to each individual item purchased. If applied symmetrically, Varya Taylor. “Trends in Retail Payments and Insights from Public Survey Results.” Bank of Canada Review. (Spring 2006): 25-36. rounding down of cash purchases ending in 1,2, 6, and 7 cents would offset the rounding up of those ending in 3,4 8, and 9 cents. In New Zealand, for example, the choice of rounding up or down on cash transactions was left to retailers after the country eliminated its one- and two-cent coins in 1989. Many larger retailers opted to round down; a few small retailers opted to round up. Ultimately, there was no noticeable effect on inflation in New Zealand. Indeed, that has been the international experience that we have seen. In both Australia and New Zealand, the elimination of small coins (one-cent and two-cent coins) has had no noticeable effect on inflation. Inflation, however, does have an influence on the value of the penny. Since the coin was first produced by the Royal Canadian Mint in 1908, the penny has lost 95 per cent of its purchasing power. In other words, the penny then had the same purchasing power as 20 cents would today. Indeed, in 1908, you could buy your daily newspaper for two cents, and a loaf of bread cost five cents. On that, I thank you for your invitation to appear here tonight, and welcome the opportunity to answer your questions related to the future of the penny.
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Remarks by Mr Mark Carney, Governor of the Bank of Canada, at the International Organization of Securities Commissions (IOSCO) meeting, Montreal, 10 June 2010.
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Mark Carney: The G-20’s core agenda to reduce systemic risk Remarks by Mr Mark Carney, Governor of the Bank of Canada, at the International Organization of Securities Commissions (IOSCO) meeting, Montreal, 10 June 2010. * * * Introduction It is a pleasure to be here at this important meeting. It comes at a critical time, as we all work to repair a global financial system that has failed our citizens. Given this failure, the G-20’s agenda to reshape the global financial system is comprehensive and radical. The coming weeks and months will be pivotal to its success. The time for debate and discussion is drawing to a close. Policymakers now need to decide and to implement. Recent tensions in Europe have underscored this urgency. Market volatility over the past couple of months has reflected both macroeconomic forces and heightened regulatory uncertainty. A flurry of tangential proposals has sown confusion about the focus and intent of regulatory reform. Could taxation and regulatory fiat really address Too-Big-to-Fail? Are markets part of the problem or part of the solution? This past weekend in Busan, South Korea, G-20 finance ministers and central bank governors refocused on the core reform agenda of capital, resolution, and market infrastructure. Later this month in Toronto, G-20 leaders can be expected to harden that resolve. Today, I would like to focus on the G-20’s core agenda, whose objective is to create a more resilient, global financial system. I will begin by discussing the nature of systemic risk and then move to the three principal strategies to mitigate it: increasing the resiliency of financial institutions; enhancing the robustness of financial markets; and reducing the interconnectedness between institutions and between institutions and markets. IOSCO is an important contributor to the G-20 process. We share a common purpose. Reducing systemic risk is at the heart of the IOSCO principles. Your ongoing efforts to enhance investor protection and market integrity will also serve to build a more resilient financial system. Systemic risk Systemic risk is the probability that the financial system will not function as needed to support economic activity. Mitigating systemic risk is challenging because it requires identifying the essential elements of a complex, modern financial system. What is essential changes as the system evolves. 1 In reducing some aspects of systemic risk, policy-makers will undoubtedly increase others. As a consequence, we will need to remain vigilant in the years that follow the initial burst of reform. O. de Bandt and P. Hartmann, “Systemic risks in banking,” in Financial Crisis, Contagion and the Lender of Last Resort, edited by C. Goodhart and G. Illing, (Oxford: Oxford University Press, 2002). (http://www.olivierdebandt.com/publications_en.html). A fully risk-proofed system is neither attainable nor desirable. The point is not to pile up so much capital in our institutions that they are never heard from again, either as a source of instability or of growth. The challenge is to get the balance between resiliency and efficiency right. The global financial crisis exposed the fallacy of composition that strong individual financial institutions collectively ensure the safety and soundness of the system as a whole. Even the most vigilant, microprudential regulatory regime can be overwhelmed by systemic risks. As a consequence, policy-makers now recognise that systemic risk is the product of the resiliency of financial institutions, the robustness of systemically-important markets; and the interconnectedness between institutions and markets. At its heart, the resilience of markets and institutions is a function of solvency and liquidity. 2 As evident in the recent crisis, uncertainty about the solvency of financial institutions causes markets to become illiquid, and illiquid markets can cause otherwise solvent institutions to become insolvent. However, while solvency and liquidity are related, the responsibility for each ultimately falls to different agents. 3 The risk of insolvency should, fundamentally, be a private concern, just as the return is appropriated by private agents. It is the job of regulation to ensure that is the case. On the other hand, liquidity is a social good, as it facilitates exchange between institutions. While individual institutions are responsible for managing their own liquidity to buffer idiosyncratic shocks, and liquidity should be endogenously created by private agents in most states of the world, the ultimate provider of liquidity to the financial system is the lender of last resort – the central bank. But the crisis has revealed that liquidity is not just a central bank’s responsibility. It is now clear that a robust financial system requires the co-operation of all financial regulatory bodies, since illiquidity can be triggered by the insolvency of a single institution, shoddy infrastructure, or poor transparency. The more successful policymakers are in ensuring that liquidity generation is robust, the more efficient we can be with respect to the amount of capital required to protect against that risk. Against this backdrop, the G-20’s priorities should become clearer. In particular, the G-20 is pursuing three main strategies to reduce systemic risk: improving the resiliency of financial institutions; enhancing the robustness of financial markets; and, reducing the interconnectedness between institutions and between institutions and markets. All are necessary, as the measures are mutually reinforcing. Allow me to expand. Improving the resiliency of financial institutions Creating more resilient institutions requires more and better capital, improved balance sheet liquidity, and enhanced risk management. The crisis clearly underscored the need to better For example, in mark-to-market accounting, illiquidity discounts can be quickly translated into accounting losses that can impair the reported capital position of a financial institution. J. Selody, “The Nature of Systemic Risk,” forthcoming, in Managing Risk in the Financial System, edited by J. R. LaBrosse, R, Olivares-Caminal and D. Singh. (Cheltenham: Edward Elgar, 2011). capture counterparty exposures, market risk, and a host of contingent claims. The so-called Basel III proposals address many of these issues. 4 The most important elements are to: Create global standards for liquidity of sufficient rigour to allow our financial firms to withstand future volatility in the global financial system. Raise substantially the quantity, quality, consistency, and transparency of the Tier 1 capital base. It is essential that this is true loss-bearing capital, which means that it must be predominantly tangible common equity. Introduce a leverage ratio as a complement to the Basel II risk-based framework. The leverage ratio should be simple to calculate and non-binding in normal states. In effect, it is a safety harness that is designed to protect against risks that regulators think are low but which, in fact, are not. Introduce a capital buffer above the minimum capital requirement in order to ensure that banks and supervisors take prompt corrective action before bank capital levels fall below the minimum. It would appear reasonable that this buffer should be large enough to absorb the losses of the last crisis. It could also vary over time so that it is at its maximum in periods when credit is growing rapidly and system-wide risks are rising, and reduced in times of stress to ensure that the flow of credit is not undermined by regulatory constraints. 5 While there will be some important innovations, in general, the final Basel III capital proposals will make the global system look more like Canada’s. The rigour of Canadian capital regulation was an important – although far from exclusive – reason why the Canadian system fared so well during the crisis. For the world as a whole, however, the changes will be substantial. Consequently, some are concerned that the implementation of these reforms could be damaging to the economic recovery. This apprehension is misplaced for several reasons. First, business models and behaviour will adjust to the new rules. For example, measures to increase the capital held against trading books will encourage redeployment of capital from trading towards conventional lending. Second, the transition timetable and grandfathering can be expected to be enlightened. The expressed intent of G-20 policy-makers is to get the measures right and then to phase them in as financial conditions improve and economic recovery is assured, with the aim of implementation by end-2012. We should not sacrifice our ambition for these measures to speed of implementation, nor the economic recovery to an arbitrary timeline. Third, policy-makers are pursuing a number of ways to enhance the efficiency of the system by limiting the required increase in capital. These include contingent capital, countercyclical capital buffers to ensure that higher capital is only carried when necessary, building resilient financial markets, and enhancing the effectiveness of resolution mechanisms. Policy-makers understand the desirability of providing as much certainty as possible as soon as possible. At present, the definition of capital, the deductions from it, the definitions of riskweighted assets, and the calibration of both the minimum requirement and the buffer all http://www.bis.org/press/p091217.htm. Banks should carry enough capital to absorb credit losses and declines in trading book asset values associated with changes in economic fundamentals. On the other hand, it is a waste of society’s resources to expect them to also carry capital to cover unrealized losses that arise simply because market prices have become unhinged from economic fundamentals due to transitory factors, such as a breakdown in market liquidity. remain to be finalised. Armed with the recent impact assessments, governors and supervisors will work quickly to make progress, consistent with the direction given by G-20 leaders to be finished by the November Summit in Seoul. If we can move faster, we will. Reducing the interconnectedness between institutions and markets In effect, the measures I just described reduce the probability of failure of a given financial institution. The second G-20 imperative is to reduce the impact of any failure that might occur. A more resilient financial system must be able to withstand the failure of any single financial institution. From Bear Stearns to Hypo Real Estate to Lehman Brothers, markets failed that test. Today, after a series of extraordinary, but necessary, measures to keep the system functioning, we are awash in moral hazard. If left unchecked, this will distort private behaviour and inflate public costs. As a consequence, there is a firm conviction among policy-makers that losses endured in future crises must be borne by the institutions themselves. This means management, shareholders, and creditors, rather than taxpayers. Measures to expose fully firms to the ultimate sanction of the market will also reduce the interconnectedness between institutions. Priorities include: All regulators should institute staged intervention regimes to catch problems early (as is the case in Canada). Banks themselves should develop “living wills,” or plans to unwind themselves in an orderly fashion if they were to fail. At a minimum, the exercise will underscore the shared responsibility for financial stability and improve regulators’ understanding of firms’ business models. The Basel oversight committee agreed to “reduce the systemic risk associated with the resolution of cross-border banks.” Closing down a multinational institution is a horrifically difficult challenge, but without progress in this area, it is likely the efficiency of the global system will decline, perhaps significantly. In the Bank’s view, less promising is a series of creative proposals to address the negative externalities created by systemically important financial institutions. Many of these require authorities to pass judgment on which institutions should be considered systemically important. However, it is hard to measure systemic importance, and making such identifications may give rise to moral hazard. Once made, would it be possible to remove such a designation? We need to reduce moral hazard in the financial system, not add to it. As Minister Flaherty has written to his G-20 colleagues, Canada’s view is that it is essential that any option respect the following principles for a robust resolution regime: Proper allocation of losses to reduce moral hazard and protect taxpayers; Certainty and uninterrupted service of critical functions and for insured depositors; Preservation of franchise value of the firm; Credibility of regime among financial institution counterparties, ex ante; and, Effective coordination and cooperation among jurisdictions in the event of a crossborder failure of an institution. One promising avenue is to embed contingent capital features into debt and preferred shares issued by financial institutions. Contingent capital is a security that converts to capital when a financial institution is in serious trouble, thereby replenishing the capital of the institution without the use of taxpayer funds. Contingent conversions could be embedded in all future new issues of senior unsecured debt and subordinated securities to create a broader bail-in approach. Its presence would also serve as a useful disciplinary device on management since common shareholders would be incented to act prudently and avoid having their stake in the institution diluted away by the prospect of conversion. Building resilient markets The third strategy to mitigate systemic risk is to enhance the resiliency of financial markets through initiatives to improve infrastructure and enhance transparency. Continuously open financial markets are essential to a system that is robust to failure. Keeping markets continuously open requires policies and infrastructure that reinforce the private generation of liquidity in normal times and allow for central bank support in times of crisis. The cornerstone is clearing and settlement processes with risk-reducing elements, particularly central clearing counterparties or “CCPs.” Properly risk-proofed CCPs act as firewalls against the propagation of default shocks across major market participants. Moreover, in the case of a single-participant default, a CCP’s standardized procedures can contribute to an orderly close out of that participant’s positions, eliminating the chance of a “fire sale” and reducing spillovers to other markets. For these reasons, the Bank of Canada has supported the development of a domestic CCP for Canadian-dollar repos, which should be launched later this year. The Bank is working with its domestic partners to develop similar infrastructure for over-the-counter (OTC) derivatives markets. Current G-20 efforts to transfer trading of standardized OTC derivatives to clearing houses have similar benefits. Securities regulators and central banks have a shared interest in ensuring that the new infrastructure is properly risk-proofed. IOSCO recently provided helpful guidance for riskmanagement practices of central counterparties that clear OTC derivatives products. 6 Central banks look forward to the results of your consultations on this issue, which should serve to set robust standards to ensure that CCPs for OTC derivatives meet the highest riskcontrol standards. Systemic risk can also be mitigated through better and more-readily available information. This reduces information asymmetry, facilitates the valuation process and, hence, supports market efficiency and stability. It also enhances investor protection by supporting informed investment decisions and a more level playing field for investors. This, in turn, reduces uncertainty regarding asset values, which translates into greater market confidence; a lower probability of unwarranted price volatility; and a lower risk of contagion, liquidity spirals, and market freezes. Trade repositories are central to G-20 commitments to enhance the transparency of OTC derivatives markets. Trade repositories would reduce systemic risk and support market integrity and investor protection by reporting such data as aggregated live positions, transaction activity, aggregate settlement data, and transaction-level pricing. Greater use of electronic trading platforms could also improve price transparency, thereby supporting market liquidity and efficiency, as well as levelling the playing field for market participants. The need for improved transparency extends to other systemically important markets, such as securitization. The nature of securitized products argues for different (and likely greater) disclosure than traditional corporate securities. IOSCO has rightly recognized this in its recently published disclosure principles for public offerings and listings of asset-backed Guidance on the application of the 2004 CPSS-IOSCO Recommendations for Central Counterparties (RCCP) to OTC derivatives CCPs. securities. 7 How securities regulators apply these principles in their respective jurisdictions could have important implications for the level of systemic risk in securitization markets. Collaboration among prudential regulators, securities regulators, and central banks is critical. To achieve the full benefits of the new infrastructure, we need to work together to establish global central counterparties and trade repositories, with appropriate oversight and legal arrangements. These may need to be complemented by national arrangements in cases where local access is inadequate. It is all related Just as systemic risk is the product of interrelationships within the financial system, the G-20 reforms are mutually reinforcing. In particular, capital requirements should buttress incentives to process standardised products centrally. That is, trading in standardised products should be capital-advantaged and limited basis risk should not result in punitive capital charges. Bespoke transactions will continue to have their place, but should be subject to higher capital requirements so that incentives are appropriately aligned. Liquidity can be enhanced by a number of strategies. More effective resolution processes will help ensure that markets are robust to the failure of participants, thereby promoting liquidity in more states of the world. Measures to develop continuously open funding markets, such as CCPs, should expand liquidity options, as will more effective securitization. Central bank liquidity facilities should reinforce continuously open markets and, potentially, securitization reforms. Securitization will also enhance liquidity options. Most fundamentally, the more successful the market infrastructure and resolution agendas are, the lower the overall capital requirements for banks, and the more efficient the overall system. Conclusion G-20 leaders have mandated a series of reforms to put the global financial system on a more solid footing. These changes are radical, not incremental. A focus on efficiently reducing systemic risk is essential. This means ensuring that individual financial institutions are both stronger and less systemically important, more options for liquidity are available in all states of the world, and the sum of the reforms is self-reinforcing and market-driven to reduce systemic risk. These solutions are being developed through closer collaboration between regulators and central banks. IOSCO’s efforts are central to this effort. I thank you for your focus on this critical agenda and for your attention today. http://www.iosco.org/library/pubdocs/pdf/IOSCOPD318.pdf.
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Remarks by Mr Mark Carney, Governor of the Bank of Canada, to the Greater Charlottetown Area Chamber of Commerce, Charlottetown, Prince Edward Island, 16 June 2010.
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Mark Carney: Fortune favours the bold Remarks by Mr Mark Carney, Governor of the Bank of Canada, to the Greater Charlottetown Area Chamber of Commerce, Charlottetown, Prince Edward Island, 16 June 2010. The original speech, which contains various links to the documents mentioned, can be found on the US Federal Reserve System’s website. * * * It is a pleasure to be here. In this birthplace of Confederation, courageous decisions were made here to found our great nation. Similar boldness, both in Canada and globally, is again required. To explain why, I would like to touch upon the recent past, the present outlook, and our challenging future. The recent past: the recession in context From the end of 2008 to the middle of last year, Canada experienced a short, sharp recession. With the exception of government spending, all major components of aggregate demand declined, and industrial production dropped 15 per cent. Canadian exporters suffered particularly, owing to the sharp fall in the components of U.S. economic activity that matter most for Canada. For example, U.S. demand for motor vehicles fell by more than half and housing starts by two-thirds. Partly as a result, several major Canadian industries are now undergoing deep restructurings. The recession had a considerable impact on employment. Some 400,000 Canadians lost their jobs, and our unemployment rate spiked by almost 3 percentage points to its highest level in more than a decade. Although the labour market is clearly improving, with threequarters of the jobs lost now recovered, too many Canadians who want to work are still out of a job, and many of those still employed are working fewer hours than they would like (see Appendix Chart 1). As painful as our recession was, Canada suffered less than most other advanced economies. Consumption, housing, and employment in Canada all held up substantially better than in the United States. The cumulative fall in Canadian real GDP of 3.3 per cent compares with declines of 3.6 in the United States, about 5 per cent in the euro area, and more than 8 per cent in Japan. Canada’s better performance can be explained by two factors. First, with a highly credible monetary policy and the strongest fiscal position in the G-7, Canadian policy-makers were able to respond swiftly and effectively with extraordinarily accommodative measures. The Bank of Canada began cutting interest rates in December 2007 and pursued an aggressive series of reductions until our policy rate reached one-quarter of one per cent in April of last year, the lowest it can effectively go. The Bank then provided exceptional guidance on the likely path of interest rates necessary to achieve the inflation target in order to maximize the monetary stimulus from its actions. Second, Canada entered the recession with notable advantages, including a well-functioning financial system, strong corporate balance sheets, and relatively healthy household finances. We will have to draw on these advantages during the recovery. While the global downturn was synchronous, economic performance across markets and sectors is likely to be increasingly uneven. For some Canadian businesses, the recovery may prove as challenging as the downturn. Do not be misled. This was the Great Recession. To claim otherwise with simplistic comparisons to prior downturns is to ignore both the rapidity and the scale of the policy response, as well as the likelihood that the aftershocks from the crisis will persist for years. 1 In particular, the Bank expects that: the pace, composition, and variability of global growth will be substantially different across economies; the level and volatility of commodity prices will be higher; the nature of the global financial system will be radically altered; and the openness of global markets for goods and capital can no longer be assured. Canada is not a bystander in this global upheaval. We can influence policies and focus reforms. Our businesses can anticipate and take advantage of emerging trends. But the efforts required of all of us will be heroic, and hesitation will be costly. For both policy-makers and businesses at this juncture, Virgil’s adage applies: fortune favours the bold. The present The current economic outlook is neither as robust as recent data indicate nor as dire as current headlines scream. The global economic recovery is proceeding, but it is increasingly uneven across countries. There is strong momentum in emerging-market economies; some consolidation of the recoveries in the United States, Japan, and other industrialized economies; and the possibility of renewed weakness in Europe. Global growth is now projected to average slightly above 4 per cent a year through 2012. Few, apart from the Bank of Canada, thought that possible at this time last year. The Bank continues to hold the view that, led by domestic demand, Canadian growth will likely be the strongest among the G-7 nations over the next two years. Recent activity in Canada is unfolding largely as expected. The economy grew by a robust 6.1 per cent in the first quarter, led by housing and consumer spending. Employment growth has resumed. Household spending is expected to decelerate to a pace more consistent with income growth. The anticipated pickup in business investment will be important for a more balanced recovery. This outlook is subject to considerable uncertainties. In most advanced economies, the recovery remains heavily dependent on monetary and fiscal stimulus. The required rebalancing of global growth has not yet materialized. In general, broad forces of household, bank, and sovereign deleveraging have barely begun and will add to the variability, and temper the pace, of global growth as they proceed. Recent tensions in Europe are likely to result in higher borrowing costs and more rapid tightening of fiscal policy in advanced economies. As I will discuss shortly, without countervailing policies, this could lead to a more protracted recovery. Nothing is easy The reality of a policy-led, multi-speed recovery is that the global economy is now bumping up against three limits. P. Cross, “Year-end review of 2009.” Canadian Economic Observer, Statistics Canada Catalogue No. 11-010-X, 23, No. 4, April 2010. The first is the supply response in commodities. With emerging-market economies’ share of global growth now two-thirds, rather than the one-half it was at the start of the millennium, global growth is more commodity-intensive. In our April forecast, the Bank projected an additional 30 per cent increase in the prices of non-energy commodities over the next few years. The second limit relates to the challenges of derivative monetary policy. Owing to managed exchange rates, many emerging-market economies are acting as if U.S. monetary policy were appropriate to their circumstances. Despite strong capital inflows, these countries are resorting to a series of measures of unproven effectiveness to address overheating pressures. Capital controls, restrictions on loan-to-value ratios on mortgages, and higher reserve requirements are all stop-gap measures in the face of broader forces. While these measures will have some impact, ultimately, there are only two possibilities in emerging-market economies: either higher interest rates or higher inflation. The third limit is fiscal stimulus. Reflecting the massive fiscal response and the recession, the International Monetary Fund projects that advanced economy debt will rise from about 80 per cent of GDP in 2008 to 110 per cent by 2015. Major efforts will be required to stabilize the situation. The canary in the coal mine, Greece, faces one of the largest primary adjustments ever undertaken. Moreover, as with other European countries, Greece cannot expect to benefit from lower interest rates, depreciation, or export growth to facilitate adjustment. It will require significant wage reductions and productivity enhancements to restore competitiveness and growth. The possible responses of other countries to the situation are denial or conviction. In the former case, growing public debt will push up global interest rates, crowding out private investment and lowering potential growth. 2 Given the scale of the fiscal challenge, it is perhaps not surprising that some eminent economists are looking for an “easier” way out. This form of denial is to allow temporarily higher inflation in order to inflate away public debt. To the Bank, this is a siren call. Those most in need of fiscal consolidation are often those with debt portfolios of the shortest duration. The “surprise” would have to be very sudden and very large to have a material impact. Of course, if temporary inflation becomes built into expectations, real rates may well increase, rather than fall, thereby exacerbating debt dynamics. Moreover, in the past, it has proven devilishly hard to keep inflation high temporarily. Would it be credible to have a oneoff increase in the inflation target? Central banks have worked for decades to get inflation down to levels consistent with price stability. We should not risk these hard-won gains. The second, more positive, and more likely, response to the fiscal challenge is conviction. We have seen that conviction in recent weeks. The European financial stabilization plan, announced in May, is a bold step towards accelerated fiscal consolidation. The plan has been followed by a series of concrete actions. Spain announced measures totalling 1.5 per cent of GDP in additional fiscal consolidation, while Portugal introduced consolidation measures amounting to 1 per cent of GDP for 2010. Greece has passed the key elements of In a simulation that assumes that advanced countries do not make any fiscal adjustments to stabilize their debt dynamics, the Bank found an increase of 175 to 300 basis points in advanced-economy yields, given the scale of the debt burden. See K. Beaton, C. de Resende, R. Lalonde, and S. Snudden, “Prospects for Global Current Account Rebalancing,” Bank of Canada Discussion Paper No. 2010-4. April 2010, available at: <http://www.bankofcanada.ca/en/res/dp/2010/dp10-4.pdf>. its austerity package, and the United Kingdom is planning for an early and tough budget. Similar measures are likely in other countries in the coming weeks. However, the coming “Age of Austerity” carries its own risks. Fiscal policy that is tighter, sooner for all could create deficient demand in the global economy. The Bank of Canada estimates that, in the absence of real exchange rate adjustment and higher domestic demand elsewhere, the shortfall in global GDP could reach $7 trillion by 2015. 3 To recoup this enormous sum, both the public and private sectors must be bold. Public boldness: the G-20 agenda At the Pittsburgh summit last September, the G-20 claimed that “It worked.” Well, it isn’t over. The G-20’s agenda is comprehensive and radical, but we need to implement, as well as propose. As a consequence, Canada’s priorities for the upcoming G-20 Leaders Summit are: To make concrete the G-20 framework for “strong, sustainable, and balanced growth.” This stresses the shared responsibility of countries to make up that $7 trillion shortfall I just highlighted. This will require changes in behaviour and policy adjustments on several fronts, including: – sustained and credible fiscal consolidation in the advanced countries; – structural and financial reforms that will increase domestic demand in major emerging-market economies; – increased real exchange rate flexibility in emerging-market economies to facilitate the adjustment from external demand to domestic demand; and – structural reforms to enhance productivity and potential growth in advanced economies. To move forward on the core G-20 financial reform agenda. There are two main approaches to reform: to protect the banks from the cycle and to protect the cycle from the banks. Both are necessary. – Protecting the banks from the economic cycle means making each bank, individually, more resilient. This will require more capital, higher liquidity, and better risk management, complemented by stronger supervision. While there is still much to be done, in general, these types of measures will make global financial institutions look more like their Canadian peers. – Protecting the cycle from the banks means making the system as a whole more resilient. This requires building a system that can withstand the failure of any single financial institution. These measures (including contingent capital, better infrastructure for key markets, and new resolution authorities) are new and will change how our financial system operates. 4 See M. Carney, “The Virtue of Productivity in a Wicked World,” Speech delivered to the Ottawa Economics Association, 24 March 2010, available at: <http://www.bankofcanada.ca/en/speeches/2010/sp240310.html>, and Beaton, de Resende, Lalonde, and Snudden (2010). See M. Carney, “The G-20’s Core Agenda to Reduce Systemic Risk,” Speech delivered to the International Organization of Securities Commissions (IOSCO), 10 June 2010, available at: <http://www.bankofcanada.ca/en/speeches/2010/sp100610.html>. Finally, to ensure that business can operate, as much as possible, in an open and stable trade and regulatory environment. We must live up to the G-20 commitment to resist trade and financial protectionism. Private boldness: thriving in a multi-polar economy And what of private boldness? With so much uncertainty, isn’t now the time for corporate caution? Waiting on the sidelines ignores both the scale of the challenge and the opportunities presented by both our historic underperformance and the transformation of the global economy. We should recognise that Canada is not as productive as it could be. Our productivity ranking has dropped from third of the 20 countries in the Organisation for Economic Co-operation and Development (OECD) in 1960 to 15th of the current 30 members. 5 After some promising signs in the late 1990s, average labour productivity growth has since slowed dramatically. A small part of this could be due to measurement errors (which will be corrected over time) and a bit more reflects lags associated with the economy’s adjustment process, but most of this yawning gap between us and our peers reflects fundamental shortcomings. Addressing these will require more concerted efforts on the part of business and government since: Canada underinvests in machinery and equipment (M&E), training, and innovation – in fact, all of the underlying drivers of productivity. Canadian workers have about half the amount of information and communications technology of their American counterparts. Canada is 16th among the member countries of the OECD in the intensity of business research and development. Even when we do invest, we are mediocre. Our poor multifactor productivity growth indicates that Canadian firms do not effectively use the capital that they purchase. In general, while there is more to do, governments have put in place many of the conditions for a productivity revival. Our tax competitiveness has improved dramatically. Comparatively, Canada invests the largest proportion of GDP in primary research. Tariffs on machinery-andequipment investment are being eliminated, and we have sound macro policies and generally effective regulation. Governments will need to maintain the reform momentum, but they cannot be expected to will individuals and companies to take risks. Business will need to step up. Productivity growth fell in the latest recession, the first time this has happened in three decades. Despite the availability of capital, relatively strong balance sheets, and improving economic conditions, business investment has been subdued compared with past downturns and the scale of the challenge (see Chart 2). Investment intentions for 2010 remain modest and largely driven by the public sector. This needs to change for a balanced recovery and a more competitive economy. This is not just a challenge for our largest corporations. Our small- and medium-sized enterprises are, in many respects, the engines of our economy. The rapidly changing global economy will mean that more, too, will be asked of them. Organisation for Economic Co-operation and Development, Compendium of Productivity Indicators, 2006 and 2008. The imperatives for Canadian businesses appear clear. New suppliers need to be sourced; new markets opened; a new approach to managing for a more volatile environment developed. The relatively slow recovery expected in our most important trading partner, along with ongoing sectoral adjustments, means that Canadian firms have to find new markets. The global economy is increasingly multi-polar. Emerging-market economies currently account for about two-thirds of global growth. They represent almost one-half of the growth in imports over the past decade, particularly of capital goods. They are the main drivers of commodity prices and are therefore important determinants of our terms of trade. More fundamentally, they are increasingly thought to be leaders and innovators in public policy and business. 6 Canada needs to become fully engaged with these emerging centres of economic power. Monetary policy going forward In the wake of the shock of the global financial crisis, the Bank of Canada was aggressive. We engaged in a series of innovative, coordinated actions with G-10 central banks; we slashed interest rates to their lowest possible levels; and we then provided unprecedented transparency on their likely future path through our conditional commitment. All of these actions were necessary for the Bank to fulfill its mandate to achieve its inflation target of 2 per cent CPI inflation. A more subtle approach is now warranted. The Bank must balance the competing influences on Canadian activity and inflation of momentum in domestic demand and the increasingly uneven global recovery. In recent months, as the need for emergency settings of monetary policy was passing, the Bank gradually reduced the degree of monetary stimulus. In April, we ended our conditional commitment, which in itself represented a tightening of monetary conditions. 7 At the start of this month, the Bank raised its target overnight rate to 50 basis points and re-established the normal functioning of the overnight market. These decisions leave considerable monetary stimulus still in place, consistent with the large degree of excess supply in Canada, the strength of Canadian spending, and the uneven global recovery. Given the ongoing uncertainty surrounding the outlook, any further reduction of monetary stimulus would have to be weighed carefully against domestic and global developments. In light of the scale and volatility of these conflicting forces, it should be evident that no particular path for monetary policy is preordained. Conclusion In conclusion, now is not the time to rest on our laurels. Public and private boldness, both at home and abroad, will be required to secure the recovery. This means G-20 action to reform the global financial system and to secure a sustainable recovery. This means investments by our businesses to improve productivity and to gain new markets. This means Canadians should fully engage the new multi-polar global economy. R. B. Zoellick, President The World Bank Group, “The End of the Third World? Modernizing Multilateralism for a Multipolar World,” Speech delivered to the Woodrow Wilson Center for International Scholars, April 14, 2010, available at: <http://web.worldbank.org >. See Bank of Canada, “Framework for Conducting Monetary Policy at Low Interest Rates,” Monetary Policy Report, April 2009, available at: <http://www.bankofcanada.ca/en/mpr/pdf/2009/mpr230409.pdf>. These are all big decisions. How quickly and how effectively they are taken will influence activity and inflation in Canada and, therefore, the stance of monetary policy. The Bank will need to be agile. The Bank will maintain its unwavering commitment to price stability. The single, most direct contribution that monetary policy can make to sound economic performance is to provide Canadians with confidence that their money will retain its purchasing power. Price stability lowers uncertainty, minimizes the costs of inflation, reduces the cost of capital, and creates an environment in which households and firms can invest and plan for the future. Appendix
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Remarks by Mr Tim Lane, Deputy Governor of the Bank of Canada, at the Winnipeg CFA Society, Winnipeg, Manitoba, 22 June 2010.
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Tim Lane: Risks to Canada’s financial stability in an uncertain world Remarks by Mr Tim Lane, Deputy Governor of the Bank of Canada, at the Winnipeg CFA Society, Winnipeg, Manitoba, 22 June 2010. * * * Good afternoon. It’s a pleasure to be here. The recent past has underscored the fact that, in finance and the economy, most things are interconnected on a global scale. Throughout its history, Canada has been powerfully affected by events elsewhere. Manitobans in particular are well aware of this reality. Waves of immigration, rapid changes in commodity prices, the Great Depression, two World Wars, and technological advances – all have had an enormous impact here. More recently, the global financial crisis has been a stark reminder that everyone – even citizens in countries with sound “fundamentals” – is affected by major shocks, regardless of where those shocks originate. Global realities and their impact on the domestic financial system inform much of the Bank of Canada’s most recent issue of its Financial System Review (FSR), which was published yesterday. In the FSR, the Bank identifies and evaluates risks and vulnerabilities in the financial system. Our goal in doing this is to contribute to the long-term resiliency of the Canadian financial system by promoting informed discussion of various relevant issues and developments. In my remarks today, I’d like to discuss two issues that are discussed in the FSR, which, directly or indirectly, pose risks to financial stability. These issues are sovereign debt and global macroeconomic imbalances. Both are “global” issues, but they will have to be managed at the national, as well as the international, level. As such, they are at the core of ongoing G20 discussions, including those taking place this week in Toronto. I’ll start by taking a very brief look at the Canadian economy – where we are now, and where we appear to be headed. Then, I’ll elaborate on the two issues I’ve identified. I’ll welcome comments and questions at the end. The Canadian economy The global economic recovery is under way, but it is an uneven one. In the emerging-market economies, growth has been vigorous – indeed it has been stronger than we expected a few months ago. At the same time, in most advanced economies, the recovery has been subdued and heavily dependent on the exceptional stimulus provided by monetary and fiscal policies. In recent months, concerns over European sovereign debt have dampened prospects for the recovery in Europe. So far, these concerns have had limited effects on Canada – mainly, a modest fall in commodity prices and some tightening of financial conditions – but they are an important risk to the recovery. In Canada, the economic recovery is proceeding somewhat more rapidly than expected. Growth has been very strong in the past two quarters, although we expect it to moderate, starting this quarter. Several factors have been supporting the recovery: fiscal and monetary stimulus, improved financial conditions, the rebound in global economic growth, more favourable terms of trade, and increased business and household confidence. At the same time, the persistent strength of the Canadian dollar, our poor relative productivity performance, and the low absolute level of demand in the United States are acting as a drag on the recovery. The Bank projects GDP growth of 3.7 per cent in 2010, with a gradual slowing to 3.1 per cent in 2011 and 1.9 per cent in 2012. Inflation is expected to remain close to our 2 percent target through this period. In view of this outlook, the Bank of Canada indicated in late April that the need for extraordinary monetary policy stimulus – which we had been providing since the beginning of the financial crisis and through the recession – was passing. On 1 June, we increased our policy interest rate from ¼ of a per cent to ½ of a per cent. Of course, that still leaves interest rates at a very stimulative level. But because of the uncertainties – particularly those emanating from Europe – we’ve been careful to emphasize that the extent and timing of any additional withdrawal of monetary stimulus would depend on how the outlook for economic activity and inflation evolves. In making those decisions, we will always stay focused on achieving the 2 per cent inflation target. In our monetary policy decisions, we are mindful of the risks to the economic outlook, both on the upside and the downside. In assessing financial stability, the downside risks are our main focus. So let me turn now to a discussion of two areas of risk that may bear on the health and stability of the financial system, both here and abroad. First, I’ll look at the issue of sovereign debt. Sovereign debt Sovereign debt – and unsustainable fiscal deficits – have been front and centre in recent global economic events. Concerns about sovereign debt have flared up in recent months in a number of European countries. But in the coming years, many advanced countries will face major challenges in achieving and maintaining sustainable fiscal positions. In Canada, we are fortunate that this task will be more manageable than elsewhere, and continued resolve is required. The current sovereign debt problems were exacerbated and brought to a head by the global financial crisis and recession. Of course, a number of countries entered the crisis with weak fiscal positions, but their situations have deteriorated substantially. In part, this reflects the direct support many governments provided to keep troubled financial institutions afloat. Although the final bill for this support is not yet known, it could be very large. Another important element is the massive fiscal stimulus that governments in all major countries delivered to mitigate the recession. And, of course, reduced tax revenues, associated with the recession, have added substantially to the problem. Both financial system support and fiscal stimulus were necessary, since the alternative would have been much worse. When private sector spending was no longer sufficient to support growth, governments had to step in to fill the gap. But the result was a shifting of the debt build-up from the private sector to the public sector. Growing sovereign debt is a source of risk for two main reasons. First, high levels of public debt tend to constrain economic growth. 1 Second, when concerns about sovereign debt become acute – even if they are limited to a few countries – they can have pervasive effects on the financial system. These effects stem from the fundamental importance of government liabilities in the financial system. Government debt instruments are typically viewed as risk-free and highly liquid assets that are held by financial institutions and individual investors, and are used as a benchmark for pricing other financial assets. What happens, then, when these assets are perceived as risky – and when they become increasingly illiquid (as we saw in early May, when European sovereign debt markets seized up)? See Carmen M. Rienhart and Kenneth S. Rogoff, “Growth in a Time of Debt,” available at http://www.economics.harvard.edu/faculty/rogoff/files/Growth_in_Time_Debt.pdf: “...whereas the link between growth and debt seems relatively weak at ‘normal’ debt levels, median growth rates for countries with public debt over 90 percent of GDP are roughly one percent lower than otherwise; average (mean) growth rates are several percent lower. Surprisingly, the relationship between public debt and growth is remarkably similar across emerging markets and advanced economies” (page 2). First, consider the chain of exposures to the credit risk – from the holders of those government securities, to their creditors, and their creditors’ creditors, and so on. And since many of these exposures are uncharted, the uncertainty about where the exposures lie may cause a spike in perceived counterparty risk, and thereby affect short-term financing decisions. As a result, funding markets become increasingly illiquid, with widening spreads and diminishing access to financing. Finally, there is a general retrenchment in risk-taking, which results in a decline in the prices of risky assets – including currencies and commodities. We saw all of these transmission channels in Europe in early May. If the situation had deteriorated further, the impact on Canada’s financial conditions, and on financial conditions more generally, could have been substantial. The market turmoil in Europe was met by a forceful policy response. In the affected countries – as happens with most sovereign debt crises – there are two dimensions to the problem: the short-term challenge of rolling over debt, and the medium-term challenge of attaining a sustainable fiscal position. Of course, these two challenges are mutually reinforcing: the markets’ skepticism about the medium-term fiscal position makes it more difficult to roll over debt, while the higher debt-refinancing costs make it more difficult to balance the budget. Thus, both problems have to be addressed in a credible manner. The funding problem is currently being addressed with the massive financing packages being provided by the European governments and the International Monetary Fund. The medium-term fiscal challenge will require hard decisions, painful adjustment, and perseverance. The fiscal austerity that is required in such a situation involves a painful dilemma. Such adjustment can impede the economic recovery. On the other hand, as I’ve stressed, in countries where sovereign debt concerns have become paramount, failing to adjust will have adverse financial effects – which will also harm the recovery. In theory, this dilemma could be sidestepped by committing to undertake serious adjustment only later, when the economy is stronger; but promises of future action are rarely enough to convince markets. The solution typically involves taking the bull by the horns: making a bold start with serious structural measures that will have a lasting effect on the fiscal position. The pension reforms that have been undertaken in some European countries are a good example. But there is a problem here for the global economy. For the past several months, there has been concern about the risks associated with the “hand-off” from public demand to private demand. The concern is that if fiscal stimulus runs out before the private sector has gathered sufficient momentum, the global economic recovery could falter. This points to the need for the pace of fiscal austerity to be consistent with continued recovery. So far, I have been focusing on two channels through which excessive sovereign debt at the global level can create risk for the financial system here in Canada – more difficult liquidity and funding conditions, and a weaker global economic outlook. These are two of the five areas of risk examined in the current FSR. I would now like to focus on a third, and related, area of risk: global macroeconomic imbalances. Global imbalances An important backdrop to the global financial crisis and the ensuing recession was the configuration of large current account imbalances in major economies. These global imbalances were evident in the high levels of savings, and the persistent current account surpluses in China and many Asian countries, counterbalanced by the credit-fuelled spending by households and governments, and the large and persistent current account deficits in the United States and some other Western economies. These imbalances were not the proximate cause of the crisis, but they contributed to its scope and intensity. In the years leading up to the crisis, high savings rates in surplus countries, together with inflexible exchange rates, helped to keep global interest rates low, encouraging consumers and governments in some advanced economies to take on more debt than was wise. The low interest rates also led to a “search for yield”, meaning that investors and financial institutions acquired riskier assets. At the same time, debt was being repackaged in various ways – sometimes into hard-to-understand, and often illiquid, products – and distributed throughout the financial system. Many of these products then unravelled – with devastating consequences – during the crisis. Global imbalances engendered financial fragility because there were also underlying weaknesses in the financial systems of many countries – including deficiencies in supervision and regulation and inadequate risk management within financial institutions. Addressing these underlying weaknesses is one of the principal objectives of the G20 agenda. Global imbalances have narrowed significantly during the past couple of years. However, this was largely the temporary effect of the recession and the policies adopted to counter it. In the United States in particular, savings rates have increased as households have been trying to recuperate from the loss of housing and equity wealth. In China, substantial stimulus measures have boosted domestic demand – including consumer spending and infrastructure. And the sizable drop in commodity prices from their 2008 peak contributed importantly to the narrowing of global imbalances. What is worrying, however, is that global imbalances appear to be growing once again as the recovery advances, and their nature is changing. Whereas before the crisis, these imbalances primarily corresponded to unsustainable household spending in the United States, they now increasingly reflect unsustainable government deficits in a number of countries. It is clear that what is needed is a “rotation of demand”: surplus countries need to increase their domestic spending, while deficit countries need to decrease theirs. Together with those adjustments in spending, exchange rates need to adjust – with a depreciation of the U.S. dollar against Asian currencies – to support the corresponding adjustment of external current accounts. In this regard, China’s recent decision to enhance the flexibility of its exchange rate is an important step forward; its full implementation will contribute to strong, sustainable, and balanced global economic growth. In the absence of these necessary policy changes, there are three main risks to the global financial system and to the global economy. One is that the status quo becomes increasingly untenable. If the surplus countries do not increase their domestic demand, the United States and other deficit countries will have trouble weaning their economies off fiscal stimulus. The result could be a buildup of public debt relative to the size of these economies, which could not continue indefinitely. These higher debt levels would tend to drive up long-term interest rates, by both increasing demand for available funds and by feeding concerns about how the ever-increasing debt burden would be resolved. Recently, the Bank of Canada looked at the implications of this status quo scenario for global economic growth. Following a short-term boost, global economic growth would fall steadily from the 4 per cent average of 2002–07 to below 3 per cent by 2013. In addition, macroeconomic imbalances would continue to grow, possibly setting the stage for another crisis. A second risk is that adjustment may be lopsided. Even if the surplus countries do not expand their demand, the deficit countries may be forced by markets to reduce their fiscal deficits. In that case, there would be a deficiency of demand worldwide. With monetary policy constrained by the zero lower bound, deflation could emerge. As a result, real interest rates would increase, fiscal consolidation would be more difficult, and growth would stall. A third risk is that exchange rates may adjust, but in a disorderly way. If increasing concerns about the U.S. current account triggered a portfolio shift away from the U.S. dollar, the resulting exchange rate adjustment could overshoot the level required to bring current accounts to sustainable levels. If that occurred, it would likely send shock waves throughout the global financial system, adversely affecting the world economy. Such an adjustment did not happen during the recent financial crisis; on the contrary, the retrenchment of risk-taking that occurred led to a shift into U.S.-dollar-denominated assets, resulting in an appreciation of that currency. But disorderly exchange rate adjustment remains one of the important risks associated with global imbalances. It is because of these risks that the G20 is placing so much emphasis on policies to achieve strong, sustainable, and balanced growth, in tandem with measures to build a more robust global financial system. The rotation of demand required to achieve such balanced global growth will require policy changes in both deficit and surplus countries. It will also involve adopting greater flexibility in exchange rates, which would facilitate adjustment to both current imbalances and future economic shocks. How can this adjustment come about? An important step is the G20 Mutual Assessment Process, now under way, through which G20 members strive to ensure that the “policies pursued by individual G20 countries are collectively consistent with more sustainable and balanced trajectories for the global economy.” 2 Each member country will submit its policies to the G20 for assessment by other members, with a view to promoting coherence among macroeconomic policies. Details of this process are now being worked out, but the most important thing is that the required policy changes be implemented, and in a timely manner. Failing that, we leave ourselves on the same unsustainable, and risky, path. Allow me to conclude. Conclusion The financial system makes a vital contribution to our welfare. A sound financial system, one that is stable, efficient, and resilient to shocks, is crucial to a well-functioning economy. While the world’s financial system is stronger than it was during the crisis, risks and vulnerabilities remain. The G20 agenda for financial and macroeconomic reform is sound and far-reaching. It provides a blueprint for building a sound foundation. But the time for action has arrived. We cannot afford to be complacent. Although Canada fared relatively well in the crisis, we are not immune to risk. We must continue to make our own financial system more resilient. Together with its partners, the Bank of Canada works to do just that. The Bank will also continue its work in international forums to reduce systemic risk in the global financial system. The issues I discussed – sovereign debt and global imbalances – are important, and they must be resolved effectively, and in a timely fashion. Our future well-being is at stake. See “Leaders’ Statement: The Pittsburgh Summit,” available at: http://www.pittsburghsummit.gov/mediacenter/129639.htm.
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Opening statement by Mr Mark Carney, Governor of the Bank of Canada, at the press conference following the release of the Monetary Policy Report, Ottawa, 22 July 2010.
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Mark Carney: Monetary policy report Opening statement by Mr Mark Carney, Governor of the Bank of Canada, at the press conference following the release of the Monetary Policy Report, Ottawa, 22 July 2010. * * * Good morning. It is my pleasure to introduce to you Tiff Macklem, who assumed the post of Senior Deputy Governor of the Bank of Canada on Canada Day. We are pleased to be here with you today to discuss the July Monetary Policy Report, which the Bank published this morning. The global economic recovery is proceeding but is not yet self-sustaining. A greater emphasis on balance sheet repair by households, banks, and governments in a number of advanced economies is expected to temper the pace of global growth relative to the Bank’s outlook in April. The policy response to the European sovereign debt crisis has reduced the risk of an adverse outcome and increased the prospect of sustainable long term growth. However, it is also expected to slow the global recovery over the projection horizon. Global growth is now projected to average slightly less than 4 per cent through 2012. The U.S. economy continues to recover, but growth is projected to be slightly weaker than anticipated in April. This is owing to the fallout from the sovereign debt crisis in Europe and a more protracted recovery in household demand. In Canada, the economic recovery is unfolding largely as expected, and is supported by continued fiscal and monetary stimulus, higher terms of trade, improved labour markets, and household confidence, as well as the global recovery. The level of real GDP is now close to its pre-recession peak. The Bank expects the pace of growth in Canada to moderate to a slightly greater degree than it had expected in April. GDP is now projected to grow 3.5 per cent in 2010, 2.9 per cent in 2011, and 2.2 per cent in 2012. The Bank continues to expect consumer spending to slow to a pace more consistent with income growth. Business fixed investment has been more subdued than expected and its level is still depressed. Going forward, we expect it to increase to levels consistent with previous recoveries, driven by the need to expand capacity and to increase productivity in a more competitive international environment. Inflation in Canada has been broadly in line with the Bank’s April projection. Both total CPI and core inflation are expected to remain near 2 per cent throughout the projection period. The Bank will look through the transitory effects on inflation of changes to provincial indirect taxes. The risks around this projection remain elevated and are judged to be roughly balanced over the projection horizon. Globally, on the upside, the boost in confidence as advanced countries restore fiscal sustainability could generate greater-than-expected offsets to the fiscal consolidation. On the downside, global private demand around the world, including in the United States, may be insufficient to sustain the recovery. In Canada, there are important two-sided risks to the outlook for private demand. On the upside, private demand might have greater momentum than expected, reflecting strong confidence and easy credit conditions. On the downside, it is possible that households reduce expenditures more than currently anticipated or that the recovery in business investment is further delayed. Since April 2010, with improvements in the economy, the Bank has ended its extraordinary conduct of monetary policy. On 20 April 2010, the Bank removed its conditional commitment, which had provided considerable additional stimulus during a period of very weak economic conditions and major downside risks to the global and Canadian economies. On 1 June 2010, the Bank raised its target for the overnight rate by one-quarter of one percentage point to 1/2 per cent. As part of that interest rate decision, the Bank re-established its normal operating framework for the implementation of monetary policy. On Tuesday, 20 July 2010, the Bank raised its target for the overnight rate by a further one-quarter of one percentage point to 3/4 per cent. These decisions leave considerable monetary stimulus in place, consistent with achieving the 2 per cent inflation target in light of the significant excess supply in Canada, the strength of domestic spending, and the uneven global recovery. Given the considerable uncertainty surrounding the outlook, any further reduction of monetary stimulus would have to be weighed carefully against domestic and global economic developments. With that, Tiff and I would be pleased to take your questions.
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Remarks by Mr John Murray, Deputy Governor of the Bank of Canada, at the Canadian Association for Business Economics, Kingston, Ontario, 24 August 2010.
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John Murray: Re-examining Canada’s monetary policy framework – recent research and outstanding issues Remarks by Mr John Murray, Deputy Governor of the Bank of Canada, at the Canadian Association for Business Economics, Kingston, Ontario, 24 August 2010. * * * Introduction I am honoured to address members of the Canadian Association for Business Economics. My remarks today will focus on critical issues that the Bank of Canada has studied over the past four years and how this research will inform our work as we move forward post crisis. Central banks were forced to use extraordinary policy measures to combat the macroeconomic consequences of the 2008–09 financial crisis. The experience also raised fundamental questions about existing monetary policy frameworks, causing central banks to revisit issues that were long thought to be resolved. Some critical observers even suggested that inflation targeting and the pursuit of price stability might be detrimental to financial stability and reduce economic welfare. The Bank of Canada, of course, like many other central banks, operates under an inflationtargeting regime. We continue to believe that this regime has served us exceptionally well, in both turbulent and tranquil times. Nevertheless, we, like many of our counterparts elsewhere, are re-examining key features of our monetary policy framework in the light of recent events. However, we are doing so as part of an ambitious and long-standing research program initiated in 2006. This research will inform the renewal of the Bank’s inflation-targeting agreement with the government in 2011. A great deal of innovative analysis and research have deepened our understanding of how the macroeconomy operates and helped us gauge the potential costs and benefits of alternative monetary policy frameworks. Experience during the crisis and in the period immediately following has provided many important and cautionary lessons, and lent a greater sense of urgency and significance to the research work already under way. I would like to review the most important elements of this research effort with you today, and indicate how it has been informed and shaped by our recent “battlefield experience.” Towards the end of my presentation, I will try to give you a sense of where things stand in our search for further improvements to the monetary policy framework, as well as some of the major outstanding issues. While much has been learned over the past four years, a great deal has yet to be resolved, and few definite conclusions will be presented. This is still very much a work in progress. Where we were in 2006 In 2006, when our inflation-control agreement with the government was last renewed, the Bank published a document entitled “Renewal of the Inflation-Control Target: Background Information.” 1 It assessed the past performance of the framework, discussed the various issues that had been examined in the run-up to the renewal, and identified a number of key questions that needed to be studied over the next five years. The two most important questions concerned the potential benefits and costs of lowering the target rate of inflation from 2 per cent, and the potential benefits and costs of moving from an The document can be found at www.bankofcanada.ca/en/press/background_nov06.pdf. inflation target to a price-level target. The distinguishing feature of price-level targeting is that, unlike inflation targeting, bygones are not bygones. Any past mistakes must be corrected. If aggregate prices overshoot the targeted price-level path in one period, prices must come back to the path in future periods. Several other issues were also identified, but were either deemed to be of lesser importance and promise, or to have been largely resolved. One of these was whether central banks should use their monetary policy instrument to lean against prospective asset bubbles and other forms of financial instability, even if this risked deviating from their inflation objective for an extended period. The events of the past three years have seriously challenged the received wisdom that existed on this issue prior to the crisis. Some well-known economists have suggested that the pursuit of price stability is not enough, and is perhaps even dangerous to the stability of the financial system and the macroeconomy more generally. 2 Consequently, the Bank’s research program on the monetary policy framework now includes three key questions: (i) whether the inflation target should be lowered; (ii) whether we should adopt a price-level target; and (iii) whether the monetary policy framework should be modified to give greater recognition to financial-stability concerns. The state of play for each of these as of 2006 is outlined briefly below, and will serve as a helpful point of departure for the discussion that follows. Is 2 per cent the optimal rate of inflation? Achieving and maintaining a low, stable, and predictable rate of inflation promotes economic welfare by reducing uncertainty and preventing arbitrary redistributions of wealth. However, it isn’t clear that these benefits are maximized at an inflation rate of 2 per cent. While the benefits of targeting a lower rate of inflation were generally believed to be positive in 2006, three possible reasons were identified at the time for not pursuing such an ambitious objective: (i) measurement error; (ii) nominal wage-price rigidity; and (iii) the so-called zero bound on nominal interest rates. The first two of these were judged to be relatively unimportant, but the third was taken more seriously because, at very low rates of inflation, monetary authorities might not be able to ease policy sufficiently to counter a sudden downturn in the economy, since nominal interest rates can’t technically fall below zero. 3 This possibility, unlike the other two concerns, was regarded as sufficiently serious to preclude consideration of a lower target without further study. The Bank didn’t realize then that the real world was about to give it a natural experiment of almost unprecedented proportions with which to test the significance of the zero bound. Price-level targeting – a renewed interest The second key question on the research agenda was price-level targeting, and the Bank had already completed a great deal of work on this issue by 2006. Price-level targeting was seen to be potentially attractive for three main reasons. The first concerned the increased certainty that it would provide regarding the price level 10, 20, or 30 years in the future. The second concerned the enhanced stabilizing properties that price-level targeting might offer in terms of reduced inflation and output variance. Provided agents were sufficiently forward See White (2006). Also see Diamond and Rajan (2009); Cagliarini, Kent, and Stevens (2010); and White (2009). Discussions of the implications for the zero bound on nominal interest rates for monetary policy can be found in Amano and Shukayev (2010) and Lavoie and Murchison (2007–2008). looking and the policy was sufficiently credible and well understood, the central bank might enjoy what Lars Svensson (1999) termed a “free lunch.” The third concerned the possibility that it might facilitate the pursuit of a lower inflation rate (or price-level path), if this were judged desirable. Unfortunately, the only country to experiment ever with price-level targeting was Sweden, and for only a brief period in the 1930s. 4 While the experience was generally viewed as positive, there was no assurance that it could be extended to other countries or periods. 5 It was clear that such a dramatic shift in regime called for some intensive research. This research would focus primarily on how expectations are formed and the challenges that a small open economy might experience when it was subject to wide swings in important relative prices, such as world commodity prices. Something that seemed to work well in a simple rational-expectations model with a single good might have severe negative consequences in practice. The research would also try to document in a more convincing way the potential benefits of price-level targeting. Monetary stability versus financial stability The third issue that needs to be highlighted involves the difficult trade-offs that can at times exist between monetary stability and financial stability. Authors such as Claudio Borio and William White at the Bank for International Settlements warned as early as 1998 that the single-minded pursuit of price stability could come at the expense of system-wide financial stability. However, the prevailing view in 2006 – indeed, right up to the crisis and slightly beyond – was that financial-stability issues were best left to regulators. Central banks had one primary monetary policy tool at their disposal – adjustment of an official short-term interest rate – and experience suggested that this was best directed at achieving price stability. The extreme version of this view rested on three basic tenets: (i) asset bubbles and other forms of potentially serious financial dislocation were difficult, if not impossible, to spot in real time; (ii) adjustment of the official interest rate was a very blunt and inefficient instrument with which to counter asset bubbles, and would likely inflict considerable collateral damage on the rest of the economy; and (iii) a more realistic strategy was to focus simply on cleaning up as quickly as possible once an asset bubble had burst. This was the best a central bank could do. 6 The more nuanced view of most inflation targeters, including the Bank of Canada, was that central banks should lean against any suspected financial instability to the extent that it might threaten aggregate economic activity and the achievement of the inflation target over the medium term, even if this implied appearing to deviate from the target in the short term. In other words, central banks were expected to pursue inflation targeting in a flexible, forwardlooking manner, and could delay achieving their target if such an action would minimize the possibility of more ominous outcomes in the future. But the pursuit of financial stability through monetary policy measures should not go any further. 7 See Berg and Jonung (1999) for a description of the Swedish experience with price-level targeting. Eggertsson (2007) contends that the United States also successfully pursued price-level targeting during the 1930s, but their experience has largely gone unrecognized. See Greenspan (2002) and Bernanke and Gertler (1999). See Selody and Wilkins (2007). Where are we now? So how have things changed in the past four years? What have we learned from our longterm research effort? What have we and other central banks learned from the bitter experience of the crisis? Have recent events dampened or strengthened our taste for reform? The optimal rate of inflation Recent research on the prospective benefits of targeting a lower inflation rate have focused primarily on the gains that might accrue through improved pricing behaviour and increased incentives for holding money. This has been balanced by research that has tried to weigh these benefits against the additional costs that might be incurred through more frequent encounters with the zero bound. In 1969, Milton Friedman published The Optimum Quantity of Money, in which he noted how inflation imposed an effective tax on money, causing households and businesses to economize on their transactions balances, thereby biasing the pattern of trade. His solution was to propose an optimal rate of deflation that would provide a positive rate of return on transactions balances. Bank of Canada researchers have extended this earlier work, evaluating the welfare effects of lowering inflation in a life-cycle, heterogeneous-agent model in which households hold a portfolio of real assets (housing), nominal debt, and money. The authors find that reducing the targeted rate of inflation not only increases aggregate welfare, but also would directly benefit a significant proportion of the current population. 8 The other major strand of our research on the optimal rate of inflation has concentrated on the allocative inefficiencies that are likely to arise in a world with positive inflation, owing to pricing distortions that arise due to infrequent price adjustments or “sticky prices.” If firms adjust prices infrequently, they have an incentive to set prices higher at the start of a contract than would be warranted by initial market conditions, knowing that inflation will gradually erode the real value of prices over time. With sticky prices, higher rates of inflation cause the price spread to widen and create larger differences between prices of otherwise similar products at different points in the term of their fixed contracts. This, in turn, increases price dispersion and leads to even larger allocative inefficiencies. 9 While earlier studies often found that the implied welfare costs associated with this behaviour, measured in terms of lost consumption or some other metric, were relatively small, Bank of Canada researchers have extended this work in a number of important ways and reported much larger effects. These extensions included: (i) incorporating more realistic wage dynamics into New Keynesian models; (ii) adding growth to standard steady-state analyses; and (iii) allowing for trend increases in inflation. The effect, in almost every instance, was to strengthen the case for a very low – if not slightly negative – target rate of inflation. 10 See Cao et al (2009). See Ambler (2007–2008) for a lucid description of the costs of inflation arising from sticky prices. Amano, Ambler, and Rebei (2007) examine the implications of trend inflation in a stochastic, environment and Amano et al. (2009) study the effect of sticky prices and wages in the presence of exogenous growth. Amano and Shukayev (2010) investigate the implications of non-zero inflation for endogenous growth in a model with sticky prices and wages. It is important to note, however, that much of this work is based on historical data that predate the crisis and therefore assigns a very low probability of ever hitting the zero bound. 11 Higher probabilities would of course alter the cost-benefit equation, since the expected longterm cost of choosing a target that is “too low” is a function of how often one is likely to hit the zero bound and the costs that are incurred once that occurs. Does the fact that we have recently hit the zero bound suggest that earlier estimates were too small, and that such encounters are likely to be more frequent in the future? Will the efforts that are under way to reform the financial system make it more stable and reduce the chances of similar occurrences in the future? Answering these questions is obviously critical to reaching a decision on whether lower is better. A second critical factor concerns the effectiveness of any alternative policy tools that authorities are likely to have at their disposal whenever the zero bound is reached. Do unconventional monetary policy instruments, such as quantitative easing, credit easing and conditional commitments, represent viable mechanisms for overcoming the zero bound? How effective are other, non-monetary, policy instruments in dealing with a crisis? While it is still early days, nothing in recent experience leads one to believe that these tools can be used with the same degree of confidence and effectiveness as conventional policy tools. 12 All of these factors play a critical role in determining how much insurance might be needed in terms of an inflation buffer to avoid such problems. 13 Some noted economists have recommended raising the inflation target to 4 or even 6 per cent to provide an extra measure of protection. 14 This idea has been universally rejected by the central banking community, however, which argues that the costs incurred through lost credibility as well as higher and more uncertain inflation would far outweigh any prospective benefits. 15 Low, stable, and predictable inflation, it is generally agreed, is the most important contribution that central banks can make to the economic well-being of a country. Price-level targeting Interest in the potential advantages of price-level targeting has, if anything, increased following the crisis. The automatic stabilization properties that might result from committing to a price-level target could reduce the probability of hitting the zero bound, thereby allowing central banks to aim for a lower target path, and make monetary policy more effective once it was reached. Absent any extensive real-world experience to draw on, however, central bank researchers have been forced to rely on model simulations to test the feasibility and desirability of such a bold move. These simulations assess the performance of alternative monetary policy regimes, both in the context of a representative set of shocks based on historical data and in more extreme examples. Billi (2007) attempts to measure optimal inflation in a model that balances the costs of hitting the zero bound with the costs arising from the presence of nominal-price stickiness. Schmitt-Grohé and Uribe (2007) argue that the probability of the U.S. economy hitting the zero bound is very small. This increased uncertainty was explicitly recognized by the Bank of Canada in its press releases and Monetary Policy Reports once the target overnight interest rate had reached its effective lower bound, since any additional easing would necessarily require the use of unconventional policy measures. See Bank of Canada, April 2009, Monetary Policy Report. Indeed, according to some early empirical work conducted by He (2010), the Bank of Canada’s conditional commitment appears to have resulted in a persistent lowering of Canadian interest rates since April 2009, relative to what would have been expected without the conditional commitment. See Williams (2009) and Blanchard, Dell’Ariccia, and Mauro (2010). See Weber and Hildebrand (2010) and Carney (2010). The results, for the most part, have favoured price-level targeting over inflation targeting, although the differences are not always large or statistically significant. In addition, price level targeting was generally found to be more robust than inflation targeting to various forms of uncertainty, owing to its self-correcting nature. 16 One of the main concerns identified in 2006 therefore seems to have been addressed; on balance, price-level targeting appears to be able to provide superior performance in a multi-good world characterized by large relative price shocks. 17 Unfortunately, all of these encouraging results are derived from models in which agents are, for the most part, forward looking, and fully conversant with the implications of price-level targeting; they also trust that policy-makers will live up to their commitment. Simulation results reported by Bank researchers suggest that if more than approximately 40 per cent of agents base their actions on rules of thumb or on backward-looking expectations, the dominance of price-level targeting no longer holds. Further work is clearly needed to better understand the ways in which Canadian businesses and households form their expectations, as well as the communication challenges that might arise if Canada were to move to price-level targeting. If the learning curve is too long and expectations are too slow to adjust, the present value of any shift to price-level targeting could easily turn negative. 18 The Bank is currently conducting some experimental work designed to shed light on both issues, and hopes to report its preliminary findings later this year. Balancing monetary and financial stability The tension that can sometimes exist between the dual objectives of monetary and financial stability is an issue that has been brought to the fore by recent events. 19 Central banks have been forced to re-examine the three tenets that I discussed earlier, and two of them have been effectively discarded. First, central banks no longer think that a strategy that relies exclusively on mopping up quickly after a bubble has burst is tenable. The costs of not taking pre-emptive action before a bubble bursts are potentially too high and, with regard to the response of the official sector, produce a destabilizing asymmetry that only encourages future misdeeds. 20 In addition, central banks are no longer as dismissive about the feasibility of identifying potential sources of financial instability before their macroeconomic consequences are felt. The one remaining complication concerns the third tenet described earlier – the fact that traditional monetary policy instruments are often a very heavy-handed means of dealing with financial sector vulnerabilities, especially if the potential source of instability is limited to a specific sector or area of activity. Such cases call for more targeted measures and a wider set of instruments that are better able to deal with financial risks. Regrettably, many of these tools are still in the development phase. 21 See Cateau (2008). Murchison (2010) provides a summary of this line of research. See Kryvtsov, Shukayev, and Ueberfeldt (2008) and Masson and Shukayev (2008) for examples of this type of research. Boivin, Lane, and Meh (2010) summarize the question of whether monetary policy should and could do more to restrain a buildup of financial imbalances. The so-called “Greenspan put.” See Bank of England (2009), Boivin, Lane, and Meh (2010), and International Monetary Fund (2009). What can one conclude from this? First, greater attention must to be paid to financial stability concerns, particularly those of a system-wide nature. Second, inflation targeters need to be forward looking and flexible, resisting any financial-system pressures that may threaten real activity and inflation in the future, even if the horizon for such outcomes extends well beyond the normal time frame for achieving and preserving the inflation target. While most inflationtargeting agreements already allow for some flexibility in the time period over which the target is achieved, whether there is sufficient flexibility and willingness to act in situations that might require even greater forbearance is an open question that has yet to be tested. The central issue that remains is whether monetary authorities should be expected to go further than the prescripts of flexible, forward-looking inflation targeting would suggest. 22 If so, what form would it take? Should the inflation-targeting agreement itself, or the central bank’s reaction function, give explicit recognition to asset prices and credit growth? Would this prejudice the clarity of the current targets? Would central bank credibility and accountability be sacrificed in the interest of achieving even greater policy flexibility? Carney (2009) has suggested that this problem might be overcome by combining flexible inflation targeting with price-level targeting. If monetary policy had to lean into the wind for financial stability purposes and deviate from target for an extended period of time, credibility and accountability perhaps could be preserved by announcing that these deviations would be offset over time, keeping the economy on a predetermined path for the price level. 23 Other important considerations relating to issues of monetary and financial stability include: How far should coordination between monetary authorities and regulators be taken? Would a clear and separate assignment of tools and targets be better? Will the introduction of new prudential tools essentially solve this dilemma? All of these questions, and many others, have been brought to the fore by the crisis. Conclusion Significant progress has been made on the research front regarding key outstanding issues identified in the 2006 document on the renewal of inflation targeting. Valuable, if painful, lessons have been learned from the crisis, and old issues that were thought to be largely resolved have resurfaced, demanding renewed attention. Shifting to a lower inflation target and/or moving to a price-level target are still possibilities, and in some respects look even more promising than they did before the crisis, although other aspects of our research results and recent experience lend an extra air of caution. A wide range of models suggest that, all other things being equal, economic welfare is maximized at inflation rates lower than 2 per cent, but considerable uncertainty still exists regarding how large these gains might be. The cost-benefit of lowering the target hinges on weighing these uncertain benefits against the increased probability of hitting the zero bound and the costs that this might impose, absent other reliable corrective instruments. Research on price-level targeting suggests that the gains from switching to a price-level target are probably positive and potentially larger in the presence of the zero bound. A pricelevel target might reduce the likelihood of hitting the zero bound and could shorten the length of time during which the economy remains there once it is reached. As a result, it might be possible to target a lower price-level path. In addition, there could be further benefits related to greater price-level certainty. Exploiting these advantages rests on a number of critical assumptions, however, including the credibility and commitment of policy-makers, as well as See Carney (2008) and Svensson (2009). See Carney (2009). the expectations-formation process of agents and the ease with which price-level targeting could be communicated. A final factor that must be considered before any decision is made is the proven track record of the present system, which has shown its worth in both turbulent and tranquil times. This represents a relatively high bar against which any future changes must be judged. One thing is certain, no matter what is decided. The most important contribution that a central bank can make to the economic well-being of households and businesses is the achievement and maintenance of price stability. This will not be sacrificed. The only question, as always, is whether it can be delivered in an even more effective and reliable manner. Bibliography Optimal rate of inflation Amano, R., S. Ambler, and N. Rebei. 2007. “The Macroeconomic Effects of Non-Zero Trend Inflation.” Journal of Money, Credit and Banking 39 (7): 1821–38. Amano, R., T. Carter, and K. Moran. 2010. “Inflation and Growth: A New Keynesian Perspective.” Bank of Canada. Manuscript. Amano, R., K. Moran, S. Murchison, and A. Rennison. 2009. “Trend Inflation, Wage and Price Rigidities, and Productivity Growth.” Journal of Monetary Economics 56 (3): 353–64. Amano, R. and M. Shukayev. 2010. “Monetary Policy and the Zero Bound on Nominal Interest Rates.” Bank of Canada Review (Summer): 3–10. Ambler, S. 2007–2008. “The Costs of Inflation in New Keynesian Models.” Bank of Canada Review (Winter): 5–14. Bank of Canada. 2006. “Renewal of the Inflation-Control Target: Background Information”. Billi, R. M. 2007. “Optimal Inflation for the U.S. Economy.” Federal Reserve Bank of Kansas City Working Paper No. 07–03. Blanchard, O., G. Dell’Ariccia, and P. Mauro. 2010. “Rethinking Macroeconomic Policy.” IMF Staff Position Note, 12 February. Cao, S., J.-V. Rios-Rull, C. Meh, and Y. Terajima. 2009. “Inflation, Nominal Debt, Housing, and Welfare.” Bank of Canada. Manuscript. Carney, M. 2010. “Fortune Favours the Bold.” Speech delivered to the Greater Charlottetown Area Chamber of Commerce, Charlottetown, Prince Edward Island, 16 June. Friedman, M. 1969. The Optimum Quantity of Money and Other Essays. Chicago: Aldine. He, Z. 2010. “Evaluating the Effect of the Bank of Canada’s Conditional Commitment Policy.” Bank of Canada Discussion Paper. Forthcoming. Lavoie, C. and S. Murchison. 2007–2008. “The Zero Bound on Nominal Interest Rates: Implications for Monetary Policy.” Bank of Canada Review (Winter): 27–34. Schmitt-Grohé, S. and M. Uribe. 2007. “Optimal Inflation Stabilization in a Medium-Scale Macroeconomic Model.” In Monetary Policy Under Inflation Targeting, edited by K. SchmidtHebbel and R. Mishkin, 125–86. Santiago, Chile: Central Bank of Chile. White, W. R. 2009. “Should Monetary Policy “Lean or Clean”?” Working Paper No. 34. Federal Reserve Bank of Dallas Globalization and Monetary Policy Institute. Williams, J. 2009. “Heeding Daedalus: Optimal Inflation and the Zero Lower Bound.” Brookings Papers on Economic Activity 2: 1–37. Price-level targeting Berg, C. and L. Jonung. 1999. “Pioneering Price-Level Targeting: The Swedish Experience 1931–37. Journal of Monetary Economics 43 (3): 525–51. Cateau, G. 2008. “Price Level versus Inflation Targeting under Model Uncertainty.” Bank of Canada Working Paper No. 2008–15. Eggertsson, G. 2007. “Great Expectations and the End of the Depression.” Federal Reserve Bank of New York. Manuscript. Gorodnichenko, Y. and M. D. Shapiro. 2007. “Monetary Policy When Potential Output Is Uncertain: Understanding the Growth Gamble of the 1990s.” Journal of Monetary Economics 54 (4): 1132–62. Kryvtsov, O., M. Shukayev, and A. Ueberfeldt. 2008. “Adopting Price-Level Targeting under Imperfect Credibility: An Update.” Bank of Canada Working Paper No. 08–37. Masson, P. R. and M. Shukayev. 2008. “Are Bygones not Bygones? Modeling Price Level Targeting with an Escape Clause and Lessons from the Gold Standard.” Bank of Canada Working Paper No. 08–27. Murchison, S. 2010. “Price-Level Targeting and Relative-Price Shocks.” Bank of Canada Review (Summer): 11–21. Svensson, L. E. O. 1999. “Price-Level Targeting versus Inflation Targeting: A Free Lunch?” Journal of Money, Credit and Banking 31: 277–95. Weber, A. and P. Hildebrand. 2010. “The IMF’S Inflation Illusion”, The Wall Street Journal (4 March). Monetary policy and financial stability Bank of England. 2009. “The Role of Macroprudential Policy.” Discussion Paper, November. Bernanke, B. and M. Gertler. 1999. “Monetary Policy and Asset Price Volatility.” Economic Review 84 (4): 17–51. Federal Reserve Bank of Kansas City. Boivin, J., T. Lane, and C. Meh. 2010. “Should Monetary Policy Be Used to Counteract Financial Imbalances?” Bank of Canada Review (Summer): 23–36. Cagliarini, A., C. Kent, and G. Stevens. 2010. “Fifty Years of Monetary Policy: What Have We Learned?” Conference paper, Reserve Bank of Australia. Carney, M. 2008. “Flexibility versus Credibility in Inflation Targeting Frameworks.” Speech to the 7th BIS Annual Conference, Lucerne, Switzerland, 27 June. Carney, M. 2009. “Some Considerations on Using Monetary Policy to Stabilize Economic Activity.” Speech delivered to a symposium sponsored by the Federal Reserve Bank of Kansas City, 22 August. Diamond, D. W. and R. D. Rajan. 2009. “Illiquidity and Interest Rate Policy.” University of Chicago and NBER. Manuscript. Greenspan, A. 2002. “Opening Remarks.” In Rethinking Stabilization Policy, 1–10. Proceedings of a symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming. International Monetary Fund. 2009. “Lessons for Monetary Policy from Asset Price Fluctuations.” World Economic Outlook, October. Selody, J. and C. Wilkins. 2007. “Asset-Price Misalignments and Monetary Policy: How Flexible Should Inflation-Targeting Regimes Be?” Bank of Canada Discussion Paper No. 2007–6. Svensson, L. E. O. 2009. “Flexible Inflation Targeting: Lessons from the Financial Crisis.” Speech to the workshop Towards a New Framework for Monetary Policy? Lessons from the Crisis, organized by the Netherlands Bank, Amsterdam, 21 September. White, W. R. 2006. “Is Price Stability Enough?” BIS Working Paper No. 205.
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Remarks by Mr Mark Carney, Governor of the Bank of Canada, at the Spruce Meadows Changing Fortunes Round Table, Calgary, Alberta,10 September 2010.
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Mark Carney: Restoring faith in the international monetary system Remarks by Mr Mark Carney, Governor of the Bank of Canada, at the Spruce Meadows Changing Fortunes Round Table, Calgary, Alberta,10 September 2010. * * * Introduction We are three years into the global financial crisis, and its dynamics still dominate the economic outlook. In particular, broad forces of bank, household, and sovereign deleveraging can be expected to add to the variability and temper the pace of global economic growth in the years ahead. This would be true even if policy were optimal; but globally, this is not the case. One of the reasons is the functioning of the current international monetary system. It promoted the enormous build-up of debt that preceded the crisis and could complicate the necessary process of balance-sheet repair in its wake. It is fostering deflationary risks in major advanced economies and asset-price inflation in emerging markets. For countries like Canada, the outlook and policy environment remain unusually challenging. It is in this context that the international monetary system is being re-examined. The question is whether to change the system or to change policies to be consistent with the current system. I will argue today that there is no miracle cure. Faith is required, but not in a barbarous relic or a utopian global central bank. Rather, countries must restore their faith in the adjustment process under the current system. Both the G-20 framework and its financial reforms are necessary to restore that trust. The international monetary system and the crisis The international monetary system consists of (i) exchange rate arrangements; (ii) capital flows; and (iii) a collection of institutions, rules, and conventions that governs its operation. These core elements are supplemented in two important ways. Domestic monetary policy frameworks are essential components of the global system. The international monetary system is also closely related to the international financial system, which comprises financial markets and the institutions, rules, and regulations that govern them. The international monetary system is an increasingly unstable hybrid of fixed and floating regimes. Following the breakdown of Bretton Woods, there was a general move to a more market-based system with an increasing number of countries adopting floating exchange rates and steadily liberalizing their capital accounts. Capital flows exploded, rising three times faster than the rate of growth of trade over the past three decades. In contrast, in the aftermath of the Asian crisis, a range of emerging markets became increasingly active managers of their exchange rates. As a by-product, with foreign exchange reserves built well beyond prudential levels, these countries have become important players in several key asset markets. The combination of these official assets and private flows has created huge gross international asset positions, which has important implications for the functioning of the international monetary system. 1 This makes internationally coordinated financial supervision M. Obstfeld, “Expanding Gross Asset Position and the International Monetary System,” Remarks delivered at the Federal Reserve Bank of Kansas City symposium on “Macroeconomic Challenges: The Decade Ahead,” Jackson Hole, Wyoming, 26–28 August 2010. and regulation a pre-requisite for system stability. It also increases the returns to deepening the liquidity of non-reserve currencies. Well-functioning markets have clear rules of engagement and robust infrastructure. That cannot be said of the current system. Its conventions can be best described as the occasional observance of the Articles of Agreement of the International Monetary Fund (IMF). Its governance is diffuse and ineffective. The IMF is effectively without the power of sanction, and informal governance mechanisms such as the G-7 have increasingly lost legitimacy as global economic power has been transformed. Moreover, events of the last few years exposed the frailties of the international financial system. A number of global banks were woefully under-capitalised; participants assumed markets would be liquid in all states of the world; and incentive problems led to a dramatic underpricing of risks. It is now clear that, in the run-up to the crisis, financial regulation was neither well-conceived nor well-coordinated. Implementation was uneven and peer review non-existent. When the crisis hit, liquidity became concentrated in a handful of markets and one currency. In the wake of the large, negative spillovers we have all just experienced, changes are clearly required. This need is doubly important as unprecedented structural changes in the global economy are straining the international monetary system itself. The integration of one-third of humanity into today’s global economy dwarfs the shock experienced when Canada and the United States emerged at the turn of the last century (Chart 1). The global economy is rapidly becoming multi-polar. Emerging-market economies are now the main drivers of commodity prices, they represent almost one-half of the growth in all imports over the past decade, and currently account for about two-thirds of global growth. 2 Any monetary system would be fragile in the face of these large, positive forces. There is cause for concern that the current system will repeat the failures of its predecessors. History shows that international systems dominated by fixed exchange rates seldom cope well with major structural change. 3 This failure is the result of two pervasive problems: the downward rigidity of nominal prices and wages and an asymmetric adjustment process. In the short run, it is generally much less costly, economically as well as politically, for countries with balance of payments surpluses to maintain them and accumulate reserves than it is for deficit countries to sustain deficits. Countries with deficits must either run down their reserves or deflate their currencies. The only limit on reserve accumulation for surplus countries is its ultimate impact on domestic prices. Depending on the openness of the financial system and the degree of sterilization, this impact can be delayed for a very long time. Such has been the case in recent years (Table 1). Indeed, given the scale of the economic miracle, it is remarkable that the currencies of the BRICs have only appreciated 5 per cent in real terms against the G-7 over the past decade (Chart 2). Another lesson from history is that major countries will not pursue policies that they do not perceive to be in their self-interest. Export-oriented growth strategies, supported in part by undervalued currencies, have proven effective catalysts in recent decades. Countries have generally been reluctant to adjust even long after demand needs to be rebalanced and the desire to self-insure has been sated. There are, however, deeper causes of the inertia of today’s emerging-market economies (EMEs). Governance problems in the international Bank of Canada calculations. See M. Carney, “The Evolution of the International Monetary System,” Speech to the Foreign Policy Association, New York City, New York, 19 November 2009, available at: http://www.bankofcanada.ca/en/speeches/2009/sp191109.html. monetary system have discouraged co-operative solutions; and legitimate concerns over the resiliency of the global financial system have slowed financial liberalisation. Emerging markets have also been somewhat slow in realising that, as they grow in importance, delayed adjustment is becoming self-defeating. Given the economic importance of emerging markets, their policy decisions are material for the stability of the international monetary system, and therefore for strong, sustainable and balanced global growth. In the end, excessive reserve accumulation represents a fallacy of composition. These efforts to secure the stability of one country are now collectively reducing the stability of the system. 4 The flip side of large current account surpluses was large current account deficits in several advanced economies, notably the United States. The combination of expansionary U.S. monetary and fiscal policies following the 2001 recession and high savings rates in East Asia generated significant global imbalances, massive capital flows, and the “conundrum” of very low, long-term interest rates. These low, risk-free rates, in turn, fed the search for yield and excessive leverage across the system. The deregulation of housing and consumer finance reinforced a secular decline in private savings. Vulnerabilities grew from the combination of macro imbalances and micro failings in risk management, supervision, and financial regulation. Policy-makers in advanced economies were too slow to recognise and address the looming risks. The overall result was a period of increasingly unbalanced growth, without the real and financial signals necessary to promote timely and orderly economic adjustment. Three years ago, the pressures became overwhelming. Financial systems in advanced economies seized up; virtually every financial asset in the world was repriced; and private demand in advanced economies collapsed. The policy response to the crash has been an unprecedented easing of fiscal and monetary policy. This has bought time for the necessary adjustments. But a durable solution requires a rebalancing of global supply and demand, which will not happen without changes to the functioning of both the international monetary and financial systems. The challenges ahead Without the successful completion of G-20 reforms, the current recovery is at risk. Structural changes in the global economy will eventually yield important adjustments in real exchange rates. These would be most effectively achieved through movements in nominal exchange rates, allowing relative wages and prices to adjust quickly and symmetrically to restore external balance. However, lacking confidence in the international monetary and financial systems, countries are resisting such nominal adjustments. As a result, real exchange rate adjustment is more likely to occur through changes in general wages and prices. The implications for asset prices, output, and employment could be considerable. Already, inflationary pressures are rising in emerging economies (Chart 3). Given divergent growth and inflation prospects, monetary policy suitable for United States may not be appropriate for most other countries (Chart 4). However, those countries with relatively fixed exchange rates and relatively open capital accounts are acting as though it is. If this divergence in optimal monetary policy stance persists, the existing strains on the system will grow. In some major advanced economies, deflationary pressures are emerging. Given the fiscal constraints and scale of balance-sheet repair that is necessary, these economies have a Obstfeld, 2010. diminished ability to expand domestic demand. External competitiveness needs to be rebuilt through changes to nominal exchange rates or, failing that lower domestic wages and prices. The dynamic is perhaps most stark in peripheral Europe where the first option is not available. The current frustration of adjustment by surplus countries, if perpetuated, risks creating a similar dynamic on a global scale. History suggests that this process could take years, repressing global output and welfare in the interim. Against these difficult dynamics, the major economies are locked into what Larry Summers once termed “the balance of financial terror.” 5 Reserves are highly concentrated by holder (the top five countries hold roughly 50 per cent) and currency (two-thirds are in U.S. dollars). Reserve accumulators trade exchange rate stability for exposure to large capital losses if the dollar were to depreciate. They confer the exorbitant privilege of lower financing costs to the United States, the principal supplier of reserve currency. The United States faces the risk that this support is suddenly withdrawn, triggering a sharp adjustment. All are aware that the decisions, actual or perceived, of a few sovereigns can have a disproportionate, disruptive impact on a range of asset prices and, ultimately, global output. What then should be done? First, maintaining an open global financial system is incredibly important. Sovereign borrowing needs and business investment requirements will be considerable. It would be sheer incompetence to move from a world with a savings glut to one that is capital starved. One of the tail risks at present is the possible repeat of the Great Reversal of globalization in the aftermath of the crash of 1929. 6 Rather than turning our backs on financial globalization, we need to build resilient globalization by changing the design and operation of both the international monetary and financial systems. Buttressing the institutions and rules that support cross-border finance is thus essential. Second, a new reserve asset is not required. Over the longer term, it is possible to envision a system with other reserve currencies in addition to the U.S. dollar. However, with few alternatives ready to assume the role, the U.S. dollar can be expected to remain the principal reserve currency for the foreseeable future. Despite the exuberant pessimism reflected in the gold price, total gold stocks represent only US$1 trillion or about 10 per cent of global reserves and a much smaller proportion of global money supply. 7 The renminbi’s prospects are moot, absent full convertibility and open capital markets, which would themselves likely do much to reduce pressure for a change. At first glance, Special Drawing Rights (SDRs) would be an intriguing alternative reserve asset. 8 Using SDRs appeals to a sense of fairness, in that no one country would enjoy the exorbitant privilege of reserve currency status. Like a multiple reserve currency system, it may reduce the aggregate incentives of countries that supply the consistent currencies of the SDR to run deficits. In addition, there appears to be no technical reason why the use of SDRs could not be expanded. L.H. Summers, “The United States and the Global Adjustment Process.” Stavros S. Niarchos lecture, Institute for International Economics, 23 March, 2004, available at: <www.iie.com/publications/papers/summers0304.htm>. For a description of that process, see R. G. Rajan and L. Zingales, “The Great Reversals: The Politics of Financial Development in the Twentieth Century.” Journal of Financial Economics 69 (2003): 5–50. Under the gold exchange standard, 40 per cent of money supply was backed by gold. See X. Zhou, “Reform the International Monetary System,” People’s Bank of China, Beijing, 24 May. 2009, available at <http://www.pbc.gov.cn/english/detail.asp?col=6500&id=178>. However, merely enhancing the role of the SDR would do little either to increase the flexibility of the system or change the incentives of surplus countries. 9 Changes to reserve currencies would not increase confidence in the global financial system. More generally, alternatives to the dollar as reserve currency would not materially improve the functioning of the system. While reserve alternatives would increase pressures on the United States to adjust, since “artificial” demand for their assets would be shared with others, incentives for the surplus countries that have thwarted adjustment would not change. The common lesson of the gold standard, the Bretton Woods system, and the current hybrid system is that it is the adjustment mechanism, not the choice of reserve asset that ultimately matters. There is no silver bullet; a constellation of policies across major economic areas is required. The answer to the question I posed at the outset is not to change the current system, but rather to change policies to be consistent with it. Changing policies will require countries to change their macro policies and all countries to agree on a series of financial reforms. The G-20 framework and globally coherent policy With the burden squarely on policy dialogue and cooperation, the G-20 has assumed a central role. The G-20 framework stresses countries’ shared responsibility to ensure that their policies support strong, sustainable, and balanced growth. Under the framework, members have agreed to a mutual assessment of their monetary, exchange rate, fiscal, financial, and structural policies. There are several reasons why this process has the potential to encourage action across a range of countries. There is a clear timetable. A comprehensive set of policies are under consideration. Policy-makers at the highest levels are directly involved, supported by international financial institutions. Finally, discussions are taking place at the G-20, where all major economies are present and where China has assumed a very constructive leadership role. As is often the case, the first step to solving a problem has been to admit that it exists. With growing recognition of the shared challenges, countries have agreed to do what is necessary to secure the global recovery in the short term and to facilitate adjustment over the medium term. More tangibly, at the Toronto leaders’ summit, advanced economies committed to complete fiscal stimulus programs and implement growth friendly fiscal consolidation. EMEs committed to reduce their reliance on foreign demand and boost internal sources of growth by (i) targeting infrastructure spending; (ii) reducing excessive precautionary saving; and (iii) increasing exchange rate flexibility. Time will tell whether G-20 nations can better the underwhelming track record of the G-7 in coordinating policies. The area with the best prospects for success is in financial reforms. SDRs could catalyze that change by facilitating any desired reserve diversification. Establishing an enhanced substitution account at the IMF, on a temporary basis, would allow large reserve holders to exchange U.S.dollar reserves for SDR-denominated securities, thereby diversifying their portfolios. With the IMF bearing the risk of changes in the U.S.-dollar exchange rate, an appropriate burden-sharing arrangement among its members would have to be agreed upon. A substitution account would create considerable moral hazard, since reserve holders would be tempted to engage in further accumulation. In addition, a substitution account would not address the fundamental asymmetry of the adjustment process. Thus, it would appear essential that a substitution account mark the transition from the current hybrid system to an international system characterized by more flexible exchange rates for all systemic countries. Given the scale of international asset positions, progress on financial reforms is essential. These are also proceeding with a focus on three core issues: improving the resiliency of institutions (raising the quality and level of capital); building robust markets (improving infrastructure and enhancing transparency); and, reducing interconnectedness between institutions (macroprudential management of systemic risk). In each regard, interim measures have already been taken. Most notably, China’s recent decision to enhance the flexibility of its exchange rate is welcome and its full implementation would contribute to strong, sustainable, and balanced global economic growth. European countries have taken measures to consolidate their fiscal positions and have conducted stress tests on their banks. The oversight board of the Basel Committee has released a broad detailed agreement on new definitions of bank capital and liquidity. With the macro analysis of tightening standards pointing to large net benefits, the calibration of these proposals will be decided shortly. Successful implementation of the G-20 financial reform agenda, when combined with the peer review process of the Financial Stability Board (FSB) and external reviews by the IMF, should increase actual and perceived systemic stability and thereby reduce incentives for reserve accumulation. This is a necessary condition for a more open, flexible, and resilient international financial system. The G-20 framework will be buttressed by institutional changes currently underway. The G-20 is now the premier forum for international economic cooperation. IMF governance reforms will further enhance the Fund’s legitimacy and effectiveness. Over time, the FSB has the potential to become the fourth pillar of the Bretton Woods system. Its expertise and broad membership should yield comprehensive and integrated global financial regulations. This will be essential to ensure ongoing cross border flows and to limit regulatory arbitrage and associated leverage. The final piece of the puzzle is the role of the IMF itself. The crisis exposed enormous strains caused by currency mismatches and large international gross asset positions. These are not best addressed by further building international reserve positions concentrated in the same currencies. It is also unrealistic to rely on the Federal Reserve to act permanently as an international lender of last resort. The IMF can enhance its role as a contingent supplier of liquidity. In recent weeks, it has made tangible and sensible improvements to its lending programs by refining its Flexible Credit Line, and adopting new a crisis-prevention instrument, the Precautionary Credit Line. However, there are limits to this approach. As with lender of last resort to private entities, there can be moral hazard when lending to sovereigns. Why extend credit to countries that have already bought expensive insurance in the form of foreign-exchange reserves that they do not use? How do you “lend freely against good collateral” at the sovereign level? Countries can do most of the work themselves. Private currency mismatches can be reduced through effective supervision, and measures to enhance the liquidity of local currency funding markets are essential. Ultimately, sound monetary policy, sustainable fiscal policy, and robust financial supervision and regulation are the best defences against crises and contagion. Conclusion The world’s economic centre of gravity is shifting. The effectiveness of the international monetary and financial systems will determine how rapidly this change will occur and how sustainable it will be. The current outlook is for continuation of a modest global recovery, balancing stronger activity in emerging market economies with weaker growth in some advanced economies. However, there are non-negligible risks on the downside. In particular, the current functioning of the international monetary and financial systems is beginning to force a wrenching real adjustment across major economies. Renewed weakness in the United States could have important implications for the Canadian outlook. In this environment, the Bank will have to chart a careful course for Canadian monetary policy. Any further reduction in monetary policy stimulus would need to be carefully considered in light of the unusual uncertainty surrounding the outlook. A few months ago, the Bank of Canada analysed the potential difference between a cooperative path for the global economy based on the G-20 framework and one in which markets forced fiscal adjustment and little else is changed. We estimated a possible shortfall in global economic output of $7 trillion by 2015 (Chart 5). Since then, the Toronto Summit secured agreement on many of the right measures to make up this shortfall. However, the only measures that have actually been implemented have been consistent with the deflation path. While the other right promises have been made, conviction is required. Adjusting to the current forces in the global economy requires finishing financial reforms, implementing greater exchange rate flexibility, and putting in place a series of structural policies. G-20 nations have started, but completing the job will require renewed faith in an open, flexible, and market-based international monetary system.
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Remarks by Mr Mark Carney, Governor of the Bank of Canada, at the 7th Bundesbank Lecture 2010, Berlin, 14 September 2010.
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Mark Carney: 7th Bundesbank Lecture 2010 – the economic consequences of the reforms Remarks by Mr Mark Carney, Governor of the Bank of Canada, at the 7th Bundesbank Lecture 2010, Berlin, 14 September 2010. * * * “The power to become habituated to his surroundings is a marked characteristic of mankind... We assume some of the most peculiar and temporary of our late advantages as natural, permanent, and to be depended on, and we lay our plans accordingly. On this sandy and false foundation we scheme for social improvement and dress our political platforms.” – J. M. Keynes, The Economic Consequences of the Peace Introduction Keynes wrote prophetically of the economic consequences of the Treaty of Versailles. Could the same be said of current financial reforms? Are policy-makers taking for granted the essential role performed by finance in a vain pursuit of its risk-proofing? Do we assume that our “late advantage” of an open, global capital market and trade environment is a “natural, permanent” feature of the economic landscape? Or is the other extreme possible? Are we being too timid? Consider the jaded attitudes of the bank CEO who recounted: “My daughter called me from school one day, and said, ‘Dad, what’s a financial crisis?’ And, without trying to be funny, I said, ‘This type of thing happens every five to seven years.’” 1 Should we be content with a dreary cycle of upheaval? Such resignation would be costly. Even after heroic efforts to limit its impact on the real economy, the global financial crisis left a legacy of foregone output, lost jobs, and enormous fiscal deficits. As is typically the case, much of the cost has been borne by countries, businesses, and individuals who did not directly contribute to the fiasco. If what’s past is prologue, growth will be lower and unemployment higher for years to come. The Bank of Canada forecasts that, as a result of the crisis, cumulative foregone economic output from 2009 to 2012 will be 16 per cent of GDP in Europe and 9 per cent of GDP in Canada (see Appendix, Chart 1). Over the longer term, we estimate that these shortfalls could grow to about 40 per cent and 30 per cent of respective GDP. Given the synchronous nature of this global crisis, there are reasons to fear such severe outcomes. Surely, and contrary to what some in the industry would have you believe, there is some price worth paying to reduce such tail risks in the future. This past weekend’s historic Basel III agreement strikes exactly the right balance. In my remarks today, I will focus on the costs and benefits of financial sector reform. I will argue that the economic case is compelling and the basic stakes enormous. Financial crises are normally followed by financial repression; economic downturns, by increased protectionism. Without credible, coordinated financial reforms, we risk losing the open trading and financial system that has underpinned the economic miracle of recent times. J. Dimon, Chairman and CEO, JP Morgan Chase & Company, in testimony to the U.S. Financial Crisis Inquiry Commission, 13 January 2010. The role of the financial sector Before analysing the impact of the reforms, allow me to discuss briefly the role of the financial sector and how it failed during the crisis. By translating savings into productive investment, finance is central to economic growth. It has three core functions. First, through the payments system, it facilitates decentralized exchange, which is fundamental to the functioning of a market economy. Second, finance transforms the maturities of assets and liabilities, taking short-term liabilities, such as deposits, and transforming them into long-term assets, such as mortgages or corporate loans. Households and businesses can therefore do the reverse, holding shortterm assets and longer-term liabilities. This helps them to plan for the future and to manage risks arising from uncertainties over their cash flows. The social value of maturity transformation is unquestioned, but its performance creates fundamental risks, which requires public intervention. 2 Third, the financial system intermediates credit, channelling funds from savers to investors. This allows savers to diversify their risk and everyone to smooth consumption over time and across states of the world. Young families can borrow to buy a house; students can pay for university. People can invest for their retirements and businesses can finance working capital and investment. However, if risk is persistently mispriced, these savings and investments will be misallocated and economic welfare reduced. The crisis Financial services are supplied by a combination of banks and markets. In recent years, markets grew to the point that they became important alternatives to banks for corporate and household finance. More and more of the traditional functions of banks – including maturity transformation and credit intermediation – were conducted through a broader range of intermediaries and investment vehicles, which have been collectively referred to as the “shadow banking” system. 3 All countries participated in these trends, to varying degrees. From a financial system perspective, the deepening of markets is generally welcome because it makes the system more robust and increases competition. However, while markets expand the choices and lower the prices available to financial consumers, they function differently from banks. Unlike banks, markets rely more completely on confidence for liquidity. To maintain that confidence, markets need clear rules and robust infrastructure. In response to the increased competitive pressure from markets, banks employed three strategies: increasing leverage, greater use of securitization, and the writing of deep out-of-the-money options. Though not recognised at the time, each increased risk in the system. By borrowing in short-term wholesale markets to fund asset growth, banks became more dependent on continuous access to liquidity in money and capital markets. By using securitization to diversify the funding sources and reduce credit risks, banks created new exposures. The severing of the relationship between originator and risk holder lowered underwriting and monitoring standards. In addition, the transfer of risk itself was frequently To manage the fundamental risk created by maturity mismatch, banks rely on two crucial supports: deposit insurance and the central bank as a lender of last resort to solvent but illiquid institutions. Banks implicitly accept a social contract that gives them access to liquidity support in times of stress in return for regulation of their behaviour at all times. Shadow banks included investment banks, mortgage brokers, finance companies, structured investment vehicles, hedge funds, and other private asset pools. incomplete, with banks retaining large quantities of supposedly risk-free leveraged super senior tranches of structured products. These exposures were compounded by the rapid expansion of banks into over-the-counter derivative products. In essence, banks wrote a series of large out-of-the-money options in markets such as those for credit default swaps. 4 As credit standards deteriorated, the tail risks embedded in these strategies became fatter. With pricing and risk management lagging reality, there was a widespread misallocation of capital. The magnitude of these developments was remarkable. In the final years of the boom, when complacency about liquidity reached its zenith, the scale of shadow banking activity exploded. The value of structured investment vehicles, for example, tripled in the three years to 2007. Credit default swaps grew sixfold. Financial institutions, including many banks, came to rely on high levels of liquidity in markets. Short-term money markets were the predominant source of financing for the one-third increase in the gross leverage of U.S. investment banks, U.K. banks, and European banks. The system’s exposure to market confidence was enormous. Through all of this, a mirage formed of relentlessly expanding profitability in the financial sector. In the United States, between 2000 and 2006, corporate profits in the sector averaged over 36 per cent of total profits. It appeared briefly that finance was the ruler, rather than a servant of, the real economy. The large losses and costly bailouts required to repair balance sheets shattered this illusion. 5 The shortcomings of regulation were similarly exposed. The shadow banking system was not supported, regulated, or monitored in the same fashion as the conventional banking system, despite the fact they were of equal size on the eve of the crisis. 6 There were also major flaws in the regulation and supervision of banks themselves. Basel II fed procyclicalities, underestimated risks, and permitted excess leverage. Gallingly, on the day before each went under, every bank that failed (or was saved by the state) reported capital that exceeded the Basel II standard by a wide margin. Most fundamentally, the global financial crisis revealed the fallacy of composition that strong individual financial institutions collectively ensure the safety and soundness of the system as a whole. Even the most vigilant, microprudential regulatory regime can be overwhelmed by systemic risks. As a consequence, policy-makers now recognise that systemic risk is the product of the resiliency of financial institutions, the robustness of systemically important markets, and the interconnectedness between institutions and markets. The G-20 reform agenda The G-20 has initiated an extensive program of reform designed to improve the safety and robustness of the global financial system. The measures are mutually reinforcing, and all are necessary. See A. Haldane, “The Contribution of the Financial Sector – Miracle or Mirage?” Speech delivered at the Future of Finance Conference, London, 14 July 2010. It was not just a question of misleading data on profitability. The basic shortcoming of financial growth accounting also plagued compensation structures. Employees were paid in cash for positive net present value of long-tailed risks. Z. Pozsar, T. Adrian, A. Ashcraft, and H. Boesky, ”Shadow Banking”, Federal Reserve Bank of New York Staff Report No. 458, July 2010. Building robust markets The first strategy is to build robust financial markets by improving infrastructure and transparency. In particular, keeping markets continuously open requires policies and infrastructure that reinforce the private generation of liquidity in normal times and facilitate central bank support in times of crisis. The cornerstone is clearing and settlement processes with risk-reducing elements, particularly central clearing counterparties or “CCPs” for repos and OTC derivatives. Properly risk-proofed CCPs act as firewalls against the propagation of default shocks across major market participants. Through centralised clearing, authorities can also require the use of through-the-cycle margins, which would reduce liquidity spirals and their contribution to boom-bust cycles. 7 Reducing the interconnectedness between institutions and markets The second G-20 imperative is to create a system that can withstand the failure of any single financial institution. From Bear Stearns to Hypo Real Estate to Lehman Brothers, markets failed that test. Today, after a series of extraordinary, but necessary, measures to keep the system functioning, we are awash in moral hazard. If left unchecked, this will distort private behaviour and inflate public costs. As a consequence, there is a firm conviction among policy-makers that losses incurred in future crises must be borne by the institutions themselves. This means management, shareholders, and creditors, rather than taxpayers. Measures to expose fully firms to the ultimate sanction of the market will also reduce the interconnectedness between institutions. In addition to changes to market infrastructure, priorities include: staged-intervention regulatory regimes, “living wills” for banks, and better cross-border resolution regimes. Another promising avenue is to embed contingent capital features into debt and preferred shares issued by financial institutions. Contingent capital is a security that converts to capital when a financial institution is in serious trouble, thereby replenishing capital without the use of taxpayer funds. Contingent conversions could be embedded in all future new issues of senior unsecured debt and subordinated securities to create a broader bail-in approach. Its presence would also discipline management, since common shareholders would be incented to act prudently to avoid having their stakes diluted by conversion. Overall, the Bank of Canada believes that contingent capital can reduce moral hazard and increase the efficiency of bank capital structures. We correspondingly welcome the Basel Committee’s recent public consultation paper on this topic. Improving the resiliency of financial institutions The third priority is to improve the resiliency of financial institutions themselves. Creating more resilient institutions requires more and better capital, improved balance sheet liquidity, and enhanced risk management. 8 This past weekend’s Basel III agreement delivers on these objectives by: Market resiliency can also be improved through better and more-readily available information. This reduces information asymmetry, facilitates the valuation process and, hence, supports market efficiency and stability. In this regard, priorities are an expansion of the use of trade repositories for OTC derivatives markets and substantial enhancements to continuous disclosure standards for securitization. The crisis also underscored the need to better capture counterparty exposures, market risk, and a host of contingent claims. Creating global standards for liquidity. Raising substantially the quantity, quality, consistency, and transparency of the Tier 1 capital base. Introducing a leverage ratio as a complement to the Basel II risk-based framework. The leverage ratio is, in effect, a safety harness that is designed to protect against risks that regulators think are low but which, in fact, are not. Introducing a capital conservation buffer above the minimum capital requirement to ensure that banks and supervisors take prompt corrective action and that banks can absorb losses during periods of financial and economic stress. This conservation buffer is to be complemented by a countercyclical buffer, which would vary over time. It should be at its maximum in periods when credit is growing rapidly and system-wide risks are rising. In times of stress, the buffer would be reduced to ensure that the flow of credit is not undermined by regulatory constraints. The goal is to make financial systems less vulnerable to booms and busts so that crises are less frequent and less severe. Through evidence-based analysis, policy-makers can determine the package of reforms that will maximise these net economic benefits. It is to this issue that I will now turn. The benefits of reform The potential economic benefits of stronger capital and liquidity standards are significant. These benefits emerge from a variety of sources: Higher capital and liquidity standards will contribute to a lower incidence of financial crises. The severity of financial crises could also be reduced. The economy should benefit from smoother economic cycles. Higher standards should help to reduce the risk that resources are misallocated. To put the magnitude of potential gains into context, consider more closely the costs of financial crises. In the 10 years following a financial crisis, the median output growth rate decreases by 1 per cent, and the unemployment rate increases by 5 percentage points. 9 Experience suggests that costs build well into the future. In studies released last month, the Basel Committee found that the median cumulative loss of past financial crises was 63 per cent of national GDP. Given the scale of potential losses, there are clearly large benefits to reducing the frequency of crises (Chart 2). The extensive analysis of the Basel Committee suggests that higher capital and liquidity standards would do just that. In particular, the combination of strengthened liquidity standards and a 2-percentage-point increase in bank capital ratios would raise the annual expected level of GDP by 1.8 per cent relative to trend. See C. Reinhart and V. Reinhart, “After the Fall”, forthcoming in Macroeconomic Policy: Post-Crisis and Risks Ahead, Federal Reserve Bank of Kansas City Economic Policy Symposium, Jackson Hole, Wyoming, 26–28 August 2010. Because this improved performance accrues over time, it is a gift that keeps on giving. Using a conservative real discount rate of 5 per cent, the cumulative present value of this better performance is equivalent to more than 35 per cent of GDP, or €0.9 trillion for Germany. 10 Some in Canada argue that our sound financial system implies that the potential gains are small for our country and the G-20 reforms are, therefore, unimportant. This is misguided. In open economies such as ours and Germany’s, reducing the incidence of foreign crises is even more important than domestic benefits. Today’s reality is one of deep interconnectedness, where financial problems in other regions spill rapidly into our own. In an increasingly multipolar economy, we simply cannot afford to lurch from crisis to crisis every five years. To reduce this frequency, we need a strong, universally applied framework. The Basel III rules, combined with the FSB and IMF’s review processes, have the potential to be just that. Costs of reform Despite the clear benefits, stronger prudential standards also impose costs. Banks can follow several strategies to meet regulatory demands for higher capital requirements. Most obviously, they could raise additional capital in public markets. If given sufficient time, they could generate capital internally through retained earnings. In addition, they could pass on some of the costs of the higher standards to their customers through higher interest spreads or increased fee income. Finally, they could shed, or slow the growth, of assets. Past experience suggests that banks will use a combination of all these methods. 11 However, to be conservative, the Basel report assumes that banks would recoup the cost of higher capital and liquidity requirements entirely through higher lending spreads. The long-term estimate of the increase in lending spreads is then used as an input to a variety of models to assess the impact on output. By combining strengthened liquidity standards with a 2-percentage-point increase in bank capital ratios, expected output growth, relative to trend, is reduced by 0.25 per cent on average for the countries analysed (0.30 per cent for Canada). In present-value terms, this equates to about 5 per cent of GDP. Together with these long-run costs, there are also costs incurred during the transition period. The Basel study estimates these through a sophisticated approach using a wide range of models. 12 The result for the group is a 1.1 per cent cumulative reduction in GDP over a four-year transition period (in present value). A conservative estimate of the net benefits Netting the long-run benefits of less frequent financial crises with the long-run and transition costs yields average net benefits for G-20 economies of 30 per cent of GDP in present-value terms, or about €10 trillion (Table 1). 13 The Bank of Canada estimates the equivalent figures for Canada would be 1.1 per cent and 20 per cent of GDP. The longer the transition period is, the more important the internal generation of earnings will be. It was necessary to make a number of assumptions in this analysis. For example, it was typically assumed that monetary policy would respond to mitigate the effects of the more stringent bank capital and liquidity requirements. It was also important to include the spillover effects that occur across borders, magnifying the impact on output. Assuming a 2-percentage-point increase in capital (plus liquidity changes). For Canada, estimates are approximately 13 per cent of GDP in present-value terms, which is equal to about Can$200 billion (Tables 2 and 3). This estimate is conservative. The analysis understates the benefits of the new rules and errs on the side of overstating the costs. This bias is reflected in several key assumptions. First, banks are assumed to fully pass on the costs of higher capital and liquidity requirements to borrowers rather than reducing their current returns on shareholders’ equity or operating expenses, such as compensation, to adjust to the new rules. Consider the alternative. If banks were to reduce personnel expenses by only 10 per cent (equal to a 5 per cent reduction in operating expenses), they could lower spreads by an amount that would completely offset the impact of a 2-percentage-point increase in capital requirements. Second, higher capital and liquidity requirements are assumed to have a permanent effect on lending spreads, and hence on the level of economic output. No allowance is made for the possibility that households and firms may find cheaper alternative sources of financing. Third, the discount rate used to calculate net benefits was more than twice current real interest rates and the longer-run real growth rates of the Canadian and German economies. Finally, the only benefit quantified is the gains to GDP resulting from a reduced probability of future financial crises. Other benefits from financial reforms are substantial However, there are a variety of other potential benefits from higher capital and liquidity standards and the broader range of G-20 reforms. First, the variability of economic cycles should be reduced by a host of macroprudential measures. Analysis by the Bank of Canada and the Basel group suggests a modest dampening in output volatility can be achieved from the Basel III proposals, as higher capital and liquidity allow banks to smooth the supply of credit over the cycle. For instance, a 2-percentage-point rise in capital ratios lowers the standard deviation of output by about 3 per cent. A much more significant impact can be expected from other macroprudential instruments under consideration. These include varying loan-to-value and other credit terms in mortgage markets, adopting through-the-cycle margining in core funding markets, and the introduction of countercyclical capital buffers. The Bank of Canada has modelled the potential impact of such a time-varying buffer and translated the gains from reduced volatility into domestic consumption and GDP. The preliminary findings suggest that the potential gains are in the range of 4 per cent to 6 per cent of GDP in present-value terms. In other words, countercyclical buffers alone could increase the net benefits of reforms by about 20 per cent. It is reasonable to expect similar results for other countries. 14 Second, there is a range of initiatives under consideration to reduce moral hazard, including new frameworks for the effective resolution of banks, more intensive supervision of key institutions, the introduction of contingent capital, and the creation of more robust infrastructure. Adoption of these measures should further reinforce the ability of Basel III standards to reduce the probability of crises and thereby increase net benefits. See C. Meh and K. Moran, “The Role of Bank Capital in the Propagation of Shocks”, Journal of Economic Dynamics and Control 34: 555–76 (2010); I. Christensen, C. Meh, and K. Moran, “Bank Leverage Regulation and Macroeconomic Dynamics”, forthcoming Bank of Canada Working Paper (2010); A. Dib, “Banks, Credit Market Frictions, and Business Cycles”, forthcoming Bank of Canada Working Paper (2010). Third, the totality of the G-20 reforms has the potential to shift the balance between resiliency and competition. By creating a system that is robust to the failure of a single firm, reforms could increase the competitive intensity in the financial services sector, with attendant benefits. A financial sector that is less volatile, less prone to debilitating crises, and more robust in the face of adverse shocks is likely to be viewed more favourably by investors and attract the investment needed to continue to expand in a sustainable manner. By reducing moral hazard, incumbents will also enjoy fewer oligopolistic privileges behind regulatory barriers to entry. Greater competition commonly leads to more innovative and diverse strategies, which would further promote resiliency of the system. Greater competition and safer banks may also contribute to lower expected return on equity (ROE) for financial institutions. This, in turn, could help offset the costs and increase the net benefits discussed earlier. These gains from competition could be considerable. The financial services sector earns a 50 per cent higher return on equity than the economy-wide average. If greater competition leads to a one-percentage-point decline in the ROE (through a decline in spreads), the estimated cost from a one-percentage point increase in capital would be completely offset. Conclusion The fundamental objective of the reforms is to create a system that efficiently supports economic growth while providing financial consumers with choice. The system must be robust to shocks, dampening, rather than amplifying, their effect on the real economy. It should also support sensible innovation. The system needs stable banks and robust markets, since both play a central role in financing, and, if properly structured, each can support the other. This means ensuring that individual financial institutions are stronger and less systemically important, that more options for liquidity are available in all states of the world, and that the new measures promote competition. A fully risk-proofed system is neither attainable nor desirable. The point is not to pile up so much capital in our institutions that they are never heard from again, either as a source of instability or of growth. The challenge is to get the balance between resiliency and efficiency right. The Basel III agreement accomplishes these objectives. Moreover, a careful analysis indicates that the economic case for the reforms is compelling. Most fundamentally, successful implementation of the G-20 agenda will increase the likelihood of an open, flexible international financial and trading system. Modern Germany has prospered in this environment and has a great stake in leading the G-20 in building a more secure foundation for modern prosperity. The Bundesbank has led the development of many of these reforms. Tremendous progress was made this past weekend, but there is still more to do. Germany’s continued leadership in the coming weeks and months will be critical, so that we can finish building a solid financial foundation for growth and social improvement. We should all heed the words of President Weber: "Policy-makers now have to muster the political will to take the necessary steps, however contested and painful they might be”. 15 Thank you. A. A. Weber, “The G20 Agenda on Financial Regulation”, Dinner speech at the International Conference on Financial Market Regulation, 19 May 2010. Appendix Chart 1 An illustration of the cumulative output loss in Canada from the financial crisis Chart 2 Expected longer-run benefits and costs of tighter capital and liquidity standards In per cent of GDP Table 1 Cumulative benefits and costs for the G-20 from stronger regulatory requirements Present value in per cent of GDP Table 2 Estimated long-run costs and benefits for Canada from stronger regulatory requirements Expressed as annual percentage impact on the level of GDP Table 3 Present value of benefits and costs for Canada from stronger regulatory requirements
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Remarks by Mr Mark Carney, Governor of the Bank of Canada, to the Windsor-Essex Regional Chamber of Commerce, Windsor, Ontario, 30 September 2010.
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Mark Carney: Employment in a modest recovery Remarks by Mr Mark Carney, Governor of the Bank of Canada, to the Windsor-Essex Regional Chamber of Commerce, Windsor, Ontario, 30 September 2010. * * * It is a pleasure to be here to discuss current economic conditions with the Windsor-Essex Regional Chamber of Commerce. I look forward to this opportunity to hear insights directly from business leaders. Insights from financial markets are somewhat fleeting at the moment. A broad range of asset prices from the Canadian dollar to S&P500 futures to European sovereign spreads are unusually correlated and volatile (Appendix, Chart 1). Every morning by looking at any one of these variables you can readily tell whether markets are in a risk-on or risk-off mode. In the current environment, the macro dominates the idiosyncratic. The good and bad moves you make as business people will, for the moment, go largely unrewarded or unpunished. What matters most is the daily perception of the answers to three very big questions: Will the U.S. recovery falter under the weight of balance-sheet repair and slow employment growth? Can the rest of the world sustainably decouple? Will there be another systemic event concerning sovereigns or banks? In this time of unusual uncertainty, businesses on either side of the border are responding in different ways. In the United States, investment has been relatively strong and productivity growth has been robust. However, hiring has been unusually weak, particularly by small businesses. In Canada, the opposites have been the case: investment has been unusually weak; productivity, poor; and hiring, strong, particularly amongst small and medium-sized enterprises (SMEs). I would like to speak today about the possible reasons for these divergences, how long they are likely to persist, and their implications for growth and inflation in Canada. The global economic outlook The global recovery is entering a new phase. The easy bit is now over. In advanced economies, the temporary boost from the turn in the inventory cycle is largely complete. In many countries, fiscal stimulus is turning to fiscal drag. The panicked postponement of consumption and investment has been unwound. The question now is whether growth in advanced economies will be self-sustaining in the face of broad forces of bank, household, and sovereign deleveraging. The evidence is mixed, depending on proximity to the crisis. For example, in Germany, where household and government finances are sound and the economy is externally oriented, growth has picked up smartly. In peripheral Europe, where households and governments are extremely leveraged and economies have been domestically focused, growth is slowing rapidly. Similar forces threaten renewed weakness in the United States. For Canada, this prospect is of concern. Financial markets are currently constructive but remain vulnerable to event risk. Renewed pessimism over the U.S. outlook has sharply reduced global bond yields. In effect, there has been a Goldilocks deterioration in the macro-financial environment as major government bond yields have fallen sharply but corporate spreads have not increased (Chart 2). For large corporations who want it, finance is readily available at historically low all-in costs. In emerging economies, growth has persistently surprised on the upside. Healthy financial sectors and very stimulative monetary and fiscal policies have overcome the drag from weaker export markets. However, with the limits to non-inflationary growth approaching and the challenges of shadowing U.S. monetary policy increasing, this above trend growth is likely to come to an end. In sum, there are several reasons to expect a modest and uneven global recovery. Not all countries can simultaneously export their way to growth. The ongoing process of balance sheet repair in major industrialised countries will restrain household consumption and business investment. The ability of some major emerging markets to maintain persistently higher domestic demand remains unproven. Finally, necessary real exchange rate adjustment threatens to come through inflationary pressures in emerging economies and deflationary pressures in major advanced economies rather than (far easier) changes in nominal exchange rates. These forces make the economic outlook and policy environment unusually challenging for countries caught in the middle, like Canada. The U.S. economic outlook When faced with a potential collapse in private demand in the wake of the financial panic, U.S. authorities instituted massive and timely monetary and fiscal stimulus. This bought time for the necessary adjustments in the economy to begin. With U.S. fiscal policy transitioning from expansion to contraction, that time is now coming to an end. The success of the necessary handoff of growth from the public to the private sector is still in question (Chart 3). The U.S. housing sector remains very weak, despite substantial falls in prices and housing starts. Valuations are more in line with historical averages, and inventories of unsold new homes have reached their lowest level since 1968. However, effective supply is much larger, given the overhang of distressed properties and the pent-up supply of “shadow inventories” in the resale market. Housing demand continues to be held back by subdued consumer confidence, the weak labour market, and the inability of some households to access financing, at historically low mortgage rates. While there appears to be limited prospect for substantial further deterioration in U.S. housing, a sharp rebound in the near term looks unlikely. U.S. businesses have responded to the challenging environment by increasing productivity. While commercial real estate investment has been unusually depressed, investment in equipment and software has been robust and consistent with prior recoveries (Chart 4). The same cannot be said of the U.S. labour market, which has borne the brunt of adjustment. The unemployment rate remains very high at 9.6 per cent, the incidence of longterm unemployment reached a record level above 40 per cent (Chart 5), and underemployment in the form of involuntary part-time work is rampant. The prolonged weakness in the U.S. labour market reflects factors that go beyond weak output growth. The jump in the unemployment rate has been higher, by about 5 million workers, than the decline in GDP would have traditionally suggested. The restructuring of major industries such as autos, finance and of course, construction has deepened the job losses. In addition, credit constraints facing U.S. SMEs have contributed to the employment dynamics. 1 The natural rate of unemployment may be increasing sharply. The scale of industry restructuring means that some unemployed workers do not have the skills suitable for the About 80 per cent of job losses in this recession have been from enterprises with less than 500 employees. expanding sectors. Other jobseekers are tied to their local area, due to an inability to sell their homes in distressed markets, hampering the mobility that has been a hallmark of the American labour market. The current cycle is also self-reinforcing. As long-term unemployment becomes more entrenched, workers’ skills deteriorate and their reintegration into the labour force becomes more difficult. Reflecting weakness in the labour market and an ongoing need to repair stretched personal balance sheets, U.S. real personal expenditures are not yet back to pre-crisis levels. Two of the most visible indicators of this weakness matter tremendously to Canada: housing starts and motor vehicle sales (Charts 6a and 6b). The good news is that recent data revisions indicate that the personal savings rate is now at 6 per cent, which is consistent with ultimately rebuilding U.S. household wealth to historic averages and stabilizing the U.S. net foreign liability position. If savings hold at this level (that is, absent a further shock to confidence), then consumption should grow next year at a moderate pace. The Canadian economic outlook Despite this challenging external environment, Canada’s recovery has been stronger than that of its G-7 peers. As a result of the combination of the scale and speed of the policy response and our well-functioning financial system, Canada’s economy is now back at its pre-crisis peak in output. However welcome, our recovery is relatively modest in comparison to its predecessors and has relied heavily on housing and personal consumption. The limitations of this reliance are becoming evident. In recent months, the speed of the recovery has diminished. A modest pace of growth can be expected in coming months as our economy faces considerable headwinds from both the external sector and the limits of household balance sheets. Allow me to expand. Housing activity in Canada is declining markedly from high levels, as the Bank had expected. The slowing since the spring in resale, renovation, and new home construction activity has been driven by a number of factors, including the passing of pent-up and pulled-forward demand; the expiration of the federal Home Renovation Tax Credit in January; the tightening of standards for government-backed insured mortgages that came into effect in April; the introduction of the HST in Ontario and British Columbia in July; declining affordability; and subdued income growth. I will come back to that last factor in a moment, but overall it appears unlikely that private consumption will be bolstered by substantial house price gains going forward. 2 The fiscal stimulus is also coming to an end. After making a major contribution to growth since the onset of the recession (Chart 7), the Bank estimates that the contribution of government spending to real GDP growth will turn negative in 2011. Until recently, business investment has disappointed relative to past experience as well as to the imperatives of lagging productivity, increasing international competition, and the development of major opportunities in emerging markets. Survey evidence and recent data suggest that is now changing. The Bank expects that business investment will increase to House prices matter principally because of the “financial-accelerator effect.” When the value of a house rises, the owner can typically borrow against this increased equity to fund home renovations, a second house, or other goods and services. These expenditures can “accelerate” a rise in house prices, reinforcing the increase in collateral values, access to additional borrowing, and, thus, an increase in household spending. Of course, this accelerator effect can also work in reverse: a decrease in house price tends to reduce household borrowing capacity and amplify the decline in spending. levels consistent with previous recoveries, reflecting competitive imperatives, firms’ strong financial position, and easy credit conditions (Chart 8). The auto sector provides an example. The recession crystallised a major restructuring, with North American capacity reduced by 3 million motor vehicles. 3 More than 576,000 jobs were lost since December, 2007. Today, U.S. demand for motor vehicles is about 11 million per year versus the average from 2000 to 2006 of 17 million, and while there will be some growth from here, the U.S. market is likely to be persistently smaller as households reduce debt. As a consequence, business models are now being substantially adjusted. Canada is competing to host some of the handful of global OEM (original equipment manufacturer) platforms, training, R&D, and capital investment are being ramped up, and some Canadian tier 1 suppliers are aggressively expanding into emerging markets. Similar bold moves will be required across our economy to create sustainable, wellpaying jobs. Labour market dynamics in Canada The most striking thing about the Canadian recovery has been the performance of the labour market (Chart 9). All 400,000 jobs lost in the recession have now been recovered. While the unemployment rate remains high at 8.1 per cent, this reflects in the aggregate the movement of more people into the labour force. With this, the incidence of longer term unemployment in Canada is about half that in the United States. However welcome, these headline figures mask some important details. Much of the employment growth is in the public sector, with only half of the new jobs in the private sector. Many jobs are involuntary part-time. In fact, although employment has regained its prerecession level, hours worked have not. Overall labour input (the combination of employment and hours worked) has made up only two-thirds of its decline during the recession. Since the crash, on the margin, the composition of labour demand has shifted from jobs in the goods sector to jobs in the services sector. The change accounts for the majority of the gap between the current level and the pre-recession level of average hours worked. In the current cycle, the goods sector, such as autos, has experienced far more adjustment than services, such as retail. This appears to be largely a result of the export-oriented nature of the shock and the strength of the Canadian dollar. These dynamics would be familiar here in Windsor-Essex, where the unemployment rate is about 3 percentage points above the national average. The Bank expects that average hours worked will return to its trend, but only very gradually. Those in involuntary part-time positions should eventually find full-time ones. This view is anchored by an expected slow recovery in goods sector employment, which in turn reflects our expectations for the pace of recoveries in U.S. demand and Canadian business investment. If the U.S. falters or the acceleration in Canadian business investment flags, then the pace of improvement in the labour market will be slower. Household balance sheets and the outlook for consumption With Canadians working, but not as much as they would like, they have been borrowing. Real household credit expanded rapidly throughout the recession, in contrast to previous downturns, and has continued to grow through the recovery. Canadian households have now R. Harbour, “Automotive Manufacturing Transition,” a presentation delivered at the Center for Automotive Research, Management Briefing Seminars, Traverse City, Michigan, 4 August 2010. Found at: <http://mbs.cargroup.org/2010/content/view/235>. collectively run a net financial deficit for 37 consecutive quarters. That is, their investment in housing has outstripped their total savings for over nine straight years. In effect, households are demanding funds from the rest of the economy, rather than providing them, as had been the case through the 1960s, 1970s, 1980s and 1990s (Chart 10). This cannot continue. The ratio of Canadian household debt to disposable income reached 146 per cent in the first quarter of this year, an all-time high and very close to the current level in the United States (Chart 11). In a series of analyses over the past year the Bank has found that Canadian households are increasingly vulnerable to an adverse shock and that this vulnerability is rising more quickly than had been previously anticipated. 4, 5 It is true that the strength of housing and other assets has meant that the net worth of Canadians remains about six times their average disposable income compared with slightly below five times in the United States. However, while asset prices can rise or fall, debt endures. Despite the buoyancy of the housing market, the debt-to-asset ratio has risen to its highest level in more than 20 years. In short, Canadian household balance sheets are becoming increasingly stretched. It is possible that Canadians are beginning to address some of these vulnerabilities. This would be consistent with recent data that indicate a slowdown in household consumption expenditures and housing activity, amid a labour market recovery that has been longer on jobs than on hours or incomes. The Bank expects balance-sheet considerations will remain important ahead, likely limiting consumption growth to a rate more consistent with income growth over the medium-term horizon. Reflecting recent developments, inflation in Canada has been slightly lower than the Bank’s expectations, with core CPI of 1.6 per cent and total CPI of 1.7 per cent in August. However, its dynamics are essentially unchanged. Inflation expectations are well anchored at the 2 per cent target. Developments in the labour market described earlier, combined with expenditure restraint in the public sector and a pickup in labour productivity, should contribute to restrained growth of unit labour costs. This downward pressure on inflation is expected to be offset by the gradual absorption of excess supply as the economy grows. As has been the case with previous changes in indirect taxes, for the purposes of monetary policy, the Bank will look through the first-round effect of recent changes in provincial sales taxes on prices. Policy implications A durable global recovery requires a major rebalancing of global supply and demand. This will be a slow process, measured over a decade. During this period of adjustment, we should expect subdued growth in major advanced economies. Consider that in the 10 years following a typical financial crisis, the median rate of output growth in the crisis economy decreases by 1 per cent and the unemployment rate increases by 5 percentage points. 6 The United States is tracking this path. In such an environment, very low policy rates could be in place for longer, and unconventional monetary policies could even be expanded in some major countries. But Bank of Canada Financial System Review, June 2010 and December 2009. This analysis has been conducted with data from the Canadian Financial Monitor survey by Ipsos Reid Canada. See C. Reinhart and V. Reinhart, “After the Fall,” Macroeconomic Challenges: The Decade Ahead, Federal Reserve Bank of Kansas City Economic Policy Symposium, Jackson Hole, Wyoming, 26–28 August 2010. clearly, monetary policy alone will not be enough. Advanced economies need to chart a course for fiscal sustainability, complete an ambitious restructuring of their financial systems, and implement domestic structural reforms. Emerging economies need to expand domestic demand and fulfill commitments to enhanced currency flexibility. Ultimately, all countries need to create a more flexible, open international monetary system to complete the transformation to a multi-polar world. The Bank of Canada is working with other major central banks on this vital international agenda but, ultimately, our most important contribution to the economic welfare of Canadians is to continue to deliver price stability as defined by our 2 percent inflation target. In response to the sharp, synchronous global recession, the Bank lowered the target rate rapidly over the course of 2008 and early 2009 to its lowest possible level. We almost doubled our balance sheet to provide the financial sector with exceptional liquidity. With our conditional commitment, the Bank provided exceptional guidance on the likely path of our target rate. These policies provided considerable additional stimulus during a period of very weak economic conditions and major downside risks to Canadian economy. With the initial rapid narrowing of the output gap, the return of employment to its precrisis peak, the highly effective transmission of monetary policy in Canada, and the sustained momentum in household borrowing, the need for such emergency policies passed. Since the spring, the Bank has unwound the last of our exceptional liquidity measures, removed the conditional commitment, and raised the overnight rate to 1 per cent. Following these actions, financial conditions in Canada have tightened modestly but remain exceptionally stimulative. This is consistent with achieving the 2 per cent inflation target in an environment of still significant excess supply in Canada and the demand headwinds described earlier. While Canada’s circumstances and the discipline of the inflation target dictate a different policy stance than in the United States, there are limits to this divergence. At this time of transition in the global recovery, with risks of a renewed U.S. slowdown, with constraints beginning to bind growth in emerging economies, and with domestic considerations that will slow consumption and housing activity in Canada, any further reduction in monetary policy stimulus would need to be carefully considered. The unusual uncertainty surrounding the outlook warrants caution. Historically low policy rates, even if appropriate to achieve the inflation target, create their own risks. Aside from monetary policy, Canadian authorities will need to remain as vigilant as they have been in the past to the possibility of financial imbalances developing in an environment of still low interest rates and relative price stability. Conclusion Today’s venue honours Giovanni Caboto, who, more than 500 years ago, combined the navigation skills of his home in Genoa with the commercial initiative of his Bristol sponsors to make landfall in Canada. His voyage marked the start of the opening of North America to global commerce. Similarly today, Canadian business must open new markets. The world’s economic centre of gravity is again shifting. With the integration of one-third of humanity into the global economy, the world is rapidly becoming multi-polar. Emergingmarket economies are now the main drivers of commodity prices, they represent almost onehalf of the growth in all imports over the past decade, and they currently account for about two-thirds of global growth. In contrast, the United States is undergoing a protracted adjustment, which will subdue demand for Canadian goods for the foreseeable future. Canadians must respond. As a country we are under exposed to the economies that will drive global growth. The imperatives for business appear clear: new suppliers need to be sourced; new markets opened; and a new approach to managing for a more volatile environment developed. Workers need to build skills and be prepared to shift jobs and even careers, if necessary. Business in Windsor-Essex has started. Our auto sector is undergoing a major restructuring and is emerging more competitive. There are recent signs that other sectors are beginning to follow. If business can sustain and then broaden this early momentum, all Canadian workers will be fully and productively employed. Appendix
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Remarks by Mr Tiff Macklem, Senior Deputy Governor of the Bank of Canada, at the International Finance Club of Montreal, Montreal, 5 October 2010.
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Tiff Macklem: Reflections on monetary policy after the Great Recession Remarks by Mr Tiff Macklem, Senior Deputy Governor of the Bank of Canada, at the International Finance Club of Montreal, Montreal, 5 October 2010. * * * Introduction I am delighted to be in Montréal and to address the International Finance Club of Montréal in the Mount Stephen Club – a beautiful and elegant venue steeped in Canadian and Quebec history. It was founded by business leaders and is still a gathering place of grace and influence. As a native Montrealer, I am particularly pleased to be coming home to deliver my first speech as Senior Deputy Governor of the Bank of Canada. The Mount Stephen Club opened its doors during the Roaring Twenties. As a meeting place for Montréal’s business elite, a great many frank discussions must have taken place in its early days about the stock market bubble, the Crash of ’29 and the ensuing Great Depression. It is with some humility that I suggest those discussions were likely similar to more recent conversations that have taken place within these walls about the credit boom, the financial crisis, and the Great Recession. What I thought I could do today is contribute to this tradition of frank discussion by sharing with you some of my reflections on monetary policy coming out of the Great Recession. My remarks today focus on three themes: What’s worked well What’s been missing And what needs to be brought back after a period of neglect After spending many years at the Bank of Canada, I was recently at the Department of Finance, where I was Associate Deputy Minister and Canada’s G-7 and G-20 Deputy. During that time, I continued to work closely with the Bank, as well as with the Office of the Superintendent of Financial Institutions (OSFI) and other partners coordinating Canada’s response to the financial crisis. But as far as monetary policy goes, that remained solely the purview of the Bank of Canada. I was a spectator like everyone else here today. So I offer these reflections as someone who was on the outside looking in during the Great Recession. Global economic growth has returned Although the Great Recession is now over and global economic growth has returned, it is not a great recovery. Growth is uneven, and there is an unusual degree of uncertainty. Globally, the financial crisis has left scars of lost output and jobs, declines in household wealth, impaired financial systems and large fiscal deficits. With households, financial firms and governments all deleveraging, the global recovery is expected to be modest and unemployment to come down only gradually. In most advanced countries the recovery remains dependent on monetary and fiscal stimulus. Private demand is recovering, but the hand-off from public stimulus to private demand has yet to be accomplished. With fiscal policy expected to begin to withdraw stimulus in the coming year, monetary policy is likely to remain stimulative for some time. Globally, the modest recovery in advanced countries is being balanced by continued strong growth in most emerging market economies. Policy responses and strengthened economic frameworks are helping emerging economies to boost internal demand, although in some cases this needs to be supported by greater exchange rate flexibility. The International Monetary Fund (IMF) predicts that annual growth for 2011 in emerging economies will be about 6½ per cent, while worldwide growth is projected to be about 4¼ per cent in 2011. As you know, Canada withstood the crisis better than most other countries, thanks to solid foundations – a mortar mix of good management and sound policy. Looking ahead, the IMF expects Canada’s economic recovery to be among the strongest of the G-7 countries over the next two years. Nonetheless, by historical standards, this is still a modest recovery. Globally, the costs of this crisis have been enormous. Economic output in the G-7 countries fell by almost 5 per cent from peak to trough with output losses of $2 trillion for the global economy. In Canada, GDP fell by more than 3 per cent from peak to trough, with output losses at $50 billion and 400,000 jobs lost. Canada has now recouped these lost jobs, but has not recovered the lost momentum and opportunity the crisis left behind. There is a great deal to fix to prevent such losses happening again. Much of this has to do with aligning incentives and enhancing risk management and governance in the private sector, strengthening financial regulation and supervision, and improving core financial infrastructure. But today I want to focus on the lessons of the Great Recession for monetary policy. What’s worked well Let me start with what worked. In the early 1990s, price stability became entrenched as the primary objective of monetary policy. This reflected both the bitter experience with inflation since the early 1970s and a growing consensus that price stability was the best contribution monetary policy could make to the welfare of Canadians. In 1991, the objective of price stability was formalized and Canada became only the second country in the world, following New Zealand, to target inflation. That same year, I was a relatively newly minted PhD working at the Bank. The move to an inflation target presented an exciting opportunity to translate my educational investment into real-world policy advice on how to implement this new inflation-targeting regime. It was a fascinating time, although the early days of inflation targeting were difficult. There was considerable skepticism about whether the Bank of Canada could control inflation and achieve the targets. In addition, in the first half of the 1990s, Canada’s government debt was high and rising. So when global risk appetite pulled back with the outbreak of the Mexican peso crisis, many foreign investors dumped Canadian-dollar assets. And the growing sovereign risk premium demanded by foreign investors to hold Canadian-dollar assets undermined the Bank of Canada’s ability to set interest rates to achieve the inflation target. This offers a cautionary tale to other countries with high and rising debt. But that is the topic for another speech. With Canada’s dramatic fiscal turnaround that started in the mid-1990s, the early challenges facing inflation targeting dissipated. The result was a tremendously successful economic expansion that spanned 16 years. By 2006, when the inflation target was last renewed, it was clear that inflation targeting was very successful – indeed, more successful than even its most ardent supporters had predicted. Inflation in Canada was much lower and more stable than it had been in the previous two decades. GDP growth was higher and more stable, and unemployment had declined. And Canada’s experience has not been unique. As other countries have implemented inflation targeting – 26 had done so by 2009 – similar results have been achieved. Many point to inflation targeting as a leading factor in the extended period of strong growth and low inflation known as the Great Moderation. But the true test of a successful policy is not how well it performs in good times, but how well it performs under stress. Monetary policy during the crisis While the financial crisis emanated beyond Canada’s borders, we were not immune, either to the virtual shutdown in global credit markets or to the consequences for the real economy. In Canada, industrial production fell 15 per cent, with exporters suffering the most as U.S. economic activity dropped sharply. The first-line monetary policy response of central banks during the crisis was to lower the policy interest rate. 1 The Bank of Canada began cutting interest rates in December 2007. This was followed by a series of aggressive reductions until the policy rate reached one-quarter of one per cent in April of last year, the lowest it can effectively go and the lowest it has ever been in the Bank’s 75-year history. In addition, the Bank provided extraordinary guidance on the likely path of interest rates that would be necessary to achieve the inflation target in order to maximize the monetary stimulus from its policy rate. The focus of monetary policy on inflation control through the financial crisis and global recession provided a beacon as well as an anchor for the bold policy response. The series of decisions that resulted in the policy interest rate being lowered effectively to zero reflected the symmetric commitment to target 2 per cent inflation. This policy response, coupled with the conditional commitment to keep the rate that low for a fixed period of time, allowed real interest rates to go negative and helped to re-establish confidence among businesses and households. The Bank of Canada provided a conditional commitment to keep the policy interest rate at one quarter of one per cent from April 2009 to mid-2010 to provide additional monetary policy stimulus by influencing rates at longer maturities. The commitment was conditional on the outlook for inflation. In other words, it was based on the Bank’s view that this path for the policy rate was consistent with hitting the inflation target. Preliminary research on the effect of this conditional commitment indicates that expressing a specific period of time proved particularly effective. Evidence suggests that the Bank of Canada’s conditional commitment lowered Canadian interest rates out the yield curve relative to what their historical relationship with inflation and unemployment rates would imply. 2 But while Canada’s inflation-targeting framework has served Canadians well, this does not mean that we can rely on the commitment to price stability to ensure financial stability. In fact, stable inflation and the associated moderation in the economic cycle may have The first response of central banks to the crisis was to inject liquidity into the financial system, but this was designed to address financial stability while protecting the monetary policy interest rate. Z. He, “Evaluating the Effect of the Bank of Canada’s Conditional Commitment Policy” (Discussion Paper No. 2010–11, Bank of Canada, 2010). encouraged excessive risk taking. The crisis reminds us that unless you ensure financial stability, you can’t achieve price stability either. This leads to my second theme. What’s been missing The Great Recession has forced us to look much more closely at crisis prevention. How do we stop history from repeating itself? The question forces us to broaden our view to consider the interaction among price stability, financial system stability, and the roles of monetary policy and other policy instruments. In particular, should monetary policy actively restrain a buildup of financial imbalances or are other instruments better suited for this role? To the extent that financial imbalances affect the inflation outlook, monetary policy does respond to them. Canada’s inflation target is expressed as the rate of change of the consumer price index (CPI). So if a financial imbalance affects the outlook for consumer price inflation, either directly through its impact on some prices in the CPI (such as house prices), or indirectly through its effects on income and wealth and hence overall price pressures, they are taken into account when the Bank sets the policy interest rate. Inflation targeting necessarily requires monetary policy to take into account anything that is affecting the inflation outlook. So the real question is not whether monetary policy takes into account financial imbalances, but should it work to mitigate them beyond what is required to keep inflation on target over the usual two-year monetary policy horizon? Or to put it more starkly, under what circumstances might it be worthwhile to accept greater deviations of inflation from target over the usual horizon to allow monetary policy to mitigate financial imbalances and potentially do a better job of maintaining low and stable inflation over a longer horizon? Prior to the crisis, many espoused the “clean doctrine”, that monetary policy should not be used to address financial imbalances in the build-up phase, but rather should restrict itself to cleaning up the mess when they unwind. This approach looks less convincing in the wake of this crisis. In considering the role of monetary policy, the first step is to understand the range of tools available to promote financial stability and what types of risks each tool is best suited to address. The first line of defence is sound regulation and supervision institution by institution. In Canada, federally regulated financial institutions are supervised by OSFI. And as Julie Dickson, the Superintendent likes to say, “a sound financial system is made up of sound financial institutions”, so getting the regulatory rules right and applying them rigorously is key to ensuring resilient financial firms. In this regard, the recent agreement at the Basel Committee to substantially increase the loss-bearing capital that financial institutions must hold relative to a more stringent definition of their risk-weighted assets, combined with a limit on leverage, provides a very significant strengthening of the rules and is an excellent outcome. With this strengthening, the rest of the world will look more like Canada. But here in Canada, financial firms will need to make adjustments as well. The second line of defence is system-wide regulation. This is a shared responsibility of the Department of Finance and all of the federal financial regulatory authorities, including, of course, the Bank of Canada, OSFI, and the Canada Deposit Insurance Corporation. An important lesson from the crisis is that regulation institution by institution is not enough. The risk to the financial system is greater than the average risk to individual institutions. This points to the need to complement institution-by-institution prudential regulation with a system-wide perspective. And this requires new system-wide policy instruments. The countercyclical capital buffer included in the new Basel Committee agreement provides a leading example of a new system-wide instrument. The countercyclical buffer provides for additional capital to be built up during periods of excessive credit growth that are associated with an increase in system-wide risk to provide additional loss-bearing capacity in the anticipation of a correction. The countercyclical buffer should also dampen excess credit growth. The development of this and other system-wide tools is a very important step forward. These tools have been missing or at least under developed and will fill a much-needed gap in the policy arsenal. There remains considerable work to be done to put them into practice and much experience will be gained in their implementation in the years to come. But even with improved prudential oversight and effective system-wide instruments, the question remains: Are there circumstances when monetary policy should “lean” to supplement these tools? As the costs of the recent crisis have made all too clear, this is an important question to consider as we approach the renewal of the inflation-targeting agreement between the Bank of Canada and the Government of Canada by the end of 2011. At this point, what we can say is the effectiveness of monetary policy to mitigate financial imbalances will depend on the sources of the shock or market failure and on the nature of the other regulatory instruments available. If financial imbalances are specific to a sector or market and a well-targeted prudential tool is available, monetary policy would likely have little role to play. If, however, the imbalances in a specific market spill over to the entire economy or if the prudential tool is itself broad-based, it is more likely that monetary policy could have a role to play. In these instances, there would likely be a need to coordinate the use of the two policy instruments. 3 What needs to be brought back My final reflection on monetary policy after the Great Recession is that some of what was old in central banking is new again. When I first started working at the Bank of Canada in 1984, research was focusing not on inflation targeting, but on finding a monetary aggregate to target. In 1981 the Bank abandoned the M1 target – or, as Governor Bouey quipped – “M1 abandoned us”. And subsequently, much of the research at the Bank was aimed at finding a new M with a stable relationship with prices, income, and interest rates. The search proved fruitless, but we did learn a great deal about how the expansions and contractions in money and credit filter their way through the financial system to affect household spending and business investment. Moreover, a legacy of the monetary-targeting era in my early days at the Bank was that there was a great deal of ongoing attention devoted to tracking financial flows and the build-up and draw-down of money and credit balances between different players in the financial system and the real economy. But with the rise of inflation targeting in the 1990s, this analysis was relegated to the back seat. Our primary focus turned to the policy interest rate and its impact on other interest rates, asset prices, the exchange rate, and these influences on output and inflation. Money and credit became invisible in much of our economic analysis. As I said earlier, the test of a good policy is how it functions under stress. Focusing on the transmission of interest rate changes to spending and inflation works well in normal times, but the crisis has reminded us of the complexity of the global financial system. For further discussion of the potential role for monetary policy in mitigating financial imbalances, see J. Boivin, T. Lane, and C. Meh, “Should Monetary Policy Be Used to Counteract Financial Imbalances?” Bank of Canada Review (Summer 2010). When the financial system is not working normally, we cannot rely on the short-cut from interest rates to output and inflation. We need a deeper understanding of how the central bank’s balance sheet affects financial intermediation and the credit and money balances of businesses and households. In other words, we need a better understanding of money and credit flows at a more disaggregated level and we need to develop models that include money, credit, and the key institutional features of banking and capital markets. If we look only at interest rates, inflation, and output, we may miss bubbles and other elements of systemic risk as they build. And, if we are to begin to consider the role of monetary policy in dampening financial imbalances, we need a deeper understanding of how one affects the other. Since the onset of the financial crisis, the Bank has intensified its effort to take into account credit flow and money in its policy analysis. Recent research at the Bank has taken important steps forward in incorporating the balance sheets of banks into standard macro-economic models. This will allow us to examine how developments in financial sectors affect the transmission of monetary policy and to analyze how monetary policy should deal with financial shocks, both international and domestic. Finally, we are also developing tools to detect the emergence of financial imbalances, which has implications for credit creation. Our research efforts continue. The Great Recession and the not-so-great recovery make clear that we face interesting challenges when it comes to the conduct of monetary policy. Conclusion Let me conclude. This crisis has taught us many lessons and reminds us of past approaches that should be dusted off and given their due. The focus of monetary policy on price stability implemented through an inflation target has been the most successful monetary regime to date. It brought us the period of the Great Moderation, or the decade that Bank of England Governor Mervyn King referred to as the NICE decade – non-inflationary and consistently expansionary – and it performed well under stress throughout the crisis. Nevertheless, the crisis has revealed some gaping holes in our regulatory rules, core financial infrastructure and policy tools. While it is unrealistic to expect a combination of microprudential, system-wide and monetary policies to eliminate procyclicality in the financial system and the broader economic cycle, our objective is to make the system more resilient to economic downturns and other aggregate shocks and to moderate the buildup of financial risks. We learned much from history in crafting the extraordinary policy response at the height of this crisis. Whereas I expect that many early members of the Mount Stephen Club may have lived through very hard times during the Great Depression of the 1930s, this time around the scale of the economic fallout was considerably less severe for Canadians. Monetary policy focused on price stability combined with bold fiscal and financial stabilization measures averted a much worse disaster. We now need to be equally diligent in learning from history in averting future crises. Ensuring that we have the policy and analytic arsenal for the job is part of that challenge.
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Opening statement by Mr Mark Carney, Governor of the Bank of Canada, at the press conference following the release of the Monetary Policy Report, Ottawa, 20 October 2010.
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Mark Carney: Summary of the latest Monetary Policy Report Opening statement by Mr Mark Carney, Governor of the Bank of Canada, at the press conference following the release of the Monetary Policy Report, Ottawa, 20 October 2010. * * * Good morning. Tiff and I are pleased to be here with you today to discuss the October Monetary Policy Report, which the Bank published this morning. The global economic recovery is entering a new phase. In advanced economies, temporary factors supporting growth in 2010, such as the inventory cycle and pentup demand, have largely run their course and fiscal stimulus will shift to fiscal consolidation over the projection horizon. The Bank expects that private demand in advanced economies will become sufficiently entrenched to sustain the recovery. However, the combination of difficult labour market dynamics and ongoing deleveraging in many advanced economies is expected to moderate the pace of growth, relative to prior expectations. These factors will contribute to a weaker-than-projected recovery in the United States in particular. Growth in emerging-market economies is expected to ease to a more sustainable pace as fiscal and monetary policies are tightened. Heightened tensions in currency markets and related risks associated with global imbalances could result in a more protracted and difficult global recovery. The economic outlook for Canada has changed. The Bank expects the economic recovery to be more gradual than it had projected in July, with growth of 3.0 per cent in 2010, 2.3 per cent in 2011, and 2.6 per cent in 2012. This more modest growth profile reflects a more gradual global recovery and a more subdued profile for household spending. Overall, the composition of demand in Canada is expected to shift away from government and household expenditures towards business investment and net exports. The strength of net exports will be sensitive to currency movements, the expected recovery in productivity growth, and the prospects for external demand. Inflation in Canada has been slightly below the Bank’s July projection. The recent moderation in core inflation is consistent with the persistence of significant excess supply and a deceleration in the growth of unit labour costs. The Bank judges that the output gap is slightly larger and that the economy will return to full capacity by the end of 2012 rather than the beginning of that year, as had been anticipated in July. The inflation outlook has been revised down and both total CPI and core inflation are now expected to converge to 2 per cent by the end of 2012, as excess supply in the economy is gradually absorbed and inflation expectations remain well-anchored. Important risks remain around this outlook. The three main upside risks to the inflation outlook are higher commodity prices, a stronger-than-anticipated recovery in the U.S. economy, and the possibility of greater-than-projected momentum in the Canadian household sector. These upside risks are balanced by three downside risks relating to Canada’s international competitiveness, global growth prospects, and the possibility of a more pronounced correction in the Canadian housing market. These risks are balanced. On 19 October 2010, the Bank maintained the target for the overnight rate at 1 per cent. This leaves considerable monetary stimulus in place, consistent with achieving the 2 per cent inflation target in an environment of significant excess supply in Canada. At this time of transition in the global recovery, with a weaker U.S. outlook, constraints beginning to moderate growth in emerging-market economies, and domestic considerations that are expected to slow consumption and housing activity in Canada, any further reduction in monetary policy stimulus would need to be carefully considered. With that, Tiff and I would be pleased to take your questions.
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Remarks by Mr Mark Carney, Governor of the Bank of Canada, at the International Center for Monetary and Banking Studies, Geneva, 9 November 2010.
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Mark Carney: Looking back, moving forward – Canada and global financial reform Remarks by Mr Mark Carney, Governor of the Bank of Canada, at the International Center for Monetary and Banking Studies, Geneva, 9 November 2010. * * * Introduction There is an old saying, “Knowledge is gained from experience, and experience is gained from mistakes”. In Canada, we made our mistakes early and often in the 1970s and 1980s. Our fiscal situation deteriorated sharply, inflation surged to double-digit levels, and a few small regional banks collapsed. The core lesson we learned from those difficult years was the importance of coherent, principle-based policy frameworks. Such frameworks discipline policy-makers and enhance credibility. In Canada, this approach yielded several attributes that helped the financial system weather the storm, including: a commitment to higher and better-quality capital, an active supervisory regime with close co-operation amongst authorities, a well-regulated mortgage market, and a limited shadow banking sector. In my remarks today, I will elaborate on these elements, many of which are now being incorporated into new global regulatory and supervisory standards. I will also discuss other measures – including more robust market infrastructure, better resolution mechanisms and macroprudential instruments – that have the potential to enhance the efficiency and resiliency of all our systems. Lessons from the crisis The crisis demonstrated the importance of incentives, the dangers of conformity, the imperative that core markets are continuously open, and the value of matching risk to riskbearing capacity. It exposed the fallacy of composition that strong financial institutions collectively ensure the safety and soundness of the system as a whole. The crisis also clearly illustrated the fundamental interconnectedness of the global economy. Strains that emerged in a few countries quickly spread around the world, resulting in a deep, synchronous recession. It is in all of our interests to get these proposed reforms right. That’s the value of sharing experiences, such as Canada’s, and I am grateful to the International Center for Monetary and Banking Studies for this opportunity. The fundamental objective of the reforms should be to create a system that efficiently supports economic growth while providing financial consumers with choice. The system must be robust to shocks, dampening, rather than amplifying, their effect on the real economy. Such a system needs resilient financial institutions and robust markets, since both play a central role in financing and, if properly structured, each can support the other. New measures should promote competition rather than concentration, and build systemic resilience rather than entrench indispensable institutions. Given the frameworks that we had at the time, Canada has largely achieved these objectives. Given the perspective we have gained from the crisis, there are some promising new avenues to extend this advantage. Even though it experienced a short, sharp recession, Canada fared relatively well. The cumulative fall in real GDP of 3.4 per cent in Canada compares with declines of over 4 per cent in the United States, 5 per cent in the euro area, and 8 per cent in Japan. Today, employment and economic activity in Canada are back at their pre-crisis levels – a situation unique in the G-7. Canada’s better performance during the crisis can be explained by two factors. First, with a highly credible monetary policy and the strongest fiscal position in the G-7, Canadian policymakers were able to respond swiftly and effectively with extraordinarily accommodative measures. Second, Canada’s sound financial system continued to function throughout the period. It was not just that no Canadian bank failed or required government capital injections – or that extraordinary liquidity was a fraction of that in other jurisdictions. 1 It was that credit continued to grow throughout the crisis period and into the recovery. 2 The obvious question is, why? In our view, it was the result of a combination of good policy and, in retrospect, some good fortune. Allow me to expand. Looking back: some lessons from Canada Higher and better-quality capital Risk-based capital adequacy – that is, the amount and quality of capital and the level of risk and leverage – emerged as a key source of strength as the turmoil intensified. Canadian banks were required to meet supervisory targets for the level and quality of capital, which more than exceeded international minimums. Canadian capital requirements were set at 7 per cent and 10 per cent for Tier 1 and Total Capital ratios instead of the 4 per cent and 8 per cent prescribed in the Basel II Capital Accords. In practice, Canada’s banks typically held more. All financial institutions had to establish internal targets to provide an operating cushion against volatility and unexpected losses from inherent risks – and to avoid breaching supervisory targets. Capital adequacy depends on a bank’s risks – which the Basel framework tries to measure. While Basel II had higher risk-weighted assets for riskier businesses, Canada’s bank supervisor, the Office of the Superintendent for Financial Institutions (OSFI), also demanded that banks with higher risks should further offset that risk with higher capital. Capital not only had to be higher, it also had to be higher quality. OSFI insisted that common equity form the predominant share (at least 75 per cent) of Tier 1 capital. 3 Focusing on risk-based capital adequacy ensured that banks with greater risks entered the turmoil with larger cushions against unexpected losses. At the time of the Lehman failure, the At its peak, the Bank of Canada liquidity extension represented just under 3 per cent of GDP. This compares to peak liquidity extensions of about 8.5 per cent of GDP in the United States, about 13 per cent in the European Union and nearly 23 per cent in the United Kingdom. For example, credit issued by the chartered banks to Canadian households and businesses has exhibited monthly year-over-year growth of around 5 per cent, on average, from the beginning of 2007 to the present. Prior to the crisis, OSFI rules required common equity to account for at least 75 per cent of Tier 1 capital. In other words, other components (preferred shares and innovative and hybrid instruments) were limited to 25 per cent. In January 2008, OSFI relaxed the rules, allowing non-common sources to account for as much as 30 per cent of Tier 1 capital. Then, in November 2008, that limit was raised again to 40 per cent. See: http://www.osfi-bsif.gc.ca. average Tier 1 capital ratio at Canadian banks was about 10 per cent and their total capital ratio stood at almost 13 per cent. During the turmoil, all major Canadian banks maintained, without reducing dividends, capital in excess of supervisory targets, and none required injections of government capital. Again, crucially, this capital was predominantly made up of tangible common equity. During the panic, investors understandably lost faith in Basel risk weights. Gallingly, on the day before each went under, every bank that failed (or was saved by the state) reported capital that exceeded the Basel II standard by a wide margin. By the autumn of 2008, investors had already seen far too many major institutions hobbled by losses on purportedly risk-free securities such as leveraged super senior tranches of securitizations. Many turned instead to simple leverage ratios to assess capital adequacy. Canadian banks were already subject to such a stringent test. As a supplement to Basel II, they were required to ensure that the ratio of total assets to total capital reached no more than 20 times. In practice, banks had to maintain their ratios well below this level. As Swiss authorities understand, a leverage ratio corrects a fundamental shortcoming and serves as a useful complement to the Basel requirements. It recognizes the limits of our knowledge and protects against understated risks by operating fully independently of sophisticated (and error-prone) risk assessments and modelling. It is an objective measure that complements the ultimately subjective risk-based Basel II. In an ideal world, we would take into account the riskiness of banks’ assets in setting leverage. But who lives in a world where risks are known with certainty and can be measured with precision? In the run-up to the crisis, when concerns about risks were at their lowest (and risks themselves were, in fact, at their highest), Canadian banks were constrained by the leverage ratio. Elsewhere, absolute leverage soared. From 2002 to 2007, simple asset-to-capital multiples at U.S. investment banks, U.K. banks and major European banks, rose by 10 to 15 turns. Actual leverage, including off-balance-sheet transactions, was even more extreme. In many cases, higher leverage fully accounted for the entire increase in banks’ returns on equity. This proved to be a mirage as the assets funded by this increased leverage contributed much to the staggering losses revealed in the crisis. When the financial panic intensified, investors increasingly simplified their judgments about capital adequacy. In the end, only true loss-bearing capital and simple leverage tests mattered. In this light, many financial emperors around the world were seen to have no clothes. Canadian banks were comparatively draped in full winter regalia. Basel III incorporates many of the advantages of the Canadian system, such as a leverage ratio and substantially higher quantity, quality and transparency of Tier 1 capital. Beyond making the global system look more Canadian, Basel III introduces some important innovations, including: a tighter definition of intangible assets; new global standards for liquidity; a capital conservation buffer that is above the minimum capital requirement to ensure that banks and supervisors take prompt corrective action and that banks can absorb losses during periods of financial and economic stress; and a complementary countercyclical buffer that would vary over time and help smooth the economic cycle. An active and co-operative supervisory regime Of course, systemic resilience is about much more than capital. Similarly, the success of the Canadian financial system was the product of strong macroeconomic fundamentals and sound risk management by the banks themselves, underpinned by an effective regulatory and supervisory regime. Four aspects of this regime were particularly important. First, supervision was focused. Consolidated supervision concentrated on prudential supervision and was not burdened by other objectives such as the promotion of home ownership or community reinvestment. It also ensured that the leverage ratio and other tests applied equally to banking and investment banking operations, which helped limit regulatory arbitrage. Second, supervision was active. Following the failure of some small regional banks in the 1980s, a framework for early intervention was established. This so-called staged intervention enabled supervisors to work with institutions to correct problems at an early stage, while they were still manageable. Board-level interaction, capital penalties and restrictions on business all helped to concentrate the minds of management to address issues in a timely fashion. Third, supervision was coordinated. Staged institutions were reviewed regularly by a joint micro-prudential committee composed of the bank regulator, the central bank, the deposit insurer, the consumer protection agency and the Department of Finance. This coordination is a central element of our regime. In general, there is close co-operation amongst all the entities responsible for financial stability, including mandated information sharing among all of these parties. 4 Finally, the entire financial framework was regularly reviewed and updated. In Canada, there is a statutory requirement to renew the legislative and regulatory framework for the financial system every five years. This has proven invaluable given the pace of change in the financial system. In addition, Canada regularly subjects its system to rigorous external examination under the International Monetary Fund’s Financial Sector Assessment Program (FSAP), and Canadian authorities conduct regular system-wide stress tests. Many of these elements are now being adopted internationally. The G-20 has made FSAPs mandatory. Many jurisdictions are adopting committees to oversee their financial systems. 5 Based on a working group report chaired by Canada’s Superintendent of Financial Institutions, the Financial Stability Board will propose to G-20 leaders in Seoul a series of recommendations to strengthen oversight and supervision. 6 Well-regulated mortgage market Given the genesis of the crisis in U.S. subprime mortgages and its subsequent potential to taint everything related to mortgages and securitization, the structure of Canadian mortgage finance also proved to be a major advantage. Common-sense attributes include mortgagors being personally liable for their debts and mortgage interest not being tax-deductible. In addition, key lending standards are effectively set by the terms of government-backed mortgage insurance. 7 Banks are required to have insurance on the mortgages of purchasers Office of the Superintendent of Financial Institutions Act, 1985. Published by Minister of Justice. Examples with an explicit macroprudential focus include the European Systemic Risk Board for the European Union, the Systemic Risk Council in the United States, and unitary models housed in central banks in the United Kingdom and Australia. Financial Stability Board, “Intensity and Effectiveness of SIFI Supervision; Recommendations for Enhanced Supervision” , 1 November 2010. The publicly owned mortgage insurer, Canada Mortgage and Housing Corporation, has an explicit sovereign guarantee and is the largest insurance provider. Lenders relying on private mortgage insurers receive a government guarantee for losses (from insurer failure) on amounts above 10 per cent of the original mortgage. with loan-to-value ratios of over 80 per cent. All borrowers must satisfy an incomes test, and insurance premiums vary with loan-to-value and amortization periods. Leading up to the crisis, the principal-agent problems that developed in originate-to-distribute models were absent in Canada. Banks largely retained the risks of their underwriting, maintained their standards, and held onto credit skills. Most mortgages originated by banks were for their own balance sheets and, as a result, underwriting standards remained high. Banks obtained natural geographic diversification of their loan portfolios through their nationwide branch system, which eliminated one motivation for securitization. Only about 30 per cent of mortgages in Canada are securitized. Moreover, securitization in Canada is dominated by government-guaranteed mortgage-backed securities (about 85 per cent pre-crisis). As a consequence, the mortgage-backed security market in Canada continued to function well during the crisis. Other private-label securitization markets were less developed. Similarly, there was little usage of credit default swaps to hedge Canadian corporate risk. With exposures largely staying on balance sheet, Canadian bankers remained bankers rather than warehousers or traders. Consider what happened elsewhere. The severing of the relationship between originator and risk holder lowered underwriting and monitoring standards. In addition, the transfer of risk itself was frequently incomplete, with banks retaining large quantities of supposedly risk-free senior tranches of structured products. These exposures were compounded by the rapid expansion of banks into over-the-counter (OTC) derivatives. In essence, banks wrote a series of large out-of-the-money options. 8 With pricing and risk management lagging reality, there was a widespread misallocation of capital. As credit standards deteriorated, the tail risks embedded in these strategies were realised. The magnitude of these developments was remarkable. In the final years of the boom, as complacency about liquidity reached its zenith, the scale of shadow banking activity exploded. The value of structured investment vehicles, for example, tripled in the three years to 2007. Credit default swaps grew six-fold. On the eve of the crisis, assets in the U.S. shadow banking sector were roughly equivalent to those in the regulated sector. 9 Limited shadow banking sector This brings me to where Canada, in hindsight, was fortunate. With sound, bank-based finance much more important than in the United States, Canada was much less exposed to the drying up of private-label securitization and the collapse of the shadow banking sector. 10 Canada’s banking system is highly concentrated, with six major banks holding almost 90 percent of total bank assets. Banks are the most important suppliers of credit. Direct and indirect bank finance accounts for 58 per cent of credit provision, while other regulated financial institutions supply 14 per cent, and traditional market instruments, 28 per cent. See A. Haldane, “The Contribution of the Financial Sector – Miracle or Mirage?” Speech delivered at the Future of Finance Conference, London, England, 14 July 2010. Z. Pozsar, T. Adrian, A. Ashcraft, and H. Boesky, “Shadow Banking”, Federal Reserve Bank of New York Staff Report No. 458, July 2010. An exception was the Canadian non-bank asset-backed commercial paper market which did freeze up and had to be restructured. However, this paper financed offshore assets and the restructuring did not have any significant effect on credit creation in Canada. The major banks also lead securities underwriting and merchant banking in Canada, and are among the country’s largest asset managers – evidence that commercial and investment banking can be successfully combined within one organization. Following mergers in the late 1980s in Canada, dealers became more like commercial banks, rather than the reverse. The structure of Canadian funding markets also made a difference. Canadian banks relied less than their American and universal banking peers on unsecured interbank transactions and short-term repos. For example the repo market in Canada is one-fifth the size of other jurisdictions and the commercial paper market is relatively small. In contrast, short-term money markets were the predominant source of financing for the one-third increase in the gross leverage of U.S. investment banks, U.K. banks and European banks. It is a simple fact that banks’ reliance on wholesale, collateral-based finance rose from $200 billion to a peak of $4 trillion during this decade. By borrowing in short-term wholesale markets to fund asset growth, banks became more dependent on continuous access to liquidity in money and capital markets. The system’s exposure to market confidence was enormous. Moving forward: what else is required? The collapse in confidence necessitated a host of extraordinary measures and bank rescues. A common motivation was fear of contagion through bilateral counterparty relationships in funding and derivatives markets. With U.S. investment banks at the hubs of so many crucial markets, such as tri-party repos, the system was profoundly fragile. Ultimately, the historic G-7 commitment to use all available tools, including public capital, to support systemically important financial institutions and prevent their failure was necessary to keep the system functioning. The cost has been enormous moral hazard that, if left unchecked, will distort private behaviour and inflate public costs. A series of concerted measures will be required to build resilient, continuously open funding and derivatives markets and to restore market discipline to financial institutions. Keeping markets continuously open requires policies and infrastructure that reinforce the private generation of liquidity in normal times and facilitate central bank support in times of crisis. The cornerstones are central clearing counterparties or “CCPs” for repos and OTC derivatives. Properly risk-proofed CCPs act as firewalls against the propagation of default shocks across major market participants. Through centralised clearing, authorities can also require the use of through-the-cycle margins, which would reduce liquidity spirals and their contribution to boom-bust cycles. To develop a robust, collateral-based, short-term financing market, the Bank of Canada is supporting the creation of a domestic CCP for Canadian-dollar repos. The Bank is working with its domestic and international partners to develop a similar infrastructure for OTC derivatives markets. Current G-20 efforts to transfer standardized OTC derivatives to clearing houses have great potential to reduce contagion from counterparty risk and to improve the transparency, pricing and management of risk. At the same time, G-20 countries will need to ensure that linkages between different CCPs do not increase the degree of market concentration amongst dealers. Access and interoperability criteria must be carefully developed in order to maximise the systemic benefits of this important reform. Addressing too big to fail and re-instilling market discipline There is a firm conviction among policy-makers that losses incurred in future crises must be borne by the institutions themselves. This means management, shareholders and creditors, rather than taxpayers. Better market infrastructure alone will not be sufficient to re-instill market discipline. Ultimately, a series of measures, including living wills and better cross-border resolution regimes, will be required to expose fully firms to the ultimate sanction of the market. All jurisdictions need the tools to intervene safely and quickly to ensure the continued performance of a firm’s essential functions and to sell, transfer or restructure part or all of a firm while apportioning losses. Statutory bail-in authority could fill a crucial gap in the resolution toolkit and should catalyze private alternatives to the restructuring process. An example of a promising market-based mechanism is to embed contingent capital and bail-in features into unsecured market debt and preferred shares issued by financial institutions. Contingent capital is a security that converts to capital when a financial institution is in serious trouble, thereby replenishing capital without the use of taxpayer funds. Contingent conversions could be embedded in all future new issues of senior unsecured debt and subordinated securities to create a broader bail-in approach. Its presence would also discipline management, since common shareholders would be incented to act prudently to avoid having their stakes diluted by conversion. Conclusion The scale and complexity of the crisis and the multiple points of failure all demonstrate that there are no panaceas. Wholesale reforms of regulation, changes to policy and adjustment of private behaviour are required. We should all approach these tasks with a measure of humility. While Canada’s experience offers some important lessons (on capital, leverage, mortgage finance, and supervision), we recognise that we do not have all the answers. Responding to challenging events, Swiss authorities, particularly President Hildebrand, are to be commended for their vision and leadership on such global innovations as contingent capital, bail-ins and cross-border supervisory frameworks. All policy-makers should redouble their efforts to reform infrastructure to achieve continuously open, competitive markets. Finally, while these official initiatives are essential, systemic resilience importantly depends on the oversight of private parties ranging from investors to management and boards. Ultimately, the private sector will remain the first line of defence. A focus on improving these oversight functions is thus required. As we look back and move forward, we would all be advised to remember that pride goes before the fall. Risks are usually the greatest when they appear the least; and financial market participants the most vulnerable when they think they know all the answers. In a dynamic financial system, all participants need to focus continually on identifying vulnerabilities and improving resilience. Our work has just begun.
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Remarks by Mr Jean Boivin, Deputy Governor of the Bank of Canada, to the Okanagan CFA Society and University of British Columbia Okanagan Faculty of Management, Kelowna, British Columbia, 18 November 2010.
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Jean Boivin: Where the economy and finance meet Remarks by Mr Jean Boivin, Deputy Governor of the Bank of Canada, to the Okanagan CFA Society and University of British Columbia Okanagan (Faculty of Management), Kelowna, British Columbia, 18 November 2010. * * * Introduction Thank you for having me here tonight. I’m delighted to be in Kelowna to deliver my first public speech as deputy governor of the Bank of Canada. As you heard in the introduction, I used to be a business school professor, so I am especially happy to be back among a group of business professionals, students and former colleagues. As the title of my speech suggests, I would like to discuss the connections between the real economy – the tangible world of jobs, goods and services – and the more intangible world of finance – of money flows, interest rates and the stock market. They have a long and eventful history. When a crisis strikes, their connections are very evident and we pay attention. Our understanding of these connections has been extremely useful in the development of a timely and coordinated policy response at the onset of the last crisis. In times of stability, however, we have an unfortunate tendency to downplay their connections. This is a mistake. The main theme of my remarks tonight is that the connection between finance and the economy is always relevant – not only in times of crisis. And while crises occur abruptly, their seeds are sown long before they happen, during periods of stability. For those of us working in economics and finance, this has two key implications: First, we need better tools to understand the highly complex dynamics by which financial imbalances build up and affect the real economy. Second, we need to improve our understanding of how the real economy can contribute to the development of financial imbalances, particularly through risktaking behaviour. As I will highlight, the Bank of Canada, together with international partners, is making progress on both fronts, but we still have a long way to go. Before I continue, I want to stress that this speech is not about what we could have done in Canada to avoid the most recent financial crisis. The source of the crisis was outside of our control and our financial sector has proven extremely resilient in the face of this huge global shock. But it did provide us with an opportunity to refine our understanding of the constantly evolving economy and how to avoid future crises. We cannot be complacent. Teaching economics in a pre-crisis world I have been thinking about the links between the real economy and finance for many years now, starting with my career as a professor in the late 1990s, when I taught macroeconomics to MBA students. One of the most striking features of a business school environment is the palpable energy of the students, their keen interest to learn, their drive and ambition. That made teaching challenging, interesting and rewarding. But all this genuine interest and energy was not automatically granted to a core macroeconomic course. We need to remember the mood of the time. Buzzwords like: “new economy,” “Dot Com,” “Great Moderation,” were on everyone’s lips. Questions like “Is the business cycle dead?” were seriously being asked and the Dow 36,000 was seen by some as the likely next frontier. Many students wanted to pursue a career in finance. In such an environment, where macroeconomic stability was taken as a permanent feature of the economy, students asked why they should “waste time and money” sitting through a core macroeconomics class. Why not jump immediately to the important stuff – finance? We even changed the name of the course to make it more appealing: “Macroeconomics” became “The Global Economic Environment.” I don’t know that this was very effective… To be fair to my former students, at the turn of the century, they weren’t the only ones to downplay the links between finance and the macroeconomy. Professionals and academics alike shared this view. I noticed a big change in attitude, however, when I last taught this course in the summer of 2009. Students took for granted that the connections between the economy and finance were crucial. There is an obvious explanation for this new-found awareness. Between the first and last time I taught this course, the world experienced its worst financial crisis since the 1930s, with real, dramatic consequences on people throughout the world. In the G-7, excluding Canada, GDP fell by 5.6 per cent from the peak in 2008 to the trough in 2009, and almost 12 million jobs were lost. The United States alone shed almost 9 million jobs, and even today, fewer than 15 per cent of those have been regained. In Canada, things were better, thanks to a financial system that has held up remarkably well and buffered us from the worst of the financial storm. Nevertheless, in Canada, real GDP fell by more than 3 per cent from peak to trough and more than 400,000 jobs were lost. We have now recouped those lost jobs, but not the lost momentum and opportunities the crisis left behind. After living through this, how can we ignore the obvious links between the economy and finance? The short answer is that when times are good, we can make the mistake of becoming complacent. The economy and finance have been meeting for a long time As I said at the outset, the economy and finance have a long and eventful history. When financial markets are functioning well, they play a background role in the overall behaviour of the real economy. At the same time, when the economy is stable, macroeconomic considerations might appear to play a more secondary role in the functioning of financial markets. Taken together, this suggests that in stable times it might be tempting to analyze the behaviour of the real economy and financial markets separately, each of them being a black box to the other, not worth opening. This approach is also convenient: Economists can build economic models without introducing too many financial details; financial wizards can price assets without thinking too much about macroeconomic risks; and business schools can build curricula where economics and finance are taught with little reference to each other. This is all very well in a stable world. But a stable world is not a perfect world. And imperfections can eventually break the stability. It has long been understood that imperfections in the financial market can generate and amplify economic fluctuations, driving the dynamics of a crisis. These imperfections typically stem from transaction costs or asymmetric information. This is economist jargon, but let me give you an example. An entrepreneur who needs to borrow funds typically knows more about the quality of her project than the lender. Moreover, the success of the project – and the likelihood of the loan being repaid – will depend on the behaviour of the entrepreneur. This information gap is an imperfection that the financial system needs to address. Financial intermediaries – for instance, banks – play an important role in partly bridging this information gap through screening and monitoring of prospective borrowers. Another way is for the borrower to put some skin in the game by pledging collateral – for example, real estate – which becomes a key determinant of borrowing capacity. Appreciating the role of information and the importance of collateral helps to explain how a financial crisis, such as the Great Depression, can unfold by setting in motion an adverse feedback loop between the real economy and financial markets. Collateral facilitates credit. If a weakening economy reduces the value of collateral, access to credit will be reduced. Reduced access to credit constrains consumption and capital investment, further weakening the economy and – closing the loop – the value of collateral that can be pledged. And if along the way, some banks are forced to shut their doors, the information gap at the origin of this problem becomes even harder to bridge. 1 These are crucially important mechanisms. They have been understood for a long time and formed part of the economist toolkit. 2 This understanding proved to be a huge asset during the last crisis, motivating policy-makers throughout the world to act swiftly to break the adverse feedback loop once the crisis started. Meeting in unsuspected places Many of the connections between the economy and finance were perceived to be relevant mainly to countries in crisis, limiting interest to the study of historical episodes or economies with poorly developed financial markets. Consequently, many of the models used by economists to analyze usually stable, advanced economies abstracted from features of the financial sector. This was seen as a reasonable approximation. But as we know, the recent crisis detonated in advanced economies after a long period of exceptional calm, often referred to as the “Great Moderation.” How does the economy shift from stability to crisis? While the links between the financial sector and the real economy are sometimes smooth and continuous, they can also be highly non-linear. These non-linear effects can manifest themselves by the slow buildup of imbalances in stable times – when many have been lulled into a false sense of security – followed by abrupt crashes. This underlines the need to improve our understanding of where the economy and finance meet during stable times and how crises erupt: Many important breakthroughs in our understanding of the role of financial market imperfections on the real economy are rooted in the work of Joseph Stiglitz, Michael Spence and George Akerlof, who were awarded the 2001 Bank of Sweden Nobel Prize in economics for their 1970s analysis of markets with asymmetric information. Bernanke and Gertler (1989) later formalized these financial market imperfections in a macroeconomic model to improve our understanding of the Great Depression. This is often referred to by economists as the financial accelerator model. See Bernanke (2007a) for a summary of the financial accelerator and the credit channel. Models incorporating the financial accelerator in the business sector are found in Bernanke, Gertler, and Gilchrist (1999); Kiyotaki and Moore (1997); Christiano, Motto, and Rostagno (2010); and Christensen and Dib (2008). Models demonstrating how the balance sheets of households affect their borrowing capacity are described in Iacoviello (2005), Christensen and Meh (2010), and Christensen et al. (2009). There is a long history of macroeconometric models that incorporate financial variables, for example, the Bank of Canada MUSE model used in the context of international analysis. First, we need better tools to understand the highly non-linear dynamics through which financial imbalances build up and affect the real economy. This involves improving our models, but also developing indicators that can help us to better track the risk of potential financial disruptions to the overall economy. Second, we need to improve our understanding of how the real economy and system-wide forces can contribute to the development of financial imbalances, particularly through risk-taking behaviour. Developing better tools Regarding better tools, we are developing a new generation of models that, unlike those that came before, consider the financial sector, including banks, not just as a transmitter of shocks, but as a potential shock in its own right. We are developing macroeconomic frameworks that take into account the balance sheets of financial intermediaries, multiple interest rates and credit spreads so that we can understand better how developments in the financial sector affect economic performance. This work is being done by academics and central bank researchers, including those at the Bank of Canada. 3 Research at the Bank of Canada has made important strides in modelling balance sheets of banks into standard macroeconomic frameworks with financial frictions. 4 Bank staff have also introduced multiple financial assets into the Bank of Canada’s main policy model (ToTEM), as well as credit and banking into the Global Economic Model (BoCGEM-FIN). The Bank of Canada has used this research to make important contributions to international reports by the Financial Stability Board (FSB) and the Basel Committee on Banking Supervision (BCBS), assessing the impact of stronger capital and liquidity requirements on economic activity. Bank staff ran simulations to provide a comprehensive assessment of the potential impact on the Canadian economy of the new Basel III global capital and liquidity standards. A report was published summarizing the Bank’s core results for Canada, including a comparison with the results published by the FSB and the BCBS. 5 It is also critical that economists and financial professionals develop empirical tools that provide statistical indicators of increased risks to the whole financial system – including various measures of credit. A credit boom – a positive feedback loop sparked by a sustained increase in collateral value – is a key feature of the buildup towards financial crisis. Historically, finding such indicators has been a difficult task and we should not expect a magic bullet. But the information gleaned from a collection of these indicators could serve as an important guide for stabilization policies, including a system-wide regulatory policy. In that respect, I am encouraged to see the large amount of work being done at the International Monetary Fund, the Financial Stability Board and the Bank for International Settlements in developing statistical tools to serve as “early warning indicators” and evaluating a variety of statistical indicators of excessive credit growth. 6 The Bank of Canada and other central See Brunnermeier and Sannikov (2010); Curdia and Woodford (2010); Christensen, Meh, and Moran (2010); Dib (2010); Gertler and Karadi (2010); Gertler and Kiyotaki (2010); Gerali et al. (2010); Meh and Moran (2010); and Van den Heuvel (2008). See Meh and Moran (2010) and Dib (2010). See Bank of Canada (2010), Basel Committee on Banking and Supervision (2010), and Basel Committee on Banking and Supervision and Financial Stability Board (2010). See Drehmann, et al. (2010). banks are also actively developing tools to support their financial system surveillance activities. 7 Financial imbalances, risk-taking behaviour and system-wide forces The second key area of work for economists and financial professionals concerns the need to understand better risk-taking behaviour and how system-wide forces contribute to the development of imbalances. 8 We see excessive risk-taking behaviour develop during periods of stability when people become complacent and believe the good times are here to stay. They become overconfident and underestimate risk. Contract incentives can also induce excessive risktaking behaviour. Let’s take an example of an insurance company that has promised premium holders returns of 6 per cent, while the long-term bond rate is 4 per cent. To meet its obligations when the short-term rate is low, the insurance company has no choice but to take on greater risk, either directly or through investments in alternative assets. 9 We also see how incentives encourage risk-taking at financial institutions where compensation depends on short-run returns. Although, the financial crisis is seen as having many significant causes, the compensation structure of some institutions is viewed as an important contributing factor. Through these channels, a tranquil macroeconomic environment can lead to the buildup of risks and financial imbalances on the balance sheets of banks. These imbalances can increasingly expose the wider economy to the risk of financial crisis. If confidence disappears, banks call back credit, balance sheets shrink and a difficult readjustment is needed, with negative effects on financial and economic stability. In particular, the buildup of big leverage within the financial system can unwind swiftly, causing more stringent general financing conditions. So what needs to be done? First, we need to be collectively aware of these connections and better understand their importance. Firms are run by people. Risk is taken by people. The more complete the understanding, the better the chance of properly assessing risk and designing appropriate contracts. But there is also a need to adopt measures to make the financial system as a whole more resilient. This includes enhanced system-wide supervision and regulation. The recent Basel III agreement will go far to enhance supervision and regulatory practices in the financial sector. G-20 leaders have agreed to strengthen their banking systems by raising the amount and quality of capital and liquidity that financial institutions must carry. These higher standards will lower the incidence of financial crises, reduce their severity and provide for smoother economic cycles. They will also reduce the risk that resources are misallocated. The agreement also includes a countercyclical capital buffer that provides for additional capital to be built up during the periods of excessive credit growth that are associated with an increase in system-wide risk. This will provide additional loss-bearing capacity in a downswing See Misina and Tkacz (2009) and Gauthier, He, and Souissi (2010). See Adrian and Shin (2009), Borio and Zhu (2008), Brunnermeier and Sannikov (2010), Diamond and Rajan (2009), and Farhi and Tirole (2009). See Rajan (2005). in a credit cycle. The countercyclical buffer itself should also help dampen excess credit growth. Recent research at the Bank of Canada estimated that for Canada, the net economic benefits to be gained from improving the safety and robustness of the Canadian and international financial system could amount to about $200 billion – or about 13 per cent of GDP. 10 While it is neither possible, nor desirable, to eliminate risk-taking, by understanding it, identifying it, tracking it, and spotting dangerous trends, we can do much to prevent the buildup of imbalances that can lead to a crisis erupting. There is no magic bullet to safeguard the financial system. We work in an exceedingly complex and dynamic environment, one that presents new – and very difficult – challenges. The task we have set for ourselves is far from easy, but when the best and the brightest in the fields of economics and finance combine their efforts and work together, we can make important progress. Complacency is the enemy. Conclusion As we move away from the crisis, we all have an obligation to remember that imbalances build during periods of calm. Our vigilance is required at all times, not just during a crisis. Better tools will help us to identify risks and better understand the human behaviour behind risk-taking. And certainly, system-wide supervision and regulation will do much to improve the global financial system. However, as I conclude tonight, I would like to reinforce the fact that all of us here are part of the “system.” Economists, finance professionals, business school professors and students are part of this “system.” We have a role, and a responsibility, to improve our understanding of, and account for, the system-wide consequences of our individual actions. We have a chance to ensure that the painful lessons of the last few years lead to a better financial system, and by extension, to a more prosperous and stable world. Thank you very much. Bibliography Adrian, T. and H. S. Shin. 2009. “Money, Liquidity, and Monetary Policy.” Federal Reserve Bank of New York Staff Report No. 360. Akerlof, G. A. 1970. “The Market for “Lemons”: Quality Uncertainty and the Market Mechanism.” The Quarterly Journal of Economics 84 (3): 488–500. Bank of Canada. 2010. “Strengthening International Capital and Liquidity Standards: A Macroeconomic Impact Assessment for Canada.” August. Basel Committee on Banking Supervision (BCBS). 2010. “An Assessment of the Long-Term Economic Impact of the New Regulatory Framework.” LEI Report. Basel Committee on Banking Supervision/Financial Stability Board. 2010. “Assessing the Macroeconomic Impact of the Transition to Stronger Capital and Liquidity Requirements.” Interim Report, MAG Report. See Bank of Canada (2010). Bernanke, B. S. 2007a. “The Financial Accelerator and the Credit Channel.” Speech delivered at the The Credit Channel of Monetary Policy in the Twenty-first Century Conference held at the Federal Reserve Bank of Atlanta, Atlanta, Georgia, 14–15 June. ——— . 2007b. “Housing, Housing Finance, and Monetary Policy.” Speech delivered at the Federal Reserve Bank of Kansas City’s Economic Symposium. Bernanke, B. S. and M. Gertler. 1989. “Agency Costs, Net Worth, and Business Fluctuations.” American Economic Review 79 (1): 14–31. Bernanke, B. S., M. Gertler, and S. Gilchrist. 1999. “The Financial Accelerator in a Quantitative Business Cycle Framework.” In Handbook of Macroeconomics, edited by J. B. Taylor and M. Woodford, edition 1, 1 (21): 1341–393. Borio, C. and M. Drehmann. 2009. “Assessing the Risk of Banking Crises – Revisited.” BIS Quarterly Review (March): 29–46. Borio, C. and H. Zhu. 2008. “Capital Regulation, Risk-Taking and Monetary Policy: A Missing Link in the Transmission Mechanism?” Bank for International Settlements Working Paper No. 268. Brunnermeier, M. and Y. Sannikov. 2010. “A Macroeconomic Model with a Financial Sector.” Princeton University. May. Christensen, I., P. Corrigan, C. Mendicino, and S. N. Nishiyama. 2009. “Consumption, Housing Collateral, and the Canadian Business Cycle.” Bank of Canada Working Paper No. 2009–26. Christensen, I. and A. Dib. 2008. “The Financial Accelerator in an Estimated New Keynesian Model.” Review of Economic Dynamics 11 (1): 155–78. Christensen, I. and C. Meh. 2010. “Counter-Cyclical Loan-to-Value Ratio and Monetary Policy.” Bank of Canada. Manuscript. Christensen, I., C. Meh, and K. Moran. 2010. “Bank Leverage Regulation and Macroeconomic Dynamics.” Bank of Canada and Université Laval. Manuscript. Christiano, L., R. Motto, and M. Rostagno. 2010. “Financial Factors in Economic Fluctuations.” European Central Bank Working Paper No. 1192. Curdia, V. and M. Woodford. 2010. “The Central Bank Balance Sheet as an Instrument of Monetary Policy.” Columbia University, Department of Economics, Discussion Paper No. 0910–16. Diamond, D. and R. Rajan. 2009. “The Credit Crisis: Conjectures about Causes and Remedies.” American Economic Review 99: 606–10. Dib A. 2010. “Banks, Credit Market Frictions, and Business Cycles.” Bank of Canada Working Paper No. 10–24. Drehmann, M., C. Borio, L. Gambacorta, G. Jiménez, and C. Trucharte. 2010. “Countercyclical Capital Buffers: Exploring Options.” Bank for International Settlements Working Paper No. 317. Farhi, E. and J. Tirole. 2009. “Leverage and the Central Banker’s Put.” American Economic Review 99 (2): 589–93. Gauthier, C., Z. He, and M. Souissi. 2010. “Understanding Systemic Risk: The Trade-Offs between Capital, Short-Term Funding and Liquid Asset Holdings.” Bank of Canada Working Paper No. 2010–29. Gerali, A., S. Neri, L. Sessa, and F. M. Signoretti. 2010. “Credit and Banking in a DSGE Model of the Euro Area.” Bank of Italy Working Paper No. 740. Gertler, M. and P. Karadi. 2010. “A Model of Unconventional Monetary Policy.” New York University Working Paper. Gertler, M. and N. Kiyotaki. 2010. “Financial Intermediation and Credit Policy in Business Cycle Analysis.” New York University and Princeton University Working Paper. Iacoviello, M. 2005. “House Prices, Borrowing Constraints and Monetary Policy in the Business Cycle.” American Economic Review 95 (3): 739–64. International Monetary Fund. 2010. “The IMF-FSB Early Warning Exercise: Design and Methodological Toolkit.” September. http://www.imf.org/external/np/exr/facts/ewe.htm Kiyotaki, N. and J. Moore. 1997. “Credit Cycles.” Journal of Political Economy 105 (2): 211–48. Meh, C. and K. Moran. 2010. “The Role of Bank Capital in the Propagation of Shocks.” Journal of Economic Dynamics and Control 34 (3): 555–76. Misina, M. and G. Tkacz. 2009. “Credit, Asset Prices, and Financial Stress.” International Journal of Central Banking 5: 95–122. Rajan, R. 2005. “Has Financial Development Made the World Riskier?” National Bureau of Economic Research Working Paper No. 11728. Rothschild, M. and J. Stiglitz. 1976. “Equilibrium in Competitive Insurance Markets: An Essay on the Economics of Imperfect Information.” Quarterly Journal of Economics 90: 629–49. Van den Heuvel, S. J. 2008. “The Welfare Cost of Bank Capital Requirements.” Journal of Monetary Economics 55 (2): 298–320.
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Remarks by Mr Mark Carney, Governor of the Bank of Canada, at the Economic Club of Canada, Toronto, 13 December 2010.
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Mark Carney: Living with low for long Remarks by Mr Mark Carney, Governor of the Bank of Canada, at the Economic Club of Canada, Toronto, 13 December 2010. * * * Introduction I would like to thank the Economic Club of Canada for this opportunity to reflect on the current economic and financial trends. I am sure many in this room would like me to stop at the title, “Living with Low for Long,” so you can go merrily into the Christmas holidays, content that I have just provided an early present of extraordinary guidance on future Canadian monetary policy. However, I am not bearing gifts today. Canadian monetary policy will continue to be set, as it has in the past, for overall Canadian conditions and guided by our 2 per cent inflation target. In my remarks today, I will focus on the factors that have led to a low-interest-rate environment in major advanced economies, and the implications of this environment for financial stability and economic growth. Global economic outlook Current turbulence in Europe is a reminder that the crisis is not over, but has merely entered a new phase. In a world awash with debt, repairing the balance sheets of banks, households and countries will take years. As a consequence, the pace, pattern and variability of global economic growth is changing, and Canada must adapt. For the crisis economies, the easy bit of the recovery is now finished. Temporary factors supporting growth in 2010 – such as the turn in the inventory cycle and the release of pentup demand – have largely run their course. Fiscal stimulus is turning to fiscal drag and, for some countries, rapid consolidation has become urgent. Household expenditure can be expected to recover only slowly. This all implies a gradual absorption of the large excess capacity in many advanced economies. This is not surprising. History suggests that recessions involving financial crises tend to be deeper and have recoveries that take twice as long. In the decade following severe financial crises, growth rates tend to be one percentage point lower and unemployment rates five percentage points higher. 1 The current U.S. recovery is proving no exception. In such an environment, very low policy rates in the major advanced economies could be in place for a prolonged period – a possibility underscored by the recent extensions of unconventional monetary policies in the United States, Japan and Europe. This tendency towards low-interest rates is being reinforced by structural forces. The global economy is rapidly becoming multi-polar, with emerging-market economies now driving commodity prices, representing almost one-half of all import growth, and accounting for about two-thirds of global growth. This is an increasingly uneasy emergence. Growth strategies reliant on exports and excess national savings are unsustainable in the long term. In the near term, for many emerging economies, the limits to non-inflationary growth are approaching and the challenges of shadowing U.S. monetary policy are increasing. See C. Reinhart and V. Reinhart, “After the Fall,” Macroeconomic Challenges: The Decade Ahead, Federal Reserve Bank of Kansas City 2010 Economic Policy Symposium. Available at: http://www.kansascityfed.org/publicat/sympos/2010/reinhart-paper.pdf. With currency tensions rising, some fear a repeat of the competitive devaluations of the Great Depression. However, the current situation is actually more perverse. In the 1930s, countries left the gold standard in order to ease monetary policy, and the system became more flexible. Today, the process is working in reverse. The international monetary system is sliding towards a massive dollar block. Over a dozen countries are now accumulating reserves at double digit annual rates, and countries representing over 40 per cent of the U.S.-dollar trade weight are now managing their currencies. This death grip on the U.S. dollar is reducing the prospects for rebalancing global demand. As the Bank of Canada has argued elsewhere, the potential costs are huge – to $7 trillion in lost global output by 2015. 2 Ultimately, excessive reserve accumulation will prove futile. Structural changes in the global economy will yield important adjustments in real exchange rates. If nominal exchange rates do not change, the adjustment will come through inflation in emerging economies and disinflation in major advanced economies. This more wrenching adjustment has already begun, raising the risk of debt deflation and deficient global demand. At a minimum, this dynamic reinforces the low-interest-rate strategies of major advanced economies and may necessitate further rounds of quantitative easing. So what does this mean for countries caught in the middle, like Canada? I will review three aspects: the effect of the second round of quantitative easing (QE2); the implications for Canadian monetary policy; and the potential financial stability implications of “low for long” interest rates. QE2 and implications for Canada Last month, the Federal Reserve launched a new program to buy US$600 billion in longerterm treasury securities by the end of the second quarter of 2011. 3 It is doing so because, even though its policy rate has been effectively zero for two years, the Fed is still missing both legs of its dual mandate to foster price stability and maximum employment. Core inflation is at an all-time low and unemployment is unusually high. The spectre of large structural unemployment threatens. QE2 is designed to support the economy through easier financial conditions. In theory, by putting downward pressure on longer-term U.S.-Treasury rates, the program stimulates interest-sensitive sectors of the economy such as housing and business investment. Portfolio rebalancing should encourage investors to shift towards riskier assets such as corporate debt and equities. This in turn increases financial wealth, which supports spending. In contrast, some financial investment may shift to harder assets such as commodities, which would reduce the disposable incomes of Americans. See M. Carney, “Restoring Faith in the International Monetary System,” speech delivered to Spruce Meadows Changing Fortunes Round Table, Calgary, Alberta, 10 September 2010. Available at: http://www.bankofcanada.ca/en/speeches/2010/sp100910.html. It will also reinvest maturing existing holdings amounting to about US$250 billion to US$300 billion. The exchange rate is another important channel. As returns on U.S. assets fall, investors could seek alternative investments outside the country, weakening the currency, boosting exports and curbing imports. Finally, and importantly, expectations of higher growth should help increase inflation expectations towards a range consistent with the Fed’s mandate. This keeps real interest rates down, which encourages investment and spending. Of course, the exact impact of the program is hard to discern as QE2 is not the only news in financial markets. Since the policy was first mooted by Chairman Bernanke in August, all the expected effects have been evident, supporting the Fed’s rationale. Since the November announcement, U.S. financial conditions have improved only slightly, reflecting the conflicting forces of some better U.S. data, heightened risk aversion caused by the European turmoil, possibly revised expectations regarding the ultimate size of the program, and the announcement of a major new fiscal package. The overall impact of QE2 may be more modest than previous interventions when market dislocations were more severe. 4 The Bank of Canada anticipated the Fed’s latest move when we published our October projection (not hard to do, given the openness with which the Fed discussed its plans). Overall, we expect the net impact on Canadian GDP to be positive but small. This balances the impact of stronger U.S. growth on demand for Canadian goods and services, as well as on our terms of trade, with the possibility of further drag on non-commodity exports arising from the persistent strength of the Canadian dollar. Canadian monetary policy While the Canadian economy is importantly affected by developments in its largest trading partner, Canadian monetary policy is set for overall Canadian conditions and is guided by our 2 per cent inflation target. Given that the United States was the epicentre of the financial crisis and that the Canadian financial system has continued to function well, it is not surprising that our two economies have performed very differently. It is entirely appropriate that our monetary policies have diverged somewhat. Consider the responses to the extraordinary monetary and fiscal stimulus enacted in the wake of the crisis. Canadian output has now surpassed its pre-crisis peak (a situation unique in the G-7). Canadian final domestic demand has grown by 5.7 per cent since the trough of the crisis – more than twice the rate (2.6 per cent) in the United States. The Canadian economy recovered all of the jobs lost in the recession and added a further 23,700; the U.S. economy has recovered only one-tenth of jobs lost, while over 40 per cent of unemployed workers have now been out of work for more than half a year. Household credit has grown by about 7 per cent in Canada since the trough in GDP; in the United States, it has fallen by 3.5 per cent. Research suggests that the first round of quantitative easing in 2009 was successful in improving market functioning and lowering long-term rates by 30-100 basis points in the United States and up to 100 basis points in the United Kingdom. See J. Gagnon, M. Raskin, J. Remache, and B. Sack, “Large-Scale Asset Purchases by the Federal Reserve: Did They Work?” (Federal Reserve Bank of New York Staff Report No. 441, March 2010) and M. Joyce, A. Lasaosa, I. Stevens and M. Tong, “The Financial Market Impact of Quantitative Easing” (Bank of England Working Paper No. 393, August 2010). The most recent rates of core inflation were 1.8 per cent in Canada versus 0.6 per cent in the United States. It is not all good news. The weak links in the Canadian economy have been poor productivity growth and declining export competitiveness. As the Bank has emphasised in recent months, a rotation of demand from household expenditures to business investment and net exports will be important to a sustained Canadian expansion. In this regard, much remains to be done. Since the spring, the Bank has unwound the last of its exceptional liquidity measures, removed the conditional commitment, and raised the overnight rate from 0.25 per cent to 1 per cent. Last week, the Bank maintained its target for the overnight rate at this level. This decision leaves considerable monetary stimulus in place, consistent with achieving the 2 per cent inflation target in an environment of significant excess supply in Canada. Any further reduction in monetary policy stimulus would need to be carefully considered. Historically low policy rates, even if appropriate to achieve the inflation target, create their own risks. Aside from monetary policy, Canadian authorities will need to remain as vigilant as they have been in the past to the possibility of financial imbalances developing in an environment of still-low interest rates and relative price stability. I would like to spend the balance of my time on the more general issue of how the perception of low rates for long could potentially distort behaviour in public, financial, corporate and household sectors. Implications for sovereigns In some countries, low interest rates may delay necessary fiscal consolidation. 5 By shifting their debt profile towards shorter-term financing, governments reduce interest rate payments. The substantial purchases of longer-term government bonds by foreign and domestic central banks could delay market signals about debt sustainability. 6 While low current interest rates create short-term fiscal flexibility, they expose budgets to any increase in policy rates and abrupt changes in private market sentiment. Countries would be wise to heed the lessons learned by Canada in the 1990s: the bond market is there until it is not. Implications of low for long for the financial sector The conviction that interest rates will be low for long can lead to various types of risky behaviour in the financial sector. As we have all just been reminded at great cost, an extended period of stability breeds complacency among financial market participants as risk-taking adapts to the perceived new equilibrium. 7 Indeed, risk appears to be at its greatest when measures of it are at their lowest. Low variability of inflation and output (reduces current financial value at risk and) encourages greater risk-taking (on a forward value-at-risk basis). Investors stretch from liquid to less-liquid markets and large asset-liability mismatches are stretched across credit and currency markets. This is why it is important to adhere to the Toronto G-20 commitment to halve deficits by 2013 and stabilize debt to GDP by 2016. Estimates of central bank ownership of U.S. Treasuries and U.K. gilts are both now over 40 per cent. Either perceptions of risk or risk preferences could change. In the former case, complacency about actual risks can mean taking greater risks within the same risk budget. These dynamics helped compress spreads and boost asset prices in the run-up to the crisis. They also made financial institutions increasingly vulnerable to a sudden reduction in both market and funding liquidity. 8 The crisis prompted a brutal reversal, culminating in the panic in the autumn of 2008. The period ahead will be somewhat different. In particular, perceptions of macroeconomic risk are more volatile, which should help limit complacency. 9 Nonetheless, some of the risky dynamics associated with perceptions of an extended period of low interest rates could still be at work going forward. For example, over the past year and a half, banks have used low short-term funding rates to rebuild capital by investing in long-term government bonds. 10 This strategy is effective to a point, provided complacency does not set in over the duration of low policy rates. Making consistent positive carry may diminish the sense of urgency with which banks reduce leverage or write down bad assets. Financial institutions may also take this game too far, underestimating the risks. This is a particular concern since banks have considerably shortened the term structure of their funding in the aftermath of the crisis. Banks would do well to remember that marginal adjustments of interest rates have non-negligible effects when leverage is high. A prolonged period of low interest rates also has important implications for insurance companies and pension funds with their longer-term guaranteed returns or benefits. By reducing yields on assets and raising the net present value of liabilities, a sustained period of low interest rates makes these guarantees harder to fulfill. To address potential shortfalls, funds could move into riskier assets in a search for yield and/or shorten their duration to limit asset-liability mismatches. 11 The extent of these strategies will depend on accounting treatment of liabilities and regulatory arrangements. Some new proposals such as the recent International Accounting Standards Board’s proposed amendments to accounting standards for insurance contracts (IFRS 4) could have far-reaching systemic implications. The Bank correspondingly welcomes the Chairman’s recent decision to consider other options to improve the transparency and international comparability of insurance accounting. Implications for the corporate sector Low rates for an extended period of time reduce the incentives for banks to enforce the terms of loans and for firms themselves to adjust. Past experience has shown that low policy rates allow “evergreening,” or the rolling-over of non-viable loans. The classic example was Japan in the 1990s when banks permitted debtors to roll over loans on which they could afford the near zero interest payments but not See M.K. Brunnermeier and L.H. Pedersen, “Market Liquidity and Funding Liquidity,” Review of Financial Studies, 2009 22(6):2201–2238. An analysis of the factors driving the weekly rates of return on a wide range of assets suggests that, since the bankruptcy of Lehman Brothers in September 2008, a higher proportion of the overall variation in weekly asset returns can be explained by a common factor. See Bank of Canada, Financial System Review, December, 2010. The expectations channel is important because it determines the term spread, net-interest margin and forward-looking capitalization (accrual) of the banks. See T. Adrian and H.S. Shin, “Financial Intermediaries, Financial Stability and Monetary Policy,” a paper prepared for the symposium, “Maintaining Stability in a Changing Financial System,” Jackson Hole, Wyoming, August, 2008. To some extent, insurance companies are sheltered from the immediate effects given the longer-term nature of their obligations as well as penalties on the withdrawals of existing plans that can be sizeable. principal repayments. By evergreening loans instead of writing them off, banks preserved their capital, but this delayed necessary restructuring of industry. Moreover, the presence of non-viable (or “zombie”) firms limited competition, reduced investment and prevented the entry of new enterprises. 12 Here in Canada, the risk of such delayed adjustment is relatively modest at present since most Canadian corporate balance sheets are in outstanding shape. Corporate leverage declined in the third quarter of 2010 – approaching its lowest level in two decades – and it remains significantly below that in the United States, the United Kingdom and the euro area. However, it is possible that a mild form of such behaviour could develop in some sectors such as homebuilding, where land values may be slow to adjust to new realities. At present, low carrying costs provide powerful incentives for developers to wait out the current softness. Unfortunately, the best contemporary analogue to the Japanese zombie firms is probably the U.S. household sector. Problems with the foreclosure process, government programs and forbearance by lenders are all delaying the adjustments. 13 Absent more aggressive restructuring, the impact of negative equity on one-quarter of U.S. homeowners will weigh on consumption for the foreseeable future. Implications for households Encouraged in part by low interest rates, Canadian household credit has expanded rapidly during the recession and throughout the recovery. As a consequence, the proportion of households with stretched financial positions has grown significantly. In a series of analyses over the past year the Bank has found that Canadian households are increasingly vulnerable to an adverse shock and that this vulnerability is rising more quickly than had been previously anticipated. 14, 15 While there are welcome signs of moderation in the pace of debt accumulation by households, credit continues to grow faster than income. In some regions, lower house prices have begun to weigh on personal net worth. Without a significant change in behaviour, the proportion of households that would be susceptible to serious financial stress from an adverse shock will continue to grow. The Bank has conducted a partial stress-testing simulation to estimate the impact on household balance sheets of a hypothetical labour market shock. The results suggest that the rise in financial stress from a 3-percentage-point increase in the unemployment rate would double the proportion of loans that are in arrears three months or more. Owing to the declining affordability of housing and the increasingly stretched financial positions of households, the probability of a negative shock to property prices has risen as well. Even if the growth in debt continues to slow, the vulnerability of Canadian households is unlikely to decline quickly given the outlook for subdued growth in income. In addition, private consumption is unlikely to be bolstered by gains in house prices going forward. “Low Interest Rates: Do the Risks Outweigh the Rewards?” Bank for International Settlements Annual Report 2009/2010, Chapter III. Governor Kevin Warsh of the Federal Reserve rightly notes: “The steep correction in [U.S.] housing markets, while painful, lays the foundation for recovery – far better than the countless programs that sought to subsidize and temporize the inevitable repricing,” from the speech, “Rejecting the Requiem,” delivered to the Securities Industry and Financial Markets Association, New York, New York, 8 November 2010. Bank of Canada Financial System Review, June 2010 and December 2009. This analysis was conducted using data from the Canadian Financial Monitor survey by Ipsos Reid Canada. Lines of defence Experience suggests that prolonged periods of unusually low rates can cloud assessments of financial risks, induce a search for yield, and delay balance-sheet adjustments. There are several defences. The first line of defence is built on the decisions of individuals, companies, banks and governments. The Bank’s advice to Canadians has been consistent. We have weathered a severe crisis – one that required extraordinary fiscal and monetary measures. Extraordinary measures are only a means to an end. Ordinary times will eventually return and, with them, more normal interest rates and costs of borrowing. It is the responsibility of households to ensure that in the future, they can service the debts they take on today. Similarly, financial institutions are responsible for ensuring that their clients can service their debts. More broadly, market participants should resist complacency and constantly reassess risks. Low rates today do not necessarily mean low rates tomorrow. Risk reversals when they happen can be fierce: the greater the complacency, the more brutal the reckoning. The second line of defence is enhanced supervision of risk-taking activities. Stress testing in major economies should focus on excessive maturity and currency mismatches, look for evidence of forbearance (such as ailing industries receiving a disproportionate share of loans or the loosening of standards for existing debtors) and analyse the impact of sharp moves in yield curves. These efforts will be aided by the imposition of the new Basel III regulations. Measures, including a leverage ratio, new trading book rules and liquidity standards, will help curtail excessive leverage and maturity transformation. The third line of defence is the development of and selected use of macro-prudential measures. In funding markets, the introduction of through-the-cycle margining can help curtail liquidity cycles. 16 In broader asset markets, counter-cyclical capital buffers can be deployed to lean against excess credit creation. Importantly, following the agreement of G-20 leaders in Seoul, the Basel Committee endorsed the Canadian-led proposal for this framework. 17 In the housing market, the Canadian government has already taken important measures to address household leverage. These include a more stringent qualifying test that requires all borrowers to meet the standards for a 5-year fixed-rate mortgage as well as a reduction in the maximum loan-to-value ratio of refinanced mortgages and a higher minimum down payment on properties not occupied by the owner. In addition, the Bank of Canada’s interest rate increases reminded households of the interest rate risks they face. These measures are beginning to have an impact. Canadian authorities are co-operating closely and will continue to monitor the financial situation of the household sector. These defences should go a long way to mitigate the risk of financial excesses. But the question remains whether there will still be cases where, in order to best achieve long-run See “The Role of Margin Requirements and Haircuts in Procyclicality,” a report prepared by a study group chaired by David Longworth and published by the Committee on the Global Financial System of the Bank for International Settlements, 23 March 2010. Available at: < http://www.bis.org/publ/cgfs36.htm >. This is the result of work prepared by the Basel Committee on Banking Supervision’s Macro-Variables Task Force, chaired by Mark Zelmer of the Bank of Canada. See Results of the December 2010 meeting of the Basel Committee on Banking Supervision, 1 December 2010. Available at: http://www.bis.org/press/p101201a.htm. price stability, monetary policy should play a supporting role by taking pre-emptive actions against building financial imbalances. As part of our research for the renewal of the inflationcontrol agreement, the Bank is examining this issue. While the bar for further changes remains high, the Bank has the responsibility to draw the appropriate lessons from the experience of others who, in an environment of price stability, reaped financial disaster. Conclusion These are extraordinary times. A massive deleveraging has barely begun across the industrialised world. Canada entered this crisis extremely well-positioned. Due to the sacrifice of Canadians and the foresight of successive governments, our public debt burden was the lowest in the G-7. Thanks to the courage of my predecessors, monetary policy had tremendous credibility. Due to the quality of public supervision and private risk management, our banks had one of the soundest capital bases in the world. And after more than a decade of success, our corporate balance sheets were in great shape. By combining these strengths with decisive policy actions, we have managed well through the turmoil. But the challenges we face have only just begun. Cheap money is not a long-term growth strategy. Monetary policy will continue to be set to achieve the inflation target. Our institutions should not be lulled into a false sense of security by current low rates. Households need to be prudent in their borrowing, recognising that over the life of a mortgage, interest rates will often be much higher. The weight of the adjustment beyond our shores means that demand for our products is weak and competition fierce. We must improve our competitiveness. Recovery after a recession demands that capital and labour be reallocated. The surge in business investment that began this past summer can only be the start. Now is not the time for complacency. Thank you.
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Remarks by Ms Agathe Côté, Deputy Governor of the Bank of Canada, at the Canadian Club of Kingston, Kingston, Ontario, 10 January 2011.
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Agathe Côté: Household finances and economic growth Remarks by Ms Agathe Côté, Deputy Governor of the Bank of Canada, at the Canadian Club of Kingston, Kingston, Ontario, 10 January 2011. * * * Introduction Good afternoon and Happy New Year. Thank you for your invitation to speak to the Canadian Club. This is my first public speech as a Deputy Governor of the Bank of Canada, and I am delighted to be delivering it in the historic city of Kingston. In my remarks I will focus on the state of the Canadian economy, with an emphasis on household finances. Why does household financial health matter to the Bank of Canada? It matters because how Canadians spend and how much they spend affect both the conduct of monetary policy and the stability of the financial system. Sound household finances are vitally important for a balanced economy. Collectively, households play a significant role in the functioning of the economy. Household spending accounts for about 60 per cent of aggregate demand in Canada, and was critical in lifting the Canadian economy out of the recession. At the same time, however, Canadian household finances have become increasingly stretched. Today, I will touch briefly on growing household indebtedness and the risks that it poses to Canada’s financial stability, but my comments will centre mainly on the macroeconomic outlook and the linkages between household finances and spending. I will start with an overview of current economic conditions and how the economy evolved during the financial crisis. Recovering from the great recession In mid-2009, the world economy began to emerge from the most severe financial crisis since the Great Depression. In Canada, the recession lasted for three quarters, from the latter months of 2008 to mid-2009. Our exports fell dramatically in response to a steep drop in U.S. demand. Firms cut back on employment; some 417,000 jobs were lost. In response to the weaker labour market, declines in net worth and increased uncertainty, household spending also fell. Government spending was the only consistent source of growth throughout this period. Despite these challenges, Canada’s recovery has been stronger than that of our G-7 peers. By mid-2010, Canadian output had returned to its pre-recession level and all of the jobs that had been lost were regained. Since then, almost 46,000 positions have been added. Canada entered the recession with critically important advantages. Our public debt burden was the lowest of the G-7 countries. Our monetary policy was highly credible. Our financial institutions were in good health, owing to the quality of public supervision and private risk management. Corporate balance sheets were robust. Finally, Canadian household finances were not as stretched as they were in some other advanced countries. Relative to the situation in the United States, in particular, the personal savings rate in Canada was higher and household debt was lower. These favourable conditions meant that the Bank of Canada could respond aggressively with substantial monetary easing, while keeping inflation expectations well anchored. They also allowed governments to roll out extraordinary fiscal stimulus, while maintaining fiscal sustainability. The fact that our banking system was well capitalized meant that Canadian banks did not face the same pressures to deleverage, and were able to maintain the supply of credit, although they did tighten the terms and conditions of lending to businesses. BIS central bankers’ speeches Because the financial system in Canada was functioning well, the cuts in the policy rate were transmitted to other interest rates in the economy, and effective borrowing costs for both households and businesses declined to exceptionally low levels. This helped cushion the downturn and fuel the recovery in household spending, with the result that consumption surpassed its pre-recession level as early as the third quarter of 2009. In contrast, business investment was unusually weak during the recession, and its recovery has been subdued. In the United States, the situation was, and still is, much worse. Of course, the United States was the epicentre of the financial crisis. The recovery in the labour market there has been weak, restraining the growth in labour income. Household balance sheets remain under pressure from elevated debt levels and the dramatic collapse in home prices. Hence, the level of consumer expenditures has just recently reached its pre-recession peak and, following a sharp contraction, the housing market has yet to rebound. Overall, the pace of recovery in U.S. private domestic demand has been slow. Since the United States is Canada’s largest trading partner, our exports have also been slow to recover. Weak external demand, combined with the deterioration in Canadian competitiveness in recent years, has led to sharp contractions in Canada’s trade balance and a return to current account deficits. Thus, despite the advantages I noted a moment ago, Canada’s recovery has been relatively modest in comparison with previous cycles, and has relied heavily on household and government spending. Going forward, the Bank expects that the composition of demand will shift away from government and household spending toward business investment and net exports. In that regard, the surge in business investment that began last year is an encouraging start. The strength in net exports will be sensitive to currency movements, the expected recovery in productivity growth, and the prospects for external demand. Household finances and spending From the outlook for the overall Canadian economy, let me now narrow my focus to the household sector and, in particular, to the links between household spending and household finances. As I mentioned at the outset, the resilience in household spending helped propel the economy out of the recession. A number of factors contributed to the rebound in consumer expenditures and housing investment, including the recovery in employment and labour income, the improvement in consumer confidence, and temporary fiscal measures, most notably the tax credit on home renovations. Equally important, consumers took advantage of low borrowing costs and, in doing so, pushed household debt levels to record highs. Since the trough of the recession, household credit has grown about twice as fast as personal disposable income. By the third quarter of 2010, the debt of Canadian households had reached 148 per cent of disposable income. In addition to low interest rates, rising house prices and home-equity extractions have played a role in the growth of credit in recent years and, therefore, have helped to boost household spending. Why is this? The main channel through which increases in house prices can raise household spending is called the financial-accelerator effect. When the value of a house rises, the owner can borrow against the increased equity through a home equity line of credit, a home equity loan or by simply increasing the size of the mortgage (an option for homeowners when they renew their mortgage, provided they have sufficient equity). The funds can be used to finance home renovations, a second house, or other goods and services. Such expenditures can accelerate the increase in house prices, reinforcing the growth in collateral values and access to additional borrowing, thus leading to a rise in household spending. Of course, this accelerator effect can also work in reverse: a decrease in house prices tends to reduce household borrowing capacity, and amplify the decline in spending. Research conducted at the Bank of Canada and elsewhere suggests that the financialaccelerator effect is economically significant. 1 This finding is also consistent with reducedform evidence of a correlation between consumer spending and housing wealth. 2 In the last decade, lending based on housing collateral has risen as a share of total Canadian household credit. According to Bank of Canada calculations, the volume of homeequity lines of credit and loans has risen by as much as 170 per cent–or almost twice as fast as mortgage debt–and now accounts for 12 per cent of the overall stock of household debt. Since these secured loans are offered at a lower interest rate than unsecured loans, consumers have used part of the funds to pay down other debts. Microdata suggest that roughly one-third of the loans are used to that effect, while about 20 per cent are used to invest in financial assets. The remaining half is spent on current consumption and renovating or purchasing another property. Over time, there has been a marked increase in the share of home-equity-backed debt held by older households, an outcome that may not be too surprising since older households have generally owned their houses longer and have significant equity in them. 3 The overall conclusion based on the microdata and the research is that lower interest rates for secured lending and increased access to credit as house prices rose have helped fuel net increases in credit and have supported household spending in Canada in recent years. Going forward, house price gains are unlikely to provide the same support to household wealth as they have in recent years. This, combined with the fact that the level of household debt has reached a record high, leads us to expect that the growth of household expenditures will slow to a pace closer to that of income. There are risks, on both the upside and the downside, to the outlook for Canadian household spending. On the upside, household spending could be stronger than expected if growth in incomes were to rebound more rapidly than the Bank projects, or if borrowing continues to exceed income growth. In our projection, we expect slow growth in personal disposable income owing to the withdrawal of fiscal stimulus, announced compensation restraints by governments and a slow recovery in average hours worked. On the downside, if there were a sudden weakening in the Canadian housing sector, it could have sizable spillover effects on other areas of the economy, such as consumption, given the high debt loads of some Canadian households. While residential investment declined in the second half of 2010, it still remains near historically high levels. The Bank expects some further weakening into 2011, reflecting subdued income growth and declining affordability, but not a major correction. See M. Iacoviello, “House Prices, Borrowing Constraints and Monetary Policy in the Business Cycle” The American Economic Review 95, No. 3 (2005): 739–64. See also: M.B. Roi and R. Mendes, “House Prices, Residential Mortgage Credit and Monetary Policy,” Bank of Canada, December 2004 (Available at: http://www.bankofcanada.ca/en/conference_papers/housing_macroeconomy/roi.pdf); and J. Campbell and J. F. Cocco, “How Do House Prices Affect Consumption? Evidence from Micro Data,” (Harvard Institute of Economic Research Working Papers No. 2045, 2004) See L. Pichette, “Are Wealth Effects Important for Canada?” Bank of Canada Review (Ottawa, Bank of Canada, Spring 2004). Available at: http://www.bankofcanada.ca/en/review/spring04/r04-2-ec.html Part of the increase may also reflect the general aging of the population. Microdata indicate that from 1999 to 2009, the share of home equity lines of credit (HELOCs) held by households in the 50-plus age group increased from 33 per cent to 54 per cent. BIS central bankers’ speeches Household finances and financial stability Household finances also have important implications for financial stability. While the rapid expansion of household credit during the recession and the early stages of the recovery is in part a testament to the resilience of Canada’s financial system, it is also a source of risk. As discussed in the Bank’s most recent Financial System Review, the proportion of households with stretched financial positions that leave them vulnerable to an adverse shock has grown significantly in recent years. At an aggregate level, the risk is that a shock to economic conditions could be transmitted to the broader financial system through a weakening in the credit quality of loans to households. This could prompt a tightening of credit conditions and, in turn, set off a mutually reinforcing deterioration of real activity and financial stability. There are welcome signs of moderation in the pace of debt accumulation, but credit continues to grow faster than income. Without a significant change in behaviour, the proportion of households that would be susceptible to serious financial stress from negative income or wealth shocks will continue to grow. To better assess the risks associated with growing household indebtedness, the Bank regularly undertakes stress tests. In the December Financial System Review, we conducted a partial stress-testing simulation to estimate the impact on household balance sheets of a hypothetical 3-percentage-point increase in the unemployment rate. The results suggest that the associated rise in financial stress among households would double the proportion of loans that are in arrears three months or more. Even without adverse shocks, household debt-service ratios would be expected to increase when borrowing costs return to more normal levels. It is the responsibility of households to ensure that, in the future, they are able to service the debts they take on today. Similarly, financial institutions are responsible for ensuring that their clients do not take on unmanageable debt loads. Policy implications In response to the global financial crisis and the recession, the Bank of Canada lowered the target interest rate rapidly over the course of 2008 and early 2009 to its lowest possible level, and provided exceptional guidance on the future path of rates through its conditional commitment. These measures delivered considerable stimulus to the economy during a period of very weak economic conditions. Since last spring, with improvements in the economy, the Bank has removed the conditional commitment, and raised the overnight rate from ¼ of one per cent to 1 per cent. This still leaves considerable monetary stimulus in place, consistent with achieving the 2 per cent inflation target in an environment of significant excess supply. Some have asked if increasing interest rates poses such a threat to households, why raise them? Yet others have asked if household debt is such a concern, why not raise rates and discourage borrowing? The cornerstone of the Bank’s monetary policy is its inflation-control agreement, the goal of which is to keep inflation near 2 per cent. In setting interest rates to achieve the inflation target, developments in household finances need to be weighed along with all the other factors influencing economic activity and inflation. Canadian monetary policy is set for overall macroeconomic conditions in Canada. The Bank recognizes that low interest rates, while necessary to achieve our inflation target, create their own risks. 4 Prudence on the part of individuals and financial institutions is the first line of defence against these risks. Supervision of financial institutions can also be effective in limiting excessive concentration of risk. The development and use of selected macroprudential tools constitute another line of defence. In the housing market, the federal government has already taken important measures to address household leverage. These include a more stringent qualifying test that requires all borrowers to meet the standards for a 5-year fixed-rate mortgage as well as a reduction in the maximum loan-to-value ratio of refinanced mortgages and a higher minimum down payment on properties not occupied by the owner. In addition, the Bank of Canada’s interest rate increases reminded households of the interest rate risks they face. These measures are beginning to have an impact. As part of our research for the renewal later this year of our inflation-control agreement with the Government of Canada, the Bank is examining whether there may be cases in the future where monetary policy should play a supporting role to these other lines of defence by taking pre-emptive actions against building financial imbalances. 5 Conclusion Sound household finances are a key element of a balanced economy. They are essential to keep household spending and overall economic growth on a sustainable track and to maintain the stability of our financial system. This is why the Bank is closely watching developments in this area. I hope my comments have provided some additional insight into the Bank’s economic outlook and the determinants of household spending and offer you some guidance about the risks. The clearer our understanding of the nature of the risks we face, the better able we will be to make informed decisions to address them. Thank you. See M. Carney, “Living with Low for Long” (speech delivered to the Economic Club of Canada, Toronto, 13 December 2010). Available at: http://www.bankofcanada.ca/en/speeches/2010/sp131210.html. See M. Carney, “Some Considerations on Using Monetary Policy to Stabilize Economic Activity” (speech delivered at a symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming, 22 August 2009). Available at: http://www.bankofcanada.ca/en/speeches/2009/sp220809.html. See also: J. Boivin, T. Lane and C. Meh, “Should Monetary Policy Be Used to Counteract Financial Imbalances?” Bank of Canada Review (Ottawa, Bank of Canada, Summer 2010). Available at: http://www.bankofcanada.ca/en/review/summer10/boivin_summer10.pdf. BIS central bankers’ speeches
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Opening statement by Mr Mark Carney, Governor of the Bank of Canada, at the press conference following the release of the Monetary Policy Report, Ottawa, 19 January 2011.
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Mark Carney: Summary of the latest Monetary Policy Report Opening statement by Mr Mark Carney, Governor of the Bank of Canada, at the press conference following the release of the Monetary Policy Report, Ottawa, 19 January 2011. * * * Good morning. Tiff and I are pleased to be here with you today to discuss the January Monetary Policy Report, which the Bank published this morning. The global economic recovery is proceeding at a somewhat faster pace than the Bank had anticipated, although risks remain elevated. Private domestic demand in the United States has picked up and will be reinforced by recently announced monetary and fiscal stimulus. European growth has also been slightly stronger than anticipated. However, ongoing challenges associated with sovereign and bank balance sheets will limit the pace of the European recovery and are a significant source of uncertainty to the global outlook. Some emerging markets have begun to implement more restrictive policy measures in response to overheating in their economies. The effectiveness of these policies will influence the path of commodity prices, which have increased significantly since October. The recovery in Canada is proceeding broadly as anticipated, with a period of more modest growth and the beginning of the expected rebalancing of demand. The contribution of government spending is expected to wind down this year, consistent with announced fiscal plans. Stretched household balance sheets are expected to restrain the pace of consumption growth and residential investment. In contrast, business investment will likely continue to rebound strongly, owing to stimulative financial conditions and competitive imperatives. Net exports are projected to contribute more to growth going forward, supported by stronger U.S. activity and global demand for commodities. However, the cumulative effects of the persistent strength in the Canadian dollar and Canada’s poor relative productivity performance are restraining this recovery in net exports and contributing to a widening of Canada’s current account deficit to a 20-year high. Overall, the Bank projects the economy will expand by 2.4 per cent in 2011 and 2.8 per cent in 2012 – a slightly firmer profile than had been anticipated in October. The Bank continues to expect that the economy will return to full capacity by the end of 2012. Underlying inflationary pressures remain subdued, reflecting the considerable slack in the Canadian economy. Core inflation is projected to edge gradually up to 2 per cent by the end of 2012, as excess supply in the economy is slowly absorbed. Inflation expectations remain well-anchored. Total CPI inflation is being boosted temporarily by the effects of provincial indirect taxes, but is expected to converge to the 2 per cent target by the end of 2012. Despite improvements in the outlook for the global and Canadian economies, the risks to inflation remain elevated. There are two main upside risks, relating to higher commodity prices and the possibility of greater-than-projected momentum in the Canadian household sector. BIS central bankers’ speeches The two main downside risks relate to Canadian competitiveness and the possibility of weaker-than-projected household expenditures in Canada. In addition, challenges in Europe continue to be a significant source of uncertainty for the global outlook. A comprehensive solution to the sovereign debt and financial stability issues in a number of countries will be required. Reflecting all of these factors, the Bank yesterday maintained its target for the overnight rate at 1 per cent. This leaves considerable monetary stimulus in place, consistent with achieving the 2 per cent inflation target in an environment of significant excess supply in Canada. Any further reduction in monetary policy stimulus would need to be carefully considered. With that, Tiff and I would be pleased to take your questions. BIS central bankers’ speeches
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Remarks by Mr Tiff Macklem, Senior Deputy Governor of the Bank of Canada, at a Productivity Summit Series Luncheon, Edmonton, Alberta, 1 February 2011.
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Tiff Macklem: Canada’s competitive imperative – investing in productivity gains Remarks by Mr Tiff Macklem, Senior Deputy Governor of the Bank of Canada, at a Productivity Summit Series Luncheon, Edmonton, Alberta, 1 February 2011. * * * Introduction I am honoured to be here to launch Productivity Alberta’s luncheon series. In addition to offering opportunities like today’s to network, learn, and discuss, Productivity Alberta is providing leadership and vision – together with practical tools and resources – to support business and industry in enhancing their competitiveness. Canada’s advantages were very apparent through the financial crisis. They sheltered us from the worst of the storm and put Canada at the front of the pack coming out of the recession. Indeed, Canada’s international brand for sound economic and financial management has rarely been stronger. This is an opportunity to capitalize on, but only if our relative success does not blind us to our own vulnerabilities. As the title of my remarks suggests, today I want to talk to you about the erosion of Canada’s international competitiveness in recent years, how this is affecting the Canadian economy, and the competitive imperative for businesses in Canada to sustain a durable rebound in investment spending and translate this into productivity gains. With household balance sheets stretched and fiscal stimulus set to wind down, the Canadian economy must regain its competitive edge to sustain a lasting expansion. Of course, this is easier said than done. Business decisions to invest and innovate inevitably entail risk. And we continue to face elevated global risks. In this environment, it may be tempting to conclude that the best business strategy is to delay investing until risks recede. This appears misguided. Our competitors are not waiting. They are raising their game. So while investment is not without risk, failure to invest will almost certainly doom Canadian business to a continuing loss of competitiveness and a shrinking share of global markets. This need not be our fate. Indeed, after a very sharp decline through the recession and a delayed recovery, business investment in Canada is finally rebounding strongly. But it is still 15 per cent below its pre-recession level. There is much lost ground to make up. Moreover, while individual firms can point to many investments that have produced tangible productivity gains, at the aggregate level, the productivity dividend of the investments made over the past decade has been alarmingly low. This has to change. We need more investment that enhances productivity and improves our international competitiveness so that Canadian businesses can seize the opportunities that arise as the global economic recovery proceeds and markets expand. Canada’s productivity underperformance is an enduring and much-studied feature of our economic landscape. And truth be told, puzzles remain. Nevertheless, the concerted research effort over the past two decades points to several clear conclusions as to what makes some firms more productive than others. I will come back to these lessons. But first let me review the outlook for the global and Canadian economies, and explore the evidence, the causes and the consequences of Canada’s declining competitiveness. The global and Canadian outlooks Two weeks ago the Bank of Canada published its updated economic outlook. BIS central bankers’ speeches The good news is that the global economic recovery has gained momentum. Global markets are expanding, and prices of the commodities Canada exports have increased. Private domestic demand in the United States has picked up and will be reinforced by recently announced monetary and fiscal stimulus. Growth in Europe has also been slightly stronger than anticipated, although ongoing challenges associated with sovereign and bank balance sheets will limit the pace of the European recovery. Continued strong growth in emerging markets is supporting commodity prices, which have increased significantly since last autumn (Chart 1 and Chart 2). With some emerging-market economies overheating, authorities there have begun implementing more restrictive policies with the goal of containing rising inflationary pressures. The recovery in Canada is proceeding broadly as anticipated, with a period of more modest growth following the strong recovery experienced in late 2009 and early 2010 (Chart 3). Going forward, demand in Canada is projected to rely less on government and household spending and more on investment and net exports (Table 1). This rotation of demand is essential to sustaining a durable expansion. Through 2009–10, government spending contributed one percentage point or more to growth each year, dampening the recession and spurring recovery. But with fiscal stimulus set to unwind as governments begin the return to fiscal balance, the contribution of government spending to growth is expected to turn negative. Household spending, supported by extraordinary monetary and fiscal stimulus, has provided the most important source of growth since the start of the recovery in the third quarter of 2009, increasing at an average annual rate of 4.3 per cent. With disposable income growing by 2.3 per cent over the same period, the ratio of household debt to disposable income has risen to a record high of 148 per cent, surpassing the comparable ratio for U.S. citizens (Chart 4). With household balance sheets becoming increasingly stretched and consumption unlikely to be bolstered by further gains in house prices, household spending is expected to moderate in line with income growth. But even with this moderation, the savings rate is projected to remain near historic lows, household debt near historic highs, and the share of the economy accounted for by household spending well above its historical average (Chart 5 and Chart 6). Prudent consumers should do no more and could well decide to do less. This leaves business investment and net exports to pick up the slack. The prospects for investment are very favourable, reflecting both propitious conditions and business imperatives. The financial positions of Canadian firms are strong. Borrowing costs for Canadian businesses are exceptionally low, access to financing has continued to improve, and the Canadian dollar has appreciated making imported machinery and equipment less expensive in Canadian dollars. Moreover, given the historically large drop in investment through the recession – almost 25 per cent – and the delayed recovery, firms have much depreciated capital to replace. This is reinforced by the imperative to improve productivity amid heightened pressures to become more competitive. Surveys of business intentions, such as the Bank of Canada’s Business Outlook Survey and the Conference Board’s survey, confirm that firms plan to invest heavily in the year ahead for a variety of purposes, but increasingly to seize new opportunities and improve productivity (Chart 7). Reflecting all these factors, the Bank is expecting a historically strong and sustained rebound in investment, with investment growing at more than 9 per cent this year and next (Chart 8). What about net exports? With the United States – our major trading partner – experiencing its worst recession since the Great Depression, our exports were particularly hard hit, falling more than 16 per cent (Chart 9). And with a moderate US recovery through 2010, an appreciating Canadian dollar, and relatively strong domestic demand supporting imports, BIS central bankers’ speeches Canada’s trade balance turned sharply negative, subtracting 2.3 percentage points from growth in 2010. Looking forward, the Bank expects an improvement in net exports over the next two years as external demand continues to recover and domestic demand moderates from its previous rapid pace. Nevertheless, competitiveness challenges are likely to mean that Canada will benefit less from improved global demand than in past recoveries. Consistent with the strong rebound in investment, this projection assumes a recovery in trend labour productivity growth from 0.6 per cent in 2010 to 1.1 per cent in 2012. At best this will stop the slide in our relative productivity performance. Making up lost ground will require superior performance by Canadian business. A key risk to the outlook is that even this modest assumed improvement in productivity could fail to materialize. Particularly if combined with persistent strength in the Canadian dollar, this would jeopardize the recovery in net exports. Moreover, renewed tensions in foreign exchange markets could put additional upward pressure on freely floating currencies. Canada’s deteriorating competitiveness Canada’s current account balance has declined substantially in recent years, reaching a deficit of 4.3 per cent in the third quarter of last year – the largest deficit in 20 years (Chart 10). This sharp deterioration reflects a large decline in Canada’s merchandise trade balance, owing to both strong imports and weak exports. Part of this shift is likely cyclical, reflecting the fact that domestic demand has been much stronger in Canada than in the United States in recent years. This suggests that we should see some cyclical recovery in the trade balance as growth in household spending in Canada moderates while it picks up south of the border. But another more structural and more worrisome explanation also appears to be at play – increased import penetration into Canada and a loss of market share among Canadian exporters abroad. Canadian exporters’ have lost considerable market share in their largest market. From 2000 to 2010, China increased its share of U.S. imports from 8 per cent to 19 per cent, surpassing Canada as the largest exporter to the United States (Chart 11). Over the same period, Canada’s share of U.S. imports fell from 20 per cent to 14 per cent, with about two-thirds of this decline occurring since 2005. Moreover, while the large rise in China’s share is also affecting other countries, a number of countries, notably Mexico, have fared relatively better than Canada. Over the same period, Canada’s competitiveness has declined, with a sharp rise in the labour cost of producing a unit of output in Canada compared with other countries, adjusted for exchange rate movements. The Organisation for Economic Co-operation and Development (OECD) calculates that the Canadian real exchange rate in terms of unit labour costs has appreciated about 17 per cent since the beginning of 2005. The bilateral Canada-U.S. measure shows a 31 per cent increase in relative Canadian unit labour costs over the period. Relative unit labour costs can be broken down into three components: the nominal exchange rate, relative hourly compensation and relative productivity (Chart 12). Since the beginning of 2005, the appreciation of the Canadian dollar explains about two-thirds of the increase in unit labour costs in Canada vis-à-vis the United States. Wage growth in the two countries has been broadly similar over the period, leaving productivity underperformance to account for the remaining deterioration in this measure of competitiveness: labour productivity in Canada has grown at an average annual rate of just 0.5 per cent since the first quarter of 2005, compared with 2.1 per cent in the United States. After a long period of productivity underperformance starting in the 1970s, productivity growth in Canada accelerated in the second half of the 1990s, keeping pace with a roughly coincident pickup in U.S. productivity growth (Chart 13). But since 2001, productivity growth BIS central bankers’ speeches in Canada has slowed to historically low rates. It has languished well below U.S. rates, and has been at the low end compared with our competitors in the U.S. market. This is showing up in our international rankings across a range of competiveness measures. For example, the World Economic Forum, while rating Canada’s banking system the soundest in the world three years in a row, dropped Canada’s ranking in world competitiveness from 7th in 2000 to 10th in 2010. Enough measurement. What do we need to do to restore Canada’s sagging competitiveness? Restoring competitiveness The public sector plays an important role in creating conditions to support productivity growth, and it is important to recognize that successive governments in Canada have done many of the right things. Canadian businesses benefit from a sound policy environment with low and stable inflation, sustainable fiscal policy, and well-regulated financial institutions. A series of important trade agreements have improved access to key markets, and tariff reductions have lowered the cost of intermediate inputs. In addition, a number of measures have substantially improved Canada’s tax competitiveness for new investment, making it among the most attractive in the industrialized world. But while the public sector can sow the seeds of productivity gains, it is up to the private sector to reap the harvest. And it is time for business to step up and deliver. That means getting on with the job of investing, innovating, developing new markets, and finding new, more efficient ways of organizing and executing production. Needless to say, there are many different business strategies to achieve success. But the results of research over the past two decades are increasingly suggesting a number of specific directions for businesses in search of improved productivity. In particular, while productivity puzzles remain, what has come into clearer focus is that the more productive firms tend to: invest more in machinery and equipment (M&E), particularly in information and communications technology (ICT), invest more in research and development (R&D) and innovation, employ more workers with higher educational attainment, and compete in foreign markets. Looking at how Canadian businesses stack up along these dimensions, there is room for improvement. Canadian businesses on average invest less in M&E and ICT than their U.S. counterparts. Between 1987 and 2009 Canadian investment per worker in M&E and ICT averaged 77 per cent and 59 per cent, respectively, of that invested in the United States. By 2009, on average, Canadian workers had only about half as much M&E and ICT capital stock to work with as their U.S. counterparts. Canada has a well-educated workforce that compares favourably when it comes to primary and post-secondary education, but Canadian firms lag in the employment of PhDs and other post-graduates, especially in the sciences, engineering, and business. There are both demand and supply elements to improving along this dimension, but business has an important role to play by placing greater value on advanced education. In business sector spending on R&D, Canada ranks a disappointing 17th among OECD countries, and when it comes to innovation, the World Economic Forum rates us 19th, far behind the United States, Germany and Japan. Admittedly this may exaggerate the R&D gap as Canadian firms also import a significant share of R&D from foreign countries and by some other measures the gap looks smaller: for example, the World Economic Forum ranked BIS central bankers’ speeches Canada 7th for university-industry collaboration in R&D. Our biggest trading partner ranked first. On openness and competition, we are a trading nation and have been very fortunate to be right beside the biggest market in the world. But as growth shifts to emerging markets, finding new markets in Asia and Latin America will be critical. Emerging-market economies now represent one-half of all import growth and about two-thirds of global economic growth. Let me conclude. Conclusion Canada’s poor productivity performance is not a new story. And there are certain facts we cannot avoid. Our workforce is aging and our labour force growth is declining. We have to compete against more countries in a globalized marketplace, and we are facing greater direct competition as emerging-market economies move up the value chain. These forces put a premium on raising our productivity growth. But our productivity performance has been particularly weak in recent years. And this now risks holding back the recovery if competitiveness challenges restrain net export growth. As stretched households in Canada pull back and government stimulus unwinds, business investment and net exports must play bigger roles in driving growth. If we needed another more immediate reason to invest in productivity gains and improve our competitiveness, this is it. At the Bank of Canada we don’t forecast the value of the Canadian dollar, but counting on a much weaker dollar to regain business competitiveness looks like a risky business model. A cheap currency is not a business strategy. Business needs to get on with investing and turning these investments into lower unit labour costs and improved competitiveness. The first part – more investment – is at least under way, and the latest productivity numbers offer a glimmer that we could begin moving in the right direction on competitiveness. Businesses in Canada can let things happen, make them happen, or see what happened. Let’s make them happen. Thank you. BIS central bankers’ speeches Appendix Canada’s competitive imperative: investing in productivity gains Chart 1 Emerging-market economies drive global growth Chart 2 Global commodity prices have risen BIS central bankers’ speeches Chart 3 Real GDP growth in Canada Chart 4 Canada’s household debt-to-income ratio on the rise BIS central bankers’ speeches Table 1 Contributions to average annual real GDP growth (percentage points) Chart 5 Personal savings rate in Canada projected to remain near historic lows BIS central bankers’ speeches Chart 6 The contribution of household expenditures to GDP is expected to fall but remain well above its historical average Chart 7 Firms intend to invest BIS central bankers’ speeches Chart 8 Business fixed investment is expected to rebound strongly Chart 9 Canadian exports fell sharply in the recession BIS central bankers’ speeches Chart 10 Canada’s current account balance has declined sharply Chart 11 Canada is losing share of the U.S. import market BIS central bankers’ speeches Chart 12 A strong Canadian dollar and poor productivity explain Canada’s weak competitiveness Chart 13 Labour productivity growth: Canada and the United States BIS central bankers’ speeches
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Remarks by Mr John Murray, Deputy Governor of the Bank of Canada, at the Institute of Public Administration of Canada (IPAC) - Saskatchewan/Johnson/Shoyama Graduate School of Public Policy, Regina, Saskatchewan, 10 February 2011.
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John Murray: Commodity prices - the long and the short of it Remarks by Mr John Murray, Deputy Governor of the Bank of Canada, at the Institute of Public Administration of Canada (IPAC) - Saskatchewan/Johnson/Shoyama Graduate School of Public Policy, Regina, Saskatchewan, 10 February 2011. * * * Commodity prices are once again making headlines. Some commodity prices, such as those for copper and cattle, have reached record highs; others are rising quickly and approaching previous peaks. Consumer prices world-wide are under mounting upward pressure, and escalating food costs have triggered riots in some developing countries. The price of OPEC crude oil, which had spiked at an all-time high of US$145 in the summer of 2008, only to collapse to US$34 within six months, is now hovering around US$96, leading to increased talk of a new super-cycle in crude. Not surprisingly, governments are under growing pressure both to contain the rising prices of these primary products and to dampen their volatile movements. Leaders of the G20 countries, meeting in Seoul, Korea, late last year, promised – “further work on the regulation and supervision of commodity derivatives markets,” and said that they would strengthen efforts to “mitigate excessive fossil fuel price volatility.” Nicolas Sarkozy has specifically identified commodity price volatility as a priority issue for France’s presidency of the G20 this year, while regulators in the United States have proposed new curbs on speculative trading in several commodities. The behaviour of commodity prices and the actions that might be taken in response to their suspected misbehaviour are of special interest to Canada. We are not only a major producer and exporter of many primary products, we are also a significant consumer of them, especially of energy. My speech today describes the distinguishing features of commodity price movements over different time horizons, running from the very long run to the very short run. It then explores the various factors – both fundamental and speculative – that might account for their unusual behaviour. It concludes with some comments on various policy responses that have been proposed to manage these movements and to improve the performance of commodity markets more generally. Why commodity prices are of special interest to Canadians Canada is unusual among advanced economies. It is the only G7 country that is a major commodity exporter. The production of primary products accounts for roughly 11 per cent of our gross domestic product. While this is much smaller than it was 50 years ago, it is nearly three times the relative size of commodity production in the United States and far higher than that of most other industrialized countries (see Appendix, Chart 1). In addition, commodities account for roughly one third of our exports. Within Canada, Saskatchewan is like a microcosm of the national economy, but with commodities playing an even more important role. All ten provinces and three territories have significant resource sectors, but among the provinces, Saskatchewan, Alberta and Newfoundland/Labrador stand out (Chart 2). The resource sector is a major source of income and investment, and movements in world commodity prices have an outsized effect on Canada’s terms of trade and national wealth. The relative importance of different commodities has shifted over time, with energy now representing a much larger share of total commodity production and food accounting for a much smaller, but still important, share (Chart 3). BIS central bankers’ speeches Commodity prices in the very long run I will have a great deal to say about the exceptional short-run volatility of commodity prices in a few minutes, but for now I would like to focus on the very long run. Commodity prices over long stretches of time, say 50 or 100 years, are actually quite stable. 1 Yet if you follow the news you would think new price records are being reached every few days. How can one explain this apparent inconsistency? One of the answers lies in the important distinction between what economists call real and nominal prices. Nominal prices are the ones you and I see reported every day. For example, the current price of oil, as I noted earlier, is approximately US$96. 2 However, this can give a misleading impression of how high or low commodity prices really are. Since inflation generally pushes all prices higher over time, it is important to adjust commodity prices for these changes in the purchasing power of money in order to get a better sense of their true relative cost. Chart 4 plots a broad-based index of commodity prices over the period 1970 to the present in both real and nominal terms. The commodities that comprise the index are weighted according to their relative importance in Canadian production. As you can see, the real price line is much flatter than the nominal price line and shows more stability through time. The results are essentially unchanged if we begin the analysis as far back as the mid-1800s or 1900. Charts 5 and 6 provide a similar decomposition, but for two subcomponents of the aggregate index that are of particular interest to Saskatchewan – oil prices and food. If you look closely, you will notice that both of the real-price series are relatively stable, unlike the nominal-price series, which have risen sharply over the past 40 years, reflecting the effects of generalized price inflation. The long-run price stability of most commodities, subject to subtle differences in trend, should not come as a surprise. Given sufficient time, consumers and producers adjust to changing market conditions. Persistent price increases encourage consumers to economize on the use of more expensive commodities and move to alternative goods. At the same time, producers find it profitable to tap new and often more expensive sources of supply, and to develop new technologies to assist them. Investment and innovation also allow producers to bring new products to market, facilitating the process of economization and substitution. All of this takes considerable time, however. While the supply responses might be shorter in some sectors such as agriculture, for major energy projects the gestation period can be as long as 10 or 15 years. Eventually, though, demand and supply adjust – in many cases taking prices back to where they started. This is what economists often refer to as “mean reversion.” What about the significant price increases we’ve seen since 2002? Although mean reversion is frequently observed in the very long run, commodity prices can also experience large and persistent swings over 5-, 10- and even 20-year periods. Price increases are usually followed by price declines, and vice versa, but the timing of these reversals is highly uncertain. 3 See D. Coletti, “The Long-Run Behaviour of Key Canadian Non-Energy Commodity Prices: 1900–91,” Bank of Canada Review (Winter 1992–1993: 47–56). For convenience and by convention, world commodity prices are usually quoted in U.S. dollars. This means that whenever the foreign exchange value of the U.S. dollar changes, commodity prices usually change too. Estimates from the International Monetary Fund (P. Cashin, C. J. McDermott and A. Scott, “The Myth of Comoving Commodity Prices,” IMF Working Paper, WP/99/169, 1999) suggest that the average length of a slump in oil prices is about 50 months, while oil-price booms typically last just over 20 weeks. However, there is obviously a great deal of variance around these averages. BIS central bankers’ speeches The magnitude and timing of commodity price movements are notoriously difficult to predict. Indeed, some have suggested that they are only slightly easier to explain after the fact! Debates about the “true” causes of the dramatic super-cycle that we have observed in commodity prices over the past eight years continue. While there is little doubt that remarkable shifts in global demand and supply have played a major role, the extent to which other forces, driven perhaps by large financial flows, might have served as an accelerant remains an open question. What is evident, looking at the data, is the significant role played by the emerging-market economies (EMEs). Over the past ten years, they have accounted for the majority of the growth in the global economy (Chart 7). More importantly for our purposes, EMEs have also accounted for most of the surge in global demand for raw materials (Chart 8). 4 Their accelerating resource needs are being driven by three developments. First is the phenomenal GDP growth that many EMEs have experienced. Second, current production processes in the EMEs are very resource intensive, particularly with regard to their energy requirements. Third, rising disposable incomes and a growing middle class in the EMEs have added an important consumption element to the mix, through increased demand for food and a broader range of energy-using household products. Bringing things a little closer to home, high demand for food in EMEs has contributed importantly to the demand for potash. Growing demand in both the EMEs and advanced economies, as well as occasional supply bottlenecks, can explain most, though perhaps not all, of the upward movement in commodity prices that we observed from 2000 to mid-2008. The same is true of the sharp correction that followed in late-2008, as well as the recent rebound. 5 These three episodes mirrored the phenomenal rise, sudden collapse, and equally sharp recovery in global growth over the period. The fact that the latest jump in commodity prices has occurred so soon in the business cycle, while growth in many advanced countries continues to lag, is testament to the growing importance of the EMEs and their considerable influence in commodity markets. Extreme short-run volatility Aside from the remarkable long-run stability of commodity prices, and their significant price swings over the business cycle, commodity markets are also notable for their extreme volatility in the short run. While the high-frequency movements of commodity prices are typically several times the size of those in the CPI or the GDP deflator, they occasionally become even larger (Chart 9). The recent spike in commodity price volatility is an obvious example, but it is by no means unprecedented. Similar, if not larger, spikes were witnessed during the Great Depression and the tumultuous 1970s and 1980s. 6 All of these high volatility episodes can be linked to exceptional macroeconomic circumstances or political unrest, but many analysts believe that destabilizing financial market dynamics have also been a contributing factor. As I noted earlier, there is an ongoing debate about the significance of speculation, however defined, and whether economic fundamentals alone can explain what we have observed. Those who favour a fundamentals interpretation of events point to the highly inelastic nature of commodity demand and supply in the short run – that is to say, their insensitivity to See D. Coletti, R. Lalonde, P. Masson, D. Muir and S. Snudden, “Commodities and Monetary Policy: Implications for Infation and Price-Level Targeting,” (Bank of Canada, forthcoming). See O. Gervais and I. Kolet, “The Outlook for the Global Supply of Oil: Running on Faith?” Discussion Paper No. 2009-09, Bank of Canada, 2009). See O. Calvo-Gonzalez, R. Shankar and R. Trezzi, “Are Commodity Prices More Volatile Now? A Long-Run Perspective” (World Bank Policy Working Paper No. 5460, 2010). BIS central bankers’ speeches unexpected price changes. 7 Even large price movements seldom elicit a significant drop in demand or increase in supply in the short run, owing to fixed consumer tastes, set production processes, the long lags associated with bringing new commodity supplies to market and the absence of close substitutes. Relatively modest shocks to the macro economy can therefore have an exaggerated effect on commodity prices. Low interest rates may also occasionally exacerbate upward pressure on prices since commodity users are inclined to hold larger inventories when carrying costs are low. In addition, commodity producers may be inclined to delay production and “leave the oil in the ground” until interest rates rise and the opportunity cost of postponing the sale of their commodities is higher. 8 As a result, demand increases while supply is squeezed. Alternative interpretations and the role of the speculator Few economists would dispute the importance of supply and demand and the special nature of commodity markets in explaining price movements. Some maintain, however, that there is more to the story and argue that zealous investors and the destabilizing dynamics of financial markets frequently cause commodity prices to overshoot their appropriate levels. Before demonizing speculators, however, it is important to define what we mean by “speculators” and remember that most financial market activity is welfare improving. In other words, there are both good and bad forms of speculation. For the purpose of our discussion, I am going to define a speculator as someone who has no direct commercial interest in holding physical commodities but is willing to take an open position (i.e. make an investment) in the form of a futures contract, derivative or other financial instrument in the expectation of earning a positive return for bearing this risk. Commodity producers, and those who use commodities to manufacture other products, typically want to hedge their positions. They use these same financial instruments to manage the extreme volatility of commodity prices by locking in future prices, thereby shifting the risk onto those more willing to bear it. Speculators can therefore fulfill an important function. Their actions permit the maintenance of active, liquid markets for hedging and assist the pricediscovery process, making the system more efficient and stable. After all, the guiding principle of buying low and selling high should actually help to reduce price volatility. Those who see speculators as risk creators, rather than risk absorbers, argue that the increased volatility observed in recent years was linked to a surge in outstanding futures contracts, derivatives, exchange-traded funds and other financial products held by individuals with no commercial interest in commodities. Commodity assets under management rose by more than US$100 billion in the past year alone, a roughly 40 per cent increase (Chart 10). Low interest rates and a search for yield, combined with the introduction of innovative financial products and what some have termed the “financialization” of the commodities market, have produced an unhealthy brew, they argue. Correlation, however, does not prove causation, and those on the other side of the debate cite a number of curious and seemingly contradictory aspects of the financial destabilization story. They argue that it is too early to race to judgement regarding the supposed “dark side” of the market. See D. Gately, “OPEC Incentives for Faster Output Growth,” (Energy Journal, 25, no.2 (2004): 75–96. Also N. Krichene, “World Crude Oil and Natural Gas: A Demand and Supply Model,” Energy Economics 24, no. 6 (2002): 557–76. See J. A. Frankel, and A. K. Rose, “Determinants of Agricultural and Mineral Commodity Prices,” in Inflation in an Era of Relative Price Shocks, R. Fry, C. Jones and C. Kent (eds.) (Reserve Bank of Australia, 2009). BIS central bankers’ speeches First, the ratio of outstanding commercial to non-commercial contracts has remained roughly unchanged, although both have grown significantly in the past four years. So there is no sense of undue pressure coming from the unhedged, non-commercial side of the market. Second, investment in commodities is concentrated in the futures market, and its impact on spot prices is mainly indirect (i.e. through arbitrage). 9 While futures prices might therefore be expected to rise as investor interest grows, the reverse has been observed – with spot prices staying higher than futures prices. Third, if speculators were pushing prices above their fundamental levels, one would expect to see inventory levels rising, reflecting unwanted output. This has not been the case, however. In most instances inventory levels have been falling as prices have been rising, suggesting excess real demand. 10 Finally, it is interesting to note that the prices of many commodities that are not actively traded on exchanges or included in commodity indexes have risen by as much as those that are. The introduction of new investment instruments and new means of speculating, then, do not appear to have made a significant difference in observed price pressures. This conclusion is reinforced by comparisons across time, which indicate volatility is no higher now than it was before these instruments were developed. Unfortunately, data limitations and the somewhat arbitrary classification of investors as either commercial or non-commercial preclude a more definitive assessment. Although both the fundamentalist and speculative camps can point to supporting evidence, the extent of destabilizing speculation and its impact on commodity prices remain open questions. It would be surprising, however, if investment flows did not have some influence on prices. How large an influence and whether it is stabilizing or destabilizing probably varies over time, as do the costs it imposes on the economy. What should policy-makers do? What, if anything, should policy-makers do about high and volatile commodity prices? The answer depends critically on the diagnosis. Is there a market failure that needs to be corrected? Do the fluctuations last long enough to do serious harm? If these movements are predominantly fundamental in nature, attempts to resist them would be largely futile and counterproductive. Efforts to dampen speculation through limits on the number of allowable contracts or tighter margin requirements would penalize both good and bad speculation, and potentially handicap the operation of markets. Efforts to put ceilings on commodity prices would prevent market clearing and reduce supply. Clearly, if anything of this sort is contemplated, it should be done cautiously. President Sarkozy, who will chair the G20 leaders’ summits for the coming year, has put reform of the commodity derivative market near the top of his agenda. However, he has also underscored the need for a more thoroughgoing review before any action is undertaken. Various supervisory and regulatory agencies have also called for greater oversight of commodity exchanges, and recently enacted legislation for financial sector reform in the United States has proposed that new limits be put on speculative trading in a number of commodities. This work, however, is still at a very early stage. Less-controversial measures have also been proposed, which both fundamentalists and market skeptics can support. The first is a call for greater transparency and information sharing with regard to commodity supply and demand. Lack of timely and comprehensive The impact on spot prices of investment in commodities is more direct in the case of commodity index funds that are physically backed by the underlying commodities. These investment products are, however, limited to commodities that can be stored (metals, for example). Care must be exercised in interpreting these results, however, since the relationship between spot and forward prices, and between prices and inventories, also depends importantly on how price expectations are formed. BIS central bankers’ speeches data hampers the functioning of both the physical and financial commodities markets. Recent work in the oil market, under the auspices of the Joint Oil Data Initiative (JODI), is serving as a useful template for these efforts. Improved information should help stabilize markets and work to everyone’s benefit, except perhaps those who profit from asymmetric information and possible manipulation of the present system. The second set of reforms focuses specifically on transparency in the over-thecounter (OTC) derivatives markets and is part of a much larger initiative launched by the Financial Stability Board to enhance financial market infrastructure. The third set of reforms targets the things that several governments do, either intentionally or unwittingly, to inhibit the smooth operation of commodity markets. Some of these take the form of price ceilings or subsidies to households, which elevate demand for certain commodities and often reduce supply. Others involve subsidies to producers, which may divert needed resources to different uses. A prime example is the support for biofuels, which reduces the amount of arable land available for food production. The fourth and final set of suggested reforms involves a number of initiatives that governments ought to take, as opposed to the various things that they should stop doing. The former include structural reforms to make their economies more flexible and resilient to shocks and, more generally, encouraging rather than resisting necessary adjustments to changing market conditions. Conclusion As we have seen, commodity prices are notable for three things: their remarkable stability in the long run; their sizable and persistent swings in the medium run; and their exceptional volatility in the short run. These tendencies pose an enduring challenge for consumers, producers and policy-makers. Over the long run, economists such as Prebisch and Singer 11 once worried that commodity producers would suffer ever-declining terms of trade relative to manufacturers. More recently, this view seems to have been overturned, with some economists now worrying about the costs that ever-increasing commodity prices will impose on consumers. Over the medium run, economists are concerned about the negative effects that large and persistent swings in commodity prices can have on the macroeconomy by destabilizing output and spurring inflation. In the short run, highly volatile prices, despite their temporary nature, can impose tremendous costs on some of the most vulnerable members of the global community. Before racing to solution, however, it is important to understand what forces are driving these prices. Available evidence suggests that most of the major swings, as well as a large proportion of the short-run volatility that we observe, can be explained by market fundamentals. Although speculation and what might be termed “excessive investor interest” might play a role in exaggerating these price movements, the supporting evidence is at best mixed. Policy-makers determined to take corrective action should therefore proceed with caution. Without a clear diagnosis it is difficult to talk about remedies and policy fixes with any confidence. There are, nevertheless, a number of measures that almost all economists can agree on, no matter where they lie on the fundamentals-to-destabilizing speculation continuum. They include improved transparency and structural reforms that will remove harmful barriers, make markets more efficient and economies more resilient. Thank you. See R. Prebisch, The Economic Development of Latin America and Its Principal Problems. (New York, United Nations, 1950). And H. W. Singer, “The Distribution of Gains between Investing and Borrowing Countries,” The American Economic Review 40, no. 4 (1950): 473–85. BIS central bankers’ speeches Chart 1 Natural resources as a percentage of GDP Chart 2 Natural resources as a percentage of provincial GDP BIS central bankers’ speeches Chart 3 The changing composition of Canadian commodity production Chart 4 Commodity prices: composite index BIS central bankers’ speeches Chart 5 Nominal and real oil-price index Chart 6 Nominal and real food prices BIS central bankers’ speeches Chart 7 Emerging-market economies continue to drive global economic growth Chart 8 Growth in world GDP and contribution to global growth of oil demand BIS central bankers’ speeches Chart 9 Year-over-year change in commodity prices BIS central bankers’ speeches
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Remarks by Mr Mark Carney, Governor of the Bank of Canada, at the Inter-American Development Bank, Calgary, 26 March 2011.
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Mark Carney: The paradigm shifts – global imbalances, policy, and Latin America Remarks by Mr Mark Carney, Governor of the Bank of Canada, at the Inter-American Development Bank, Calgary, 26 March 2011. * * * Introduction Globalization is the opportunity and the challenge of our age. It has the potential to lift billions out of poverty, vastly expand economic prospects, and develop a more diverse and resilient global economy. However, globalization also brings stresses, so policy-makers will need both discipline and new frameworks to realise its promise. The financial crisis has accelerated the shift in the world’s economic centre of gravity. Emerging-market economies (EMEs) now account for almost three-quarters of global growth – up from just one-third at the turn of the millennium. Although this paradigm shift to a multipolar world is fundamentally positive, it is also disruptive. Labour, capital and commodity markets are changing rapidly. The effective global labour supply quadrupled between 1980 and 2005 and may double again by 2050.1 Crossborder capital flows have exploded, growing at a rate almost seven times the peak during the last wave of globalization.2 Commodity markets are in the midst of a supercycle. Large imbalances are a natural consequence of globalization. These imbalances can be good or bad. Good imbalances are the product of capital moving to where it can be best used, production being reoriented and expanded, and the economic cycle becoming more commodity intensive. Bad imbalances arise when countries resist or misread the consequences of this shift of activity and demand from advanced to emerging economies. Indeed, the response to such pressures will influence the resiliency of the globalization process itself. In the run-up to the crisis, poor policy choices reinforced vulnerabilities. Countries frustrated exchange rate adjustment, and the recipients of large capital inflows squandered them. Price stability was achieved, but financial stability was forfeited. The result was unbalanced, unsustainable growth, culminating in economic catastrophe. It is not clear that the commitment to open markets will withstand a repeat of such mistakes. Today, I will concentrate on two current policy challenges for our region that could prove decisive: 1) maintaining price stability in the face of a major commodity shock, and 2) maximizing the return to large, volatile capital flows. In each case, there is a risk that policy-makers downplay longer-term forces when setting short-term policy. As a consequence, destabilizing global imbalances could re-emerge and undermine the globalization process itself. Adjusted for the percentage of the population in the traded-goods sector. See M. Carney, “The Implications of Globalization for the Economy and Public Policy,” speech delivered to the British Columbia Chamber of Commerce and the Business Council of British Columbia, Vancouver, British Columbia, 18 February 2008. Cross-border capital flows were roughly 20 per cent of global GDP before the crisis, compared with 3 per cent at the turn of the last century. BIS central bankers’ speeches Commodities Major commodity exporters, including Canada and much of Latin America, are experiencing a large, positive terms-of-trade shock (see Appendix, Chart 1). Real prices for energy and metals have been well above their long-term averages for more than five years, and real food prices are now at their highest levels in twenty years (Chart 2).3 The question is whether such strength will persist. From a policy perspective, it matters whether prices are being primarily driven by demand, supply or speculation. In general, supply shocks and speculative overshoots tend to be short lived and can be looked through. Demand shocks are different. While there have been supply disruptions due to geopolitical unrest and natural disasters, and while speculative pressures have reinforced, on occasion, the direction of fundamentally driven price moves, the Bank’s view is that a large, sustained increase in demand is the primary driver of this boom. The breadth and durability of the commodity rally underscores this conclusion. This surge in demand is the result of rapid growth in the emerging world, particularly in Asia (Chart 3). With convergence still a long way off, the demand for commodities can be expected to remain robust for some time. Based on the experiences of Japan in the 1960s and Korea in the 1980s, emerging Asia’s energy and metals intensities should gain momentum.4 Rapid urbanization underpins this growth. Since 1990, the number of people living in cities in China and India has risen by nearly 500 million, the equivalent of housing the entire population of Canada 15 times over (Chart 4). This process can be expected to continue for decades, since urbanization rates in China and India are currently 30 to 50 percentage points below those in Brazil, Mexico and Canada. In parallel, a massive new middle class is being formed. The world’s middle class is growing by 70 million people each year and will double to 40 per cent of the global population by the end of this decade.5 The ramifications will be considerable for a wide range of commodities, through higher protein diets, refrigeration and travel. Whether it is cars, airports or meat, consumption and development levels in major emerging markets are currently fractions of those in advanced economies (Table 1). Even though history teaches that all booms are finite, this one could go on for some time. With the demand story intact, the profile of commodity prices will turn on supply. Time will tell whether new supply will be sufficient, and whether consumption converges at current Western levels or whether price signals and serious attempts at reducing carbon intensity will ultimately force a more sustainable equilibrium. The fundamental issue is that the relationship between U.S. economic activity and commodity prices has changed, and that this is complicating the policy response for exporters and importers alike (Chart 5). In all, 18 of 23 commodities in the Bank of Canada’s commodity index are above their long-term average. Current per capita income is between $5,000–$10,000 per capita for China, Thailand, and Malaysia. Commodity demand should continue to grow rapidly before slowing once income levels reach about $15,000–$20,000 per capita. See C. Cheung and S. Morin, “The Impact of Emerging Asia on Commodity Prices,” Bank of Canada Working Paper 2007-55. Adding to the potential momentum is the fact that per capita income levels remain below $5,000 in India, Indonesia and the Philippines. McKinsey & Company, “The Great Rebalancing,” June 2010. BIS central bankers’ speeches Policy implications All IDB member countries are currently facing some similar challenges, which are best addressed with an eye to these longer-term trends. First, large and persistent changes in relative prices will encourage substantial structural adjustment in all of our economies. In past decades, commodity-price increases were often driven by strong growth in the G-3 economies. More recently, however, higher commodity prices have been generated, in large part, from strong growth in emerging markets, particularly in China (Chart 6). Consequently, commodity importers in our region have had to face the adverse implications of higher commodity prices, without the cushion of a demand boost from stronger growth in G-3 economies. Similarly, there is greater pressure on the manufacturing sectors of commodity exporters coming from the strength in their exchange rates, again in the absence of traditional demand from the G-3. Adjustment is inevitable – and it will be substantial. In general, such changes should not be frustrated, but rather facilitated by policies that enhance economic flexibility. Second, all countries need to maintain price stability in an environment where G-3 monetary policy cannot be expected to lead the global cycle. As I will discuss in a moment, a key mistake would be to let fears of capital inflows and exchange rate pressures dominate the imperative of domestic price stability. It is paramount that monetary policy everywhere acts to ensure that inflation expectations remain in line with medium-term policy objectives. Everything else being equal, higher commodity prices usually necessitate higher policy interest rates. The degree of the policy response depends on many factors, including the reasons behind the price increases, the expected persistence of the shock, and whether a country is a net exporter. Policy-makers also need to weigh the importance of commodities in the consumption basket (Chart 7), the historic experience with price pass-through, and how well anchored are inflation expectations. It bears consideration that the terms-of-trade shock could be even more disruptive. Most of us have become heavily reliant on manufactured goods and components from China (Table 2). For example, in Canada, partly as a consequence of Chinese trade, goods price inflation has run about 1 per cent for the past decade. However, with commodity prices rising sharply in China, second-round effects on manufactured goods pricing are possible, due to rising wages and input costs and, potentially, exchange rate appreciation. Finally, it has to be considered that the process of globalization, with its large-scale displacement, may actually reduce potential growth in advanced economies during the adjustment phase.6 Canada has learned through long experience that the role of the exchange rate is crucial. For commodity exporters, improvements in the terms of trade tend to put upward pressure on the exchange rate. When such movements in the nominal exchange rate are limited, wages and a range of other prices respond. This is a more disruptive form of adjustment that can have profound implications for employment, financial stability and competitiveness – the very objectives exchange rate management seeks to protect. Recent experience suggests that many emerging economies are taking the real adjustment through higher domestic inflation (Chart 8), in part because of concerns over capital inflows. To the extent that the nominal exchange rate responds, it helps offset the expansionary effect of the increase in investment, and gives price signals to the production sector for labour and capital to shift to the areas of higher return. L. Bini Smaghi, “The Challenges of Surveillance and Coordination,” speech delivered at the International Symposium of the Banque de France, Paris, 4 March 2011. BIS central bankers’ speeches Capital flows will move to hasten that adjustment, which leads to the second policy challenge. Capital flows Capital can be expected to flow, on a net basis, from advanced economies towards higher expected risk-adjusted returns in emerging-market economies. Such was the case during the last wave of globalization at the turn of the twentieth century when Canada, then an emerging economy, ran current account deficits averaging 7 per cent of GDP over three decades. The scale of the potential reallocation today is significant. Investors from advanced economies are substantially overweight their home markets: advanced economies represent half of current global GDP, but their equity market capitalization is nearly three-quarters of the global capital market.7 A reallocation of 5 per cent of advanced economy portfolios to emerging markets translates into a potential flow of $2 trillion or $400 billion to Latin America.8 This is eight times current annual flows to Latin America.9 Paradoxically, despite these secular forces, emerging markets are currently net capital exporters (Chart 9). In effect, there is a large recycling of capital: private capital flows from advanced to emerging economies are being more than offset by official outflows.10 Central banks now hold more than 40 per cent of U.S. Treasuries, which delays adjustment at home and abroad by muting price signals in both locations. Two dynamics are particularly important. First, the expansion of gross capital flows has dwarfed that of net flows. For example, since the 1990s the increase in gross flows into and out of the United States has expanded three times more rapidly than the increase in net flows.11 Emerging economies are having difficulties absorbing large private flows, while advanced economies have often misallocated the surge in yield-insensitive gross claims. In both cases, the scale of movements and the impact of any reversal have important ramifications for financial stability. Second, in the face of stimulative G-3 monetary policy and limited nominal exchange rate appreciation by China, many emerging markets are trying to forestall capital inflows and delay necessary monetary tightening. This in turn is feeding domestic demand, which drives commodity prices up further and leads to more generalized overheating. Third-best policies, including capital controls under the trendy guise of macroprudential policy, are being pursued. Arguably, Latin America is the region most affected by these pressures and, therefore, it has the greatest interest in durable solutions. Advanced economies represent half of current global GDP on a purchasing-power-parity basis. Advanced equity market capitalization should be somewhat overweight in its GDP representation, given the large exposure of global companies to emerging-market growth. These calculations assume that emerging-market investors hold only a fraction of existing market capitalization in advanced economies. The conundrum for EMEs is that the more they reform, the more they encourage these inflows. Supplemented by EME private diversification flows. J. Caruana, “Capital Flows to the Emerging Market Economies: A Perspective on Policy Challenges,” speech delivered at the SEACEN Governors’ Conference, Colombo, Sri Lanka, 24–26 February 2011. BIS central bankers’ speeches G-20 initiatives Two related G-20 initiatives can help spring this trap: the Mutual Assessment Process (MAP) and the reform of the international monetary system. The MAP process stresses countries’ shared responsibility to ensure that their policies are consistent domestically and globally. This process will establish indicative guidelines and benchmarks to identify instances of external imbalances. Then, using these guidelines, G-20 members will undertake a mutual assessment of their monetary, exchange rate, fiscal, financial and structural policies. The immediate focus is to identify short-term policy measures to address global imbalances. These will likely include: financial sector repair and reform; timely fiscal consolidation; structural reforms to enhance growth; and more market-determined exchange rates over time. Transition to a new international monetary system The G-20’s second imperative is the refounding of the international monetary system, which has degenerated into an increasingly dysfunctional hybrid of fixed and floating regimes. There are two options for redress. The first is to enforce the current rules of the game – as codified in the articles of the International Monetary Fund (IMF) and World Trade Organization (WTO). While this is possible, enforcing behaviour through trade sanction is obviously extremely divisive and runs the risk of reversing the globalization process itself. A more constructive approach – favoured by Canada – is to renew the rules of the game so that country actions are both predictable and mutually consistent. Given the scale of transition under way, in our view, it makes sense to agree to the long-term objective and then implement short-term measures consistent with a transition to it. Our long-term objective should be a well-functioning international monetary system that delivers sufficient nominal stability in exchange rates and domestic prices, with timely adjustment to shocks and structural change. All countries should accept their responsibilities for promoting an open, flexible and resilient system. This responsibility includes recognizing the spillovers between economies and financial systems and working to mitigate them. Fundamentally, it means adopting coherent macro policies and allowing real exchange rates to adjust to achieve external balance over time. Indeed, in a multipolar world of global capital and trade, all systemically important countries and common economic areas should move towards flexible market-based exchange rates. These objectives will not be realised overnight. However, informal commitments to improve the functioning of the current system could be implemented to guide current policy while maintaining momentum towards the longer-term vision. Short-term measures First, as Bob Zoellick has suggested, major advanced economies should reaffirm the G-7 norm for flexible exchange rates without intervention, unless special circumstances warrant BIS central bankers’ speeches and the action is agreed.12 The reality is that unilateral intervention seldom is effective without surrendering monetary sovereignty and control over domestic prices. By reaffirming this principle, advanced economies could set the stage for a broader accord among all systemically important economies. Last week’s concerted intervention by the G-7 provides an example of these principles in action. The circumstances were clearly exceptional: movements in the yen had become disorderly, volatility was excessive, and there were potential adverse implications for economic and financial stability. To address these problems and in response to a request of the Japanese authorities, the G-7 acted in concert in foreign exchange markets for the first time since 2000. Second, the Bank believes there could be value in agreeing to an informal code of conduct for capital flows as a precursor to renewing the more formal Articles of Agreement of the IMF.13 Certain guidelines – in the form of a notional checklist or decision tree – could prove useful to maximize the cost-benefit of capital controls, from both national and global perspectives. Capital controls may be appropriate in certain circumstances. Sudden capital inflows raise legitimate concerns about currency overvaluation, overheating and, conversely, the consequences of sudden stops. This is especially true for countries with less-developed capital markets and weak institutional infrastructures, where the capacities to absorb and benefit from large inflows are limited. However, we should all recognise that short-term expediency could take precedence, and eventually turn back the clock on an open, flexible system. This risk grows more tangible as emerging economies become more systemically important. A Code of Conduct for Capital Flows could include the following four elements to guide countries during the transition to the long-term system: 1. A clear objective to promote a sustainable and effective flow of private capital between economies in order to facilitate economic growth and prosperity through the efficient allocation of resources, specialization in production, and diversification of risk. 2. A decision framework that recognizes that capital controls should not be the first option. They are a complement to, not a substitute for, macro and macroprudential policies. Consideration should always be given to adjusting monetary, exchange rate and fiscal policy, consistent with budgetary and inflation conditions. 3. Principles to guide the design of measures: a) Temporary. Time-limiting measures recognize that capital controls create distortions, adverse market reactions and negative externalities, as well as the reality that, over time, controls are often evaded. This principle is also consistent with the positive longer-term fundamentals that are driving capital flows to emerging market economies. b) Targeted. Measures should address specific vulnerabilities, such as Korea’s restrictions on foreign exchange derivative contracts. R. Zoellick, “A Monetary Regime for a Multipolar World,” Financial Times, 17 February 2011. Specifically, Articles IV and VIII should be clarified with respect to country responsibilities for exchange rate adjustment. The Fund’s role in the surveillance of the capital account and members’ obligations in the surveillance process could also be better specified and resourced. BIS central bankers’ speeches c) 4. Transparent. An example is Chile’s pre-announced buildup of foreign exchange reserves. Measures should be consistent with the principles and should be peer reviewed. Recognition of the responsibilities of capital-exporting countries to monitor the risks run by host institutions with respect to currency mismatches, maturity transformation and leverage. The Financial Stability Board’s current initiatives for both the formal and shadow banking sectors are central in these regards. Conclusion The shift to a multipolar economy is having a profound impact on capital flows and a broad range of relative prices, including commodities. Imbalances are the result of advanced and emerging economies not recognising this new paradigm. Some countries are postponing monetary tightening in the hope that old relationships reassert. Others are resisting capital inflows by misreading the secular for the cyclical. All appear to be underestimating the scale of what is happening. Therein lies the risk of another crisis. Avoiding it requires leadership, purpose and legitimacy. The G-20 is well suited to building global economic co-operation, as the response to the crisis demonstrated. Resolving global imbalances is a much more complicated challenge. Countries will need to draw on a sense of common analysis and shared destiny to strike what Mervyn King has termed a “Grand Bargain” across a host of policies. The G-20 cannot, however, relaunch the global monetary system by itself. The G-20 can create momentum: it can take important interim steps; but ultimately, to be legitimate, a new system will require the concurrence of all IMF member countries. Thus, the perspectives of member countries of the Inter-American Development Bank (IDB) on the appropriate code of conduct for capital flows and on financial reforms are essential. The stakes are very high. The current dynamics of commodity prices and capital flows create major risks to financial stability and sustainable growth across our region. When large economies with undervalued exchange rates keep their currencies from appreciating, others feel pressured to follow. Over time, macro policy becomes contorted: exchange rates more inflexible, monetary policy more hesitant, and economic controls more prevalent. The collective impact of this behaviour risks inflation and asset bubbles in emerging economies and, over time, subpar global growth. Neither outcome is in the global interest. Neither is consistent with IDB principles. IDB countries can help lead a co-operative approach by their example and influence. The transformation of Latin America during the past decade has been nothing short of remarkable. Greater reliance on policy frameworks, enhanced economic flexibility and decisive action have fed superior macroeconomic outcomes and economic resilience. During coming challenges, others would do well to draw on the lessons so evident in this room of the virtues of openness and sound domestic policies. BIS central bankers’ speeches Appendix BIS central bankers’ speeches BIS central bankers’ speeches BIS central bankers’ speeches BIS central bankers’ speeches BIS central bankers’ speeches
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Remarks by Mr Jean Boivin, Deputy Governor of the Bank of Canada, at the Montreal Chartered Financial Analyst (CFA) Society, Montreal, 28 March 2011.
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Jean Boivin: The “Great” Recession in Canada – perception vs reality Remarks by Mr Jean Boivin, Deputy Governor of the Bank of Canada, at the Montreal Chartered Financial Analyst (CFA) Society, Montreal, 28 March 2011. * * * Introduction I am very pleased to be able to deliver this speech today to the Montréal CFA Society – my first speech in Quebec as a Deputy Governor of the Bank of Canada. As active stakeholders in the Quebec and Canadian economies, you are at the centre of the economic life of the country. Thus, I don’t have to tell you that the past few years have been challenging. Barely three years ago, the financial crisis was a source of major concern worldwide. This unprecedented event had serious and costly repercussions, which we continue to feel today. In the aftermath of the crisis, the global economy entered a recession that we can rightly characterize as “great.” Economic activity in the G-7 countries dropped by more than 5 per cent. According to the International Monetary Fund (IMF), the number of unemployed persons around the world jumped by more than 30 million, most of them from advanced economies.1 This is a striking figure, especially when we think of it as almost equal to the entire population of Canada. The Canadian economy was not spared: It still faces major difficulties, and significant risks remain on the road ahead. Yet, it is also true that the country’s economic prospects have improved since the crisis, as we see in Montréal, which has enjoyed the strongest growth among Canadian urban centres. In fact, coming out of the recession, Canada is a leader among the G-7 countries. Employment and economic activity have surpassed their prerecession levels. In light of the progress we have made, we can now ask: What was the real extent of this recession? What are the lessons to be learned, and what are the implications for the future? The purpose of my speech today is to reflect on events that are still fresh in our minds. Let us remember, however, that the answers to these questions will become clearer over time, as new data and analysis become available.2 The recession: first impressions At first glance, the answers seem simple. After all, a recession is defined as a generalized and sustained decrease of economic activity, of which the broadest measure available is GDP. It would then appear that our task is simply to measure the extent of the decrease in GDP during the most recent recession and then to compare this decrease with other, similar episodes in Canada, or elsewhere. Child’s play, you might think. This could be the first approach that our descendants – future economists, yet to be born, with no inkling of what we just lived through – would take: to study and compare economic cycles in Canada. Examining the economy from this angle, they would observe that the recession of 2007–09 did not seem to be any more serious than previous recessions in Canada and that, in fact, it was much shorter (Chart 1). The behaviour of employment would M. Dao et P. Loungani (2010), “The Human Cost of Recessions: Assessing It, Reducing It,” IMF Staff Position Note No. SPN/10/17, International Monetary Fund, 11 November. With the publication of the national accounts for the first quarter of 2011, scheduled for 30 May, Statistics Canada will begin a historical review of the past four years. BIS central bankers’ speeches seem to confirm such a diagnosis: employment losses were much less serious and, compared with other recessions of the past 30 years, jobs were regained much sooner (Chart 2) But any diagnosis based on a narrow, mechanistic reading of statistical measures of economic activity could prove to be false, or at the very least, incomplete. If our descendants were open-minded enough, they might be led to examine some of the headlines from this time: « L’Économie canadienne paralysée », La Presse, le 31 mai 2008 “A Financial Drama with No Final Act in Sight,” New York Times, 14 September 2008 « Nous sommes au milieu d’une crise grave », Le Droit, le 25 septembre 2008 “It Couldn’t Get Worse, But It Did,” New York Times, 12 October 2008 « L’économie canadienne s’atrophie encore », La Presse Affaires, le 2 mars 2009 « Nous étions au bord de la catastrophe,» Le Devoir, le 18 juillet 2009 On the basis of their preliminary diagnosis, our descendants might wonder what all the fuss was about. Let us hope, however, that curiosity spurs these future economists on to further inquiry. Behind this first impression hides a much more complex reality. Canada’s economy weathered a very violent storm, but thanks to wise precautions and appropriate navigation, it arrived safely in port, damaged perhaps, but still afloat. The global economy on the edge of the precipice But we cannot judge the severity of the storm on the basis of a safe arrival. Let’s go back to the autumn of 2008. Ministers of finance and central bank governors from around the world meet in Washington. The tension and anger in the air are palpable. After the credit bubble burst in August 2007, the financial crisis spread like wildfire. The liquidity crisis turned into a solvency crisis. In September 2008, the crisis worsened, and its effects were felt throughout the entire American financial system, triggering a series of events at breathtaking speed. In very short order, we witnessed the bankruptcy of Lehman Brothers and the nationalization of Fannie Mae and Freddie Mac.3 The contagion then spread to Europe, where key British, German and Belgian banks were either nationalized or needed major bailouts. Stock markets registered their greatest drops in more than 75 years. The spectre of the Great Depression of the 1930s hovered on the horizon, reminding us that recessions following financial crises are usually longer and more difficult than others and leave behind indelible scars.4 Implications for Canada Although Canada was not at the epicentre of the crisis, the contagion can spread through a number of transmission channels. The financial crisis was clearly leading to a massive Officially, the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation. In the decade following a financial crisis, growth of annual GDP is usually one percentage point lower, while the unemployment rate is generally five percentage points higher. See C. Reinhart and V. Reinhart (2010), “After the Fall,” National Bureau of Economic Research Working Paper No. 16334. In a recent study conducted with its international partners, the Bank estimated that the costs of a financial crisis for an economy represent about 63 per cent of GDP. See Strengthening International Capital and Liquidity Standards: A Macroeconomic Impact Assessment for Canada (Bank of Canada, 2010). BIS central bankers’ speeches slowdown of global economic activity, with a direct impact on foreign trade. Since threequarters of our exports are destined for markets in the United States, experience taught us that when the United States sneezes, Canada catches a cold (Chart 3). Further, with the increasing integration of the global economy, the fates of national economies are much more closely interrelated, even more than might be expected based on the scale of our international trade.5 A global financial crisis, therefore, can affect Canada not only through international trade, but also by weakening financial markets, shaking consumer and business confidence, and postponing capital investments, in light of the high level of uncertainty.6 Phase one: sudden slowdown For all these reasons, the financial crisis was expected to have a significant impact in Canada, and for the first phase of the cycle, this was certainly the case. During the last recession, GDP declined by 3.3 per cent over three quarters. In contrast, over the same period of time in the 1980s and the 1990s, it fell by 2.2 per cent and 1.9 per cent, respectively A prominent feature of the recent recession was the spectacular drop in exports. Exports were harder hit than in any previous recession, decreasing by 16 per cent over three quarters, while the most significant drop during the recessions of the 1980s and 1990s was only 8 per cent (Chart 4). Investments were equally hard hit by the recession. There was a 22 per cent downturn in investments over just three quarters (Chart 5). Nothing like this has ever been seen. It took two years during the 1980s recession, and three years during the 1990s recession, before a downturn of comparable magnitude was recorded. This recent decline in investment is partly due to the exceptionally high levels of uncertainty haunting the global economy. In sum, the recent recession was different from previous ones, owing to a more pronounced slowdown triggered by unusually steep drops in exports and investment. During its initial phase, the effects of the crisis in Canada – albeit to a somewhat lesser degree – were comparable to those in the United States and showed real signs of becoming a “Great Recession” (Chart 6). Phase two: rapid recovery Despite the rapid slowdown, the recovery was faster than those that followed previous recessions. Why? Neither exports nor investments can provide the answer. While GDP has recovered to prerecession levels, business investment and exports have only recovered 45 per cent and 67 per cent, respectively, of the losses incurred during the recession. Empirical studies show that the links between countries are particularly tight when countries simultaneously sustain the same shock. See, for example, J. Boivin and M. Giannoni, “Global Forces and Monetary Policy Effectiveness,” in International Dimensions of Monetary Policy, J. Gali and M. Gertler (eds.) (Chicago: University of Chicago Press, 2008). Recent research at the Bank of Canada has empirically demonstrated that the financial channel plays a key role in the transmission of shocks originating from the United States. See K. Beaton and B. Desroches, “Financial Spillovers Across Countries: The Case of Canada and the United States,” Bank of Canada Discussion Paper No. 2011–1 (2011); and K. Beaton, R. Lalonde and S. Snudden, “The Propagation of U.S. Shocks to Canada: Understanding the Role of Real-Financial Linkages,” Bank of Canada Working Paper No. 2010–40 (2010). BIS central bankers’ speeches If the recovery was speedier, despite weaker contributions from investment and exports, support for the recovery must have come from household and government spending. This was indeed the case. Household spending declined by only 2 per cent between 2009 and 2010, compared with 6 per cent during the previous two recessions. The contribution of government spending to growth was more than one percentage point in each year. The greater strength of household and government spending reflects Canada’s favourable position at the outset of the recession. Major adjustments had been made to the structure of the Canadian economy. Business and household balance sheets were relatively sound, and the banking system was robust, managed prudently, and sufficiently capitalized. Canada’s monetary policy framework had been effective and was credible. The fiscal situation was favourable, and the social safety net and regulatory framework were effective. As well, household spending was boosted by the prosperity arising from strong demand for our natural resources and by improved terms of trade. This favourable position gave Canada the flexibility it needed to respond strongly to the crisis without compromising the credibility of our public policy frameworks. Thanks to the expansionary monetary and fiscal measures adopted in concert with other G-20 countries, Canada was able to support domestic demand which contributed significantly to the economic recovery. Important lingering issues In Canada, then, we had room to manoeuvre to help us effectively absorb the aftershocks of the global economic crisis. It is essential to maintain this buffer in light of the elevated risks that still exist worldwide and the structural issues that persist in the Canadian economy, even after the recession. The standard of living that we will be able to sustain in the medium term will depend, in fact, on our ability to address these issues. Allow me to address three of these issues: household indebtedness, international competitiveness and, more importantly, our productivity. Household indebtedness Let us start with household debt. Since the beginning of the recovery, household credit has increased at twice the rate of personal disposable income. In the autumn of 2010, Canadian household debt climbed to an unprecedented level of 147 per cent of disposable income (Chart 7). The relatively healthy financial condition of Canadian households at the beginning of the “Great” Recession helped the Canadian economy to better withstand the initial shocks of the crisis. However, going forward, it is essential to maintain the necessary room to manoeuvre to keep household spending on a viable path. This leads us to believe that the rate of household spending will more closely correspond to future earnings, and certain signs to that effect have already been observed. Canada’s international competitiveness The second issue is our ability to compete internationally. The slow recovery of exports is due in part to the sluggishness of global economic activity. It is also due to the continued erosion of Canadian business competitiveness over the past ten years. This erosion can be attributed to the appreciation of the Canadian dollar and Canada’s poor productivity performance. Thus, Canadian exporters are seeing their market shares for a wide range of goods drop in the U.S. market – by far the most important market for Canada – while exporters in other countries, such as China and Mexico, are gaining ground (Chart 8). BIS central bankers’ speeches As global economic growth continues to take root, we are seeing early evidence of a recovery in net exports. But, at this point, exports are still weak when compared with previous recessions. And in a world of growing international competition, we should not assume that the forces causing the erosion of competitiveness through the previous decade will simply fade away because of a global recovery. This situation highlights the need to diversify our export markets and increase our ability to compete, not only with American producers, but also with other foreign exporters. Productivity and investment This brings us to the third issue. As I just discussed, international competitiveness is based on our ingenuity, the efficiency with which we produce, or, for short, productivity. But beyond its influence on international competitiveness, productivity is a fundamental determinant of our economic well-being. To improve productivity, we need investment. The slow recovery of investment in this cycle is particularly surprising in light of relatively favourable financial conditions: interest rates remain low, and the exchange rate facilitates imports of machinery and equipment. The elevated level of uncertainty experienced during the recession, especially from a global perspective, was a major hindrance to business investment. This uncertainty was not confined to our borders: the link between uncertainty and business investment was clearly evident in the economies of the United States, Germany and the United Kingdom.7 Yet heightened uncertainty is only part of the explanation. Although the recession in the United States was more serious and Americans faced at least the same degree of global uncertainty as we experienced in Canada, Canadian business investment in machinery and equipment lags behind that of the United States (Chart 9). In 2009, Canadian workers had access, on average, to approximately half the capital expenditures in machinery and equipment and information and communication technologies (ICT) of those available to their American counterparts. This is not a new phenomenon. In fact, between 1987 and 2009, Canadian investment in machinery and equipment and ICT per worker represented, on average, 77 per cent and 59 per cent, respectively, of similar American investments. It is true that business investment started to recover at the end of 2009. Yet much progress remains to be made: less than half of the extraordinary drop in investments of the last recession have been recovered. With the increasing globalization of markets and the demographic challenges we face, maintaining our standard of living will require improved productivity. We must continue to innovate and to invest in promising projects. Conclusion: perception vs. reality We are fond of repeating the old adage: “An ounce of prevention is worth a pound of cure.” Recent experience expands the notion and shows that good prevention measures can also make the cure more effective. Before the Great Recession, Canada was able to protect itself by ensuring that it had room to manoeuvre to absorb the shocks of the crisis. The lessons we learned from the past were reflected in the adoption of sound public policy frameworks. A See R. Bachmann, S. Elstner and E. Sims, “Uncertainty and Economic Activity: Evidence from Business Survey Data,” National Bureau of Economic Research Working Paper No. 16143 (2010); N. Bloom, “The Impact of Uncertainty Shocks,” National Bureau of Economic Research Working Paper No. 13385 (2007); and N. Bloom, J. Van Reenen and S. Bond, “Uncertainty and Investment Dynamics,” National Bureau of Economic Research Working Paper No. 12383 (2006). Many older studies on this issue are also available. See, for example, B. S. Bernanke (1983), “Irreversibility, Uncertainty, and Cyclical Investment,” The Quarterly Journal of Economics 98 (1): 85–106. BIS central bankers’ speeches solid position, combined with the relatively healthy state of Canadian households, gave us the flexibility to withstand the worst effects of the global shock. Future economists studying the 2007–09 recession in Canada may find it difficult to go beyond their first impressions and assess its true impact. Some will undoubtedly surmise that the economic activity of this time did indeed reflect, not only the extent of the shock, but also our ability to absorb it. The storm we weathered was a major one. We should not forget that it could have struck at a time when we were more vulnerable and less flexible. Things could have unfolded very differently, with disastrous results. It is some comfort to know that, collectively, we were able to limit the damage. We must proceed with the strategy that has served us so well: continue to learn from our experiences to ensure better prevention and, when necessary, a better cure. For this, we must strive to deal with the issues that confront us with strength and determination. Thank you. BIS central bankers’ speeches BIS central bankers’ speeches BIS central bankers’ speeches BIS central bankers’ speeches BIS central bankers’ speeches BIS central bankers’ speeches
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Opening statement by Mr Mark Carney, Governor of the Bank of Canada, at the press conference following the release of the Monetary Policy Report, Ottawa, 13 April 2011.
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Mark Carney: Summary of the latest Monetary Policy Report Opening statement by Mr Mark Carney, Governor of the Bank of Canada, at the press conference following the release of the Monetary Policy Report, Ottawa, 13 April 2011. * * * Good morning. Tiff and I are pleased to be here with you today to discuss the April Monetary Policy Report, which the Bank published this morning. As anticipated in January, the global economic recovery is becoming more firmly entrenched and is expected to continue at a steady pace. In the United States, growth is solidifying, although consolidation of household and, ultimately, government balance sheets will limit the pace of the expansion. European growth has strengthened, despite ongoing sovereign debt and banking challenges in the periphery. The disasters that struck Japan in March will severely affect its economic activity in the first half of this year. The resulting disruptions to global supply chains are projected to reduce the growth in the Canadian economy in this quarter by about half of a percentage point, with that lost activity likely to be recovered in subsequent quarters. Robust demand from emerging-market economies is driving the underlying strength in commodity prices, which is being further reinforced by supply shocks arising from recent geopolitical events. These price increases, combined with persistent excess demand conditions in major EMEs, are contributing to broader global inflationary pressures. Despite the significant challenges that weigh on the global outlook, financial conditions remain very stimulative and investors have become noticeably less risk averse. In Canada, recent economic activity has been stronger than anticipated, although the profile is largely consistent with the underlying dynamics outlined in January. Aggregate demand is rebalancing toward business investment and net exports, and away from government and household expenditures. As in January, the Bank expects business investment to continue to rise rapidly and the growth of consumer spending to evolve broadly in line with that of personal disposable income, although higher terms of trade and wealth are likely to support a slightly stronger profile for household expenditures than previously projected. In contrast, the improvement in net exports is expected to be further restrained by ongoing competitiveness challenges, including headwinds from the persistent strength in the Canadian dollar. Overall, the Bank projects that the economy will expand by 2.9 per cent in 2011 and 2.6 per cent in 2012. Growth in 2013 is expected to equal that of potential output, at 2.1 per cent. The Bank expects that the economy will return to capacity in the middle of 2012, two quarters earlier than had been projected in January. While underlying inflation is subdued, a number of temporary factors will boost total CPI inflation to around 3 per cent in the second quarter of 2011 before total CPI inflation converges to the 2 per cent target by the middle of 2012. This short-term volatility reflects the impact of recent sharp increases in energy prices and the ongoing boost from changes in provincial indirect taxes. Core inflation has fallen further in recent months, in part due to temporary factors. It is expected to rise gradually to 2 per cent by the middle of 2012 as excess supply in BIS central bankers’ speeches the economy is slowly absorbed, labour compensation growth stays modest, productivity recovers, and inflation expectations remain well-anchored. The persistent strength of the Canadian dollar could create even greater headwinds for the Canadian economy, putting additional downward pressure on inflation through weaker-than-expected net exports and larger declines in import prices. An additional downside risk to inflation in Canada relates to household spending, which could be weaker than projected, given high household debt levels. On the upside, commodity prices and global inflation could rise faster than anticipated and there could be stronger-than-expected momentum in household expenditures. Overall, the Bank judges the risks to the Canadian inflation outlook are roughly balanced over the projection horizon. Reflecting all of these factors, the Bank decided yesterday to maintain the target for the overnight rate at 1 per cent. This leaves considerable monetary stimulus in place, consistent with achieving the 2 per cent inflation target in an environment of material excess supply in Canada. Any further reduction in monetary policy stimulus would need to be carefully considered. With that, Tiff and I would be pleased to take your questions. BIS central bankers’ speeches
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Remarks by Mr Mark Carney, Governor of the Bank of Canada, presented to the Canadian Club of Ottawa, Ottawa, Ontario, 16 May 2011.
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Mark Carney: Canada in a multi-polar world Remarks by Mr Mark Carney, Governor of the Bank of Canada, presented to the Canadian Club of Ottawa, Ottawa, Ontario, 16 May 2011. * * * Introduction It is a pleasure to speak to this venerable institution. When the Canadian Club was founded in 1903, the world economy was being transformed. A great wave of globalization was under way with commerce expanding and distance shrinking. International trade and capital flows were growing at historically rapid paces and, just a year earlier, Marconi had started a communications revolution from the peak of Signal Hill. It was a time of tremendous opportunity for a young country with immense potential. Canada took advantage, posting the fastest growth in the world in the 20 years preceding the First World War. Our economy evolved rapidly as trends that would extend far into the century began to crystallize. New industries, notably the wheat boom on the Prairies and steel in central Canada, emerged, supported by mass immigration and new technologies. Our principal markets began to shift from the historic Empire preferences towards the rapidly rising United States. By 1990, after almost a century of continental integration, the share of our exports to the United States would double. In the early decades of the 20th century, the new economic order supported, and occasionally buffeted, the Canadian economy. The United States went through the boombust-boom cycles typical of an emerging hegemon. The international monetary system strained to the breaking point under the weight of disruptive change in the economic order. A reflexively isolationist America was slow to replace the ebbing Pax Britannia, until depression and war gave birth to an uneasy multilateralism.1 In the process, Canada learned some important lessons: Openness is better than protectionism. Trade brings innovation, growth and jobs. However, it also brings shocks, which demand resilient institutions and dynamic policy responses. Economic flexibility is essential. Markets change; industries rise and fall; exciting new products emerge and then become commoditized. In a rapidly shifting world, only sustained education, ingenuity and investment can maintain competitiveness. Sound macroeconomic policy is the cornerstone of prosperity. Fiscal profligacy erodes economic sovereignty; inflation hurts the most vulnerable while undermining confidence and investment; price stability is paramount. These lessons will remain valid in the years ahead. The new paradigm shift We meet today in the midst of another great transformation – one that is occurring more rapidly than most recognise. C. Kindleberger, The World in Depression 1929?1939 (Berkeley: University of California Press, 1973). BIS central bankers’ speeches The financial crisis has accelerated the shift in the world’s economic centre of gravity. Emerging-market economies now account for almost three-quarters of global growth – up from just one-third at the turn of the millennium. Robust emerging market economies Recent strength in emerging economies reflects the combination of spectacular secular trends reinforced by powerful cyclical forces. Emerging Asia is rapidly urbanizing. Since 1990, the number of people living in cities in China and India has risen by nearly half a billion, the equivalent of housing the entire population of Canada every 18 months. This process can be expected to continue for decades. In parallel, a massive new middle class is being formed, growing by 70 million people each year and set to double to 40 per cent of the global population by the end of this decade.2 Accommodative monetary policies, capital inflows and credit booms are currently reinforcing these secular forces and driving strong – in some cases, unsustainably strong – domestic demand in major emerging markets. While many emerging economies have begun raising interest rates and applying other restrictive measures, monetary policies remain quite stimulative. Real interest rates are negative in many cases, despite excess demand (Chart 1). In some large emerging-market economies, nominal exchange rate adjustment is being thwarted and real effective exchange rate appreciation is being driven by inflation – in Asia, exclusively so (Chart 2). These policies risk asset bubbles in emerging economies, more acute inflationary pressures globally and subpar global growth. Listless advanced economies The contrast between the emerging world and the advanced economies could not be starker. The major advanced economies, particularly the United States, were Canada’s future once. However, in the years ahead, they will be weighed down by the legacy of the crisis. Repairing the balance sheets of banks, households and countries will take some time (Charts 3 and 4). None of this is surprising. History suggests that recessions involving financial crises tend to be deeper and have recoveries that take twice as long. In the decade following severe financial crises, growth rates are about one percentage point lower and unemployment rates five percentage points higher.3 The current U.S. recovery is proving no exception. In Europe, the recovery is being restrained by major competitiveness and fiscal challenges in peripheral economies, as well as the risks of contagion from under-capitalised banks. We support the current efforts of our European partners to resolve these issues through aggressive bank stress tests and, in conjunction with the International Monetary Fund (IMF), credible programs to support durable recoveries in the affected economies. In Japan, the cost of the physical damage of the earthquake, tsunami and subsequent nuclear crisis could reach as high as 6 per cent of GDP. The resulting supply chain disruptions will hit growth in Japan and other advanced economies, including Canada, this McKinsey & Company, “The Great Rebalancing,” McKinsey Quarterly, June 2010. See C. M. Reinhart and V. R. Reinhart, “After the Fall,” Macroeconomic Challenges: The Decade Ahead, Federal Reserve Bank of Kansas City 2010 Economic Policy Symposium. Available at: http://www.kansascityfed.org/publicat/sympos/2010/reinhart-paper.pdf BIS central bankers’ speeches quarter. Over the longer term, Japanese growth will be weighed down by significant fiscal and demographic pressures. The balance of these two major forces – weakness in advanced economies and strength in emerging economies – determines the global economic outlook. Last fall, the consensus was that a faltering recovery in advanced economies was a greater risk than overheating in emerging markets. Today, it is the opposite. Such reversals can be expected to continue. Although this shift to a multi-polar world is fundamentally positive, it is also disruptive. Labour, capital and commodity markets are changing rapidly. The effective global labour supply quadrupled between 1980 and 2005 and may double again by 2050.4 Cross-border capital flows have exploded, growing at almost seven times their rate when this club was founded. Commodity markets are in the midst of a super cycle. Once again, it is a time of great opportunity for Canada, but navigating the cross-currents in the global economy will require boldness and skill. Allow me to expand on three consequences for Canada. Changing patterns of trade Patterns of trade are evolving rapidly. In particular, the expanding urban middle class in emerging economies is having a major impact on a wide range of commodities. Whether it is travel, housing or protein, consumption levels in major emerging markets are currently fractions of those in advanced economies.5 With convergence still a long way off, the demand for commodities can be expected to remain robust for some time. Based on the experiences of Japan in the 1960s and Korea in the 1980s, emerging Asia’s energy and metals intensities should gain momentum in coming years. Even though experience suggests that all booms are finite, this one could go on for some time. The Bank’s view is that a large, sustained increase in demand (most notably in China) is the primary driver of this boom. With more than three-quarters of commodities above their longterm averages, the breadth and durability of the rally underscores this conclusion (Chart 5). This is not to say commodity prices will not continue to fluctuate, sometimes abruptly. Recent declines could reflect a re-rating of global growth prospects combined with some adjustments to positions of financial market participants. But these are fluctuations around high levels. The reorientation of production to Asia and the dramatic increases in its infrastructure spending have also fuelled an export boom of capital goods, which is supporting the recoveries in major economies.6 This is one reason why U.S. production has led domestic demand. These exports of capital goods have fed the hiring and, by extension, the consumption growth that has occurred.7 Going forward, Canada’s exposure to emerging markets will be increasingly important. At this stage, it is largely derivative (gaining more from the price impact of commodities than Adjusted for the percentage of the population in the traded-goods sector. See M. Carney, “The Implications of Globalization for the Economy and Public Policy,” speech delivered to the British Columbia Chamber of Commerce and the Business Council of British Columbia, Vancouver, British Columbia, 18 February 2008. See M. Carney, “The Paradigm Shifts: Global Imbalances, Policy, and Latin America,” speech delivered to the Inter-American Development Bank, Calgary, Alberta, 26 March 2011. During the financial crisis, U.S. machinery & equipment exports fell sharply relative to other export categories. The subsequent strength in growth of this category has largely been a recovery towards pre-crisis levels. It now sits at 54 per cent of total exports, slightly above its pre-recession share. Labour input growth in the goods sector is 28 per cent. BIS central bankers’ speeches from broader export sales). Higher commodity prices raise profits in the primary sector, which in turn stimulates production and investment in that sector, as well as greater spending more broadly on domestically produced goods and services. However, since only 10 per cent of Canada’s exports go to emerging economies and our non-commodity export market share in the BRICS has been almost halved over the past decade, activity in Canada does not benefit to the same extent as in past commodity booms driven by U.S. growth.8 The current situation is more akin to a supply shock for our dominant trading partner, with higher commodity prices acting as a net brake on growth. With oil prices up 50 per cent since last summer, the effect is material.9 Increasing market share in emerging markets will require sustained efforts to develop trade, technical and academic partnerships. In tandem, Canadian business needs to improve its competitiveness, source new suppliers, and prepare to manage in a more volatile environment. Changing capital flows The second consequence of the shifting global landscape is dramatic changes in the scale, composition and direction of capital flows. These dynamics will have important implications for returns for Canadian investors, the cost of capital for our businesses, and the risks to our economy. Given the expected growth differentials between emerging and advanced economies and the substantially underweight positions of most Canadian investors, the opportunities appear substantial. However, it will be a crowded field in the short term. Investors from advanced economies are substantially overweight in their home markets: advanced economies represent half of current global GDP, but their equity market capitalization is nearly three-quarters of the global capital market. A reallocation of 5 per cent of advanced-economy portfolios to emerging markets translates into a potential flow of $2 trillion, or 10 times portfolio equity flows to all emerging markets. Unlike Canada, which imported on average 8 per cent of GDP per year in the three decades before World War I, emerging markets are currently net capital exporters (Chart 6). In effect, there is a massive recycling operation under way: private capital flows from advanced to emerging economies are being more than offset by official outflows in the opposite direction. While emerging economies are having difficulties absorbing large private flows, advanced economies have often misallocated surges in yield-insensitive gross claims. In Canada, as elsewhere, large capital inflows will require vigilance from public authorities and private financial institutions. Financial history, particularly during times of large power shifts, is rife with examples of booms stoked by dumb money that turn good situations to bad. Moreover, the current dynamics could have important effects on the exchange rates of countries like Canada. With some countries managing their exchange rates and restricting capital inflows, pressure for U.S.-dollar depreciation is re-directed to freely floating currencies. As well, the stock-flow problem of investors looking to rebalance portfolios towards emerging markets could lead them to invest in proxies such as Australia and Canada. Finally, the desire of major reserve holders to diversify their portfolios provides additional support. With financial market participants trying to ride these trends, volatility could become excessive. BRICS refers to Brazil, Russia, India, China and South Africa. All else being equal, the IMF estimates that a 10 per cent increase in oil prices, reduces U.S. growth by about 0.2 to 0.4 per cent. BIS central bankers’ speeches The imperative of macro stability In this environment, domestic macro stability is paramount. Sustained fiscal adjustment is now required in most advanced economies. Debt-to-GDP in G-7 countries is now the highest since the Second World War. The Age of Austerity is not a slogan but a timetable. The task is enormous (Chart 7). Stabilizing debt will require increases in the primary balances of between 8 and 11 per cent of GDP for the United States, the United Kingdom and Spain. Moreover, these forecasts assume that nominal interest rates will be roughly the same level as nominal growth rates. However, if markets begin to lose patience, higher rates will ensue and the required adjustment will be even larger.10 Canada is one of the few advanced economies on a path to avoid this outcome. However, despite this crucial advantage, we cannot fully insulate ourselves from the spillovers from others. Fiscal slippage by some major countries may increase interest rates for all. Moreover, experience suggests that when debt exceeds 90 per cent of GDP (as it will for most of our trading partners), growth slows, with predictable consequences for our exports.11 In the extreme, if fiscal consolidation abroad is delayed too long, investors may even call into question the existence of a risk-free asset. This would have far-reaching consequences, including less-diversified portfolios, higher risk premia across asset classes and greater asset market volatility.12 The resulting higher borrowing costs for individuals and firms would have broad-based implications for capital allocation and economic growth.13 In the end, given these risks, all countries should follow the Toronto G-20 accord to halve their deficits by 2013 and stabilize their respective debt-to-GDP ratios by 2016. Implications for monetary policy in Canada In this volatile world, the best contribution that monetary policy can make is to keep inflation low, stable and predictable. The outlook for inflation in Canada is importantly influenced by current manifestations of some of the longer-term trends I have mentioned. Following the depths of the crisis, Canadian domestic demand grew very strongly, supported by highly stimulative fiscal and monetary policy. Now, aggregate demand is rebalancing towards business investment and net exports and away from government and household spending. However, the relative weakness in the U.S. economy, our under-representation in emerging markets, and our competitiveness challenges will likely weigh on export performance for some time. While underlying inflation is relatively subdued, the Bank expects that sharp increases in energy prices (when combined with ongoing changes in provincial indirect taxes) will keep total CPI inflation above 3 per cent in the short term, as was the case in March, before it returns to the 2 per cent target by the middle of 2012. Core inflation is expected to rise to 2 per cent over the same period, as excess supply in the economy is slowly absorbed, labour compensation growth remains modest, productivity recovers and inflation expectations remain well anchored. A 2 per cent increase in interest rates could require another 4 per cent of GDP fiscal adjustment for some countries. C. M. Reinhart and K. Rogoff, “Growth in a Time of Debt,” American Economic Review 100, No. 2 (May 2010): 573–578. A. Damodaran, “Into the Abyss: What if nothing is risk free?” (2010). Available at: <http://pages.stern.nyu.edu/~adamodar/>. F. Black, “Capital market equilibrium with restricted borrowing,” Journal of Business 45, no. 3 (1972): 444–455. BIS central bankers’ speeches Data received since the April decision have generally supported the Bank’s near-term outlook. Recent inflation and employment have been modestly stronger; auto sales and retail purchases have been a touch weaker. Indicators have been consistent with continued, strong business investment. The possibility of greater momentum in household borrowing and spending in Canada represents an upside risk to inflation in Canada. The persistent strength of the Canadian dollar could create even greater headwinds for our economy, putting additional downward pressure on inflation in Canada. The Bank’s 1 per cent target for the overnight rate leaves considerable monetary stimulus in place, consistent with achieving the 2 percent inflation target in an environment of material excess supply in Canada. Any further reduction in monetary stimulus would need to be carefully considered. Conclusion The lessons of the past century would serve us well in this one. As Barry Eichengreen observed, “Global shifts have almost always fanned economic conflict, created problems for economic management, and heightened diplomatic tensions.”14 Challenges for economic management can be addressed by economic flexibility and sound macro policy. Canada’s fiscal strength and monetary policy credibility represent crucial advantages that must be preserved. Our commitment to openness should drive us not only to create new markets but also to help secure the new economic order. That is why we are investing so heavily in current G-20 efforts to develop a framework for open capital flows and reforms for more resilient financial systems. That is why we are working to help guide the multilateral cooperation and policy coordination required to support the global recovery. That is why we are trying to convince others to follow the lessons we learned in the last century, so that we can all realise the great promise of this one. This is how we can best fulfill Laurier’s vision, expressed in his inaugural address to this Club, when he called for a century “filled” by Canada.15 B. Eichengreen, “Global Shifts,” Paper presented at the Bank of Finland 200th Anniversary Conference, Monetary Policy Under Resource Mobility, held in Helsinki, Finland, 5?6 May 2011 Laurier said, “Canada has been modest in its history, although its history, in my estimation, is only commencing. It is commencing in this century. The 19th century was the century of the United States. I think we can claim that it is Canada that shall fill the 20th century.” Canadian Club of Ottawa, Ottawa, Ontario, 18 January 1904. BIS central bankers’ speeches BIS central bankers’ speeches BIS central bankers’ speeches BIS central bankers’ speeches BIS central bankers’ speeches
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Remarks by Mr Timothy Lane, Deputy Governor of the Bank of Canada, at the Canadian Pension & Benefits Institute, Vancouver, British Columbia, 19 May 2011.
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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, that view was reinforced by the bursting of the dot-com bubble in 2001, which may have shaken the financial markets and given a number of you some sleepless nights but was seen as a test of the resilience of the global financial system. The Great Moderation was believed to be, at least in part, the product of sound economic policies and a sophisticated financial system that could transform and reallocate risks efficiently. Emerging-market economies had quite a different experience during that period. Mexico, Korea, Indonesia, Thailand, Russia, Brazil and Argentina all suffered devastating crises that arose from a combination of financial system weaknesses, unsustainable public debt and external imbalances. Then, during the last decade, the emerging-market economies, too, became progressively more stable. In most cases, they persevered in setting their public finances in order, in BIS central bankers’ speeches cleaning up their financial systems and in undertaking bold reforms to unfetter their dynamic economies. They made use of a benign global environment to reduce their external debts and build up international reserves. There were still concerns about vulnerabilities – notably the global current account imbalances – but the risks were widely underestimated. The 2008 crisis When the global crisis did occur, it started in an unexpected place: not on the periphery, but at the very core of the global economy, in the world’s most sophisticated financial system. As stresses began to appear in the U.S. subprime-mortgage market, many knowledgeable people thought that those stresses would be easily contained, since the problem loans were relatively small and securitized so that the risk could be borne by well-informed, diversified and adequately financed investors. In the autumn of 2008, however, as we all know, this turned into a global cataclysm, which spread through the world economy and financial system. Liquidity dried up as institutions became afraid to lend to one another. Their balance sheets deteriorated as they held fire sales of assets, and investors worldwide fled from risky assets. With the resulting credit crunches and massive loss of wealth, the financial stresses triggered the “Great Recession” – the most severe since the Second World War. In this recession, no country escaped unscathed. However, the emerging-market economies were slower to be drawn into recession and quicker to recover than the advanced economies. The global economy is now in a two-speed recovery. Emerging-market countries have resumed robust growth. But in many of the advanced economies, notably the United States and Europe, economic growth has been sluggish, as households, firms and financial institutions continue to repair the damage to their balance sheets. As I will discuss later, this two-speed recovery creates a new configuration of risk in the global financial system. Here in Canada, the financial system proved more robust than in other advanced economies, although problems with asset-backed commercial paper could have had very serious ramifications had it not been for timely official intervention. The Bank of Canada had to inject substantial amounts of liquidity into the system to keep core funding markets functioning. Nonetheless, Canada suffered a severe recession, mainly because of the collapse in our exports. The recovery is now well under way, both in Canada and globally. Indeed, in Canada, we are already in an expansion, as we have surpassed pre-crisis levels of economic activity and employment. But we must still ask how the crisis happened, and what must be done to avoid a recurrence. What happened in the crisis? Perhaps the biggest surprise of the crisis was the fact that defaults of subprime mortgages in the United States – a small segment of that country’s housing market – could cause the global financial system to unravel. As events unfolded in the autumn of 2008, we were reminded that the global financial system is bound together by an extensive web of interconnections. These interconnections among financial institutions and markets can spread trouble to unexpected places and cause small shocks to have outsized effects. The financial crisis highlighted three main weaknesses in the way that the system handled risk. First, many financial institutions were excessively leveraged, had inadequate cushions of capital to absorb losses and insufficient liquidity to function in stressed market conditions. BIS central bankers’ speeches Second, the complex and opaque web of securitized lending and derivatives markets, which were believed to help the economy better manage and distribute risk, instead turned out to transmit and amplify that risk. Third, financial institutions that were “too big to fail” had diminished incentives to manage risk and, ultimately, shifted those risks to taxpayers. These vulnerabilities were permitted to build up – or were even fostered – by the perception of diminishing risks in the Great Moderation. Financing patterns that appeared wellconstructed in the context of ever-diminishing risk turned out to be imprudent once the system came under stress. Regulation fell well behind financial innovation. The global response The global financial reforms launched by G-20 leaders are designed to address the three weaknesses I have just discussed. First, to reduce the incidence and severity of financial crises, financial institutions will be required to have more ample cushions of capital and liquidity. Second, steps will be taken to reduce the risk that financial markets become channels of contagion. And third, mechanisms to deal with the too-big-to-fail problem will be made more robust. I will briefly discuss each of these elements. The centrepiece of the agenda for global financial reform is the new Basel III rules on capital and liquidity. These rules substantially increase the loss-bearing capital that financial institutions must hold, combined with required liquidity ratios and a limit on leverage. In addition, a countercyclical buffer will be established so that capital is built up in good times, which can subsequently be available to absorb losses.1 On financial markets, a key step is to strengthen market infrastructure to reduce systemic risk. The G-20 leaders agreed to require clearing and settlement of over-the-counter derivatives through central counterparties, and to increase transparency in those markets – which proved to be a channel of financial contagion during the crisis. A central counterparty is also being established in Canada for clearing repurchase agreements (repos), a key form of short-term financing. A related issue is market-based financing, including securitized lending. Work has begun under the auspices of the Financial Stability Board to define the sector, to develop the data and methodology to systematically monitor it, and to develop policy options.2 To address the too-big-to-fail problem of systemically important financial institutions, work is under way to ensure that they are appropriately supervised and adequately capitalized to absorb losses, and to establish a framework for resolution in the event that they do fail. So this, in a nutshell, is what is being done to address the weaknesses underlying the 2008 crisis, with a view to creating a more resilient global financial system. I will now go on to discuss a new pattern of risks that has emerged since the recession. Risks in a two-speed global recovery As I have already mentioned, the current global recovery is operating at two speeds, with robust growth in emerging-market economies and anaemic growth in the advanced The Bank of Canada’s research report on the costs and benefits of the new rules can be found at <http://www.bankofcanada.ca/2010/08/secondary-page/strengthening-international-capital-and-liquiditystandards-a-macroeconomic-impact-assessment-for-canada-2/>. See “Shadow Banking: Scoping the Issues–A Background Note of the Financial Stability Board,” Financial Stability Board, 12 April 2011 <http://www.financialstabilityboard.org/publications/r_110412a.pdf>. BIS central bankers’ speeches economies. This two-speed recovery, accompanied by a widening of global economic imbalances, is at the centre of a new configuration of risks to global financial stability. These risks comprise sovereign risks, financial fragility, the search for yield, and related stresses in emerging-market economies and foreign exchange markets. Twice a year, the Bank of Canada publishes its Financial System Review (FSR), which examines developments in the financial system with a view to identifying potential risks to its overall soundness. This publication also highlights the efforts of the Bank, and other domestic and international regulatory authorities, to mitigate those risks. The pattern of risks I am going to discuss was examined in our December 2010 issue. We are continuing to track them and will provide an updated assessment in June. Sovereign risks have become increasingly prominent in a number of advanced economies. Many countries entered the crisis with weak fiscal positions and then were further weakened by the effect of low growth on tax revenues and the costs of economic stimulus and the bailouts of financial institutions. These problems are most acute in the peripheral countries of Europe – notably Greece, Ireland and Portugal. But many advanced economies still have precarious public finances and will need to persevere to address these problems. Canada’s fiscal position, in contrast, is stronger than that of most other advanced economies. Moreover, the domestic financial sector has limited direct exposure to the sovereign debt of peripheral euro-area countries. Nevertheless, there are a number of potential channels through which the Canadian financial system could be adversely affected by sovereign debt problems elsewhere, such as higher funding costs and a decline in asset-price valuations. The low growth of many advanced economies has led to lingering financial fragility. The outlook for banks in Europe – and, to a lesser extent, the United States – continues to be clouded. Although many banks around the world made substantial progress in repairing their balance sheets, some remain unusually strained. They are also exposed to vulnerable economic sectors, notably residential and commercial property markets. In some cases, their funding positions are fragile, subject to fragile investor confidence. With the weak growth of the major advanced economies, interest rates in a number of those economies are at extraordinarily low levels and are expected to remain so for an extended period. While stimulative monetary policy is needed to support the global economic recovery, this “low-for-long” scenario creates risk for the global financial system, and for the pension industry in particular. As you know, institutional investors such as insurance companies and pension funds are often expected – or in some cases even required by contract or mandate – to deliver a target rate of return. In many cases, these targets are now unrealistic and can be met only by taking on more risk than is prudent. Changes in accounting rules, which use low, risk-free interest rates to discount liabilities while valuing assets at current market prices, increase the pressure to achieve these high returns on a continuous basis. This is a particular instance of the “search for yield” that often accompanies a long period of very low interest rates. It may be associated with excessive credit creation and undue risktaking as investors seek higher returns, leading to the underpricing of risk and unsustainable increases in asset prices. A number of other developments – the record issuance of highyield debt securities in the United States, the rebound of capital flows into emerging-market economies and the popularity of commodity exchange-traded funds in recent quarters – are consistent with this pattern. The influence of sustained low interest rates in major advanced economies on risk-taking behaviour is a powerful dynamic that bears watching. Global imbalances are linked to the three risks I have just described and also pose some additional risks to the global financial system. The counterpart of these imbalances is that surplus countries in many cases are resisting upward pressure on their currencies and this is resulting in domestic inflationary pressures. As the authorities try to bottle up these BIS central bankers’ speeches inflationary pressures, that puts further stress on their financial systems. There is also the risk that the needed exchange rate adjustment, when it does come, will be disorderly. Resolving global imbalances requires that the United States and other deficit countries boost domestic savings in a timely and sustained manner. At the same time, surplus economies – particularly the emerging economies of Asia – need to undertake structural reforms to bolster internal sources of growth in order to reduce their reliance on external demand. Greater exchange rate flexibility is also an essential part of the solution.3 These are some of the main risks to financial stability that we see emerging in the two-speed global recovery. Let me now talk briefly about how the Bank of Canada is working to sharpen its analysis of risks. Strengthening risk assessment At the Bank of Canada, we are developing new risk-assessment tools and models that capture the diverse sources of risk and help us understand how they propagate through the financial system. While the Bank is making important progress in this area, we are not alone. The International Monetary Fund and the Financial Stability Board, as well as central banks and academics, are also making significant efforts in this area. Improvements in risk-assessment frameworks will focus on detecting vulnerabilities in the financial system. The Bank of Canada is thus developing a more rigorous empirical analytic framework to complement our current analysis and market intelligence. It may be that a single model of the financial system is neither practical nor realistic. Given the complexity of the financial system, a suite of models combining a number of analytical tools, approaches and indicators could provide the best avenue for success. While we are working to identify key risks, recent events have reminded us that we have to expect the unexpected. The earthquake and tsunami in Japan are examples of the kind of shocks that nobody had foreseen. Another example is the – no less seismic – political unrest of the Middle East. Clearly we can’t anticipate every shock. That’s why it so important to ensure that the financial system is more robust, so that it can withstand the shocks that will occur. Resilience, therefore, is the main goal of the G-20 reform agenda. Conclusion Allow me to conclude. Risk is ever-present, but its nature and sources change over time. Complacency is itself a source of risk – and indeed, the Great Moderation sowed the seeds of its own destruction as vulnerabilities were allowed to build up. This calls for vigilance in assessing the shifting nature of risk. The Bank of Canada continues to evaluate risks, sharing its assessment with other public institutions, international counterparts and the private sector. But we must also expect the unexpected. The only defence against the unexpected is the development of a more resilient financial system – and the current set of financial reforms will do just that. Thank you. All are key goals of the G-20 Framework for Strong, Sustainable and Balanced Growth. Canada co-chairs the committee monitoring the implementation of policies under this framework. BIS central bankers’ speeches
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Remarks by Mr Tiff Macklem, Senior Deputy Governor of the Bank of Canada, to "Conférence de Montréal", Montreal, Quebec, 6 June 2011.
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Tiff Macklem: Mitigating systemic risk and the role of central banks Remarks by Mr Tiff Macklem, Senior Deputy Governor of the Bank of Canada, to “Conférence de Montréal”, Montreal, Quebec, 6 June 2011. * * * Introduction It’s a pleasure to be here today and to be part of this panel. My assignment is to talk about the role of central banks with respect to systemic risk–in ten minutes. Needless to say, this is a tall order, made all the more challenging by the fact that systemic risk requires looking across the entire financial system and considering the full sweep of policy instruments and how they interact. But I will do my best to break it down into the essential points and look forward to the panel discussion and questions afterwards. There are three points that I want to make. First, we have made considerable progress in reforming the core of the global financial system. Basel III represents a very significant strengthening of the global rules. The reform agenda is now turning to the important issue of shadow banking–or market-based financing, as it is more aptly called–and the appropriate perimeter of supervision and regulation. Completing this reform agenda is critical to strengthening the resilience of the financial system. Second, central banks have a pivotal role to play in mitigating systemic risk by: identifying system-wide vulnerabilities and using their panoramic view of the financial system to connect the dots; supporting financial stability by providing emergency liquidity assistance to solvent, but illiquid institutions; and protecting the global financial system from the failure of one institution by promoting robust core financial infrastructure and overseeing systemically important clearing and settlement systems, including central counterparties for over-the-counter (OTC) derivatives. And third, while a better-regulated financial system should make inflation control easier, in the post-crisis world, monetary policy-makers have some new things to think about. Let me add some colour on each of these points. G-20 financial regulatory reform The logical place to start the reform agenda was at the core of the system, and there has been a great deal of progress. The financial crisis revealed all too starkly that the global banking system was dangerously undercapitalized and over-leveraged, and liquidity buffers were glaringly inadequate. The new global standards in the Basel III Capital Adequacy Accord redress this core vulnerability. The crisis also taught us that regulating on an institution-by-institution basis is important, but it is not enough. The risk to the financial system is greater than the average risk to individual firms. Managing this risk requires new system-wide tools, and here, too, there has been considerable progress. The counter-cyclical capital buffer included in Basel III is a giant step forward. The Bank of Canada played a leading role in the development of the buffer, which BIS central bankers’ speeches provides for additional capital to be built up during periods of excessive credit growth in anticipation of a future economic downturn. The reform agenda is now moving beyond the core. This means taking into account the considerable importance of shadow banking or market-based financing. The credit intermediation activities of banks are closely regulated and supervised, and are backstopped with deposit insurance and central bank liquidity. In contrast, market-based financing is less regulated and does not have access to public liquidity support. But it is big, and the crisis highlighted the systemic vulnerabilities market-based financing can pose. For both these reasons the international agenda is now turning to the perimeter of regulation and market-based financing. It will be essential that reforms strike an effective balance between the benefits of market-based financing in terms of competition, diversification and innovation, and the risks related to regulatory arbitrage and systemic vulnerabilities. The role of central banks This leads to the role of central banks in mitigating systemic risks. As I said at the outset, a key role for central banks is to use their panoramic view of the financial system to identify system-wide vulnerabilities. Central banks are well placed to recognize risks and prioritize them within a framework that maps potential weaknesses and traces the chain of cause and effect throughout the system. But to do this effectively, we need to raise our game. We need a deeper understanding of the links between financial intermediation, money and credit flows, the balance sheets of households and businesses, and the range of available policy instruments. And this understanding needs to be combined with better detection of emerging financial imbalances. This requires engagement with the private sector and building multidisciplinary teams that bring together economists, financial experts, accountants and lawyers, among others. And it is not enough to simply draw up long lists of vulnerabilities. Risks need to be assessed and ranked, providing a clear sense of priority. Since the outset of the crisis, the Bank of Canada has intensified its efforts to take account of credit flows in its policy analysis. Recent research has made important strides in incorporating financial intermediation into macro-economic models. This will allow us to assess new developments in the financial system and how alternative policy interventions will affect financial stability and economic activity. We have also sharpened our analysis of systemic vulnerabilities in our Financial System Review, where we provide both an assessment and a ranking of the top-tier risks. In addition to identifying system-wide risk, central banks have a historic role to play in providing liquidity to avert banking panics and crises. This role of lender of last resort is as old as central banking itself. The central bank acting as lender of last resort does not prevent shocks, but it can neutralize their secondary repercussions. We inject liquidity where the system had generated it before by exchanging less-liquid assets for more-liquid ones. Our actions to support liquidity in markets are guided by principles: lending to support liquidity should reduce moral hazard; interventions should be graduated, targeted, well-designed and created to prevent further market distortions. BIS central bankers’ speeches The financial crisis demanded new types of liquidity facilities, including longer terms, broader pools of eligible collateral and a wider range of counterparties. This was necessary in Canada as domestic banks found it more difficult to fund themselves when global credit markets seized up during the financial crisis. The Bank is now assessing the effectiveness of the various extraordinary facilities used in the crisis with a view to strengthening contingency plans in the event of new shocks. Finally, central banks play an important role in mitigating the harmful knock-on effects of failure through robust oversight of systemically important clearing and settlement systems. One of the few parts of the global financial system that worked well through the crisis was clearing and settlement systems. They handled enormous volumes against a backdrop of extraordinarily volatile financial conditions and successfully closed out the positions of failed counterparties, reducing harmful spillover effects. But the crisis also highlighted the systemic importance of over-the-counter derivatives markets and the need to clear standardized OTC derivatives through risk-proofed central counterparties. Globally, the derivatives market is huge. The amount of notional outstanding in OTC derivatives last year was $618 trillion. Here in Canada, the Canadian-dollar-denominated OTC derivatives market was about $9 trillion, of which a little over $6 trillion was in interest rate swaps. Central counterparties (CCPs) for OTC derivatives will provide greater certainty of payment, mitigating the harmful spillovers resulting from the failure of a counterparty, and reducing contagion in times of stress. But CCPs also have the potential to create new single points of vulnerability. This calls for the careful design of CCPs, as well as robust regulation and supervision. It will also be important to ensure sufficient access to CCPs to avoid limiting competition. This is of particular concern in countries, like Canada, that are not host to a large global CCP. Two paths to addressing these design issues are being actively considered. The first is to promote fair and open access to global CCPs, combined with shared oversight arrangements, so that strong, large and mid-tier derivatives market participants can have efficient access to central clearing. The second is to build local CCPs that are better aligned to local risks and local market conditions. A number of jurisdictions are committed to building their own onshore CCPs, including, Japan, Korea, China, Hong Kong, Singapore and Brazil. Here in Canada we need to give serious consideration to the onshore option. This isn’t to say that we should take the global option off the table. However, there are good reasons to consider onshore CCPs. Going local would give regulatory authorities a high degree of oversight and supervision over systemically important financial market infrastructure. Canadian authorities would also have much more control over the design and implementation of emergency measures, including the provision of emergency liquidity. The Bank of Canada is co-operating with our peers in the public sector and the Canadian financial sector to determine the best path for the central clearing of OTC derivatives. The Bank of Canada has also supported the development of a domestic CCP for Canadian-dollar repos, which is scheduled to be launched later this year. Implications for monetary policy I’d like to conclude with a few thoughts on what all this means for monetary policy. The first and most obvious point is that life should be better. Putting Basel III into effect, combined with expanding the perimeter and reducing contagion, will reduce the frequency and ease the severity of financial crises. Counter-cyclical capital buffers should help to lean against the build-up of excessive credit, moderating the financial accelerator and dampening economic fluctuations. All this should make the implementation of monetary policy easier. BIS central bankers’ speeches However, there will also be some new things for monetary policy-makers to think about. The very fact that new macroprudential tools are being employed will have an impact on the transmission of monetary policy. Using these tools will change the behaviour of both the economy and the financial sector. Monetary policy-makers will have to understand these effects. Moreover, new trade-offs may arise. Consider a situation where excess credit growth requires the counter-cyclical capital buffer to be activated at a time when inflation is already well contained. Since the tightening of such a broad-based macroprudential tool could be expected to put downward pressure on inflation, monetary policy can either accommodate this restraint and let inflation return to target over a longer horizon, or it could lower the policy interest rate and risk undermining the effectiveness of the counter-cyclical capital buffer. Finally, even the best-designed regulatory and supervisory framework will have limitations. And there could be circumstances in which monetary policy should play a complementary role in support of financial stability. This is more likely to occur in situations where an imbalance is broad-based or is being fuelled by a low interest rate environment. We know that monetary policy has a far-reaching influence on financial markets and on the leverage of financial institutions. This wide-scale impact makes it inappropriate for dealing with sector-specific imbalances, but potentially valuable in addressing imbalances that have spread to multiple sectors of the economy. Needless to say, clarifying the role that monetary policy should play in supporting financial stability is an important issue to be considered in the renewal of the inflation-targeting framework. Thank you for your attention. I look forward to the discussion and your questions. BIS central bankers’ speeches
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Remarks by Mr Mark Carney, Governor of the Bank of Canada, to the Vancouver Board of Trade, Vancouver, British Columbia, 15 June 2011
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Mark Carney: Housing in Canada Remarks by Mr Mark Carney, Governor of the Bank of Canada, to the Vancouver Board of Trade, Vancouver, British Columbia, 15 June 2011. * * * Introduction It is a pleasure to be back in Vancouver, a place often rated as the world’s most liveable city. Less frequently is it viewed as the most affordable. In the past three years, the average Vancouver house price is up about 30 per cent, making this city an extreme example of general developments in Canadian housing. In my remarks, I will discuss the Canadian residential real estate market, consider some of the lessons from recent international experience and, finally, draw the policy implications. Importance to Canadians The single biggest investment most Canadian households will ever make is in their home. Housing represents almost 40 per cent of the average family’s total assets, roughly equivalent to their investments in the stock market, insurance and pension plans combined. In recent years, housing has proved a very good investment indeed. The value of residential real estate holdings in Canada has climbed more than 250 per cent in the past 20 years, vastly outpacing increases in consumer prices and disposable income over that period (Chart 1). However, Canada is arguably no better off because of it. That’s because while homeowners may feel wealthier because of this rise in prices, housing is not net national wealth. Some Canadians are long housing; others are short. Housing developments can have important implications for equality both across and between generations. Though some people in this room may have been enriched, their children and neighbours may have been relatively impoverished. Importance to the Bank of Canada Housing not only meets a fundamental human need, it also has a wider economic significance. The Bank of Canada cares about the housing market because it can affect both price and financial stability. Let me address these in turn. Price stability The objective of Canadian monetary policy is low, stable and predictable inflation, defined as a 2 per cent annual rate of increase in the consumer price index (CPI). Housing can influence inflation in three principal ways. First, it is a major element of the CPI, accounting for more than a fifth of the basket of goods and services that makes up the index. The prominence of housing in the Bank’s target index provides an important advantage in that it ensures that the most important asset price in the economy is directly relevant to monetary policy. Second, the real estate sector makes a significant, if volatile, call on resources and labour in our economy, thereby influencing wages and price pressures more generally. While residential investment has accounted for only 6 per cent of GDP on average over the past 30 years, activity in the sector has been four times more volatile than the overall economy BIS central bankers’ speeches over that period. Thus developments in housing substantially affect the business cycle and by extension inflation. Third, while changes in housing values may not lead to changes in net wealth, they do influence consumption by affecting households’ access to credit. Through this “financial-accelerator” effect, homeowners can borrow more against increases in home equity to finance home renovations, the purchase of a second house, or other goods and services. Such expenditures can accelerate the increase in house prices, reinforcing the growth in collateral values and access to borrowing, leading to a further rise in household spending. Of course, this financial accelerator can also work in reverse: a decrease in house prices tends to reduce household borrowing capacity, and amplify the decline in spending.1, 2 Financial stability A home purchase triggers the biggest liability most families will ever take on. The value of housing-related debt in Canada has nearly tripled over the past decade to $1.3 trillion. This debt is also the single largest exposure for Canadian financial institutions, with real estate loans making up more than 40 per cent of the assets of Canadian banks, up from about 30 per cent a decade ago (Chart 2). This unprecedented exposure exists in the context of a Canadian mortgage market that is subject to more stringent checks and balances than in the United States. For instance, almost all Canadian mortgages are full recourse, mortgage interest is not tax-deductible, and high-ratio lending standards are generally prudent. These factors help instil responsibility and discipline on both homeowners and lenders. Nonetheless, the central position of housing assets and liabilities on the balance sheets of both households and financial institutions means that any housing excesses could generate important vulnerabilities in the financial system. Housing market developments in Canada and abroad A review of the recent history is instructive. A benign global macroeconomic environment and rapid financial innovation contributed to a global housing market boom through much of the past decade. In some countries, it went too far. Most prominently, in the United States, a substantial deterioration in underwriting standards turned boom to bubble and, ultimately, to bust. U.S. housing starts are now down three-quarters from their peak and prices have fallen by one-third. There have been over nine million foreclosures initiated since the cycle turned, and almost one in four mortgages is now in a negative equity position. While some details differ, most notably in the scale of defaults, recent trends have been similar in the United Kingdom, Spain and Ireland, where housing markets remain acutely challenged. This finding is also consistent with reduced-form evidence of a correlation between consumer spending and housing wealth. See L. Pichette, “Are Wealth Effects Important for Canada?” Bank of Canada Review (Spring 2004): 29–35. Research conducted at the Bank of Canada and elsewhere suggests that the financial-accelerator effect is economically significant. See M. Iacoviello, “House Prices, Borrowing Constraints and Monetary Policy in the Business Cycle” The American Economic Review 95, No. 3 (2005): 739–64. See also: M.B. Roi and R. Mendes, “House Prices, Residential Mortgage Credit and Monetary Policy,” Bank of Canada, December 2004; and J. Campbell and J. F. Cocco, “How Do House Prices Affect Consumption? Evidence from Micro Data,” (Harvard Institute of Economic Research Working Papers No. 2045, 2004 BIS central bankers’ speeches Elsewhere, however, the global financial crisis proved to be only a brief setback, with the growth of house prices resuming, or even exceeding, its former pace.3 Canada falls into this latter group. Nationally, our house prices have risen 31 per cent from their trough in early 2009, to stand 13 per cent above their pre-crisis peak (Chart 3).4 Here in Vancouver, the recovery has been even stronger, with prices up 55 per cent from their trough to a level 29 per cent above the prior peak. The rebound in housing market transactions and new construction, both locally and nationally, has been similarly robust. The performance of Canadian housing during the recent cycle has been unusual. For example, it took nearly 12 years for real residential investment to regain its level on the eve of the 1990s recession; this time it took only a year and a half (Chart 4). This rapid recovery importantly reflects the evolution of monetary policy during the recent recession. In response to the sharp, synchronous global recession, the Bank lowered its policy rate rapidly to its lowest possible level, doubled our balance sheet, and provided exceptional guidance on the likely path of our target rate. With the initial rapid narrowing of the output gap, the return of employment to a level above its pre-crisis peak, the highly effective transmission of monetary policy in Canada, and the sustained momentum in household borrowing, the need for such emergency policies passed (Chart 5). As a consequence, the conditional commitment was removed, our balance sheet was normalized, and rates were successively tightened until they reached 1 per cent last autumn, where they have remained. These policies provided considerable stimulus to the Canadian economy during a period of very weak global economic conditions and major downside risks. The housing market, highly sensitive to interest rates, responded. The rapid bounce-back in housing activity was also supported by federal government initiatives, notably the Insured Mortgage Purchase Plan and the Home Renovation Tax Credit. As a result, the recovery in the housing market played an important role in ensuring that the recession in Canada, while sharp, was also short. With this renewed vigour building on the decade-long boom that preceded the crisis, the average level of house prices nationally now stands at nearly four-and-a-half times average household disposable income. This compares with an average ratio of three-and-a-half over the past quarter-century (Chart 6). Simple house price-to-rent comparisons also suggest elevated valuations (Chart 7). While neither of these metrics reflect the impact of low interest rates, even after adjusting for these effects, valuations look very firm. For example, the ratio between the all-in monthly costs of owning a home and renting a home, as measured in the CPI, is close to its highest level since these series were first kept in 1949 (Chart 8). Financial vulnerabilities have increased as a result. Canadians are now as indebted (relative to their income) as the Americans and the British (Chart 9). The Bank estimates that the proportion of Canadian households that would be highly vulnerable to an adverse economic shock has risen to its highest level in nine years, despite improving economic conditions and the ongoing low level of interest rates.5 This partly reflects the fact that the increase in aggregate household debt over the past decade has been driven by households with the highest debt levels (Chart 10). There are some offsets. Debt is largely fixed rate and household net worth is at an all-time high. However, borrowers should remember that a fixed-rate mortgage will reprice a number of times over the life of the mortgage and, while asset prices can rise and fall, debt endures. This has been the pattern in many emerging-market economies, notably China, as well as in a number of advanced economies that were not directly implicated in the crisis, such as Australia, Sweden and Israel. According to the Canadian Real Estate Association’s Multiple Listing Service. The Bank defines highly vulnerable indebted households as those with a debt-service ratio greater than or equal to 40 per cent. BIS central bankers’ speeches The fact that the “official” personal savings rate in Canada has remained consistently positive is of limited comfort.6 The personal savings rate has fallen to historically low levels, despite the fact that the baby-boom generation is entering its highest saving years.7 Adjusting for housing expenditures, Canadian households have now collectively run a net financial deficit for 40 consecutive quarters, in effect, demanding funds from the rest of the economy, rather than providing them, as had been the case through the 1960s, 1970s, 1980s and 1990s (Chart 11). How concerned should we be? To answer requires a deeper examination of the fundamental forces of supply and demand in the Canadian housing market. The forces of supply and demand Canada’s housing supply is relatively flexible, compared with other countries (Chart 12), and it appears to have grown at rates broadly consistent with underlying demand forces, the most important of which is the rate of household formation (Chart 13).8 Some excesses may exist in certain areas and market segments. In particular, the elevated level of “multiples” inventories (Chart 14), the ample pipeline of developments under way, and heavy investor demand (much of it foreign) reinforces the possibility of an overshoot in the condo market in some major cities. Moreover, looking at the amount being spent on Canadian housing, rather than simply the number of houses being built, suggests that overall activity has been quite robust. Residential investment as a whole (including new home construction, renovations and ownership transfer costs) has consistently exceeded its long-term average share of the overall economic activity for more than seven years. Residential investment is now at levels that have previously proved to be peaks in Canada and, on a relative basis, in the United States (Chart 15). This partly reflects the generally strong performance of Canada’s labour market over the past decade, which has driven solid gains in employment and income. However, it also reflects historically favourable borrowing conditions, and potentially overly optimistic assumptions about future developments. Lower interest rates reduce the cost of financing the purchase or construction of houses and increase the value of collateral, enabling more borrowing than would otherwise be possible. While monetary policy rates influence mortgage rates across the yield curve, mortgage rates are ultimately set in the market, where a broad set of domestic and global forces play a role. Among these forces, the so-called “global savings glut” has been particularly important in underpinning the trend decline in long-term borrowing rates over the past decade. Flows of excess savings from emerging markets into the U.S. Treasury market have restrained the long-term U.S. interest rates that provide the benchmark for yield curves globally. Rough calculations suggest that the lower real rates from this phenomenon could justify a substantial proportion of the increase in house valuations across mature markets.9 The The “official” savings rate refers to the personal savings rate as calculated in the Canadian System of National Accounts. The calculation of the personal savings rate does not incorporate spending on housing such as ownership transfer costs and renovations, which are considered investments, even though it could be argued that they are more akin to consumption. However, regardless of whether such spending is classified as investment or consumption, it is often financed with borrowed funds. A. Caldera Sánchez and Å. Johansson, “The Price Responsiveness of Housing Supply in OECD Countries”, OECD Economics Department Working Papers, forthcoming, 2011. S. Nickell, “Household Debt, House Prices and Consumption Growth,” speech delivered at Bloomberg in London on Tuesday, 14 September 2004. BIS central bankers’ speeches eventual rebalancing of the global economy from deficit countries, like the United States, to surplus countries, like China, should dampen this effect. As in many other countries, cheap credit has been used to bid up the price of Canadian houses, a non-tradable good, rather than invest in expanding the productive capacity and export competitiveness of our businesses. For example, over the past decade, housing debt grew by more than 150 per cent, while business borrowing rose by only 40 per cent. As a result, the stock of housing-related debt went from less than business debt to almost two-thirds more. Domestic demand factors are not the only forces at work. Some Asian wealth is being invested in selected international housing markets as those investors seek out diversification and hard assets. This has become a familiar phenomenon in this city. Partly as a consequence, the average selling price of a home in Vancouver is now nearly 11 times the average Vancouver family’s household income, a multiple similar to those seen in Hong Kong and Sydney – cities that have also become part of a more globalized real estate market. Such valuations are extreme in both Canada and globally (Chart 16). Given such developments, one cannot totally discount the possibility that some pockets of the Canadian housing market are taking on characteristics of financial asset markets, where expectations can dominate underlying forces of supply and demand. The risk is that expectations become extrapolative, prompting the classic market emotions of greed and fear – greed among speculators and investors – and fear among households that getting a foot on the property ladder is a now-or-never proposition. Policy implications The Bank manages policy for the economy as a whole, rather than any specific region or sector. In this context, what does the Bank of Canada expect for housing? In a word: moderation. In the Bank’s view, Canadian housing market developments in recent years have largely reflected the evolution of supply and demand. While supply of new homes should remain relatively flexible, many of the supportive demand forces are now increasingly played out. For example, while measures of housing affordability remain favourable, this is largely because interest rates are unusually low. Rates will not remain at their current levels forever. The impact of eventual increases is likely to be greater than in previous cycles, given the higher stock of debt owed by Canadian households. At a 4 per cent real mortgage interest rate – equivalent to the average rate since 1995 – affordability falls to its worst level in 16 years (Chart 17).10 As I have observed, some markets are already severely unaffordable even at current rates. Since 2008, the federal government has taken a series of prudent and timely measures to tighten mortgage insurance requirements in order to support the long-term stability of the Canadian housing market. These will reduce the possibility that prices are further driven up simply through higher leverage. The Bank has been expecting moderation in the housing sector as part of a broader rebalancing of demand in Canada as the expansion progresses. Overall economic growth is expected to rely less on household and government spending, and more on business investment and net exports. Household expenditures are expected to converge toward their historic share of overall demand in Canada (Chart 18), with expenditures growing more in The affordability index represents the proportion of the average personal disposable income per worker that goes toward mortgage payments, based on current house prices and mortgage rates. A decline in the ratio indicates an improvement in affordability. BIS central bankers’ speeches line with household income. In this context, the Bank anticipates a slowing in both the rate of household credit growth and the upward trajectory of household debt-to-income ratios. There are conflicting signals regarding the extent to which this moderation is proceeding (Chart 19). While growth in consumer spending slowed markedly in the first quarter, housing investment re-accelerated, as did household borrowing, with mortgage credit growing at a double-digit annual rate (Chart 20). It is likely that some of this resurgence in borrowing is transitory, reflecting the lagged effects of the surge in existing home sales in the fourth quarter of last year, as well as recent changes in mortgage insurance regulations that may have resulted in some activity being pulled forward into the first quarter. Mortgage credit growth slowed in April, reinforcing the view that the particularly strong increase in borrowing in the first quarter was temporary. Nonetheless, at a 5 per cent annual rate, growth in mortgage credit in April was slower but not slow, particularly given the sustained above-trend increases of recent years. As the Bank emphasized in its recent rate announcement, the possibility of greater momentum in household borrowing and spending in Canada represents an upside risk to inflation. Conclusion In conclusion, historically low policy rates, even if appropriate to achieve the inflation target, create their own risks. Canadian authorities will need to remain as vigilant as they have been in the past to the possibility of financial imbalances developing in an environment of still-low interest rates and relative price stability. We continue to co-operate closely and monitor the financial situation of the household sector. In the short term, economic growth in Canada is expected to slow to modest rates, due to a number of temporary factors. These include supply chain disruptions that will dampen automotive production and the drag from adjusting to higher energy prices on consumer spending in Canada and the United States. Overall, the Bank expects a re-acceleration of growth in the second half of the year, consistent with a renewed narrowing of the output gap. While global uncertainties persist, to the extent that the Canadian economic expansion continues and the current material excess supply in the economy is gradually absorbed, some of the considerable monetary policy stimulus currently in place will be eventually withdrawn, consistent with achieving the 2 per cent inflation target. Such reduction would need to be carefully considered. With monetary policy continuing to be set to achieve the inflation target, our institutions should not be lulled into a false sense of security by current low rates. Similarly, households will need to be prudent in their borrowing, recognising that over the life of a mortgage, interest rates will often be much higher. Thank you. BIS central bankers’ speeches BIS central bankers’ speeches BIS central bankers’ speeches BIS central bankers’ speeches BIS central bankers’ speeches BIS central bankers’ speeches BIS central bankers’ speeches BIS central bankers’ speeches BIS central bankers’ speeches BIS central bankers’ speeches BIS central bankers’ speeches
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Remarks by Mr Mark Carney, Governor of the Bank of Canada, at the presentation of new polymer bank notes, Bank of Canada, Ottawa, Ontario, 20 June 2011.
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Mark Carney: Canada’s new polymer bank notes – celebrating Canada’s achievements at the frontiers of innovation Remarks by Mr Mark Carney, Governor of the Bank of Canada, at the presentation of new polymer bank notes, Bank of Canada, Ottawa, Ontario, 20 June 2011. * * * I am very proud to represent the Bank at this historic unveiling of a new generation of bank notes. Secure, durable and innovative, these new notes are at the frontier of bank note technology. They will set a benchmark worldwide and will help maintain the confidence Canadians already have in their currency. Designing and issuing bank notes that you can trust is an important element of the Bank’s mandate to promote the economic and financial welfare of our country. This new series of bank notes combines innovative technology and Canadian ingenuity. They were developed by a team of physicists, chemists, engineers and other experts from the Bank of Canada and from across the bank note industry. This work was borne out of necessity. Beginning in 2001, counterfeiting in Canada increased dramatically, to levels that were very high by Canadian and international standards. By 2004, counterfeiting was at a historic peak of 470 counterfeit notes detected per one million notes in circulation. The Bank responded with an aggressive strategy to deter counterfeiting, which included training retailers to recognize genuine notes, working with law enforcement to catch and prosecute criminals, and improving the quality of those notes in circulation. We succeeded. Today there are only 35 counterfeit notes detected per million notes – a more than ten-fold reduction. Of course, even one counterfeit note is one too many! That is why the Bank is continuing to work closely with our partners in law enforcement and that is why we are investing heavily in new technology to stay ahead of counterfeiting threats. And we are. The polymer notes we are introducing today are unique. There is simply no other currency like it. These new notes combine transparency, holography and other sophisticated security elements. These new bills are not only more secure; they are also more cost effective. In addition, we have independently verified that the environmental footprint of polymer notes will be smaller than that of currency made from cotton-based bank note paper. The new bills will last at least 2.5 times longer than cotton-based bank note paper bills, and after being removed from circulation, for the first time in Canada, they will be recycled into other products. Safer, cheaper, and greener: these new bank notes are a 21st century achievement in which all Canadians can take pride and place their confidence. We have heard how these new bank notes will explore the frontiers of Canadian history and innovation, all while being at the frontier of bank note security. The product of leading-edge technology, these notes will be among the most secure in the world. These polymer bills will last at least two-and-a half times longer than the current cotton-paper bills now in circulation, thereby costing less to produce and leaving a smaller ecological footprint: in every way, this is better money. BIS central bankers’ speeches We will be phasing in these new bills, working closely with financial institutions and manufacturers of bank note equipment to ensure a smooth transition from cotton-paper to polymer. There are many important partners in this process. We will be working with law enforcement agencies, as well as retailers. Today, we unveil the new $100 and $50 notes so that Canadians can start to learn about the new features and appearances of each denomination. Starting in November 2011, the $100 bill will be available and the $50 notes will follow in March 2012. The $20, $10, and $5 notes will be unveiled and issued by the end of 2013. So after telling you about the new money, the time has come to show it to you. BIS central bankers’ speeches
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Opening Statement by Mr Mark Carney, Governor of the Bank of Canada, to the Standing Senate Committee on Banking, Trade and Commerce, Ottawa, Ontario, 22 June 2011.
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Mark Carney: Opening Statement for Appearance before the Standing Senate Committee on Banking, Trade and Commerce Opening Statement by Mr Mark Carney, Governor of the Bank of Canada, to the Standing Senate Committee on Banking, Trade and Commerce, Ottawa, Ontario, 22 June 2011. * * * Good afternoon, Mr. Chairman and committee members. Tiff and I are pleased to appear today to discuss the Bank of Canada’s analyses of the economic outlook and the stability of the financial system. We look forward to your questions and the discussion that follows. The Bank’s most recent comprehensive assessment of the economy was presented in its April Monetary Policy Report (MPR). On 31 May, the Bank issued its latest policy rate announcement. These provide the basis for my comments today. Please bear in mind that the Bank’s next full economic analysis will be published in the upcoming MPR, which will be released on 20 July 2011. I will also take a few moments this afternoon to outline the highlights of the Bank’s Financial System Review (FSR), which was released just this morning. The FSR reviews developments in the financial system and identifies potential vulnerabilities. Beginning with the economic outlook: The global recovery is proceeding broadly as we had expected in April. The U.S. economy continues to grow at a modest pace, limited by the consolidation of household balance sheets. Growth in Europe is maintaining momentum, although the risks related to peripheral economies have clearly increased. The disasters that struck Japan in March are severely affecting its economic activity and are also causing temporary supply chain disruptions in advanced economies, including Canada. Although commodity prices have declined recently, they are expected to remain at elevated levels, supported by tight global supply and very strong demand from emerging markets. These high prices, combined with persistent excess demand conditions in major emerging-market economies, are contributing to broader global inflationary pressures. Despite the challenges that weigh on the global outlook, financial conditions remain very stimulative. In the short term, economic growth in Canada is expected to slow to modest rates, due to a number of temporary factors. These include the supply chain disruptions that will dampen automotive production, as well as the drag from adjusting to higher energy prices on consumer spending in Canada and the United States. Overall, a broad rebalancing of demand in Canada is underway as the economic expansion progresses. Business investment is now growing strongly, and contributions to growth from both household consumption and government spending are diminishing. As I will discuss in a moment, in this context, the Bank anticipates a slowing in both the rate of household credit growth and the upward trajectory of household debt-to-income ratios. The recovery in net exports is expected to be modest given the relative weakness in the U.S. economy, Canada’s underrepresentation in fast-growing emerging markets, BIS central bankers’ speeches While underlying inflation is relatively subdued, the Bank expects that high energy prices and changes in provincial indirect taxes will keep total CPI inflation above 3 per cent in the short term. Total CPI inflation is expected to converge with core inflation at 2 per cent by the middle of 2012, as excess supply in the economy is gradually absorbed, labour compensation growth stays modest, productivity recovers and inflation expectations remain well-anchored. The Bank expects a re-acceleration of growth in the second half of the year, consistent with a renewed narrowing of the output gap. We will update the projection in the July MPR. Allow me to turn now to the Bank’s monitoring of developments in the financial system. Although the Canadian financial system is currently on a sound footing, the Bank judges that, largely because of external factors, risks to its stability remain elevated and have edged higher since December. Of the five risks identified in the FSR, I would like to concentrate on three: – First, sovereign balance sheets remain strained in many advanced economies. Fiscal strains in the euro-area periphery have continued to build despite continued efforts by the affected countries and assistance from the International Monetary Fund and the European Commission. Whether or not a sovereign credit event occurs, these strains could trigger a sharp repricing of credit risk for other governments with high debt burdens, as well as a more generalized retrenchment from risk-taking in global markets, including markets in Canada. – Second, a long period of low interest rates globally may fuel excessive risktaking. The search for yield could cause risk to be underpriced or lead investors to take on exposures that they may not be able to manage if conditions become less benign. Our institutions should not be lulled into a false sense of security by current low rates. – Lastly, the high level of household indebtedness has increased financial vulnerabilities in Canada. Canadians are now as indebted (relative to their income) as the Americans and the British. The Bank estimates that the proportion of Canadian households that would be highly vulnerable to an adverse economic shock has risen to its highest level in nine years, despite improving economic conditions and the ongoing low level of interest rates. This partly reflects the fact that the increase in aggregate household debt over the past decade has been driven by households with the highest debt levels. – There are some offsets. Debt is largely fixed rate and household net worth is at an all-time high. However, borrowers should remember that a fixed-rate mortgage will reprice a number of times over the life of the mortgage and, while asset prices can rise and fall, debt endures. The elevated levels of household debt require continued vigilance. Since 2008, the federal government has taken a series of prudent and timely measures to tighten mortgage insurance requirements. These will reduce the possibility that prices are further driven up simply through higher leverage and, more broadly, support the long-term stability of the Canadian housing market. While these measures will help moderate the pace of debt accumulation by households, it will take some time for their full effect to be felt. Canadian authorities BIS central bankers’ speeches Despite the challenging international environment and increasing strains on household balance sheets, the Canadian financial system remains healthy. For example, asset quality at Canada’s major banks has improved further in recent months. Moreover, the aggregate financial position of the domestic non-financial corporate sector is solid, with corporate leverage remaining at low levels. Finally, I would like to note that on Monday, the Bank, along with the Minister of Finance and the Commissioner of the RCMP, unveiled a new generation of bank notes. These new notes are at the frontier of bank note technology. They are secure, durable and green. They will set a benchmark worldwide and will help maintain the confidence Canadians already have in their currency. With that, Tiff and I would be pleased to take your questions. BIS central bankers’ speeches
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Remarks by Ms Agathe Côté, Deputy Governor of the Bank of Canada, to the Financial Markets Association of Canada in association with Women in Capital Markets, Toronto, Ontario, 28 June 2011.
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Agathe Côté: Financial risks and global reforms Remarks by Ms Agathe Côté, Deputy Governor of the Bank of Canada, to the Financial Markets Association of Canada in association with Women in Capital Markets, Toronto, Ontario, 28 June 2011. * * * Introduction Good afternoon. I want to thank our hosts, the Financial Markets Association of Canada and Women in Capital Markets, for the invitation to speak to you today. I am very pleased to be here. Last week, the Bank released its Financial System Review (FSR), a semi-annual publication in which we summarize the main risks to the stability of the Canadian financial system, and the policy actions required to mitigate those risks. This issue of the FSR also includes three articles that focus on issues related to financial markets. Today, I am going to devote the largest part of my presentation to one of those articles, which discusses shadow banking, or what we at the Bank prefer to call market-based financing or MBF.1 We favour this term because it highlights the fact that the creditintermediation activities that constitute shadow banking – such as securitization or repurchase agreements – are conducted primarily via markets. If properly monitored and regulated, these activities can bring significant economic benefits and do not have to be “shadowy.” The agenda for global financial reform that was launched by the G-20 at its London Summit in 2009 has, to date, been primarily directed at the banks. Banks are the core of the global financial system, and governments and central banks in many countries had to intervene heavily to support them during the crisis. But the financial crisis has shown that MBF activities can also be an important source of systemic risk. Moreover, with the standards applied to banks set to increase with Basel III, the incentives for activities to migrate to shadow banking may increase. For these reasons, the international financial reform agenda, under the auspices of the Financial Stability Board (FSB), is now turning its attention to this area. In my remarks today, I will describe the key characteristics of the MBF sector, examine potential risks associated with it and discuss the policy options being considered to address these risks. I will conclude with comments on an important aspect of the reform agenda for this sector, which is the move to strengthen market infrastructure through greater use of central clearing services for derivatives and repo transactions. First, however, I want to start with a brief summary of our assessment of the key risks to Canada’s financial system. Risks to Canada’s financial system The process of financial sector repair is continuing and the economic recovery is proceeding at a steady pace in most advanced economies. As expected, however, it is taking considerable time and effort to resolve the underlying economic and financial imbalances. The path to a more resilient global financial system is further complicated by the two-speed J. Chapman, S. Lavoie and L. Schembri, “Emerging from the Shadows: Market-Based Financing in Canada,” Bank of Canada Financial System Review (June 2011):29–38. BIS central bankers’ speeches recovery in economic activity, with relatively modest growth in advanced economies and increasing signs of overheating in emerging-market economies. Despite the challenging international environment, the Canadian financial system remains healthy. For example, asset quality at Canada’s major banks has improved further in recent months. Moreover, the aggregate financial position of our non-financial corporate sector is solid. The main source of concern domestically continues to be the high level of debt carried by households, with the aggregate debt-to-income ratio of Canadians at a record high. This raises the risk that the impact of an adverse macroeconomic shock on the financial system could be exacerbated by a deterioration in the ability of households to service their debts. This risk remains elevated and is broadly unchanged since our previous FSR in December. Aside from our concern about household finances, the principal sources of risks to Canada’s financial stability come from the external environment. They are: First, sovereign balance sheets remain strained in many advanced economies. In the near term, the principal threat is that the acute fiscal strains in peripheral Europe could trigger a generalized retrenchment from risk-taking in global markets, including markets in Canada. Second, large current account imbalances cannot persist indefinitely. Implementing the structural changes needed to resolve these imbalances will be a lengthy process and the risk of a disorderly adjustment involving sharp movements in asset prices remains high. Third, while the majority of banks have made substantial progress in strengthening their balance sheets, some foreign banks continue to struggle, and the risk that further progress may be delayed by the protracted recovery in advanced economies is still elevated. Lastly, a long period of low interest rates globally may fuel excessive risk-taking. The “search for yield” could cause risk to be underpriced or lead investors to take on exposures that they may not be able to manage if conditions become less benign. Since December, there has been mounting evidence of this search-for-yield dynamic in the global financial system, although the risk that it could lead to financial instability in Canada remains moderate. Key features of market-based financing The market behaviours I have just outlined – excessive risk-taking and the potential underpricing of risks – can, and often do, manifest themselves in the market-based financing or shadow banking sector. Let me describe the principal characteristics of the sector. In broad terms, MBF refers to credit-intermediation activities similar to those performed by banks because they involve maturity or liquidity transformation, possibly with some degree of leverage. But, as I mentioned at the outset, these activities are conducted primarily through markets rather than within financial institutions, although they can involve banks as well as other financial institutions, such as securities dealers, finance companies and hedge funds. The MBF sector is subject to a different regulatory framework and is typically not regulated or supervised to the same extent as the traditional banking system. But MBF serves useful and legitimate economic functions. It can contribute to the efficient funding and transfer of credit risk. It provides competition for the traditional banking sector and helps diversify credit sources. In fact, the rapid expansion of MBF in the pre-crisis years was driven largely by competitive market forces, financial innovation, and the ongoing expansion and deepening of BIS central bankers’ speeches financial markets. So, if the associated risks are properly managed, MBF can be beneficial to the economy. In aggregate, the MBF sector is big. MBF activities are significant in several advanced economies, and are comparable in size to traditional lending activities performed by banks. If we estimate total activity by liabilities outstanding, since 1999 the MBF sector in Canada has been about the same size as the traditional banking sector. In comparison, in the United States, at their peak before the crisis, MBF liabilities were roughly twice as large as traditional bank liabilities. They are currently about 25 per cent larger. Another key characteristic of the MBF sector is its diversity, both within and across countries. It involves a wide range of activities with different levels of benefits and risk. For example, we view government-guaranteed, mortgage-backed securities as part of the MBF sector because they transform illiquid assets into more liquid securities, in part through market channels. But these securities clearly lie at the less-risky end of the range. They do not embed leverage, and credit risk is eliminated by the government guarantees. By contrast, activities at the riskier end of the continuum would include highly complex, opaque and leveraged securities, such as some of the non-bank-sponsored, asset-backed commercial paper (ABCP) that existed in Canada prior to the crisis. The size and composition of shadow banking also vary across jurisdictions, partly in response to the structure and regulation of the banking system. In Canada, at the end of 2010, the most prominent MBF activities were repurchase agreements (repos), which accounted for over half of total MBF liabilities. This was followed by mortgage-backed securities, at about one quarter of the total, and short-term debt instruments, at less than 10 per cent. In the United States, in comparison, government-sponsored enterprises, money market mutual funds and asset-backed securities represent the major components of the overall MBF sector. Canada and the United States also differ in the role that regulated financial institutions play in MBF activities. In Canada, regulated financial institutions are dominant players. In addition, the widespread use of government, or government-guaranteed, securities as collateral to underpin these transactions (both repos and mortgage-backed securities) make the sector in Canada relatively less vulnerable. Key vulnerabilities in market-based financing Generally speaking, there are two main concerns with MBF activities: the opportunity for regulatory arbitrage and the possibility of systemic risk. The first one is straightforward: shadow banking activity can be used to circumvent and undermine banking regulations. This may become increasingly important given the new Basel III standards for bank capital and liquidity coming into force. The second concern reflects a number of vulnerabilities inherent in MBF, perhaps the most important of which is exposure to panics. Entities that rely on MBF are exposed to liquidity crises that resemble a classic bank run. This is owing to their funding structure, with the important difference that MBF lenders are not protected by deposit insurance, and MBF borrowers typically do not have direct access to central bank liquidity. The 2007 crisis in the Canadian market for non-bank-sponsored ABCP was a prime example of how a liquidity crisis can unfold. Short-term instruments were used to fund illiquid, risky and long-term assets. Those instruments also embedded significant leverage. When signs of trouble emerged, investors shied away from ABCP. Maturing paper was not rolled over as investors became more aware of, and concerned with, the potential risks, especially the uncertainty surrounding the willingness and the capacity of the sponsors to provide a liquidity backstop. A second vulnerability is counterparty credit risk arising from the interconnected nature of the MBF sector. MBF investors are exposed to credit risk, both from their direct counterparties but also, more generally, from their counterparties’ counterparties, and so on. The network of BIS central bankers’ speeches obligations that arises from MBF activities thus requires an investor to be aware of the creditworthiness of its direct counterparty, including risks that could arise from how that counterparty is connected to the rest of the financial system. During a crisis, however, the difficulty of properly assessing one’s exposure to this complex network and the resulting uncertainty may cause or amplify a financial panic as risk aversion increases. A third vulnerability is related to the opacity of some of the securitized assets being used as collateral in secured borrowing. During the recent crisis, this type of collateral became more illiquid and difficult to evaluate. This opacity may also impede the transfer of credit risk. Finally, there is a vulnerability associated with the build-up of leverage that can take place in MBF activities, which can be exacerbated by the lower level of regulation. The build-up of leverage embedded in very complex financial products, followed by forced deleveraging, played a crucial role during the crisis. Reforming the shadow banking sector While we have a much better understanding of the MBF sector today than we did before the crisis, we still have much to learn. The FSB has created a task force to study shadow banking.2 It is currently assembling information and developing a methodology to systematically monitor the sector and to explore possible regulatory measures. Broadly speaking, there are four types of responses that policy-makers can consider: First, indirectly regulating MBF activities by regulating the banks’ involvement in them; Second, directly regulating entities that are active in MBF and that pose systemic risk concerns or create opportunities for regulatory arbitrage; Third, focusing on instruments and activities that potentially create risk in the financial system, rather than on entities; and, Fourth, enacting a range of macroprudential measures, such as those that would reduce procyclicality and strengthen market infrastructure. Three points merit emphasis. First, it is important that the approach to reform strikes an effective balance between the benefits of market-based financing and the risks. Second, given the important differences in the structure of market-based financing across countries, it is important to balance the need to take account of these differences against the need for international consistency to address common risks and to avoid creating cross-border arbitrage opportunities. Third, the approach taken should put a premium on adaptability, since changes in regulation and innovation can lead to rapid expansion and mutation of these activities. This also implies that the MBF sector necessitates continuous monitoring to identify emerging vulnerabilities. Strengthening market infrastructure A number of reforms are already under way both in Canada and globally to address shadow banking risks exposed by the crisis. Let me turn to one aspect I just alluded to, which is to strengthen market infrastructure. One of the key lessons of the crisis was the excessive vulnerability of the financial system to individual institutions, where weaknesses in one financial institution had cascading effects on others, ultimately posing risks to the entire “Shadow Banking: Scoping the Issues,” Financial Stability Board background note, 12 April 2011. BIS central bankers’ speeches financial system. For example, the near-collapse of Bear Stearns threatened the viability of the tri-party repo market. As a result, central banks took extraordinary measures to support core funding markets. Similarly, the failure of Lehman revealed the vulnerabilities and unforeseen exposures that had been propagated through the commercial paper markets and derivatives markets, among others. That is why the agenda for global financial reform is aimed at strengthening both individual financial institutions and financial market resilience. And here, infrastructure plays a critical role. As I just noted, the Lehman crisis highlighted the systemic importance of the highly complex, multi-counterparty, cross-border derivatives markets. As a result, the G-20 decided that all standardized over-the-counter (OTC) derivatives should be cleared through central counterparties (CCPs) by the end of 2012. CCPs can act as firewalls against the propagation of shocks across market participants. But in order to reap these benefits, CCPs have to be carefully designed and subject to robust regulation and supervision. The Bank of Canada is responsible for overseeing major clearing and settlement systems for the purpose of controlling systemic risk.3 Two key infrastructure initiatives that we are involved in address systemic risk by enhancing the resiliency of the system. We are working with the industry to develop a domestic CCP for Canadian-dollar repos that will underpin the resiliency of that core funding market. Again, I want to remind you that repos are half of market-based financing in Canada. It is our expectation that this system will be designated for oversight when it begins operating, likely later this year. And the Bank is working on how best to implement the G-20 commitment for OTC derivatives – a market in Canada of roughly $9 trillion notional, of which $6 trillion is interest-rate swaps. Its size and interconnectedness point to its systemic importance and the critical need for rigorous oversight. One way to build resiliency may be a domestic infrastructure for centrally clearing OTC Canadian-dollar denominated derivatives.4 As market infrastructure supporting the Canadian financial system evolves, the Bank will continue to exercise its oversight role. We must be able to fulfill our legislative responsibility for oversight of major clearing and settlement systems – not just at a moment in time, but over time. If all aspects of systemic clearing systems were within Canada – for example, the physical location, management, and risk controls – clearly it would be easier to fulfill that responsibility. If, on the other hand, those systems were managed in foreign jurisdictions, then the Bank would need to judge the extent to which it could rely on foreign authorities for principal oversight – a judgement that has not yet been required. And, if our ability to rely on foreign jurisdictional authorities were to diminish over time, we would also need to ensure that we would have the ability to remedy the situation. We at the Bank must be able to fulfill our obligations to Canadians to ensure sound management of the risks associated with these systemically important clearing and settlement systems. Conclusion Let me conclude. Throughout the global financial crisis, Canada’s financial system showed its strength and resilience. Nonetheless, an important lesson from the non-bank ABCP episode in particular and the global crisis more generally is that our financial system is not immune to vulnerabilities in market-based financing. The sector represents roughly half of The legislative authority is set out in the Payment Clearing and Settlement Act. Systems which are currently designated as having the potential to pose systemic risk are: CDSX, which is the system that clears and settles securities transactions; the Large Value Transfer System; and CLS Bank, a global system for the settlement of foreign exchange transactions. See J. Slive, C. Wilkins and J. Witmer, “Access to Central Clearing Services for Over-the-Counter Derivatives,” Bank of Canada Financial System Review (June 2011):39–45. BIS central bankers’ speeches the financial system in several advanced economies. Since the crisis, it has not been subject to the same degree of regulatory reform as the traditional banking system. That is now changing. This is why regulatory authorities in Canada, including the Bank of Canada, are actively involved, both at the FSB table and here in Canada, in assessing market-based financing activities and helping to develop new financial regulations and market infrastructure, such as central clearing services, that will reinforce the safety and efficiency of our financial system. More broadly, with the international financial system still facing serious risks, it is crucial that we maintain the momentum of reform. Thank you. BIS central bankers’ speeches
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Opening statement by Mr Mark Carney, Governor of the Bank of Canada, at the press conference following the release of the Monetary Policy Report, Ottawa, 20 July 2011.
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Mark Carney: Summary of the latest Monetary Policy Report Opening statement by Mr Mark Carney, Governor of the Bank of Canada, at the press conference following the release of the Monetary Policy Report, Ottawa, 20 July 2011. * * * Good morning. Tiff and I are pleased to be here with you today to discuss the July Monetary Policy Report, which the Bank published this morning. The global economic expansion is proceeding broadly as projected in April, with modest growth in major advanced economies and robust expansions in emerging economies. Growth in the U.S. economy has been slower than expected. It continues to be restrained by the consolidation of household balance sheets and slow growth in employment. While growth in core Europe has been stronger than expected, necessary fiscal austerity measures in a number of countries will restrain growth over the projection horizon. In Japan, the economy has begun to recover from the disasters that struck on 11 March, but the level of economic activity will remain below previous expectations. In contrast, growth in emerging-market economies, particularly China, remains very strong. As a consequence, commodity prices are expected to remain at elevated levels, following recent declines. These high prices, combined with persistent excess demand in major emerging-market economies, are contributing to broader global inflationary pressures. Widespread concerns over sovereign debt have increased risk aversion and volatility in financial markets. The Bank’s projection assumes that authorities are able to contain the ongoing European sovereign debt crisis, although there are clear risks around this outcome. In Canada, the economic expansion is proceeding largely as projected, although the expected rotation of demand is somewhat slower than had been anticipated. Household spending remains solid and business investment robust. Net exports remain weak, reflecting modest U.S. demand and ongoing competitiveness challenges, particularly the persistent strength of the Canadian dollar. Despite increased global risk aversion, financial conditions in Canada remain very stimulative and private credit growth is strong. Following an anticipated slowdown in growth during the second quarter due to temporary supply chain disruptions and the impact of higher energy prices on consumption, the Bank expects growth in Canada to re-accelerate in the second half of 2011. Over the projection horizon, business investment is expected to remain strong, household spending to grow more in line with disposable income, and net exports to become more supportive of growth. Relative to the April projection, growth in household spending is now projected to be slightly firmer, reflecting higher household income, and net exports to be slightly weaker, reflecting more subdued U.S. activity. BIS central bankers’ speeches Overall, the Bank projects the economy will expand by 2.8 per cent in 2011, 2.6 per cent in 2012, and 2.1 per cent in 2013, returning to capacity in the middle of 2012. In the near term, total CPI inflation is expected to remain above 3 per cent, largely reflecting temporary factors such as significantly higher food and energy prices. It is expected to return to the 2 per cent target by the middle of 2012 as the temporary factors unwind, excess supply in the economy is gradually absorbed, labour compensation growth stays modest, productivity recovers, and inflation expectations remain well-anchored. Core inflation is slightly firmer than anticipated, owing to temporary factors and to more persistent strength in the prices of some services. Core inflation is now expected to remain around 2 per cent over the projection horizon. Although the global outlook remains broadly unchanged, global risks have intensified, most notably in Europe. The three main upside risks to inflation in Canada relate to the possibility of higher-than-projected commodity prices and global inflation, stronger momentum in Canadian household spending, and the possibility that there is less excess capacity in the Canadian economy. The three main downside risks to inflation in Canada relate to sovereign debt concerns in Europe, headwinds from the persistent strength of the Canadian dollar, and the possibility that growth in Canadian household spending could be weaker than projected. Overall, the Bank judges that the risks to the inflation outlook in Canada are roughly balanced over the projection horizon. Reflecting all of these factors, the Bank yesterday maintained the target for the overnight rate at 1 per cent. To the extent that the expansion continues and the current material excess supply in the economy is gradually absorbed, some of the considerable monetary policy stimulus currently in place will be withdrawn, consistent with achieving the 2 per cent inflation target. Such reduction would need to be carefully considered. With that, Tiff and I would be pleased to take your questions. BIS central bankers’ speeches
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Remarks by Mr Tiff Macklem, Senior Deputy Governor of the Bank of Canada, presented to the G-20 Workshop, Paris, 7 July 2011.
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Tiff Macklem: Global financial reform – maintaining the momentum Remarks by Mr Tiff Macklem, Senior Deputy Governor of the Bank of Canada, presented to the G-20 Workshop, Paris, 7 July 2011. * * * Introduction It is now almost three years since the financial crisis went viral in the autumn of 2008 and threatened a complete meltdown of the global financial system. Thanks to the bold and concerted actions of G-20 nations, the financial system was stabilized and an economic depression avoided. But the fallout was nonetheless severe – the worst global recession since the Great Depression, with almost 28 million jobs lost worldwide. And we continue to struggle with the aftershocks of the crisis. A central pillar of the policy response to the crisis was a sweeping reform of the financial regulatory and supervisory framework. Launched at the G-20 Leaders Summit in London, the multi-pronged reform agenda included several key elements: enhanced transparency and disclosure; higher prudential and liquidity standards; a new system of macroprudential oversight; credible and effective resolution regimes for large financial institutions; a broader scope for regulation and oversight spanning all systemically important financial institutions, markets and instruments; stronger infrastructure for key financial markets; and measures to promote adherence to international prudential regulatory and supervisory standards. Our challenge as policy-makers is to strike the right balance. We don’t want to undermine efficiency or stifle innovation, but we do want to deter reckless behaviour. The regulatory reform agenda began, appropriately, at the core of the financial system. In many respects, this was the easy part since we have considerable experience with the regulated sector. As we move beyond the core to consider issues of perimeter and interconnectedness, the intellectual and practical challenges are larger. At the same time, as the desperation of the crisis fades from memories, so will the urgency to tackle these issues. Our collective responsibility is to ensure that our efforts redouble as the going gets tougher. Since the London Summit, considerable progress has been made along three fronts: standards, tools and enforcement. Standards The financial crisis revealed all too starkly that liquidity buffers were glaringly inadequate, and that the banking system as a whole was dangerously undercapitalized and over-leveraged. The new global standards in the Basel III Capital Accord redress this core vulnerability. They substantially increase the loss-bearing capital that financial institutions must hold. They establish new liquidity standards and a limit on leverage. These represent a significant strengthening of the global rules. The combination of greater emphasis on true loss-bearing capital – namely tangible common equity – and increased minimum capital levels has effectively raised the minimum global capital requirement seven times. Moreover, for the largest and most interconnected global banks, this is being supplemented with additional loss-absorbing capacity. The Group of Governors and Heads of Supervision just agreed on a proposed methodology for assessing systemic importance, the amount of additional required capital, and the timeline over which this will be phased in. These additional measures will further strengthen the resilience of global systemically important banks and create incentives for them to reduce their systemic importance over time. BIS central bankers’ speeches Tools The crisis taught us that while regulating on an institution-by-institution basis is important, it is not enough. The risk to the financial system is not equivalent to the average risk to individual firms. This was strikingly illustrated in the crisis, as it was individual institutions’ attempts at self-preservation that transmitted and amplified stresses throughout the global system. Addressing system-wide risks requires new tools, and here, too, there has been considerable progress. The countercyclical capital buffer included in Basel III is a giant step forward. The Bank of Canada played an important role in the development of the buffer, which provides for additional capital to be built up during periods of excessive credit growth in anticipation of a future downturn. This broad macroprudential instrument complements other tools designed to contain financial imbalances in specific markets. These include mortgage loan-to-value ratios and amortization periods, as well as countercyclical margin requirements. What remains is much work on implementation. In particular, how best to combine, sequence and implement these tools, how they will affect financial intermediation, and their implications for other policy instruments, including monetary policy. Enforcement New rules are only as good as their application and adherence. Last year in Seoul, G-20 leaders endorsed recommendations to strengthen the mandate, capacity and resourcing of supervisors. They also reviewed the powers required to monitor, identify and address excessive risk-taking, including early intervention. It is imperative that these recommendations are now translated into new standards for supervision and implemented on the ground. International assessment and review are also being strengthened. Financial Stability Board (FSB) member jurisdictions are living up to their commitments to undergo regular assessments under the IMF’s Financial Sector Assessment Program. And under the FSB’s new system of international peer reviews, six reviews have now been completed and published. Building a new system of international peer review is a major accomplishment. But heavier lifting lies ahead. As new, higher standards come into force, ensuring equivalent implementation will become increasingly important. Three critical areas stand out: Basel III, resolution regimes and central clearing for OTC derivatives. We will need rigorous and effective assessment of implementation across all jurisdictions to ensure that they are living up to their commitments. The goal is to create a race to the top in national adherence to international standards. Agreement on these three elements – higher standards, new tools and strengthened enforcement mechanisms – will substantially enhance financial stability at the core of the system. Agreement in these areas has been hard. But the truly tough work of consistent, rigorous and relentless implementation is just beginning. Now that we have largely agreed on the reforms to reduce the likelihood of failure at the core of the system, the reform agenda is turning appropriately to two further priorities: expanding the perimeter of oversight and regulation, and reducing contagion and harmful international spillovers. Expanding the perimeter of supervision and regulation The existing prudential regulatory framework was designed around banks whose credit-intermediation activities are closely regulated and supervised, as well as backstopped with deposit insurance and central bank liquidity. By contrast, the shadow banking sector is less regulated and does not have access to public liquidity support. However, like the BIS central bankers’ speeches credit-intermediation activities of banks, shadow banking also involves liquidity and maturity transformation, and often with some degree of leverage. The label “shadow banking” is unfortunate. It is not shadowy. Market-based financing, as it is more appropriately called, provides competition for the banking sector and is an important source of innovation and diversification. And it is also big. In the United States, market-based financing was roughly twice as large as traditional bank intermediation at the peak of the credit boom and is still about 25 per cent larger today. In several other advanced economies, including Canada, the sector is at least as large as the banking sector. The crisis highlighted the systemic vulnerabilities market-based financing can pose. The opaque and excessively levered securitization of U.S. mortgages, combined with undue reliance on short-term wholesale funding, greatly intensified the consequences of the U.S. housing collapse. With the capital and liquidity standards applied to banks set to increase, we can expect to see further incentives for regulatory arbitrage. This has the potential to expand the scope and scale of market-based financing activities. For all these reasons, the international agenda, under the auspices of the FSB, is turning its attention to the perimeter of regulation and shadow banking or market-based financing. The FSB’s task force on shadow banking is taking a two-pronged approach. The first prong is to cast a wide net to ensure that data gathering and surveillance cover all non-bank credit-intermediation activities where risks might arise. The second prong is narrower in focus. It concentrates on the subset of non-bank credit-intermediation where risks can arise from maturity or liquidity transformation, credit risk transfer, or leverage. A key characteristic of market-based financing is its diversity, both within and across countries. It involves a wide range of activities with different benefits and risks. At one end of the continuum are government-guaranteed, mortgage-backed securities; at the other end are highly complex, opaque, leveraged securities. The composition of the sector in terms of instruments varies considerably across jurisdictions, partly in response to the structure and regulation of the domestic banking system. In Canada, for instance, the most prominent market-based financing activities are repurchase agreements (repos). In the United States, government-sponsored enterprises, money market mutual funds and asset-backed securities represent the major components. The dominant players in the sector also differ from one jurisdiction to another. In Canada and Australia, for example, a much larger proportion of market-based financing is undertaken by regulated financial institutions, compared with the United States. The diversity across jurisdictions of risk levels, composition and players demonstrates the need for a better understanding of the shape, reach and scale of market-based financing. While we have a much better grasp today of the sector than we did before the crisis, we still have much to learn. We need to understand the complete chain, from origination through to the final sale, with all the links along the way clearly exposed, including the links to the regulated sector. This requires mapping the sector to identify potential problems, inconsistencies and data gaps in the monitoring framework, and to assess the risks to the broader financial system. In terms of reform, the lowest-hanging fruits have already been harvested. These include enhanced disclosure requirements, the new consolidation accounting standard and minimum risk-retention rules. But much more work is needed to consider the full range of policy options. These include: direct regulation; indirect regulation via links to the regulated sector; targeting specific products and activities; and various macroprudential measures. As we consider the vulnerabilities posed by market-based financing and the appropriate policy response, it will be important to keep three points front of mind. First, reforms should BIS central bankers’ speeches strike an effective balance between the benefits of market-based financing, including competition, innovation and diversification, and the risks related to regulatory arbitrage and systemic vulnerabilities. Second, given important differences in the structure of market-based financing across countries, the best approach to mitigating systemic risks in this sector is likely to differ across jurisdictions. And third, the best approach will be the one that is adaptable, since changes in regulation and innovation can lead to rapid expansion and mutation of market-based financing activities. Reducing contagion and spillovers Reducing contagion and spillovers when accidents do happen has two critical elements. First, resolution. We must be able to resolve institutions, no matter how large, in a way that preserves their remaining value while ensuring the costs are borne by shareholders and uninsured counterparties – and not by taxpayers. The effective resolution of insolvent, globally active banks will require clear rules for cross-border resolution. It will also require new instruments and a range of other powers and tools, including an expanded capacity for bridge banks and clear recovery and resolution plans. Contingent convertible (CoCo) bonds and broader bail-in solutions can also be helpful in providing a kind of pre-packaged priority in bankruptcy. Resolving firms in crisis is something no one wants to do, but ensuring authorities have a full spectrum of tools and powers is critical if we are to roll back the moral hazard that has distorted incentives for the so-called “too-big-to-fail” financial institutions. The second element is the need for central counterparties for OTC derivatives combined with trade repositories. Globally, the notional derivatives market is immense. The amount of notional outstanding in OTC derivatives last year was US$618 trillion. In Canada, the Canadian-dollar-denominated OTC derivatives market was about $9 trillion, of which a little over $6 trillion was in interest rate swaps. This is huge for a country with a GDP of Can$1.6 trillion in 2010. The systemic significance of this market was made all too obvious during the financial crisis. By global standards, Bear Stearns was a mid-sized institution. But its significance as a counterparty in the OTC derivatives market was such that U.S. authorities were required to assist in a transaction to prevent its complete collapse. To prevent this from happening again, G-20 leaders have agreed that by the end of 2012, all standardized OTC derivatives contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties (CCPs). A great deal of work remains if this goal is to be realized. Central counterparties for OTC derivatives will provide greater certainty of payment, mitigating the harmful spillovers resulting from the failure of a counterparty, as well as increased transparency, thereby reducing contagion and maintaining continuous markets in times of stress. But CCPs also have the potential to create new single points of vulnerability. This calls for the careful design of CCPs, as well as robust regulation and supervision. It will also be important to ensure sufficient access to CCPs to avoid limiting competition. This is of particular concern in countries that are not host to a large global CCP. There are two potential paths to address these design issues. The first is to promote fair and open access to global CCPs with shared oversight arrangements, so that strong, large and mid-tier derivatives market participants have efficient access to central clearing. The second is to build local CCPs that are better aligned with local risks and local market conditions. A number of jurisdictions are pursuing the local, or onshore option, including Japan, Korea, China, Hong Kong, Singapore and Brazil. Potentially, these local CCPs could be linked globally through risk-controlled interoperability. BIS central bankers’ speeches Canada is giving serious consideration to an onshore option. This is not to say we are taking the global option off the table, but there are good reasons to consider onshore CCPs. Going local would give regulatory authorities a high degree of oversight and supervision over systemically important market infrastructure. Authorities would also have much more control over the design and implementation of emergency measures, including the provision of emergency liquidity, and influence over a CCP’s actions in the event of a member’s default. Regardless of whether global or local CCPs become the path to central clearing, new kinds of interdependencies among jurisdictions will be created. To protect the stability of the financial system, authorities must define shared-oversight arrangements across jurisdictions, the framework and principles for emergency liquidity support to CCPs, and policies for failure resolution. This work is under way, but much more needs to be achieved, and the details matter. Conclusion Since the financial reform agenda was launched at the London Summit, the Pittsburgh, Toronto and Seoul Summits have each marked considerable progress. New standards are now agreed that will significantly enhance the resilience of regulated financial institutions. The easy part is done. These new rules must now be rigorously implemented in every institution. Supervision and oversight need to be strengthened in all jurisdictions. Scrupulous international assessment must ensure equivalent implementation of these new higher standards. We must agree on and implement a perimeter of regulation and oversight that encompasses systemically important financial institutions, markets and instruments. And a new system of firewalls needs to be built to prevent the failure of one counterparty in the OTC derivatives market from creating systemically perilous knock-on effects. This will all require considerable energy. But as we move further from the crisis, we risk losing the sense of urgency that brought us together at the start. This would be a great disservice to our citizens. The costs of the crisis were enormous. And the lesson from history is that memories in financial markets are short. Without our collective determination, the under appreciation of risk and the build up of vulnerabilities in the system will almost certainly return. We have within our grasp a new financial landscape with less-frequent and less-severe crises, and with institutions, markets and products that better serve the needs of households and businesses. If we have learned anything from the crisis, this is an opportunity we cannot afford to squander. BIS central bankers’ speeches
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Opening statement by Mr Mark Carney, Governor of the Bank of Canada, presented to the House of Commons Standing Committee on Finance, Ottawa, Ontario, 19 August 2011.
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Mark Carney: Opening statement for appearance before the House of Commons Standing Committee on Finance Opening statement by Mr Mark Carney, Governor of the Bank of Canada, presented to the House of Commons Standing Committee on Finance, Ottawa, Ontario, 19 August 2011. * * * Thank you for this opportunity to appear here today. Recent economic and financial developments In recent weeks, several downside risks to the Bank’s July Monetary Policy Report (MPR) projection have been realised. The European sovereign crisis has intensified, the U.S. credit rating has been downgraded, and a broad range of data has signalled slower global growth. The United States is in the midst of the weakest recovery since the Great Depression. This is not a surprise as history teaches that recessions involving financial crises tend to be more severe and have recoveries that take twice as long. Recent benchmark revisions show that the U.S. recession was even deeper and the recovery from the trough has been even shallower than previously reported. The Bank expects that American household spending will remain subdued in the face of high personal debt burdens, large declines in wealth and tough labour market conditions. In addition, fiscal stimulus in the United States will soon turn to fiscal drag. For well over a year, the Bank has been concerned about the prospects for resolving internal tensions within the Euro area. Some of these concerns are now being realised as acute fiscal and financial strains in Europe have triggered a generalized retrenchment from risk-taking and could yet prompt more severe dislocations in global funding markets. In response to uncertainties in Europe and the evidence of slowing global growth, equity and commodity prices have fallen significantly, and financial market volatility has increased markedly. The spillovers to Canadian financial markets have been less pronounced but are still notable. Importantly, Canadian financial stocks have considerably outperformed their peers in the United States, the United Kingdom and Europe and our core funding markets have remained orderly. This will help ensure an appropriate flow of credit to Canadian households and businesses. Recent events serve as a reminder that in a world awash with debt, repairing the balance sheets of banks, households and countries will take years. As a consequence, the pace, pattern and variability of global economic growth is changing, and Canada must adapt. In short, the considerable external headwinds that the Bank has long identified are now blowing harder. For Canadian producers, the persistent strength of the Canadian dollar is compounding the sluggishness of U.S. demand. Largely reflecting such external factors, recent Canadian data has been consistent with minimal to slightly negative growth in the second quarter. At the same time, labour market developments and business investment intentions suggest continued strength in our domestic economy. The Bank continues to expect that growth will accelerate in the second half of the year, led by business investment and household expenditures. Ongoing strength in major emerging markets should also help maintain commodity prices at relatively high levels. However, relative to our prior expectations, we expect somewhat weaker economic momentum globally and, as a result, in Canada, with attendant consequences for resource utilization and inflationary pressures. BIS central bankers’ speeches Policy considerations Since the crisis began, the broad economic strategy has been to grow domestic demand in the face of these considerable external headwinds and to encourage Canadian businesses to retool and reorient to the new global economy. In response to the sharp, synchronous global recession, the Bank lowered our target rate rapidly to its lowest possible level. We almost doubled our balance sheet to provide the financial sector with exceptional liquidity. And we gave exceptional guidance on the likely path of our target rate, through our conditional commitment. In tandem, federal and provincial fiscal stimulus provided important further support to domestic demand, contributing significantly to Canadian economic growth through 2009 and 2010. Owing to the underlying strength of domestic fundamentals, particularly our resilient financial system, these policies proved highly effective. Domestic demand in Canada grew more than twice as fast as in the United States. Canada has recovered all of the output and about 140 per cent of the jobs lost during the recession. Throughout, price stability has been maintained. As the Minister of Finance has rightly emphasised and recent events have reinforced, fiscal sustainability is fundamental. It is essential to maintain Canada’s fiscal advantage with an appropriately paced fiscal consolidation plan, consistent with the G-20’s Toronto Summit commitments. Similarly, private credit cannot grow without limit. Canadians are now as indebted as the Americans and the British. In an environment of exceptionally low interest rates, we must be careful not to repeat the mistakes of others who now face the challenges of simultaneously lowering unsustainable public and private debt burdens. Bank policy There are five ways in which the Bank will continue to support Canada’s economic expansion in this difficult external environment. First, the best contribution that monetary policy can make is to keep inflation low, stable and predictable. Monetary policy is guided by our 2 per cent target for total CPI inflation. This is a symmetric commitment. That is, the Bank cares as much about inflation being below target as above. Since the crisis erupted, the Bank has demonstrated its flexibility and nimbleness in the conduct of monetary policy. As the Canadian recovery has progressed, we have emphasised that we would be prudent with respect to the possible withdrawal of any degree of monetary stimulus. As we highlighted in our most recent MPR, our approach will always be guided by comprehensive, considered analysis and informed judgment rather than mechanical rules. This is particularly important in the current environment of material external headwinds. To state the obvious, if the outlook for growth and inflation changes, the path for monetary policy will be affected accordingly. Second, the Bank will take the necessary steps to ensure that core funding markets remain liquid. In the event of a major systemic shock, the Bank has a wide range of tools to provide exceptional liquidity, consistent with a principles-based framework. At the same time, central bank liquidity should not be a substitute for sound risk management by private financial institutions. Accordingly, the Bank will continue to work with the Office of the Superintendent BIS central bankers’ speeches of Financial Institutions (OSFI) to guard against moral hazard by ensuring that private banks maintain adequate liquidity buffers. Third, we must continue to build a more resilient financial system in Canada and globally. Recent events underscore the importance of implementing G-20 financial reforms, notably the capital and liquidity requirements under Basel III. Given the leading positions of our banks and the consistency of the new standards with Canada’s, now is not the time for Canada to move from the front to the back of the class. Moreover, it is in Canada’s interests to ensure that others follow our example. This will reduce the risk that another foreign financial crisis sideswipes our economy. Fourth, the Bank will continue to work with its federal partners to monitor risks to financial stability and to develop appropriate responses. An example has been the measured approach to rising household indebtedness. Since 2008, the federal government has taken a series of prudent and timely measures to tighten mortgage insurance requirements in order to support the long-term stability of the Canadian housing market. Finally, since the biggest risks to our economy come from abroad, the Bank must work with international colleagues as they tackle the twin challenges of reducing excessive private and public debt. The situation is most acute in Europe where credible national fiscal plans need to be supplemented by broader changes to European economic governance and fiscal arrangements. We are in constant, intensive discussions with our European colleagues bilaterally and through the G-7, the G-20, the Bank for International Settlements and the Financial Stability Board. As the Bank has stressed repeatedly, the core challenge is to rebalance demand between advanced and emerging economies. To this end, the Bank is investing in current G-20 efforts to develop a framework for open capital flows, working with the FSB to devise and implement comprehensive financial reforms, and collaborating with our colleagues in the Department of Finance to guide the G-20 framework for strong, sustainable and balanced growth. Rebalancing will require significant changes to fiscal, structural and exchange rate policies across a broad range of countries. To conclude, the challenges in the current global economic environment are significant, but so too are the opportunities for Canada. Our corporations and governments have strong balance sheets, our financial institutions are among the most resilient in the world, and our economy can be geared to the future sources of global growth. To take advantage of these attributes, we will need continued, heavy investment to improve productivity and sustained, innovative efforts to develop new markets. For its part, the Bank has a wide range of tools and policy options that it will continue to deploy as appropriate in order to ensure that Canadians can seize these opportunities in an environment of domestic macroeconomic and financial stability. BIS central bankers’ speeches
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Remarks by Mr Tiff Macklem, Senior Deputy Governor of the Bank of Canada, at the FICCI-IBA (Federation of Indian Chambers of Commerce & Industry - Indian Banks' Association) Conference on "Global Banking: Paradigm Shift", Mumbai, 24 August 2011.
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Tiff Macklem: The role of the G-20 in sustaining the recovery and protecting financial stability Remarks by Mr Tiff Macklem, Senior Deputy Governor of the Bank of Canada, at the FICCI-IBA (Federation of Indian Chambers of Commerce & Industry – Indian Banks’ Association) Conference on “Global Banking: Paradigm Shift”, Mumbai, 24 August 2011. * * * Introduction In some respects, Canada and India could not be more different. Canada is the world’s second-largest country in geographic size, with a population of 34 million. India, as one of only two countries with more than a billion people, is the world’s second largest in population and is expected to be the largest within 15 years. However, there is much we share, not least, vast and diverse geographies, diversity among our citizens, a common democratic heritage as members of the British Commonwealth, and market-based economies. In my remarks today, I will focus on these and other similarities between India and Canada, as well as our strong, joint interest – indeed, our leadership role – in the G-20 reform program to achieve durable financial stability and sustainable and balanced economic growth. My message, in a sentence, is that while the G-20 has made considerable progress in strengthening the microeconomic rules governing the regulated financial system, we have fallen short in correcting the imbalances that are plaguing the global economy and fuelling financial vulnerabilities. And this is having consequences. The slow progress by some countries in implementing adjustments needed to address macroeconomic imbalances is holding back the global recovery and increasing the risk of financial instability. Canada and India are caught in the crosshairs. What can we do? Individually, we can ensure our own macroeconomic policies – monetary, fiscal and exchange rate – are sound and supporting necessary adjustments. We can advance the implementation of higher global regulatory standards in our own financial systems. And we can ensure rigorous regulatory supervision of our financial sectors. Together, Canada and India can provide a strong voice encouraging G-20 countries to accelerate their efforts to develop and implement concrete, measurable plans to reduce macroeconomic imbalances, address financial vulnerabilities and support a sustainable expansion. Canada and India weathered the financial crisis better than most Worldwide, the cost of the financial crisis that broke out in 2007 and escalated dramatically in the fall of 2008 has been enormous. The ensuing recession was the worst the world had seen since the 1930s and the most globally synchronized in history. Almost 28 million jobs were lost globally. Economic output in the major advanced countries, as represented by the G-7, fell by 5 per cent from peak to trough. For emerging-market countries, a collapse in trade led to a marked growth slowdown. And today, four years from the start of the crisis and two years into the recovery, we are still not out of the woods. The European sovereign crisis has intensified, the U.S. credit rating has been downgraded, and a broad range of data has come in weaker than expected. All have led to an abrupt loss of risk appetite in financial markets. The implication is somewhat weaker economic momentum globally together with elevated risks. BIS central bankers’ speeches Both Canada and India weathered the financial crisis better than most, and remain wellpositioned to absorb aftershocks. To an important degree, this reflects the guidance we took from our own past mistakes. A central lesson we both learned is that adjustment deferred is inevitably adjustment magnified and intensified. And in response to this bitter experience, we put in place sound economic frameworks that have increased the resilience of our economies. In the early 1990s, Canada and India both experienced serious economic crises and deep recessions. These crises produced similar epiphanies, which galvanized the political will necessary to make substantive policy reforms: in particular, to liberalize trade; to strengthen monetary, fiscal and financial policy frameworks; and to undertake needed structural reforms. In Canada, a series of factors coalesced, including the lack of a credible nominal anchor for monetary policy, inefficient production, large and chronic fiscal deficits, and structural rigidities in labour markets. The resulting crisis led to key reforms. These included a free trade agreement with the United States and Mexico, an inflation-targeting framework for monetary policy, and a major fiscal consolidation that reduced the federal deficit from almost 6 per cent of GDP in 1992–93 to near zero five years later. Our employment insurance and public pension plans were also reformed as were regulations governing the financial sector. The initial impact of each of these separate reforms was modest, but the benefits quickly cumulated and reinforced each other to become very substantial: low and stable inflation, declining government debt, stronger and more stable output growth, lower unemployment and financial stability. I won’t presume to lecture on the history of the reforms instituted here in India, but I would suggest the world needs to hear more about India’s success story. The impact of the changes put in place is both impressive and instructive. As the Indian economy became more open to the rest of the world and its economy more market-oriented, economic growth doubled, rising from about 4 per cent in the early 1990s to more than 8 per cent by the end of the decade and this trend of strong growth performance has continued since the turn of the century. India’s exports of goods and services, as a share of GDP, more than tripled, rising from 7 per cent in 1990 to 22 per cent in 2010. But the most remarkable measure of success was that from 1994 to 2005, almost 29 million people – or close to the entire population of Canada – were lifted out of poverty. The reforms adopted by Canada and India left our economies better able to adjust to the financial crisis and ensuing recession. This was a crisis that did not ignite within our borders. Yet our sound policy frameworks, combined with diligent implementation, have fortified our countries against the international shock waves and afforded us greater policy flexibility to respond to adverse real and financial spillovers. Canada, India and the G-20 So it should perhaps not be a surprise that as the G-20 emerged as the premier forum for economic co-operation, Canada and India were approached to take on a leadership role in forging a global consensus around needed policy reforms. In particular, our countries were asked to co-chair two critically important G-20 working groups. First, the G-20 Working Group on Enhancing Sound Regulation and Strengthening Transparency was established in the lead-up to the London Summit to tackle weaknesses in the financial system that had been laid bare by the crisis. In a remarkably short period of time, our working group was able to achieve agreement among G-20 members on the broad directions of financial sector policy reform. The recommendations in our report were adopted BIS central bankers’ speeches by G-20 leaders at the London Summit and set in train an ambitious financial reform agenda.1 I will come back to this in a moment. Second, the G-20 Working Group on the Framework for Strong, Sustainable and Balanced Growth, which is ongoing, was launched following the Pittsburgh Summit to build a consensus around the policies required across the G-20 to sustain the recovery and ensure that policy frameworks and actions are consistent domestically and globally. Let me say a few words about both projects – what has been achieved and what remains to be accomplished. Financial sector reform The financial crisis revealed all too starkly that liquidity buffers were glaringly inadequate, and that the global banking system as a whole was dangerously undercapitalized and overleveraged. To redress this core vulnerability, new global standards in the form of Basel III have been agreed. They substantially increase the loss-bearing capital that financial institutions must hold and establish new liquidity standards and a limit on leverage. These new standards represent a significant strengthening of the global rules. The combination of greater emphasis on true loss-bearing capital – namely, tangible common equity – and increased minimum capital levels has effectively raised the minimum global capital requirement seven times. Moreover, for the largest and most interconnected global banks, these requirements are being supplemented with additional loss-absorbing capital. These are major accomplishments. The new rules must now be assiduously implemented in every institution. All jurisdictions must ensure strong supervision and oversight. Scrupulous international assessment must ensure equivalent implementation of these new higher standards. Furthermore, we must agree on and implement a perimeter of regulation and oversight that encompasses all systemically important financial institutions, markets and instruments. And a new system of firewalls needs to be built to prevent the failure of one counterparty in the over-the-counter derivatives market from creating systemically perilous knock-on effects. In short, much has been achieved and much remains to be accomplished. It is critically important that the momentum driving financial sector reform be maintained. G-20 Framework for Strong, Sustainable and Balanced Growth Progress on the Framework for Strong, Sustainable and Balanced Growth has lagged that of financial sector reform – and needs to accelerate. The G-20 leaders launched the Framework in 2009, just as the global economy began recovering. Their goal was to safeguard the nascent recovery and achieve stronger global growth over the medium to long term. Leaders recognized the importance of beginning in the early stages of the recovery to put in place policies that would foster the adjustments needed to sustain recovery, prevent a re-emergence of global imbalances and support financial stability. At the Toronto G-20 Summit in 2010, agreement was reached on a comprehensive, threepillared policy package to support stronger, more sustainable and more balanced growth. It included: fiscal consolidation in advanced countries that is credible and clearly communicated; G-20 Working Group on Enhancing Sound Regulation and Strengthening Transparency, “Final Report.” 25 March 2009, which can be found at: <http://www.g20.org/Documents/g20_wg1_010409.pdf>. BIS central bankers’ speeches for emerging markets, strengthened social safety nets, infrastructure spending and, for some, increased exchange rate flexibility; and, for the entire G-20 membership, the pursuit of structural reforms to increase and sustain our growth prospects. Advanced countries made their commitment to fiscal consolidation more concrete by agreeing to at least halve their fiscal deficits by 2013 and stabilize or reduce government debt-to-GDP ratios by 2016. Six months later, in Seoul, G-20 leaders called for indicative guidelines to identify large and persistent macroeconomic imbalances and for corrective policy actions to address the underlying root causes. But actions have not always kept pace with commitments. In advanced countries, the difficult task of legislating credible, well-defined fiscal consolidation plans is under way, but in some of these countries, current plans have yet to gain the full confidence of markets. Moreover, the consequences of inadequate progress have become more immediate. Sovereign debt concerns have contributed to a retrenchment in risk taking in global markets, sending the prices of safe-haven assets to record highs and pushing those of risky assets sharply lower. In emerging markets, the pace of foreign exchange reserve accumulation has not slowed; on the contrary, it has accelerated. In 2010, aggregate reserves of G-20 emerging-market economies reached nearly US$5 trillion, or 32 per cent of their GDP. At US$3.2 trillion, China’s reserves alone have increased by almost a third since January 2010. This is also having more visible consequences. The slow pace of exchange rate adjustment between the United States and China is holding back the recovery in the former and fuelling inflation in the latter. With only very modest adjustments of the renminbi against the U.S. dollar, China’s real effective exchange rate against its full range of trading partners has actually depreciated since June 2010. Moreover, as the consequences of this lack of adjustment spill over onto others, G-20 members are increasingly taking individual actions that collectively risk further thwarting needed global adjustment. The number of G-20 countries that are intervening against exchange rate movements has increased. And more emerging markets are taking measures to reduce capital inflows. As a result, countries representing more than 50 per cent of the U.S.-dollar trade weight are actively thwarting foreign exchange adjustment, either through quasi-fixed exchange rates or with newly introduced capital controls. Canada and India are not part of this group. But we are bearing the not insubstantial consequences of a weakened global recovery and the re-emergence of global imbalances.2 As co-chairs of the Framework working group, Canada and India are working together to develop concrete and measurable policy commitments to be tabled at the Cannes G-20 Summit in November. We have made good progress at the G-20 table on indicators and guidelines to define significant and harmful economic imbalances. This experience has helped to foster a common understanding of the issues and problems across the G-20 which, in turn, serves as a first step in achieving greater policy coordination. The working group’s focus now is on the key challenges of fostering greater exchange rate flexibility in emerging markets, encouraging deeper and more significant structural reforms, and strengthening the fiscal commitments made in Toronto. Both co-chairs also believe that there is a symmetry of interests between advanced and emerging economies in reducing the pace of reserve accumulation and are pursuing measurable commitments on this front. Achieving consensus Projections made by the International Monetary Fund show that imbalances narrowed from 2008 to mid-2009, but have been widening ever since and, without policy adjustments, are expected to worsen. BIS central bankers’ speeches on all of these issues will require a shared understanding of the mutual benefits and, here, Canada and India have an important role to play. Conclusion Let me conclude. The G-20 countries have had considerable success outlining what must be done to enhance the resilience of the global financial system and to achieve stronger, more balanced growth. And the potential achievable benefits of taking collective action are large. The Bank of Canada conservatively estimates that the average net economic benefit to be gained over time by G-20 economies from the stronger agreed capital and liquidity standards is 30 per cent of GDP in present-value terms, or about US$13 trillion.3 Further, if the G-20 initiatives to unwind global imbalances are realized, the Bank estimates that the level of global demand could be $6 trillion to $9 trillion dollars higher by 2015 than when compared to a scenario of deficient global demand.4 But to achieve this promise, the pace of implementation of the G-20 Framework must step up. We are already bearing the consequences of inadequate adjustment. Unsustainable macroeconomic policies are increasing uncertainty, undermining a sustainable economic recovery and raising financial stability risks. And the longer needed adjustments are delayed, the more serious the consequences will ultimately be. Financial stability that is durable cannot be achieved without balanced sustainable growth – nor can growth be sustained without financial stability. As the recent extreme market volatility has made all too stark, we hand financial markets the opportunity to speculate against needed adjustments at our collective peril. Financial markets are content until they are not. Policy-makers cannot predict when market sentiment will shift, but every delay in implementing policies to safeguard and support sustainable economic growth increases the likelihood of another calamity. Canada and India are a world apart. My country is a medium-sized, advanced economy. India is an emerging giant. But the elements we have in common are significant and powerful, including our democratic heritage, our market-based approach to economic policy and our commitment to a prosperous global economy. We are strengthening the ties between our countries. And together we share a leadership role on the world stage to achieve a global economy that sustains strong and balanced growth to the benefit of all citizens. Thank you. Bank of Canada, “Strengthening International Capital and Liquidity Standards: A Macroeconomic Impact Assessment for Canada,” August, 2010. See also Mark Carney, “Bundesbank Lecture 2010: The Economic Consequences of the Reforms,” speech to Deutsche Bundesbank, Berlin, 14 September 2010. K. Beaton, C. de Resende, R. Lalonde, and S. Snudden, “Prospects for Global Current Account Rebalancing,” Bank of Canada Discussion Paper 2010-4. See also Mark Carney, “Restoring Faith in the International Monetary Sysem,” speech to Spruce Meadows Changing Fortunes Round Table, Calgary, 10 September 2010. BIS central bankers’ speeches
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Remarks by Mr Jean Boivin, Deputy Governor of the Bank of Canada, presented to the Canadian Association for Business Economics, Kingston, Ontario, 23 August 2011.
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Jean Boivin: How people think and how it matters Remarks by Mr Jean Boivin, Deputy Governor of the Bank of Canada, presented to the Canadian Association for Business Economics, Kingston, Ontario, 23 August 2011. * * * It is always an honour for the Bank of Canada to be invited to CABE’s annual summer conference. I am especially pleased to find myself in the company of so many fellow economists. My remarks today will be about expectations – how people form them and how it matters for monetary policy. I will be talking about how we think we think. At some level, this might sound absurd. Don’t we actually know how we are thinking? This reminds me of a question once asked of me. While completing graduate school and looking for a job, I presented my dissertation at various institutions. The goal of my work at the time was to use historical data to document the behaviour of the Federal Reserve and how it had changed over time. On one occasion, after I had spent the better part of an hour explaining the brilliant methodology I was so proud of, someone asked, “Wouldn’t it have been easier to just go and ask Chairmen Greenspan and Volcker what they did?” This was meant as a joke – although I am not sure I laughed much at the time. Whether it would have been conceivable to question directly the Fed Chairmen, I don’t even know. I would have certainly loved to. But that was not the point. Although we obviously learn much by talking directly to people and get important colour, actions are the results of a very complex process – believe me, something I appreciate even more now – and we cannot hope to get a complete understanding of behaviour simply by asking. That’s why I needed to take a hard look at the actions themselves. This should resonate even louder in the context of today’s topic. As economists, we spend our professional lives trying to make sense of how the economy works. Ultimately, this understanding depends on how we think we think – and that’s not something we can fully understand by simply asking ourselves. My goal today is to paint a portrait of the uncertainty we have about how expectations are formed and discuss the implications for two current policy questions: the desirability of pricelevel targeting and the implications of financial imbalances for monetary policy. I will end with a few remarks about efforts to deal with the uncertainty surrounding expectation formation and ongoing challenges. Why are expectations so important for monetary policy? But the first question is: why are expectations so important to monetary policy? Economic outcomes are the result of people’s collective decisions and these decisions depend on how people think and what they expect the future to bring. For example, a decision to buy a house will depend on expectations of future income, what interest rates might be, and whether one thinks the real estate will increase or decrease in value. The price a firm sets and the wages it negotiates with employees are influenced by its expectations about the rate of inflation in the coming quarters. The future is inherently uncertain. Firms, individuals, families and policy-makers – all of us – form best guesses, or expectations, regarding events we are uncertain about. BIS central bankers’ speeches This means that current economic outcomes are determined by what people think the future will be, not necessarily by what the future will actually be. People will be right or wrong about the future, but what matters to their decision today is their perception of it. This perception can be fast changing, as recent developments in financial markets have once again made clear. A reassessment of the global economic outlook and a heightened degree of uncertainty contributed to the significant fall in equity prices and increase in overall market volatility of the past few weeks. But Keynes coined the term “animal spirits” to describe the emotional, non-purely logical state that influences our decision-making.1 With the unusual sequence of large drops and rebounds in capital markets in recent weeks,2 it is difficult to argue that fear and animal spirits were not also at play. Obviously, given that expectations determine the evolution of the economy, they matter for monetary policy. But it works both ways. Monetary policy also influences expectations. In fact, expectations management – or the expectations channel – is a powerful tool through which monetary policy can influence and stabilize the economy. What people think future policy will be influences their decisions and can have an important impact today. Through the adjustment of expectations, the monetary authority has the opportunity to better offset fluctuations in the level of output or inflation. This expectations channel of monetary policy has always been at work, but as its existence has become better appreciated, its influence might have become greater as well.3 We can see a clear illustration of its importance in the conditional commitment the Bank of Canada used during the financial crisis – one of three types of potential unconventional monetary policy tools at its disposal.4 In April 2009, the Bank stated that it would maintain the policy interest rate at 0.25 per cent from April 2009 to mid-2010, conditional on the outlook for inflation. This exceptional guidance provided additional monetary policy stimulus through greater certainty about the policy path and by influencing rates at longer maturities.5 The Federal Reserve used a similar device two weeks ago with the statement that interest rates are likely to remain at current levels through mid-2013. But the expectations channel can also seriously handicap policy if not managed properly. As research and experience have shown, policy makers cannot manipulate the economy by creating false expectations without damaging their credibility. And with impaired credibility, a central bank’s influence on the economy is seriously diminished.6 Keynes (1936). For instance, the Dow Jones Index dropped by 5.5 per cent and 4.6 per cent on 8 and 10 August, respectively, followed by pick-ups of 4.0 per cent and 3.9 per cent on 9 and 11 August. Woodford (2003) emphasized the importance of “managing” the public’s expectations through systematic monetary policy. Boivin, Kiley and Mishkin (2010) showed that changes in the behaviour of monetary policy in developed countries have anchored inflation expectations better and significantly changed the transmission of shocks to economic activity and inflation. Bank of Canada, Monetary Policy Report, April 2009. The Annex to this report describes the Bank of Canada’s approach to and the principles surrounding the conduct of monetary policy when the overnight interest rate is at the effective lower bound. Evidence suggests that the Bank of Canada’s forward-guidance lowered Canadian interest rates out the yield curve relative to what their historical relationship with inflation and unemployment rates would imply. See He (2010). Kydland and Prescott (1977); and Barro and Gordon (1983). For more recent contributions, see Clarida, Galí and, Gertler (1999); and Athey, Atkeson and Kehoe (2005). For a discussion of challenges involved in trying to build credibility in the early days of inflation targeting in Canada see Clinton and Zelmer (1997). BIS central bankers’ speeches This reciprocal dynamic between expectations and monetary policy is one of the most important insights of economic research of the past forty years. The successful achievement of monetary policy objectives helps to establish credibility and anchor inflation expectations. This credibility, in turn, gives the central bank greater scope and flexibility to stabilize the economy more effectively while keeping inflation expectations in line with monetary policy objectives. These insights are the cornerstone of Canada’s inflation-targeting regime. Since its adoption, well-anchored inflation expectations have allowed businesses, individuals and families to take a longer view in their planning, which has led to a better allocation of economic and financial resources and a more stable economy overall. Decision making and expectation formation So we know that expectations are crucial, but what do we know about how they are formed? Trying to understand better how we think is a timeless quest, spanning numerous disciplines such as philosophy, psychology, biology, neuroscience and political science, as well as economics. These all offer different perspectives and the picture that emerges confirms in some ways the obvious: decision making is an extremely complex process. It is in part about conscious rational calculations, but it is also about the unconscious influences of intuition, beliefs, perceptions and emotions. In recent years, important progress has been made in satisfying the rigorous part of our brains and providing scientific support for Keynes’ intuition on the importance of animal spirits. So what’s an economist to do? How do we form a view on how people think? A useful starting point has been rational expectations. As the name states, it’s based on the optimistic assumption that people are as sophisticated as they can possibly be – that they fully understand how economies and markets work, take into account all the information available, fully appreciate the future consequences of their actions today, and make decisions that are fully consistent with this understanding. Taken at face value, this might look like a completely crazy idea. The mere fact that we economists have jobs – and think that we play a useful role – contradicts rational expectations. After all, if everyone was so sophisticated in their understanding of how the economy works, why would the world need us? But, while crude and simplistic, the assumption of rational expectations is a useful and tractable way to capture two fundamental ideas. First, what people think about the future can affect their current decisions. Second, in the face of changing circumstances, people will not forever do the same thing expecting a different outcome, to paraphrase Einstein’s oft-cited definition of insanity. They will eventually adapt their behaviour to changing circumstances or policies. These insights have proven to be powerful7. As I discussed earlier, they make a compelling case for the importance of expectations for monetary policy and form the intellectual foundation of inflation targeting regimes around the world. But rational expectations should come with warning labels: “Handle with care.” “Keep away from children.” The concept was never meant to be taken literally and never should be. While useful for some policy issues, it can be a very misleading assumption for others. In trivializing the decision-making process, it leaves out elements that have the potential to overturn important policy prescriptions. For instance, they are the basis of both the Friedman (1968) and Phelps (1968) hypotheses on the absence of the long-run trade-off between inflation and real activity, and the Lucas critique (Lucas 1976). BIS central bankers’ speeches Researchers across disciplines have investigated various aspects of decision making that are not consistent with a literal and simplistic interpretation of rational expectations. Here are a few key examples. First, our conscious cognitive capabilities are limited. People are able to retain only a finite number of signals in their memory. Consequently, it may in fact be rational to ignore some types of information, or to be “rationally inattentive.”8 It also seems that these cognitive constraints may make us overreact or under-react to information depending on the general degree of uncertainty we perceive. Second, perceptions and emotions can play an important role, even in the most practical business decisions. For instance, price changes might appear unfair to consumers and they may experience regret, disappointment and anger when they occur. To avoid alienating its consumer base, a firm might take these fairness considerations into account in its pricing decision, even if that means sacrificing some short-term profits.9 Some would say that this is just good marketing. Third, dozens of unconscious tendencies and biases have been found to be “hardwired” into human behaviour. People often rely on a limited number of “heuristic” rules, or rules of thumb, to reduce a complex task of assessing probabilities of future events.10 These tendencies can lead us to: evaluate outcomes within a frame of reference or preexisting beliefs so that we see only what we want to see; react to the order in which information arrives or put too much weight on some particular piece; be impatient and put more weight on the present; be overconfident in the face of uncertainty; be subject to herd mentality and believe what we do simply because others believe it as well; have a preference for the status quo; or see patterns where there are none and mechanically extrapolate current outcomes and views into the future.11 To be clear, the issue is not whether these behaviours and tendencies are ultimately rational. For instance, some patterns of behaviour, even if unconscious, could represent automated responses that millions of years of evolution and adaptation have refined and perfected. Rather the issue is that, rational or not, how we think involves many dimensions that a stylized view might miss and these have key implications for monetary policy. Expectations and monetary policy issues For example, the way people form expectations has a significant impact on two issues that have been the subject of research at the Bank related to the renewal of the inflation-control target agreement between the Government and the Bank of Canada. These are the desirability of price-level targeting versus inflation targeting and the nexus between financial stability and monetary policy. Let me talk about price-level targeting first. The concept of “bounded rationality” (i.e., in making decisions, people are limited by the amount of information they have or can process, by the amount of time they need to make a decision or by other limitations of their minds) was introduced by Herbert Simon (1955) and further developed by Tversky and Kahneman (1974). See also Kahneman (2003). Sims (2010) reviews the literature on rational inattention. Kahneman, Knetsch and Thaler (1986); Akerlof and Yellen (1987); Rotemberg (2010, 2011). Tversky and Kahneman (1974). Hostile media effect: Vallone, Ross, and Lepper (1985); hyperbolic discounting: Ainslie (1992) and Laibson (1997); anchoring: Tversky and Kahneman (1974); confirmatory bias: Lord, Ross and Lepper (1979); overconfidence effect: Hoffrage (2004); bandwagon effect: Bikhchandani, Hirshleifer and Welch (1992); status quo bias: Samuelson and Zeckhauser (1988); primacy and recency effects: Luchins (1957). BIS central bankers’ speeches Research has shown that targeting the price level instead of the rate of inflation could help better stabilize the economy. Under price-level targeting, the monetary authority would commit to reverse deviations of the price level from its target path. If properly understood, firms should feel less compelled to change their price since they know that the effect of shocks on the price level will be reversed. Since prices do not move as much, smaller adjustments in production levels are required. In essence, what price-level targeting does is to make expectations act as a buffer against shocks, delivering lower volatility in both inflation and output.12 This could prove particularly useful in situations where deflationary forces cause the zero lower bound on the policy rate to bind. The promise that the effects of shocks pushing the price level below target will be reverted means that prices don’t have to fall as much today. The only way by which monetary policy can bring the price level back up to its target is by eventually injecting further monetary stimulus. The promise of bringing the price level back to target is thus equivalent to a promise of future monetary policy stimulus which helps to stimulate the economy today.13 Clearly, then, under price-level targeting, expectations do the heavy lifting. They serve as automatic stabilizers in response to shocks. But if people’s expectations do not adjust favourably, the edge of price-level targeting over inflation targeting diminishes.14 The success of a price-level targeting regime would depend on how quickly the public learns and adjusts its expectations and on the degree of credibility with which policy-makers can implement price-level targeting.15 Our understanding of behaviour and of expectation formation also has an impact on a second question that has come to the forefront in the aftermath of the crisis: to what extent does monetary policy have a role to play in supporting financial stability? A blind faith in purely rational expectations would tilt one towards the conclusion that monetary policy – and in fact most policies – would have a limited role in this regard. Asset prices should reflect all available information and the best decisions people could make given this information. Contracts should be designed optimally, reflecting a complete understanding of the consequences of the incentives at play. If expectations are assumed to be fully rational – while not impossible – it may be harder to see how bubbles could form. But, as the recent financial crisis made clear, various facets of human behaviour and decision making can contribute to the build-up of financial vulnerabilities. People show a tendency to forget the past and assume that the future will be like the present. Periods of stability could breed complacency, making us overconfident that good times are here to stay and generate an excessive appetite for risk. For a recent review of research on price-level targeting see Côté (2007); Amano et al. (2009); Ambler and Murray (2010). Krugman (1998), Svensson (2001), Egertsson and Woodford (2003), Lavoie and Murchison (2008), Murchison (2011). Amano and Shukayev (2010) provide an overview of implications of the zero bound on nominal interest rates for monetary policy. Price-level targeting leads to smaller welfare gains than inflation targeting if the fraction of backward-looking agents is larger than half, see Steinsson (2003); and Ambler (2009). Dorich (2009) provides a review of the literature estimating backward-looking rule-of-thumb price-setting behaviour. Kryvtsov, Shukayev and Ueberfeldt (2007) examine the desirability of switching to price-level targeting if imperfect credibility caused the private sector to be slow in adjusting their inflation expectations under the new policy regime. They find that when imperfect credibility lasts for more than 10 quarters, the cost of switching to price-level targeting outweighs the benefits. BIS central bankers’ speeches The existence of such patterns of behaviour reinforces the importance of proper regulatory and supervisory policies.16 After personal responsibilities of the borrower and the lender, these are the next lines of defence against the build up of financial imbalances. But we cannot rule out the possibility that monetary policy might also, in some circumstances, have a role to play. In fact, monetary policy could itself be a contributing factor. For instance, if people mechanically extrapolate the present into the future, or overweight the present in their risk assessment, low interest rates – or a perceived certainty around their future path – could generate excessive risk taking on the part of financial institutions or induce people to take on more debt than they should. These are some of the manifestations of what is known as the risk-taking channel of monetary policy.17 Policy makers are grappling with these and other issues, all of which are affected by the formation of expectations. What does it mean for policy? Faced with the uncertainty and complexity of decision making and our imperfect understanding of it, what should policy makers do? For a start, we need to embrace this uncertainty. We cannot be dogmatic. We need to take a broad perspective and make sure that our decisions are robust by choosing policies that would be desirable under different types of expectation formation. This is another important reason why monetary policy cannot simply follow mechanistic and simplistic rules. This is why various types of expectation formation mechanisms are explicitly included in our analysis at the Bank of Canada. We look at different surveys of expectations from forecasters and business owners. Also, one of our main policy models, ToTEM, allows for different types of expectation formations – incorporating both forward-looking expectations and alternative types as well.18 We also need to push our understanding of decision making further. This requires that insights and tools from the other disciplines that study the human brain and its decisionmaking processes from different perspectives be more integrated in our economic research and policy analysis. In that spirit, Bank researchers have recently been drawing on the growing field of experimental economics to investigate more directly how people’s expectations behave and adapt under different policy regimes. Simulations that replicate key features of the Canadian economy have allowed us to observe how people’s expectations change when we tweak some aspects of the environment. For instance, in one set of experiments, we looked at how inflation expectations would change if monetary policy evolved from inflation targeting to price-level targeting. The results suggest that expectations do adapt to a change in regime. However, the subjects’ behaviour revealed only incomplete understanding of the implications of price-level targeting.19 These experiments constitute a useful starting point and can be Macklem (2011) reviews G-20 efforts and achievements toward a more resilient financial system and the challenges related to oversight and regulation. Carney (2010) discusses the factors that have led to a low interest rate environment in major advanced economies and the implications for financial stability and economic growth. Borio and Zhu (2008) discuss the need to incorporate the risk-taking channel in monetary policy analysis, including that of extrapolative expectations. Sims (2008) argues that rational inattention and differences of opinion in expected inflation can generate excess investment in real capital. See also Adrian and Shin (2009). ToTEM is the Bank of Canada’s principal projection and policy-analysis model for the Canadian economy. It is a medium-scale, open-economy, dynamic-stochastic general-equilibrium (DSGE) model with multiple goods. See Murchison and Rennison (2006); and Dorich, Mendes, and Zhang (2011). Amano, Engle-Warnick and Shukayev (2011). BIS central bankers’ speeches extended to investigate many more questions, including how central bank communications influence people’s decisions or the tendency people have to extrapolate the present into the future. Conclusion I would like to conclude with the following observation. I have argued that the uncertainty we have about how we think has important policy implications. But we should not forget a fundamental lesson from rational expectations. The way we think is not set in stone. People learn and eventually adapt. Even if people are constrained by their cognitive ability and a hardwired need for simple rules of thumb, effective communication and greater common knowledge can override some unconscious biases; make it possible to switch to still simple, but better, rules of thumb; learn more quickly; make more informed decisions; and, ultimately, reach better outcomes. A better understanding of expectation formation and effective communications can positively reinforce each other. This is not only true for monetary policy, but for decision making in general. This is why, even though I am not sure how you think, I’m sure you expect me to be done just about now. And you are right. Thank you. References Adrian, T. and H. S. Shin. 2009. “Money, Liquidity, and Monetary Policy.” Federal Reserve Bank of New York Staff Report No. 360. Ainslie, Gorge W., “Picoeconomics,” Cambridge, UK: Cambridge University Press, 1992. Akerlof, George A & Yellen, Janet L, 1987. “Rational Models of Irrational Behavior,” American Economic Review, American Economic Association, vol. 77(2), pages 137–42, May. Amano, R., T. Carter, and D. Coletti. 2009. “Next Steps for Canadian Monetary Policy.” Bank of Canada Review, Spring. Amano R. and M. Shukayev. 2010. “Monetary Policy and the Zero Bound on Nominal Interest Rates.” Bank of Canada Review, Summer. Amano R., J. Engle-Warnick, and M. Shukayev. 2011. “Price-Level Targeting and Inflation Expectations: Experimental Evidence,” Forthcoming Bank of Canada working paper. Ambler, S. 2009. “Price-Level Targeting and Stabilization Policy: A Review.” Bank of Canada Review, Spring. Athey, S., A. Atkeson, P. Kehoe. 2005. “The Optimal Degree of Monetary Policy Discretion,” Econometrica 73 (5), September, 2005, 1431–1476. Barro, Robert J.; Gordon, David B. (1983). “A Positive Theory of Monetary Policy in a Natural Rate Model”. Journal of Political Economy 91 (4): 589–610. Bikhchandani, Sushil; Hirshleifer, David; Welch, Ivo (1992). “A Theory of Fads, Fashion, Custom, and Cultural Change as Informational Cascades”. Journal of Political Economy 100 (5): 992–1026. Boivin, J., M. Kiley, F. Mishkin, How Has the Monetary Transmission Mechanism Evolved Over Time? In: Benjamin M. Friedman and Michael Woodford, Editor(s), Handbook of Monetary Economics, Elsevier, 2010, Volume 3, Pages 369–422. Borio, C. and H. Zhu. 2008. “Capital regulation, risk-taking and monetary policy: a missing link in the transmission mechanism?” BIS Working Paper No 268. BIS central bankers’ speeches Carney, Mark. 2010. “Living with Low for Long,” Remarks at Economic Club of Canada, 13 December 2010, Toronto, Ontario. Clarida, G., J. Gali and M. Gertler (1999), “The Science of Monetary Policy: A New Keynesian Perspective,” Journal of Economic Literature, American Economic Association, 37(4), 1661–1707. Clinton, K. and M. Zelmer. 1997. “Constraints on the Conduct of Canadian Monetary Policy in 1990s: Dealing with Uncertainty in Financial Markets,” Technical Reports 80, Bank of Canada. Côté, A. 2007. “Price-Level Targeting.” Bank of Canada Discussion Paper No. 2007–8. Dorich, J. 2009. “Forward-looking versus backward-looking behavior in inflation dynamics: a new test.” Bank of Canada manuscript. Dorich, J., Mendes, R. and Y. Zhang. 2011. “Introducing Multiple Interest Rates in ToTEM.” Bank of Canada Review, Summer 2011. Eggertsson, G. and M. Woodford. 2003. “The Zero Bound on Interest Rates and Optimal Monetary Policy.” Brookings Papers on Economic Activity 1: 139–211. Friedman, Milton. 1968. “The Role of Monetary Policy”. American Economic Review (American Economic Association) 58: 1–17. He, Z., “Evaluating the Effect of the Bank of Canada’s Conditional Commitment Policy” (Discussion Paper No. 2010–11, Bank of Canada, 2010). Hoffrage, Ulrich (2004), “Overconfidence”, in Rüdiger Pohl, Cognitive Illusions: a handbook on fallacies and biases in thinking, judgement and memory, Psychology Press. Kahneman, Daniel (2003). “Maps of bounded rationality: psychology for behavioral economics”. The American Economic Review 93 (5): 1449–75. Kahneman, Daniel, Jack Knetsch, and Richard Thaler (1986). “Fairness as a Constraint on Profit: Seeking Entitlements in the Market.” American Economic Review, 76, 728–741. Keynes, John M. The General Theory of Employment, Interest and Money, London: Macmillan, 1936, pp. 161–162. Krugman, Paul R. 1998. “It’s Baaack: Japan’s Slump and the Return of the Liquidity Trap,” Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 29(2), pages 137–206. Kryvtsov, O., M. Shukayev and A. Ueberfeldt. 2008. “Adopting Price-Level Targeting under Imperfect Credibility: An Update.” Bank of Canada Working Papers 08–37. Kydland, Finn E & Prescott, Edward C, 1977. “Rules Rather Than Discretion: The Inconsistency of Optimal Plans,” Journal of Political Economy, University of Chicago Press, vol. 85(3), pages 473–91, June. Laibson, D., 1997. “Golden eggs and hyperbolic discounting,” Quarterly Journal of Economics 112, 443–478. Lavoie, C. and S. Murchison. 2008. “The Zero Bound on Nominal Interest Rates: Implications for Monetary Policy,” Bank of Canada Review, Winter 2007–2008. Lord, Charles G.; Ross, Lee; Lepper, Mark R. (1979), “Biased assimilation and attitude polarization: The effects of prior theories on subsequently considered evidence”, Journal of Personality and Social Psychology (American Psychological Association) 37 (11): 2098–2109. Lucas, Robert Jr, 1976. “Econometric policy evaluation: A critique,” Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 1(1), pages 19–46, January. Luchins, Abraham S. The Order of Presentation (1957) Hovland, C. I. New Haven: Yale University Press. BIS central bankers’ speeches Macklem, T. 2011. “Global Financial Reform: Maintaining the Momentum,” Remarks at the G-20 Workshop, 7 July 2011, Paris, France. Murchison, S. 2011. “Consumer Price Index Targeting,” forthcoming Bank of Canada Working Paper. Murchison, S. and Andrew Rennison (2006), “ToTEM: The Bank of Canada’s New Quarterly Projection Model,” Bank of Canada Technical Report No. 97. Murray, John. 2010. “Re-examining Canada’s Monetary Policy Framework: Recent Research and Outstanding Issues,” Remarks at Canadian Association for Business Economics, 24 August 2010, Kingston, Ontario. Phelps, Edmund S. (1968). “Money-Wage Dynamics and Labor-Market Equilibrium”. Journal of Political Economy (Chicago University Press) 76: 678–711. Rotenberg, Julio. 2010. “Altruistic Dynamic Pricing with Customer Regret,” Scandinavian Journal of Economics, 112 (4), pages 646–672, December. –––. 2011. “Fair Pricing.” Harvard Business School Working Paper. Samuelson, W. & R. J. Zeckhauser. (1988). Status quo bias in decision making. Journal of Risk and Uncertainty, 1, pp. 7–59. Simon, H. A. (1955). A behavioural model of rational choice. Quarterly Journal of Economics, 69, 99–118. Sims, Christopher A. Rational Inattention and Monetary Economics, In: Benjamin M. Friedman and Michael Woodford, Editor(s), Handbook of Monetary Economics, Elsevier, 2010, Volume 3A, Pages 155–181. Sims, Chris. 2008. “Inflation expectations, uncertainty and monetary policy,” BIS Working Paper No 275. Steinsson, Jon, 2003. “Optimal monetary policy in an economy with inflation persistence,” Journal of Monetary Economics, Elsevier, vol. 50(7), pages 1425–1456, October. Svensson, L. 2001. “The Zero Bound in an Open Economy: A Foolproof Way of Escaping from a Liquidity Trap.” Monetary and Economic Studies 19 (Special edition): 277–312. Tversky, A. & Kahneman, D. (1974). Judgment under uncertainty: Heuristics and biases. Science, 185, 1124–1130. Vallone, R.P., Ross, L., & Lepper, M.R. (1985). The hostile media phenomenon: Biased Perception and Perceptions of Media Bias in Coverage of the “Beirut Massacre”. Journal of Personality and Social Psychology, 49, 577–585. Woodford, M., 2003. Interest and prices. University Press, Princeton, NJ. BIS central bankers’ speeches
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Remarks by Mr Timothy Lane, Deputy Governor of the Bank of Canada, to the Society for Worldwide Interbank Financial Telecommunication Annual Sibos Conference, Toronto, Ontario, 19 September 2011.
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Timothy Lane: Curbing contagion – options and challenges for building more robust financial market infrastructure Remarks by Mr Timothy Lane, Deputy Governor of the Bank of Canada, to the Society for Worldwide Interbank Financial Telecommunication Annual Sibos Conference, Toronto, Ontario, 19 September 2011. * * * Introduction Good afternoon and, to our guests from abroad, welcome to Canada. This conference is taking place at a troubled time. Concerns over sovereign debt have intensified, particularly in Europe’s periphery. Economic growth in the United States and other advanced economies now appears to be significantly weaker than expected. In the face of these developments, there has been mounting skepticism in a number of countries over whether policy-makers will be able to do what it takes to address these problems. The current bout of turbulence, like the financial crisis of three years ago, serves as a reminder of why it is fundamentally important to have a resilient financial system. Periods of market turbulence are a fact of life. In a resilient system, financial shocks are absorbed, creating losses for individual investors, but leaving the system intact. If the system is not sufficiently resilient, however, shocks can be amplified. We saw this in 2008, when losses in a relatively small segment of the U.S. housing market cascaded into a near-meltdown of the global financial system. That process reflected a mixture of frailties – excessive leverage, reliance on forms of liquidity that proved illusory in stressful times, the use of securitized products with risks that were not fully understood, the complex web of counterparty relationships that spread risk and bred fear in core funding markets, and the absence of resolution mechanisms to deal with insolvency in systemically important institutions without endangering the entire system. In the wake of that crisis, leaders of the G-20 countries launched a broad agenda of reforms. These reforms aim to ensure that financial institutions have adequate levels of lossabsorbing capital and liquidity to cope with periods of market stress; to establish robust financial market infrastructure; and to develop stronger resolution mechanisms for financial institutions, particularly across borders. When implemented, the G-20 reforms will create a more resilient global financial system. Canada will benefit significantly from these reforms. Even though our financial system performed much better through the crisis than those of many other advanced countries, we are certainly not immune to events beyond our borders. In my talk this afternoon I want to focus on one element of the G-20 reform agenda: building robust financial market infrastructure. That infrastructure includes a number of components: payment and securities settlement systems, trading venues and exchanges, information and price providers, and collateral management systems. For the most part, these key elements not only functioned well during the crisis, they were in fact a source of strength. Just after the onset of the crisis, the CLS Bank, which settles foreign exchange transactions, successfully processed roughly three times its normal daily volume of transactions; and CDSX, which clears and settles trades in Canadian-dollar-denominated debt securities, handled double its normal volume. Efficient clearing and settlement systems such as these were able to perform a stabilizing role during the crisis. That is exactly what they were intended to do. The crisis did, however, illuminate some key areas in which financial market infrastructure needed to be broadened and put to better use. Here, I am talking about expanding the use of central counterparties or CCPs to replace bilateral clearing and settlement for a number of core markets. In my presentation today I am going to review how bilateral clearing contributed to contagion during the financial crisis, describe why greater use of resilient BIS central bankers’ speeches financial infrastructure is needed and tell you how CCPs will strengthen the financial system. CCPs are of particular interest to us at the Bank of Canada because we are responsible for overseeing systemically important financial infrastructure that affects the stability of the Canadian financial system and, therefore, the health of the economy. What happens when robust market infrastructure is not in place? During the crisis, we had two stark illustrations of why greater use of financial infrastructure is needed. The crisis did not start or end with the following shortcomings in bilateral clearing and settlement, but they were channels through which problems in an obscure part of the U.S. housing market cascaded into a global crisis. Although these are familiar stories, they illustrate the need for change. One instance is the near-failure of Bear Stearns. Bear Stearns wasn’t one of the largest investment banks in the United States, but it was one of the most leveraged, with large broker-dealer and proprietary operations. It played a pivotal role in the global repo market, holding collateral for transactions and acting as a counterparty for repo financing. When the firm’s mounting losses, extensive leverage and reliance on potentially unstable short-term funding markets threatened to cause its failure, there was a risk that Bear Stearns’ collapse would cause serious disruptions in the repo market – a core funding market. Anticipations of disruptions in Bear Stearns’ operations led cash investors and collateral providers alike to withdraw, initiating a process of leverage reduction through asset sales. Funding conditions for collateral providers deteriorated sharply, and the liquidity and efficiency of related markets were severely affected. In the event, Bear Stearns was rescued and the immediate threat averted, but the danger was real. A second instance is related to Lehman Brothers and its role as a counterparty in myriad bilaterally settled over-the-counter (OTC) derivatives transactions. Lehman’s default and the doubts it raised about the viability of the few remaining investment dealers struck at the heart of both the funding and the OTC derivatives market. The strains broadened to a general evaporation of market liquidity and a retrenchment from risk. In both cases, a basic problem was counterparty risk associated with financial contracts that are cleared and settled bilaterally. Holders of such bilaterally cleared repos and OTC derivatives were exposed not only to the market risk associated with the position taken in the financial instruments themselves, but also the risk that their counterparty would be unable to honour its commitment. Counterparty risk became a key channel of contagion, posing a major threat to the global financial system. In contrast, some of Lehman’s derivatives, notably interest rate swaps valued at $9 trillion, were cleared through a CCP, which successfully managed the impact of Lehman’s failure. What are the objectives for reform? At the Pittsburgh Summit, the G-20 leaders moved to put the lessons learned from the crisis into practice. Specifically, they called for all standardized OTC derivatives to be centrally cleared and, where appropriate, traded on exchanges or electronic trading platforms. In addition, all trades, whether centrally cleared or not, are to be reported to trade repositories.1 Efforts are under way in a number of countries, including Canada, to establish arrangements for clearing interest rate swaps and other OTC derivatives that were not previously centrally cleared. In Canada, we are also developing a new CCP for repo and fixed-income transactions. http://www.g20.org/Documents/pittsburgh_summit_leaders_statement_250909.pdf BIS central bankers’ speeches These reforms will have far-reaching effects on global and Canadian financial markets. The move to CCPs is intended to reduce the complexity of the network and enhance netting efficiencies, and to establish robust risk management practices and clear default procedures. Since CCPs – which interpose themselves between buyer and seller in financial markets – concentrate risk by becoming the counterparty to all transactions, they must have stringent risk-management standards. The use of sufficiently robust CCPs is likely to increase the strength of the financial system. It will also reduce the counterparty credit exposures of major participants, which will be reflected in capital requirements for financial institutions. To be safely cleared the contracts that CCPs process must, at a minimum, be sufficiently standardized. And the push to standardize OTC derivatives contracts will have important ancillary benefits for how these markets function. Standardization will create more liquid, transparent and efficient markets for the contracts. It will also help set the stage for shifting trading onto exchanges or electronic trading platforms. The challenges of the G-20 reforms The G-20 objectives are necessary and appropriate, but achieving them is going to be challenging, for several reasons. First, they may require the development of new CCP services, a complex and timeconsuming process. We are experiencing this in Canada in connection with the work now underway to build a CCP for repos and fixed-income transactions. The Canadian industry selected the Canadian Derivatives Clearing Corporation (CDCC) to develop this facility. The process of creating a CCP for repos in Canada, although not yet complete, has been instructive. Two fundamental requirements are that the CCP has adequate and robust riskcontrol systems and the capacity to implement them. Operational issues, such as developing and testing the relevant software – both for the CCP and its participants – and its interaction with existing systems, also take time to resolve. The challenges of establishing a CCP for repos are considerable. But at least the overall parameters are clear. Fulfilling the G-20 commitments on OTC derivatives is a more complex task, requiring coordination among many stakeholders, with a wide range of possible outcomes. The complexity of clearing OTC derivatives Central clearing of OTC derivatives transactions will reduce systemic risk by decreasing the likelihood that one failing institution will bring down others. But, given the globalized nature of the industry, there are several ways to make the transition to CCPs. Clearing could take place on large international CCPs serving the global market (such as ICE Clear, CME or LCH.Clearnet), or new central clearing services could be established in individual countries.2 We are seeing a variety of arrangements emerging. In some countries, such as Japan and Singapore, new central clearing services are under development. Other countries are likely to rely on offshore CCPs or – as in Canada – are still evaluating their options. The task before us is to ensure that this emerging configuration of CCPs achieves a significant reduction of systemic risk, both at the global level and for Canada. The G-20 commitment sets a very tight timetable for developing a strategy to meet this challenge. The selection of an appropriate CCP strategy for OTC derivatives is a particularly important issue for Canadian market participants and regulators. To put it in perspective, Canadian- Five Canadian banks currently qualify to be direct participants in LCH.Clearnet, the primary CCP for interest rate swaps. And interest rate swaps are the most important OTC derivatives products in the Canadian market. BIS central bankers’ speeches dollar OTC derivative contracts have a notional outstanding value of just under $9 trillion. Moreover, OTC derivatives, especially interest rate swaps, are closely connected via arbitrage and financing relationships with other financial markets in Canada, including other derivative, bond and money markets. That’s big enough and connected enough that any disruptions would likely result in significant reverberations throughout our markets. At the same time, these derivatives markets are innately global: for example, over half of the trading in Canadian-dollar interest rate products involves at least one party that is not a resident of Canada; and Canadian-dollar OTC derivatives products are only about 2 per cent of the global market. Whatever solution we adopt must come to grips with both of these realities – the systemic importance of OTC derivatives to Canada and the globalized nature of the market. Large offshore CCPs serving multiple markets Given the globalized nature of the market, clearing through large offshore CCPs has important advantages. These CCPs can benefit from economies of scale and, potentially, provide greater scope for netting and risk mutualization. A key concern, however, is access. Until recently, access was limited to the largest financial institutions with global reach. Access is now is being broadened, but the global dealers – the so-called “G-14” – have considerable entrenched advantages in settlement costs. Those institutions that do not have direct access to offshore CCPs would have to clear indirectly through one of the direct clearing members. The primary rationale for restricting access is risk control. Direct clearing members of a CCP are required to share the losses and take over positions in the event that another member fails – which requires that they have large financial resources and a wide scope of activities. But here lies an important challenge. In carrying out the G-20 mandate requiring all OTC derivatives to be centrally cleared, it is essential to ensure that we do not unduly concentrate risk in a relatively small number of institutions that are direct clearing members of global CCPs. These were the very institutions that spread and amplified contagion through the global financial system in 2008. This potential concentration of risk has several dimensions. First, if one of the direct clearing members fails, that poses risks to the CCP and to the other direct clearing members. Second, the failure of one of these large institutions would pose risks to institutions that clear indirectly through it. Third, the offshore dealers may be able to use their dominance in direct clearing to heighten their competitive edge in other financial market activities, such as trading and other investment banking services. That, in turn, could lead to greater concentration of business, and of risk, across a whole range of activities. So if we are going to rely on central clearing through large offshore CCPs, direct access has to be broadened in a manner compatible with ensuring that these CCPs have robust risk controls. Indeed, financial market infrastructure standards are now being revised to ensure that CCPs and their members can withstand such shocks. There is also a need to ensure that indirect clearing is safe and efficient. Here, a key priority is to ensure that these indirect clearers’ positions are protected through appropriate segregation of collateral and portability of positions in the event that the direct clearer fails. The Bank of Canada is working at the international level, in co-operation with our colleagues at other Canadian agencies, to design measures for the safe and effective use of offshore CCPs no matter where they are located. BIS central bankers’ speeches Domestic CCPs While offshore CCPs may be a suitable choice for some jurisdictions, a few countries have decided to develop their own CCPs, particularly for products that can have important repercussions on their domestic financial systems. So what would be the advantage of building a Canadian CCP to clear OTC Canadian-dollar interest rate derivatives? First and foremost, it would be more straightforward for Canadian authorities – including the Bank of Canada – to exercise our responsibilities for overseeing systemically important financial infrastructure if a CCP were located in Canada. We would also be better placed to manage a crisis and provide emergency liquidity support for a Canadian CCP should that be necessary. While cooperative arrangements for oversight and crisis management of offshore CCPs can be developed, and are currently being discussed at the international level, this work is still in progress. Such arrangements will need to be adequate to enable the Bank to fulfill its responsibilities for overseeing and safeguarding the stability of the Canadian financial system. A domestic CCP could offer other advantages as well. It could, in some situations, reduce – although certainly not eliminate – the impact on Canadian markets of financial shocks from abroad. It could be tailored to the needs of the Canadian financial system and support the development of market expertise and innovation. The key questions are whether a domestic CCP would be economically viable and whether it would support financial stability and efficiency. We know that much of the OTC market is global in nature and that, for a Canadian clearing service for OTC interest rate swaps to be a success, wide participation of both Canadian and global firms is necessary. Without that, the market could become fragmented, market liquidity could decline and the domestic CCP’s own risk controls could be undermined. Yet another key question is whether a domestic CCP would adequately address the clearing needs of Canadian financial institutions. As a related point, a Canadian CCP would need to be reasonably cost-effective; otherwise it could push transactions offshore, undermining its potential benefits. Developing links between CCPs in different jurisdictions could help to minimize fragmentation of the market. But establishing such links would be a complicated undertaking, and risk within the links would have to be properly managed. In practice, while a few CCP links exist and are in operation (for cash markets, in particular), there is not yet a generally accepted model that could be used for the establishment of links among CCPs clearing trades in OTC derivatives. In assessing the best clearing strategy for Canadian OTC derivatives, the Bank of Canada is moving forward on two fronts. First, we are working with our domestic and international counterparts to ensure that global CCPs, particularly those of systemic importance to Canada, are able to deliver the intended benefits of financial stability. Second, we are actively exploring the possibility of developing a Canadian-domiciled CCP, in collaboration with the financial industry and other public policy institutions. We must choose the arrangements that best support the stability and efficiency of Canada’s financial system. Conclusion We are in the midst of an enormous financial regulatory transformation, easily the most sweeping set of reforms in 70 years. Not only are the issues complex, they present crossborder challenges that must be addressed at both the global level and in Canada. The Bank supports the objectives of the G-20 reform agenda. Reform is critical if we are to prevent a crisis similar to that of 2008 from occurring. However, we must be alert to the risk of unintended consequences. At the Bank of Canada, we are working actively, both here and internationally, to ensure that the proposed reforms to the global and domestic financial infrastructure substantially improve the functioning of the financial system and significantly reduce systemic risk. BIS central bankers’ speeches
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Remarks by Mr Mark Carney, Governor of the Bank of Canada, to the Saint John Board of Trade, Saint John, New Brunswick, 20 September 2011.
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Mark Carney: Recent economic developments Remarks by Mr Mark Carney, Governor of the Bank of Canada, to the Saint John Board of Trade, Saint John, New Brunswick, 20 September 2011. * * * Introduction It is a pleasure to be here in Saint John. When I got up this morning, things had changed. For the first time, there was that sense of the turn in the seasons. It is fitting, of course, with the autumn equinox this week, but looking at the calendar doesn’t dispel that wistful feeling: where did summer go? Instead of looking forward to a string of lazy, hazy days, we face the touch of frost in the air ... and the smell of fear in financial markets. Canadians entered the summer brimming with confidence. Expecting strong sales, our businesses were full of plans to add jobs and invest in plant and equipment. Canadians themselves had a very positive view of their economic prospects. Now, in the face of alarming events abroad, some are less sure. What happened? And how should the public and private sectors respond? What happened? The fear currently dominating global financial markets has three causes: the deterioration in the global economic outlook, the intensification of the European sovereign debt crisis and growing questioning of the ability of policy-makers to respond. High government debt leaves the Euro area extremely vulnerable to changes in global growth prospects and investor sentiment. These challenges are compounded by the nature of European monetary union, which demands prolonged deflationary adjustments in countries that have lost competitiveness. The most immediate concern is growing funding pressures on European banks. Most have seen their costs of borrowing rise sharply, their access to important financial markets curtailed, and their equities trading at historic lows relative to the value of their assets. If not quickly reversed, this situation could create a damaging negative feedback loop among the banks, lending and the real economy. This would occur at a time when the European economy – the largest in the world – is already slowing dramatically. While the immediate concern is about banks, the broader issues are the fiscal and competitive positions of a number of countries. Most European governments have little choice but to reduce their budget deficits, despite weak private demand (Chart 1). Ultimately, Europe’s problems cannot be solved by fiscal austerity alone. Any durable solution must include a series of measures to rebuild competitiveness. For example, Spain runs a 4 per cent current account deficit despite its depressed economy, and Greek unit labour costs have risen by a third relative to Germany’s since the start of the European monetary union. In the short term, the problems in Europe are being compounded by slowing global growth. In particular, the U.S. economy has lost momentum. BIS central bankers’ speeches Recent benchmark revisions show that the U.S. recession was deeper and its recovery has been shallower than previously reported. What we learned over the summer does not suggest that the dynamics currently affecting the U.S. economy have changed, just that the magnitudes are much larger. In short, the housing market remains a mess, the consumer is weak, and government actions can be expected to reduce growth after materially boosting it in recent years. American households have experienced a major shock to their net worth, which has fallen from a peak of 6.4 times income pre-crisis to 5.0 in the second quarter of this year (Chart 2). These losses can only be recovered through a combination of increased savings and rising prices for houses and financial assets. Each will clearly take time. Overall, the United States is in the midst of the weakest recovery since the Great Depression, and the Bank does not expect that to change at any time soon (Chart 3). In fact, the U.S. economy is tracking exactly the dreary path of other advanced economies that have experienced major financial crises. BIS central bankers’ speeches The Bank expects the U.S. economy to continue to grow at or below its trend rate of around 2 per cent until the second quarter of 2012. This reflects a combination of modest growth in consumption, the beginnings of fiscal drag, solid business investment in equipment and software, and relatively strong export growth. These last two factors will of course be importantly influenced by global developments. At this stage, the Bank of Canada does not expect a recession in the United States, although the risk has clearly risen. The U.S. economy is close to stall speed, where a negative feedback loop between weak employment, consumer demand, and business hiring and investment could emerge. The possibility that markets themselves could tip the balance cannot be dismissed. Further declines in the value of financial assets could encourage higher savings and discourage corporate investment, and it remains possible that credit conditions for American firms could tighten materially. What does this mean for Canada? The direct impact of weaker European growth on Canada is relatively modest. However, the financial and confidence effects could be considerable. In response to uncertainties in Europe, global equity and commodity prices have fallen significantly, and financial market volatility has increased markedly. The spillovers to Canadian financial markets have been less pronounced but are still notable. Overall financial conditions have tightened in Canada, largely due to declines in equity values. Importantly, our financial system continues to work well. Our banks have virtually unmatched access to funding and capital; credit to Canadian households and businesses remains widely available at historically low rates. The direct impact of a renewed slowdown in the United States, our largest trading partner, is more material. Moreover, the U.S. slowdown has further hit activity in sectors, such as autos and housing, that matter for Canada. To put this into perspective, consider that if this had been an average U.S. recovery, U.S. GDP would be 2.5 per cent higher and Canadian exports would be 6.5 per cent greater, equivalent to $30 billion in additional sales (Chart 4). But this is not an average recovery and, now, the considerable external headwinds our economy has faced in recent years are blowing harder. Net exports are now expected to remain a major source of weakness, reflecting more modest global demand and ongoing competitiveness challenges, in particular the persistent strength of the Canadian dollar. BIS central bankers’ speeches It is worth remembering that reduced competitiveness typically means higher penetration of imports into Canada. The ratio of imports to GDP has risen 7 percentage points over the past decade. There is also some good news: over the same period, an increasing proportion of our imports is for investment purposes, rather than consumption. This indicates that an increasing share of Canada’s imports is adding to the capital stock, rather than simply being consumed (Chart 5). This will need to continue. The Bank expects that growth will resume in the second half of this year, led by business investment and household expenditures, although lower wealth and incomes will likely moderate the pace of investment and consumption growth. Slower global economic momentum will dampen domestic resource utilization and inflationary pressures. The Bank expects total CPI inflation to continue to moderate as temporary factors, such as significantly higher food and energy prices, unwind. Core inflation is expected to remain well contained as the growth of labour compensation stays modest, productivity recovers, and inflation expectations remain well anchored. The risks to our economy remain largely external and are skewed to the downside. BIS central bankers’ speeches What then must be done? The debt-ceiling fiasco in the United States and the inability, to date, of European policymakers to get ahead of their crisis have reduced investor confidence in the effectiveness of policy. The combination of high debt loads and unpredictable politics is toxic. Still, it is important to distinguish between the willingness to act and the ability to address the current challenges. There is much that policy can do. The European situation is fragile but fixable; manageable if it is managed. The European Central Bank stands ready to supply virtually unlimited liquidity to European banks. This should prevent the sort of dramatic liquidity events we saw in 2008, but it is not a cure. Banks in these situations become highly defensive. The lesson of Japan in the 1990s is that once such behaviour starts, it is hard to reverse. The point of central bank efforts is to create a bridge. The follow-up actions must be swift and sizeable. European authorities need to move decisively to contain the crisis. Measures taken must draw private capital back in, rather than merely fund its exit. Actually implementing announced measures will start to rebuild confidence. Enhancements to existing European funding facilities should be put in place. Financial reforms, including Basel III capital measures, should be implemented in a timely fashion. Paths for sustained fiscal consolidation should be established, consistent with the agreement reached at last year’s G-20 Summit in Toronto. But more is required. In the Bank of Canada’s opinion, what is needed now is a comprehensive capital plan for European banks, and crucially, a sizeable funding backstop for European sovereigns. The reality is that the best commitments and even the most binding legislation will not restore investor confidence overnight. As Canada learned in the mid-1990s, countries need to build a sustained track record of tangible results in order to rebuild trust. Similarly, structural policies to enhance growth have a long pay back. Thus, European authorities must create time to re-found their monetary union based on credible fiscal arrangements and more flexible economies that can adjust quickly to inevitable shifts in internal European competitiveness. In our opinion, the existing European resources, including the European Financial Stability Facility and the European Central Bank facilities, can be used much more efficiently to create a multi-year window for these adjustments. Just as demand must be rebalanced in Europe between countries with current account deficits, such as Spain, and those with surpluses, such as Germany, so too must it adjust globally. Under current policies, large current account imbalances can be expected to persist. Continued reliance on domestic demand in advanced economies promises disappointment. As we have seen in recent weeks, the hand-off from the public to the private sector in the United States and Europe is in danger of being fumbled. Fiscal consolidation has begun, without autonomous private demand picking up the slack because of unresolved fragilities and a barrage of negative shocks. Rebalancing demand across economies will require the implementation of comprehensive financial reforms; open trade and capital markets; and significant changes to fiscal, structural and exchange rate policies across a broad range of countries, including major emerging markets. When the G-20 meets later this week in Washington and next month in Paris, these issues must be at the centre of the agenda. In the face of this difficult external environment, the Bank will continue to support Canada’s economic expansion by keeping inflation low, stable and predictable. Since the crisis erupted four years ago, the Bank has demonstrated its nimbleness in the conduct of monetary policy. We reacted quickly and forcefully during the downturn. As the BIS central bankers’ speeches Canadian recovery has progressed, we have emphasised that we would be prudent with respect to the possible withdrawal of any degree of monetary stimulus. The Bank always takes a flexible approach. Our decisions are guided by considered analysis and informed judgment rather than mechanical rules. For example, as we have emphasised, given current material headwinds, the policy rate can return to its long-run level after inflation is projected to reach the 2 per cent target and output is projected to reach its potential. The Bank also exercises considerable flexibility with respect to the time horizon over which inflation should be expected to return to target. In general, both the size and nature of the shocks that hit our economy can have a bearing on the appropriate targeting horizon. Over the last 20 years, the persistence of the effects of the shocks on the economy has been such that it was typically desirable to return inflation to target over a period of six to eight quarters. However, there has been considerable variation in this horizon from as short as 2 quarters to as long as 11 quarters.1 On at least eight occasions, the Bank has extended the targeting horizon beyond eight quarters. It did so most recently in April 2009, when returning inflation to target over a longer period was warranted, given the unusually large shock confronting the Canadian economy at the time. Just as we do not have mechanical rules for the path of policy rates, we do not outsource our monetary policy to the U.S. Federal Reserve. What happens in the United States obviously matters for Canada, but this does not mean that our rates are tied to those of the Americans. Over the two decades of inflation targeting, the overnight rate in Canada has been more than 200 basis points above, and more than 200 basis points below, the Federal funds rate. These variations reflect differences in our respective economic outlooks. Canadian monetary policy will be appropriate to Canadian circumstances and consistent with achieving price stability in Canada. Canadians can also be assured that the Bank will take the necessary steps to ensure that core financial markets remain liquid and operating. In the event of a major systemic shock, the Bank has a wide range of tools to provide exceptional liquidity, consistent with a principles-based framework. This will help ensure that all Canadians benefit from the strength of our financial system, in bad times as well as good. While we experience the fallout of events in Europe and the United States, Canada should also draw the lessons from these experiences. The European sovereign crisis reinforces the importance of sustainable government debt and the value of a flexible exchange rate. American difficulties underscore the risks of excessive household debt. Should you wait out the storm? Financial markets appear paralysed. You shouldn’t be. These events are like the waves on the sea. The underlying currents – those forces that affect the long-term outlook for our businesses and economy – are much stronger. Today, the charts reveal three major currents: Canadian firms are underexposed to the fastest growing parts of the global economy; commodity prices can be expected to remain elevated relative to historic averages; and our firms are not as productive as they could or need to be. Regardless of what happens in the United States or Europe, these challenges and opportunities need to be seized through sustained efforts here in Canada. The world’s economic centre of gravity is shifting rapidly from advanced to emerging economies. The game in the United States will be more about taking market share (something we have not been doing recently) than participating in a growing market. To put it According to projections published since 1998 by the Bank in our Monetary Policy Report, this is the variance in the horizon over which inflation was projected to return to the 2 per cent target. BIS central bankers’ speeches bluntly, the U.S. economy can be expected to be relatively weak for some time as households repair balance sheets and governments wrestle with deficits. How weak depends on the choices Americans make but, given the pressures, there is limited upside. Canada will have to look elsewhere to grow our exports. Emerging markets already account for almost one-half of the growth in all imports over the past decade. In a process that can be expected to continue for decades, emerging Asia is rapidly urbanizing. China and India are housing the equivalent of the entire population of Canada every 18 months. In parallel, a massive new middle class is being formed, growing by 70 million people each year. Thus, even though commodity prices have eased in recent weeks, they can be expected to remain at elevated levels, supported by large, sustained demand increases from the emerging world, particularly Asia. We will need to take advantage of such opportunities because the limits of domestic debt and demography mean that the potential growth of our economy is slowing. As the boomer generation ages, labour force participation rates will decline and hours worked will fall. The direction is clear. The question is merely one of degree. If we do not develop new markets and if we do not improve productivity, the cumulative loss of income from slower potential growth could be almost $30,000 for every Canadian over the next decade.2 Conclusion It is often said that Canada is not an island. This is true and illustrates that we are not immune to global events. Perhaps a better analogy for us today here on the shores of the Bay of Fundy is that Canada is like a ship. We can be tossed by the waves or pulled by the current, but we are still able to chart our course in even the stormiest of seas. The challenges in the current global economic environment are significant but so, too, are the opportunities. Our corporations and governments have strong balance sheets, our financial institutions are among the most resilient in the world, and our economy can be geared to the future sources of global growth. To take advantage of these attributes, we will need continued, heavy investment to improve productivity and sustained, innovative efforts to develop new markets. For its part, the Bank of Canada has a wide range of tools and policy options that it will continue to deploy as appropriate in order to ensure that Canadians can seize these opportunities in an environment of domestic macroeconomic and financial stability. Fall may be around the corner, but we all know that Canadians are at their best during winter. See M. Carney, “The Virtue of Productivity in a Wicked World,” speech to the Ottawa Economics Association, Ottawa, Ontario, 24 March 2010, available at: <http://www.bankofcanada.ca/2010/03/speeches/virtue-productivity-wicked-world/>. BIS central bankers’ speeches
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Remarks by Mr Mark Carney, Governor of the Bank of Canada, to the Institute of International Finance, Washington DC, 25 September 2011.
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Mark Carney: Some current issues in financial reform Remarks by Mr Mark Carney, Governor of the Bank of Canada, to the Institute of International Finance, Washington DC, 25 September 2011. * * * Thank you for the invitation to speak today. In the hope of addressing some of your concerns, I waded through the more than 1,000 pages of reports and notes that the Institute of International Finance (IIF) has produced over the past year. Your messages have been consistent, if not always concise, so I would like to focus on three particular concerns about the financial reform agenda you have recently expressed: 1. the consistency in implementation across jurisdictions; 2. the possibility of substantial regulatory arbitrage in the shadow banking system; and 3. the macroeconomic impact of the reforms. Before I do, allow me a general observation. The G-20 is undertaking a radical and comprehensive program to strengthen the regulation, supervision and infrastructure of the global financial system. Its ambition can hardly be a surprise. Four years ago, manifest deficiencies in capital adequacy, liquidity buffers and risk management led to the collapse of some of the most storied names in finance and triggered the worst financial crisis since the Great Depression. The complete loss of confidence in private finance – your membership – could only be arrested by the provision of comprehensive backstops by the richest economies in the world. With about $4 trillion in output and almost 28 million jobs lost in the ensuing recession, the case for reform was clear then and remains so today. Let me now turn to your issues. Consistency in implementation Authorities are increasingly hearing concerns about the pitch of the playing field for Basel III implementation. Everyone is claiming to be a boy scout while accusing others of juvenile delinquency. However, neither merit badges nor detentions will be self-selected but, rather, determined by impartial peer review and mutual oversight. It is important to remember that the Basel rules have always been, and continue to be, international minimums, rather than a “one-size-fits-all” approach. There are legitimate reasons why implementation may differ across countries. Some countries will implement Basel III faster than others. The current transition period to 2019 for Basel III has been variously described as enlightened, leisurely and generous. It reflects a lowest-common-denominator compromise that gives the time needed to rebuild capital buffers in those crisis economies that are furthest from compliance. Some countries may decide it is not in their best interests to take full advantage of this flexibility. Indeed, how quickly the new rules are adopted is bound to be a function of both the current health of the financial system and the macrofinancial environment in each jurisdiction. In Canada, we expect banks to be fully compliant with Basel III (2019 definitions) by early in the transition period, which starts in January 2013. This reflects the strong starting positions of Canadian banks and the benefits of building capital in the face of currently buoyant credit expansion. Some will adopt tougher rules. Countries such as Sweden, Switzerland and the United Kingdom, with very large banking sectors relative to their domestic economies, have BIS central bankers’ speeches signalled their preference for higher loss-absorbency capacity. In these jurisdictions, since the failure of a major bank would have disproportionately large consequences, additional prudence is desirable. Finally, there will always be countries that opt for a tighter interpretation of the rules, even as they adhere to the international minimum standards. For example, national supervisors may take a more conservative approach to approving bank internal risk measurement systems under the advanced measurement approach of Basel II. I would stress that in order to foster a race to the top, Basel III permits better rules, but it is a minimum standard. As the IIF has emphasised, it is vital that we prevent regulatory fragmentation. In this regard, there are several new measures that will help to contain unwarranted differences in implementation across countries. For example, the new leverage ratio acts as a backstop that effectively limits differences in risk weights. Speaking from experience, we in Canada know that the leverage ratio protects banks from risks that people think are low but are, in fact, high. In addition, policy-makers are significantly enhancing the mutual-surveillance processes that each jurisdiction accepts as part of its membership on the Basel Committee on Banking Supervision (BCBS). In particular, the Financial Stability Board (FSB) and the standardsetting bodies, including the Basel Committee, are jointly developing an implementationmonitoring framework that will coordinate activities and include annual progress reports on a country-by-country basis to the FSB and G-20, as well as less frequent, but more in-depth, peer reviews. Ad hoc reviews of new legislation and regulations could also be conducted. In this regard, a review by the BCBS of new European and American rules would be welcome to build confidence today in the consistency of application in major jurisdictions. Coordinated FSB/BCBS monitoring mechanisms will be in addition to the International Monetary Fund’s (IMF) annual Article IV surveillance and the IMF and World Bank’s periodic independent assessments across countries of compliance with international standards.1 All in all, while there will be legitimate reasons for some countries to adopt standards more quickly or to go beyond international minimums, there will be much less scope in the future for countries to give their banks a competitive advantage by not fully implementing the agreed global rules. If some jurisdictions do not comply, I am certain that you will let us know. The IIF’s commitment to fair application and peer review would complement official initiatives, and I urge you to develop a more formal approach. In the end, it is in your interests to comply. While there will be periods of exuberance during which aggressive banks and jurisdictions can sail close to the wind, financial history suggests that well-capitalised institutions and transparent systems will ultimately have premium ratings, valuations and outcomes. Regulatory arbitrage Let me turn to your second issue: regulatory arbitrage. There are valid concerns that the recent measures will push risk into shadow banking. Even as reforms make the core of the financial system more resilient, they increase incentives to move classic banking activities, such as maturity transformation and credit intermediation, to the unregulated periphery. The IMF and the World Bank jointly conduct both the Financial Sector Assessment Program (FSAP) and Reports of the Observance of Standards and Codes (ROSCs). BIS central bankers’ speeches This tendency is of particular concern, given the role the shadow banking sector played in the run-up to the crisis. In the final years of the boom, when complacency about liquidity reached its zenith, the scale of shadow banking activity exploded. The value of structured investment vehicles, for example, tripled in the three years to 2007, and credit default swaps grew sixfold. The feedback to the regulated sector was pernicious. Financial institutions, including many banks, had come to rely on high levels of market and funding liquidity. For instance, shortterm money markets, particularly repo markets, were the predominant source of financing for the one-third increase in the gross leverage of American investment banks, as well as British and European banks. The system’s exposure to market confidence was enormous. The crisis exposed how boom-bust liquidity cycles cascade through the shadow banking sector and reverberate on the regulated core. Market forces proved inadequate to manage these swings between confidence and despair. Today, despite the fact that shadow banking, or as we prefer to call it, market-based financing (MBF), is at least as large as the regulated sector in most jurisdictions, it is often unregulated and/or overseen by authorities without a systemic focus. This should change. As it does, regulation and supervision must strike a balance between mitigating systemic risks and realizing the benefits from financial deepening. Properly structured, shadow banking can increase efficiency, provide diversification, and spur competition and innovation. It has the potential to make the system more robust, provided it does not rely on the regulated sector for liquidity or pretend to provide it with liquidity in times of stress. However, experience also teaches that shadow banking activities mutate, usually through complex and highly leveraged instruments, into regulatory gaps created by the response to the last crisis. With all of this in mind, there are four broad categories of regulatory initiatives under consideration. The first, and most important, is indirect regulation through limits on the size and nature of banks’ exposure to shadow banking entities. Examples include tighter consolidation rules for bank-sponsored conduits and higher risk-based capital requirements for liquidity lines. These measures will help to reduce opportunities for regulatory arbitrage, in which banks seek to reduce capital or liquidity requirements by organising transactions wholly or in part through shadow banking entities while retaining much of the underlying tail risk. The second approach would try to address systemic risks in shadow banking directly. For example, macroprudential measures are being considered to address procyclical haircut and collateral rules for securities lending and repo transactions. These measures could do much to dampen liquidity cycles. Contagion could be further constrained by strengthening financial market infrastructure. In Canada, in the coming months, a central counterparty (CCP) for repo transactions will be launched. This repo CCP will strengthen counterparty credit risk management, reduce collateral and balance sheet requirements via netting, and reduce the impact if there were a failure of one of its participants. By helping to ensure that core funding markets are continuously open, the heart of the financial system will be more resilient to shocks. The third approach is to regulate shadow banking activities themselves, such as money markets and exchange-traded funds (ETFs), through disclosure obligations or restrictions on certain financial transactions and instruments. This will require dynamic monitoring of the financial system and coordination across authorities. Finally, the FSB is examining the possible regulation of shadow banking entities, such as hedge funds, that may pose systemic risks by limiting their maturity transformation and leverage. This last option should take into account the relative size of these institutions and the cumulative impact of other measures. BIS central bankers’ speeches Whatever decisions are taken in the coming months, no one should be tempted to declare “mission accomplished.” In order to maintain systemic resilience, the monitoring, supervision and regulation of shadow banking will need to be dynamic.2 The recent loss incurred by UBS on its Delta One trading desk demonstrates the need for vigilant risk management of complex new products. Fortunately for the system, the loss was manageable, given the increased capital buffer at the bank, and a broader liquidity squeeze was avoided. The FSB has been prescient in highlighting the risks associated with synthetic ETFs.3 Synthetic ETFs are sometimes being used to fund illiquid collateral which, if financed on a bank’s balance sheet, would carry a higher risk weight. The potential for a procyclical liquidity cycle needs to be monitored carefully. Reform of the shadow banking sector offers an opportunity to ensure the consistency of the overall financial reform package. For example, capital rules will have to balance risks to institutions with the benefits of incentivizing direct and indirect settlement of standardized derivatives through CCPs. Liquidity standards and market infrastructure should reinforce the continuous availability of core funding markets. In this manner, both systemic resiliency and efficiency can increase. As authorities examine measures on a comprehensive, system-wide basis, adjustments may need to be made. Liquidity standards are one example. The Basel Committee and the Committee on the Global Financial System (CGFS) are currently using the observation period to review contentious design issues concerning the Liquidity Coverage Ratio (LCR), such as uncertainty regarding how the liquid assets can be used in times of stress, and how the liquidity rules are supposed to operate in tandem with the new leverage ratio requirement. They are also examining potential unintended consequences on the commercial paper market and market-making for equities. The FSB’s work on shadow banking will shed more light on the intersection among these standards, key markets and economic performance. These issues need to be addressed before the new rules are fully implemented.4 There would appear to be little value in delaying decisions on potential amendments to the LCR beyond early in the new year. Work on the Net Stable Funding Ratio (NFSR) will take longer. Macroeconomic implications of financial reform Let me now turn to your third, most fundamental, concern. Based on the current challenging economic outlook, some argue that we should revisit the pace and breadth of financial reforms. This position is based on two questionable propositions. The first is that the prospect of financial reforms is contributing to current economic weakness. A corollary is that delayed implementation of the Basel III capital rules, for example, will somehow strengthen the recovery. Really? The FSB has developed a two-step approach to monitoring. The first step calls for a broad scanning of the shadow banking sector to understand the key developments and trends. The second involves detailed assessments of the activities and entities of the sector to identify systemic risks, paying particular attention to regulatory arbitrage, excessive maturity and liquidity transformation, imperfect credit risk transfer and undue leverage. Although the goal is to implement this approach by the end of 2012, obtaining sufficiently granular data will be a challenge. “Potential Financial Stability Issues Arising from Recent Trends in Exchange-Traded Funds (ETFs),” Financial Stability Board, 12 April 2011. As part of this work on liquidity rules, banks have been asked to supply data every six months and to complete a detailed survey on their liquidity-management practices to help gather information about the impact of their practices on the financial system. BIS central bankers’ speeches Weak credit growth in the crisis economies is often cited as supporting evidence. However, the fact that household credit is flat to falling in the United States and the United Kingdom can hardly be a surprise. American and British households are overleveraged. With personal net worth substantially lower following the crisis, the need to rebuild balance sheets in an environment of economic uncertainty is quite naturally weighing on credit demand. In the vast array of countries that did not experience a home-grown financial crisis, the issue has been that household borrowing has been too robust, despite adherence to a common timetable for implementing Basel III. The issue in the crisis economies is primarily one of demand, not supply. More broadly, the G-20’s comprehensive reform program seeks to boost confidence in global financial institutions and markets by providing a path to a more resilient system and an end to government support. It is hard to see how backsliding would help. Indeed, at a time when the conviction of policymakers across a range of issues is being called into question, there appears to be little value in feeding this concern. Moreover, recall that the implementation timetable for Basel III begins in two years and ends in 2019. It is difficult to believe that prolonging this implementation phase even further would have a material impact on real economic outcomes. If some institutions feel pressure today, it is because they have done too little for too long, rather than because they are being asked to do too much, too soon. The second proposition is that, once implemented, the reforms will substantially reduce global growth. A recently released IIF report estimates output losses during the transition phase that are more than an order of magnitude greater than those produced by the Bank for International Settlements, the Bank of Canada, the IMF and other public institutions and academic bodies. Allow me to raise a few of the many problems with the IIF’s analysis. The IIF study assumes banks pay out most of their earnings and therefore must rely heavily on external sources to raise capital. Debt-fuelled consumption is a central driver of output growth in its econometric model, despite the obvious bias to reduce debt in most major economies. Monetary policy is assumed to be in suspended animation until 2020. While I would welcome the time off, this presumption is inconsistent both with the range of unconventional tools that central banks have and the medium-term prospects for the global economy. The estimated impact of the reforms on the cost of bank debt exceeds the increase experienced during the crisis! It is hard to see how more capital, better liquidity and stronger infrastructure would lead to such a result. Put differently, the IIF is suggesting that the current public subsidy of the financial sector is massive. Finally, the analysis assumes that all of these reform efforts are for naught as it includes none of the benefits. Given the recent experience, no one would argue that financial crises are without costs, and only the most jaded would argue that their probability and severity cannot be reduced. Countries like Canada and Australia, with well-capitalized and well-managed banks, did not experience any failures or bailouts. Partly as a consequence, their economies have substantially outperformed those of their advanced-economy peers. Our estimates indicate that even if Basel III were to reduce slightly the probability of such crises in the future, the potential gains would far exceed the cost of marginally slower growth. The Bank of Canada estimates a net present value of Basel III for G-20 economies is 30 per cent of GDP in present-value terms, or about $US13 trillion.5 Assuming a 2-percentage-point increase in capital (plus liquidity changes). For Canada, estimates are approximately 13 per cent of GDP in present-value terms, which is equal to about Can$200 billion. See Bank of Canada, “Strengthening International Capital and Liquidity Standards: A Macroeconomic Impact BIS central bankers’ speeches In short, while the worsening global economic outlook has implications for bank performance, it does not provide a rationale for delaying the implementation of Basel III. Conclusion To conclude, critics of reform generally succumb to three world-weary arguments: any rule will be arbitraged; any insurance will promote greater risk taking; and there will always be financial crises. Such fatalism should be rejected. In no other aspect of human endeavour do men and women not strive to learn and to improve. The sad experience of the past few years shows that there is ample scope to improve the efficiency and resilience of the global financial system. By clarity of purpose and resolute implementation, we can do so. The current reform initiatives mark real progress. The fundamental objective of the G-20 measures is a resilient, global financial system that efficiently supports global growth. Our destination should be one where financial institutions and markets play critical – and complementary – roles to support long-term economic prosperity. This requires institutions that are adequately capitalized, with sufficient liquidity buffers to manage shocks. It also requires that market forces be allowed to determine the relative sizes and boundaries of the banking and shadow banking sectors; and that the market decides which firms prosper and which firms fail. The FSB has a clear role to oversee and coordinate the development of the G-20 reforms. It should provide a system-wide perspective and assess the total impact of reforms. It must strive to resolve any conflicts that may arise between regulations that are locally optimal but systemically inconsistent. It must balance the need to guard against regulatory arbitrage with the value of preserving diverse risk-taking strategies and productive innovation. Finally, it must ensure consistent implementation across jurisdictions to build an open and competitive system. It is also important not to lose sight of the limitations of regulation. New and better rules are necessary, but not sufficient. People will always try to find ways around them. Some may succeed, for a while. That is why good supervision is paramount. Rules are only as good as the supervisors who enforce them, and good supervisors look beyond the letter of the rules to their spirit. Of course, belief by the industry in the appropriateness of the measures will also aid their application. As you are well aware, you have the ultimate duty to ensure your institutions bear responsibly the risks you are taking. We have all learned from the events of the past few years, and so I look forward to a continued constructive dialogue with the IIF as we develop and implement this vital agenda. See also: Financial System Reform Initiatives Mark Real Progress, Says Mark Carney, Governor of the Bank of Canada (Press Releases) Assessment for Canada,” August 2010, and M. Carney, “Bundesbank Lecture 2010: The Economic Consequences of the Reforms,” speech to Deutsche Bundesbank, Berlin, 14 September 2010. BIS central bankers’ speeches
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Remarks by Mr Tiff Macklem, Senior Deputy Governor of the Bank of Canada, at the National Insurance Conference of Canada, Vancouver, British Columbia, 27 September 2011.
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Tiff Macklem: Managing risks in the new global economic landscape Remarks by Mr Tiff Macklem, Senior Deputy Governor of the Bank of Canada, at the National Insurance Conference of Canada, Vancouver, British Columbia, 27 September 2011. * * * It is a great pleasure to be speaking here in Vancouver at the annual National Insurance Conference of Canada. Few industries know more about the personal, economic and financial impacts of disasters – or “extreme events” as insurance experts like to call them. And few know more about risk management. Today I want to talk about both topics – an extreme event and private and public risk management in its wake. This morning you discussed earthquake insurance. Earthquakes, like other natural disasters – tsunamis, hurricanes and ice storms come to mind – are entirely exogenous, extreme events – acts of God, if you will. They are not preventable, although their impact can be reduced by building resilience and by timely and effective disaster response. Your industry, of course, plays a vital role in helping households and businesses to mitigate the consequences of natural disasters. Other extreme events are endogenous – or manmade. The recent financial crisis falls into this category. The crisis that began in August 2007 and exploded in the autumn of 2008 was self-inflicted. The financial system was fragile and it failed. We are still paying. We will be paying for many years to come. The global recession that followed the financial crisis was the deepest since the Great Depression. And today, we are two years into what is shaping up to be the weakest recovery since the Great Depression. This is the new economic and financial landscape we find ourselves in. And while it may be less than we desire, it should not be terribly surprising. The lesson from history is that the recessions that follow financial crises are bigger than normal recessions. On average, the loss in output in a recession after a financial crisis is two to three times the loss in a normal recession. Output falls further in a recession after a financial crisis. Normally, the deeper the recession, the sharper the recovery. Not so with the recoveries after financial crises. Recoveries after a financial crisis are slower. Typically, it takes output twice as long to return to its pre-recession level after a financial crisis than in a normal recovery, and output is permanently lower compared with its pre-crisis growth trajectory. The essential reason for this is that the legacy of a financial crisis is a lot of debt, and paying down that debt acts as a dragging anchor on the economy that takes many years to break free from. If we had forgotten this lesson from history, recent economic and financial data have provided a reminder that in a world awash with debt, repairing the balance sheets of banks, households and governments will take years. In Canada, we weathered the crisis better than most advanced economies. Our recession, while sharp, was shallower and shorter than many, and we have few internal impediments to recovery. Our banks are among the strongest in the world, and we have the best fiscal situation among the G-7. Nonetheless, an anemic U.S. recovery, as well as a persistently strong Canadian dollar and elevated global risks, are all weighing on growth here. This new, more modest global economic landscape has implications for a number of issues. I will develop three of these under the headings sovereign risk, shifting economic centre of gravity, and low for long. I will then say a few words about private risk management in this new landscape, as well as the public policy priorities that are necessary to sustain the recovery and support financial stability. BIS central bankers’ speeches Sovereign risk Let me start with sovereign risk. The immediate issue is Europe: I don’t need to tell this audience that the fiscal and financial strains in Europe are acute. Widening sovereign spreads on an expanding group of euro-area country bonds are challenging fiscal sustainability in these countries. The leading-edge consequence is the buildup of funding pressures on European banks. Most have seen their funding costs rise sharply, their access to financial markets curtailed and their equities trading at historic lows relative to the value of their assets. These challenges are compounded by the impossibility of currency adjustments within a monetary union. Without the option of devaluation, prolonged deflationary adjustments are required in countries that must restore competitiveness. While the situation in Europe is immediate, the need for agreed measures to restore fiscal sustainability in the United States and Japan is no less important. Increasing uncertainty about the ability of the political process to deliver the needed adjustments is reflected in recent sovereign downgrades. These fiscal challenges are manageable with political will and sound execution, but as long as large debts need to be refinanced, sovereigns will remain vulnerable to changes in global growth and investor sentiment. This presents a fundamentally new landscape in which government debt can no longer be considered a risk-free asset in many advanced countries. Given the central role of government liabilities in the financial system, prolonged concerns over sovereign risk could have profound implications for the functioning of the financial system. In particular, the role of government bonds as the benchmark against which a broad array of financial assets are priced is likely to be eroded. Shifting economic centre of gravity A second consequence of a weak recovery in advanced countries is an acceleration in the shift in the economic centre of gravity to emerging markets. This is not a new trend, but it has been turbocharged. The growth differential between advanced and emerging economies has widened sharply. Emerging-market economies now account for close to 80 per cent of global growth – up from just one-third at the start of the millennium. Improved economic management in emerging markets has both increased their potential growth and reduced their riskiness. And with most portfolios underweight in emerging-market exposure, increasing the allocation to emerging markets has the potential to boost returns without taking on excessive risk. Of course, emerging-market economies do not represent a homogeneous asset class. They offer a higher range of both volatility and opportunity that investors must take into account. Large capital inflows and sudden outflows can present challenges for emerging markets and investors alike. In particular, there is a risk that large inflows could fuel asset-price bubbles. A reallocation of only 5 per cent of advanced-economy portfolios to emerging markets translates into a potential flow of $1.6 trillion, or eight times the portfolio equity flows to all emerging markets. This is a considerable shock. The robust growth in emerging economies is a welcome source of strength for the global economy. With strong growth, however, comes the risk of overheating, followed by an abrupt correction. For investors, the exits could be crowded. These are risks that both private investors and public authorities need to manage. BIS central bankers’ speeches Low for long The last feature of this new economic landscape I wanted to address is low for long. With weak recoveries in the United States and Europe and a tentative hand-off from public stimulus to private demand, policy interest rates can be reasonably expected to remain below normal for some time to come. While providing needed stimulus, prolonged periods of unusually low rates could contribute to excessive risk taking. They can cloud assessments of financial risks, induce a search for yield and delay balance-sheet adjustments. Low for long is a special concern for insurance companies and pension funds with guaranteed returns or benefits. You made promises that you need to keep. And by reducing yields on assets and raising the net present value of liabilities, a sustained period of low interest rates makes guarantees harder to fulfill. To address potential shortfalls, investors may move funds into riskier assets to pick up yield. In the first half of 2011, we saw a significant expansion in a variety of risky exposures offering higher returns – and volatility – including assets such as high-yield bonds, leveraged loans, emerging-market equity and debt, and commodities. The signs of growing risk tolerance in financial markets were evident in data on issuance, pricing and flow across a range of markets, and financial instruments with a riskier and more complex structure were returning. With the dramatic fall-off in risk appetite in recent weeks, investors have shifted from a search for yield to a search for safety. This has sent the prices of risky assets sharply lower and safe-haven assets to record highs. Indeed, in a world of high sovereign debt, weak growth and a low-for-long-induced search for yield, the impact of new information will tend to be magnified. For investors, this means contending with more volatility. In short, the legacy of the crisis is a treacherous economic landscape that puts a premium on private sector risk management and public sector risk mitigation. Let me say a few words about both. Strengthening private sector risk management For the long-term investor, a fundamental shift is required, from thinking about a return target to considering appetite for risk and measuring and managing risk to the desired risk tolerance. The experience of the crisis provides some clear lessons for risk measurement and management, and points to the need for better tools for risk assessment, better information systems and information sharing, improved governance and compensation practices, and better communication. To assess the risk of an extreme event like a major earthquake, insurance experts do not rely on short spans of data because there would be very few, if any, major earthquakes in the sample. Yet, financial risk managers routinely use tools such as value-at-risk models that use relatively short windows of recent data to assess the likelihood of financial loss. To measure financial risk accurately, we need better tools that capture tail events and mitigate procyclicality. In particular, there is a need to draw on longer spans of data and to complement standard tools with other methods, such as stress tests, that allow risk managers to explore the implications of extreme events. Better information systems will help firms to measure risk and identify vulnerabilities. The financial crisis exposed the need to perform due diligence with respect to new products and instruments. A crucial lesson from the crisis is to avoid embedded leverage, which is extremely difficult to measure. We must be able to measure and quantify risks, and these risks need to be understood and considered across business lines. This means developing limits and controls that absorb the amount of risk that a firm can take and putting in place reliable enforcement mechanisms. BIS central bankers’ speeches Sound governance is fundamental to ensuring appropriate investment in risk management and application of its principles. Boards must be involved in establishing levels of risk tolerance and overseeing risk management. Directors need to question growth rates in businesses and assess whether controls are keeping up with risks and if the business is resilient to shocks. This requires board members with expertise in banking, insurance and risk management. Boards also play an important role in ensuring that compensation systems are part of an integrated risk-management strategy. Tying bonuses to short-term profits without adequate consideration of long-term risk is a recipe for excessive risk taking. The Financial Stability Board has developed principles for compensation practices that align compensation with prudent risk taking. Implementation must be system-wide so that professionals and firms have a level playing field. Finally, financial firms, credit-rating agencies and financial advisers need to do a better job of communicating the suitability of products, and their inherent risks, to their clients. This requires better plain language disclosure. It also requires improved financial literacy and improvements in consumer protection. This is a shared responsibility of the private and public sectors – and we both have much to learn about which methods are the most effective. Public policy priorities Sound risk management makes the best of the situation at hand; mitigating risk improves the situation. And there is much public policy can do. While the lesson from history is that recoveries after financial crises are disappointingly gradual and bumpy, the future is not preordained. Public policy has a critical role to play in securing the recovery and promoting financial stability. There is no doubt that the timely and concerted actions of the G-20 countries in 2008–09 to inject considerable monetary and fiscal stimulus averted a much worse disaster. But, today, uncertainty about the willingness of policy-makers to respond has become part of the problem. This needs to change. European authorities must move decisively to contain their sovereign debt crisis. This starts with delivering on fiscal austerity in key countries and full implementation of announced measures to make the European Financial Stability Facility more flexible. But more is required. The immediate priorities are to provide a funding backstop for vulnerable European sovereigns that is sized to the scale of the problem and a comprehensive capital plan for European banks. In our opinion, this can be done by using existing European resources more efficiently. These steps must be complemented by governance reforms and credible fiscal arrangements within the European monetary union. In other advanced countries, the priority must be to agree on credible, concrete and executable plans to restore fiscal sustainability consistent with the commitments made at last year’s G-20 Leaders Summit in Toronto. In many emerging-market economies, greater exchange rate flexibility is necessary to better manage demand pressures and inflationary risks, while facilitating a global rebalancing of demand. Greater exchange rate flexibility between the United States and China is required to help the recovery in the former and control inflation in the latter. Finally, advanced and emerging countries alike must implement agreed financial sector regulatory reforms to build a more resilient financial system that better serves the needs of households and businesses. In the face of a difficult external environment, the Bank of Canada will continue to support Canada’s economic expansion by keeping inflation low, stable and predictable. BIS central bankers’ speeches Since the crisis erupted four years ago, the Bank has demonstrated its nimbleness in the conduct of monetary policy. We reacted quickly and forcefully during the downturn. As the Canadian recovery has progressed, we have emphasized that we would be prudent with respect to the possible withdrawal of any degree of monetary stimulus. Conclusion I must conclude. Recoveries after financial crises feel more like a convalescence. For private sector investors, the fundamentals of sound portfolio management have not changed, but the economic landscape has. Sovereign debt is no longer a risk-free asset, the shift in the economic centre of gravity to emerging-market economies has accelerated, and low-for-long interest rates are changing behaviours and straining some business models. The private sector bears much responsibility for the excesses at the heart of the 2008–09 financial crisis. Risk management can and should be strengthened, and adapted to new realities. Public policy has a critical role to play in mitigating systemic macroeconomic risks. More action is needed to contain sovereign risks, promote a rebalancing of global demand and implement financial regulatory reform. The distant horizon of the new landscape is bright. Getting there will take some time, but moving steadfastly in the right direction will get us there safely. Thank you. BIS central bankers’ speeches
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Opening statement by Mr Mark Carney, Governor of the Bank of Canada, at the press conference following the release of the Monetary Policy Report, Ottawa, 26 October 2011.
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Mark Carney: Summary of the latest Monetary Policy Report Opening statement by Mr Mark Carney, Governor of the Bank of Canada, at the press conference following the release of the Monetary Policy Report, Ottawa, 26 October 2011. * * * Good morning. Tiff and I are pleased to be here with you today to discuss the October Monetary Policy Report, which the Bank published this morning. The global economy has slowed markedly as several downside risks to the projection outlined in the Bank’s July MPR have been realized. Volatility has increased and there has been a generalized retrenchment from risk-taking across markets. The combination of ongoing deleveraging by banks and households, increased fiscal austerity and declining confidence is expected to restrain growth across the advanced economies. The Bank now expects that the euro area – where these dynamics are most acute – will experience a brief recession. The Bank’s base-case scenario nonetheless assumes that the euro-area crisis will be contained, although this assumption is clearly subject to downside risks. In the United States, real GDP growth is expected to be weak through the first half of 2012, reflecting diminished household confidence, tighter financial conditions and increased fiscal drag. Growth in China and other emerging-market economies is projected to moderate to a more sustainable pace. These developments, combined with recent declines in commodity prices, are expected to dampen global inflationary pressures. The outlook for the Canadian economy has weakened since July, with the significantly less favourable external environment affecting Canada through financial, confidence and trade channels. Although Canadian growth rebounded in the third quarter with the unwinding of temporary factors, underlying economic momentum has slowed and is expected to remain modest through the middle of next year. Domestic demand is expected to remain the principal driver of growth over the projection horizon. Household expenditures are now projected to grow relatively modestly as lower commodity prices and heightened volatility in financial markets weigh on the incomes, wealth and confidence of Canadian households. Business fixed investment is still expected to grow solidly in response to very stimulative financial conditions and heightened competitive pressures, although it will be dampened by the weaker and more uncertain global economic environment. Net exports are expected to remain a source of weakness, owing to sluggish foreign demand and ongoing competitiveness challenges, including the persistent strength of the Canadian dollar. Overall, the Bank expects that growth in Canada will be slow through mid-2012 before picking up as the global economic environment improves, uncertainty dissipates and confidence increases. The weaker economic outlook implies greater and more persistent economic slack than previously anticipated, with the Canadian economy now expected to return to full capacity by the end of 2013. As a result, core inflation is expected to be slightly softer than previously expected, declining through 2012 before returning to 2 percent by the end of 2013. BIS central bankers’ speeches The projection for total CPI inflation has also been revised down, reflecting the recent reversal of earlier sharp increases in world energy prices as well as modestly weaker core inflation. Total CPI inflation is expected to trough around 1 per cent by the middle of 2012 before rising with core inflation to the two per cent target by the end of 2013, as excess supply in the economy is slowly absorbed. There are several significant risks to the inflation outlook in Canada. The three main upside risks relate to the possibility of stronger-than-expected inflationary pressures in the global economy, stronger momentum in Canadian household spending, and the possibility of a faster-than-expected rebound in business and consumer confidence, due to more decisive policy action in the major advanced economies. The three main downside risks relate to sovereign debt and banking concerns in Europe, the increased probability of a recession in the U.S. economy, and the possibility that growth in household spending in Canada could be weaker than projected. Reflecting all of these factors, the Bank yesterday maintained the target for the overnight rate at 1 per cent. With the target interest rate near historic lows and the financial system functioning well, there is considerable monetary policy stimulus in Canada. The Bank will continue to monitor carefully economic and financial developments in the Canadian and global economies, together with the evolution of risks, and set monetary policy consistent with achieving the 2 per cent inflation target over the medium term. With that, Tiff and I would be pleased to take your questions. BIS central bankers’ speeches
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Opening statement by Mr Mark Carney, Governor of the Bank of Canada, presented to the House of Commons Standing Committee on Finance, Ottawa, Ontario, 1 November 2011.
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Mark Carney: Opening statement for appearance before the House of Commons Standing Committee on Finance Opening statement by Mr Mark Carney, Governor of the Bank of Canada, presented to the House of Commons Standing Committee on Finance, Ottawa, Ontario, 1 November 2011. * * * Good morning. Tiff and I are pleased to be here with you today to discuss the October Monetary Policy Report, which the Bank published last week. The global economy has slowed markedly as several downside risks to the projection outlined in the Bank’s July MPR have been realized. Volatility has increased and there has been a generalized retrenchment from risk-taking across markets. The combination of ongoing deleveraging by banks and households, increased fiscal austerity and declining confidence is expected to restrain growth across the advanced economies. The Bank now expects that the euro area – where these dynamics are most acute – will experience a brief recession. The Bank’s base-case scenario nonetheless assumes that the euro-area crisis will be contained, although this assumption is clearly subject to downside risks. We welcome the agreement announced last week by euro area leaders on a comprehensive plan to address the ongoing challenges in Europe. We look forward to additional details on modalities of the various measures and to their implementation in the coming weeks. In the United States, real GDP growth is expected to be weak through the first half of 2012, reflecting diminished household confidence, tighter financial conditions and increased fiscal drag. Growth in China and other emerging-market economies is projected to moderate to a more sustainable pace. These developments, combined with recent declines in commodity prices, are expected to dampen global inflationary pressures. The outlook for the Canadian economy has weakened since July, with the significantly less-favourable external environment affecting Canada through financial, confidence and trade channels. Although Canadian growth rebounded in the third quarter with the unwinding of temporary factors, underlying economic momentum has slowed and is expected to remain modest through the middle of next year. Household expenditures are projected to grow relatively modestly as lower commodity prices and heightened volatility in financial markets weigh on the incomes, wealth and confidence of Canadian households. Business fixed investment is still expected to grow solidly in response to very stimulative financial conditions and heightened competitive pressures, although it will be dampened by the weaker and more uncertain global economic environment. Net exports are expected to remain a source of weakness, owing to sluggish foreign demand and ongoing competitiveness challenges, including the persistent strength of the Canadian dollar. Overall, the Bank expects that growth in Canada will be slow through mid-2012 before picking up as the global economic environment improves, uncertainty dissipates and confidence increases. BIS central bankers’ speeches The weaker economic outlook implies greater and more persistent economic slack than previously anticipated, with the Canadian economy now expected to return to full capacity by the end of 2013. As a result, core inflation is expected to be slightly softer than previously expected, declining through 2012 before returning to 2 per cent by the end of 2013. The projection for total CPI inflation has also been revised down, reflecting the recent reversal of earlier sharp increases in world energy prices, as well as modestly weaker core inflation. Total CPI inflation is expected to trough around 1 per cent by the middle of 2012 before rising with core inflation to the 2 per cent target by the end of 2013, as excess supply in the economy is slowly absorbed. There are several significant risks to the inflation outlook in Canada. The three main upside risks relate to the possibility of stronger-than-expected inflationary pressures in the global economy, stronger momentum in Canadian household spending, and the possibility of a faster-than-expected rebound in business and consumer confidence, due to more decisive policy action in the major advanced economies. The three main downside risks relate to sovereign debt and banking concerns in Europe, the increased probability of a recession in the U.S. economy, and the possibility that growth in household spending in Canada could be weaker than projected. Reflecting all of these factors, the Bank last week maintained the target for the overnight rate at 1 per cent. With the target interest rate near historic lows and the financial system functioning well, there is considerable monetary policy stimulus in Canada. The Bank will continue to monitor carefully economic and financial developments in the Canadian and global economies, together with the evolution of risks, and set monetary policy consistent with achieving the 2 per cent inflation target over the medium term. I would now like to say a word about an issue that this Committee has raised recently – the renewal of the Bank’s inflation-control agreement with the Government of Canada. This is central to the Bank’s mission and we appreciate the Committee’s interest in it. Since 1991, inflation targeting has proven its worth in both tranquil and turbulent times. Even so, we are always looking to improve the framework. At the time of the last renewal, the Bank committed to continue its research into potential improvements that might build on the success of the current framework. A concerted and ambitious research agenda focused on evaluating whether two specific changes – targeting a lower rate of inflation or a path for the level of prices – could provide significant net benefits to the Canadian economy and Canadian households. Subsequently, the experience of the global financial and economic crisis prompted the Bank to add a third item to its research agenda – asking to what extent monetary policy should take account of financial stability considerations. Allow me to highlight just some of the initiatives and work undertaken by the Bank over the past five years. Since 2008, we have had three major conferences for our staff and other researchers to present work on inflation targeting and the monetary policy framework. The most important of these research papers have been published in three special issues of the Bank of Canada Review – Winter 2007–08, Spring 2009 and Summer 2010. As well, Governing Council members have spoken regularly and publicly about the issues. BIS central bankers’ speeches We have been pleased to answer questions before this Committee regarding progress to date toward renewing the inflation-control target. And Tiff and I are happy to answer more of these questions today, as well of course, questions about the outlook for the Canadian economy. Thank you. BIS central bankers’ speeches
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